Question

QUESTION 4 Diversified Industries is a large conglomerate that is continually in the market for new acquisitions. The company has grown rapidly over the last ten years through buyouts of medium-size companies. Diversified does not limit itself to companies in any one industry, but looks for companies with a sound financial base and the ability to stand on their own financially. The CEO of the company recently told his executive team that “I want to impress two points on all of you. First, we are not in the business of looking for bargains. Diversified has achieved success in the past by acquiring companies with the ability to be a permanent member of the corporate family. We don’t want companies that may appear to be a bargain on paper bit can’t survive in the long run. Secondly, a new member of our family must be able to come in and make it on its own – the parent is not organised to be a funding agency for struggling subsidiaries.” Ron Patrys is responsible for acquisitions for Diversified. He is responsible for making recommendations to the board of directors on potential acquisitions. You are one of his assistants, and he has recently asked you to analyse a possible “can’t miss” opportunity. Summaries of the most recent comparative balance sheets and income statement for the company: Heavy Duty Tractors Statement of financial position for the year ending 31 December 2012 2012 2011 ASSETS R R Current assets: Cash Marketable securities Accounts receivable Inventories Prepaid expenses 324 120 48 500 3 750 128 420 135 850 7 600 215 180 24 980 0 84 120 96 780 9 300 Long term investments 45 000 45 000 Property plant and equipment: Land Buildings, equipment less accumulated depreciation(R385 000) 2012; (R325 000) 2011 590 000 45 000 545 000 650 000 45 000 605 000 5 PBA4807 MAY/JUNE 2015 PORTFOLIO EXAMINATION [TURN OVER] TOTAL ASSETS 970 010 921 070 LIABILITIES AND OWNERS EQUITY R R Current liabilities: Short term notes Accounts payable Salaries and wages payable SARS 162 300 80 000 65 350 14 360 2 590 126 250 60 000 48 760 13 840 3 650 Long term bonds payable, due 2019 275 000 275 000 Owners equity: Share capital Retained earnings 532 710 350 000 182 710 519 820 350 000 169 820 TOTAL LIABILITES AND OWNERS EQUITY 970 010 921 070 Heavy Duty Tractors Statement of comprehensive income for the year ending 31 December 2012 R Sales revenue 875 250 Cost of goods sold (542 750) Gross profit 332 500 Selling, general and admin expenses (264 360) Operating income 68 140 Interest expense (45 000) Net income before taxes and extraordinary items 23 140 Income tax expense (9 250) Income before extraordinary item 13 890 Extraordinary gain, less taxes of R6 000 9 000 Net income 22 890 Retained earnings, January 1 2012 169 820 Dvidends paid (10 000) Retained earnings, December 31 2012 182 710 6 PBA4807 MAY/JUNE 2015 PORTFOLIO EXAMINATION [TURN OVER] Required: 1. How liquid is Heavy Duty Tractors? Support your answer with any ratios you believe are necessary to justify your conclusion. Also indicate any other information that you would want to have in making a final determination on its liquidity. (8) 2. In light of the CEO’s comments, should you be concerned about solvency of Heavy Duty Tractors? Support your answer with the necessary ratios. (6) 3. Has Heavy Duty Tractors demonstrated the ability to be a profitable member if the Diversified family? Support your answer with the necessary ratios. (6) 4. What will you tell your boss? Should he recommend to the board that Diversified put in a bid for Heavy Duty Tractors? (5)

Answer 1

• Current ratio =Current Assets/Current Liabilities
• = 324120/162300 = 1.99 (2014)
• = 215180/126250 =1.70 (2013)

	2014	2013
Current ratio	1.99	1.70
inventory	135,850	96,780
Receivables	128,420	84,120
Working capital	168820	52930

• Inventory turnover =Cost of inventory/Average inventory
• =542750/ [(13850+96780)/2]
• =9.8
• Days of inventory holding =360/ inventory turnover = 360/9.8=36.7
• The working capital has nearly doubled over the two-year period. The current ratio for 2014 is 1.99 and for 2013 to 1.7
• One area of concern is the large increase in both receivables and inventories from the prior year. The 2014 average collection period is days and the 2014 average number of days’ sales in inventory is days
• 2)
• Debt/Equity ratio (2014) =Total debt/net worth = (162,300+275,000)/532,710 = 0.82
• Debt/Equity ratio (2013) =Total debt/net worth = (126,250+275,000)/519,820=0.77
• Debt to equity ratio increased has increased from 2013 to 2014
• Interest Coverage ratio = EBIT/interest charges
• (Net earnings before extraordinary item +all income tax + interest charges)/ interest charges
• = ($23,140 + 9,250 +45,000)/ 45,000 =1.7
• The debt-to-equity ratio has increased slightly nearly from the prior year. The times interest covered is 1.7 times. The company is carrying a heavy debt burden even though the bonds are not due until 2021.

3.

Let us analyse the brief income statement of Heavy Duty Tractors Inc. to assess the financial performance of the company:

Heavy Duty Tractors Inc.
Particulars	Amount ($)
Revenue from sales	875250
Less: Cost of goods sold	542750
Gross Profit	332500
Earnings before interest and tax	77140
Less: Interest	45000
Earnings before tax (EBT)	32140

Earnings before tax (EBT)	32140
Less: Tax	9250
Net income	22890

As can be seen from the above table that the company has earned significant amount of gross profit in the latest accounting period ending on December 31, 2017. However, compare to gross profit of $332,500 the company has merely earned a net income of $22,890.    

Profitability ratios:

The profitability ratios of the company will help us to assess the profitability of the company strategically. Let us analyse the ability of the company to generate profit from its business activities.

Gross profit ratio (All ratios are in %)
Revenue from sales	875250
Gross Profit	332500
Gross profit ratio	37.98915
EBIT ratio
Revenue from sales	875250
Earnings before interest and tax	77140
EBIT ratio	8.813482
EBT ratio
Revenue from sales	875250
Earnings before tax (EBT)	32140
EBT ratio	3.672094
Net income ratio
Revenue from sales	875250
Net income	22890
Net income ratio	2.615253

The gross profit of ratio of 37.99%, i.e. almost 38% suggests that the company has earned a gross profit of $38 for sale of each $100. Thus, the company has been quite successful in managing its core business operations and in generating revenue from its core business operations. However, the company has suffered very badly with its EBIT and EBT of 8.81% and 3.67% respectively. In-fact the net profit ratio of the company is quite low at 2.61%. Thus, the company though demonstrate ability to be a profitable member of the diversified family however, the management of the company must take necessary steps to improve its profitability in the future.

4.

We recommed to the BOD to bid for Heay Duty Tractors.

We take this decision based on the following.

There are two stage of decisions to know whether to acquire the business or not:-

1) Financial condition

2) Non-financial condition

1) Financial condition of business can be checked using various ratios. Ratios can be financial ratio, liquidity ratio, profitability ratio. Ratio analysis for 12/31/2017 ios as follows:-

a) Current Ratio

- This ratio helps to know whether the company has enough assets with the to pay of the liabilities. The higher the ratio, more strong the company is.

- Current Asset/Current liabilities

= 324120/162300

= 1.99 times.

b) Debt to equity ratio:-

This ratio helps to know that how much external parties contribute to assets relative to owmers. The lower the ratio, more the stake of owners in the assets.

= Total debt/Total Equity

= Current Liab + Non current liab / Total Equity

= 437300/532710

= 0.82 times

c) Return on equity ratio:-

This is overall measure of rate of return on investment

= Net income/Total Equity * 100

= 22890/350000*100

= 6.54%

d) Cash ratio:-

Cash ratio is used to know whether company has enough financial stability to pay out the liabilities.

= Cash and cash equivlents/Current liability

= 48500 + 3750 / 162300

= 0.3219 times.

So, company can payout 0.32 % of liabilities without relying on accounts recaivable and inventory.

Based on the above analysis, it looks that the comapny is sound in its financial aspects. Based on these, we recommend to acquire the new company.

However, apart from the financial aspects, certain non-financial aspects also needs to be seen.

They can be buying capacity of the company, goodwill of the company, market where the company is operating, integrity of the management, its suppliers, customers etc.