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Bigger Isn't Always Better!

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by

Lorenz Mae Acain

on 1 December 2015

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Transcript of Bigger Isn't Always Better!

Bigger Isn't Always Better
Case 2

Andre Pires opened his automobile parts store, Quickfix Auto Parts, five years ago, in a mid-size city located in the Mid-western region of the United States. Having worked for an automobile dealership, first as a technician, and later as the parts department manager, for over 15 years, Andre had learned the many nuances of the fiercely competitive automobile servicing business. He had developed many contacts with dealers and service technicians, which came in really handy when establishing his own retail store. Business had pick up significantly well over the years, and as a result, Andre had more than
doubled his store size by the third year of operations.
The industry and local forecasts for the next few years were very good and Andre was confident that his sales would keep growing at or above recent levels.
Case Overview
Andre had more than doubled the store size by the third year of operations.
Andre’s knowledge of finance and accounting was limited
Growth prospects had been good.
However,
no more funds available from its operations.
suppliers could become concerned if the company's financial situation was known to them.
Owner need financial assistance.
Owner believes the firm's need for external financing to fund more growth.
Major Issues
The net income figures for the past two years was negative.
The Earnings per share(EPS) also is negative in the last two years.
Suppliers might quit supplying the parts if the knew the company's financial situation
Most of the available funds have been used up for expansion.
For the past two years, the store’s net income figures had been negative and his cash flow situation had gotten pretty weak.
Liquidity constraints because the firm run out of cash from operations.
Alternatives
Case Problem
However, Andre had
used up most of his available funds in expanding the business
and was well aware that
future growth would have to be funded with external sources of funds.
What was worrying Andre was the fact that over the past two years, the store’s net income figures had been negative, and his cash flow situation had gotten pretty weak (See Tables 1 and 2). He figured that he had better take a good look at his firm’s financial situation and improve it, if possible, before his suppliers found out. He knew fully well that being shut out by suppliers would be disastrous!
Andre’s knowledge of finance and accounting, not unlike many small businessmen’s, was very limited. He had often entertained the thought of taking some financial management courses, but could never find the time. One day, at his weekly bridge sessions, he happened to mention his problem to Tom Andrews, his longtime friend and bridge partner. Tom had often given him good advice in the past and Andre was desperate for a solution. “I’m no finance expert, Andre,” said Tom, “But you might want to contact the finance department at our local university’s business school and see if you can hire an MBA student as an intern. These students can often very insightful, you know. “
That’s exactly what Andre did. Within a week he was able to recruit
Juan Plexo
, a second semester MBA student, who had an undergraduate degree in Accountancy and was interested in concentrating in Finance. When Juan started his internship, Andre explained exactly what his concerns were. “I’m going to have to raise funds for future growth, and given my recent profit situation, the prospects look very bleak. I can’t seem to put my finger on the exact cause. The bank’s commercial loan committee is going to want some pretty convincing arguments as to why they should grant me the loan. I need to put some concrete remedial measures in place, and was hoping that you can help sort things out, Juan,” said Andre. “I think I may have bitten off more than I can currently chew.”
Questions
Q1. How does Quick fix’s average compound growth rate in sales compare with its earnings growth rate over the past five years?
Q2. Which statements should Juan refer to and which ones should he construct so as to develop a fair assessment of the firm’s financial condition? Explain why?
Q3. What calculation should Juan do in order to get a good grasp of what is going on with Quickfix's performance
Q4. Juan knows that he should compare Quickfix’s condition with an appropriate benchmark. How should he go about obtaining the necessary comparison data?
Q5. Besides comparison with the benchmark what other types of analyses could Juan perform to comprehensively analyze the firm's condition? Perform the suggested analysis and comment on your findings.
Q6. Comment on Quick fix’s liquidity, asset utilization, long-term solvency, and profitability ratios. What arguments have to be made to convince the bank that they should grant Quick fix the loan?
Q7. If you were the commercial loan officer and were approached by Andre for a short-term loan of $25,000, what would your decision be? Why?
Q8. What recommendations should Juan make for improvement, if any?
Q9. What kind of problems do you think Juan would have to cope with when conducting a comprehensive financial statement analysis of Quickfix Auto parts? What are the limitations of financial statement analysis in general?
Juan should refer to the
income statement and balance sheet
over the past 3-5 years period.In addition, he should prepare a cash flow statement, common size income statement and common size balance sheet.
Cash flow statement
helps determine where the cash came from and where it was spent.
Common size statement
provide useful information regarding the relative trends of the various assets, liabilities, revenue sources and expense items. It also helps in making meaningful comparisons betweeen firms of varying sizes
Income Statement
shows how much revenue a company earned over a specific period of time.
Balance Sheet
showcases the financial strength of the company at any point of time.
Juan could also use
Time Trend Analysis
which compares the past years data to find out the changes
The
peer group analysis
is to identify firms similar in the sense that they compete in the same markets, have similar assets and operate in similar ways.
Juan could use the
Standard Industrial Classification (SIC) codes.
These are the four-digit codes established by the U.S government for statistical reporting.
There are certain smaller peer companies in the same industry that have filled their return with security exchange commission. Juan could download their financial statements; read footnotes and Management Decision Analysis of those companies which would help him in decide where his company stands.
Juan could collect industry averages of the key financial ratios

Juan could perform common size analysis of the financial statements and a DuPont analysis of the ROA and ROE.
Common Size
Income Statement
The common size income statement indicates that the firm's cost of goods increased quite a bit since 2000. Its operating expenses also increased from 9.5% to 10.4% o sales. On the other hand, selling, administrative and interest expenses have come down a bit. The firm needs to look into its cost structure and try to reduce its overall cost of doing business
Common Size Statement:
Balance Sheet
This shows that the firm's inventory and accounts receivable levels have gone up sharply, while its cash balance has significantly declined (from 24.22% to 1.90%) . the firm has taken on large amount of short-term and long-term debt relative to its total assets. Equity has not increased proportionately with debt. As a result, its capital has become more leveraged.
DuPont Analysis
The firm's ROA is currently negative . Most of the decrease has come from the deteriorating profit situation. The firm's total asset turnover has improved consistently since 2002. The firm's ROE has declined since 2001 because of the drop in the profit margin.
Need to improve its inventory management since its turnoves is low which means the firm needs more time to deplete its asset.
Needs improvement in the credit collection policies to reduce the firm's liquidity problems.
The firm need to pause the expansion plans until the cash flow situation is viable.
Delay the payables or extend credit terms.
Control the cost of the firm.
The firm does not need additional funds for the long-term, rather focus on inventory and receivable management
Problems: Prepare Statement of Cash Flows and statement of Owner's Equity
Selection of Comparison benchmark
Limitations:
Past performance, good or bad is, not necessarily a good indicator of what will happen with a customer in the future.
The more, out-of-date a customer’s financial statements are, the less value they are to the credit department.
Without the notes to the financial statements, credit mangers cannot get a clear picture of the scope of the credit risk they are considering.
The financial statement analysis is limited by the fact that financial statements are “window dressed” by creative accountants.
The financial statement analysis just provides a snapshot of a business’ financial health but not the complete moving picture.
It is also difficult to say whether a company is healthy seeing its financial statements because that depends on the nature and size of the business.
Juan should calculate the various liquidity, leverage, profitability, activity and coverage ratios for at least a three-year period. Financial ratios can be very helpful in comparing trends from past performance or from other similar firms. In addition, a DuPont analysis would Juan determine what has affected the profitability and the liquiity problems of the firm.
Liquidity
The firm's liquidity is quite good with a current ratio of 3.79 ad it has improved a bit for the past three years. However, much of its current asset is tied up in inventory, since its quick ratio is only 0.62 . The ability of the firm to pay of its current liabilities from its cash reserves is not very good either and has deteriorated significantly in the past 5 years.
Asset Utilization
The firm's inventory turnover and the receivables turnover has declined considerably since 2000. The asset turnover is not very high although it is in its highest level in five years. The capital intensity ratio declined in 2004 which means that it requires less asset to accumulate sales.
Long-Term Solvency
The firm's debt ratio is 64% of the total assets. Its debt level has also gone up by almost 37% since 2000. Since the firm's coverage ratios are fairly low, the firm's financial structure can be considered to be risky.
Profitability
The firm's profitability ratio has declined significantly over the past three years. The firm is currently making losses.
Given the firm's poor profitability and cash flow situation, I would not grant the loan. However, I would tell him that if he can demonstrate improvement in inventory management and better profitability for the next two quarters, we would reconsider.
1. Seek out a new loan
Would improve the cash situation but then more interest payments are required and it does not improve profitability. Bank may not even give the company additional funds (or it would with a very unfavorable interest rates
2. Sell inventory
Could quickly improve the cash situation and offer a means to restore some immediate profitability. For example, may sell off the older inventory at a discount without hurting the sales of the newer inventory
3. Collect receivables
The receivables have climbed in the past five years. The firm should not allow this given the current cash situation. They need to find the means of converting receivables into cash.
4. Delay the payables
Suppliers might be willing to extend the time for making payment. However, the company need to be more cautious or the suppliers might become concerned. Extending short term debt to long term debt might also be an option but it will probably not restore profit.
5. Control the cost of the firm
The cost have gone up over the past 5 years. The cash needs of the firm can be addressed by not replacing the inventory until the older inventory is sold.
6. Downsize the firm.
The firm has expanded sales and yet the profits are negative. Reducing inventory might be a viable option in restoring profit.
Reporters
Lourenz Mae R. Acain
Charamae De Loyola
Sharmaine Perez
Average Compound Growth Rate
CAGR in sales = (1,013,376/600,000^1/5)-1
= 0.1105
Average CAGR = CAGR/No of years
= 0.1105/5 = 0.0221
= 2.21%
Earnings Growth Rate
Average earnings growth = Sum of earnings growth rate/5
= -100%
= -20%

In analyzing a firm's growth, we should make sure that both sale and earnings growth is increasing. But it more preferable that the earnings should grow faster than the sales. The firm should cut or reduce the cost to provide more income.

0
Growth rate = (present earnings/ beginning earning ^1/5 )-1
=(-102-16,634)
Full transcript