Integrated Case

D’Leon Inc., Part II

Financial Statements and Taxes

Part I of this case, presented in Chapter 3, discussed the situation

of D’Leon Inc., a regional snack foods producer, after an expansion
program. D’Leon had increased plant capacity and undertaken a
major marketing campaign in an attempt to “go national.” Thus far,
sales have not been up to the forecasted level, costs have been
higher than were projected, and a large loss occurred in 2021 rather
than the expected profit. As a result, its managers, directors, and
investors are concerned about the firm’s survival.
Donna Jamison was brought in as assistant to Fred Campo,
D’Leon’s chairman, who had the task of getting the company back
into a sound financial position. D’Leon’s 2020 and 2021 balance
sheets and income statements, together with projections for 2022,
are given in Tables IC 4.1 and IC 4.2. Note that D’Leon is exempt
from the interest deduction limitation because its average gross
receipts for the prior 3 years was less than $25 million. So 100% of
its interest expense is deductible. Also, many of D’Leon’s assets
have lives greater than 20 years and thus qualify for the alternative
depreciation system (straight line) rather than the 100% bonus
depreciation. In addition, Table IC 4.3 gives the company’s 2020
and 2021 financial ratios, together with industry average data. The
2022 projected financial statement data represent Jamison’s and
Campo’s best guess for 2022 results, assuming that some new
financing is arranged to get the company “over the hump.”
Jamison examined monthly data for 2021 (not given in the case),
and she detected an improving pattern during the year. Monthly
sales were rising, costs were falling, and large losses in the early
months had turned to a small profit by December. Thus, the annual
data look somewhat worse than final monthly data. Also, it appears
to be taking longer for the advertising program to get the message
out, for the new sales offices to generate sales, and for the new
manufacturing facilities to operate efficiently. In other words, the
lags between spending money and deriving benefits were longer
than D’Leon’s managers had anticipated. For these reasons,
Jamison and Campo see hope for the company—provided it can
survive in the short run.
Jamison must prepare an analysis of where the company is now,
what it must do to regain its financial health, and what actions
should be taken. Your assignment is to help her answer the
following questions. Provide clear explanations, not yes or no
answers.

Table IC 4.1. Balance Sheets

2022E 2021 2020

Assets
Cash $ 85,632 $ 7,282 $ 57,600
Accounts receivable 878,000 632,160 351,200
Inventories 1,716,480 1,287,360 715,200
Total current assets $2,680,112 $1,926,802 $
1,124,000
Net fixed assets 817,040 939,790 344,800
Total assets $3,497,152 $2,866,592 $
1,468,800

Liabilities and Equity

Accounts payable $ 436,800 $ 524,160 $ 145,600
Accruals 408,000 489,600
136,000
Notes payable 300,000 636,808 200,000
Total current liabilities $1,144,800 $1,650,568 $
481,600
Long-term debt 400,000 723,432 323,432
Common stock 1,718,986 460,000 460,000
Retained earnings 233,366 32,592 203,768
Total equity $1,952,352 $ 492,592 $
663,768
Total liabilities and equity $3,497,152 $2,866,592 $
1,468,800

Note: “E” indicates estimated. The 2022 data are forecasts.

 Table IC 4.2. Income Statements

2022E 2021 2020

Sales $6,900,600 $6,126,796 $
3,432,000
Cost of goods sold 5,875,992 5,528,000
2,864,000
Other expenses 550,000 519,988 358,672
Total operating costs
excluding deprec. & amort. $6,425,992 $6,047,988 $
3,222,672
EBITDA $ 474,608 $ 78,808 $
209,328
Deprec. & amort. 116,960 116,960 18,900
EBIT $ 357,648 ($ 38,152) $
190,428
Interest expense 70,008 122,024 43,828
EBT $ 287,640 ($ 160,176) $
146,600
Taxes (25%) 31,866a 0a
36,650
Net income $ 255,774 ($ 160,176) $
109,950

EPS $ 1.023 ($ 1.602) $

1.100
DPS $ 0.220 $ 0.110 $ 0.275
Book value per share $ 7.809 $ 4.926 $ 6.638
Stock price $ 12.17 $ 2.25 $ 8.50
Shares outstanding 250,000 100,000 100,000
Tax rate 25.00% 25.00%
25.00%
Lease payments 40,000 40,000 40,000
Sinking fund payments 0 0 0

Note: “E” indicates estimated. The 2022 data are forecasts.

a
The firm had sufficient taxable income in 2022 (the 2021 loss wasn’t greater than
80% of its 2022 taxable income before the loss was deducted) to carry forward its
2021 loss in its entirety. As a result, its 2022 taxes were reduced by 0.25 × the loss
amount.
 Table IC 4.3. Ratio Analysis

Industry
2022E 2021 2020
Average
Current 1.2 2.3 2.7
Quick 0.4 0.8
1.0
Inventory turnover 4.3 4.0 5.5
Days sales outstanding (DSO)a 37.7 37.4 32.0
Fixed assets turnover 6.5 10.0 7.0
Total assets turnover 2.1 2.3 2.6
Debt-to-capital ratio 73.4% 44.1% 40.0%
TIE -0.3 4.3 6.2
Operating margin -0.6% 5.5% 7.3%
Profit margin -2.6% 3.2% 4.3%
Basic earning power -1.3% 13.0% 19.1%
ROA -5.6% 7.5% 11.2%
ROE -32.5% 16.6% 18.2%
Price/earnings -1.4 7.7 14.2
Market/book 0.5 1.3 2.4
Book value per share $4.93 $6.64 n.a.
EV/EBITDA 20.02 6.29 8.0

Note: “E” indicates estimated. The 2022 data are forecasts.

a
Calculation is based on a 365-day year.

A. Why are ratios useful? What are the five major categories
of ratios?

Answer: [S4-1 through S4-6 provide background information. Then,

show S4-7 and S4-8 here.] Ratios are used by managers to
help improve the firm’s performance, by lenders to help
evaluate the firm’s likelihood of repaying debts, and by
stockholders to help forecast future earnings and
dividends. The five major categories of ratios are: liquidity,
asset management, debt management, profitability, and
market value.
B. Calculate D’Leon’s 2022 current and quick ratios based on
the projected balance sheet and income statement data.
What can you say about the company’s liquidity positions
in 2020, in 2021, and as projected for 2022? We often
think of ratios as being useful (1) to managers to help run
the business, (2) to bankers for credit analysis, and (3) to
stockholders for stock valuation. Would these different
types of analysts have an equal interest in these liquidity
ratios? Explain your answer.

Answer: [Show S4-9 and S4-10 here.]

Current ratio22 = Current assets/Current

liabilities
= $2,680,112/$1,144,800 = 2.34.

Quick ratio22 = (Current assets – Inventories)/Current

liabilities
= ($2,680,112 – $1,716,480)/$1,144,800
= $963,632/$1,144,800 = 0.842.

The company’s current and quick ratios are close to its

2020 current and quick ratios, and they have improved
from their 2021 levels. However, both the current and
quick ratios are well below the industry averages.

C. Calculate the 2022 inventory turnover, days sales

outstanding (DSO), fixed assets turnover, and total assets
turnover. How does D’Leon’s utilization of assets stack up
against other firms in the industry?

Answer: [Show S4-11 through S4-16 here.]

Inventory turnover22 = COGS/Inventory

= $5,875,992/$1,716,480 = 3.42.
 DSO22 = Receivables/(Sales/365)
= $878,000/($6,900,600/365) = 46.44 days.

Fixed assets turnover22 = Sales/Net fixed assets

= $6,900,600/$817,040 = 8.45.

Total assets turnover22 = Sales/Total assets

= $6,900,600/$3,497,152 = 1.97.

The firm’s inventory turnover and total assets turnover

ratios have been steadily declining, while its days sales
outstanding has been steadily increasing (which is bad).
The firm’s fixed assets turnover ratio is below its 2020
level; however, it is above the 2021 level.
The firm’s inventory turnover and total assets turnover
are below the industry average. The firm’s days sales
outstanding ratio is above the industry average (which is
bad); however, the firm’s fixed assets turnover is above
the industry average. (This might be due to the fact that
D’Leon is an older firm than most other firms in the
industry, in which case, its fixed assets are older and thus
have been depreciated more, or that D’Leon’s cost of fixed
assets were lower than most firms in the industry.)

D. Calculate the 2022 debt-to-capital and times-interest-

earned ratios. How does D’Leon compare with the industry
with respect to financial leverage? What can you conclude
from these ratios?

Answer: [Show S4-17 and S4-18 here.]

Debt-to-capital ratio22 = Total debt/Total invested capital

= 26.39%.
 TIE22 = EBIT/Interest = $357,648/$70,008 = 5.11.

The firm’s debt-to-capital ratio is much improved from

2021 and 2020, and it is well below the industry average
(which is good). The firm’s TIE ratio is also greatly
improved from its 2020 and 2021 levels but it is still below
the industry average.

E. Calculate the 2022 operating margin, profit margin, basic

earning power (BEP), return on assets (ROA), and return
on equity (ROE) . What can you say about these ratios?

Answer: [Show S4-19 through S4-25 here.]

Operating margin22 = EBIT/Sales

= $357,648/$6,900,600 = 5.18%.

Profit margin22 = Net income/Sales

= $255,774/$6,900,600 = 3.71%.

Basic earning power22 = EBIT/Total assets

= $357,648/$3,497,152 = 10.23%.

ROA22 = Net income/Total assets

= $255,774/$3,497,152 = 7.31%.

ROE22 = Net income/Common equity

= $255,774/$1,952,352 = 13.10%.

The firm’s operating margin has improved from the

2021 level but it is lower than the 2020 level and it is still
below the industry average. The firm’s profit margin is
above 2020 and 2021 levels but below the industry
average. The firm’s basic earning power, ROA, and ROE
ratios are above 2021 levels; however, they are still below
2020 levels and the industry averages.
F. Calculate the 2022 price/earnings ratio and market/book
ratio. Do these ratios indicate that investors are expected
to have a high or low opinion of the company?

Answer: [Show S4-26 through S4-28 here.]

EPS22 = Net income/Shares outstanding

= $255,774/250,000 = $1.0231.

Price/Earnings22 = Price per share/Earnings per share

= $12.17/$1.0231 = 11.9.

Check: Price = EPS  P/E = $1.0231(11.9) = $12.17.

BVPS22 = Common equity/Shares outstanding

= $1,952,352/250,000 = $7.81.

Market/Book22 = Market price per share/Book value per

share
= $12.17/$7.81 = 1.56.

The P/E and M/B ratios are above the 2021 and 2020
levels but below industry averages.

Enterprise Value = MVE + MVD + MVClaims – (Cash and

Equivalents)

For D’Leon, EV/EBITDA calculations are as follows

(assuming bonds are at par value):

2022E: EV/EBITDA = [($12.17 × 250,000) + ($300,000

+ $400,000) −
$85,632]/$474,608

EV/EBITDA = 7.7050, or approximately 7.71.

 2021: EV/EBITDA = [($2.25 × 100,000) + ($636,808 +
$723,432) −
$7,282]/$78,808

EV/EBITDA = 20.02, or approximately 20.

2020: EV/EBITDA = [($8.50 × 100,000) + ($200,000 +

$323,432) −
$57,600]/$209,328

EV/EBITDA = 6.2860, or approximately 6.3.

G. Use the DuPont equation to provide a summary and

overview of D’Leon’s financial condition as projected for
2022. What are the firm’s major strengths and
weaknesses?

Answer: [Show S4-29 and S4-30 here.]

DuPont equation =  

= 3.71%  1.97 

= 13.10%.

Strengths: The firm’s fixed assets turnover was above the

industry average. However, if the firm’s assets were older
than other firms in its industry this could possibly account
for the higher ratio. (D’Leon’s fixed assets would have a
lower historical cost and would have been depreciated for
longer periods of time.) Its debt-to-capital ratio has been
greatly reduced, so it is now below the industry average
(which is good). The 2022 profit margin has improved from
both the 2020 and 2021 levels. The 2022 profit margin
was helped somewhat from the 2021 tax loss carryforward;
 however, the improving margin would indicate that the
firm has worked to lower operating costs (as indicated by
its improving operating margin) as well as interest
expense (as shown from the reduced debt-to-capital ratio).
Interest expense is lower because the firm’s debt-to-
capital ratio has been reduced, which has improved the
firm’s TIE ratio from 2020 and 2021 levels.

Weaknesses: The firm’s current asset ratio is low; most of

its asset management ratios are poor (except fixed assets
turnover); most of its profitability ratios are low (except its
improving profit margin is closer to the industry average);
and its market value ratios are low.

H. Use the following simplified 2022 balance sheet to show, in

general terms, how an improvement in the DSO would tend
to affect the stock price. For example, if the company
could improve its collection procedures and thereby lower
its DSO from 46.4 days to the 32-day industry average
without affecting sales, how would that change “ripple
through” the financial statements (shown in thousands in
the following table) and influence the stock price?

Accounts receivable $ 878 Current liabilities $ 845

Other current assets 1,802 Debt 700
Net fixed assets 817 Equity 1,952
Total assets $3,497 Liabilities plus equity
$3,497

Answer: [Show S4-31 through S4-34 here.]

Sales per day = $6,900,600/365 = $18,905.75.

Accounts receivable under new policy = $18,905.75  32

days
= $604,984.
 Freed cash = old A/R – new A/R
= $878,000 – $604,984 = $273,016.

Reducing accounts receivable and its DSO will initially

show up as an addition to cash. The freed-up cash could
be used to repurchase stock, expand the business, and
reduce debt. All these actions would likely improve the
stock price.

I. Does it appear that inventories could be adjusted? If so,

how should that adjustment affect D’Leon’s profitability
and stock price?

Answer: The inventory turnover ratio is low. It appears that the

firm either has excessive inventory or some of the
inventory is obsolete. If inventory were reduced, this
would improve the current asset ratio, the inventory and
total assets turnover ratios, and reduce the debt-to-capital
ratio even further, which should improve the firm’s stock
price and profitability.
J. In 2021 the company paid its suppliers much later than the
due dates; also, it was not maintaining financial ratios at
levels called for in its bank loan agreements. Therefore,
suppliers could cut the company off, and its bank could
refuse to renew the loan when it comes due in 90 days. On
the basis of data provided, would you, as a credit
manager, continue to sell to D’Leon on credit? (You could
demand cash on delivery—that is, sell on terms of COD—
but that might cause D’Leon to stop buying from your
company.) Similarly, if you were the bank loan officer,
would you recommend renewing the loan or demanding its
repayment? Would your actions be influenced if, in early
2022, D’Leon showed you its 2022 projections along with
proof that it was going to raise more than $1.2 million of
new equity?

Answer: While the firm’s ratios based on the projected data appear
to be improving, the firm’s current asset ratio is low. As a
credit manager, you would not continue to extend credit to
the firm under its current arrangement, particularly if your
firm didn’t have any excess capacity. Terms of COD might
be a little harsh and might push the firm into bankruptcy.
Likewise, if the bank demanded repayment this could also
force the firm into bankruptcy.
Creditors’ actions would be influenced by an infusion
of equity capital in the firm. This would lower the firm’s
debt-to-capital ratio and creditors’ risk exposure.

K. In hindsight, what should D’Leon have done in 2020?

Answer: Before the company took on its expansion plans, it should

have done an extensive ratio analysis to determine the
 effects of its proposed expansion on the firm’s operations.
Had the ratio analysis been conducted, the company would
have “gotten its financial house in order” before
undergoing the expansion.

L. What are some potential problems and limitations of

financial ratio analysis?

Answer: [Show S4-35 through S4-37 here.] Some potential

problems are listed below:

1. Comparison with industry averages is difficult if the

firm operates many different divisions.

2. Different operating and accounting practices distort

comparisons.

3. Sometimes hard to tell if a ratio is “good” or “bad.”

4. Difficult to tell whether company is, on balance, in a

strong or weak position.

5. “Average” performance is not necessarily good.

6. Seasonal factors can distort ratios.

7. “Window dressing” techniques can make statements

and ratios look better than they actually are.

8. Inflation has badly distorted many firms’ balance

sheets, so a ratio analysis for one firm over time, or a
comparative analysis of firms of different ages, must
be interpreted with judgment.

M. What are some qualitative factors analysts should consider

when evaluating a company’s likely future financial
performance?
Answer: Top analysts recognize that certain qualitative factors
must be considered when evaluating a company. These
factors, as summarized by the American Association of
Individual Investors (AAII), are as follows:

1. Are the company’s revenues tied to one key customer?

2. To what extent are the company’s revenues tied to one

key product?

3. To what extent does the company rely on a single

supplier?

4. What percentage of the company’s business is

generated overseas?

5. How much competition does the firm face?

6. Is it necessary for the company to continually invest in

research and development?

7. Are changes in laws and regulations likely to have

important implications for the firm?