Case H Pearson Air Conditioning & Service Managing a Firms Working Capital Brothers Scott and Bob Pearson, father and son, are the owners of Pearson Air Conditioning & Service, based in Peterborough, Ontario. Scott serves as president, and Bob as general manager. The firm sells General Electric, Carrier, and York air-conditioning and heating systems to both commercial and residential customers and services these and other types of systems. Although the business has operated successfully since the Pearsons purchased it in 2002, it continues to experience working-capital problems. PEARSONS FINANCIAL PERFORMANCE The firm has been profitable under the Pearsons ownership. In fact, profits for 2011 were the highest for any year to date. Exhibit H-1 shows the income statement for the year ending December 31, 2011. The balance sheet as of December 31, 2011, is presented in Exhibit H-2. Note that the firms total debt now exceeds the owners equity. However, $10,737 of the firms liabilities was a longterm note payable to a shareholder. This note was issued at the time the Pearsons purchased the business, with payments going to the former owner. PEARSONS CASH BALANCE The Pearson Air Conditioning & Service currently has a cash balance in excess of $28,000. The owners have a policy of maintaining a minimum cash balance of $15,000, which allows them to sleep well at night. Recently, Bob has thought that they would still be able to breathe comfortably as long as they kept a minimum balance of $10,000. PEARSONS ACCOUNTS RECEIVABLE The accounts receivable at the end of 2011 were $56,753, but at times during the year, receivables could be twice this amount. These accounts receivable were not aged, so the firm had no specific knowledge of the number of overdue accounts. However, the firm had never experienced any significant loss from bad debts. The accounts receivable were thought, therefore, to be good accounts of a relatively recent nature. Case H: Pearson Air Conditioning & Service 2 Customers were given 30 days from the date of the invoice to pay the net amount. No cash discounts were offered. If payment was not received during the first 30 days, a second statement was mailed to the customer and monthly carrying charges of 1/10 of 1 percent were added. On small residential jobs, the firm tried to collect from customers when the work was completed. When a service representative finished repairing an air-conditioning system, for example, he or she presented a bill to the customer and attempted to obtain payment at that time. However, this was not always possible. On major items, such as unit changeoutswhich often ran as high as $2,500billing was almost always necessary. On new construction projects, the firm sometimes received partial payments prior to completion, which helped to minimize the amount tied up in receivables. EXHIBIT H-1 Pearson Air Conditioning & Service Income Statement for the Year Ending December 31, 2011 Sales revenue $727,679 Cost of goods sold 466,562 Gross profit $261,117 Selling, general, and administrative expenses (including officers salaries) 189,031 Profits before tax 72,086 Income tax 17,546 Net profits 54,540 EXHIBIT H-2 Balance Sheet for Pearson Air Conditioning & Service for December 31, 2011 Assets Current assets: Cash $ 28,789 Accounts receivable 56,753 Inventory 89,562 Prepaid expenses 4,415 Total current assets $179,519 Loans to shareholders 41,832 Autos, trucks, and equipment, at cost, less accumulated depreciation of $36,841 24,985 Case H: Pearson Air Conditioning & Service 3 Other assets 16,500 Total Assets $262,836 Debt (Liabilities) and Equity Current debt: Current maturities of long-term notes payable* $ 26,403 Accounts payable 38,585 Accrued payroll taxes 2,173 Income tax payable 13,818 Other accrued expenses 4,001 Total current debt $ 84,980 Long-term notes payable* 51,231 Total shareholders equity 126,625 Total Debt and Equity $262,836 *Current and long-term portions of notes payable: Current Long-Term Total 10% note payable, secured by pickup, due in monthly installments of $200, including interest $ 1,827 $ 1,367 3,194 10% note payable, secured by equipment, due in monthly installments of $180, including interest 584 0 584 6% note payable, secured by inventory and equipment, due in monthly installments of $678, including interest 6,392 39,127 45,519 9% note payable to stockholder 0 10,737 10,737 12% note payable to bank in 30 days 17,600 0 17,600 $26,403 $51,231 $77,634 PEARSONS INVENTORY Inventory accounted for a substantial portion of the firms working capital. It consisted of the various heating and air-conditioning units, parts, and supplies used in the business. The Pearsons had no guidelines or industry standards to use in evaluating their overall inventory levels. They believed that there might be some excessive inventory, but, in the absence of a standard, this was basically an opinion. When pressed to estimate the amount that might be eliminated by careful control, Scott pegged it at 15 percent. The firm used an annual physical inventory that coincided with the end of its fiscal year. Since the inventory level was known for only one time in the year, the income statement could be prepared only on an annual basis. There was no way of knowing how much of the inventory had been used at other points and, thus, no way to calculate profits. As a result, the Pearsons Case H: Pearson Air Conditioning & Service 4 lacked quarterly or monthly income statements to assist them in managing the business. Scott and Bob had been considering changing from a physical inventory to a perpetual inventory system, which would enable them to know the inventory levels of all items at all times. An inventory total could easily be computed for use in preparing statements. Shifting to a perpetual inventory system would require that they purchase new computer software. However, the cost of such a system would not constitute a major barrier. A greater expense would be involved in the maintenance of the systementering all incoming materials and all withdrawals. The Pearsons estimated that this task would necessitate the work of one person on a half-time or three-fourths-time basis. PEARSONS NOTE PAYABLE TO THE BANK Bank borrowing was the most costly form of credit. The firm paid the going rate, slightly above prime, and owed $17,600 on a 90-day renewable note. Usually, some of the principal was paid when the note was renewed. The total borrowing could probably be increased if necessary. There was no obvious pressure from the bank to reduce borrowing to zero. The amount borrowed during the year typically ranged from $10,000 to $25,000. The Pearsons had never explored the limits the bank might impose on borrowing, and there was no clearly specified line of credit. When additional funds were required, Scott simply dropped by the bank, spoke with a bank officer (who also happened to be a friend), and signed a note for the appropriate amount. PEARSONS ACCOUNTS PAYABLE A significant amount of Pearsons working capital came from its trade accounts payable. Although accounts payable at the end of 2011 were $38,585, payables varied over time and might be double this amount at another point in the year. Pearson obtained from various dealers such supplies as expansion valves, copper tubing, sheet metal, electrical wire, and electrical conduit. Some suppliers offered a discount for cash (2/10, net 30), but Bob felt that establishing credit was more important than saving a few dollars by taking a cash discount. By giving up the cash discount, the firm obtained the use of the money for 30 days. Although the Pearsons could stretch the payment dates to 45 or even 60 days before being put on C.O.D., they found it unpleasant to delay payment more than 45 days because suppliers would begin calling and applying pressure for payment. Their major suppliers (Carrier, General Electric, and York) used different terms of payment. Some large products could be obtained from Carrier on an arrangement known as floor planning, meaning that the manufacturer would ship the products without requiring immediate Case H: Pearson Air Conditioning & Service 5 payment. The Pearsons made payment only when the product was sold. If still unsold after 90 days, the product had to be returned or paid for. (It was shipped back on a company truck, so no expense was incurred in returning unsold items.) On items that were not floor-planned but were purchased from Carrier, Pearson paid the net amount by the 10th of the month or was charged 18 percent interest on late payments. Shipments from General Electric required payment at the bank soon after receipt of the products. If cash was not available at the time, further borrowing from the bank became necessary. Purchases from York required net payment without discount within 30 days. However, if payment was not made within 30 days, interest at 18 percent per annum was added. CAN GOOD PROFITS BECOME BETTER? Although Pearson Air Conditioning & Service had earned a good profit in 2009, the Pearsons wondered whether they were realizing the greatest possible profit. The slowdown in the construction industry during 2011was currently affecting their business. They wanted to be sure they were meeting the challenging times as prudently as possible. QUESTIONS 1. Evaluate the overall performance and financial structure of Pearson Air Conditioning & Service. 2. What are the strengths and weaknesses in this firms management of accounts receivable and inventory? 3. Should the firm reduce or expand the amount of its bank borrowing? 4. Evaluate Pearsons management of accounts payable. 5. Calculate Pearsons cash conversion period. Interpret your computation. 6. How could Pearson Air Conditioning & Service improve its working-capital situation