Ratio Analysis_Holly Fashion - CASE 6Billiondollar apparel...

Ratio Analysis_Holly Fashion
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Unformatted text preview: CASE 6Billiondollar apparel companies such as Calvin Klein and Liz Claiborne areunusual in the garment industry, which consists primarily of much smallerapparel makers. One such firm is Holly Fashions (HF), located in Cherry Hill,New Jersey. HF was started 14 years ago by William Hamilton and John White,who between them had over 25 years of experience with a major garment man-ufacturer. And the partnership initially blended very well. Hamilton, reservedand introspective, is extremely creative with a real flair for merchandising andtrend spotting. Mainly as a result of his genius, the HF label is synonymouswith quality and in fashions. White, outgoing and forceful, has contributedimportant merchandising and marketing ideas, but has mainly assumed theduties of the firms chief operating officer.Hamilton has had little interest in the financial aspects of the company, muchpreferring to work on designing new fashions and the development of market-ing strategies. A few months ago, however, he decided that he had betterbecome more involved with the company's financials.His motivation is twofold. First, he is considering the sale of his 50 percentinterest in HF. Though he enjoys the creative side of the business, he is tired ofthe cash crunches that the firm has experienced in recent years. Periodically, theretailers HF deals with have encountered financial problems and have strungout their payments, which often caused a mad scramble for cash at HF. And ifHamilton decides to sell, he knows that he is likely to be involved in somestressful negotiations surrounding the companys value. Though he would hirea consultant to aid him in any negotiations, he decides it is a good idea to edu-cate himself about HFs financials.Another reason that Hamilton is interested in the firms financials is so hecan better judge the managerial competence of White. When HF was smallHamilton thought White did a fine job, but now he wonders whether White iscapable of running a firm as large as HF. Actually, if Hamilton were convincedthat White is a competent manager, he would not consider selling out since he 36PART II FINANCIAL ANALYSISgenuinely enjoys being an owner of an apparel firm. But he thinks the apparelindustry will face even tougher times in the next few years, and wonders ifWhite is talented enough to successfully meet these challenges.BORROWING CONCERNSWhites personality is such that he makes virtually all major operating andfinancial decisions. An important example of this was his decision three yearsago to retire all long-term debt, a move triggered by Whites fear that HFs busi-ness risk was increasing. He cited the difficulties of seemingly rocksolid retail-ers like Bloomingdales and Campeau to support his claim. White is alsoconcerned that firms the size of HF have had difficulty maintaining stable bankrelationships. Due to increasingly strict federal regulations, some banks havecalled in loans at the slightest technicality, and most are scrutinizing new busi-ness loans very carefully. Consequently White views bank debt financing asunreliable and thinks that loan officers are capable of chewing up my time.Hamilton isnt sure what to make of these arguments, but he is concerned thatthis debt avoidance has significantly reduced HFs financial exibility because itmeans that all projects will have to be equity financed. In fact, over the past fiveyears there have been no dividends because all earnings have been reinvested.And two years ago each of the partners had to contribute $15,000 of capital in orderto meet the companys cash needs. Another infusion of capital may be necessarysince the firms present cash position is low by historical standards. (See Exhibit 2.)More importantly, however, Hamilton feels that the company is not benefit-ing from the leverage effect of debt financing, and that this hurts the profita-bility of the firm to the two owners.WORKING CAPITAL CONCERNSHamilton suspects that HFs inventory is excessive and that capital is unnec-essarily tied up in inventory. Whites position is that a large inventory is nec-essary to provide speedy delivery to customers. He argues that our customersexpect quick service and a large inventory helps us to provide it.Hamilton is skeptical of this argument and wonders if there isnt a moreefficient way of providing quicker service. He knows that a consultant recom-mended that HF very seriously consider building a state-ofthe-art distributioncenter. The proposed facility would allow HF to reduce inventory and alsohandle big orders from retailers such as Kmart and Wal-Mart. White rejected thesuggestion arguing that the estimated $5-million to $8-million cost is excessive.Hamilton also questions Whites credit standards and collection procedures.Hamilton thinks that White has been quite generous in granting paymentextensions to customers, and at one point nearly 40 percent of the companysreceivables were more than 90 days overdue. Further, White would continue to CASE 6 HOLLY FASHIONS 37accept and ship orders to these retailers even when it was clear that their abil-ity to pay was marginal. Whites position is that he doesnt want to lose salesand that the rough times these retailers face are only temporary.Hamilton also wonders about the wisdom of passing up trade discounts. HEis frequently offered terms of 1 / 10, net 30. That is, the company receivesa 1percent discount if a bill is paid in ten days and in any event full paymentis expected within 30 days. White rarely takes these discounts because hewants to hold onto our cash as long as possible. He also notes that "the dis-count isnt especially generous and 99 percent of the bill must still be paid.FINAL THOUGHTSDespite all of Hamiltons concerns, however, the relationship between the twopartners has been relatively smooth over the years. And Hamilton admits thathe may be unduly critical of Whites management decisions. After all,he con-cedes, the man seems to have reasons for what he does, and we have been inthe black every year since we started, which is an impressive record, really, fora firm in our business.Further, Hamilton has discussed with two consultants the possibility of selling his half of the firm. Since HF is not publicly traded, the market value of thecompanys stock must be estimated. These consultants believe that HF is worthbetween $55 and $65 per share, figures that seem quite good to Hamilton.QUESTIONS1. Calculate the firms 1996 ratios listed in Exhibit 3.2. Part of Hamiltons evaluation will consist of comparing the firms ratios tothe industry numbers shown in Exhibit 3.(a) Discuss the limitations of such a comparative financial analysis.(b) In View of these limitations, why are such industry comparisons sofrequently made?3. Hamilton thinks that the profitability of the firm to the owners has been hurtby Whites reluctance to use much interest-bearing debt. Is this a reasonableposition? Explain.4. The case mentions that White rarely takes trade discounts, which aretypically 1 / 10, net 30. Does this seem like a wise financial move? Explain.5. Calculate the companys market-to-book (MV/BV) ratio. (There are 5,000shares of common stock.)6. Hamiltons position is that White has not competently managed the firm.Defend this position using your previous answers and other information inthe case. 38PART II FINANCIAL ANALYSIS7. Whites position is that he has effectively managed the firm. Defend thisposition using your previous answers and other information in the case.8. Play the role of an arbitrator. Is it possible based on an examination of thefirms ratios and other information in the case to assess Whites managerialcompetence? Defend your position.9. (a) Are the ratios you calculated based on market or book values? Explain.(b) Would you prefer ratios based on market or book values? Explain. EXHIBIT 1Holly Fashions Income Statements: 19931996 (0005)I993 I994 I995 1996Sales $985.0 $1,040.0 $1,236.0 $1,305.0Cost of goods 748.6 774.8 928.2 9788Gross margin 236.4 265.2 307.8 326.3Administrative 169.4 202.8 236.1 249.3Depreciation 10.8 11.4 13.6 14.4EBIT 56.1 51.0 58.1 62.6Interest 7.0 6.0 5.0 4.0EBT 49.1 45.0 53.1 58.6Taxes 19.7 18.0 21.2 23.5Net income $27.0 $31.9 $35.2EXHIBIT 2Balance Sheets of the Holly Fashions Company: 19931996 (0005)I993 I994 1995 1996ASSETSCash $40.4 $51.9 $38.6 $10.6Receivables 153.2 158.9 175.1 224.8Inventory 117.0 121.1 193.4 191.9Other current 5 9 6.2 7.4 7.8Current assets 316 5 338.0 414 5 435.1Gross fixed 44 8 58.9 78 1 96 4Accumulated depreciation (12.0) (23.4) (37.0) (51 4)Net fixed 32.8 35.5 41.1 45.0Total assets $349 3 $373.5 $455 5 $4801(continued) CASE 6 HOLLY FASHIONS 39 EXHIBIT 2(Continued)I993 I994 1995 1996LIABILITIES 8: NET WORTHAccounts payable $53.8 $54.7 $86.2 $84.2Debt due 10.0 10.0 10.0 10.0Accruals 19.7 26.0 24.7 26.1Current liabilities 83.5 90.7 120.9 1203Longterm debt 60.0 50.0 40.0 30.0Common stock 150.0 150.0 180.0 180.0Retained earnings 55.8 82.8 114.6 149.8Total L&NW EXHIBIT 3Financial Ratios for the Holly Fashions Company: 19931996Industry(Present) Average1993 I994 1995 I 996 199371996Liquidity Ratios2.6Current 3.8 3.7 3.4 1.71.31.6Quick 2.4 2.4 1.8 .8.6Leverage Ratios41Debt(%) 41.1 37.7 35.3 5771Times interest 7.4earned 8.0 8.5 11.6 3.91.3Activity RatiosInventory Turnover 8.1(CGS) 6.4 6.4 4.8 6.03.5Fixed Asset 40Turnover 30.0 29.3 30.1 2512Total Asset 3.5Turnover 2.8 2.8 2.7 2.820(continued) 40 PART II FINANCIAL ANALYSIS EXHIBIT 3(Continued)Industry(Present) Average1993 1994 I995 I996 19931996*Average Collection 41Period 56 55 51 5068Days Purchases 18OutstandingM 25 22 31 2532Profitability Ratios 28Gross Margin ("/o) 24.0 25.5 24.9 26244.2Net Profit Margin (0/0) 3.0 2.6 2.6 3.11.2273Return on Equity (0/0) 14.3 11.6 10.8 19.57.8Return on Total 11.8Assets (0/0) 8.4 7.2 7.0 8.73.49.9Operating Margin*** (0/0) 6.8 6.0 6.1 7.23.1*The three numbers for each ratio are computed in the following way. Ratios for all firms in the industry arearranged in what is considered a strongestto-weakest order. The middle number represents the median ratio;that is, half the firms in the industry had ratios better than the median ratio and half had ratios that were worse.The top number represents the upper quartile figure, meaning 25 percent of the firms had ratios better than this.The lower number represents the lowest quartile, that is, 25 percent of the firms had ratios worse than this.MThis shows the average length of time that trade debt is outstanding. Also called the average payment period.Calculated as A/P + (CGS/360).***Calculated as (EBIT + Dep) / Sales....
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