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CASE 4 HELPING HAND ACCOUNTING FUNDAMENTALS I got real lucky when I was fired, William Pendleton was fond of telling his employees and business associates. Pendleton was an insurance salesman in Illinois nea hobby, he loved to tinker around the house and he developed a local reputation as a person who knew how to fix things. Pendleton decided to capitalize on this reputation and opened a hardware store, Helping Hand, based on the phi- losophy that customers need help in selecting the right tools, parts, and materi- als for the job at hand. The philosophy was sound and subsequently a number of other stores were opened in the Midwest. rly 70 years ago and was dismissed due to insufficient sales. As a When Pendleton died in 1965, the business was sold to the Stafford family and has remained in their control ever since. The familys main contribution was to expand the product line to include building materials, and over half of the companys sales are now made to contractors. THE LETTER Sharon Vincent is the current general manager of Helping Hand, and she re- cently received a letter from the present owner, Justin Stafford. Stafford is best described as a passive stockholder who pretty much leaves the operation of the firm to Vincent. From time to time, however, he is fond of bringing in consul- tants in order to evaluate the companys performance and to help Stafford de- velop pointed questions to ask management. Apparently as a result of a recent- but not exhaustive study by one of these consultants, Stafford has raised a number of issues that he wants addressed. The three most important issues cen- ter on the firms return on equity (ROE), debt policy, and what Stafford calls a logical inconsistency in Helping Hands 1995 financial statements. 4720 PARTI FINANCE FUNDAMENTALS In the letter, dated February 9,1996, Stafford wrote Vincent that he was trou- bled by our consistently low ROE and urged Vincent to seek ways to bring this ratio at least up to industry standards. At the same time, he encouraged Vincent to minimize the firms use of debt. Stafford notes that the sales of Helping Hand are quite sensitive to economic downturns, and he believes that the company will face intense competition from nationwide chains like Lowes. Consequently he worries aboutour ability to repay what we borrow, especially during a recession. Though he is aware that the company is not highly lever- aged relative to industry standards, Stafford recommended that Vincent strongly consider (1) retiring all long-term debt as quickly as possible and (2) increasing the firms liquidity position. Actually, Vincent is quite surprised at these two suggestions. Stafford is something of a high roller and he spends much of his time racing automobiles and playing bridge and poker for large stakes. Thus Vincent is a bit amused at Staffords apparent fear of financial dis- tress, given the chances he takes driving fast cars and his willingness to risk thousands of dollars on a single hand of poker. Still, she thinks that his points are well worth Stafford is also perplexed by Helping Hands need for funds during 1995 and worries that the firm may be chewing up cash unnecessarily. He notes that 1995 was highly profitable and yet he was asked to contribute $407,000 to sup- port the companys operation. It seems illogical, Stafford wrote, for a prof itable firm to have such a need for cash. THE REACTION As Vincent reflects on Staffords letter, she decides that it is wise to develop a forecast for the coming year to see if any external funds will be needed. She re- alizes that part of the problem from Staffords point of view is that he was un- expectedly-if not inappropriately-asked to contribute capital in 1995. It is a good idea, therefore, to alert Stafford as soon as possible to any poten- tial cash shortfall in 1996. She estimates that sales in 1996 will total $24,707,000, a forecast that assumes no change in the firms credit policy. About 15 months ago she decided that the companys credit terms and standards were downright stingy and certainly more conservative than those of the competition -especially the nationwide chains. It became quite clear that Helping Hand had to loosen its credit policy in order to remain competitive. An absolutely essential defensive move, she argued at the time. The firm presently offers credit terms of 2/10, net 30 to qual- ified buyers. That is, Helping Hand offers a 2-percent discount to customers who pay within 10 days, and customers who pass up the discount are expected to pay in full within 30 days. Assuming no change in credit standards, Vincent expects that 60 percent of all sales will be on credit. She estimates that 50 percent of all credit sales will be paid on the tenth day, 40 percent on day 30, and 10 per- cent will pay late on day 40. 48CASE 4 HELPING HAND 21 Vincent also thinks that inventory control can be tightened. She intends to purge slow-moving items and use purveyors with relatively short delivery times. These changes should increase inventory turnover, and she expects that cost of goods sold divided by inventory will rise to 3. Vincents forecast of accounts payable needs to consider the easier credit terms offered by many suppliers. Two years ago about 80 percent of the firms purchases were on terms of net 30. That is, most suppliers offered no discount, and payment-in-full was expected by day 30. The remaining 20 percent were on terms of 2/10, net 30. Increased competition among hardware and lumber sup- pliers has resulted in more attractive credit terms. During the last year about half of Helping Hands purchases were made on terms of 2/10, net 30. Vincent expects this to rise to 75 percent in 1996 with the remaining 25 percent on terms of net 30 After she completes the 1996 forecast, Vincent intends to respond to Stafford?s ROE and debt concerns. Her initial reaction, though, is that Stafford is much too cautious on the issue of debt financing. In fact, she really thinks that the firm is underleveraged and should increase its debt ratio to industry standards. She re- alizes, however, that such an increase is simply out of the question unless s position softens considerably. As Vincent rereads Staffords letter she is struck by the thought that two per- fectly sane and intelligent people can look at the same number, understand com- pletely where it comes from, and yet disagree entirely on whether the number is good or bad. There is, of course, her difference with Stafford regarding the firms debt ratio. And in the same letter Stafford also noted that the firms cur- rent ratio (Current assets/Current liabilities) looked suspiciously high. Yet a few weeks ago, the firms banker complimented Vincent on Helping Hands extremely solid working capital position. QUESTIONS 1. Stafford apparently thinks that it is a good idea to increase Helping Hands liquidity position. Lets suppose that a firm increases its cash position. That is, assume that cash on a firms balance sheet increases and there is no change in any other current asset nor in any current liability (a) What will happen to the companys current rati (b) What are the advantages of an increase in liquidity? What are the dis- ra advantages? 2. Whats the problem? Tim McClinton, a store manager, asked when Sharon Vincent casually mentioned to him that new capital might be re- quired during the coming year. Ive seen our balance sheet, McClinton continued, and we seem to be rolling in dough, at least judging from the impressive amount of retained earnings. Respond to McClintons com- ments. 49

22 PART1 FINANCE FUNDAMENTALS 3. (a) Stafford thinks that it is logically inconsistent for a profitable firm to have cash problems. Is it logically inconsistent? Explain to Stafford how even a well-managed and highly profitable company can have cash flow difficulties. dends were paid in 1995 and capital spending was 165.1(000)] situation. Use this format on Helping Hand for 1995. (b) Construct Helping Hands 1995 sources and uses statement [no divi- (c) Many bankers use the format of Exhibit 3 to analyze a firms cash flow (d) Why did Helping Hand have a need for outside capital in 1995? (e) Does it appear that the firms need for outside capital in 1995 was to be expected, or does it appear that this need for cash was the result of sus- pect managerial practices? Use information in the case and any other fi- nancial statistics you think are appropriate to answer this question. 4. (a) The owner, Justin Stafford, is disturbed by the firms consistently low return on equity (ROE). At the same time, he is reluctant to use much debt. Use the Dupont system to see if these views are complementary or competing. Defend your choice. (b) Compute Helping Hands 1995 ROE. Use the Dupont system to help de- termine why the 1995 ROE differed from the industry median shown in Exhibit 4. 5. Vincent does not believe that Helping Hand is overleveraged at present. Part of her argument involves calculation of the firms debt, times interest earned (TIE) and fixed charge coverage (FCC) ratios. (a) The debt ratio was 34 percent in 1995, well below the industry average of 57 percent shown in Exhibit 4. In addition, Vincent believes that the firms debt ratio would be even lower if she adjusted for the fact that interest rates have risen since the long-term debt recorded on the balance sheet was incurred. Explain why a firms debt ratio-other relevant factors the same-will be overstated during a period of rising interest rates if it is calculated from information on the balance sheet. (Hint: consider the difference be- tween book value and market value.) (b) What are some other balance sheet items where a divergence may well exist between book and market value? (c) Vincent will compute the TIE as EBIT/INT. She doesnt like this ratio as a measure of the firms ability to meet its financial expenses since it ig- nores contractual obligations such as leasing payments (LP) and debt due (DD). She prefers to compute the fixed charge coverage as follows. FCC EBITIINT LP DDI(1 - t)] Explain why only debt due is divided by 1-t, where t is the relevant tax rate. 50

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Answer #1

Question 1(a)-In the given case,Justin Stafford thinks that it is good idea to increase Helping Hand's liquidity position by improving it's cash position.

The equation for calculating Current ratio is current assets/current liabilities,where current assets means every asset which will be converted into cash within 12 months including cash and cash equivalents and the equation for calculating Quick ratio is liquid assets/current liabilities,where liquid assets means current assets-inventory-prepaid expenses.

Therefore,when cash on firm's balance sheet increases considering the fact that there is no change in any other current assets nor in any current liability,such increase in cash will increase the current ratio as well as the quick ratio of Helping Hand

Example-If the total amount of current assets of firm X is $20000,current liabilities $7000,inventory $5000 and prepaid expenses $2000 and if firm X decides to increase the cash by $1000,the current ratio of firm will increase from 2.85714 to 3 and quick ratio will increase from 1.85714 to 2

Question 1(b)-Advantages of increase in liquidity:

1.Cushion of security- In case of any tragic event in unforeseeable future liquidity provides a safe position for the firm.Liquidity also provides other benefits of lowering the risk and an immediate access to cash in case of emergency

2.Flexibility in operations- Liquidity provides a sound financial position in case of buying assets or dealing with expenses.Many times a low reserve of liquid assets or low liquidity restricts the organisation to take benefit of any opportunity

3.Diversion of overall risk- Holding an adequate amount of liquidity helps in diverting the overall risk of a portfolio.Cash holds its value and is therefore not risky like other assets

Disadvantages of increasing the liquidity:

1. Inflation risk- Due to inflation in the market,the value of cash diminishes from time to time.Therefore,in case of holding more and more cash,it increases more and more inflation by reducing the buying power

2.Opportunity costs- It's always said that money pulls money.Thus,when you keep liquidity and reserves of cash,that cash will be available to the firm with an opportunity cost of interest,dividend etc

3.Tax Liability- In case of keeping more and more cash,the tax liability of a firm increases which can be reduced by investment in assets,research and development etc

Question 2- The comments of Tim McClinton regarding the impressive amount of retained earnings provide another alternative to acquire capital for Helping Hand through the safest source,ie. Retained Earnings.Retained earnings are the pool of funds which are retained by the company from the profits of the company before issuing the dividends to the shareholders.Retained earnings are the safest and the most economic source of finance as there is no responsibility regarding returning of funds as they are all self generated,and they do not consist of any external cost of capital in the form of interest or dividend.Thus,if Helping Hand have significant amount of retained earnings,Sharon Vincent must consider them before issuing the debt financing.Utilisation of retained earnings decrease the weighted average cost of capital and therefore increasing the shareholders earnings

Question 3- (a) Adequate cash flow is essential to keep the business running as it is considered as the blood of a company.Poor cash management could end up putting a profitable company out of business.Cash in hand is required in every activity of a business organisation no matter if it's purchasing the asset or day to day operations.Profits are considered as main objective of business but there is no significance of profit without cash.Therefore,the statement of Stafford regarding the cash problems for a profitable firm is logically inconsistent is completely wrong as profit and cash flow are two different elements of business and one cannot be substituted in place of other.

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