2) Prepare Common-size financials for the Balance Sheet and Income Statement for the two years. GLOBAL AUTO PARTS, LTD. Global Auto Parts (GAP), Ltd. is a retail car parts chain with a network of company-owned stores in Texas. The company was formed by Jack Hardwick in 1973. In 2004, Jack decided to retire and transferred the company's management and the responsibilities for the day to day operations to his son John Hardwick. By early 2007, GAP was having difficulties and Jack Hardwick decided to become actively involved again in the company to turn things around. His first action was to hire Kathy Rutkowski, CPA, CGMA, CFA from one of the Big 4 accounting firms to review current operations and make recommendations. John Hardwick's Tenure John had led a privileged life and his father did not feel that he would be able to operate the business successfully, but he had little choice if he wanted to keep the business under family control. Despite his MBA degree, Jack Hardwick did not feel that his son had the patience and the general business acumen to operate the business. He was also fearful that he would recklessly try to expand the business and lose interest if things did not go as planned. Upon taking over operations in the beginning of 2004, John began to put a major expansion plan into effect that he had worked on as project in his MBA. This plan had two major focal points. One was to expand the number of retail auto parts outlets in smaller communities and the other was to diversify the products provided at each of the outlets to include automotive maintenance services such as tire changes, battery changes and fluids changes. A number of auto parts retail chains in Texas had allowed a similar strategy of diversification and were successful. In 2004, all the outlets were expanded to include bays for maintenance work. Sales of these new services were poor over the next two years. To have their fluids or their tires changed, customers had to leave the vehicle and wait for a considerable period of time in the reception area. An appointment was also required. This was not as convenient as other stores where patrons did not need to schedule an appointment or to get out of their vehicles and generally could have the work done in less than thirty minutes. For more complicated maintenance work, GAP mechanics had a reputation in the community of not being highly qualified. There had been a number of cases that received extensive coverage in the local news, where GAP mechanics had made mistakes that caused major damage to the vehicles they were working on. Instead of admitting they were at fault and keeping damage to a minimum, GAP was taken to court a number of times and forced to pay the repair costs. In addition to its sales outlets in nine cities, in 2004 additional stores were opened in five other cities. By early 2007, all outlets were underutilized. Local service stations with strong ties to the community, lowered their prices and improved their customer service which increased competition. 1 Prior to 2004, GAP's workforce was composed of a number of experienced professionals who had been with the company for years. When John Hardwick took over operations, he decided to try to increase profitability by cutting wages and benefits. The result was that most of the employees left and were replaced by less experienced staff. The sales staff was taken off salary and put on straight commission as a means of increasing sales. The sales staff did become "hungrier," but the more aggressive practices alienated many customers. In order to increase gross profits, GAP began buying more no-name car parts from overseas suppliers. These sales generated a higher gross profit margin for the retailer initially and the customers did receive a lower price, but quality concerns due to the parts' durability, performance and safety features soon caused sales and margins to fall. A new accounting system was purchased in 2005 in order to better automate the record keeping, payroll, billing and inventory functions of the company. The low-cost vendor was selected to save cash to help expansion. This vendor provided very poor software installation and training and then went bankrupt. GAP's staff struggled with the new system and matters were made worse by high employee turnover due to low wages and John's disorganized management style. A lot of overtime had been used to clear the backlog of clerical work, while customers, staff and suppliers were becoming alienated over delays and errors. In the first quarter of 2006, Jack Hardwick suspended all dividend payments. John had been drawing too much from the company to fund his personal expenses. Financial Statements Income Statement For the Year Ended December 31 Sales Cost of Goods Sold Gross Profit Depreciation Other Operating Expenses Earnings Before Interest and Tax Interest Expense Earnings Before Tax Income Tax Expense Net Income 2006 2005 2004 6,500,000 5,550,000 4,050,000 3.965,000 3,385,500 2,535,000 2,164,500 1,620,000 2,430,000 485,600 287,200 158,500 1,690,000 1,387,500 1,012,500 359,400 489,800 449,000 331,956 160,125 50,645 27,444 329,675 398,355 10,978 131,870 159,342 16,467 197,805 239,013 Cash Accounts Receivable Inventory Prepaid Expenses Total Current Assets Property, Plant and Equipment Less: Accumulated Depreciation Property, Plant and Equipment, net Total Assets Balance Sheet As of December 31 2006 2005 2004 57,000 110,000 155,000 95,000 59,000 45,000 723,000 540,000 36,000 25,000 1,050,000 42,000 1,244,000 928,000 765,000 7,288,800 4,819,200 3,245,000 2,432,800 1,947,200 1,660,000 4,856,000 2,872,000 1,585,000 6,100,000 3,800,000 2,350,000 Accounts Payable 440,556 165,000 99,000 Line of Credit 570,638 353,000 267,435 Current Portion of Long-term Debt 325,346 162,000 41,461 Total Current Liabilities 1,336,540 680,000 407,895 Long-term Debt 3,253,460 1,620,000 414,605 Equity Total Liabilities and Equity 1,510,000 1,500,000 1,527,500 6,100,000 3,800,000 2,350,00 Financial Situation GAP has a $600,000 line-of-credit with Texas Investment Bank. The limit could be extended, but only if the bank has sufficient loanable funds and the company is in a good financial condition. The company must maintain a current ratio of 1.5, a times interest earned ratio of 5.0. and can only borrow up to 50 per cent of the value of its accounts receivable and inventory. The company negotiates separate term loans and mortgages to finance its capital purchases. Under Jack's leadership, GAP had an excellent relationship with its bank, but John's poor management and interpersonal skills had put this relationship in jeopardy. Retail sales were paid for in cash or by credit card so there were no accounts receivable. Sales to businesses made up to 40 per cent of sales and were on terms 2/10, net 30 with negligible bad debts. GAP bought its auto parts from the manufacturers on terms 2/15, net 30, which was the norm in the industry. Interest was charged on overdue accounts at 12 per cent per annum and many retailers who got too far in arrears were put on a cash-and-carry basis. A slowdown was forecasted in the local economy in 2007 due to the com fields fires that took place in the summer of 2006 and the collapse of the beef industry caused by the discovery of mad cow decease in more than half of the farms in Texas. The following industry average ratios (based on year-end figures) were available for companies that sold both tires and automotive maintenance services Current Ratio Quick Ratio Inventory Tumover in Days Account Receivable tumover in Days Accounts Payable Turnover in Days Fixed Assets Turnover 1.90 0.51 60 days 30 days 15 days 3.19 Total Assets Turnover 200 Debt Ratio 30.00% Times Interest Earned 14.63 Cost of Borrowing 6.50% Gross Profit Margin 42.00% Operating Profit Margin 12.00% Net Profit Margin 6.71% Return on Assets 13.42% 19.17% Return on Equity GAP's marginal tax rate was 40 percent. Turnaround Kathy Rutkowski had just returned to her office at the Big 4 accounting firm from a meeting with Jack Hardwick in 2007. Jack asked her to prepare a comprehensive review of GAP's operations with a focus on why things have deteriorated and what can be done to improve operations. Also, she was asked to make further recommendations on the future management of the company.