Unformatted text preview: CASE 6
Billiondollar apparel companies such as Calvin Klein and Liz Claiborne are
unusual in the garment industry, which consists primarily of much smaller
apparel 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, reserved
and introspective, is extremely creative with a real flair for merchandising and
trend spotting. Mainly as a result of his genius, the HF label is synonymous
with quality and in fashions. White, outgoing and forceful, has contributed
important merchandising and marketing ideas, but has mainly assumed the
duties of the firms chief operating officer.
Hamilton has had little interest in the financial aspects of the company, much
preferring to work on designing new fashions and the development of market-
ing strategies. A few months ago, however, he decided that he had better
become more involved with the company's financials.
His motivation is twofold. First, he is considering the sale of his 50 percent
interest in HF. Though he enjoys the creative side of the business, he is tired of
the cash crunches that the firm has experienced in recent years. Periodically, the
retailers HF deals with have encountered financial problems and have strung
out their payments, which often caused a mad scramble for cash at HF. And if
Hamilton decides to sell, he knows that he is likely to be involved in some
stressful negotiations surrounding the companys value. Though he would hire
a 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 he
can better judge the managerial competence of White. When HF was small
Hamilton thought White did a fine job, but now he wonders whether White is
capable of running a firm as large as HF. Actually, if Hamilton were convinced
that White is a competent manager, he would not consider selling out since he 36
PART II FINANCIAL ANALYSIS
genuinely enjoys being an owner of an apparel firm. But he thinks the apparel
industry will face even tougher times in the next few years, and wonders if
White is talented enough to successfully meet these challenges.
Whites personality is such that he makes virtually all major operating and
financial decisions. An important example of this was his decision three years
ago 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 also
concerned that firms the size of HF have had difficulty maintaining stable bank
relationships. Due to increasingly strict federal regulations, some banks have
called in loans at the slightest technicality, and most are scrutinizing new busi-
ness loans very carefully. Consequently White views bank debt financing as
unreliable 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 that
this debt avoidance has significantly reduced HFs financial exibility because it
means that all projects will have to be equity financed. In fact, over the past five
years 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 order
to meet the companys cash needs. Another infusion of capital may be necessary
since 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 CONCERNS
Hamilton 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 customers
expect quick service and a large inventory helps us to provide it.
Hamilton is skeptical of this argument and wonders if there isnt a more
efficient way of providing quicker service. He knows that a consultant recom-
mended that HF very seriously consider building a state-ofthe-art distribution
center. The proposed facility would allow HF to reduce inventory and also
handle big orders from retailers such as Kmart and Wal-Mart. White rejected the
suggestion 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 payment
extensions to customers, and at one point nearly 40 percent of the companys
receivables were more than 90 days overdue. Further, White would continue to CASE 6 HOLLY FASHIONS 37
accept 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 sales
and that the rough times these retailers face are only temporary.
Hamilton also wonders about the wisdom of passing up trade discounts. HE
is frequently offered terms of 1 / 10, net 30. That is, the company receives
a 1percent discount if a bill is paid in ten days and in any event full payment
is expected within 30 days. White rarely takes these discounts because he
wants 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.
Despite all of Hamiltons concerns, however, the relationship between the two
partners has been relatively smooth over the years. And Hamilton admits that
he 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 in
the black every year since we started, which is an impressive record, really, for
a firm in our business.
Further, Hamilton has discussed with two consultants the possibility of sell
ing his half of the firm. Since HF is not publicly traded, the market value of the
companys stock must be estimated. These consultants believe that HF is worth
between $55 and $65 per share, figures that seem quite good to Hamilton.
1. Calculate the firms 1996 ratios listed in Exhibit 3.
2. Part of Hamiltons evaluation will consist of comparing the firms ratios to
the 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 so
3. Hamilton thinks that the profitability of the firm to the owners has been hurt
by Whites reluctance to use much interest-bearing debt. Is this a reasonable
4. The case mentions that White rarely takes trade discounts, which are
typically 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 5,000
shares 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 in
the case. 38
PART II FINANCIAL ANALYSIS
7. Whites position is that he has effectively managed the firm. Defend this
position 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 the
firms ratios and other information in the case to assess Whites managerial
competence? 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.
Holly Fashions Income Statements: 19931996 (0005)
I993 I994 I995 1996
Sales $985.0 $1,040.0 $1,236.0 $1,305.0
Cost of goods 748.6 774.8 928.2 9788
Gross margin 236.4 265.2 307.8 326.3
Administrative 169.4 202.8 236.1 249.3
Depreciation 10.8 11.4 13.6 14.4
EBIT 56.1 51.0 58.1 62.6
Interest 7.0 6.0 5.0 4.0
EBT 49.1 45.0 53.1 58.6
Taxes 19.7 18.0 21.2 23.5
Net income $27.0 $31.9 $35.2
Balance Sheets of the Holly Fashions Company: 19931996 (0005)
I993 I994 1995 1996
Cash $40.4 $51.9 $38.6 $10.6
Receivables 153.2 158.9 175.1 224.8
Inventory 117.0 121.1 193.4 191.9
Other current 5 9 6.2 7.4 7.8
Current assets 316 5 338.0 414 5 435.1
Gross fixed 44 8 58.9 78 1 96 4
Accumulated depreciation (12.0) (23.4) (37.0) (51 4)
Net fixed 32.8 35.5 41.1 45.0
Total assets $349 3 $373.5 $455 5 $4801
(continued) CASE 6 HOLLY FASHIONS 39
I993 I994 1995 1996
LIABILITIES 8: NET WORTH
Accounts payable $53.8 $54.7 $86.2 $84.2
Debt due 10.0 10.0 10.0 10.0
Accruals 19.7 26.0 24.7 26.1
Current liabilities 83.5 90.7 120.9 1203
Longterm debt 60.0 50.0 40.0 30.0
Common stock 150.0 150.0 180.0 180.0
Retained earnings 55.8 82.8 114.6 149.8
Financial Ratios for the Holly Fashions Company: 19931996
1993 I994 1995 I 996 199371996
Current 3.8 3.7 3.4 1.7
Quick 2.4 2.4 1.8 .8
Debt(%) 41.1 37.7 35.3 57
Times interest 7.4
earned 8.0 8.5 11.6 3.9
Inventory Turnover 8.1
(CGS) 6.4 6.4 4.8 6.0
Fixed Asset 40
Turnover 30.0 29.3 30.1 25
Total Asset 3.5
Turnover 2.8 2.8 2.7 2.8
(continued) 40 PART II FINANCIAL ANALYSIS
1993 1994 I995 I996 19931996*
Average Collection 41
Period 56 55 51 50
Days Purchases 18
OutstandingM 25 22 31 25
Profitability Ratios 28
Gross Margin ("/o) 24.0 25.5 24.9 26
Net Profit Margin (0/0) 3.0 2.6 2.6 3.1
Return on Equity (0/0) 14.3 11.6 10.8 19.5
Return on Total 11.8
Assets (0/0) 8.4 7.2 7.0 8.7
Operating Margin*** (0/0) 6.8 6.0 6.1 7.2
*The three numbers for each ratio are computed in the following way. Ratios for all firms in the industry are
arranged 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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