The cupboard is bare.(Instructor's Note)

Richards, Curtis A. ; Byrd, John T. ; Collins, David 等

INSTRUCTORS' NOTES

Case Objective

The objective of this case is to provide students with an opportunity to perform financial statement analysis both before and after a failed investment. The first part of the case illustrates how an investor might perform a less-than-complete analysis that could lead to an investment decision that proves to be wrong. The second part of the case performs a "post-mortem" to determine what was missed in the first analysis and how the new data might have influenced the original investment decision.

PART ONE: CHIP'S INITIAL REVIEW OF MHC CABINET COMPANY

1. During Chip's initial review of MHC's operations he performed what he considered necessary financial analysis and sufficient due diligence. First, he selected industry data to compare MHC's financial results (Exhibit 2). Chip reasoned that if MHC could compare favorably to the industry, then it likely was a sound investment.

2. Based on the industry data in Exhibit 2, develop similar values for MHC Cabinet Company using the financial data in Exhibit 1. (Because he only had two years of data to work with, except for the percent change in sales, Chip used the two year average for the other data measures.)

Chip first considered the percentage change in year-to-year sales from 2003 to 2004 (Table 1). MHC compared very favorably to the industry (17% vs. 8%), and Chip was much impressed by that showing.

Next Chip reviewed a favored set of operating percentages (Table 2). Here, MHC compared very favorably to the industry in every area except operating expenses (32% vs. 20%), which Chip saw as comparable because he viewed it as a function of economies of scale. As with sales growth, Chip was much impressed with MHC's ability to achieve results comparable to or better than the industry. His proposed purchase of an equity interest in MHC was looking better and better.

Chip considered one final set of measures (Table 3). Return on assets for MHC was less than the industry (7% vs. 9%), but not much less and, again, he saw this as a consequence of economies of scale. Besides, MHC's return on equity at 21% was dazzling compared to the 11% generated by the industry. The success of Chip's investment seemed assured.

Yes, the debt to asset ratio was worrisome (70% vs. 30%), but this was a very small, very closely-held firm being compared to the much larger industry. Certainly MHC debt ratios would be much higher on average; that went with the territory. And, look at the positive financial leverage such a debt ratio produced--a 21% average return on equity!

While the worrisome debt ratio would prove prophetic, it was not a large enough red flag to stop Chip from investing in MHC.

3. Based on this analysis, why did Chip consider MHC to be a good investment?

Clearly, based on the limited analysis that he completed, Chip saw the investment in MHC as desirable and financially profitable. This may have been based on his mistaken enthusiasm for MHC's sales growth and return on equity. After all, those values were based on very limited data. Also, Chip's decision might have been clouded by his emotional desire to get back into a successful business, particularly one that he thought he knew something about.

4. Based on this analysis, would you consider MHC to be a good investment?

Students are likely to have many different views on this question.

PART TWO: CHIP'S POST-MORTEM REVIEW OF MHC CABINET COMPANY

5. During his post-mortem review of what went wrong, Chip wondered what other red flags he had missed. Since his initial review mostly took an Income Statement approach--concentrating on operating results, which had convinced him that MHC was enjoying strong success--Chip's accountant convinced him to turn to the Balance Sheet for his answers. Hindsight reminded Chip that good operating results might not be sufficient if a firm is built on a shaky foundation.

6. Based on the industry data in Exhibit 3, develop similar values for MHC Cabinet Company using the financial data in Exhibit 1. (Because he only had two years of data to work with, Chip used the two year average for the data measures.)

Knowing that the long-term accounts had not been the primary problem, Chip focused on the current accounts--particularly the operating accounts (Table 4). The results did not compare well to the industry. The lower accounts receivable might have indicated a lack of large (and profitable) customers and/or a future slowing in sales. That slowing of sales might also be foretold by the much higher percentage of inventory. The nearly complete lack of accounts payable (only 1% vs. 18%) almost certainly indicated precious cash being used to pay suppliers too quickly, creating potential cash flows problems. The much lower balance in cash (partly the result of "overpaying" accounts payable) provided another indicator of potential cash flow problems. Chip's initial euphoria (and over confidence) in this investment may have caused him to overlook some sobering future effects that showed up on the balance sheet.

Recognizing that he did not properly consider a number of important balance sheet relationships, Chip went on to analyze MHC's operating cycle (Table 5). The current ratio (6.74 vs. 1.50), at first glance, appeared outstanding. However, it is essentially an artifact of significantly higher inventory and essentially non-existent accounts payable. Further, since almost all of MHC's working capital is tied up in accounts receivable and inventory, the large current ratio does not represent good liquidity.

The number of days in accounts receivable was not totally unfavorable compared to the industry (48 vs. 40); so, this may not be a source of problems--other than those mentioned previously. However, the number of days in inventory is almost five times larger than the industry (137 vs. 28). Even adjusting for firm size, this was a most troubling discovery, and one that did not bode well for his previous expectations about sales growth. Finally, the number of days in accounts payable (13 vs. 48) suggests that payments to suppliers were much too quick--as was mentioned when discussing the size of accounts payable relative to working capital.

Bringing this together, it is clear that the MHC cash cycle (172 days) vs. that of the benchmark firm (20 days) is a significant source of potential cash flow problems lurking just beneath the surface of apparently good operating results.

7. What impact might this analysis have had on Chip's original investment decision?

What Chip had not learned, until much too late, was that MHC struggled to maintain sufficient cash flows to meet its needs. That hidden danger (because of the downturn in sales and upturn in expenses that had occurred during his time with the company, and the too high debt red flag that he should have paid attention to earlier), pushed MHC over the cash flow ledge and caused Chip to lose a significant part of his investment.

8. What did Chip learn from this experience?

Students are likely to have many different views on this question.

Curtis A. Richards, Bellarmine University

John T. Byrd, Bellarmine University

David Collins, Bellarmine University Table 1 MHC Cabinets Industry % Change in Sales: 2003 vs. 2004 17% 8% Table 2 (Two-Year Averages) MHC Cabinets Industry Working Capital (% of Total Assets) 23% 7% Cost of Goods Sold (% of Sales) 55% 72% Operating Expenses (% of Sales) 32% 20% Gross Profit (% of Sales) 45% 28% Operating Profit (% of Sales) 13% 8% Net Income 9% of Sales) 10% 5% Table 3 (Two Year Averages) MHC Cabinet Industry Debt to Asset Ratio 70% 30% Return on Assets 7% 9% Return on Equity 21% 11% Table 4 (Two-Year Averages--% of Assets) MHC Cabinets Industry Cash 4% 10% Table 5 (Two Year Averages) MHC Cabinets Industry Current Ratio 6.74 1.50 # of Days in A/R 48 40 # of Days in Inventory 137 28 # of Days in A/P 13 48 # of Days in Cash Cycle 172 20