E17.12. Tracking Changes in Net Operating Assets and the Asset Turnover: Regina Company (Medium) (Based on an analysis by Patricia Fairfield, Georgetown University.) The Regina Company once marketed a successful line of vacuum cleaners, but then ran into trouble and failed. As you can see from the income statements below, the firm had dra- matic sales growth during the 1980s. Using the income statements and balance sheets below, track operating income (after tax), free cash flow, changes in net operating assets, and asset turnovers over the period. Use a tax rate of 39 percent.

a. For 1988, calculate normalized operating, income. What does this number tell you about the earnings quality in 1988?

b. What do the changes in asset turnover tell you about earnings quality in each of the years?

c. What detail in the statements raises further red flags?

REGINA COMPANY Comparative Statement of Income 1985-1988 in thousands) Year Ended June 30 1985 1986 1987 1988 Net sales $67,654 $76,144 $128,234 $181,123 Operating costs and expenses Cost of goods sold 43,988 46,213 70,756 94,934 Selling, distribution, and administration 9,121 10,366 14,621 21,870 Advertising 9,416 8,557 26,449 39,992 Research and development 573 1,182 1,530 Total operating costs 63,198 66,318 113,356 2,423 159,219 Operating income $4,456 $9,826 9,826 14,878 $ 21,904 Interest expense 2.930 1,930 1,584 3,189 income before income taxes $ 1,526 $ 7,896 $13,294 $18,715 Income tax expense 405 3.807 6,189 7,761 Net income $ 1,121 4,089 7,105 $10,954 Comparative Balance Sheet 1904-1988 In thousands) Year Ended June 30 1984 1985 1986 1987 1988 Assets Current assets: Cash $ 328 $36 $ 63 $ 514 $885 Accounts receivable, net 8.551 11,719 14,402 14,402 27,901 51,076 Inventory 11,109 6,325 9,762 19.577 39,135 Other 6 475 708 1,449 3,015 17,219 Total current assets Property, plant, and equipment cost Less accumulated depreciation Other assets Total assets Liabilities and Stockholders' Equity Current liabilities Short-term borrowings 1,118 $38,331 $37,513 $43,202 565,241 $118,140 $19,994 $18,555 $24,935 $49,341 $ 94,111 18,486 19,523 19,736 27,884 0 (1,304) (3,140) (4,948) (6.336) 1,775 1,884 1,112 2,481 $7,500 $3,732 $2,707 $0 $ Current portion of term loan 1,400 1,400 0 900 1,250 Accounts payable 3,082 4,724 7,344 15,072 13,288 Accrued liabilities Income taxes payable Total current liabilities Long-term debt: Term loan 3,800 3,091 3,127 5,468 4,710 2.349 1,145 1,554 2,619 3,782 $18,131 $14,092 $14,732 $24,059 $23,030 12,600 0 Industrial revenue bonds 0 14,800 14,800 13,900 12,650 Subordinated note 5,000 5,000 0 0 0 Bank debt 0 0 0 5,941 47,432 Mississippi state debt Total long-term debt Deferred income taxes 0 0 0 0 0 1,975 $17,600 $19,800 $14,800 $19,841 $62,057 118 685 1,254 1,881 Stockholders' equity Common stock, $.0001 par value 1 1 1,100 1,499 0 0 Common stock purchase warrant Additional paid-in capital Retained earnings Less: treasury stock, cast Total stockholders equity Total liabilities and shareholders' equity $ 2,600 $3,503 $12,985 $38,333 $37,513 $43,202 565,241 $118,140 1,100 0 0 0 1,473 8,010 8,018 8,149 1,121 5,210 12,315 23,269 (192) (236) (247) (247) $20,087 $ 31,172