Sylvia Banks and National Software's financial turnaround

National Software

Sylvia Banks sold 60% of the company. As a 40%stake owner, she continues to be responsible for the management of everyday business operation. Sylvia has 40% ownership of the firm. An agency problem can be outlined as a conflict of interest that is intrinsic within any relationship in which one party is expected to operate and function in the best interests of another party. As a result, this implies that Sylvia Banks is the agent of the other stakeholders. Sylvia Banks has turned around the financial performance of National Software. Despite the fact that it generated losses in the first two years of its operation, in the subsequent years, from 2013 to 2017, the company has experienced significant improvement in financial performance. During these years, the company generated progressively more net profit after taxes from $15,000 in 2013 to $48,000 in 2017. This is mirrored in the constantly improving earnings per share. Reasons for this growth aspect encompass the advancement in technology and improvement in the software industry. This implies that software has become an imperative element across various industries. Therefore, the company has experienced improved sales and revenues. In addition, Sylvia has managed to accomplish her main objective of maximizing profit. In analyzing the time-series and cross-sectional financial ratio of the company, it can be perceived that the company has experienced financial performance improvement in the past financial year. With respect to liquidity, activity, profitability and market, National Software has experienced an improved financial performance. However, the downside is that the company continues to register poor performance compared to rival companies. This is because its financial ratios are lower compared to the industry average. Therefore, this explains the need for Sylvia to hire a software developer in order to augment the firm\'s performance.

Analysis of Situation

Sylvia Banks is responsible for developing National Software\'s cost-accounting software program as its primary product offering. At the outset, the company experienced significantly poor financial performance. In 2011 and 2012, the company generated negative net profit after taxes being -$50,000 and -20,000 respectively. However, since then, the company has experienced a remarkable turnaround. In particular, from 2013 to 2017, the company generated progressively more net profit after taxes from $15,000 in 2013 to $48,000 in 2017. Sylvia Banks partly owns National Software Inc. Due to initial losses, she was forced to sell 60% of the company. However, despite being a 40% share owner of the company, Sylvia is responsible for the management and everyday operations of the company. Sylvia is focusing on generating cash flows for the company owners and creditors. However, this is not the correct goal. This is largely for the reason that the profits generated by the company does not essentially give rise to cash flows available to the owners and creditors of the company. Regardless, Sylvia has been successful in achieving her main objective, which is profit maximization. In recent periods, Sylvia provided detailed information regarding National Software for prospective investors. In response, Jimmy Perez provided an investment offer to acquire the company for $200,000. After having a dialogue with the prospective investor, Sylvia found out that he employs a 10% discount rate on projects with this level of risk. By making comparisons, Sylvia uses a 9% required rate of return on new projects.

Critical Evaluation

EPS Performance Assessment

National Software, Inc. does not have any preferred shares. In addition, the company\'s total shares have remained the same from the time it was founded. Therefore, the earnings per share of the company is calculated as follows:

Earnings per Share = Net Profit after Taxes / Number of Shares of Common Stock Outstanding

2011 = -50,000 / 50,000 = -$1.00

2012 = -20,000 / 50,000 = -$0.40

2013 = 15,000 / 50,000 = $0.30

2014 = 35,000 / 50,000 = $0.70

2015 = 40,000 / 50,000 = $0.80

2016 = 43,000 / 50,000 = $0.86

2017 = 48,000 / 50,000 = $0.96

National Software had negative earnings per share in the 2011 and 2012 financial years. This is because in these two years, the company generated negative net incomes. In the subsequent years between 2013 and 2017, National Software has been experiencing positive and constantly increasing earnings per share, rising from $0.30 in 2013 to $0.96 in 2017. This progressively increasing EPS is in line with the company\'s main objective of profit maximization for the owners. Therefore, this indicates that Sylvia is accomplishing her main objective of maximizing profit as the manager of National Software.

The company has experienced significant changes in its EPS performance. Reasons for this growth aspect encompass the advancement in technology and improvement in the software industry. This implies that software has become an imperative element across various industries. Therefore, the company has experienced improved sales and revenues (Lytras, 2012). The software is related to streamlining the accounting processes of medium and large-sized manufacturers. Therefore, with more and more companies using the software, the performance of National Software Inc. keeps improving. Another general financial factor is the economic status of the nation. With an economic boom, there is an increase in spending, which enhances the level of revenue generated.

Cash Flow Statement

Free cash flow (FCF) is delineated as the amount of cash flow that is accessible to investors who provide debt and equity capital. It signifies the net amount of cash flow that is left once the firm satisfies all operating requirements and pays for current and fixed investments. On the other hand, the operating cash flow (OCF) is delineated as the amount of money that is generated by a company from its operations (Frino et al., 2015). OCF is obtained through the following formula:

1. Operating Cash Flow for 2017

OCF = [EBIT x (1 -- Tax Rate)] + Depreciation

= [89,000 x (1 -- 0.2)] + 11,000

= 71,200 + 11,000

= 82,200

2. Free Cash Flow for 2017

Free Cash Flow = Operating Cash Flow -- Net Fixed Assets Investments -- Net Current Assets Investment

That is, FCF = OCF -- NCFAI -- NCAI

i. Net Fixed Assets Investments = Change in net fixed assets + Depreciation

= (487,000 -- 408,000) + 11,000

= 90,000

ii. Net Current Assets Investment = Change in current assets -- Change in (Accounts Payable + Accruals)

= (355,000 -- 280,000) -- [(136,000 + 27,000) -- (126,000 + 25,000)]

= 75,000 -- (163,000 -- 151,000)

= 75,000 -- 12,000

= 63,000

Therefore, FCF = OCF -- NCFAI -- NCAI

= 82,200 -- 90,000 -- 63,000

= -70,800

The operating cash flow is positive whereas the free cash flow is negative. As a result, this indicates that Sylvia was able to generate sufficient cash flow to cover operating expenses, but did not have adequate cash generated for investment in assets.

Financial Statement Ratio Analysis

Financial ratio analysis is employed to analyze and investigate different aspects of a firm\'s operating and financial performance. This makes it possible to ascertain trends over time for a firm as well as make comparisons between two or more firms within a certain industry for a given period of time (Peterson and Fabozzi, 2012). The following is an analysis of National Software\'s financial condition in 2017 in relation to liquidity, debt, profitability, activity and market ratios. The analysis will also encompass an appraisal of the firm\'s performance on a cross-sectional and a time-series basis.

Liquidity

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

= 355/297

= 1.20

2. Quick Ratio

Quick Ratio = (Total Current Assets -- Inventories) / Current Liabilities

= (355 -- 191) / 297

= 0.55

The current ratio of the firm increased from 1.06 in 2016 to 1.20 in 2017. This indicates the company\'s improved performance with the capability to cater for its current liabilities. However, from a cross-sectional perspective, National Software has poor performance as the industry average has a higher current ratio of 1.82. On the other hand, the quick ratio of the firm declined from 0.63 in 2016 to 0.55 in 2017. This indicates the company\'s deteriorating performance. Moreover, the company has a significantly lower quick ratio compared to the industry average with a ratio of 1.1. In general, this indicates that despite the liquidity of the firm slightly improving, through the current ratio, its performance is considerably below average as both the firm\'s current ratio and quick ratio are substantially lower than the industry average (Needles and Powers, 2010).

Activity

1. Inventory Turnover

Inventory turnover = Cost of Goods Sold / Average Inventory

= 1,030 / ((191 + 145) / 2)

= 1,030 / 186

= 6.131

2. Average Collection Period

Average collection period = (Accounts receivable / Annual Sales) x 365

= (152 / 1,550) x 365

= 35.79

3. Total Asset Turnover

Total asset turnover = Net Sales / Average Total Assets

Average total assets = (487 + 408) / 2 = 447.5

Therefore, total asset turnover = 1,550 / 447.5

= 3.46

The inventory turnover of the firm indicates its capability to sell its inventory and replace it over a period of time. The ratio declined from 10.40 in 2016 to 6.13 in 2017. This indicates the firm\'s significant improvement in performance with the ability to clear its inventory. Moreover, compared to its competitors, National Software has remarkable performance with the industry average inventory turnover at 12.45. Secondly, the average collection period of the company increased from 29.6 days to 35.79 days. This implies that the company takes a long time to collect funds from its debtors. From a cross-sectional perspective, the firm has substantially poor performance as its competitors, in average, collect their receivables in 20.2 days. Third, the total asset turnover ratio of the company indicates its ability to generate sales from its total assets. The total asset turnover of the firm increased from 2.66 in 2016 to 3.46 in 2017. This indicates that the firm improved its performance in utilizing its total assets to generate revenue. Despite having a lower ratio compared to the industry average, the company is competitive against its rivaling firms. In overall, the activity performance of the firm has improved in the past financial year. However, the firm continues to register below-average performance in accordance to the industry standards (Needles and Powers, 2010).

Debt

1. Debt Ratio

Debt ratio = Total debts/ total assets

= 355 / 487

= 0.73

2. Times Interest Earned Ratio

Times interest earned ratio = Interest before Interest and Taxes / Interest Expense

= 89 / 29

= 3.069

The debt ratio of a firm makes a comparison of its total debt to total assets. This measure gives insight on the amount of leverage employed by a firm. The debt ratio of National Software was 0.78 in 2016 and slightly declined to 0.73 in 2017. The company\'s high debt ratio implies that it is highly dependent on leverage; these are funds borrowed from others. In contrast, majority of companies in the industry are slightly reliant on leverage. This implies that National Software takes more risk compared to other companies in the industry. Times interest earned ratio is a measure of the firm\'s ability to complete its debt payments. The times interest earned ratio of the firm slightly increased from 3.0 in 2016 to 3.1 in 2017. Despite the slight improvement, the company\'s performance is considerably below average as most companies in the industry have a considerably higher ratio at 5.6 (Warren et al., 2013).

Profitability

1. Gross Profit Margin

Gross profit margin = Gross profit / Revenue

= 520 / 1,550

= 0.34

2. Operating Profit Margin

Operating profit margin = operating profit / Revenue

= 89 / 1,550

= 0.057

3. Net Profit Margin

Net profit margin = Net Profit / Revenue

= 48 / 1,550

= 0.031

4. Return on Total Assets

Return on Total Assets = EBIT / Total Net Assets

= 89 / 487

= 0.183

5. Return on Common Equity

Return on Common Equity = Net Income / Average Common Shareholder\'s Equity

= 48 / ((152 + 109) / 2)

= 48 / 130.5

= 0.37

The gross profit margin of the firm increased from 32.1% in 2016 to 34% in 2017. Similarly, the operating profit margin of the firm increased from 5.5% to 5.7% in 2016 and 2017 respectively. Moreover, the net profit margin slightly increased from 3.05 in 2016 to 3.1% in 2017. From a time-series perspective, the profitability of the company has increased in the past financial year, indicating improved performance. However, from a cross-sectional perspective, the operating profit margin, gross profit margin and net profit margin are all below the industry average. Therefore, with respect to profitability, despite the improved level of performance, the firm continues to have below-average performance with regards to the majority of the competitors in the industry. The return on common equity ratio indicates the firm\'s ability to utilize the shareholders\' equity to generate income. The ROCE of the company slightly improved from 36.4% in 2016 to 37% in 2017. The industry average has a ROCE of 34.7%. This indicates that the company is able to utilize its equity more effectively compared to most companies in the industry. In addition, the return on total assets of the company significantly improved from 8% in 2016 to 18.3% in 2017. The ratio is considerably higher than the industry average as well. This indicates that the company has an effective and improved financial performance not only from a time-series standpoint, but also from a cross-sectional perspective (Warren et al., 2013).

Market

1. Price/Earning (P/E) Ratio

Price-Earnings Ratio = Share Price / Earnings per Share

= 5.28 / 0.96

= 5.5

2. Market/Book (M/B) Ratio

Book value per share of common stock = (Stockholder\'s Equity -- Preferred stock) / Average Shares Outstanding

= 152,000 / 50,000

= 3.4

The price/earnings ratio is a metric for valuing a company. This remained the same for the company in the past financial year. However, the ratio of the company is considerably lower compared to the industry average, which is 7.1. This means that what the market is willing to purchase for the firm\'s shares is lower compared to most of the companies in the industry. The market/book ratio is a metric that is indicative of the value of a firm by making comparison of its book value to the market value. The market/book ratio of the company increased from 2.1 in 2016 to 3.04 in 2017. Moreover, the ratio is considerably higher compared to the industry average. This financial ratio of the company shows an improved financial condition. Having the higher ratio mirrors expected greater future gains, owing to perceived growth opportunities (Weygandt et al., 2015).

Hiring a New Employee

Sylvia ought to try to find the funds to employ the software developer. This is largely for the reason that the financial ratios indicate performance that is considerably below the industry average yet should be better performance for the company in its industry of operation. Moreover, the substantial sales and revenue are an outcome of the efforts put in place for increased profitability; this is in tandem with Sylvia\'s main focus.

Firm Valuation: Discount Rate Focused

This is the present value of a perpetuity that generates a cash flow of $5,000 every year at a 10% interest rate.

Rate is obtained by Cash flow / Interest rate

= 5,000 / 0.10

= $50,000

Firm Valuation: Cash Flow Focused

This is the P.V of a firm that generates a perpetual stream of free cash flow of -70,800 per year at a 10%interest rate.

= Cash Flow / Interest Rate

= -70,800 / 0.01

= -708,000

The difference between the two lies in the sense that OCF encompasses cash flow for operations whereas FCF is for investment.

Zero

Operations (50,000) Investment (708,000)

Conclusion

In conclusion, National Software has been experiencing improved financial performance in the past number of years. This can be perceived in the constantly improving earnings per share. However, it is imperative to note that despite this financial improvement, the company still performs poorly in the industry. This can be seen through the firm\'s below average financial ratios compared to the industry average. Therefore, this shows the need for Sylvia to hire a software developer in order to augment the firm\'s performance. Finally, thus far, Sylvia banks is achieving her main objective of maximizing profit. Corporate behavior and ethics is purposed to provide the direction in which the company together with its personnel are meant to take. Organizational behavior and ethics, particularly, have an impact on the opportunities and chances of success. If a company has unethical behavior, this is bound to have an adverse impact on the success of the entity. Similarly, if the corporate behavior is not targeted at the organizational goals and objectives, then this has a disparaging impact on the success of the business (Trevino and Weaver, 2003).