Prepare an analysis of the Dr. Jay Stevenson case situation and answer the following questions.
Examine the ratio analysis and statement of sources and uses of cash provided. What do they tell you about the financial position of the company?
Prepare projected statements of earnings for 2001 and 2002. What do they tell you?
Prepare a 5C evaluation.
Financial Analysis of Ottawa Dentistry
Financial Analysis via Ratios & Comparison with competitor:
Current Ratio is one of the important liquidity ratios. Ideal Current Asset Ratio is 2:1 i.e., 2/3 i.e., 0.67. This ratio measures the company’s ability to pay the current liability. Dentistry CR in 2000, is 0.94 times indicating that the company is not having a efficient operating cycle & a good liquidity position also the CR of 0.94 times means that the company is having current assets 0.94 times its current liabilities. However in year 2001 and 2002, it is forecasted that the firm’s current ratio will improve to 6.33 and then to 5.08 in year 2002 because the accounts payable would significantly reduce as the suppliers has reduced their credit terms.
Due to non-availability of Industry average ratio, cross sectional analysis cannot be made.
Quick Ratio is calculated but taking into account all liquid assets (i.e., assets readily convertible to cash) by total current liabilities. For accurate analysis it is also important to compare with the overall average industry quick ratio. Further, we see an increasing trend in quick ratio of the firm indicating improved liquidity position of the company year by year. The ratio is expected to improve from 0.94 in the year 2000 to 6.33 in the year 2001.
Inventory Turnover: Higher the better. Trend Analysis for Inventory turnover ratio cannot be made and we do not find any trend in this ratio because of absence of inventory for the firm.
ROE calculates the profitability of the company based on its total equity. (ROE) is calculated the return the company is offering on the stockholders fund. This calculated is calculated as net income/stockholder’s equity. Here net Income means profit available for equity stockholders i.e., profit after taxes & preference dividends. Higher the ROE, higher is the return on shareholders’ fund. The return on equity of the firm is much higher year by year. Higher return on equity is desirable by the investors. Trend Analysis in terms of Return on equity ratio shows that the ratio improved from 1620% in year 1999 to 1746% in the year 2000.
Debt ratio: Lower the debt ratio, lower is the leverage or debt load in the company. Since the debt ratio of the firm continues to fall for the period 1998 to 2000, the firm is attractive for lenders as an investment option. However, the firm is expected to leverage out of debt in the year 2000 because the total assets of the firm has reduced comparative to previous year 2000 even though the debt remains at $ 300000. This has led to an expected increase in debt asset ratio to 0.95 in year 2001 and then expected to reduce to 0.2 in year 2002 because of repayment of debt in year 2002. Debt to equity ratio falls in year 2000 from 8.95 to 6.05 which debt has reduced compared to previous year and equity has increased.
Times Interest Earned Ratio (TIER): It is also called as Interest coverage ratio. TIER of the firm is 35.31 times in 2000, from 20.81 in the year 1999 which means that company has enough funds to meet its interest expenses. It is also one of the solvency ratios. Higher ratio is desirable. TIER is expected to decrease drastically in year 2001 and 2002, which may raise concern for the lenders and act against the firm.
Net Profit Margin: Net Profit ratio is one of the important profitability ratios used to find the profit available for the stockholders after meeting all company expenses & statutory payments like taxes . When cost of sales increases the net profit ratio falls drastically. Here the NP Ratio of the firm in 1998, 1999 and 2000 has been increasing from 21.16% to 27.06% and then to 28.37%. However, for the year 2001 and 2002 the net profit margin is expected to remain somewhat consistent.
Gross/Total profit margin: Gross profit is the profit available after meeting the cost of goods sold. Cost of Goods sold include direct costs like cost of material , labour, manufacturing overhead & other expenses directly related to the manufacture of a product. Moreover, Gross profit ratio is one of the profitability ratio used to compute the profit percent available after meeting the operating & direct expenses. Higher Gross Profit is always desirable by the stockholders. This ratio is calculated to know about the profitability condition of the company.
In terms of Gross Margin turnover, we observe almost a moderate increased gross margin for the firm from period 1998 to 2000 which is 58.07% for year 2000. The gross margin ratio for year 2001 and 2002 is expected to hover around the same margin as was for year 2000.
From above analysis, it is clear that the overall financial condition of the dentistry firm is is sound and stable as the solvency, liquidity and profitability condition in the company is sound and stable as evidenced by the ratios given above. The company is growth oriented and profit-making company. Cash flows generated from the operating activities, with cash inflows from short-term borrowings, line of credit and long-term debt have sufficiently funded the operations and also allowing to invest in long term growth activities. Further, the sources of liquidity have proved to be adequate and will continue to adequately fund the operations of the firm and finance its global expansion activities.
5 C Evaluation
It is recommended that sharing good picture about our business with our lenders and banker helps us to create and enhance relationship with them so that they may themselves be interested in providing debt funds to us. Here we see that the debt asset ratio and debt equity ratio both re expected to fall in year 2002 compared to year 2001 because of the repayment of long-term debts. This character of keeping commitments and repaying the debts as and when due attracts lenders to invest in the firm.
- Cash Flow
Some lenders are open to help with funds when we have urgent cash flow requirements. However, to have this favorable situation, borrowers need to win trust of lenders and this can only happen when they fulfill their repayment obligation timely and ensure enough income to repay the interest timely. For the dentistry firm, times earned interest ratio is showing an increasing trend ensuring timely payment of interest to lenders and the firm is also careful to repay its debt timely. The firm has surplus cash flow to meet its debt obligations, as depicted by the cash flow statement.
Banks are more willing to lend to those who have invested some of their own money into the venture. Most lenders are not willing to take on 100% of the financial risk, and the lenders do face such risk in this firm because the debt to equity is showing a falling trend from year 1999 to 2000 from 8.95 to 6.05 and expected to be 2.06 in year 2001. This is further expected to fall to 0.14 in year 2002.This acts against the firm and lenders will have to think carefully before lending their funds to such a firm where the owners investment is not significant enough and owners mostly relies on debt capital.
This relates to the manner the firm will use the funds obtained by way of debt. Not only the manner of fund usage, the repayment of loan also depends on the income of the firm which in turn depends on economic factors, market factors and industry factors. To ensure that loans are repaid timely, banks want to lend to businesses operating under favorable conditions. Lenders ensure that they lend to those firms whose cash flows, income can be forecasted without much suspicion. This is done by identify future risks and factors leading to variations in income and debt repayment capacity. Dr Stephenson wants to use the loan to expand his operation which entails hiring new staffs, leasing additional space, purchasing equipment and making leasehold improvements. Additional capital and recurring costs are incurred with forecast of additional revenue for the year 2001 and 2002.However there is lot of competition in the dentist field work there being 450 dentist in the region, hence with unrealistic revenue prediction, it would endanger the lenders.
Collateral acts a backup source if the borrower cannot repay a loan. From hard assets such as real estate and equipment; working capital, such as accounts receivable and inventory can be counted as collateral. Here the firm’s owner Dr. Stephenson maintains a good relation with bank and most of its employees being his patient, he was a familiar face to bank. So, bank did not ask for any collateral from the owner and based on his reputation and income tax documents, loan was granted to him.
After detailed analysis based on 5C evaluation we recommend that lenders should be careful in lending the funds to Dr Stephenson because his investment in the firm is comparatively not enough to secure the lenders. Moreover if the lenders wants to lend him based on his business reputation and familiarity, they should seek collateral to protect themselves in the event of some unfavorable happenings.
Life of leasehold improvement and computer introduced in year 2001 has been assumed to be 10 years and straight-line depreciation method has been used.
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