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Solution to Case 1

Cash Flow Analysis

Signal Cable Company*

* Note to Instructors: When assigning this case, inform the students that the firm’s stock price has recently dropped from \$7 per share to \$5.50 per share.

Case objective:

The objective of this case is to cover financial statement analysis and cash flow analysis, with a particular emphasis on liquidity and net working capital.

Student Preparation time:

Approximately 2 hours.

1. Why has the stock price fallen despite the fact that the net income has increased?

Although Signal has made a net profit that is higher than that of the previous year, its net profit margin is lower (6.98% vs 7.43%). Most of this decrease has been caused by the significant increase in debt in 2001 resulting in much higher interest expenses (\$111,000 higher than 2000). Higher debt is not necessarily bad, if profitability is proportionately higher as well. However, the interest coverage ratio of this firm has dropped considerably from 5.72 in 2000 to 2.53 in 2001. Stock prices are affected by earnings as well as by risk expectations. The drop in price is an indication that investors are concerned about the increased risk of high debt.

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2.

How liquid would you say that this company is? Calculate the absolute liquidity of the firm. How does it compare with the previous year's liquidity position?

Liquidity is defined as the ability of converting an asset into cash without significant loss of value. A firm’s liquidity refers to its ability to pay its short-term bills and current liabilities by converting its current assets into cash. Liquidity is also referred to a firm’s short-term solvency. There are various measures of liquidity such as the current ratio, the quick ratio, the cash ratio, the ratio of net working capital to total assets, and the interval measure.

 2001 2000 Cash Ratio 0.0056 0.113 Current Ratio 1.01 1.50 Quick Ratio 0.61 0.68 NWC to TA 0.33 0.43 Interval Ratio 426.9979398 236.072555 Absolute Liquidity = NWC 950,450 535,000

The above ratios indicate that although the absolute liquidity (Net working Capital) of the firm has increased in 2001, the relative liquidity of the firm has decreased. The current ratio has significantly declined. However, the liquidity situation is not critical because, as the interval measure indicates, the firm could continue operating for at least another 427 days if its cash inflows began to dry up. This interval coverage has increased significantly from its level in 2000. Thus one can conclude that although the relative liquidity condition of the company has deteriorated since 2000, it is not critically low.

3. How does the market value of the stock compare with its book value? Is the book value accurately reflecting the true condition of the company?

Signal’s Market Value = Current Stock Price X 200,000 shares

Signal’s Book Value in 2001 = (Total Assets – Total Liabilities) = Shareholders’ Equity = \$2,913,450-\$2,121,280 =

Signal’s Book Value per share = \$792,170/200,000 shares = \$3.96

\$792,170

The book value per share rarely equals the market value per share. In the case of Signal, the stock price is higher than its book value since it has been growing and has had a run up of sales and profits over the past few years. The drop in price recently reflects the increased risk due to higher debt levels and the lower relative liquidity position of the company. Although the book value per share has increased slightly in 2001, it is the market value that reflects the true condition of the company.

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4.

The board of directors is not clear as to why the cash balance has dropped so much despite the increase in sales and the reduction in cost of goods sold.

In order to ascertain why the cash balance has dropped so much, it would be necessary to do a Statement of Cash Flows for 2001.

Signal Cable Company 2001 Statement of Cash Flows

 Cash at beginning of year 2001 \$ 40,000 Operating activity Net income 143,100 Plus: Depreciation 79,000 Increase in accounts payable 90,000 Less: Increase in accounts receivable (340,000) Increase in inventory (650,450) Net cash from operating activity (678,350) Investment activity Fixed asset acquisitions (790,000) Net cash from investment activity (790,000) Financing activity Increase in notes payable 450,000 Increase in long-term debt 1,026,280 Dividends paid (42,930) Increase in common stock - Net cash from financing activity 1,433,350 Net decrease in Cash (35,000) Cash, end of year \$ 5,000

The statement of cash flows shows that the firm has invested heavily in accounts payable, inventories and fixed assets. These investments were only partially funded by an increase in payables and retained earnings. Signal Cable borrowed \$1.47million worth of short and long-

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term debt and drew down on its cash reserves to fund the balance. Thus, although sales went up and cost of goods sold declined, the acquisition of assets and business expansion activities led to a reduction in the cash balance.

5. Measure the free cash flow of the firm. What does it indicate?

The free cash flow (FCF) of a firm (also known as cash flow from assets) indicates how much cash a firm can freely distribute to its creditors and stockholders. It is cash, which is not needed for working capital or fixed asset investments. Free cash flow is measured as follows:

FCF = Operating cash flow – Net capital spending – Change in net working capital

Where:

Operating Cash flow (OCF) = Earnings before interest and taxes +Depreciation -Taxes

Net Capital Spending (NCS)= Ending Net Fixed Assets -Beginning Net Fixed Assets +Depreciation

Change in Net Working Capital = Ending NWC – Beginning NWC

 OCF = \$393,500 + \$79,000 – \$95,400 = \$377,100 NCS = \$1,068,000 - \$357000 + \$79,000 = \$790,000

Change in NWC = [(\$1,845,450- \$895,000)- (\$890,000-\$355,000)]

=[\$950,450 – \$535,000]

=\$415,450

Free Cash Flow = \$377,100 -\$790,000 – \$415,450 = -\$828,350

Signal Cable had a negative amount of free cash flow in 2001primarily due to its increase in net capital spending and net working capital. A negative free cash flow means that the amount of net new borrowing and equity would have increased.

Let’s check…

Net increase in Long-term debt = \$1,226,280 – \$200,000 = \$1,026,280 Dividends and interest paid = \$42,930+\$155,000 = \$197,930 Net amount of additional capital raised = \$1,026,280 – \$197,930 = \$828,350

The free cash flow calculation shows that Signal cable raised additional long-term debt to Finance its increase in net fixed assets and net working capital.

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6. Calculate the net working capital of the company for each of the two years. What can you conclude about the firm's net working capital?

 2000 2001 Current Assets - Current Liabilities = Net Working Capital \$890,000 \$1,845,450 355,000 895,000 535,000 950,450

Signal Cable has significantly increased its net working capital (almost 77% higher) in

2001.

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