A CASE STUDY OF D’LEON INC.

A Case Study of D’Leon INC.

California Baptist University

BUS539-BE Financial Management

Dr. John Obradovich

May 17, 2020

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A CASE STUDY OF D’LEON INC.
Abstract

In 2017, D’Leon’s president decided to undertake an expansion to “go national” and compete

with major snack foods companies. After doubling plant capacity, opening new sales offices

and launching expensive advertising campaign, sales have not been satisfactory. The board of

directors informed the president, Al Watkins, that changes needed to be made quickly or he

would be fired. The board insisted that Donna Jamison be brought on as an assistant to Fred

Campo, D’Leon’s chairperson and largest stockholder. Ms. Jamison and her assistant are tasked

with helping answer Mr. Campo’s questions regarding the state of the company. This case study

addresses those questions along with recommendations on what is needed for the company to

regain its financial health.

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A CASE STUDY OF D’LEON INC.
Purpose

In 2017, D’Leon’s, a snack food company, president decided to undertake an expansion

to “go national” and compete with major snack foods companies. After doubling plant capacity,

opening new sales offices and launching expensive advertising campaign, sales were not

satisfactory. The company’s cash position was weak, which lead to suppliers being paid late and

the bank threatening to cut off its credit. The board of directors informed the president, Al

Watkins, that changes needed to be made quickly or he would be fired.

At the board’s insistence, Donna Jamison, a graduate of the University of Florida with

four years of banking experience, was brought in as an assistant to Fred Campo, D’Leon’s

chairperson and largest stockholder. Ms. Jamison is tasked with answering Mr. Campo’s

questions regarding the state of the company. Acting as Ms. Jamison’s assistant it is my

responsibility to help her addresses these questions.

Responses to Questions Regarding Financial Statements and Taxes Part I

a. The expansion lead to a 76% increase in sales from 2017’s to 2018’s income statement.

However, looking at the numbers after-tax operating income shows 2018 ended at -$78,569

whereas 2017 ended at $114,257. This was a decrease of $192,826. The net operating working

capital (NOWC) was $905,760 at the end of 2018, in 2017 it was $84,800, which results in an

increase of $120,960. The net income is truly telling as the numbers plummeted from $87,960

in 2017 to -$160,176 in 2018, a -$248,136 decrease. Overall, the expansion had negative effects

on operations.

b. The company had a negative cash flow of -$794,519 for 2018 as a result of the expansion.

This isn’t necessarily a bad thing. The company spent significantly which resulted in less cash

due to the investments needed to support the expansion.

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A CASE STUDY OF D’LEON INC.
c. The balance sheet for 2017 shows accounts payable (AP) at $145,600. In 2018, AP soared to

$524,160, almost tripling, an increase of 260%. With this significant increase, D’Leon probably

can’t pay its suppliers on time, even with their 76% sales increase. If suppliers are not paid on

time, they may without future orders, put liens on D’Leon and might even drive the company to

the brink of bankruptcy.

d. The 2018 Income Statement shows sales of $6,034,000 with a cost of goods sold of

$5,525,000 and other expenses of $519,988 for a total of $6,047,988. This is $13,988 less than

sales. Therefore, the sales price per unit sold does not exceed the cost. This will decrease the

cash balance as the company is spending more than what it is selling.

e. By offering 60-day credit terms instead of 30-day terms, the company would need to wait an

additional month to received revenue from its customers. This means the cash account would

decrease and accounts receivables (AR) would significantly increase. With less cash on hand, it

is likely that AP would also increase. If sales were to double because of the credit policy

change, the company would need to spend more money to have additional inventory, as well as

increase expenditures on fixed assets to meet the increase demand in sales. The company would

be forced to borrow additional monies or sell shares of stock to be able to support the increase

in sales.

f. A situation in which the sales price exceeds the cost of producing and selling a unit of output,

yet a dramatic increase in sales volume causes the cash balance to decline would happen when a

company launches a new product which it demands a premium price for. For example, when

Apple launches a new cell phone. A premium price is demanded and consumers flock to buy it.

Apple sales would increase, production for the new phone also increases, monies spent on
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A CASE STUDY OF D’LEON INC.
supplies, and fixed assets also increase to produce the new phone. These additional expenses

would cause cash balance to decline even when the product is sold for more than cost of goods.

g. A review of D’Leon’s Balance Sheet: Liabilities and Equity shows that $400,000 was

externally financed as long-term debt to fund its expansion program. By taking on long-term

debt rather than issuing stock to finance the expansion, D’Leon weakened its financial strength

and flexibility. This debt results in lower after-tax earnings when compared to equity financing.

Usually, the best type of financing is the one that maximizes cash flows.

h. If the company broke even in 2018, in that sales revenues equaled total operating costs plus

interest charges, D’Leon would still have a cash shortage since it would need to raise external

capital to finance fixed asset due to the expansion.

i. If D’Leon started depreciating fixed assets over 7 years rather than 10 years, this would have

no effect on the physical stock of assets. However, the balance sheet account for fixed assets

would decline because of the additional increase of depreciation, shortening the timeframe by 3

years, 7 instead of 10 years. The company’s reported net income would likely decline since

depreciation would increase. Also, the company’s cash position would increase because

payments of taxes would decrease.

j. Earnings per share are calculated by dividing net income by the number of outstanding shares.

This is a measure of how much profit a company has generated. Dividends per share are

calculated by dividing dividends by shares outstanding. Dividends per share is the sum of

declared dividends issued by a company for every ordinary outstanding share. The book value

per share is calculated as total common equity divided by outstanding shares. Book value is a

market value ratio that weighs stockholders’ equity against outstanding shares. The market price
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A CASE STUDY OF D’LEON INC.
per share does not equal the book value per share because the market value has to do with future

profitability whereas, book value represents historical cost of shares.

k. In business, interest paid is an expense that is paid from pre-tax income. This interest is tax

deductible. Dividends distributed by a business are paid with after tax income. Interest earned is

taxable income. Dividends received are taxed at capital gains rates for people, thereby resulting

in double taxation of dividends. Once by the corporation as income, and again for an individual

as income.

The profits from a sale of an asset not used in normal course of business are known as

capital gains. For D’Leon, capital gains would be taxed as ordinary income. Both tax loss

carrybacks and carryforwards all businesses to use a loss in current year to offset profits in the

previous two years. If losses have not been offset by past profits, then they can be carried

forward to be offset for up to twenty years in the future.

In 2018, D’Leon paid $136,012 in interest. This resulted in EBT of -$266,960 and a tax

credit of -$106,784 resulting in a net income of -$160,176. The tax loss carrybacks and

carryforwards provisions all the company to obtain its full tax refund in 2018 since the firm had

enough taxable income in the two previous years.

Responses to Questions Regarding Financial Statements and Taxes Part II

a. Financial ratios are helpful in gauging the profitability, strength and efficiency of a business

over time. They help to evaluate the health from several different financial angels a reflect

changes in operating metrics over a specific time period. The five major categories of ratios are

1) Liquidity - can the company cover its liability, 2) Asset Management - does the company

have the right amount of assets when compared to sales, 3) Debt Management such as debt-to-

equity ratio. 4) Profitability - shows how lucrative a business is in relation to a specific metric,
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A CASE STUDY OF D’LEON INC.
and 5) Market Value - do investors like what they see in Price to Earning and Market to Book

Value ratios.

b. To calculate D’Leon’s 2019 current and quick ratios it is necessary to solve:

Current Ratio = Current Assets divided by Current Liabilities.

= $2,680/$1,145 = 2.34x

Quick Ratio = (Current assets – Inventories)/Current liabilities

= ($2,680 - $1,716)/$1,145 = 0.84x

2019
E 2018 2017 Industry Average
Current ratio 2.34x 1.17 2.33x 2.70x
Quick Ratio 0.84x 0.39x 0.85x 1.00x

The company’s quick and current ratios are like the ratios in 2017. The comparison from 2018

to 2019 shows that the ratios are expected to improve, yet they are still below the industry

average. The company’s managers, potential bankers, and stockholders would care about this

information since it shows that liquidity is in a weak position compared to the industry average.

c. To calculate the 2019 inventory turnover it is necessary to solve for:

Inventory turnover = Sales divided by Inventories

= $7,036/$1,716 = 4.10x

2019E 2018 2017 Industry Average

Inventory T/O 4.10x 4.69x 4.80x 6.10x
D’Leon has a much lower inventory turnover at 4.10x than the industry Average of 6.10x. It is

possible that the company has old inventory or that it doesn’t have efficient inventory controls

in place. It doesn’t seem and any improvements are expected or forecasted.

To calculate the 2019 days sales outstanding (DSO) it is necessary to solve for:

DSO = Receivables divided by the average daily sales, which

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A CASE STUDY OF D’LEON INC.
= Receivables/(Yearly sales/365) =$878/($7,036/365) = 45.55 days

2019E 2018 2017 Industry Average

DSO 45.55 38.24 37.35 32

This reflects that the company collect too slowly compared to the industry average. Year over

years, this issue is getting worse. Management needs to address D’Leon’s poor credit policy.

Stricter AR measures are needed to improve DSO.

To calculate the 2019 fixed assets turnover and total assets turnover it is necessary to solve for:

Fixed Assets Turnover = Sales divided by Net fixed assets

= $7,036/$817 = 8.61x

Total Assets Turnover = Sales divided by Total Assets

= $7,036/$3,497 = 2.01x

2019E 2018 2017 Industry Average

Fixed Assets T/O 8.61x 6.42x 9.95x 7.00x
Total Assets T/O 2.01x 2.10x 2.34x 2.60x

D’Leon’s utilization of fixed assets turnover is project to exceed the industry average by 1.61x.

Total assets turnover is below the industry average, which is probably caused by an excess of

current assets, mainly A/R and inventory.

d. To calculate the 2019 debt-to-capital and times-interest-earned (TIE) ratios, one must solve

for: Debt-to-capital ratio = total debt divided by total invested capital

=($300+400)/($300+$400+1,952.40) = $700/2652.4 = 26.39%

Second part is TIE = EBIT/Interest =$492.60/$70 = 7.04x

Industry
2019E 2018 2017 Average
26.39
Debt/Total Invested Capital % 73.41% 44.09% 40.00%
Total Interest Earned (TIE) 7.04x (.96x) 4.34x 6.20x
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A CASE STUDY OF D’LEON INC.
D’Leon shows that it is doing better than the industry average with respect to financial leverage.

e. To calculate the 2019 operating margin, profit margin, basic earning power (BEP), return on

assets (ROA), return on equity (ROE), and return on invested capital (ROIC), it is necessary to

solve for:

Operating Margin = EBIT divided by Sales = $492.60/$7,036 = 7.00%

Profit Margin = Net income divided by Sales = $253.60/$7036 = 3.60%

Basic Earning Power = EBIT divided by Total Assets = $492.60/$3,497 = 14.09%

2019E 2018 2017 Industry Average

Operating Margin 7.00% -2.17% 5.55% 7.30%
Profit Margin 3.60% -2.65% 2.56% 3.50%
Basic Earning Power 14.09% -4.57% 12.96% 19.10%

In 2018, operating margin was a -2.17% compared to an industry average of 7.30%, this shows

a very poor performance. It is projected that 2019 will be much better but still slightly below the

industry average. Profit margin was also poor in 2018. Similarly, to operating margin, this too is

projected to improve in 2019. Basic earning power is useful as a comparison tool since it

removed the effects of taxes and financial leverage. Basic earning power is projected to improve

in 2019, but it still will be 5.01% lower than the industry average.

ROA = Net Income divided by total assets = $253.60/$3,497 = 7.25%

ROE = Net Income divided by total common equity = $253.60/$1,952 = 12.99%

ROIC = [EBIT(1-T)] divided by total invested capital = $295.60/$2,652.40 = 11.14%

2019E 2018 2017 Industry Average

ROA 7.25% -5.59% 5.99% 9.10%
ROE 12.99% -32.52% 13.25% 18.20%
ROIC 11.14% -4.24% 9.62% 14.50%
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A CASE STUDY OF D’LEON INC.
Even though all ratios are projected to significantly improve over 2018’s ratios, they are still

below the industry average. These variation on ROE reflect the effects that leverage has on

profitability.

f. To calculate the 2019 price/earnings ratio and market/book ratio it is necessary to solve:

P/E = Price divided by Earning per share = $12.17/$1.014 = 12.00x

M/B = Market price divided by book value per share = $12.17/($1,952/250) = 1.56x

2019E 2018 2017 Industry Average

P/E 12.00x (1.40x) 9.66x 14.20x
M/B 1.56x 0.46x 1.28x 2.40x

The P/E ratio indicates how much investors are willing to pay for $1 of earnings. The M/B ratio

indicates how much investors are willing to pay for $1 of book value equity. The higher the

ratios the better. When both P/E and M/B are high, expected growth is high and risk is low.

Since both ratios are below the industry average, investors opinion of the company is most

likely low.

g. By using the DuPont equation to, D’Leon’s financial condition as projected for 2019 shows a

PM greater than int industry average. TATO and EM are below the industry and the projection

for 2019 are lower than the two previous years. This shows financial weakness and a concern
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A CASE STUDY OF D’LEON INC.
for investors. However, ROE is projected to improved tremendously compared to 2018.

h. By calculating the sales per day at $7,035,600/365 = $19,275.62, this would give an average

of $19,275.62*32 for the new policy, for a total of $616,820. This would increase cash by

$878,000 (Old AR) -$616,820 (New AR) = $261,180. By reducing the amount of AR

outstanding, its DSO will show up as an addition to cash. The funds could be used to reduce

debts, possibly repurchase stock, or to expand the business further. All of these should cause the

stock price to rise.

i. Since the inventory turnover ratio is low, inventories should be adjusted as it appears that

D’Leon has excessive inventory. If inventories are reduced, this would improve the current asset

ratio, the inventory ratio and total assets turnover ratio. With the reduction of inventory, debt

would also be reduced and an improvement to the company profitability would increase its

stock price.

j. D’Leon’s ratios seem to be improving as the 2019 projected data shows, however the current

asset ratio is low. As a credit manager, it would be necessary to evaluate the company historical
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A CASE STUDY OF D’LEON INC.
payment data. Was it only in 2018 that payments were delayed or is this a common trend How

long does it take the company to pay invoices? Would also need to be evaluated. By reviewing

this information, then the credit manager would be able to decide on future credit terms.

Similarly, a bank manager would review the relationship history. By demanding payment, this

might for the company into bankruptcy and the bank may only collect pennies on the dollar of

what it is owed. Seeing the projections would most likely give the credit and bank managers

some assurance that finances should improve in the following year.

k. Prior to the expansion, D’Leon should have hired an outside consultant to evaluate its ratios

compared to the industry averages. This could have been used to determine the effects of the

expansion on current operations. It is possible that the expansion may have been delayed until

the company was able to manage operations without the negative consequences it is currently

handling.

l. Some potential problems and limitations of financial ratio analysis are:

1. Differing operating and accounting practices between companies distort comparisons.

2. Average performance for one company doesn’t mean the same for another company.

3. Window dressing techniques can make ratios appear better than they are.

4. Strictly using industry average is difficult if a company operates several divisions.

m. Some qualitative factors that analysts should consider when evaluating a company’s likely

future financial performance are:

1. Are the company’s sales/revenues tied to one customer?

2. Are the company’s sales/revenues tied to one product?

3. Are the company’s sales/revenues tied to a single supplier?

4. What percentage of the company’s sales/revenues are internationally driven?

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A CASE STUDY OF D’LEON INC.
5. What does the competition look like?

7. Are recent changes or regulations like to have implication for the company?

Conclusion

D’Leon’s undertaking to “go national” and compete with major snack foods companies

did not deliver the expected sales. This led to the company having a weak cash position,

suppliers paid late, and the bank threatened to cut off its credit. Turning the company’s financial

ratios around will be a high order for R. Campos and Ms. Jamison. But, by carefully analyzing

all the information that Ms. Jamison gathered, the company can act accordingly to improve

DOS, reduce debt, buy back stock and overall improve its financial strength and profitability.

Reference

Brigham, E.F., & Houston, J.F. (2018). Fundamentals of Financial Management. Mason, OH.

Cengage Learning.