Financial Ratio Analysis Term Paper

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Financial Analysis

There are some interesting dynamics with this case. First, Snead would not purchase this company for one penny more than the net present value of future cash flows. Second, the business cannot possibly be a sole proprietorship -- with the chemicals and the risk of damage this has to be incorporated. That means that the company can borrow, and can borrow against its assets and future cash flows. I'm not convinced that Sheldon's personal credit is relevant to borrowing for new equipment. New ventures are not going to be taken into consideration here -- neither for cash flows nor for valuation. These are all speculative, and there are no coherent dollar figures attached to it. Lastly, the assumption that Sheldon will have to pay employees more than what they are being paid now is unfounded. His uncle is not running this business solo, so there is no reason to assume that Sheldon must pay a premium. Indeed, these are already the highest-paid dry-cleaning workers in the country (BLS.gov, 2015), so Sheldon would be categorically insane to fire them and replace them with more expensive people. I don't even know where he would find more expensive people.

Sheldon, before he commits to going down this road, should get a sense mainly of whether this is a viable, ongoing business. Even the question about valuation is irrelevant if Sheldon isn't going to buy for a couple of years.

Financial Condition

There are several different ratios that can be calculated with respect to determining the financial condition of this company. The current ratio is 0.5, and the quick ratio is the same, because there is no inventory. This is a relatively low current ratio, though acceptable as a quick ratio. Having $10,000 in cash on hand and $30,000 in accounts payable is of particular concern. The reason this is a worry is that the accounts payable are usually due within a few months, and they might not be generating enough cash to cover these -- there may be a liquidity issue.

The current liabilities to net worth ratio is 0.13. Most of the value in this company is in equity. There are few long-term liabilities, just a small loan, so that means that the current liabilities are a relatively small portion of net worth, but a large portion of the total liabilities. Indeed, one of the other ratios covers this: the total liabilities to net worth ratio, which is 0.21. That is a healthy number, indicating that this operation is healthy over the long run.

That low level of leverage should make it easy for the company to get a loan to invest in new equipment. The bank looks at the liquidity and solvency of the company (and not of Sheldon). The bank will want to see that the current ratio is higher than 0.5, but otherwise the numbers appear to be in line with what a bank would want. Basically, there is stable cash flow, and the company collects quickly from its customers. There is barely any debt. The only real issue would be that the company has such a low current ratio -- the bank will want to see more cash reserves. Maybe this can be achieved by paying the going rate for employees, instead of $60K per FTE.

Almost all of the company's net worth is in its fixed assets, as the current assets are only the cash and some receivables. Fixed assets to net worth is 94.7%, and the vast majority of this is in property, since the equipment is near the end of its useful life and only has a net value of $20,000 on the balance sheet. The accounts receivable turnover is just three days. The company has a very quick turnover -- it will be difficult to improve upon this. The sales/inventory ratio is irrelevant because no inventory is listing on the balance sheet. That's sort of a red flag because clearly there are supplies, chemicals and hangars, all of which are noted as expenses on the income statement. They should be listed on the balance sheet as well -- Sheldon might want to get an accountant to clean up the statements in order to get a more accurate valuation of the business.

The assets to sales ratio is 0.49, while the sales to net working capital ratio cannot be calculated because the denominator is negative. The final set of ratios are the profitability ratios. The net margin is 13.5%, and the gross margin is 27.7%, both of which seem to be healthy.

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The ROA is 27.5%, and the ROE is 35%, and both of these numbers are quite healthy.

It is not possible to extrapolate trends into the future based on a single year's statements. A trend requires multiple data points, from which the slope of a line can be drawn. With just one data point, we cannot determine what line items are increasing, what are decreasing, and at what rate. Thus, trend analysis isn't worth two cents here, because it would be entirely a work of fiction. Sheldon will need to get prior year's accounting statements from his uncle in order to get a better sense of the company's financial situation.

Valuation

To value the business, you look at the current value of the assets, and you look at the present value of the future cash flows. The book value of the equity is worth $223,500. The future cash flows should be based on what the cash flows for the past year are. This is especially true for this company, which appears to be very stable in terms of its operations. The cash mentions something vaguely about competition, but does not provide any insight, and without multiple years' financial statements the effects of competition are unknown. The current cash flow from operations is $95,500. The company's discount rate is not known, but an estimate of around 10%, given its small size, but offset by its low leverage and cash flow stability. The present value of the future cash flows will be worth $955,000.

There are mitigating factors, however. First, the business is going to require some immediate investment in new equipment. While Sheldon will not be paying much for the existing equipment (it has a book of only $20K), he will immediately need to make an investment. This should be factored into the price he is willing to pay his uncle. Moreover, his uncle has no other takers for the business. While Sheldon should pay him a fair value, there is no reason for Sheldon to pay a purchase premium -- if anything the business should be discounted because the arrangement is so favorable to the uncle. The uncle should provide financial incentive for Sheldon to make this deal. Also, the valuation only stands for the present moment: a future purchase will come with a future valuation. Indeed, Sheldon has no incentive to purchase at fair market value! He needs a plan either to grow the business, or to cut costs, or get the business at a discount. In his estimation, this is not a growing market, so it should concern Sheldon that at best, his cash flow will accrue to his uncle as payment for the business, and Sheldon himself will not see a return for years unless he dramatically grows the business somehow.

Equipment Purchase

As of now, it is known that the business will need an equipment purchase. This is not something that will be too important for the valuation, for a couple of reasons. First, it is its own financial decision. Second, there are many different options regarding the equipment. Sheldon was spitballing about buying equipment that would increase capacity. That's great -- but he has a lot of choices. Reasonably, Sheldon needs to find out more about the market before he can commit to increasing his capacity. An increase in capacity is just an increase in cost, unless there is surplus demand in the market that Sheldon can absorb. Sheldon needs to study the market prior to making this decision, and get a sense of whether or not additional capacity will pay off. The same can be said for the retail space. $3,500/mo adds 10% to his costs, an additional $42,000 per year. Before doing anything, he needs to evaluate the traffic in that lobby and estimate how much incremental business he can get from that investment -- will it pay for itself, and will it return more than the business is earning from its existing operations. That's not even to think about dealing with a landlord -- that's a big headache for a company that otherwise owns its own building and does not have to deal with a landlord.

Conclusions

There are a lot of different unknowns, and issues here. The key for Sheldon is to distinguish between the issues because the temptation is to view them all as one. The first issue is to determine if this is a viable, ongoing business, because if it….....

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