Please answer question 1,2,3 in details and explanation

CASE 4 HELPING HAND ACCOUNTING FUNDAMENTALS "I got real lucky when I was fired," William Pendleton was fond of telling his employees and business associates. Pendleton was an insurance salesman in Illinois nea hobby, he loved to tinker around the house and he developed a local reputation as a person who knew how to "fix things." Pendleton decided to capitalize on this reputation and opened a hardware store, Helping Hand, based on the phi- losophy that customers need help in selecting the right tools, parts, and materi- als for the job at hand. The philosophy was sound and subsequently a number of other stores were opened in the Midwest. rly 70 years ago and was dismissed due to "insufficient sales." As a When Pendleton died in 1965, the business was sold to the Stafford family and has remained in their control ever since. The family's main contribution was to expand the product line to include building materials, and over half of the company's sales are now made to contractors. THE LETTER Sharon Vincent is the current general manager of Helping Hand, and she re- cently received a letter from the present owner, Justin Stafford. Stafford is best described as a passive stockholder who pretty much leaves the operation of the firm to Vincent. From time to time, however, he is fond of bringing in consul- tants in order to evaluate the company's performance and to help Stafford de- velop pointed questions to ask management. Apparently as a result of a recent- but not exhaustive study by one of these consultants, Stafford has raised a number of issues that he wants addressed. The three most important issues cen- ter on the firm's return on equity (ROE), debt policy, and what Stafford calls "a logical inconsistency" in Helping Hand's 1995 financial statements. 47 20 PARTI FINANCE FUNDAMENTALS In the letter, dated February 9,1996, Stafford wrote Vincent that he was "trou- bled by our consistently low ROE" and urged Vincent to "seek ways to bring this ratio at least up to industry standards." At the same time, he encouraged Vincent to minimize the firm's use of debt. Stafford notes that the sales of Helping Hand are quite sensitive to economic downturns, and he believes that the company will face intense competition from nationwide chains like Lowe's. Consequently he worries about"our ability to repay what we borrow, especially during a recession." Though he is aware that the company is not highly lever- aged relative to industry standards, Stafford recommended that Vincent "strongly consider" (1) retiring all long-term debt as quickly as possible and (2) increasing the firm's liquidity position. Actually, Vincent is quite surprised at these two suggestions. Stafford is something of a "high roller" and he spends much of his time racing automobiles and playing bridge and poker for large stakes. Thus Vincent is a bit amused at Stafford's apparent fear of financial dis- tress, given the chances he takes driving fast cars and his willingness to risk thousands of dollars on a single hand of poker. Still, she thinks that his points are well worth Stafford is also perplexed by Helping Hand's need for funds during 1995 and worries that the firm may be "chewing up cash unnecessarily." He notes that 1995 was highly profitable and yet he was asked to contribute $407,000 to sup- port the company's operation. "It seems illogical," Stafford wrote, "for a prof itable firm to have such a need for cash." THE REACTION As Vincent reflects on Stafford's letter, she decides that it is wise to develop a forecast for the coming year to see if any external funds will be needed. She re- alizes that part of the problem from Stafford's point of view is that he was un- expectedly-if not inappropriately-asked to contribute capital in 1995. It is a good idea, therefore, to alert Stafford as soon as possible to any poten- tial cash shortfall in 1996. She estimates that sales in 1996 will total $24,707,000, a forecast that assumes no change in the firm's credit policy. About 15 months ago she decided that the company's credit terms and standards were "downright stingy" and certainly more conservative than those of the competition -especially the nationwide chains. It became quite clear that Helping Hand had to loosen its credit policy in order to remain competitive. "An absolutely essential defensive move," she argued at the time. The firm presently offers credit terms of 2/10, net 30 to qual- ified buyers. That is, Helping Hand offers a 2-percent discount to customers who pay within 10 days, and customers who pass up the discount are expected to pay in full within 30 days. Assuming no change in credit standards, Vincent expects that 60 percent of all sales will be on credit. She estimates that 50 percent of all credit sales will be paid on the tenth day, 40 percent on day 30, and 10 per- cent will pay late on day 40. 48 CASE 4 HELPING HAND 21 Vincent also thinks that inventory control can be tightened. She intends to purge slow-moving items and use purveyors with relatively short delivery times. These changes should increase inventory turnover, and she expects that cost of goods sold divided by inventory will rise to 3. Vincent's forecast of accounts payable needs to consider the easier credit terms offered by many suppliers. Two years ago about 80 percent of the firm's purchases were on terms of net 30. That is, most suppliers offered no discount, and payment-in-full was expected by day 30. The remaining 20 percent were on terms of 2/10, net 30. Increased competition among hardware and lumber sup- pliers has resulted in more attractive credit terms. During the last year about half of Helping Hand's purchases were made on terms of 2/10, net 30. Vincent expects this to rise to 75 percent in 1996 with the remaining 25 percent on terms of net 30 After she completes the 1996 forecast, Vincent intends to respond to Stafford'?s ROE and debt concerns. Her initial reaction, though, is that Stafford is much too cautious on the issue of debt financing. In fact, she really thinks that the firm is underleveraged and should increase its debt ratio to industry standards. She re- alizes, however, that such an increase is simply out of the question unless s position softens considerably. As Vincent rereads Stafford's letter she is struck by the thought that "two per- fectly sane and intelligent people can look at the same number, understand com- pletely where it comes from, and yet disagree entirely on whether the number is 'good' or 'bad'." There is, of course, her difference with Stafford regarding the firm's debt ratio. And in the same letter Stafford also noted that the firm's cur- rent ratio (Current assets/Current liabilities) looked "suspiciously high." Yet a few weeks ago, the firm's banker complimented Vincent on Helping Hand's extremely solid working capital position." QUESTIONS 1. Stafford apparently thinks that it is a good idea to increase Helping Hand's liquidity position. Let's suppose that a firm increases its cash position. That is, assume that "cash" on a firm's balance sheet increases and there is no change in any other current asset nor in any current liability (a) What will happen to the company's current rati (b) What are the advantages of an increase in liquidity? What are the dis- ra advantages? 2. "What's the problem?" Tim McClinton, a store manager, asked when Sharon Vincent casually mentioned to him that new capital might be re- quired during the coming year. "I've seen our balance sheet," McClinton continued, "and we seem to be rolling in dough, at least judging from the impressive amount of retained earnings." Respond to McClinton's com- ments. 49 22 PART1 FINANCE FUNDAMENTALS 3. (a) Stafford thinks that it is "logically inconsistent" for a profitable firm to have cash problems. Is it "logically inconsistent?" Explain to Stafford how even a well-managed and highly profitable company can have cash flow difficulties. dends were paid in 1995 and capital spending was 165.1(000)] situation. Use this format on Helping Hand for 1995. (b) Construct Helping Hand's 1995 sources and uses statement [no divi- (c) Many bankers use the format of Exhibit 3 to analyze a firm's cash flow (d) Why did Helping Hand have a need for outside capital in 1995? (e) Does it appear that the firm's need for outside capital in 1995 was "to be expected," or does it appear that this need for cash was the result of sus- pect managerial practices? Use information in the case and any other fi- nancial statistics you think are appropriate to answer this question. 4. (a) The owner, Justin Stafford, is disturbed by the firm's consistently low return on equity (ROE). At the same time, he is reluctant to use much debt. Use the Dupont system to see if these views are complementary or competing. Defend your choice. (b) Compute Helping Hand's 1995 ROE. Use the Dupont system to help de- termine why the 1995 ROE differed from the industry median shown in Exhibit 4. 5. Vincent does not believe that Helping Hand is overleveraged at present. Part of her argument involves calculation of the firm's debt, times interest earned (TIE) and fixed charge coverage (FCC) ratios. (a) The debt ratio was 34 percent in 1995, well below the industry average of 57 percent shown in Exhibit 4. In addition, Vincent believes that the firm's debt ratio would be even lower if she adjusted for the fact that interest rates have risen since the long-term debt recorded on the balance sheet was incurred. Explain why a firm's debt ratio-other relevant factors the same-will be overstated during a period of rising interest rates if it is calculated from information on the balance sheet. (Hint: consider the difference be- tween book value and market value.) (b) What are some other balance sheet items where a divergence may well exist between book and market value? (c) Vincent will compute the TIE as EBIT/INT. She doesn't like this ratio as a measure of the firm's ability to meet its financial expenses since it ig- nores contractual obligations such as leasing payments (LP) and debt due (DD). She prefers to compute the fixed charge coverage as follows. FCC EBITIINT LP DDI(1 - t)] Explain why only "debt due" is divided by 1-t, where t is the relevant tax rate. 50