ACC 308 Management Analysis Memo Final

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Management Analysis Memo Zach Langendorfer Southern New Hampshire University ACC 308: Intermediate Accounting II Dr. Linda Orlando December 10, 2023

Financial Health and Ratio Analysis The following management analysis memo is to explain the financial health of Peyton Approved Baking Company and to assess the opportunity of their intended expansion goals in 2018. There are many ratios that we use at Peyton Approved Co. to evaluate our financial position, and these include current ratio, quick ratio, A/R turnover, inventory turnover, gross margin, return on sales, return on equity, and return on assets. Current ratio analyzes our ability to convert our assets into cash in order to cover our current liabilities. According to Business Insider, “A good current ratio is typically considered to be anywhere between 1.5 and 3.” Our company has improved our current ratio from 5.18 to 5.78. We are exceeding market standards, in fact, almost doubling the high end of the spectrum. This indicates that we are in a solid financial state for year two. Along with the remaining following ratios below, we will educate you on why Peyton Approved Baking Co. is a smart investment in opening a second location. Along with current ratio, we have the quick ratio. To investors and creditors, this may be the most important ratio because it provides a more accurate representation of our liquidity, because it does not consider all of our assets, just the ones that can be quickly converted into cash, accounts receivable, cash equivalents such as money market funds, and short term investments as they can be converted generally within 12 months. We are still above an acceptable rate of 3 at 4.89. Our inventory turnover took a 1.2 point drop from 2016, which is considered a significant drop, so this could mean a few things. Weak inventory management, such as overstock of certain items or supplies, could also mean weaker sales. To combat this, I would recommend that Peyton Approved Baking Company reassess the baked goods that it provides, even though it is a new company. Understanding customer favorites and preferences will help increase the inventory turnover back to normal and hopefully higher. When looking at return on equity and return on

assets, we notice a pretty significant drop from 2016 to 2017. Return on assets (ROA), is a measure of how efficiently a company uses the assets it owns to generate profits” (Forbes, 2021). This means we are making $1.01 for every $1 of assets we own. Being a new company, investing in equipment, and having equipment destroyed led to a decrease in our ROA, but as mentioned previously, implementing good marketing strategies and sales focuses will allow us to increase this ratio, along with all others. Peyton Approved Ratio Analysis 2017 2016 Current Ratio (Working Capital) 5.78 5.18 Quick Ratio 4.89 4.60 A/R Turnover 5.91 5.53 Inventory Turnover 7.67 8.81 Gross Margin 68% 66% Return on Sales 53% 52% Return on Equity 125% 160% Return on Assets 101% 108% Compounding Periods and Interest Rates “Compound interest is the interest on a deposit calculated based on both the initial principal and the accumulated interest from previous periods”, according to Central Bank. Compounding periods and interest rates are important because it is essentially the business’s free

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way of making an extra return on the investment. This is especially important in our business account with our lenders/investors because we are reinvested in their banks. The more compounding periods there are during the year, the more we are going to have a return. The same result goes with interest rates. The higher the interest rates, the more compound interest we will build off of the initial principal plus the interest we have accrued. The same goes for the borrower, such as the bank. This is how they make their money with loans and investing. This highlights the importance of ‘planning’ for future investments, if the interest rate is too high, then the amount of principal and interest you pay is going to increase significantly, taking away from our total net income. Pro Forma and Interpretation According to Harvard Business School Online, “A pro forma financial statement leverages hypothetical data or assumptions about future values to project performance over a period of time that hasn’t occurred yet.” Analyzing these pro forma statements will allow us to create an educated prediction/outlook into the upcoming years, or in this case, to analyze if Peyton Approved can continue with their expansion plans. Peyton Approved is forecasting 80% of revenues, costs, and expenses for the forecasted new building based off of year 2017. Since these are pro forma statements and they are predictions, the information taken off of these financial statements should be done with a little caution. Between the income statement and the balance sheet, we are able to forecast sales and expenses to align our growth plans. Another main objective of pro forma statements is to try and provide the most accurate information to investors and management when seeking additional funding. Without these pro forma statements, you may lack an ability to forecast so higher risk would turn investors away. A good indicator to look at is our forecasted current ratio, which is at 4.45, meaning our company’s liquidity can cover our

current liabilities at almost 4.5 times to one. With pro forma financial statements, there are many possibilities for misinterpretation of the financial information. One way to provide the most accurate “hypothetical information” is to ensure we are abiding by our GAAP accounting basics so we have consistent reporting for our investors. “Pro forma” financial information creates concern about misleading investors because its nature departs from traditional accounting standards, making it difficult for investors to compare the issuer’s financials with other reporting periods and with other companies, according to the U.S. Securities and Exchange Commission. Investors can be misled with pro forma statements because companies can include nonrecurring, high cost sales that will impact the ‘view’ of cash flows within the company. They can also exclude expenses deemed as noncash such as depreciation, amortization, losses on the sale of assets (Michigan Ross). Using these pro forma statements, we can provide enough information to determine that our expected gross margin for 2018 in the new location would be 68%, meaning for every $1 spent, we as a company bring .68 cents to the bottom line after paying expenses. This is an average to slightly above average margin, so investing in our baking company is smart business decision for you. Regulations and Ethical Reporting “The FASB’s financial reporting model identifies the five specific financial statements required, they are: Balance sheet, Income Statement, Comprehensive Income Statement, Statement of Cash Flows, and Statement of Shareholder’s Equity”, (Wahlen, J. M., Jones, J. P., Pagach, D. P., 2017). These also include the notes to the statements, our methods, and estimates that we use in our calculations. It is imperative that we include all of this information to our investors to give them full reigns. Peyton Approved Co. was founded off of ethical standards and bases all operations from there.

Inventory Costing, Contingent Liabilities, Revenue Recognition Adhering to GAAP for our financial reporting procedures is what Peyton Approved Baking Company is focused on. It allows us to provide consistent, reliable financial reporting strategies that are not misleading to us, investors, and creditors. For example, our revenue recognition is being recorded as accrual based which means as the sales/money, etc. are being generated. This allows Peyton Approved to stay up to date on the money received and the money owed. For investors, this ensures them that there are no hidden expenses or revenues that would skew the outlook of our company. Inventory costing methods can have different implications and can have certain effects on our reported costs. Peyton Approved uses Last in First Out inventory methods, checking periodically throughout the year. LIFO methods could result in a lower COGS in a time of falling prices for inventory, as an example. We may want to consider switching methods to a weighted average inventory to prevent fluctuations in profits, etc. According to Investopedia, “A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.” For Peyton Approved Baking Company, there are no contingent liabilities that would show up on these pro forma statements, however, looking back at our current ratio and knowing we can cover 4 times liabilities with our assets, is reassuring in case there is a case that comes up such as food poisoning, etc. In order for us to record a contingent liability, it would have to have either occurred or be very likely to. For our baking company, an individual getting sick from food poisoning could be a possibility. A common liability could be if someone fell or got hurt in any way inside our store. This would be the responsibility of us, we could then know a lawsuit is coming, and we could more than likely determine the amount that is going to be paid out. Therefore, we have information that can be journalized and on the books. Unless it is reportable in the way that I just mentioned, we will

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ignore all other contingent liabilities. Revenue recognition is a principle that identifies the specifics in how revenue is recognized. Most businesses utilize accrual based revenue recognition because it provides a more accurate view of a company’s financial status by recording revenue when it is earned, not when cash is actually received, according to NetSuite. For companies who utilize different methods, it can be hard to compare financial statements for those who use a cash basis. Peyton Approved will use accrual revenue recognition to better predict our expansion project. With this brief, I hope to have highlighted the benefits of pro forma financial statements and the good financial outlook for Peyton Approved in 2018 when it comes to expanding into a second operation. With these statements, we wanted you to be informed about the risks and proper areas to analyze with caution as it is all information that can be ‘interpreted’. Investors should be aware of what certain accounts mean, how they recognize their revenues, manage their inventory, and maintain high liquidity levels to support their hopes for continued growth.

References Banton, C. (2023, August 24). Contingent liability: What is it, and what are some examples? . Investopedia. https://www.investopedia.com/terms/c/contingentliability.asp#:~:text=A%20 contingent%20liability%20is%20a%20potential%20liability%20that%20may %20occur,accounting%20records%20of%20a%20firm . Birken, E. G. (2022, October 16). Understanding return on assets (ROA) . Forbes. https://www.forbes.com/advisor/investing/roa-return-on-assets/#:~:text=Return%20on %20assets%20(ROA)%20is,evaluate%20a%20company’s%20financial%20health . Central Bank. (2023). What is compound interest and why it’s important . https://www.centralbank.net/learning-center/what-is-compound-interest-and-why-its- important/ Impact web portal . Pro Forma Earnings Mislead Investors - University of Michigan Business School. (n.d.). https://www.bus.umich.edu/FacultyResearch/InTheNews/Archive/ProForma Earnings.ht Katz, J. (2001, December 4). Cautionary advice regarding the use of “pro forma” financial information in earnings releases . SEC Emblem. https://www.sec.gov/rules/2001/12/cautionary-advice-regarding-use-pro-forma-financial- information-earnings-releases Kibet, L. (2022, July 8). Current ratio: A liquidity measure that assesses a company’s ability to sell what it owns to pay off debt. Business Insider. https://www.businessinsider.com/personal-finance/current-ratio Miller, K. (2021, October 28). What are Pro Forma Financial Statements?: HBS Online . Business Insights Blog. https://online.hbs.edu/blog/post/pro-forma-financial-statements Wahlen, J. M., Jones, J. P., Pagach, D. P. (2017.). Intermediate Accounting: Reporting and Analysis. (2 nd Edition.) Cengage Learning.