PROFITABILITY ANALYSIS HAWTHORNE BUSINESS INSTRUMENTS In late September 1990, Billy Edwards, vice president of finance for...

  

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PROFITABILITY ANALYSIS HAWTHORNE BUSINESS INSTRUMENTS In late September 1990, Billy Edwards, vice president of finance for Hawthorne Busi- ness Instruments, was preparing for the October meeting of the finance committee. He examined various sources of funds available to finance the company's capital expansion and reviewed the company's financial statements (see Exhibit 1) with an eye toward establishing a new working capital policy. Hawthorne Business Instruments was founded in 1952 by Tessie Barnes to produce manual typewriters. Through the 1950s and 1960s, the company grew at a rapid pace, expanding its product line to include manual calculators and other business instru- ments. But the company's growth then stagnated until the late 1970s, when electric typewriters and calculators replaced their manual counterparts as the company's major products. Hawthorne Business has expanded rapidly since 1978, when its first plant was established in Raleigh, North Carolina, to produce a new generation of business instruments. The company placed two other plants on line in 1988, one in Richmond, Virginia, and another in South Carolina. Hawthorne Business' major problem has been increasing production fast enough to meet the demand for its products. The company's capacity has been expanded steadily since 1988, but it has often lost sales because of insufficient production. Recognizing this problem, Jeanette Amoroso, president and chief executive officer, called a meeting of the finance committee to consider ways to increase production and to review financing alternatives proposed by Mr. Edwards. The meeting was attended by Jeanette Amoroso, president; Billy Edwards, vice president of finance; Courtney Cole, vice president of marketing; and Evan Weinstein, director and banker. Courtney Cole reported that the company needs a new plant to produce enough typewriters and calculators to meet market demand. She also said that the company will have to diversify into the mini and desk computer field in the near future because 19ajor competitors have expanded their product line to include this product since 1986. Evan Weinstein agreed that it is important for Hawthorne Business to expand its production capacity, but he indicated that it would be very difficult to obtain long-term debt financing at the present time. Because the company's debt ratio is the same as the industry average, he felt that long-term lenders would demand a healthy risk premium on the new debt. He proposed that the capital expansion be financed by a new issue of common stock. 394 PART 2: CASE STUDIES Jeanette Amoroso interrupted at this point and stated that a common stock offering was perhaps out of the question for two reasons. First, the sale of new common stock is not desirable because it was currently selling in the over-the-counter market at $12 per share, which is at least a three-year low. Second, most current stockholders are not in a position to purchase additional common stock, and the sale of new common stock to outsiders would produce a significant dilution of earnings and control. Exhibit 1 Hawthorne Business Instruments Financial Data for Year-Ending August 30, 1990 A. Current assets Net fixed assets Balance Sheet Total assets. Current liabilities (8%) Long-term debt (10%) Common equity Total liabilities & common equity B. Income Statement Sales Operating expenses Earnings before interest & taxes Interest Taxable income Taxes (50%) Earnings after taxes C. Key Ratios Current ratio Return on common equity Operating expenses to sales Debt to total assets Midwest Business $4,320,000 6.480,000 $ 10,800,000 $ 1,404,000 4,320,000 5.076.000 $ 10,800,000 $14,400,000 12.240.000 $2,160,000 544.320 $1,615,680 807,840 $ 807,840 3.08x 15.92% 85.0% 53.0% Percent of Industry Total Averages 40% 60% 100% 13% 40% 47% 100% 30% 70% 100% 13% 40% 47% 100% 2.31x 13.85% 85.0% 53.0% Case Study 3: Profitability Analysis 395 Billy Edwards, who has responsibility for accounting and finance, entered the discus- reduction of dividend payments were probably also out of the question. Restrictions in sion at this point and stated that other financing alternatives such as leasing and the the company's long-term debt agreements made lease financing practically impossible. The company cannot reduce its dividend payments drastically without risking further declines in its stock price. Thus, Mr. Edwards said that the best way to obtain funds for the company's capital expansion would be in the working capital area. Cur- rent liabilities might be increased and/or current assets might be decreased to produce the necessary funds. Mr. Edwards proposed three working capital policies for consideration: (1) a conservative policy that would maintain the current working capital structure; (2) an intermediate policy that calls for reducing current assets to the industry average percentage with no change in current liabilities; and (3) a liberal policy that calls for reducing current as- sets by 20 percent and increasing current liabilities by 20 percent. Long-term debt and common equity would be maintained at present levels under all of these policies. The intermediate policy is expected to increase sales by 5 percent, and the liberal policy is expected to increase sales by 10 percent. All finance committee members except Billy Edwards indicated apprehension about any change in working capital policy, but agreed to postpone the final decision on this matter until Mr. Edwards could prepare a more detailed analysis of the possibilities. QUESTIONS 1. Prepare an exhibit that will show (a) the balance sheet, (b) the income statement, and (c) the key ratios for each policy. 2. As current ratio is a measure of liquidity adequacy, does it mean the higher the current ratio, the better position the company is in? 3. Discuss the risk-return tradeoff among the alternative policies. 4. Which of the three alternatives should Mr. Edwards recommend at the next meeting? PROFITABILITY ANALYSIS HAWTHORNE BUSINESS INSTRUMENTS In late September 1990, Billy Edwards, vice president of finance for Hawthorne Busi- ness Instruments, was preparing for the October meeting of the finance committee. He examined various sources of funds available to finance the company's capital expansion and reviewed the company's financial statements (see Exhibit 1) with an eye toward establishing a new working capital policy. Hawthorne Business Instruments was founded in 1952 by Tessie Barnes to produce manual typewriters. Through the 1950s and 1960s, the company grew at a rapid pace, expanding its product line to include manual calculators and other business instru- ments. But the company's growth then stagnated until the late 1970s, when electric typewriters and calculators replaced their manual counterparts as the company's major products. Hawthorne Business has expanded rapidly since 1978, when its first plant was established in Raleigh, North Carolina, to produce a new generation of business instruments. The company placed two other plants on line in 1988, one in Richmond, Virginia, and another in South Carolina. Hawthorne Business' major problem has been increasing production fast enough to meet the demand for its products. The company's capacity has been expanded steadily since 1988, but it has often lost sales because of insufficient production. Recognizing this problem, Jeanette Amoroso, president and chief executive officer, called a meeting of the finance committee to consider ways to increase production and to review financing alternatives proposed by Mr. Edwards. The meeting was attended by Jeanette Amoroso, president; Billy Edwards, vice president of finance; Courtney Cole, vice president of marketing; and Evan Weinstein, director and banker. Courtney Cole reported that the company needs a new plant to produce enough typewriters and calculators to meet market demand. She also said that the company will have to diversify into the mini and desk computer field in the near future because 19ajor competitors have expanded their product line to include this product since 1986. Evan Weinstein agreed that it is important for Hawthorne Business to expand its production capacity, but he indicated that it would be very difficult to obtain long-term debt financing at the present time. Because the company's debt ratio is the same as the industry average, he felt that long-term lenders would demand a healthy risk premium on the new debt. He proposed that the capital expansion be financed by a new issue of common stock. 394 PART 2: CASE STUDIES Jeanette Amoroso interrupted at this point and stated that a common stock offering was perhaps out of the question for two reasons. First, the sale of new common stock is not desirable because it was currently selling in the over-the-counter market at $12 per share, which is at least a three-year low. Second, most current stockholders are not in a position to purchase additional common stock, and the sale of new common stock to outsiders would produce a significant dilution of earnings and control. Exhibit 1 Hawthorne Business Instruments Financial Data for Year-Ending August 30, 1990 A. Current assets Net fixed assets Balance Sheet Total assets. Current liabilities (8%) Long-term debt (10%) Common equity Total liabilities & common equity B. Income Statement Sales Operating expenses Earnings before interest & taxes Interest Taxable income Taxes (50%) Earnings after taxes C. Key Ratios Current ratio Return on common equity Operating expenses to sales Debt to total assets Midwest Business $4,320,000 6.480,000 $ 10,800,000 $ 1,404,000 4,320,000 5.076.000 $ 10,800,000 $14,400,000 12.240.000 $2,160,000 544.320 $1,615,680 807,840 $ 807,840 3.08x 15.92% 85.0% 53.0% Percent of Industry Total Averages 40% 60% 100% 13% 40% 47% 100% 30% 70% 100% 13% 40% 47% 100% 2.31x 13.85% 85.0% 53.0% Case Study 3: Profitability Analysis 395 Billy Edwards, who has responsibility for accounting and finance, entered the discus- reduction of dividend payments were probably also out of the question. Restrictions in sion at this point and stated that other financing alternatives such as leasing and the the company's long-term debt agreements made lease financing practically impossible. The company cannot reduce its dividend payments drastically without risking further declines in its stock price. Thus, Mr. Edwards said that the best way to obtain funds for the company's capital expansion would be in the working capital area. Cur- rent liabilities might be increased and/or current assets might be decreased to produce the necessary funds. Mr. Edwards proposed three working capital policies for consideration: (1) a conservative policy that would maintain the current working capital structure; (2) an intermediate policy that calls for reducing current assets to the industry average percentage with no change in current liabilities; and (3) a liberal policy that calls for reducing current as- sets by 20 percent and increasing current liabilities by 20 percent. Long-term debt and common equity would be maintained at present levels under all of these policies. The intermediate policy is expected to increase sales by 5 percent, and the liberal policy is expected to increase sales by 10 percent. All finance committee members except Billy Edwards indicated apprehension about any change in working capital policy, but agreed to postpone the final decision on this matter until Mr. Edwards could prepare a more detailed analysis of the possibilities. QUESTIONS 1. Prepare an exhibit that will show (a) the balance sheet, (b) the income statement, and (c) the key ratios for each policy. 2. As current ratio is a measure of liquidity adequacy, does it mean the higher the current ratio, the better position the company is in? 3. Discuss the risk-return tradeoff among the alternative policies. 4. Which of the three alternatives should Mr. Edwards recommend at the next meeting?

Answer rating: 100% (QA)

Here is an exhibit that will show the balance sheet income statement and the key ratios for each policy Policy Balance Sheet Income Statement Key Ratios Conservative Current assets 1592M Operating ear... View the full answer