Chemalite Inc. deals with the production of glow light by using a number of chemicals. Bennett invented the company with a total capital of $500,000. He brought a number of investors on board in order to raise the capital. The business commenced on 2nd January 2003. However, by 30th June, the capital that had been raised dropped significantly since the bank balance of $375,000 decreased. The investors were convinced that the business was not doing well since there was no revenue generated during this period. However, in the second half of the year, the company made some sales, and the investors thought that the business was performing well. The bank balance dropped further to $113,000, and the investors were still concerned about the performance of the business despite the progress made. Even though the cash balance dropped, a closer review of the company shows that it is profitable. Further, the cash balance of $113,000 at the end of the first year of operation shows that the company is solvent. In addition, the loans borrowed were cleared during the first year of operation. This shows that the company has a bright future and should continue its operations in the future.
When evaluating the profitability of an entity, a lot of emphases is laid on the income statement. Specifically, the items that will be analyzed are the gross profit, operating profit, and net income. From the raw data for the first year of operation that is provided by the management of Chemalite, Inc., it is possible to prepare the income statement and the balance sheet. The value of gross profit at the end of the first year of operation amounted to $209,000. The operating income was $40,125, while the net income totaled $39,375. From the income statement, a number of ratios can be computed in order to evaluate the profitability of Chemalite Inc. These ratios are gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity. The estimated balance of total assets is $539,375. This value is equivalent to the value of total equity. From the values listed above, the gross profit margin is estimated at 27.77%, while the operating profit margin is 5.32%. The net profit margin is estimated at 5.22%. When the ratios are compared with the industry average, it can be observed that the company performed fairly well. The gross profit margin for the equipment industry in 2003 was 25.56%, the operating profit margin was 5.2%, and the net profit margin was 3.34% (Clarke, 2012). Thus, it can be noted that the performance of Chemalite Inc. in 2003 was fairly higher than the industry average. This shows that the company is profitable and should continue its operations in 2004.
The return on equity/assets was 7.30%. The ratio measures the ability of the management to effectively handle resources available in the organization and their ability to generate positive returns from the investments made by the shareholders (Collier, 2009). A positive ratio of 7.3% for a company that has been in operation for only one financial year is quite favourable. It shows that once the product has penetrated the market well, the company will be able to generate higher returns for the shareholders.
Solvency is a vital element when evaluating the performance of an organization. It presents a good yardstick that can be used to measure the ability of the company to continue with operations in the future because it gives information on the ability of the company to pay the long-term obligations. Therefore, the solvency position of the company will be analyzed by computing two ratios. These ratios are the interest coverage ratio and debt to equity ratio. The interest coverage ratio for Chemalite Inc. in 2003 was 53.5. This implies that in the first year of operation, Chemalite Inc. was able to pay the interest expense 53.5 times the operating income. This implies that the company is solvent. The industry average for the interest coverage ratio was 28.97. This shows that the solvency level for the company is higher than the industry. In the case of the debt to equity ratio, the value in 2003 was 0% since the company did not have debt at the end of the financial year. This shows that the leverage level of the company is zero. The industry average for the ratio is 35%. A low leverage level gives the company room to borrow more money for future expansion and for investing in opportunities that may arise in the future. Evaluation of cash flow and liquidity is of great significance (Fraser & Ormiston, 2010).
The case study shows that Chemalite Inc. generated positive cash flow during the two accounting periods. At the end of the financial year, the company had a cash balance of $113,000. The value is quite favorable for a new company. Further, a review of the transactions for the first year shows that the company did not have liabilities. This translates to a high liquidity level. Therefore, zero debt, high liquidity, positive cash flow, and a high solvency level will give the company stability and an opportunity to grow in the future. Therefore, a review of profitability and solvency shows that the company should continue its operation in 2004 and beyond.
The calculations in the sections above show that Chemalite Inc. has a good financial performance in terms of profitability and solvency (Atrill, 2009). The future of the business is bright because currently, they have an order for The Olympic Games, Athens. The Olympics Committee placed an order for 60,000 Chemalites. The price of each Chemalite is $1.50. This shows that the company will earn revenue of $90,000 from the order in 2004. Besides, this order will improve the publicity of the product and the bottom line. Further, a review of the inventory shows that the company had a balance of 55,000 raw materials. This will enable the company to manufacture more than enough Chemalites for this order. Therefore, the company has a high potential of generating more profit at the beginning of 2004. Another area to look at is the duration of the patent. The patent is still valid for an additional four years. Thus, the company has four years to be the sole producer of Chemalites and to build to their brand. This will grant the company a competitive advantage in the market at the end of the five years.
Thirdly, the value of the prototype is likely to go up. This has the potential of increasing the future bottom line of the company. Therefore, the business should continue because it has a bright future (Arnold, 2008).
Arnold, G. (2008). Corporate financial management. United States: Pearson Publishers.
Atrill, P. (2009). Financial management for decision makers. United States: Pearson Publishers.
Clarke, E. (2012). Accounting: An introduction to principles and practice. USA: Cengage Learning.
Collier, P. (2009). Accounting for managers. London: John Wiley & Sons Ltd, London.
Fraser, L. M., & Ormiston, A. (2010). Understanding financial statements. Upper Saddle River, NJ: Prentice-Hall.