Case 73-2: Amerbran eB)

Note: This case is unchangedfront the Eleventh Edition.

Approach

This is a straightforward exercise in calculating various ratios for two years' of an actual company's (American Brands) financial statements. Although the numbers have been revised, the magnitudes and relationships have been preserved. (Most of the data appear in Exhibit 1 of Amerbran Company (A).) I discuss question 1 after the gross margin percentage has been calculated, and question 2 after all of the ratios have been presented. It is worthwhile to have students give the definition of each ratio and a brief statement as to what it indicates before presenting their numbers for the ratio for space each year.

The required calculations are shown in the table below. The only tricky one is days' cash. For 20xO, no information is available in either the (A) or (8) case to estimate cash expenses. For 20xl, two approaches are available. One is to use the "quick and dirty" estimate of total expenses less depreciation (given in item 1 of the (A) case), which results in an estimate of$7,177,930; this is the approach taken for 20x] in the table below. Of course, a better option would be to use a variation on the approach from preparing the cash flow statement for the (A) case: Cash generated by operations was $574,128. Collections would have been sales less the increase in accounts receivable: $7,622,677 - $68,827 = $7,553,850. Thus cash expenses would have been $7,553,850 - $574,128 = 6,979,722. With this number the 20x] days' cash result would have been 1.51 days. For 20xO, the approach taken here was to take 20x] depreciation, $115,974 and multiply it by the ratio of 20xO to 20x] property, plant, and equipment (at cost), giving an estimate of $1 0 1,198. Other approaches are also possible, but aren't likely to change the result very much

, since depreciation is such a small percentage of total expenses (1.6 percent in 20xl).

Question J

Some years ago in looking at some oil company annual reports, I discovered (to my surprise) that there was not uniform treatment of excise taxes on gasoline. Some companies included excise taxes in revenues and then subtracted them below the gross margin line as a period cost (nonincome tax expense). Other compan ies ignored excise taxes altogether in their statements, reflecting the view that the company was in effect an involuntary tax collector and that the taxes collected were neither revenues 110r expenses to the firm, (I personally support this view.) The pretax income reported by the two approaches is identical, but the absolute amount of revenues is inflated by the first approach, thus affecting the gross margin percentage (and any other ratio that involves revenues in its calculation).

Arnerbran Company collects excise taxes on tobacco products and uses the approach of including the excise taxes in revenues and subtracting them as an expense-s-but with the twist of treating the taxes as a product cost (pregross margin) rather than as a period cost. This approach results in the same absolute amount of gross margin as if the taxes were ignored altogether. However, it makes the company's sales look greater by a significant amount: in 20xO, revenues excluding the taxes would have been $4,223,130, or 36 percent lower than the amount reported. On the other hand, treating the taxes as a product cost reduces the gross margin percentage, For example, with the taxes included in revenues but subtracted below the gross margin line, in 20xO the percentage would have been $4,004,] 30/ $6,577,480 = 60.9%; and with the taxes ignored altogether the percentage would have been $],649,780/ $4,223,]30 = 39.1%. As treated by Arnerbran, the 20xO gross margin percentage was 25.1 %. Thus, one must speculate that the company sees some advantage in trying to downplay (i.e., understate) its actual margin while at the same time overstating its size (revenues).

'This teaching note was prepared by James S. Reece. Copyright r() James S. Reece.

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Question 2

This question is intended to get students to think about the ratios, not just mindlessly calculate them. It also suggests that ratio analysis raises questions, but it seldom automatically answers them, and that some important questions are only indirectly related to the ratios. The overriding question is why net income was down 13 percent from 20xO to 20xl while revenues (including excise taxes) were up ]6 percent: this is directly reflected in the decreased net income percentage (return on sales) ratio. (I stress that though this ratio is clown only 1.45 percentage points, this is a decrease in the ratio of 25 percent.) This profit margin question also at least indirectly relates to the downward trend in interest coverage, ROA, and ROE. In fact, improved asset turnover (as well as equity turnover, which students weren't asked to calculate) helped offset part of the effect on ROA (and ROE) of the lower profit margin. Since the gross margin percentage actually increased slightly in 20xl, the explanation of the narrowed profit margin must lie in SG&A expenses, which were 14.8 percent of sales in 20xO but 17.4 percent in 20xl. The decline in the current and acid-test ratios may not be a concern, but rather may simply reflect better credit and inventory management (notice that collection periocl---days' receivables-----is clown and inventory turnover is up). Financial leverage as measured by the debt/capitalization ratio has declined a bit, but even in 20xO was at a relatively safe level for a firm of this basic stability.

Definition 20xO 20xl
Return [Net Income + [$378,782 + [$328,773 -
on Assets ....... Interest $105,165 $102,791
*(1- Tax Rate)] *(l-.4394)L __ = 0.0987 *(1-.4551)] = 00797
Total Assets $4,433,448 = 9.87% $4,826,512 =: 7.97%
2 Return Net Income $378,782 $328,773
on Equity ....... = .1735 =0.1417
Shareholders' $2,182,869 $2,320,620
Equity 17.35 14.17
% %
3 Gross Gross Margin $1,649,780 $1,931,438
Margin = 0.2508 = 0.2534
Percentage ..... Net Sales Revenue $6,577,480 $7,622,677
25.08 25.34
% %
4 Return Net Income $378,782 $328,773
011 Sales ......... = 0.0576 = 0.0431
Net Sales Revenue $6,577,480 = 5.76% $7,622,677 4.31%
5 Asset Sales Revenue $6,577,480 $7,622,677
Turnover ....... =1.48 = 1.58
-~--"----
Total Assets $4,433,448 Times $4,826,512 Times
6 Days' Cash $23,952 $28,912
Cash .............. = 1.43 =1.47
Cash Expenses / ($6,198,698 - Days ($7,293,904 - Days
365 $101,198)/365 $115,974/365
7 Days' Accounts $687,325 $756,152
Receivables ... Receivable = 38.1 = 36.2
Sales / 365 $6,577,480/365 Days $7,622,677/365 Days 228

8 D8ys' Inventory $1,225,402 $1,244,912
Inventories .... = 173.8 = 162.1
~-----.--- ----,.
Cost of sales / 365 $2,573,350/365 Days $2,803,623/365 Days
9 Inventory Cost of Sales $2,573,350 $2,803,623
Turnover ....... =2.10 = 2.25
. ----- --- .
Inventory $1,225,402 Times $1,244,912 Times
Current Current Assets $2,013,846 $2,106,116
0 Ratio .............. = 1.53 = 1.30
._---
Current Liabilities $1,3 17,751 $1,625,218
Acid- Test Monetary Current $711,277 $785,064
Ratio ............. Assets = 0.54 = 0.48
Current Liabilities $1,317,751 1,625,218
1 Debt/ Noncurrent $932,828 $880,674
2 Capitalizatio Liabilities = 0.2994 = 0.2751
n
Ratio ............. (Noncurrent $932,828 + 29.94 $880,674 -I- 27.51
Liabilities $2,182,869 % $2,320,620 %
+ Shareholder's
Equity)
I Times Pretax Operating
3 Interest Profit $675,659 + $105,165 $603,331
Earned ........... -I- Interest = 7.42 $102,791 = 6.87
Interest $]05,165 times $102,791 Times Case 13-3: Iden/ifF the Industries-1996*

Note: Unchanged front the Eleventh Edition.

Approach

This case is effective as an exercise to reinforce concepts learned in a financial accounting course oriented toward user understanding. While it could be used as a take-home exercise, I have found it most useful as an in-class group exercise. Students can be divided into groups of four to six, given the case, and sent off to break-out r00111S for approximately 45 minutes. This is sufficient time to identify many of the industries, and allows time for class discussion afterwards for a total class time of an hour and a half. Before the groups leave the room, instruct them to have one person assigned to return to the room and write that group's answers in a column on the board in this format

-This leaching note was prepared by Professor Sharon M. McKinnon of Northeastern University. Copyright ri;) 1997 by the President and Fellows of Harvard College Harvard Business School Teaching Note 5·198-018.

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;;:1,

GROLJP x

A - chemical company B - autorn aker, etc.

When the groups return and the results are in columns on the board, the discussion can take several forms. I'vc found it very successful to encourage the natural rivalry in the room by keeping score and allowing lots of leeway in the level of boisterous comments made by the groups to each other. The students have a lot of fun, but at the same time see how difficult the task is when they discover the differences between their choices. The success rate tends to be fairly low.

One way to proceed is to see how many groups successfully identified the bank, which should be the most obvious company. How can you find the bank? As a successful robber said when asked why he robbed banks, "because that's where the money is." The groups who fail to find the bank generally suffer great embarrassment and jeers from their peers.

However the instructor proceeds, it is useful to follow a plan for identifying groups of industries with similar types of characteristics and working in a systematic way to identify and eliminate possibilities. Following is one plan for solving the puzzle.

1. Isolate the service firms by the N.M. (not meaningful) inventory turnovers and their usually low or nonexistent inventories. There are five of these, A, E, G, J, and K. There are also five service firms on the list on page one of the case: Airline, Bank, Hospital, Hotel, and Temporary Office Personnel.

A) Find the bank: Banks have high cash, receivables, and deposits (accounts payable), which eliminates all but E. E = bank.

B) Which of the remaining four industries have high investment in property, plant, and equipment? Hotels, Airlines, and Hospitals. The letters of the high PPE companies left without meaningful inventories are A, G, J and K.

I. A has significant unearned revenues. This sounds like an airline which gets paid in advance of travel. It also might sound like a for-profit hospital which has a prepayment plan like an HMO. However, 1110st hospitals are paid by HMOs, insurers, and Medicare at or after treatment, so A must be the airline.

2. There are very few differences between G and J which makes some sense because hotels and hospitals are very sim ilar in many ways. The I ittle differences lean toward choosing G as the hotel and J as the hospital. Hospitals probably have more receivables. Also, big for-profit hospital companies have expanded greatly through acquisitions, producing a high likelihood of substantial goodwill.

C) The remaining service firm is K which must be the Temporary Office Personnel firm. It also has lots of cash and payables and this makes sense.

II. Find the warehouse club and department stores through high inventories and high inventory turnovers, with some substantial fixed assets. These three firms are D, F, and L. B has significant inventory but it's hard to imagine a grocery store or department store with only 2.5 inventory turnovers per year. There's also a subtle hint in the titles, in that these three have January and September year-ends.

A) The upscale department store is different in nature from both a warehouse club and a discount department store in that it might service its own receivables and it would have fewer inventory turns. This means D = upscale store.

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B) The only major difference between F and L is the inventory turns. Since warehouse clubs arc like grocery stores, it makes sense that L is the warehouse club and F the discount department store.

III. The remaining firms are the utility, the oil company, the consumer products producer and the defense contractor.

A) Two of these (C and I) have very, very high plant and equipment and one of these should be the utility. The major clues are in stockholders' equity. Utilities c01111110nly have preferred stock as in I, but they do not usually have retained earnings of the level ofC because they are regulated industries with standard rates of return on assets. So I = utility.

B) Of the three remaining (B. C, and H), all are similar except that C has so much PPE, but all three are industries that seem like they would have high investment in this area. There is a clue in the descriptions that the oil company is international and that retained earnings adjustments are foreign translation adjustments. So maybe the oil company is either C or H. C has 1110re P&E but fewer inventories. An argument could be made that oil companies have fewer inventories in relation to the other two industries, and lots of tankers. This is a good argument for C = oil companies.

C) So the last call to make is between Band H, the defense contractor or the consumer products manufacturer. The high inventories and low inventory turnover of B are keys that B = defense contractor.

Solution

A = Airline = Delta

B = Defense contractor = Raytheon C = Oil Company = Exxon

D = Upscale department stores = Nordstrom E = Bank = Baybanks

F = Discount department store = WalMari

G = Hotel = Hilton

H = Consumer products = Colgate Palmolive I = Utility = Boston Edison

J = Hospital = Columbia/HCA

K = Personnel temps = Kelly Services L = Warehouse club = Price/CostCo

Case 13-4: Supplement to Jelen/in' the Industries *

Note: Unchanged from the Eleventh Edition. Approach

This case is a supplement to "Identify the Industries" case, It can be used as an in-class test of the students' ability to apply the lessons learned in "Identify the Industries" case. The industries listed on Exhibit I are:

A. Coal-carrying railroad

B. Automobile manufacturer

C. Basic chemicals

D. Meat packer

E. Retail jewelry chain

F. Maker of men's apparel

G. Advertising agency

The students quickly identify the meat packers high turnover of inventory and total assets) as "D."

'Copyright :g J 995 by the President and Fellow of Harvard College. Harvard Business School Teaching Note 5-196-107.

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Two of the industries CA" and "G") have no inventories. The advertising agency is identified as "G" (service industry, high receivables representing pass-through client advertising billings and low plant and eq u iprnent).

The coal carrying railroad is "A" (by elimination and confirmed by the high plant and equipment). The remaining four industries ("B," "C," "E," and "F") are more difficult to identify. "B" is the automobile manufacturer (low receivables due to fact dealers are given vel)' short payment terms, highcr payables due to practice of using vendor credit as a significant source of funding, and high investment in affiliated companies, which probably is a finance subsidiary). "C" is the basic chemical company (high plant and equipment relative to the retail jewelry chain and maker of men's apparel). Of the remaining t\\70 industries CE" and "F"), "E" is the retail jewelry chain. It has higher inventory relative to "F's" (high) inventory. By eI im ination, "F" is the maker of men's apparel.

In the United States companies are required to consolidate all owned subsidiaries. As a result, finance subsidiaries are consolidated with manufacturing subsidiaries. This rule distorts industry ratio profits. To avoid this problem (i.e. an automobile manufacturer with major finance subsidiary looking like a bank), the case uses consolidated statement ratios in which the equity method is used to account for subsidiaries that are not homogenous with the industry category (i.e., the automobile manufacturer's finance subsidiary is accounted for using the equity method).

Case 13-5: Springfield Bal1k*

Note: Unchanged from the Eleventh Edition.

Approach

This case was used by Professor Ray G. Stephens in a study of the use of accounting information by bank lending officers, For a full account of the study, see Ray G. Stephens, The Uses of Financial Information in Structuring and Improving Decision Processes for Bank Lending Officers (an unpublished thesis, Harvard Business School). The data for Dawson Stores, Inc., are the consolidated 1974 - 77 financial statements for Dayton-Hudson Corporation, multipl ied by 13 and /1,000.

Excerpts from interviews with three loan officers are given below to indicate the diversity of approaches to the problem, (The loan officers reviewed the data before the rnultiplier effect used in this case.) In addition, students can act as Joan officers, presenting various arguments supported by ratio analysis,

Loan Officer B

Loan Officer B reael the first two pages of the empirical study problem and turned to the financial statements. In examining the financial statement, he noted: (1) accounts receivable were up, (2) company had deferred taxes 011 installment sales which he inferred meant that they were seiling fixed assets off. (3) questioned the accounts receivable as he would think that the company would be primarily a cash business, (4) wondered what the bad debt write-offs were, (5) wondered whether the company would be better off factoring accounts receivable, (6) was curious about the purpose of the requested line of credit because of the nonutilization of bank credit in the past, but felt that it would be a desirable account from the deposit balances, ane! (7) wondered to whom the long-term debt was owed, At this point Loan Officer 13 felt that he could not make a decision about the extension of credit without further clarification on four issues: (1) What were the credit terms of Dawson stores, Inc.? (2) Had the company changed stores recently? (3) Who was the lender 011 the long-term debt? and (4) What did the company feel was the purpose of the request for funds and when would the funds be usee! and repaid?

'This teaching note was prepared by Ray O. Stephens. Copyright © Ray G. Stephens.

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