1. Compute the profitability ratios, including the a and b components (DuPont Methods) of ratios 2 and 3 as shown in the textbook. The profitability ratios should be shown for all three years. 2. Write a brief one-paragraph description of any trends tha

Jim Harrod knew that service, above all, was important to his customers. Jim and Becky Harrod had opened their first store in Omaha, Nebraska in 1991. Harrod’s carried a full line of sporting goods including everything from baseball bats and uniforms to fishing gear and hunting equipment. By the year 2006, there were twelve Harrod stores producing $5 million in total sales and generating a profit of over

$200,000 per year.

In January of 2007, Becky, who served as the company’s chief financial officer, walked into

Jim’s office and said, “I’ve had it with the First National Bank of Omaha. It is willing to renew

our loan and line of credit, but the bank wants to charge us 2½ percentage points over prime. The

prime rate is the rate at which banks make loans to their most creditworthy customers. It was

4.75 percent at the time Becky had visited the bank, so that the total rate on the loan would be

7.25 percent. It was not so much the total rate that Becky objected to, as the fact that Harrod’s

was being asked to pay 2½ percent over prime. She felt that Harrod’s was a strong enough company that one percent over prime should be all that the bank required. Her banker told her he would review the firm’s financial statements with her next week and reconsider the premium Harrod’s was being asked to pay over prime. While Becky knew the bank “crunched all the numbers,” she decided to do some additional financial analysis on her own. She had a bachelor’s degree in finance with a 3.3 GPA. She began by examining Figures 1, 2, and 3.

Figure 1

Harrod’s Sporting Goods

Income Statement

(2004–2006)

2004 2005 2006

Sales .................................................. $4,269,871 $4,483,360 $5,021,643

Cost of goods sold............................. 2,991,821 2,981,434 3,242,120

Gross Profit ....................................... 1,278,050 1,501,926 1,779,523

Selling and administrative expense... 865,450 1,004,846 1,175,100

Operating profit................................. 412,600 497,080 604,423

Interest expense................................. 115,300 122,680 126,241

Extraordinary loss ............................. __ __ 170,000

Net income before taxes ................... 297,300 374,400 308,182

Taxes................................................. 104,100 131,300 107,864

Net income........................................ $ 193,200 $ 243,100 $ 200,318

Figure 2

Harrod’s Sporting Goods

Balance Sheet

(2004–2006)

2004 2005 2006

Cash .......................................................... $ 121,328 $ 125,789 $ 99,670

Marketable securities ................................ 56,142 66,231 144,090

Accounts receivable .................................. 341,525 216,240 398,200

Inventory................................................... 972,456 1,250,110 1,057,008

Total current assets ............................. 1,491,451 1,658,370 1,698,968

Net plant and equipment .........................1,678,749 1,702,280 1,811,142

Total assets................................................ $3,170,200 $3,360,650 $3,510,110

Liabilities and Stockholders’ Equity

Accounts payable ...................................... $ 539,788 $ 576,910 $ 601,000

Notes payable............................................ 160,540 180,090 203,070

Total current liabilities........................ 700,328 757,000 804,070

Long-term liabilities ................................. 1,265,272 1,292,995 1,372,240

Total liabilities .................................... 1,965,600 2,049,995 2,176,310

Common stock .......................................... 367,400 368,000 368,000

Retained earnings*.................................... 837,200 942,665 965,800

Total Stockholders’ equity..................1,204,600 1,310,655 1,333,800

Total liabilities and stockholders’ equity .. $3,170,200 $3,360,650 $3,510,110

Figure 3

Harrod’s Sporting Goods

Selected Industry Ratios for 2006

1. Net income/Sales 4.51%

2a. Net income/Total Assets 5.10%

2b. Sales/Total Assets 1.33 x

3a. Net income/Stockholder’s Equity 9.80%

3b. Debt/Total Assets 0.48

4. Sales/Receivables 5.75 x

5. Sales/Inventory 3.01 x

6. Sales/Fixed Assets 3.20 x

Questions

1. Compute the profitability ratios, including the a and b components (DuPont Methods) of ratios 2 and 3 as shown in the textbook. The profitability ratios should be shown for all three years.

2. Write a brief one-paragraph description of any trends that appear to have taken place over the three-year time period.

3. In examining the income statement in Figure 1, note that there was an extraordinary loss of $170,000 in 2006. This might have represented uninsured losses from a fire, a lawsuit settlement, etc. It probably does not represent a recurring event or affect the earnings capability of the firm. Forthat reason, the astute financial analyst might add back in the extraordinary loss to gauge the true operating earnings of the firm. Since it was a tax-deductible item, we must first multiply by (1-tax rate) before adding it backin.* Thetax rate was 35 percent for the year.*

$170,000 Extraordinary loss

.65 (1-tax rate)

$110,500 Aftertax addition to profits from eliminating

the extraordinary loss from net income

The more representative net income number for 2003 would now be:

Initially reported (Figure 1) $200,318

Adjustment for extraordinary loss being eliminated +110,500

Adjusted net income $310,818

Based on the adjusted net income figure of $310,818, recompute the profitability ratios for 2006 (include part a and b for ratios 2 and 3).

4. Now with the adjusted net income numbers as part of the ratios for 2006, write a brief one-paragraph description of trends that appear to have taken place over the three-year time period (refer back to the data in Question 1 for2004 and 2005).

5. Once again, using the revised profitability ratios for 2006 that you

developed in Question 3, write a complete one paragraph analysis of the

company’s profitability ratios compared to the industry ratios (figure 3).

Make sure to include asset turnover and debt to total assets as supplemental

material in your analysis.

6. Harrod’s has a superior sales to total assets ratio compared to the industry.

For 2006, compute ratios 4, 6 and 7 as described in the text and compare

them to industry data to see why this is so. Write a brief one-paragraph

description of the results. Note: for ratio 4, only half the sales are on credit

terms.

7. Conclusion: Based on your analysis in answering Questions 4 and 5, do you

hink that Becky Harrod has a legitimate complaint about being charged 2½

percent over prime instead of one percent over prime? There is no absolute

right answer to this question, but use your best judgment