Answers to questions:

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Solution to Case 1

Financial Statements, Cash Flows and Taxes

Ultra Cable Corporation

Answers to questions:

• Using a cash flow statement explain why Ultra Cable Corporation’s cash balance has

declined so precipitously this past year.The statement of cash flows shows that the firm has invested heavily in accounts receivable, inventories and fixed assets. These investments were only partially funded by an increase in payables and retained earnings. Ultra Cable borrowed $2.565million worth of short and long-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.

(Cases In Finance, 3e Jim Demello) (Case Solution) 1 / 4

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• Why has Ultra Cable’s stock price dropped so much recently despite an increase in its

revenues and its earnings per share?Although Ultra Cable 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 the current year resulting in much higher interest expenses Ultra Cable Corporation Statement of Cash Flows Current Year Cash at beginning of current year 100,000 $ Operating activity Net income 357,750

Plus:

Depreciation 197,500 Increase in accounts payable 225,000

Less:

Increase in accounts receivable (850,000) Increase in inventory (1,626,125) Net cash from operating activity (1,695,875) Investment activity Fixed asset acquisitions (1,975,000) Net cash from investment activity (1,975,000) Financing activity Increase in notes payable 1,125,000 Increase in long-term debt 2,565,700 Dividends paid (107,325) Increase in common stock - Net cash from financing activity 3,583,375 Net decrease in Cash (87,500) Cash, end of current year 12,500 $ 2 / 4

©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.1-3 ($277,500 higher than the previous year). Higher debt is not necessarily bad, if profitability is proportionately higher as well. However, the interest coverage ratio (EBIT/Interest expenses) of this firm has dropped considerably from 5.72 in the prior year to 2.54 this year. 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 bankruptcy due to high debt.

• Evaluate the firm’s absolute and relative liquidity positions and compare them with

its liquidity position last year.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 [Current Assets/((CGS+S&A)/365)].

The above ratios indicate that although the absolute liquidity (Net working Capital) of the firm has increased in the current year, the relative liquidity of the firm has decreased.Current Year Last Year Cash Ratio = Cash / Current Liabilities) 0.56% 11.27% Current Ratio 2.06 2.51 Quick Ratio 0.61 0.68 NWC to TA 0.33 0.43 Interval Measure = Current Assets/(CGS+S&A) 427 days 236 days Absolute Liquidity = NWC = CA - CL

$2,376,125

$1,337,500

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©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.1-4 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 the prior year. Thus, one can conclude that although the relative liquidity condition of the company has deteriorated since last year, it is not critically low.

• Compare the firm’s market value with its book value. Is the book value a good

representation of the firm’s true condition? Explain your answer

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

= $25*200,000

= $5,000,000

Ultra Cable’s Book Value last year = (Total Assets – Total Liabilities) = Shareholders’ Equity

= $3,117,500 - $1,387,500

= $1,730,000

Ultra Cable’s Book Value per share (Last year) = $1,730,000/200,000 shares = $8.65

Ultra Cable’s Book Value this year = (Total Assets – Total Liabilities) = Shareholders’ Equity

= $7,283,625-$5,303,200

= $1,980,425

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