In her 2003 annual report to the shareholders of Growth Industries, Inc., the president wrote: "2003 was another successful year for Growth Industries. As in 2002, sales, assets, and operating income all continued to grow at a rate of 20%."
Is she right?
We can evaluate her statement by conducting a full-scale ratio analysis of Growth Industries. Our purpose is to assess GI's performance in the recent past, to evaluate its future prospects, and to determine whether its market price reflects its intrinsic value.
Table 13.12 shows some key financial ratios we can compute from GI's financial statements. The president is certainly right about the growth in sales, assets, and operating income. Inspection of GI's key financial ratios, however, contradicts her first sentence: 2003 was not another successful year for GI—it appears to have been another miserable one.
ROE has been declining steadily from 7.51% in 2001 to 3.03% in 2003. A comparison of GI's 2003 ROE to the 2003 industry average of 8.64% makes the deteriorating time trend especially alarming. The low and falling market-to-book-value ratio and the falling price-earnings ratio indicate that investors are less and less optimistic about the firm's future profitability.
The fact that ROA has not been declining, however, tells us that the source of the declining time trend in GI's ROE must be due to financial leverage. And we see that, while GI's leverage ratio climbed from 2.117 in 2001 to 2.723 in 2003, its interest-burden ratio fell from 0.650 to 0.204—with the net result that the compound leverage factor fell from 1.376 to 0.556.
The rapid increase in short-term debt from year to year and the concurrent increase in interest expense make it clear that, to finance its 20% growth rate in sales, GI has incurred sizable amounts of short-term debt at high interest rates. The firm is paying rates of interest greater than the ROA it is earning on the investment financed with the new borrowing. As the firm has expanded, its situation has become ever more precarious.
In 2003, for example, the average interest rate on short-term debt was 20% versus an ROA of 9.09%. (We compute the average interest rate on short-term debt by taking the total interest expense of $34,391,000, subtracting the $6 million in interest on the long-term bonds, and dividing by the beginning-of-year short-term debt of $141,957,000.)
GI's problems become clear when we examine its statement of cash flows in Table 13.13. The statement is derived from the income statement and balance sheet in Table 13.8. GI's cash flow from operations is falling steadily, from $12,700,000 in 2001 to $6,725,000 in 2003. The
13 Financial Statement Analysis 469
2001 2002 2003
Cash flow from operating activities
+ Depreciation 15,000 18,000 21,600
+ Decrease (increase) in accounts receivable (5,000) (6,000) (7,200)
+ Decrease (increase) in inventories (15,000) (18,000) (21,600)
+ Increase in accounts payable 6,000 7,200 8,640
Cash flow from investing activities
Investment in plant and equipment* $(45,000) $(54,000) $(64,800) Cash flow from financing activities
Short-term debt issued 42,300 54,657 72,475
Change in cash and marketable securities* $ 10,000 $ 12,000 $ 14,400
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