Impacts of Diversification and Expansion
Melissa Hampton was reviewing the recent performance of the EASY Chair Company, a company with a reputation for producing high-quality home furniture. Over the years, the name EASY had become synonymous with a kind of chair called a recliner. By 2000, the company was producing a variety of home furnishings, including reclining sofas, sleep sofas, living room cabinets, upholstered furniture, and solid-wood dining room furniture. In the past decade, the company had also entered the office furniture business by producing office systems and patient seating for clinics and hospitals. To determine the impact that diversification and expansion had on EASY, Ms. Hampton collected the following data for the company:
| EASY CHAIR COMPANY FINANCIAL DATA (dollars in millions) | |||||
| 2000 | 1999 | 1998 | 1997 | 1996 | |
| Sales | $592.3 | $553.2 | $486.8 | $420.0 | $341.7 |
| Net Income | $28.3 | $27.5 | $26.5 | $24.7 | $23.0 |
| Dividends per share | $0.5 | $0.5 | $0.4 | $0.4 | $0.4 |
| Number of shares | 17.9 | 17.9 | 18.3 | 18.4 | 18.3 |
| Total Assets | $361.9 | $349.0 | $336.6 | $269.9 | $233.0 |
| Total equity | $214.6 | &194.3 | $178.8 | $165.3 | $147.0 |
- How had EASY’s sustainable growth rate changed over time? What caused any changes you found?
- The home furniture industry had the following ratios over the same time. How did EASY compare with the industry?
| HOME FURNITURE INDUSTRY RATIOS | ||||
| 2000 | 1999 | 1998 | 1997 | |
| Return on equity | 15.12% | 15.54% | 15.31% | 15.74% |
| Retention rate | 71.00% | 71.00% | 71.00% | 72.00% |
| Sustainable growth rate | 10.73% | 11.03% | 10.87% | 11.33% |
- Perplexed by the declining profit margin and the rate of growth of EASY’s net income, Melissa Hampton pressed the company management for more detailed information. The management asks you, one of EASY’s financial analysts, to compute component and percentage changes for the following statements and determine if there were any positive or negative trends.
| EASY CHAIR COMPANY INCOME STATEMENT (dollars in millions) | ||||
| 2000 | 1999 | 1998 | 1997 | |
| Net sales | $592.3 | $553.2 | $486.8 | $420.0 |
| Cost of sales | (430.4) | (397.8) | (352.1) | (289.8) |
| Gross profit | 161.9 | 135.4 | 134.7 | 130.2 |
| Selling, general, and administrative expenses | (111.6) | (106.9) | (91.4) | (85.5) |
| Income from operations | 50.3 | 48.5 | 43.3 | 44.7 |
| Interest expense | (7.2) | (7.6) | (4.0) | (1.9) |
| Other income | 2.5 | 3.1 | 2.7 | 2.1 |
| Income before taxes | 45.6 | 44.0 | 42.0 | 44.9 |
| Taxes | (17.3) | (16.5) | (15.5) | (20.3) |
| Net income | $28.3 | $27.5 | $26.5 | $24.6 |
- Hampton was not satisfied with EASY’s performance. She believed that the company could achieve the following ratios:
| EASY CHAIR COMPANY MS. HAMPTON’S TARGET RATIOS | |||
| Dividend payout | 45.0% | Profit margin | 5.1% |
| Market price | $15.00 | Gross margin | 27.6% |
| Dividend yield | 5.2% | Return on assets | 9.4% |
| Number of shares outstanding | 18,000 | Inventory turnover | 733.3% |
| Return on equity | 13.7% | Operating profit | 8.7% |
| Long-term debt/equity | 27.3% | Accounts receivable collection period | 92.5 days |
| Current ratio | 551.0% | Accounts payable payment period | 28.7 days |
| Acid-test ratio | 407.3% | Tax rate | 34.0%
|
Using Ms. Hampton’s target ratios for EASY, complete the following financial statements:
| EASY CHAIR COMPANYMS. HAMPTON’S REVISED FINANCIAL STATEMENTS | |
| Income Statement | |
| Sales | |
| Cost of sales | |
| Gross profit | |
| Selling, general, and administrative expenses | |
| Operating profit | |
| Interest | |
| Earnings before taxes | |
| Taxes | |
| Net income | |
| Balance Sheet | |
| Cash | |
| Accounts receivable | |
| Inventory | |
| Total current assets | |
| Net property, plant, and equipment | |
| Total assets | |
| Accounts payable | |
| Other current liabilities | |
| Total current liabilities | |
| Long-term debt | |
| Total liabilities | |
| Owners’ equity | |
| Total liabilities and owners’ equity | |
| Dividends per share | |
- As the new financial analyst for Peterson’s Chemicals, you have been asked to analyze the profitability problems encountered during the last two years. Current financial statements and selected industry averages are as follows:
| PETERSON’S CHEMICALS FINANCIAL STATEMENTS (dollars in millions) | ||
| Income Statement | 2000 | 1999 |
| Sales | $1,478 | $1,435 |
| Cost of goods sold | (1,182) | (1,076) |
| Gross profit | 296 | 359 |
| Selling and administrative expenses | (443) | (445) |
| Operating profit | (147) | (86) |
| Interest expense | (27) | (29) |
| Net income | $(174) | $(115) |
| Balance Sheet | 2000 | 1999 |
| Cash and equivalent | $120 | $76 |
| Accounts receivable (net) | 432 | 437 |
| Inventory | 324 | 284 |
| Other current assets | 37 | 38 |
| Total current assets | 913 | 835 |
| Plant, property, and equipment | 300 | 376 |
| Total assets | $1,213 | $1,210 |
| Accounts payable | $500 | $412 |
| Other current liabilities | 309 | 98 |
| Total current liabilities | 809 | 510 |
| Long-term debt | 178 | 300 |
| Total liabilities | 987 | 810 |
| Owners’ equity | 226 | 400 |
| Total liabilities and owners’ equity | $1,213 | $1,210 |
Using your analysis of the financial statements, how does Peterson’s compare to the following industry averages?
| CHEMICAL INDUSTRY AVERAGES | |
| Industry Ratios | |
| Current ratio | 150% |
| Acid-test ratio | 90% |
| Receivables collection period | 65 days |
| Payables payment period | 60 days |
| Debt/equity | 110% |
| Return on assets | 7% |
| Return on equity | 19% |
- Peterson’s management has decided to reexamine the company’s short-term credit policies. The chief financial officer estimates that reducing the receivables collection period to 78 days would result in a sales decrease of 3 percent. The purchasing department reports that by reducing the payables period to 68.5 days, discounts would be available that would reduce the cost of goods by 9 percent. Initially the cash required to finance these changes would come from additional long-term debt, resulting in a debt to equity ratio of 100 percent. As an analyst:
Determine whether Peterson’s Chemicals would have been profitable if management had made these changes at the beginning of 2000.
- Determine how the ROE and ROA would have been affected.
- Prepare new financial statements to reflect these changes.
