FIN – Track Software, Inc.

Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and O’Brien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings, all of which would be related to streamlining the accounting processes of medium- to large-sized manufacturers. Although Track experienced losses during its first 2 years of operation—2009 and 2010—its profit has increased steadily from 2011 to the present (2015). The firm’s profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1.Stanley started the firm with a $100,000 investment: his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2009), he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The firm’s stock was valued at $4.50 per share in 2014 and at $5.28 per share in 2015.TABLE 1Track Softare, Inc.Profit, Dividends, and Retained Earnings, 2009-20015Year Net profits aftet taxes (1) Dividends Paid (2) Contributions to retained earnigns [(1)-(2)] (3)2009 ($50,000) $0 ($50,000)2010 (20,000) $0 ($20,000)2011 15,000 $0 15,0002012 35,000 $0 35,0002013 40,000 $1000 39,0002014 43,000 $3000 40,0002015 48,000 $5000 $43,000Stanley has just prepared the firm’s 2015 income statement, balance sheet, and statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014 balance sheet. In addition, he has compiled the 2014 ratio values and industry average ratio values for 2015, which are applicable to both 2014 and 2015 and are summarized in Table 5. He is quite pleased to have achieved record earnings of $48,000 in 2015, but he is concerned about the firm’s cash flows. Specifically, he is finding it more and more difficult to pay the firm’s bills in a timely manner and generate cash flows to investors, both creditors and owners. To gain insight into these cash flow problems, Stanley is planning to determine the firm’s 2015 operating cash flow (OCF) and free cash flow (FCF). Stanley is further frustrated by the firm’s inability to afford to hire a software developer to complete development of a cost estimation package that is believed to have “blockbuster” sales potential. Stanley began development of this package 2 years ago, but the firm’s growing complexity has forced him to devote more of his time to administrative duties, thereby halting the development of this product.Stanley’s reluctance to fill this position stems from his concern that the added $80,000 per year in salary and benefits for the position would certainly lower the firm’s earnings per share (EPS) over the next couple of years. Although the project’s success is in no way guaranteed, Stanley believes that if the money were spent to hire the software developer, the firm’s sales and earnings would significantly rise once the 2- to 3-year development, production, and marketing process was completed. With all these concerns in mind, Stanley set out to review the various data to develop strategies that would help ensure a bright future for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firm’s 2015 results would provide important additional insights.TABLE 2Track Software, Inc., Income Statement ($000)for the Year Ended December 31, 2015Sales revenue $ 1,550Less: Cost of goods sold $ 1,030Gross profits $ 520Less: Operating expensesSelling expense $ 150General and administrative expenses 270Depreciation expense 11Total operating expense 431Operating profits (EBIT) $ 89Less: Interest expense 29Net profits before taxes $ 60Less: Taxes (20%) 12Net profits after taxes $ 48TABLE 3Track Software, Inc., Balance Sheet ($000)December 31Assets 2015 2014Cash $ 12 $ 31Marketable securities 66 82Accounts receivable 152 104Inventories 191 145Total current assets $421 $362Gross fixed assets $195 $180Less: Accumulated depreciation 63 52Net fixed assets $132 $128Total assets $553 $490Liabilities and stockholders’ equityAccounts payable $136 $126Notes payable 200 190Accruals 27 25Total current liabilities $363 $341Long-term debt $ 38 $ 40Total liabilities $401 $381Common stock (50,000 shares outstandingat $0.40 par value) $ 20 $ 20Paid-in capital in excess of par 30 30Retained earnings 102 59Total stockholders’ equity $152 $109Total liabilities and stockholders’ equity $553 $490TABLE 4Track Software, Inc.,Statement of Retained Earnings ($000)for the Year Ended December 31, 2015Retained earnings balance (January 1, 2015) $ 59Plus: Net profits after taxes (for 2015) 48Less: Cash dividends on common stock (paid during 2015) 5Retained earnings balance (December 31, 2015) $102TABLE 5Ratio Actual Industry Average2014 2015Current ratio 1.06 1.82Quick ratio 0.63 1.10Inventory turnover 10.40 12.45Average collection period 29.6 days 20.2 daysTotal asset turnover 2.66 3.92Debt ratio 0.78 0.55Times interest earned ratio 3.0 5.6Gross profit margin 32.1% 42.3%Operating profit margin 5.5% 12.4%Net profit margin 3.0% 4.0%Return on total assets (ROA) 8.0% 15.6%Return on common equity (ROE) 36.4% 34.7%Price/earnings (P/E) ratio 5.2 7.1Market/book (M/B) ratio 2.1 2.2TO DO:a. (1) On what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not?(2) Could a potential agency problem exist in this firm? Explain.b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your response in part a.c. Use the financial data presented to determine Track’s operating cash flow (OCF) and free cash flow (FCF) in 2015. Evaluate your findings in light of Track’s current cash flow difficulties.d. Analyze the firm’s financial condition in 2015 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial statements provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis.e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a.f. Track Software paid $5,000 in dividends in 2015. Suppose that an investor approached Stanley about buying 100% of his firm. If this investor believed that by owning the company he could extract $5,000 per year in cash from the company in perpetuity, what do you think the investor would be willing to pay for the firm if the required return on this investment is 10%?g. Suppose that you believed that the FCF generated by Track Software in 2015 could continue forever. You are willing to buy the company in order to receive this perpetual stream of free cash flow. What are you willing to pay if you require a 10% return on your investment?