Financial statement analysis

The financial statements (balance sheet + income statement) of company Kappa for the year 2011
include the following items:
Cash
Accounts payable
Net fixed assets
Purchase of materials
Accounts receivable
Licenses
Interests
Issued common stocks
Sales revenues
Inventory
Long-term loans
Tax
Depreciation
Administration overheads
Short-term debt
Labour costs
Long-term investments
Sales and marketing expenses
Current portion of long-term debt

40 000
220 000
450 000
240 000
210 000
25 000
40 000
500 000
700 000
320 000
290 000
9 000
80 000
90 000
35 000
150 000
30 000
70 000
30 000

1) Reconstruct the two documents; indicate the basic sections of the balance sheet, and calculate
profits at various stages of the profit and loss account [15 points].
2) Calculate [9 points] and discuss [5 points] profitability, financial strength and liquidity ratios.
Assess the overall financial situation of this company and propose actions to improve it [2
points].

SOLUTIONS
Balance Sheet
Net fixed assets
Intangibles
Long-term investments
Total fixed assets

450,000
25,000
30,000
505,000

Accounts receivable
Inventory
Cash
Total current assets

210,000
320,000
40,000
570,000

Total assets

1,075,000

Owner's funds (Equity)

500,000

Long-term loans

290,000

Accounts payable
Short-term debt
Current portion of long-term debt
Total current liabilities

220,000
35,000
30,000
285,000

Total funds

1,075,000

Income statement
Sales revenues

700,000

Operating costs
Materials
Labour
Administration
Sales and marketing
Total operating costs
EBITDA

240,000
150,000
90,000
70,000
550,000
150,000

Depreciation
Operating profit (EBIT)

80,000
70,000

Interests
Earnings before tax (EBT)

40,000
30,000

Tax
Net income (EAT)

9,000
21,000

Profitability

ROE
ROTA
Profit margin
Asset turn

Financial strength

Debt/Equity ratio (D/E)

Interest cover
Cost of debt

Liquidity

Current ratio
Quick ratio
Working Capital

Kappa
=
=
=
=

4.20%
6.51%
10.00%
0.65

=
=
=

1.15
1.75
6.96%

=
=
=

2.00
0.88
285,000

Profitability The companys profitability is very low; its ROTA and ROE are hardly positive,
but lower than the cost of debt. Our shareholders are earning a smaller percentage on their
investment than our debtholders. This fact is due mainly to low asset turn (profit margin is
relatively good). The company seems to be in a declining market (reflected in low sales volume).
Financial Strength Cost of debt is not high, but since the ROTA is low, we have a very low
interest cover. The company is slightly overcapitalised (debt-to-equity ratio is around 1) and is
not exploiting all the advantages of financial leverage. However, in these conditions this is not
necessarily a bad thing. Though the cost of debt is low, with such low sales and subsequently
ROTA, the impact on ROE could be worse.
Liquidity The liquidity situation is also somewhat unfavourable. Working capital is positive
and the current ratio is 2, but the quick ratio is only a bit more than a third of that value (0.88).
This indicates high accumulation of inventories that comprise over 50% of total current assets
in the balance sheet. On the other hand, cash reserves represent a relatively low proportion in
the amount of total current assets (only 40,000). The company is producing goods and not
selling them (high inventory days and low asset turn).
Overall Comment This company is in a shrinking market that cannot absorb all the products
of the company (low sales revenues, asset turn, and high inventories). The interest rate the
company is paying is not so high, but the level of debt and the amount of interest payments
cannot be covered with realised sales revenues. There is room for profitability improvements in
both profit margins per sale and more importantly, in the asset turn. Regaining profitability
seems to require mainly a reduction of operating costs (most of all materials and labour costs)
to improve the asset turn and/or to additionally improve margins on sales. This would in turn
increase ROTA and subsequently ROE. The company could try to raise more debt and increase
debt exposure to invest more profitably, but with such low sales and interest cover, this
possibility should be undertaken with caution (only in case of favourable market forecasts). The
liquidity situation is not a strong point and cash reserves cannot be used to reimburse the shortterm loans and reduce interest payments. The managers might think of divesting the least
profitable business areas and reinvest the proceeds in the profitable ones. The final measure
could be an exit from an unprofitable market (if it continues to shrink and the sales do not
improve in the foreseeable future).