FIN 370 Week 1 Financial Management and Statement Analysis Example

Reading a Pet Supply Chain's Numbers the Way a Finance Manager Would: The Goal of the Firm, Agency Problems and a Ratio and DuPont Analysis of Two Years

[Student Name]

University of Phoenix

FIN/370: Finance for Business

Week 1 Assignment

[Instructor Name]

[Date]

The pet supply chain and all figures are composites written for a model paper; concepts and research findings come from the sources listed.

A composite chain sells pet food, supplies and grooming services from twelve stores in a growing metropolitan area. The founding family owns 70% and two local investors own the rest. Sales rose from $18.4 million to $20.1 million last year, but the investors noticed that profit barely moved and asked the chain's new finance manager to explain. A finance manager's first job is not to make the numbers bigger; it is to understand what they say about how much the business is worth. This paper explains the goal the finance manager serves and analyzes the chain's statements.

What the Investors Asked

The two outside investors put money in three years ago expecting growth in the value of their shares, not only in store count or sales. They asked three questions: whether the chain can keep paying its bank without new equity, whether growth is creating value and whether management's incentives match the owners' goals. The analysis below answers each.

The Goal of the Firm

Financial management aims to maximize the value of the owners' investment. That goal differs from maximizing profit in one year, because value depends on the amount, timing and risk of cash flows over many years (Brigham & Houston, 2022). A store opening that lowers this year's profit but produces steady cash for a decade can raise value; a cut in staff training that raises this year's profit but loses customers can lower it. For a family business, value maximization also means managing risk carefully, since much of the owners' wealth is tied up in the company.

An Agency Problem in the Stores

Jensen and Meckling (1976) described agency costs arising when owners delegate decisions to managers whose interests differ. The chain pays store managers a bonus of 1% of their store's sales. Managers therefore have reason to push sales through discounts, even when the discounts reduce margin. Last year several managers ran unauthorized promotions on premium food. The owners are considering basing bonuses on store contribution, sales less cost of goods sold and store expenses, which aligns managers more closely with value.

Liquidity

Current assets rose from $4.2 million to $4.9 million, and current liabilities from $2.4 million to $2.9 million. The current ratio fell slightly, from 1.75 to 1.69. Leaving inventory out, the quick ratio slid from 0.38 to 0.31, since inventory accounted for nearly all of the growth in current assets. The chain can meet its bills, but it depends more on selling its stock than it did a year ago.

Efficiency

Cost of goods sold rose from $11.2 million to $12.5 million, and average inventory from $3.2 million to $3.9 million, so inventory turnover fell from 3.5 to 3.2, about 114 days of inventory. Sales divided by average total assets fell from 1.75 to 1.66. The chain carried more stock per dollar of sales, partly because it added a new line of premium freeze-dried food that sells slowly.

Debt Ratios

Total debt to total assets rose from 48% to 52% as the chain borrowed to remodel two stores. Operating income covered interest 4.8 times, down from 6.1 times. These levels are acceptable but moving in the wrong direction.

Profitability

Gross margin fell from 39.1% to 37.8% because of discounting. Net profit margin fell from 4.3% to 3.9%, so net income rose only from $791,000 to $784,000 despite higher sales. Return on equity fell from 14.1% to 12.8%.

The DuPont Breakdown

Multiplying the three DuPont pieces reproduces the return. Last year that was 3.9% times 1.66 times about 1.98, or roughly 12.8%. The year before, 4.3% times 1.75 times about 1.87 gave about 14.1%. Soliman (2008) found that investors use the DuPont components, not just the total, to evaluate firms. Here the components show that falling margin and slower turnover lowered returns, while the higher equity multiplier from new borrowing partly offset them.

Cash Flow Behind the Ratios

The ratios point to a cash problem the income statement hides. Operating cash flow fell from $1.35 million to $0.92 million, even though net income was nearly unchanged, because $700,000 more was tied up in inventory. The chain funded the remodels and the inventory growth partly with its credit line, which is why its debt ratio rose. A finance manager watching only profit would miss the fact that the business consumed more cash to earn the same income.

Comparing With Industry Figures

The owners asked how the chain compares with others. Benchmarks the owners obtained from a peer group of independent pet retailers of similar size show median inventory turnover of about 4.0 and net margins of about 4.5%. The chain trails on both, which confirms that the problems are inventory and discounting rather than the market as a whole.

Recommendations

The finance manager recommends three changes. First, replace the sales-based bonus with one based on store contribution, addressing the agency problem that is eroding gross margin. Second, reduce the freeze-dried food inventory by returning slow sizes to the supplier under its return program and ordering in smaller lots, which would release cash and improve turnover. Third, hold off on further remodels until interest coverage recovers above five.

Limits of the Analysis

Two years is a short period, and the peer benchmarks are informal, drawn from a small group rather than audited industry data, so they indicate direction more than precise gaps. Ratios also depend on accounting choices, such as how inventory is costed, and one-time items, such as remodel disruption, can distort a single year.

Conclusion

The chain's sales grew, but discounting driven by a sales-based bonus lowered margins, slow-moving premium inventory lowered turnover and borrowing for remodels raised the debt ratios. Return on equity fell from about 14% to about 13%. Financial management's goal of maximizing value points to changing the incentive plan, managing inventory and pacing investment, so growth in sales becomes growth in value.

References

Brigham, E. F., & Houston, J. F. (2022). Fundamentals of financial management (16th ed.). Cengage.

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X

Soliman, M. T. (2008). The use of DuPont analysis by market participants. The Accounting Review, 83(3), 823-853. https://doi.org/10.2308/accr.2008.83.3.823