Question

Scandi Home Funishings, Inc.

     Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2016. Sales during the first full year (2017) of operation reached $1.3 million. Sales increased by 15 percent in 2018 and another 20 percent in 2019. However, after increasing in 2018 over 2017, profits fell sharply in 2019, causing Kaj to wonder what was happening to his “pride and joy” business venture. After all, Kaj worked as closely as possible to a 24/7 pace, beginning with the startup of Scandi and continuing through the first three full years of operation.

     Scandi Home Furnishings, located in eastern North Carolina, designs manufacturers, and sells Scandinavian-designed furniture and accessories to home furnishings retailers. The modern Scandinavian design has a streamlined and uncovered look. While this furniture style is primarily associated with Denmark, both Norwegian and Swedish designers have contributed to the allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian design can be traced to the elegant curves of art nouveau from which designers were able to produce aesthetically pleasing, structurally strong modern furniture. Danish furnishings and the home furnishings produced by other Scandinavian countries—Sweden Norway, and Finland—are made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics.

     Kaj grew up in Copenhagen, Denmark, and received an undergraduate degree from a technical university in Sweden. As is typical in Europe, Kaj began his business career as an apprentice at a major home furnishings manufacturer in Copenhagen. After learning the trade, he quickly moved into a management position in the firm. However, after a few years, Kaj realized that what he really wanted to do was to start and operate his own Scandinavian home furnishings business. At the same time, after travelling throughout the world, he was sure that he wanted to be an entrepreneur in the United States. Kaj moved to the United States in early 2016. With $140,000 of his personal assets and $210,000 from venture investors, he began operations in mid-2016. Kaj, with a 40 percent ownership interest and industry-related management expertise, was allowed to operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure he did the right thing.

     Following are the three years of income statements and balance sheets for Scandi Home Furnishings. Kaj felt that he would need to continue to expand sales to maintain a competitive advantage. After first concentrating on selling Scandinavian home furnishings in the Northeast in 2017 and 2018, he decided to enter the West Coast market. An increase in expenses occurred associated with identifying, contacting, and selling to home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen hopes that you can help him better understand what has been happening to Scandi Home Furnishings from both operating and financial standpoints.

SCANDI HOME FURNISHINGS, INC. IN COME STATEMENTS 2017 2018 2019 Net Sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes (40%) Net income (loss) Cash Dividends $1,300,000 780,000 520,000 130,000 150.000 40.000 200.000 45,000 155,000 62,000 $99.000 SO $1,500,000 900,000 600,000 150,000 150,000 53,000 247.000 57.000 190,000 76,000 $114,000 $74,000 $1,800,000 1.260.000 540,000 200,000 200.000 60.000 80,000 70,000 10.000 4.000 S8.000 SO SCANDI HOME FURNISHINGS, INC. BALANCE SHEETS 2017 2018 2019 Cash Accounts receivable Inventories Total current assets Fixed assets, net Total assets Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity $50.000 200.000 450.000 700,000 300,000 $1,000,000 130.000 50.000 90.000 270.000 $300,000 $350,000 80,000 $1,000,000 S40,000 260,000 500,000 800,000 400,000 $ 1.200.000 170,000 70,000 90,000 330,000 $400,000 $350,000 120,000 $ 1.200.000 $10.000 360,000 600,000 970,000 500,000 $1,470.000 180,000 80,000 184,000 444,000 S550,000 $350,000 126,000 $1,470,000 *350.000 shares of commonstock were issued to Kaj Rasmussen and the venture investors when Scandi Home Furnishings was incorporated in mid-2016.

You second challenge is to advise Kaj on what has been happening to Scandi from a financial leverage, profitability, and efficiency perspective.

1. Creditors, as well as management, are also concerned about the ability of the venture to meet its debt obligations as they come due, the proportion of current liabilities to total debt, the availability of assets to meet debt obligation in the event of financial distress, and the relative size of equity investments to debt levels. Calculate average ratios in each of these areas for the 2017-2018 and 2018-2019 periods. Interpret your results and explain what has happened to Scandi.
2. Of importance to Kaj and the venture investors is the efficiency of the operations of the venture. Several profit margin ratios relating to the income statement are available to help analyze Scandi’s performance. Calculate average profit margin ratios for 2017-2018 and 2018-2019 and describe what is happening to the profitability of Scandi Home Furnishings.
3. Kaj and the venture investors are also interested in how efficiently Scandi is able to convert its equity investment, as well as the venture’s total assets, into sales. Calculate several ratios that combine data from the income statements and balance sheets and compare what has happened between the 2017-2018 and 2018-2019 periods.
4. An ROA model consisting of the product of three ratios and simultaneously shows an overview of a venture’s efficiency and profitability at the same time. An ROE model consists of the product of three ratios and simultaneously shows an overview of a venture’s efficiency, profitability, and leverage performance. Calculate ROA and ROE models for the 2017-2018 and 2018-2019 periods. Provide an interpretation of your findings.

Answer 1

Answer :

Part A

(a)   Ratio calculations involving asset items on the balance sheet are averages of the prior and current years.  For example, the ratios for 2009 use average balance sheet account amounts for 2008 and 2009.  Likewise, ratios for 2010 use average balance sheet account amounts for 2009 and 2010.

  

  Liquidity Ratios:    

  2009   2010   Change

Current Ratio   2.500 2.287 Lower

Quick Ratio 0.917 0.866 Lower

NWC-to-Total-Assets     0.409 0.373 Lower

All three liquidity ratios declined.

(b)   Ratios are based on the current year's income statement amounts and average amounts (past year and current year) for balance sheet items.

Cash Conversion Cycle (in Days):

  2009        2010       Change

Inventory-to-Sale   192.64 159.33 Better

Sale-to-Cash     55.97    62.86 Worse

Purchase-to-Payment    (85.17)    (72.42)    Worse

  Cash Conversion Cycle 163.44 149.77   Better

The cash conversion cycle declined from 163.44 days in 2009 to 149.77 days in 2010 due to a sharp decline in the inventory-to-sale conversion period which more than offset an increase in the sale-to-cash conversion period and a decrease in the purchase-to-payment conversion period.

(c)

Cash Build Versus Cash Burn:

      2009              2010   

Cash Build:

Net Sales     $1,500,000   $1,800,000

Increase in Receivables    -60,000    -100,000

  Cash Build     1,440,000     1,700,000

Cash Burn:         

Cost of Goods Sold     -$900,000      -$1,260,000

Marketing     -150,000    -200,000

General & Admin.     -150,000    -200,000

Interest          -57,000    -70,000

Income Taxes     -76,000    -4,000

  Cash Burn from Inc. Stmt.    -1,333,000 -1,734,000

Increase in Inventories     -50,000    -100,000

Change in Payables    40,000     10,000

Change in Accrued Liab.     20,000     10,000

Increase in Fixed Assets, Net   -100,000    -100,000

Depreciation     -53,000    -60,000

  Inc. in Gross Fixed Assets -153,000    -160,000

  Cash Burn -$1,476,000      -$1,974,000

Net Cash Build (Burn)     -$36,000   -$274,000

The venture had a $36,000 net cash burn in 2009 and a larger $274,000 net cash burn in 2010.  Operating expenses and interest expenses increased resulting in lower cash from operations.  The net cash burn also increased due to the increase in accounts receivable and in inventories.

Part B

(d)

Financial Leverage:   

2009        2010       Change

Total-Debt-to-Total-Assets 0.5909 0.6457 Higher

Equity Multiplier 2.444 2.822 Higher

Debt-to-Equity Ratio   1.444 1.822 Higher

Current-Liab.-to-Total Debt 0.4615 0.4490 Lower

Interest Coverage   5.263 2.000 Lower

Financial leverage (as measured by the total-debt-to-total-assets ratio, the equity multiplier, and the debt-to-equity ratio) increased in 2010 versus 2009.  This indicates that financial risk also increased.  The current-liabilities-to-total debt ratio improved (was lower in 2010) indicating a more than proportional use of long-term debt relative to short-term debt to meet financing needs in 2010.  The interest coverage dropped substantially due to an increase in the amount of interest and a drop in EBITDA.

(e)

Profitability Ratios:

2009        2010       Change

Gross Profit Margin   0.4000 0.3500 Lower

Operating Profit Margin 0.1593 0.1046 Lower

Net Profit Margin 0.0738 0.0397 Lower

NOPAT Margin   0.0956 0.0627 Lower

All profitability ratios decreased in 2010 versus 2009.  For example, the gross profit margin decreased from 40.00% to 35.00% and the net profit margin decreased from 7.38% to 3.97%.  

(f)

Efficiency and Return Ratios:

2009        2010       Change

Sales-to-Total-Assets   1.3636 1.3483 Same

Operating Return on Assets   0.2245 0.0599 Lower

Return on Assets (ROA)   0.1036 0.0045 Lower

Return on Equity (ROE) 0.2533 0.0127 Lower

The sales-to-total-assets ratio remained about the same at 1.3636 in 2009 to 1.3483 in 2010.  Profitability was sharply lower in terms of the ROA results (from 10.36% to .45%) and the ROE results (from 25.33% to 1.27%).  

(g)

  ROA 2009:  10.36% = 7.60% x 1.3636

  ROA 2010:  0.45% = 0.33% x 1.3483

  ROE 2009:  25.33% = 7.60% x 1.3636 x 2.444

  ROE 2010:  1.27% = 0.33% x 1.3483 x 2.822

Both the ROA and ROE model results show declining performance due to a large decline in the net profit margin combined with a relatively unchanged (slight decline) sales-to-assets ratio.  The financial leverage (as measured by the equity multiplier) increased from 2009 to 2010 during this period of declining operating performance.  

Part C

(h)   Scandi's inventory-to-sale conversion period (192.64 days and 159.33 days) was lower (and thus better) relative to the 200 day average for the industry.  Thus, the firm was turning over its inventories more quickly than the industry average.  The firm's sale-to-cash conversion period decreased from being better than the 60-day industry average at 55.97 days to being worse than the industry average at 62.86 days.

(I)   If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1 - .55).  If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for the industry of 2.222.  Thus, the industry ROE model is:

ROE Industry: 18.78% = 6.50% x 1.300 x 2.222

From Part G:

  ROA 2009:  10.36% = 7.60% x 1.3636

  ROA 2010:  0.45% = 0.33% x 1.3483

  ROE 2009:  25.33% = 7.60% x 1.3636 x 2.444

  ROE 2010:  1.27% = 0.33% x 1.3483 x 2.822

Scandi's ROE declined from above the industry average in 2009 to well below the industry average in 2010.  The firm's net profit margin also declined from above the industry average to below the industry average.  Also, while the turnover of assets declined slightly for the firm, the ratio remained above the industry average.  Scandi's use of debt to finance its assets was above the industry average in 2009 and even more so in 2010.