What recommendation would you make to stanley regarding

Question

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- 1997 and 1998-its profit has increased steadily from 1999 to the present (2003). 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,

 Table 1

Track Software, Inc. Profit, Dividends, and Retained Earnings, 1997-2003
	Net profits after taxes		Contribution to
Year	(1)	Dividends paid (2)	retained earnings [(1) - (2)] (3)
1997	($50,000)	$ 0	($50,000)
1998	( 20,000)	0	( 20,000)
1999	15,000	0	15,000
2000	35,000	0	35,000
2001	40,000	1,000	39,000
2002	43,000	3,000	40,000
2003	48,000	5,000	43,000

but after experiencing a $50,000 loss during the first year of operation (1997), 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 closed at $4.50 per share in 2002 and at $5.28 per share in 2003. Stanley has just prepared the firm's 2003 income statement, balance sheet, and statement of retained earnings, shown in Tables 2, 3, and 4 (on pages 143-145), along with the 2002 balance sheet. In addition, he has compiled the 2002 ratio values and industry average ratio values for 2003, which are applicable to both 2002 and 2003 and are summarized in Table 5 (on page 145). He is quite pleased to have achieved record earnings of $48,000 in 2003, 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 2003 operating cash flow (OCF) and free cash flow (FCF).

Table 2

Track Software, Inc. Income Statement ($000) for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses		1,030
Selling expense	$150	$520
General and administrative expense	270
Depreciation expense	11
Total operating expense		431
Operating profits (EBIT)		$89
Less: Interest expense		29
Net profits before taxes		$60
Less: Taxes (20%)		12
Net profits after taxes		$48

Table 3

Track Software, Inc. Balance Sheets ($000)
	December 31
Assets	2003		2002
Current assets
Cash	$12		$31
Marketable securities	66		82
Accounts receivable	152		104
Inventories	191		145
Total current assets	$421		$362
Gross fixed assets	$195		$180
Less: Accumulated depreciation	63		52
Net fixed assets	$132		$128
Total assets	$553		$490
Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$136		$126
Notes payable	200		190
Accruals	27		25
Total current liabilities	$363		$341
Long-term debt	$38		$40
Total liabilities	$401		$381
Stockholders' equity
Common stock (50,000 shares outstanding
at $0.40 par value)	$20		$20
Paid-in capital in excess of par	30		30
Retained earnings	102		59
Total stockholders' equity	$152		$109
Total liabilities and stockholders' equity	$553		$490

Table  4

Track Software, Inc. Statement of Retained Earnings ($000) for the Year Ended December 31, 2003
Retained earnings balance (January 1, 2003)	$ 59
Plus: Net profits after taxes (for 2003)	48
Less: Cash dividends on common stock (paid during 2003)	(5 )
Retained earnings balance (December 31, 2003)	$ 102

Table 5

	Actual	Industry average
Ratio	2002	2003
Current ratio	1.06	1.82
Quick ratio	0.63	1.10
Inventory turnover	10.40	12.45
Average collection period	29.6 days	20.2 days
Total asset turnover	2.66	3.92
Debt ratio	0.78	0.55
Times interest earned ratio	3.0	5.6
Gross 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	7.1
Market/book (M/B) ratio	2.1	2.2

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 of these concerns in mind, Stanley set out to review the various data to develop strategies that would help to ensure a bright future for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firm's 2003 results would provide important additional insights.

Required

a. (1) Upon 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 2003. Evaluate your findings in light of Track's current cash flow difficulties.

d. Analyze the firm's financial condition in 2003 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.