Appendix 6C-4 Answer-1
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APPENDIX 6C-4
6C-4 KCN Analysis of ratios
Answer The following are the observations on ratios which indicate red flags or unusual fluctuations that should be investigated and the reasons for the red flags. 1.
RETURN ON TOTAL ASSETS
—This ratio indicates the profitability of the company by effectively employing its assets. Across the board increases in Assets (excluding leasehold improvements and intangibles). The main drivers are:
Inventory-why the 11% increase in inventory? Are the items not selling?
Receivables-Why is there a 20% increase?
Cash-Why did it jump nearly 50%? Is it due to an increase in operating cash flow activity of financing activities (debt)? How will cash be used?
Net Income-Why did bottom line drop 75%?
In 2018, this ratio has declined to 1.7%, which is lower than the industry average of 9%. It has been observed that there was a considerable decline in this ratio in 2018. KCN is not in a position to derive profits from its assets which is much lower than the industry average. The difference is material because of the significant decrease in return on total assets to income. Reasons for this are: an increase in assets and a significant decrease in income.
2.
RETURN ON NET WORTH
Net income-Why did bottom line drop 75%?
Dividend Paid—This is a new account so why did they pay dividends this year?
It has been observed that there was a considerable decline in this ratio of about 23%. KCN is not able to effectively generate revenue from its capital. Could be due to and increase in net worth. The difference is material due to a significant decrease as well as the ratio being significantly below industry average. There has been a material decrease in net income. Net worth decreased due to the decrease in retained earnings, caused by the dividend paid out this year.
3.
RETURN ON NET SALES
Sales-Why the 4% decrease? This ratio indicates the profitability of KCN from its operating activities. In 2018, there was a further decline to from 1.0% to 0.2% which is lower than the industry average of 2.3%. Ratio is material due to the significant decrease which is driven by lower sales and lower net income. 4.
TOTAL LIABILITIES TO NET WORTH
Credit Line-Why the increased credit line 30%? What is the money being used
for?
This ratio indicates KCNs ability to meet its long term debt. The solvency position of KCN is healthy in 2018 at 3.5% which is slightly higher than the industry average of 2.9%.
5.
CURRENT RATIO
The short term solvency position of KCN in 2018 is much better. This is also better than the industry average of 1.3%.
6.
DAYS SALES IN AVERAGE ACCOUNTS RECEIVABLE
Accounts Receivable-Why the 20% increase? Is there risk of significant uncollectable accounts?
The difference between the Sales/A/R ratio is immaterial to the industry average but it still needs to be investigated to see why A/R has increased as a % of sales. 7.
BAD DEBT EXPENSE
In 2018, KCN’s bad debt expense was 0.3% and 0.2% in 2017.
8.
GROSS PROFIT
COGS-Why have costs increased as a % of sales from76.8% last year to 77.9% this year? Are inventory costs rising?
Gross margin has been declining and is materially lower than the industry average. Per review of the financial statements, the decrease is driven by an increase in COGS. This increase should be investigated by looking at the increase in inventory costs.
9.
TIMES INTEREST EARNED
Credit Line—Why the 30% increase in the credit line? What is the money being used for? Buying assets? Working capital? Paying other liabilities?
This ratio has a material difference to the prior year and the industry average. The significant decrease is driven by a large increase in liabilities, the biggest increase is in the line of credit, explaining the increase in interest expense. Another driver to the decrease is the decrease in operating income due to the decrease in gross margin.
This ratio indicates how effectively KCN discharged it interest obligations on its debt payment. In 2018, this ratio declined to 1.7%, which is lower than the industry average of 5.5%.
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Blank Sheet for Calculating Ratios
Table 2, NKU, Inc.
2017
2018
Percent change
Current Ratio
1.98
2.11
6.6%
Days’ sales in receivables
18.02
27.38
51.9%
Days’ sales in inventory
133.70
127.62
-4.76%
Receivable Turnover
20.25
13.33
-16.88%
Inventory Turnover
2.73
2.86
4.76%
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