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A B C D E F G H J K L M N o F 1 Q1: 2 An important task in performing business valuations is normalizing the historical financial statements. (a). Using the information provided in this case, identify required normalization adjustments, prepare a normalized income statement, and determine net cash flow to 3 equity interests. (b). Recalculate the ratios provided in Exhibit 4 using the normalized income statement 4 and net cash flow to equity interests (use the historical balance sheets). 5 Assume an income tax rate of 25% for this requirement. 6 7 EXHIBIT 2 8 JH Outfitters' Income Statements for Five Years Ending June 30, 2017 9 10 ($ in millions) 2013 2014 2015 2016 2017 11 Online and Catalog Sales 29.83 30.89 36.93 39.18 40.853 12 Retail Rentals and Sales 15.19 15.72 16.35 16.93 17.508 13 Total Sales (net) 45.02 46.61 53.28 56.11 58.361 14 Cost of Goods Sold 28.552 30.965 33.964 35.452 38.737 15 Gross Profit 16.468 15.65 19.316 20.658 19.625 16 17 OPERATING EXPENSES 18 Selling, General and Admin Expenses 10.177 10.553 12.03 12.386 13.885 19 Operating Income Before Depreciation 6.2908 5.09 7.2868 8.2717 5.7398 20 Depreciation and Amortization 0.6273 0.7295 1.1039 1.1658 1.251 21 Operating Income After Depreciation 5.6635 4.36 6.1829 7.1059 4.4888 22 23 OTHER NON-OPERATING EXPENSES 24 Interest and Related Expense 0.111 0.0454 0.1402 0.1387 0.0603 25 Non-Operating Expense (Income) 0.0142 0.0215 0.0228 2.574 0.0456 26 27 Income Taxes Total 0.7898 0.892 0.7164 0.2283 1.0635 28 NET INCOME 4.7485 3.40 5.3035 4.1649 3.3194 29 30 net decrease in expenses Assumed tax rate rate adjustment to increase income taxes actual GAAP income tax amounts total adjusted income taxes 2013 -0.47 0.25 0.1175 0.7898 0.9073 2014 -0.47 0.25 0.1175 0.892 1.0095 2015 -1.55 0.25 0.3875 0.7164 1.1039 2016 -3.75 0.25 0.9375 0.2283 1.1658 2017 -0.75 0.25 0.1875 1.0635 1.251 H . . B C D E F G 30 31 ADJUSTMENTS THAT MEET THE DEFINITION for "normalized" income statement (page 58 of case) 32 33 1. JH Outfitters (JHO) recorded and paid a litigation settlement in 2016 2.6 in millions 2. JHO entered into a 10-year lease agreement of a private jet on 1/1/2010 for 34 Mr. Holden with an entity controlled by Mr. Holding requiring annual payments 750,000 3. rental of additional warehouse space with another entity controlled by Mr. 35 Holden; annual rental expense is 140,000 10000 sqft The market rate for comparable warehouses in the area range from $1.00 per 36 sq ft per month to $1.20 per sq ft per month 37 Warehouse space rented is 4. In 2015, due to a major hurricane that disrupted the supply change, JHO paid 38 additional product costs of 39 The additional product costs should be allocated to Cost of Goods Sold as follows: 40 2015 41 2016 42 1.2 in millions 0.8 0.4 Valuing the Business of JH Outfitters Anna J. Johnson-Snyder East Carolina University Mark J. Kohlbeck Florida Atlantic University ABSTRACT: This case uses a goodwill impairment setting to introduce intermediate and advanced accounting students to business valuation (that is, estimating the fair value of a business unit). Tombstone, Inc. previously acquired JH Outfitter's (JHO) and recorded $2.2 million of goodwill. In prior years, management utilized an outside service to provide fair value estimates of JHO for purposes of the goodwill impairment testing. The business valuation is to be done in-house this year. Three common valuation approaches are discussed in the case to provide students with a background that is sufficient to apply these methods to estimate the fair value of JHO for the goodwill impairment tests. Sufficient, yet conflicting, information is also provided to complete the basic requirements. As such, the case provides students an opportunity to apply the goodwill impairment model (as revised in 2017) where the fair value of a business unit is uncertain. Keywords: goodwill impairment; fair value; estimation; income approach; market approach. CASE T ombstone, Inc. (Tombstone or the Company) is a 30-year old retailer headquartered in the western part of the United States. As of July 1, 2014, Tombstone exchanged $16.2 million of Tombstone common stock for 100 percent of JH Outfitter's (JHO) closely held stock in order to expand into internet sales. James Holden, the founder of JHO, created an online store and service program in 2002 that is still unrivaled over a decade later. Since the acquisition, Tombstone has operated JHO autonomously as a reporting unit. At the time of the acquisition, the fair value of the identifiable net assets (total identifiable assets less liabilities) measured in accordance with GAAP (ASC 350-20-25) was $14.0 million, and $2.2 million in goodwill was recorded. The required fair value adjustments included writing down inventory and other assets by $0.46 and $0.92 million, respectively. Property, plant, and equipment were adjusted upward by $2.0 million. In addition to recording the goodwill, identifiable intangible assets totaled $3.4 million, requiring an upward adjustment of $0.80 million. Both the property, plant, and equipment and identifiable intangible assets are estimated to have a remaining life of ten years from the date of acquisition. This transaction was treated as a stock purchase for tax purposes. Therefore, there are no deferred tax issues associated with this acquisition. Tombstone also applied pushdown accounting whereby the acquisition accounting is recorded directly in JHO's accounting records. Management determined that goodwill was not impaired in either of the past two years. The business valuation of the JHO reporting unit for goodwill impairment testing was outsourced to a local valuation firm in fiscal 2015 and 2016. This year, the business valuation of JHO is being performed in-house. Management also decided to adopt early the provisions of Accounting Standards Update 2017-04 (FASB 2017). The following sections provide information on JHO's financial statements, as well as its industry and management plans to complete this task. In addition, two business valuation models based on the income approach and one based on the market approach are discussed in order to provide an introduction to business valuation and guidance to apply the methods. FINANCIAL STATEMENT INFORMATION JHO's historical financial statements for the past five years are presented in Exhibits 1 to 3. A company's historical financial statements provide information on its financial condition for a period and include common and unusual events. To evaluate the fair value of a company, the financial statements should be normalized or "adjusted to reflect the economic realities of 'normal' operating conditions (Hitchner 2011, 89).? This is especially important when applying the income approach to valuation and determining assumptions for the valuation model. Normalization means that items that can be defined as unusual, nonrecurring, noneconomic, or related to non-operating assets and liabilities are removed to "eliminate anomalies and/or facilitate comparisons (AICPA 2017, 23). For example, costs to repair a manufacturing facility that was damaged during a "100-year" storm or Hurricane Irma should be removed from the financial statement data during a business valuation to allow for comparability of the company to others in the industry not impacted by the storm. Other common normalization adjustments include removing the effect of acquisitions and dispositions, labor strikes, major litigation, natural disasters, infrequent and/or nonrecurring items, and related tax effects. Tombstone has not prepared normalized financial statements for JHO. Management has identified four transactions over the past five years that may meet the definition for normalization purposes. First, JHO recorded and paid a litigation settlement of $2.6 million in 2016. Second, the company has a ten-year lease, which commenced on January 1, 2010, with an entity controlled by James Holden for which JHO pays $750,000 to rent a private jet for Mr. Holden. Third, additional warehouse space was required to support an increase in sales. Another entity controlled by James Holden built a 10,000sqft warehouse for JHO and rents storage space to JHO for $140,000 annually. The market rate for warehouses in this area ranges from $1.00 to $1.20 per square foot per month. Fourth, a major hurricane in 2015 upset the supply chains for its products. As a result, JHO paid $1.2 million more in product costs. Two-thirds of the extra costs are reflected as increased cost of goods sold (COGS) in 2015; the balance is reported in 2016. Ratio analysis is also important in understanding a company's operations and supporting various valuation assumptions. Common ratios based on the historical financial statements are computed for the past four years to provide insight on JHO's liquidity, activity, leverage, and profitability, and are presented in Exhibit 4. An analysis based strictly on the firm only tells part of the story. Comparison with industry information is also necessary to provide context, develop assumptions, and perform a business valuation. Tombstone's accounting staff assembled the following industry data to assist in the analysis. INDUSTRY ANALYSIS Establishments within the sporting goods retail industry (SIC 5941; NAICS 451110) primarily sell goods, equipment, and accessories for sports and recreational activities. Historically, sporting goods were offered by small, local companies, which were more like today's outfitters; however, in the latter part of the 20th century, availability of the internet and sporting goods superstores resulted in an unprecedented level of industry growth (Referenceforbusiness.com 2016). Currently, the industry is experiencing a slow decline. In 2015, there were 46,330 U.S.-based sporting goods companies, which is a 5.01 percent decrease from the 2013 high of 48,773 firms (Bizminer 2015). The vast majority of these firms are considered small firms (45,186 small and 1,144 large firms). Between 2013 and 2015, 16 large retailers (1.40 percent of large firms) entered the market while 2,459 small retailers (5.44 percent of the small firms) left the market. The shift in industry demographics was anticipated; small retailers have difficulty competing with the large, superstore retailers. Little changed in the industry during 2016; however, in 2017, there were three significant changes in the large sporting goods retailer industry. First, Bass Pro Shops acquired Cabela's Inc.; it is estimated that the large retailer may control "more than 20 percent of the 50 billion U.S. hunting, camping, and fishing market (Germano 2016, 1). Second, Gander Mountain filed bankruptcy in March 2017 and was purchased during those proceedings by Camping World, Inc. (Fitzgerald 2017; Fung 2018). A Camping World representative reported in early 2018 that of the 160 stores closed by Gander Mountain, approximately 69 will be reopened as "Gander Outdoor if rent relief negotiations are successful (Fung 2018, 1). Finally, Dick's Sporting Goods, Inc. bought 30 stores from a bankrupt Golfsmith International Holdings, Inc., a U.S. golf specialty retailer (Fitzgerald 2017). Product offerings and the store type vary depending on retailer size. For instance, small privately held establishments, e.g., JHO, Smith's Archery, and MK's Golf, are more likely to have "feeder" stores located near or within a retail strip or mall and offer more specialized products or custom services to a niche market. Large publicly traded companies (e.g., Tombstone, Bass Pro Shops, and Camping World) are more likely to have freestanding, independent superstores with a vast range of popular products from boats to cabin kits. Thus, large companies are more able to weather the seasonal fluctuations of product desirability. Barriers to entry concerning large versus small sporting goods retailers differ drastically. Superstores are mature firms; these companies require much more capital and planning to open a store. In contrast, many small firms, such as outfitters, are young, start-up companies that need much less capital to open and owners usually have advanced knowledge of the equipment and garments required for an activity or expedition. In contrast to the large sporting goods retailer industry, the outfitter industry has experienced steady growth. In 2015, there were 101 firms in the industry, which is a 16.09 percent increase from the 87 companies reported in 2013 (Bizminer 2015). The financial ratios of the outfitter industry are somewhat mixed as to whether the overall industry is improving (see Exhibit 5). Solvency ratios suggest the industry is using suppliers less to maintain operations (declining accounts payable divided by revenue) and paying debts more timely (fewer days payable), yet there is an overall decrease in industry ability to meet short-term obligations (current and quick ratios). Efficiency and leverage ratios also provide some mixed signals. On the one hand, the ratios suggest improving sales efforts and stronger cash flow management (decreasing assets divided by revenue; increasing cost of sales divided by inventory; declining days receivable, inventory, and working capital). On the other hand, there are indications of deteriorating ability to pay interest on debt (declining EBITDA divided by interest expense). However, reported turnover ratios are generally improving over the past four years. Demographics of the consumer-base are changing. Currently, the United States has a large aging yet physically active population that is retired or entering retirement (Bizminer 2015). In the next five years, analysts predict this trend to continue, albeit at a much slower pace. This increase in the retirement community will have two major impacts on the outfitter industry: (1) a decrease in a more experienced workforce and (2) a decrease in specific consumer purchases. Aging demographics are forcing companies to make changes from marketing products to training the workforce. For instance, although expected to have a longer life and more disposable income, Baby Boomers are more self-indulgent than previous generations and at higher risk of having multiple health issues, i.e., hypertension, higher cholesterol, diabetes, and obesity (Barr 2014, 23). Product lines and marketing strategies that focused on the youth and ignored older customers will soon be a thing of the past (Coleman, Hladikova, and Savelyeva 2006). The real threat to the workforce is the unprecedented shortage of specialized knowledge that is a result of mass retirements (Roberts 2017; Bruno-Britz 2009; National Institute on Aging 1997; He, Goodkind, and Kowal 2016; Berk, Haid, Pettus, and Yahr 2014; Illinois CPA Society 2016). For instance, the scarcity of knowledgeable and certified staff in some industries may drive up the cost of obtaining and keeping such personnel (Illinois CPA Society 2016). To retain highly skilled workers, employers will have to adjust training and mentoring programs. Although the younger generations are more technologically savvy, members are acclimated to receiving immediate feedback (Bruno-Britz 2009). To partially fill the gap, less skilled employees may rise to upper management positions at a younger age (Roberts 2017). Companies in the outfitter industry need to adapt to the changing customer and workforce base to survive. Analysts anticipate a 5 percent increase in gross sales for companies that deploy a diversification strategy and a minor (less than 1 percent) change for those that do not. Depending upon the type of products offered, establishments that fill extreme-activity market niches, e.g., mountain climbing, may be more influenced by the shift in population demographics than firms that fill other niches, e.g., golf. Growth varies regionally in the United States; the most promising areas are in the West where growth is expected to be 1 percent to 2 percent higher than the rest of the country. MANAGEMENT PLANS JHO launched the "Rough Diamond apparel product line on September 1, 2016. This product is sold as a clothing layer that provides warmth in the winter and cools in the summer. It is lightweight and wicks moisture away from the skin. Management expects demand in all seasons and in a variety of other activities within the current Utah market area. Consistent with management's predictions, the launch of the new product was successful; the company met their sales predictions in the four months following the launch. In January 2017, sales of the new product just met management's forecast. Preliminary sales numbers for the new product line for February 2017 were below forecasts, while targets were met for all other lines except one. Management concluded that this was due to particularly harsh weather in the second and third weeks of the month that resulted in lower economic activity in certain geographic areas where demand for the new product was projected. Sales information by region was reviewed and is consistent with management's analysis of February performance. On July 15, 2017, management held a conference call during which the sales of the Rough Diamond line were discussed. Management acknowledged that Rough Diamond sales met projections for the last two quarters and comprised 14 percent of total sales in June. As a result, the fiscal 2017 sales growth rate for Rough Diamond is expected to be 6 percent. Management believes this growth will continue for the next five years and expects that Rough Diamond will comprise 25 percent of total sales. Sales growth rates for other product lines were not discussed during this call. During the call, management also discussed product costs and the gross margin that is expected to be realized. The uniqueness of the Rough Diamond line is expected to sell at a premium and increase the overall gross margin realized by JHO to 40 percent for the next two years, after which the gross margin is expected to decline to historical levels. Other expenses, including depreciation using the straight-line method, are expected to continue at historical levels in relation to sales. VALUATION APPROACHES Goodwill impairment testing requires determining the fair value of the reporting unit. A quoted market price is generally the preferred evidence of fair value, but may not be available or not representative of the fair value (ASC 350-20-35-22). In this situation, estimation is required. Three traditional approaches can be used to value an interest in an operating business such as JHO: the income approach, the market approach, and the asset (or cost) approach. The discussion on valuation approaches in this section is based on two professional valuation reference books: Hitchner (2011) and Pratt (2008). These books are considered by valuation professionals to be two of the best reference books. The income approach determines the value of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated benefits into a present single amount. The application of the income approach establishes value by methods that discount or capitalize earnings and/or cash flow, using a discount or capitalization rate that reflects market rate of return expectations, market conditions, and the relative risk of the investment. Generally, this can be accomplished by the capitalization of earnings or cash flow method and/or the discounted cash flow method. The market approach calculates the value of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Generally, this can be accomplished by comparison to publicly traded guideline companies or by an analysis of actual transactions of similar businesses sold. It may also include an analysis of prior transactions in the company's stock, if any. The asset (or cost) approach calculates the value of a business, business ownership interest, or security by using one or more methods based on the value of the assets of that business net of liabilities. This approach can include the value of both tangible and intangible assets. However, this approach is often unnecessary in the valuation of a profitable operating company as a going concern, as the tangible and intangible assets are automatically included, in aggregate, in the market and income approaches. All three approaches should be considered as options when performing a business valuation, but all three do not need to be used. The evaluator determines whether one or more of the approaches are not justified. Tombstone decided to use the income and market approaches. The asset approach was not necessary for the valuation as the business enterprise value clearly exceeds the value of the underlying tangible and financial assets and captures the value of all intangible assets and goodwill. JHO is worth more as a going concern than in liquidation. For the income approach, Tombstone considers the capitalization of cash flow method and the discounted cash flow method. A guideline company analysis is to be used for the market approach. Each of these methods provides a going concern valuation of a 100 percent equity interest in the business. These methods are discussed more in the following paragraphs. Income Approach-Capitalized Cash Flow Method The capitalized cash flow method (also known as the Gordon growth model) is one method that is used to apply the income approach. The capitalized cash flow method is a simplified version of the more detailed discounted cash flow method discussed in the following section. For the capitalized cash flow method, two key assumptions are made that simplify its application. First, a constant growth rate for net cash flows is assumed. The same growth rate is therefore assumed for each year in perpetuity. Second, the inter-relationships among financial statement items also remain the same in perpetuity. For example, the gross profit percentage is assumed to remain constant. Under the capitalized cash flow method, one estimate is used to represent future net cash flow. The method is applied using the following model. NCF for next year FV = k-8 where FV is the fair value estimate, NCF is net cash flows attributable to equity shareholders (direct equity), k is the cost of capital, and g is the long-term growth rate. For example, assume that the current year's net cash flows for Zebra Company are $1.8 million, its cost of capital is estimated to be 16 percent, and the expected long-term growth rate is 4 percent. Using these inputs, the estimated business valuation is $15.6 million and is computed as follows: FV = (1.8 X 1.04)/(16% -4%) = 15.6 A number of assumptions are made in applying the capitalized cash flow model (or any other income approach-based model). The evaluator must assess the relevance and reliability of the available information in determining any assumptions that need to be made and which inputs to use. Information is obtained from reviewing historical financial information, management plans, discussions with management, market and industry data, among others. Generally, market-based data is preferred when available and should be considered in evaluating management plans. The determination of net cash flows starts with normalized net income after tax. Depreciation and amortization are added back to better reflect cash flow. When valuing the equity ownership interest of a business, new debt is added and debt repayments and capital expenditures are subtracted. The result is net cash flow to equity interests, which is used in the valuation of an equity interest (Hitchner 2011, 132). A common approach to approximating next year's net cash flows is by adjusting the current year's net cash flows on a normalized basis) for one year of growth. If the company is fairly stable, net income may be used in place of all net cash flows. Alternatively, if net cash flows vary considerably from year to year, even after normalizing, net income may be used if it has a more stable pattern. The growth rate that is applicable to a firm is commonly based on a combination of historical growth rates, industry data, and management plans. Each of these is important in developing a long-term growth rate projection for the firm because it is assumed, in the capitalized cash flow method, that the growth lasts into perpetuity. Projected gross domestic product (GDP) growth rate is an alternative proxy that may be used when firm-specific information is unreliable or not available. Overall, the estimated growth rate must be sufficiently large for the business to survive, and not too large so as to overtake the economy. There are a number of methods to estimate a firm's cost of capital. The method discussed here is referred to as the build-up method (the following discussion provides one approach to the build-up method). In applying the build-up method, each component of a firm's cost of capital is separately determined and then summed to provide an estimate of a firm's cost of capital (COC). Components consist of the risk-free rate of return, the market's equity risk premium, size premium (smaller firms have higher costs of capital), industry adjustment, and firm-specific risk factors not captured elsewhere. COC = RF + MERP + SIZE + IND + OTHER The risk-free rate (RF) is typically captured by the yield on 20-year U.S. Treasury Bonds (the U.S. Treasuries represent a combination of a real rate of return and inflation). The market equity risk premium (MERP) represents the additional return investors expect to invest in public equity markets. Historically, the market equity risk premium averages between 6 percent and 8 percent (Duff & Phelps 2015). For purposes of this case, assume a risk-free rate of 2.4 percent and market equity risk premium of 7 percent. The size premium (SIZE) captures the fact that smaller companies are riskier and investors demand a higher return as a result. The industry adjustment (IND) captures the fact that industries differ as to risksome are riskier than the market, while others are less risky. Additional information about the size premium and industry adjustment is provided in Panels A and B, Exhibit 6. The final component captures other company-specific risk factors (OTHER) and is very judgmental. Some (but not all) of the factors that may be considered include management quality, brand loyalty, supply chain characteristics, and macroeconomic factors. For example, if management is inexperienced, then the risk and the cost of capital is increased. How much it increases is a judgment call. Hitchner (2011) provides a structured approach adopted here to perform analysis for this partthe component observation method (see Panel C, Exhibit 6). Each component listed is evaluated in the context of the business being valued as either risk-increasing, neutral, or risk-decreasing. This information is then used to determine how much cost of capital is increased or decreased. Unfortunately, there is no formulaic approach; determining this cost of capital component is based on judgment. For example, if the result of applying the component observation method resulted in four components that were rated as risk-increasing, eight as neutral, and one as risk-decreasing, the overall conclusion would suggest an increase in risk. Ascribing a number to the level of risk is more difficult. The incremental effect of these components on risk is clearly risk- increasing, but there are numerous neutral factors as well as one that is risk-decreasing. A risk premium between 1 percent and 3 percent could probably be justified. Income Approach-Discounted Cash Flow Method The discounted cash flow method is a second method for applying the income approach to estimating the value of a business. This method estimates the future net cash flows and then discounts the cash flows to the present to provide an estimate of value as illustrated in the following model. NCFP+1 k-8 + NCF; (1 + k) FV = (1 + k) where FV is the fair value estimate, NCF is net cash flows attributable to equity shareholders (direct equity), k is the cost of capital, g is the long-term growth rate, t is the year in the projection period, and P is the total number of years in the projection period. The model above consists of two terms. The first term focuses on the estimated net cash flows for each of the years in the projection period (the projection period is commonly three to five years). The starting point is the normalized information for the most current period. As opposed to the capitalized cash flow approach for which only one assumption is required (long-term growth rate), assumptions for the discounted cash flow method may be numerous in determining the net cash flow for each year during the projection period. Each line item in the projection, therefore, requires a separate assumption for each year. For example, sales in Year 1 are expected to increase 4 percent, then improve to 6 percent in Years 2 and 3, and decline to 3 percent in Years 4 and 5. Additional assumptions are required for cost of goods sold, selling, general, and administrative expenses, other income (expenses), and income taxes, as well as any other items that affect net cash flows (such as depreciation and capital expenditures). The net cash flows for each of the years in the projection period are then discounted using the cost of capital. Cost of capital is determined similarly to that using the capitalized cash flow method as described above. The second term concerns the period after the projection period and captures the additional value from operations through perpetuity (the terminal period). As a simplification, the Gordon growth model is used to determine the terminal period value. Similar to the capitalized cash flow method, assumptions for the cost of capital and long-term growth rate are required. First, the net cash flows from the last year in the projection period are increased to account for additional growth to provide an estimate of net cash flows from the first year in the terminal period. Second, these net cash flows are divided by the difference between the cost of capital and the long-term growth rate to provide the terminal value at the beginning of the terminal period. Finally, this value is discounted to the present. The two terms are then combined to provide a fair value estimate of the business. For example, assume that Zebra Company's net cash flows for the next five years are estimated (in millions) at $1.0, $1.2, $1.8, $1.6, and $2.0, respectively. Further, the cost of capital stimated to be 15 percent and the expected long-term growth rate is 3 percent. Using these inputs, the estimated business valuation is $13.4 million and is computed as follows: Terminal Period Period 1 2 5 Net Cash Flows $1.00 $1.20 $1.80 $1.60 $2.00 Terminal Value $17.17 -2.06/(15% -3%) Total Cash Flows 1.00 1.20 1.80 1.60 2.00 17.17 Present Values 0.87 0.91 1.18 0.91 0.99 8.54 Fair Value = sum of the present values = $13.4 * The 0.87 represents the present value of 1.00 using the 15 percent cost of capital for one year. Market Approach-Guideline Company Analysis The market approach is based on using the observed market price for a sample of businesses (guideline companies) similar to the one you are trying to value. That is, a known price is used to estimate your unknown value. This approach relies on determining a pricing ratio that links the values of comparable firms to a parameter, such as market value of equity/earnings. The parameter is then used to estimate the value of the subject firm of interest. This method is discussed in more detail in the following paragraphs. First, the prices and other descriptive variables of a sample of similar companies are obtained. Pricing data based on a sample of firms is better than data based on one firm as data for a sample of firms provide more reliable and unbiased information. This sample can be easily prepared using publicly traded firms. However, publicly traded firms may not be the best comparable firms. In this case, data on private company transactions (or purchase and sale transactions involving segments of publicly traded companies) can be purchased. Generally, the comparable companies in the sample should be similar to the subject firm in terms of industry and size, and the valuations of the comparable companies should be recent, i.e., within the last two to three years. A number of different attributes are included for each business in this sample. For example, financial data obtained may include total assets, total liabilities, book value of equity, total revenue, gross profit percentage, earnings before interest and taxes (EBIT), net income, and earnings per share (EPS). In addition, the total market value for each business is obtained. The market data for each business is then standardized as a pricing parameter (divide the total market value by an attribute of the business such as total revenue or net income). If you are valuing a going concern business, then a pricing parameter based on revenue or earnings may be more appropriate. Next, the comparable companies are compared to the firm being valued (the subject firm). If a comparable company is substantially different from the subject firmi terms of size or some other factor, the observations should be removed from the sample. Likewise, if a comparable company reports a net loss, it should be excluded because the pricing parameter would be negative. Each omission should be explained. For the remaining comparable firms, summary statistics are computed. Common summary statistics include mean, median, 25th percentile, and 75th percentile. The subject firm, i.e., the firm you are trying to value, is then compared to the summary statistics to determine how well it compares to the comparable companies in order to select the appropriate pricing parameters to use. That is, do the subject firm's financial and nonfinancial attributes look more like those in rows for the mean, median, 25th percentile, or 75th percentile of these firms? The row that is more like the subject firm's attributes is then used to determine the appropriate pricing parameters, and these are used in determining the business value (that is the Price/Parameter for the comparable firms in the formula below). The basis for this selection should be clearly articulated. The pricing parameter (such as the market value/income ratio) for the selected summary statistic of the comparable companies is then applied to the subject firm's parameter (subject's income level) to determine the fair value of the equity capital of a business as follows: FV = Price Parameter) comparable X Parameter Subject For example, assume there is a sample of eight guideline companies from the same industry as Zebra Company, the subject to be valued, and the market values are based on recent private purchase and sale transactions. Using total assets, leverage, revenue, gross profit, and net income, the subject is most similar to the median values of these eight firms. The median pricing parameter (market valueet income) is 20.6. If the subject's net income is $6 million, then the business valuation of Zebra Company is $123.6 million (20.6 x $6 million). Combination When more than one fair value is estimated, the individual values must be combined to provide one valuation. If no valuation is superior to any other, then a simple average may be used. If it is determined that one or more methods provide a more reliable value estimate than the others, differing weights can be assigned to each value estimate (weights must add to 100 percent). The weights are applied to the respective value estimate and summed to provide an overall fair value estimate. The evaluator also provides an explanation supporting the weights used. REQUIREMENTS You work as a staff accountant in the Controller's office at Tombstone. For 2015 and 2016, the Company enlisted the services of an external valuation expert who concluded that the goodwill related to the JHO reporting unit was not impaired. The valuation expert applied the capitalized cash flow method (income approach) and a market approach in determining the value of the business. This year, Tombstone management decided to perform the analysis in-house and you are tasked with the job. Management has decided not to complete a qualitative assessment, but to proceed directly to the quantitative goodwill impairment test as required under Accounting Standards Update No. 2017-04 (FASB 2017). You are to use methods similar to those used by the valuation expert in determining the fair value of the business in applying the goodwill impairment model; unfortunately, the valuation expert was not willing to share her work papers that supported her analyses. Complete the following requirements to accomplish your assignment. A common criticism of accountants is the lack of support or evidence for a professional judgment (Adler 2012). You are to support your response well, yet concisely, where noted in the requirements. Requirements 3, 7, and 8 provide a more advanced and complex case and are assigned at the discretion of the instructor (labeled as Optional). 1. An important task in performing business valuations is normalizing the historical financial statements. Using the information provided in this case, identify required normalization adjustments, prepare a normalized income statement, and determine net cash flow to equity interests. In addition, recalculate the ratios provided in Exhibit 4 using the normalized income statement and net cash flow to equity interests (use the historical balance sheets). Assume an income tax rate of 25 percent for this requirement. 2. Using the information provided in this case and the normalized financial information from Requirement 1, apply the capitalized cash flow method (income approach), and determine the fair value of JHO. Provide support for each of the inputs you use and assumptions you make. 3. Optional. Using the information provided in this case and the normalized financial statements from Requirement 1, apply the discounted cash flow method (income approach), and determine the fair value of JHO. For this method, assume that net cash flows to equity interests are approximated by net income. Therefore, you will only need to project net income for the next five years and estimate a terminal value as of the end of the sixth year. Provide support for each of the inputs you use and assumptions you make. Assume an income tax rate of 25 percent for this requirement. 4. Management purchased market value guideline company data for a set of ten comparable firms (see Exhibit 7). The comparable data is based on private sales transactions of companies similar to JHO. Using this data and other information provided in this case, apply the market value/earnings ratio method (market approach) to determine the fair value of JHO. Provide support for each of the inputs you use and assumptions you make. 5. Is JHO's goodwill impaired? In making this determination, use your responses to Requirements 2, 3, and 4, as applicable. Identify and support the business valuation method(s) used in this determination. 6. Sensitivity analysis is an important part of understanding fair value estimates. Many assumptions are commonly made when estimating fair value and, in many situations, there may be evidence that supports multiple values for a given assumption or input. Identify key assumptions used in both methods where there reasonable evidence that supports an alternative input amount. Calculate and determine the impact on the fair value and the goodwill impairment conclusion if each alternative is used. Does this affect your conclusion as to whether goodwill is impaired? Explain. 7. Optional. Certain assumptions underlie the values you estimated above. Two key concepts that may affect the determination of fair value are marketability of the equity interest and control of the company by the equity interest. Fair value estimates may be adjusted up (premium) or down (discount) for the presence or absence of marketability and control in determining the preliminary business valuation. Use the internet and research the discount for lack of marketability and a control premium. Without providing specific amounts, would either of these be appropriate in estimating the fair value of JHO? Provide citations as needed for sources. 8. Optional. In reviewing your analysis above, which qualitative and quantitative factors are most important in determining a reliable fair value estimate? What additional information could be obtained to provide a more relevant and reliable fair value estimate and improve the overall decision making? Provide citations as needed for sources. 2014 2017 EXHIBIT 1 JH Outfitters' Balance Sheets for June 30, 20132017 (S in millions) 2013 2015 2016 CURRENT ASSETS Cash and Short-Term Investments $0.7484 $2.2561 $3.4605 54.3440 Accounts Receivables 0.6633 0.4711 0.4823 0.4537 Allowance for Doubtful Accounts (0.0289) (0.0326) (0.0420) (0.0292) Accounts Receivables (net) 0.6344 0.4385 0.4403 0.4245 Inventories 8.5477 8.9578 8.9690 10.1500 Other Current Assets 0.5681 0.5712 0.7735 0.7654 Total Current Assets 10.4986 12.2236 13.6433 15.6839 LONG-TERM ASSETS PPE 10.4433 12.3315 9.6295 11.5171 Accumulated Depreciation (4.7629) (5.7085) (0.7906) (1.7368) PPE (net) 5.6804 6.6230 8.8389 9.7803 Identifiable Intangible Assets (net) 2.5007 2.5903 3.4245 3.3108 Goodwill 2.2000 2.2000 Other Assets 0.9855 1.0164 0.8587 0.9895 Total Long-Term Assets 9.1666 10.2297 15.3221 16.2806 TOTAL ASSETS $19.6652 $22.4533 $28.9654 $31.9645 $2.4521 0.5281 (0.0244) 0.5037 11.9619 1.0413 15.9590 13.0920 (2.7602) 10.3318 3.7950 2.2000 1.5228 17.8496 $33.8086 $4.3137 $3.6575 0.0302 3.3337 7.0214 $2.9911 0.0869 3.1273 6.2053 $4.4651 0.2948 4.0104 8.7703 $5.1040 0.6875 3.9283 9.7198 3.5464 7.8601 CURRENT LIABILITIES Accounts Payable - Trade Income Taxes Payable Other Current Liabilities Total Current Liabilities LONG-TERM LIABILITIES Long-Term Debt Other Liabilities Total Long-Term Liabilities TOTAL LIABILITIES 2.3331 2.2216 4.5547 11.5761 1.4127 2.2516 3.6643 9.8696 1.9076 1.7057 3.6133 11.4734 1.8986 2.4097 4.3083 13.0786 1.6976 2.7254 4.4230 14.1428 EQUITY Common Stock Additional Paid-In Capital Retained Earnings Total Equity TOTAL LIABILITIES AND EQUITY 6.4814 0.7062 0.9015 8.0891 $19.6652 6.4814 2.7471 3.3552 12.5837 $22.4533 6.4814 2.7471 8.2635 17.4920 6.4814 2.7471 9.6574 18.8859 6.4814 2.7471 10.4373 19.6658 $28.9654 $31.9645 $33.8086 EXHIBIT 2 JH Outfitters' Income Statements for Five Years Ending June 30, 2017 ($ in millions) 2013 2014 2015 2016 2017 Online and Catalog Sales $29.8300 $30.8900 $36.9300 $39.1800 $40.8528 Retail Rentals and Sales 15.1900 15.7200 16.3500 16.9300 17.5084 Total Sales (net) 45.0200 46.6100 53.2800 56.1100 58.3612 Cost of Goods Sold 28.5518 30.9650 33.9636 35.4522 38.7366 Gross Profit 16.4682 15.6450 19.3164 20.6578 19.6246 OPERATING EXPENSES Selling, General and Admin Expenses Operating Income Before Depreciation Depreciation and Amortization Operating Income After Depreciation 10.1774 6.2908 0.6273 5.6635 10.5525 5.0925 0.7295 4.3630 12.0296 7.2868 1.1039 6.1828 12.3861 8.2717 1.1658 7.1059 13.8848 5.7398 1.2510 4.4888 OTHER NON-OPERATING EXPENSES Interest and Related Expense Non-Operating Expense (Income) Income Taxes Total NET INCOME 0.1110 0.0142 0.7898 $4.7485 0.0454 0.0215 0.8920 $3.4041 0.1402 0.0228 0.7164 $5.3035 0.1387 2.5740 0.2283 $4.1649 0.0603 0.0456 1.0635 $3.3194 EXHIBIT 3 JH Outfitters' Net Cash Flow to Equity Interests for Five Years Ending June 30, 2017 ($ in millions) 2013 2014 2015 2016 2017 NET INCOME $4.7485 $3.4041 $5.3035 $4.1649 $3.3194 Add: Depreciation and amortization 0.6273 0.7295 1.1039 1.1658 1.2510 Debt issues 1.0000 Less: Capital expenditures Repayment of debt (1.4680) (0.2500) (1.8882) (0.9205) (1.0065) (0.5050) (1.8877) (0.0090) (1.5749) (0.2010) NET CASH FLOWS TO EQUITY INTERESTS $3.6578 $1.3249 $5.8959 Note: Incremental working capital needs are assumed to be zero each year. $3.4340 $2.7945 2017 EXHIBIT 4 JH Outfitters' Ratio Analyses (Historical) 2014 2015 2016 Liquidity Ratios Current Ratio 1.9699 1.7358 1.7883 Quick (Acid-Test) Ratio 0.4342 0.4963 0.5437 1.6419 0.3041 Activity Ratios Accounts Receivable Turnover Days Outstanding in AR Inventory Turnover Days Inventory Total Asset Turnover Cost of Sales to Sales * Operating Expenses to Sales * Operating Margin * 82.1756 4.4417 3.5378 103.1729 2.2133 0.6643 0.2264 0.0936 111.7625 3.2659 3.7892 96.3273 2.0724 0.6375 0.2258 0.1160 119.8880 3.0445 3.7086 98.4199 1.8418 0.6318 0.2207 0.1266 118.8873 3.0701 3.5037 104.1757 1.7746 0.6637 0.2379 0.0769 Leverage Ratios Total Debt to Total Assets * Long-term Debt to Equity 0.4396 0.1123 0.3961 0.1090 0.4092 0.1005 0.4183 0.0863 Profitability Ratios Gross Profit Margin * Operating Profit Margin * 0.3357 0.0936 0.3625 0.1160 0.3682 0.1266 0.3363 0.0769 Rate of Return Ratios Return on Assets * Return on Common Equity * 0.1324 0.3293 0.1741 0.3527 0.1266 0.2290 0.0982 0.1722 Sales Growth Rates Online and Catalog Sales * Retail Rental and Sales * Total Sales (net) * 0.0355 0.0348 0.0353 0.1955 0.0400 0.1431 0.0609 0.0354 0.0531 0.0427 0.0341 0.0401 * Industry data is not available for this ratio. EXHIBIT 5 Industry Data 2013 2014 2015 2016 Liquidity Ratios Accounts Payable/Revenue (%) Current Ratio Quick Ratio Days Payable 8.26 2.58 0.73 53.95 7.34 2.27 0.60 50.40 6.36 2.43 0.67 40.87 5.63 2.44 0.67 36.20 14.45 19.55 21.03 4.30 3.10 46.14 19.11 3.91 55.12 6.62 5.29 . 3.69 48.45 7.533 4.72 1.12 61.76 5.91 5.79 2.1 Activity Ratios Cash Turnover Current Asset Turnover Accounts Receivables Turnover Days Outstanding in AR Inventory Turnover Days Inventory Working Capital Turnover Days Working Capital Fixed Asset Turnover Assets/Revenue Total Asset Turnover Cost of Sales/Inventory 145.40 121.47 111.02 7.91 4.56 4.56 143.33 5.06 3.00 72.20 15.45 0.44 2.27 2.55 6.59 . 55.35 21.43 0.37 2.73 2.51 6.66 54.82 21.49 0.34 2.94 3.00 7.30 50.03 23.87 0.31 3.25 3.29 Leverage Ratios EBITDA/Interest Expense Long-term Liabilities/Net Worth 12.35 0.65 9.28 0.67 9.93 0.63 9.77 0.65 EXHIBIT 6 Cost of Capital Components Panel A: Size Premium Decile Size Premium -0.36% 0.63% Market Capitalization Range (S in millions) $24,428 - $591,015 10,170 -24,272 5,864 -10,105 3,725 - 5,844 2,552 - 3,724 0.91% 1.06% 1,689-2,543 1,011 - 1,686 8 549 - 1,010 9 301 - 548 10 3 - 300 Source: Appendix 3, Duff & Phelps 2015 Valuation Handbook, Guide to Cost of Capital 1.60% 1.60% 1.749 1.71% 2.15% 2.69% 5.78% Panel B: Industry Adjustment Industry Segment Unlevered Beta Number of Firms Retail (Automotive) 0.75 Retail (Building Supply) 5 1.29 Retail (Distributors) 83 0.81 Retail (General) 19 0.90 Retail (Grocery and Food) 17 0.76 Retail (Online) 39 1.46 Retail (Special Lines) 124 0.78 Source: http://pages.stern.nyu.edu/-adamodar/New Home Page/datafile/Betas.html Risk Premium (Assumes a 7% Market Equity Risk Premium) -1.75% 2.03% -1.33% -0.70% 1.68% 3.22% -1.54% Panel C: Company-Specific Risk Factors Risk Factor Neutral Risk- increasing Risk- decreasing Management depth Access top capital Customer concentration Customer pricing leverage Supplier concentration Supplier pricing leverage Product to service diversification Geographical distribution Volatility of earnings or cash flows Technology life cycle Potential new competitors Life cycle of current products or services Availability of labor EXHIBIT 7 Market Data for Firms Comparable to JH Outfitters ($ in millions) Comparable Loc. Assets Leverage Sales EBIT 0.01 #1 #2 #3 0.08 #4 #5 #6 #7 #8 #9 #10 KY CO WI DC PA WI CO WI NH FL 9.14 12.85 7.09 28.85 12.99 27.91 603.90 135.34 63.91 134.15 Total Equity 7.03 8.39 3.68 21.60 6.99 8.16 159.20 40.42 39.25 14.66 10.45 18.80 23.19 39.71 46.26 61.03 82.00 155.54 257.40 369.06 0.90 1.50 6.01 2.79 10.73 4.67 (13.50) 35.72 19.64 73.70 Net Income 1.57 0.99 5.91 5.24 6.54 2.63 57.25 18.45 11.71 42.31 Market Value 6.44 15.31 35.11 22.19 63.26 8.00 640.95 110.86 59.99 265.40 MV/ Net Income 4.11 15.42 5.94 4.23 9.68 3.04 11.20 6.01 5.12 6.27 0.53 0.36 0.38 0.48 0.18 0.22 Mean Std. Dev. 25th Ptl. Median 75th Pt1. 103.61 182.52 12.89 28.38 134.92 30.94 47.00 7.31 11.53 40.01 106.34 119.59 27.32 53.64 221.75 14.22 24.58 1.82 5.34 30.09 15.26 19.24 3.28 6.22 33.96 122.75 197.91 17.03 47.55 211.31 7.10 3.85 4.46 5.97 10.66 0.05 0.44 The comparable data is based on private purchase and sales transactions of companies similar to JHO and was purchased by Tombstone for purposes of the valuation. A B C D E F G H J K L M N o F 1 Q1: 2 An important task in performing business valuations is normalizing the historical financial statements. (a). Using the information provided in this case, identify required normalization adjustments, prepare a normalized income statement, and determine net cash flow to 3 equity interests. (b). Recalculate the ratios provided in Exhibit 4 using the normalized income statement 4 and net cash flow to equity interests (use the historical balance sheets). 5 Assume an income tax rate of 25% for this requirement. 6 7 EXHIBIT 2 8 JH Outfitters' Income Statements for Five Years Ending June 30, 2017 9 10 ($ in millions) 2013 2014 2015 2016 2017 11 Online and Catalog Sales 29.83 30.89 36.93 39.18 40.853 12 Retail Rentals and Sales 15.19 15.72 16.35 16.93 17.508 13 Total Sales (net) 45.02 46.61 53.28 56.11 58.361 14 Cost of Goods Sold 28.552 30.965 33.964 35.452 38.737 15 Gross Profit 16.468 15.65 19.316 20.658 19.625 16 17 OPERATING EXPENSES 18 Selling, General and Admin Expenses 10.177 10.553 12.03 12.386 13.885 19 Operating Income Before Depreciation 6.2908 5.09 7.2868 8.2717 5.7398 20 Depreciation and Amortization 0.6273 0.7295 1.1039 1.1658 1.251 21 Operating Income After Depreciation 5.6635 4.36 6.1829 7.1059 4.4888 22 23 OTHER NON-OPERATING EXPENSES 24 Interest and Related Expense 0.111 0.0454 0.1402 0.1387 0.0603 25 Non-Operating Expense (Income) 0.0142 0.0215 0.0228 2.574 0.0456 26 27 Income Taxes Total 0.7898 0.892 0.7164 0.2283 1.0635 28 NET INCOME 4.7485 3.40 5.3035 4.1649 3.3194 29 30 net decrease in expenses Assumed tax rate rate adjustment to increase income taxes actual GAAP income tax amounts total adjusted income taxes 2013 -0.47 0.25 0.1175 0.7898 0.9073 2014 -0.47 0.25 0.1175 0.892 1.0095 2015 -1.55 0.25 0.3875 0.7164 1.1039 2016 -3.75 0.25 0.9375 0.2283 1.1658 2017 -0.75 0.25 0.1875 1.0635 1.251 H . . B C D E F G 30 31 ADJUSTMENTS THAT MEET THE DEFINITION for "normalized" income statement (page 58 of case) 32 33 1. JH Outfitters (JHO) recorded and paid a litigation settlement in 2016 2.6 in millions 2. JHO entered into a 10-year lease agreement of a private jet on 1/1/2010 for 34 Mr. Holden with an entity controlled by Mr. Holding requiring annual payments 750,000 3. rental of additional warehouse space with another entity controlled by Mr. 35 Holden; annual rental expense is 140,000 10000 sqft The market rate for comparable warehouses in the area range from $1.00 per 36 sq ft per month to $1.20 per sq ft per month 37 Warehouse space rented is 4. In 2015, due to a major hurricane that disrupted the supply change, JHO paid 38 additional product costs of 39 The additional product costs should be allocated to Cost of Goods Sold as follows: 40 2015 41 2016 42 1.2 in millions 0.8 0.4 Valuing the Business of JH Outfitters Anna J. Johnson-Snyder East Carolina University Mark J. Kohlbeck Florida Atlantic University ABSTRACT: This case uses a goodwill impairment setting to introduce intermediate and advanced accounting students to business valuation (that is, estimating the fair value of a business unit). Tombstone, Inc. previously acquired JH Outfitter's (JHO) and recorded $2.2 million of goodwill. In prior years, management utilized an outside service to provide fair value estimates of JHO for purposes of the goodwill impairment testing. The business valuation is to be done in-house this year. Three common valuation approaches are discussed in the case to provide students with a background that is sufficient to apply these methods to estimate the fair value of JHO for the goodwill impairment tests. Sufficient, yet conflicting, information is also provided to complete the basic requirements. As such, the case provides students an opportunity to apply the goodwill impairment model (as revised in 2017) where the fair value of a business unit is uncertain. Keywords: goodwill impairment; fair value; estimation; income approach; market approach. CASE T ombstone, Inc. (Tombstone or the Company) is a 30-year old retailer headquartered in the western part of the United States. As of July 1, 2014, Tombstone exchanged $16.2 million of Tombstone common stock for 100 percent of JH Outfitter's (JHO) closely held stock in order to expand into internet sales. James Holden, the founder of JHO, created an online store and service program in 2002 that is still unrivaled over a decade later. Since the acquisition, Tombstone has operated JHO autonomously as a reporting unit. At the time of the acquisition, the fair value of the identifiable net assets (total identifiable assets less liabilities) measured in accordance with GAAP (ASC 350-20-25) was $14.0 million, and $2.2 million in goodwill was recorded. The required fair value adjustments included writing down inventory and other assets by $0.46 and $0.92 million, respectively. Property, plant, and equipment were adjusted upward by $2.0 million. In addition to recording the goodwill, identifiable intangible assets totaled $3.4 million, requiring an upward adjustment of $0.80 million. Both the property, plant, and equipment and identifiable intangible assets are estimated to have a remaining life of ten years from the date of acquisition. This transaction was treated as a stock purchase for tax purposes. Therefore, there are no deferred tax issues associated with this acquisition. Tombstone also applied pushdown accounting whereby the acquisition accounting is recorded directly in JHO's accounting records. Management determined that goodwill was not impaired in either of the past two years. The business valuation of the JHO reporting unit for goodwill impairment testing was outsourced to a local valuation firm in fiscal 2015 and 2016. This year, the business valuation of JHO is being performed in-house. Management also decided to adopt early the provisions of Accounting Standards Update 2017-04 (FASB 2017). The following sections provide information on JHO's financial statements, as well as its industry and management plans to complete this task. In addition, two business valuation models based on the income approach and one based on the market approach are discussed in order to provide an introduction to business valuation and guidance to apply the methods. FINANCIAL STATEMENT INFORMATION JHO's historical financial statements for the past five years are presented in Exhibits 1 to 3. A company's historical financial statements provide information on its financial condition for a period and include common and unusual events. To evaluate the fair value of a company, the financial statements should be normalized or "adjusted to reflect the economic realities of 'normal' operating conditions (Hitchner 2011, 89).? This is especially important when applying the income approach to valuation and determining assumptions for the valuation model. Normalization means that items that can be defined as unusual, nonrecurring, noneconomic, or related to non-operating assets and liabilities are removed to "eliminate anomalies and/or facilitate comparisons (AICPA 2017, 23). For example, costs to repair a manufacturing facility that was damaged during a "100-year" storm or Hurricane Irma should be removed from the financial statement data during a business valuation to allow for comparability of the company to others in the industry not impacted by the storm. Other common normalization adjustments include removing the effect of acquisitions and dispositions, labor strikes, major litigation, natural disasters, infrequent and/or nonrecurring items, and related tax effects. Tombstone has not prepared normalized financial statements for JHO. Management has identified four transactions over the past five years that may meet the definition for normalization purposes. First, JHO recorded and paid a litigation settlement of $2.6 million in 2016. Second, the company has a ten-year lease, which commenced on January 1, 2010, with an entity controlled by James Holden for which JHO pays $750,000 to rent a private jet for Mr. Holden. Third, additional warehouse space was required to support an increase in sales. Another entity controlled by James Holden built a 10,000sqft warehouse for JHO and rents storage space to JHO for $140,000 annually. The market rate for warehouses in this area ranges from $1.00 to $1.20 per square foot per month. Fourth, a major hurricane in 2015 upset the supply chains for its products. As a result, JHO paid $1.2 million more in product costs. Two-thirds of the extra costs are reflected as increased cost of goods sold (COGS) in 2015; the balance is reported in 2016. Ratio analysis is also important in understanding a company's operations and supporting various valuation assumptions. Common ratios based on the historical financial statements are computed for the past four years to provide insight on JHO's liquidity, activity, leverage, and profitability, and are presented in Exhibit 4. An analysis based strictly on the firm only tells part of the story. Comparison with industry information is also necessary to provide context, develop assumptions, and perform a business valuation. Tombstone's accounting staff assembled the following industry data to assist in the analysis. INDUSTRY ANALYSIS Establishments within the sporting goods retail industry (SIC 5941; NAICS 451110) primarily sell goods, equipment, and accessories for sports and recreational activities. Historically, sporting goods were offered by small, local companies, which were more like today's outfitters; however, in the latter part of the 20th century, availability of the internet and sporting goods superstores resulted in an unprecedented level of industry growth (Referenceforbusiness.com 2016). Currently, the industry is experiencing a slow decline. In 2015, there were 46,330 U.S.-based sporting goods companies, which is a 5.01 percent decrease from the 2013 high of 48,773 firms (Bizminer 2015). The vast majority of these firms are considered small firms (45,186 small and 1,144 large firms). Between 2013 and 2015, 16 large retailers (1.40 percent of large firms) entered the market while 2,459 small retailers (5.44 percent of the small firms) left the market. The shift in industry demographics was anticipated; small retailers have difficulty competing with the large, superstore retailers. Little changed in the industry during 2016; however, in 2017, there were three significant changes in the large sporting goods retailer industry. First, Bass Pro Shops acquired Cabela's Inc.; it is estimated that the large retailer may control "more than 20 percent of the 50 billion U.S. hunting, camping, and fishing market (Germano 2016, 1). Second, Gander Mountain filed bankruptcy in March 2017 and was purchased during those proceedings by Camping World, Inc. (Fitzgerald 2017; Fung 2018). A Camping World representative reported in early 2018 that of the 160 stores closed by Gander Mountain, approximately 69 will be reopened as "Gander Outdoor if rent relief negotiations are successful (Fung 2018, 1). Finally, Dick's Sporting Goods, Inc. bought 30 stores from a bankrupt Golfsmith International Holdings, Inc., a U.S. golf specialty retailer (Fitzgerald 2017). Product offerings and the store type vary depending on retailer size. For instance, small privately held establishments, e.g., JHO, Smith's Archery, and MK's Golf, are more likely to have "feeder" stores located near or within a retail strip or mall and offer more specialized products or custom services to a niche market. Large publicly traded companies (e.g., Tombstone, Bass Pro Shops, and Camping World) are more likely to have freestanding, independent superstores with a vast range of popular products from boats to cabin kits. Thus, large companies are more able to weather the seasonal fluctuations of product desirability. Barriers to entry concerning large versus small sporting goods retailers differ drastically. Superstores are mature firms; these companies require much more capital and planning to open a store. In contrast, many small firms, such as outfitters, are young, start-up companies that need much less capital to open and owners usually have advanced knowledge of the equipment and garments required for an activity or expedition. In contrast to the large sporting goods retailer industry, the outfitter industry has experienced steady growth. In 2015, there were 101 firms in the industry, which is a 16.09 percent increase from the 87 companies reported in 2013 (Bizminer 2015). The financial ratios of the outfitter industry are somewhat mixed as to whether the overall industry is improving (see Exhibit 5). Solvency ratios suggest the industry is using suppliers less to maintain operations (declining accounts payable divided by revenue) and paying debts more timely (fewer days payable), yet there is an overall decrease in industry ability to meet short-term obligations (current and quick ratios). Efficiency and leverage ratios also provide some mixed signals. On the one hand, the ratios suggest improving sales efforts and stronger cash flow management (decreasing assets divided by revenue; increasing cost of sales divided by inventory; declining days receivable, inventory, and working capital). On the other hand, there are indications of deteriorating ability to pay interest on debt (declining EBITDA divided by interest expense). However, reported turnover ratios are generally improving over the past four years. Demographics of the consumer-base are changing. Currently, the United States has a large aging yet physically active population that is retired or entering retirement (Bizminer 2015). In the next five years, analysts predict this trend to continue, albeit at a much slower pace. This increase in the retirement communit