– Profitability Ratios: Constant growth from 2002-05, particularly year 2004 and 2005 with impressive growth in revenue with12.5% and 15.5% respectively, much higher than the benchmark just -1.8%. Gross, operating and net profit margin were all performing better than the benchmarks.
– Management: Co-owner Bob Brown has been brought up to value a strong work ethic, which he has obtained through his father since at young age by working for his father at the mill. After finishing his study, he returned to the mill and excelled at his job (supervisor) and was highly respected. Bob was a “people person”, his warm personality made beloved by all customers and employees.
– Activity Ratios: takes increasingly time to receive payments from sales – 51 days year 2005 (far exceeded the benchmark – 22 days). Days of inventory on hand (476 days) has been increased gradually much higher than the benchmark (386 days). Payables turnover (10 days) is too short compared with the benchmark (27 days) and slowly declined as years pass by.
– Liquidity problems seen through cash on hand kept decreasing since 2002 and sharply reduced in 2005 probably resulted from the issue that quick payables and slow receivables happened simultaneously every year. Since 2005, they had not reach their target balance of 8% cash over total revenue (fell to 0.9% – 2005)
2. Free cash flow to the owners of the firm (FCFE) for 2005:
FCFE = Operating Cash Flow – Change in Net Working Capital – Change in Investments
|Operating profit | |100.0 | | − Taxes | |39.2 | | + Depreciation | |40.9 | |Operating cash flow |101.7 | | − Capital expenditure | | (4.5) | | − Increase in NWC | |(156.3) | | Increase in CA |803.3 – 642.9 = 160.4 | | |- Increase in CL |47.3 – 43.2 = (4.1) | | |Free cash flow | |(59.10) |
Cash cycle of the business for 2005:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)
= 476 + 51 – 10 = 517 (days)
Using cash: Even though HH had rapidly increased gross profit, operating profit and net profit since 2002, the firm’s cash balance had massively declined from $120,100 (2002) to $9,400 (2005). Increasing in inventory as extending property by 12-acres, with an expected capital expenditure of $75,000 in 2006, HH has also increased their product range by 40%. Therefore cash has been used a lot in this period. The firm’s credit terms have been improved as HH offers longer payment periods for customer (DSO of 51 days), firm’s payment of purchases within 10 days (DPO) to receive a 2% discount, this shows that HH is making payments five times faster than receiving them. DIO is also a concern that HH has a hand in, HH is choosing to focus on more maturing plants, therefore its inventory will naturally be longer than the benchmark, in fact, HH’s lowest end was still 10% over the benchmark.
3. The growth trend would be expected to be stronger in 2006. However the cash deficit is still a significant issue due to both capital expenditure and working capital would be further increased in order to maintain the
business expansion. Therefore, they need to work out some financial leverage to solve this problem.
|Projected Horniman Horticulture Financial Summary (in thousands of dollars) | | | | | | | | | | |2002 |2003 |2004 |2005 |2006E |20% | |Profit and loss statement | | | | | | | |Revenue |788.50 |807.60 |908.20 |1048.80 |1258.56 | | | Cost of goods sold |402.90 |428.80 |437.70 |503.40 |630.49 | | | |51.10% |53.10% |48.19% |48.00% |50.10% |Percentage of Sales | |Gross profit |385.60 |378.80 |470.50 |545.40 |628.07 | | |SG&A expense |301.20 |302.00 |356.00 |404.50 |482.53 | | | |38.20% |37.39% |39.20% |38.57% |38.34% |Percentage of Sales | |Depreciation |34.20 |38.40 |36.30 |40.90 |37.45 |Average over 4 years | | Operating profit |50.20 |38.40 |78.20 |100.00 |108.09 | | |Taxes |17.60 |13.10 |26.20 |39.20 |42.37 | | | |35.06% |34.11% |33.50% |39.20% |39.20% |Similar as year 2005 | | Net profit |32.60 |25.30 |52.00 |60.80 |65.72 | | | | | | | | | | |Balance sheet | | | | | | | |Cash |120.10 |105.20 |66.80 |9.40
|13.43 | | |Accounts receivable |90.60 |99.50 |119.50 |146.40 |160.24 | | | |11.49% |12.32% |13.16% |13.96% |12.73% |Percentage of Sales | |Inventory |468.30 |507.60 |523.40 |656.90 |763.03 | | | |59.39% |62.85% |57.63% |62.63% |60.63% |Percentage of Sales | |Other current assets |20.90 |19.30 |22.60 |20.90 |20.93 |Average over 4 years | | Current assets |699.90 |731.60 |732.30 |833.60 |957.62 | | |Net fixed assets |332.10 |332.50 |384.30 |347.90 |300.10 | | | Total assets |1032.00 |1064.10 |1116.60 |1181.50 |1257.72 | | | | | | | | | | |Accounts payable |6.00 |5.30 |4.50 |5.00 |5.20 |Average over 4 years | |Wages payable |19.70 |22.00 |22.10 |24.40 |31.41 | | | |2.50% |2.72% |2.43% |2.33% |2.50% |Percentage of Sales | |Other payables |10.20 |15.40 |16.60 |17.90 |21.19 | | | |1.29% |1.91% |1.83% |1.71% |1.68% |Percentage of Sales | | Current liabilities |35.90 |42.70 |43.20 |47.30 |57.80 | | | Net worth |996.10 |1021.40 |1073.40 |1134.20 |1199.92 | | | | | | | | | | |Capital expenditure |22.00 |38.80 |88.10 |4.50 |75.00 | | |Purchases |140.80 |145.20 |161.20 |185.10 |224.13
| | | |17.86% |17.98% |17.75% |17.65% |17.81% |Percentage of Sales |
4. The company’s accounts-payable policy: Currently the firm’s DSO was 10 days (in order to receive a 2% discount), approx. 2.7 times as fast as the benchmark of 27 days. This policy is not suitable as their current credit terms offered to customer up to 51 days, which is double the benchmark. The firm’s net profit margin was 5.8% (the benchmark is just 2.8% – 2005), so HH does not need to continuously make payment to suppliers early (adversely, HH should take advantage of the offered credit terms allowing firm 30 days to payback for purchased goods), and also HH will also reduce the credit terms even though the sales probably drops, which would leave more cash available for firm as well as the cash cycle will be shorter so that the business will avoid the insufficient liquidity of the cash. If HH does not change the policy, in the long run, the shortage of cash may adversely influence the purchasing power and operating capacity of the business and further business’s profitability.
5. What can the company do to solve its cash problem?
– Offers discount payment terms (i.e. 2% discount if payments are received within 10 days): enable HH to collect cash immediately.
– Takes advantage of the offered credit terms (allow firm 30 days to payback the purchased goods): keeps more cash for operating activities in long-term period.
– Slows down the expansion pace to decrease the capital expenditure. Starts selling product ranges that are not “instant landscape” plants (as these take a long time to mature and also can eliminate some risks for keeping the plants for longer periods of time – feature of this industry: rely heavily on weather that is unpredictable)
– Raising funds: starts financing through debt, also can receive the
tax shield benefit on interest payments. Transforms business from sole proprietorship into partnership in effort of not only increasing cash available for business but also receiving contributions of property, labor and skills form partners.
6. Calculate the sustainable growth of the company in 2005:
|Sustainable growth = ROA x Leverage x Retention | | |5.36% | |ROA (Net profit / Total assets) | | | |5.15% | |Leverage (Total Assets/Net Worth) | | | |1.04 | |Retention (1- Dividend Payout ratio) | | | |1.00 | |Economic profit = (ROA – Cost of capital) x Total Assets | |-57.35 | |Cost of capital | | | |10.00% | |Total Assets | | | |1181.50 | |Net Worth | | | |1134.20 |
The negative economic profit shows that the firm does not earn a sufficient return on capital. The firm is facing their dismissing level of cash and as a result, the negative cash level in the forthcoming years will be clearly observed. As shown above, the majority of the firm’s cash expenditure is held up in inventory (with cash cycle being 517 days compared with the benchmark of 381 days) and account receivables (due to the collection policy). The trade-off that company has to face is an increase in their credit terms. Even though this may reduce the sales volume, the company will probably avoid the risk involved with having a more mature product range.
Case 9 Horniman Horticulture 1. The financial performance of a company can be determined by analyzing different financial ratios. The Horniman’s company financial performance looks strong and healthy if one looks at their 2005-projected financial summary net profit of 60. 8 thousand dollars. Also they have a steady growth and increase from 2002 to 2004 in their revenue, profits and assets. In addition, Exhibit 2 demonstrates that all but one financial ratio supersede the benchmark for other horticultural producers.
However, someone like Warren Buffet might look at their cash flow balance and determine that the financial performance of the company is poor. A company may seem profitable on paper but may not have liquidity due to low cash balance. A company must realize that there is a difference between cash flow and accounting profits. In the case of the Horniman’s the financial performance appears healthy but they do not have enough cash flow to liquidate their liabilities. 2. Horniman is growing at a fast pace; therefore, it has a negative effect on cash flow because they are purchasing supplies, inventory and additional land.
Maggie usually pays her suppliers in 10 days for a 2% discount and they are not going to finance the purchase of the land because of an interest rate of 6. 5%. However, Maggie should not be so rigid with her accounts payable policy, she should allow for some cash to accumulate before she sends out her payments. In addition, Maggie needs to determine her opportunity costs of whether the 2% discount is worth her making payments in 10 days rather than waiting the 30 days. In addition, Maggie should consider financing the purchase of the land.
If she has a healthy cash flow she can demonstrate to the bank that they are a low risk investment and may even get a better interest rate on a loan. 3. The erosion of their cash balance can be explained by two factors. First, by looking at the accounts receivable section of their balance sheet in Exhibit 1. It shows that their receivables keep increasing from year to year. Which means that they are not collecting payments (cash) from their customers or buyers fast enough or are allowing for a very long payment term.
If the Horniman’s wanted to increase their cash, they can implement a shorter 30-day payment policy or a discount for payments made within 10 days. Secondly, their inventory turnover is too low. This means that they are purchasing too much inventory and not selling it fast enough. They are carrying over too much inventory, which also incurs additional costs to the company. Therefore, the Horniman’s do not have a good sales forecast model because they are assuming that they are going to sell everything they have.
In fact, in Exhibit 2, the Inventory day’s ratio is the only ration in which the company underperforms compared to the industry benchmark. Part of the reason is because Bob is investing in growing specimens that take years to mature so this inventory is not able to be sold for a couple of years which affects their inventory turn over. The combination of not collecting their receivables fast enough and purchasing too much inventory with cash and not selling it fast is eroding the Horniman’s cash balance.
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