Introduction:

Analysis of Business Report

Pejenca Industrial Supply Ltd.

date of submission: April 28, 2014Table of Contents

1. Introduction and background

2. Analysis of the Company

3. Ratio Analysis

3.1 Liquidity Ratios

3.2 Stability Ratios

3.3 Efficiency Ratios

3.4 Growth Ratios

3.5 Debt Ratios

3.6 Net Profit Margin

3.7 Asset Turnover

3.8 Cash Debt Coverage

3.9 Current Cash Debt Coverage

3.10 Expense Ratio

3.11 Free Cash Flow

3.12 Gross Profit Margin

3.13 Return on Equity

3.14 Return on Total Assets

4.0 Vertical & Horizontal Analysis

5.0 Recommendations

6.0 ConclusionExecutive Summary

1.0 Introduction and BackgroundThis paper is based on the request from Peter Charles of a report on the performance of Pejenca Industrial Supply LTD based on the companys financial statements for the period 1998 to 2002. This report is prepared for his upcoming appointment with the bank. The bank as a preliminary to the granting of a loan will review these financial statements. Appropriate vertical, horizontal and ratio analysis of these financial statements will be produced. Through this analysis, the nature and causes of trends will be identified thus relevant recommendations will be made in regards to Pejencas resources efficiencies in the areas of profitability, liquidity and solvency during this period.

At the completion of high school, a London industrial supply company employed Charles where he worked at the shipping and receiving order desk. Eventually he moved into a sales role and within a few years was promoted to sales manager and then general manager. After seventeen years of working with this firm, the owners son joined the family business in which Charles found lack of promotional opportunities could no longer be achieved. Charles decided to join former co-workers David Stanley (who was also in the same situation) in starting up their own business and thus, Pejenca Industrial Supply was founded in September 1989. Stanley operated the Hamilton division independently of Charles London division. The London operation consisted of Charles and his wife Jennifer as employees for the first four months. Charles responsibilities consisted of shipping; receiving and Jennifer (former teacher) role consisted of handing out the catalogue of a U.S supply company. Originally, Pejenca concentrated on supplying industrial businesses with specified cutting tools. These included drills, taps (tools to thread the inside of pipes), and carbides (specialized saws which remove metal from solid rods, thus enabling a rods thickness to be adjusted as necessary). Eventually, the company achieved a reputation for experts in specialized cutting tools. The first year consisted of sale levels above what was expected and thus another employee was hired in December. Further products were added to the catalogue throughout the years. In 1999, the company not only specialized industrial cutting tools but precision tools, abrasives, and machine accessories as well. The three major goals for Pejenca were being in solid financial shape, recognizing that the people, the business and that satisfying the customers expectations for quality and service was paramount. Thus, Charles and Stanley developed a company mission statement (see Exhibit 1), quality statement (see Exhibit 2), and value statement (see Exhibit 3) to guide the company and its employees to meet the desires of the owners. Lastly, Pejenca was dedicated to producing equitable revenues for the long-term advantage and financial health of the company (Ivey Management Services 2000)2.0 Analysis of the CompanyPejenca Industrial Supply Limited need to increase their office size with extra stock space and they have a budget of $150,000. The decision to expand their space requires assessment whether it would be wise to take a loan from the bank or whether it can be paid through their own income operations.

Peter Charles, the president and major shareholder, in in need of $150,000 for the extension in order to increase the space of the facility. But, before approaching the bank, he wants to have a concrete understanding about Pejencas financing which the bank might question. Charles need to make a decision is less than a week.

Peter Charles must make a decision whether it is feasible to take a loan to build the new extension and must decide whether the company can keep its profitability with the additional debt. He must make a decision within one week in order to avoid any customer service delays. Charles also knows that the company is operating without a working capital and knows that the company needs at least $130,000 in cash to sustain the company throughout the whole year.

Other issues that Charles need to defend any concerns or objection that the bank may have are:

Involvement with the Independent Distributions INC (IDI) where the company needs to pay a certain percentage of a fee but excludes other competitors from joining IDI. But if another competitor joins IDI then Pejenca loses veto rights and cannot exclude them and may lose the exclusive distribution rights. There is an expectation of growth in the company with 15% to 20% sales growth with an improved gross margin.

There is no minimum billing requirement as other competitors practice which could affect the operations and cause the company to have a surplus or deficit of their resources and inventory. The net cash flow from financial and investing activities sees a negative value from the year 2000-2001. This means that more cash is being spent then is being received. This could effect Pejenca in a negative way.

The effect of low season sales on December, July and August is a concern.

Charles had started working just after high school even though he has good amount of experience in the supply industry of cutting toolsTo avoid any service related delays, Pejenca requires a new extension and is seeking a loan from a bank. We as analysts would try to recommend whether it would be feasible to take the loan or not.2.1 Ratio SummaryPEJENCA: Industrial Supply Ltd.

Ratios

SIRatio20022001200019991998

1Net Profit Margin3%3%3%4%4%

2Acid Test Ratio2.0161.9222.3232.0151.409

3Asset Turnover10489969951

4Average Accounts Payable Settlement period3336233144

5Average Accounts Receivable Settlement Period 41 45 40 42 42

6Average Inventory Turnover Period3932343630

7Cash Debt Coverage0.31560.22250.44770.0444N/A

8Cash Return on Sales Ratio0.0360.0160.0360.004N/A

9Current Cash Debt Coverage0.1080.0620.1430.013N/A

10Current Ratio2.922.713.452.972.00

11Debt Ratio0.48150.31450.27620.34110.4128

12Expense Ratio25%24%23%23%22%

13Free Cash Flow($130.50)$73.00 $139.50 $9.50 N/A

14Gross Profit Margin28%27%27%28%27%

15Interest Coverage88.9x40.36x27.05x20.89xN/A

16Return on Equity15%15%15%23%N/A

17Return on Total Assets9%10%11%15%N/A

3.0 Ratio Analysis

We will be using different ratio analysis techniques to evaluate various aspects of Pejencas operating and financial performance such as efficiency, liquidity, profitability and solvency. We would check the trend of these ratios to see whether Pejenca Industrial Supply Ltd. is improving or deteriorating. The ratios would be compared against the industry average ratios to see the performance of Penjenca Industrial Supply Ltd.3.1 Liquidity

3.1.1 Current Ratio

It is balance-sheet financial performance measure of company liquidity. Current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months (Current Ratio 2014).PEJENCA: Industrial Supply Ltd.

Current Ratio20022001200019991998

2.92:12.71:13.45:12.97:12.00:1

Fig: 01 Current Ratio

The current ratio indicates Pejencas ability to meet its short-term obligations. There is a gradual increase of the ratio from the year 1998 to 2000 and again a drop from the year 2001 to 2002 but overall it is quite strong against the market average ratio of 1.7:1. In the year 2002 it had a current ratio of 2.92:1 which means that for every dollar in current liabilities, there is the presence of $2.92 in current assets. This means Pejenca has a good solvency ratio. They can repay their current liabilities on time quite efficiently. This means Pejenca has a good solvency ratio. But on the other hand as it is very high compared to the market average ratio, Pejenca is not utilizing its assets completely to generate profits.3.1.2 Acid Test Ratio / Quick Ratio:

The term Acid-test ratio is also known asquick ratio. The most basic definition of acid-test ratio is that, it measures current (short term) liquidity and position of the company. To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company (Acid-Test Ratio 2014).PEJENCA: Industrial Supply Ltd.

Acid Test Ratio/ Quick Ratio20022001200019991998

2.0161.9222.3232.0151.409

Fig: 02 Acid Test RatioPejenca's acid test ratio has also increased from 1.409:1 in 1998 to 2.016:1 in 2002. The industry average in 0.6:1. This is positive aspect for Pajenca Industrial Ltd. This means that Pajenca Industrial Ltd. has $2 of current assets against $1 of current liabilities. It means that they can repay the current liabilities if required to.

3.1.3 Working Capital

Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations (Investopedia 2014)Fig: 03 Working Capital

Pajencas working capital has substantially increased from 1998 when it was $348,800 to $838,300 in 2002. This ratio varies heavily with the size of the company; however the large increase in working capital is an extremely positive outcome for this liquidity ratio and shows that Pejenca has the ability to meet its current liabilities.

3.2 Stability3.2.1 Net Worth: Total AssetsThe net worth to total assets shows a decrease from the initial value at 1998. There is a big growth in 2000 with 72.4% of increase but overall there is a decrease which is not good for Pejenca but overall good in comparison to the industry average of 39.2% (See exhibit 8). This gives them a competitive advantage over the competition with a lower net worth to total assets. This also shows to lenders that with a higher net worth, Pejenca has the ability to raise more capital and would give them more confidence in financing Pejenca.Fig: 04 - Net worth: Total Assets3.2.2 Interest Coverage

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable (Interest Coverage Ratio 2014)

PEJENCA: Industrial Supply Ltd.

Interest Coverage Ratio20022001200019991998

88.9x40.36x27.05x20.89xN/A

Interest coverage has increased drastically over the years. This indicates that there is a very minimal risk for Pejenca to repay the new interest if a new loan is taken. It also is a big indicator for investors and lenders that Pejenca is a less risky company to invest in and thus tells us that Pejenca has the potential to take loans.

3.3 Efficiency

3.3.1 Age of receivables / Average Accounts Receivable Settlement Period

The average time it takes for a business to receive the amount owed from the customers in a specific accounting period. The shorter the period the better is their position.

PEJENCA: Industrial Supply Ltd.

Average Accounts Receivable Settlement Period20022001200019991998

4145404242

Fig: 05 Average Accounts Receivables Settlement PeriodPejenca's average accounts receivables settlement period has been constant over the periods of 1998 to 2002. The industry average is 55 days which is positive since it needs less cash to operate as it collects its receivable amounts much quicker than the industry average. The higher the days the higher amounts of money it would require to operate.

3.3.2 Age of Payables / Average Accounts Payable Settlement Period

The average time it takes for a business to pay off its creditors in a specific accounting period. This equation can assess the companys cash situation. This demonstrates how a business handles its outgoing payments. (Ready Ratios 2014)

PEJENCA: Industrial Supply Ltd.

Average Accounts Payable Settlement Period20022001200019991998

3336233144

Fig: 06 Average Accounts Payable Settlement Period

According to Exhibit 8, Pejenca's average accounts payable settlement period has a slight decrease on average from Year 1998 to Year 2002 which is 33 days. This is a positive decrease in the efficiency. It tells us that Pejenca is able to pay off their debt faster and more efficiently. This helps in to reduce the liabilities and saves money and helps in faster repayments.

3.3.3 Age of Inventory / Average Inventory Turnover Period

The average inventory turnover period is the number of days the inventory must be replaced during a given period of time, typically a year. It is one of the most commonly used ratio in inventory management, as it reflects the overall efficiency of the supply chain, from supplier to customer. This ratio can be computed for any type of inventory (materials and supplies, work in progress, finished products or all combined), and it can be used for retail as well as manufacturing. (Inventory Turnover 2014)

PEJENCA: Industrial Supply Ltd.

Average Inventory Turnover Period20022001200019991998

3932343630

Fig: 07 Average Inventory Turnover Period.The industry average of inventory turnover period is 54 days. But Pejencas ratio is negative and is not positive in par with the industry average. This means that they are taking too much inventory for their sales or it is becoming redundant. As more inventories require more inventory space, the extra cash can complement Pejenca to use the space efficiently giving them lower storage costs against the competition.3.4 Growth3.4.1 Sales

There is a positive trend in sales growth as per exhibit 8 from 1998 to 2001. But there is -1.7% decreases which shows a sales deficit which shows that there are less sales in 2002 than in 2001. This is a major problem but Pejenca can overcome this since they have a high sales growth and maybe in 2002 the sales for a particular season on 2002 was not good.3.4.2 Net EarningsThe net earnings at Pejenca Industrial Supply Ltd. in on the declining trend.

3.4.3 Total Assets

The total assets is also declining as he took a loan of three hundred thousand from shareholders in 2002. 3.5 Debt Ratio

Debt ratio is a ratio that indicates the proportion of a company's debt to its total assets. It shows how much the company relies on debt to finance assets. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The higher the ratio, the greater the risk associated with the firm's operation. A low debt ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk (Debt Ratio 2014).

PEJENCA: Industrial Supply Ltd.

Debt Ratio20022001200019991998

0.48150.31450.27620.34110.4128

Fig: 08 Debt Ratio

Pajencas debt ratio remained more or less stable over the years but has increased from the year 2000 to 2002 with 48% which means their debt is increasing and it means that 48% of the companys assets are financed by debt. Pejanca needs to decrease the amount and reduce it to make it sustainable in the long run.3.6 Net Profit MarginNet profit margin is a key ratio of profitability. It is very useful when comparing companies in similar industries. A higher net profit margin means that a company is more efficient at converting sales into actual profit (Net Profit Margin 2014).

PEJENCA: Industrial Supply Ltd.

Net Profit Margin20022001200019991998

3%3%3%4%4%

Fig: 09 Net Profit Margin

Pajenca Industrial Supply Ltd. net profit margin is decreasing slightly from 4% in 1998 to 3% in 2002. The net profit margin is still positive and is good.3.7 Asset Turnover

Asset turnover (total asset turnover) is a financial ratio that measures the efficiency of a company's use of its assets to product sales. It is a measure of how efficiently management is using the assets at its disposal to promote sales. The ratio helps to measure the productivity of a company's assets (Asset Turnover 2014).

PEJENCA: Industrial Supply Ltd.

Asset Turnover20022001200019991998

10489969951

Fig: 10 Asset Turnover

By analyzing the asset turnover we can see that Pejenca Industrial Ltd. is utilizing their assets very well with 104 times of turnover which is a better increase over the years. It is improving from year to year.

3.8 Cash Debt CoverageIt is a liquidity ratio that measures the relationship between net cash provided by operating activities and the average current liabilities of the company. It indicates the ability of the business to pay its current liabilities from its operations. A highercurrent cash debt coverage ratio indicates a better liquidity position. Generally a ratio of 1:1 is considered very comfortable because having a ratio of 1:1 means the business is able to pay all of its current liabilities from the cash flow of its own operations. (Cash-Debt Coverage Ratio 2014)PEJENCA: Industrial Supply Ltd.

Cash Debt Coverage20022001200019991998

0.31560.22250.44770.0444N/A

Fig: 11 Cash debt Coverage

Pejenca has a positive cash debt coverage. It means that they have the ability to pay its current liabilities from its operations using cash. And thus showing better liquidity.3.9 Current Cash Debt CoveragePEJENCA: Industrial Supply Ltd.

Current Cash Debt Coverage20022001200019991998

0.1080.0620.1430.013N/A

It gives the measure that what is the actual cash available to pay for interest expense. Pejenca shows an increase in the coverage ratio. This shows that Pejenca has the ability to generate cash from operations from year to year gradually. Thus they are stable.3.10 Expense RatioThe expense-to-sales ratio measures the operating expenses of a business shown on the profit and loss statement, with the gross sales of the business that are also shown on the profit and loss statement. This ratio is a quick indicator of rising or decreasing costs or rising or declining sales (Expense to sales ratio 2014)PEJENCA: Industrial Supply Ltd.

Expense Ratio20022001200019991998

25%24%23%23%22%

Fig: 12 Expense Ratio

The expanse ratio shows that the sales of Pajenca Industrial Supply Ltd. is increasing at a stable rate. Which shows it is quite positive in meeting its sales targets.

3.11 Free Cash FlowFree Cash Flow is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes (Free-Cash Flow 2014)PEJENCA: Industrial Supply Ltd.

Free Cash Flow20022001200019991998

($130.50)$73.00 $139.50 $9.50 N/A

Fig: 13 Free Cash Flow

The free cash flow is negative in the year 2002 in comparison to strong positive growth in the years 1998 to 2001. This shows that Pejenca is unable to account for its capital expenditures and is using other sources to keep their inventory. And also this is due cash outflow due to dividend payment of $300,000.

3.12 Gross Profit MarginThe gross profit margin ratio is used as one indicator of a business's financial health. It shows how efficiently a business is using its materials and labor in the production process and gives an indication of the pricing, cost structure, and production efficiency of your business. The higher the gross profit margin ratio the better (Gross Profit Margin 2014)PEJENCA: Industrial Supply Ltd.

Gross Profit Margin20022001200019991998

28%27%27%28%27%

Fig: 14 Gross Profit Margin

The gross profit margin is stable along the years which shows that Pejenca has efficiently maintaining its sales, pricing and production. They are quite efficient in their gross profit margin and in generating profit.3.13 Return on EquityReturn on Equity measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are generally considered good (Wikipedia 2014)PEJENCA: Industrial Supply Ltd.

Return on Equity20022001200019991998

15%15%15%23%N/A

One of the most important profitability measures is return on equity [ROE]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. The amount of net incomereturnedas a percentageof shareholders equity.Return on equitymeasures a corporation's profitabilityby revealing how muchprofit a company generateswith the money shareholders have invested.

Fig: 15 Return on Equity

Pejencas ROE is stable meaning that it has been earning 15% of common equity net of all costs. The company is thus earning 15% of profitiability every year which is stable. Pejenca needs to increase it.

3.14 Return on Total Assets:

This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. ROAs over 5% are generally considered good (ROA, Wikipedia 2014)PEJENCA: Industrial Supply Ltd.

Return on Total Assets20022001200019991998

9%10%11%15%N/A

The return on assets is declining from 15% in 1999 to 9 % in 2002 showing that Pejenca is becoming inefficient to manage their total assets to generate higher net income.

4.0 Vertical AnalysisVertical analysis (also known as common-size analysis) is a popular method of financial statement analysis that shows each item on a statement as a percentage of a base figure within the statement. So, in order to analyze Pajencas each years financial performance we have pointed out some of the major highlighted areas in respect vertical analysis as below:

Earnings before income taxes:

From the vertical analysis of Income statement we can see that Pejenca is showing declining earnings before taxes starting from 1998 to 2002 where earnings was 5.4% which came down to 3.4% in 2002.

Return on Equity:

We can see from the Income statement that Pejenca is showing declining trend of return on equity. They had 29.1% of return on equity having 27.2% gross profit. This means that Pejenca is making $0.15 from every $1 of shareholders equity. But even gross profit increased to 28% in 2002 having the return on Equity 15.2% showing a decrease whereas industry average is 23%. This could be the reason of higher wages & employee benefit increment (it increased from 15% to 18.4% in 1998 and 2002).

From the vertical analysis of Statement of Financial position, we can see that Pajencas Current asset percentage to Total Asset is increasing steadily which is 73% the year 1998 to 83% in the year 2002. This is due to higher incremental Cash sales increment and decline in credit sales. This denotes better company control over credit sales.

Liabilities:

Pajencas liabilities management is showing good control over its debt especially in the account payable areas. In 2002, Pajenca has been able to reduce its accounts payable drastically in this year cutting down by half which is from 86% to 46%.

5.0 Recommendations 1. Utilizing of Assets efficiently and effectively: There is a gradual increase of the ratio from the year 1998 to 2000 and again a drop from the year 2001 to 2002 but overall it is quite strong against the market average ratio of 1.7:1. This means Pejenca has a good solvency ratio. But on the other hand as it is very high compared to the market average ratio, Pejenca is not utilizing its assets completely to generate profits. So they need to utilize the assets. They can make full utilization of assets by Investing idle assets like cash. Rent out or lease the non-current assets to different business entities and seek further revenues from it.2. Improvement in technology to meet the market trends and competition3. By building a new inventory storage Pejenca is hoping to increase their inventory capacity and their sales growth would be expected to start to increase once again rather than continue to decrease. 4. Pejenca should concentrate more on Just-in-Time Inventory Management system. It would enable them manage their huge inventory and improve their productivity and efficiency enabling them to expand their sales and profitability.5. In 2002 Pejenca Industrial Supply Ltd. took a loan of $300,000 but again is seeking a loan of $150,000 which shows that it is taking too much external finances and increasing its debt. It should try to utilize its current assets and inventory and reduce its debts before undergoing taking another loan.6. For the past three years Pejenca has been providing 15% return on equity. If Pejenca takes $150,000 loan then Pejenca has to ensure that the ROE needs to be stable or needs to be improved to keep the shareholders confident in the company and its operations.

7. Consider reviewing employees benefit and wages. They may consider outsourcing non-vital operations to third party vendors so that overall costs could be minimized.

8. Pejenca has a good acid test ratio and they can repay their creditors on time. They need to maintain their acid test ratio.9. Pejenca can improve their Average Accounts Receivable Settlement Period by reducing the number of days to collect their receivables.Please refer to Appendix for projected Income Statement, Cash Flows and Balance Sheet. The projected figures mentioned below are based on year 2002 since we do not have sufficient information present on the report.

As per the requirement from the bank Loan taken after deduction of

On 2003, dividend given to shareholder is assumed to be $210,000 as there is an expansion of Pejencas capital if a loan of %Account receivable would increase due to efficiency in inventory management.

We thus recommend Pejenca to expand their space without taking the loan. They can start production of a new inventory space during the off-season when the production and storage is less and thus it will not affect their productivity.

If Pajenca does not take the loan then they will have 177

A bank loan would require extra interest payments of 6% on the loan. Without the loan Pejenca can save around ________________ in interest. It is not absolutely necessary to take the loan and pay interest payments. The main concern with not getting a loan is that the company must be entirely sure that they can afford to finance the extension without a loan and still operate efficiently.

A few other things for Pejenca to consider in the long-run would be to re-evaluate their credit policy so that they can reduce bad debts and collect their receivables more quickly. Charles should also decide whether he needs more employees with the additional space and a growing company.

6.0 Conclusion 2