Question

Cash Flow Summary (in $000s) Company Name: Pacesetters, Inc. Target Line Number 20Y2 Sales revenue (net) A Accounts receivable (1) (2) (3) 9,000 (190) 8,810 Cash collected from sales Cash cost of goods sold (4) (6,199) A Inventory A Accounts payable (5) (134) (6) 168 Cash paid for production (7) (6.165) Cash from trading activities (3) + (7) (8) 2,645 Cash SG&A expense (9) (10) (1,559) A Prepaid expenses A Accrued expenses 31 (11) 22 Cash paid for operating costs Cash after operations (1,506) 1,139 (12) (8)+(12) (13) Other income (expense) (14) 0 A 0ther current and noncurrent accounts (15) 54 Income tax expense (446) (16) A Deferred income taxes (17) 4 A Income taxes payable Taxes paid and other income (expense) Net cash after operations (18) 5 (19) (13)(19) (20) (383) 756 Interest expense (21) (126) AInterest payable (22) 0 Dividends declared or owners' withdrawals (23) (254) A Dividends payable Cash paid for dividends and interest Cash after financing costs (24) 0 (25) (380) (20)(25) (26) 376 Current portion long-term debt (prior year) (27) (200) Cash after debt amortization (26)(27) (28) 176 (29) (30) A Fixed assets (117) A Investments 0 A Intangibles (31) 0 Cash paid for plant and investments (32) (117 Financing surplus (requirement) (28) (32) (33) 59 A Short-term debt (notes payable) (34) 10 A Long-term debt (35) A Preferred stock (36) 0 A Common stock (37) (38) 0 Total external financing 10 Financing surplus (requirement)+ Total external financing (33)+(38) (39) 69 PROOF: A Cash and marketable securities (40) 69

Answer 1

Hello,

The best explanation would be option-3.

First of all, let's understand what is meant by "leverage". A company needs funds to operate and those funds can be from either shareholders (equity) or borrowed capital (debt). Leverage means how much debt the company uses in its business. If the company's leverage is said to be decreasing, it means the company has less debt than equity. Hence the major factors we need to keep in mind while calculating leverage are debt and total owners' equity (shareholders' equity plus retained earnings).

Let's analyze each of the given options (in 000's):

Option 1- Though the company's net income is steadily increasing, its total liabilities are not steadily decreasing, During 20Y2 it decreases by 51, but during 20Y3 it INCREASES by 279. Hence this explanation is not completely accurate. (See Appendix-1 below)

Option 2 - Dividend payout ratio is seen as 20Y1 - 40%; 20Y2 - 43%; 20Y3 - 41%. It doesn't look that company is steadily reducing its dividend payout ratio. The trend is more or less fluctuating. Hence this explanation is not accurate as well. (See Appendix-2 below)

Option 3 - The company is consistently profitable, which is true and can be seen by seeing the increase in net income year-over-year. Also it reduces the Long Term debt by $200 each year, which is also true. This seems to be the best explanation due to two reasons :

- A decrease in long term debt directly impacts the leverage of the company (leverage decreases).

- An increase in net profits leads to increase in total shareholders' equity (due to increased retained earnings), which again leads to decreased leverage,

Option 4 - Current liabilities get paid in less than an year, so we need not consider it for the impact of leverage, due to they being less risky. Rather than saying that most of the company's liability growth is in current liabilities and they have less impact on leverage, a more suitable explanation would be the decrease in long term debt, which in turn leads to a decreased leverage.

Let me know if you have any questions on this. Thank you! Have a great day.

Calculations :

Appendix-1

		20Y1	20Y2	20Y3
Current liabilities	a	955	1100	1577
LT Debt	b	1392	1192	992
Deferred taxes	c	54	58	60
Total Liabilities	a+b+c	2401	2350	2629
Variance			-51	279

Appendix - 2

		20Y1	20Y2	20Y3
Dividend paid	d	194	254	286
Net income	e	486	589	700
Dividend payout ratio	d/e	40%	43%	41%
Variance			-3%	2%