Question (5) Directions: Click the "Case-link" displayed above and use the information provided in Hearth and Home, Parts A and B, to answer this question: In a downside-case scenario, you assume that a recession slows housing starts by 30 percent. If so, which of the following hypotheses would be the most reasonable? O Cost of goods sold and SG&A expenses both decrease as percentages of sales O Gross profit margin decreases and SG&A expenses decrease as percentages of sales OInventory days on hand decrease by 5 days and cost of goods sold as a percentage of sales decreases OInventory days on hand increase by 5 days and SG&A expenses as a percentage of sales increase learth and Home Part B Hearth and Home Balance Sheets (in $000s) As At June 30: 201 20Y2 203 ASSETS Current assets Cash 100 123 66 240 Accounts receivable 303 376 417 Inventory 461 547 117 70 Other current assets 107 874 Total current assets 1,096 957 257 245 313 Fixed assets 71 107 71 Trademarks and goodwill $ 1,190 1,516 $ 1,285 TOTAL ASSETS LIABILITIES AND OWNERS' EQUITY Current liabilities S Current portion-LTD 67 67 $ 67 Notes payable Accounts payable Accrued expenses 101 5 244 204 148 69 64 57 Other current liabilities 46 28 47 Total current labilities 527 368 319 Long-term debt 330 397 464 Other noncurrent liabilities 20 19 18 Owners' equity 639 501 389 TOTAL LIABILITIES AND OWNERS' EQUITY 1,516 1,285 1,190 Working investment $ 610 $ 496 452 40 earth and Home Part B Hearth and Home Income Statements (in $000s) Years Ended June 30: 20Y1 20Y2 20Y3 $ 2,500 $ 3,000 $ Sales 3,570 1,773 2,093 Cost of goods sold 2,467 727 Gross profit 907 1,103 33 36 36 Interest expense 50 60 52 Depreciation expense 586 477 371 Operating expense 345 270 421 Profit before taxes 188 149 108 Taxes 233 Net profit after taxes 196 162 Dividends 95 84 65 Earnings retalned 138 $ $ 112 97 88 + Quick Cash Flow (in $000s) (U) WI Company Name. (U) Hearth and Home GFA 20Y3 202 Net profit Plus: Depreciation, amortization expense Plus (or less): A Working investment Equals: Cash after operating cycle 233 196 60 52 (114) (44) 179 204 (92) Plus (or less): A Gross fixed assets (12) 87 192 Equals: Cash after capital investment cycle (95) (84) Less: Dividends declared (8) 108 Equals: Cash available for all debt repayment (67) (67) Less: Current portion long-term debt (prior year) (75) 41 Equals: Cash available for other debt repayment ENDING BEGINNING Change in working investment Accounts receivable (net) Plus: Inventory Less: Accounts payable Less: Accrued expenses 303 240 461 417 204 148 64 57 496 452 Equals: Working investment 452 Beginning working investment Less: Ending working investment Equals: & Working investment 496 202 (44) ENDING BEGINNING Change in working investment Accounts receivable (net) Plus: Inventory Less: Accounts payable 303 376 461 547 204 244 69 64 Less: Accrued expenses 496 610 Equals: Working investment Beginning working investment Less: Ending working investment Equals: A Working investment 496 610 (114) 203 Change in working investment Accounts receivable (net) Plus: Inventory Less: Accounts payable Less: Accrued expenses BEGINNING ENDING Equals: Working investment Beginning working investment Less: Ending working investment Equals A Working investment Are any changes in income taxes payable, interest payable, prepaid expenses, investments, or miscellaneous other accounts large enough distort quick cash flow? Cash Flow Summary (in $000s) Company Name: Hearth and Home A (U) S L/E Line Number 20Y3 20Y2 Sales revenue (net) A Accounts receivable Cash collected from sales 3,570 3.000 (1) (73) (63) 3.497 2.937 (1)+ (2) (3) Cash cost of goods sold A Inventory A Accounts payable Cash paid for production Cash from trading activities (2.467) (2.093) (4) (5) (6) (86) (44) 40 56 (2.513) (2.081) 984 (3)+(7) ( 8) 856 (586) Cash SG&A expense A Prepaid expenses A Accrued expenses Cash paid for operating costs Cash after operations (477) (9) C (10) (11) (12) (8)+ (12) (13) 7 (581) (470) 403 386 0 Other income (expense) (14) A Other current and non-current (18) 29 (15) (16) (17) (18) accounts Income tax expense (188) (149) A Deferred income taxes A Income taxes payable Taxes paid and other income (expense) Net cash after operations (206) (120) 266 (19) 197 (13) (19) (20) (36) (33) (21) Interest expense A Interest payable Dividends declared or owners withdrawals (22) (84) (95) (23) (24) A Dividends payable Cash paid for dividends and interest Cash after financing costs (117) (131) (25) (20)+ (25) (26) 66 149 Current portion long-term debt (prior year) (27) (26) (27) (28) (67) (67) Cash after debt amortization 82 (1) A Fixed assets (64) (116) (29) A Investments (30) 4 Intangibles Cash paid for plant and investments Financing surplus (requirement) (36) (31) (64) 18 (32) (28) + (32) (33) (152) (153) 4 Short-term debt (notes payable) (34) 96 A Long-lerm debt A Preferred stock 4 Common stock (35) C (36) C (37) (38) 0 Total external financing Financing surplus (requirement) Total external financing 5 96 (33)+ (38) (39) (57) PROOF: A Cash and marketable securities (40) 23 (57) 23 Home Company Information Part A Hearth and Home sells, installs. and services residential fireplaces. Formed 22 years ago by Len Wilkinson as a retailer of fireplaces and accessories, the company installed virtually all of the fireplaces it sold and guaranteed its work for 10 years. The company built a reputation for prompt, quality workmanship and gradually, starting six years ago, several of the area's leading contractors began to subcontract chimney and fireplace installation to Hearth and Home. During its early years, most of the company's sales took place from October to March. As it expanded, subcontracting sales occurred throughout the year, though slightly months. Sales are now more in the summer fairly evenly divided between retail and subcontracting. The Wilkinsons have financed the company with long-term debt. The family has provided term loans totaling $350,000, and your organization has provided $200,000 in long-term debt Your organization also made available to the company what is now a $400,000 revolving credit. H and H may borrow up to 50 percent of receivables outstanding for less than 60 days and up to 40 percent of inventory, excluding inventory work in process. The company must be out of debt for 30 consecutive days during the second quarter of every calendar year. Until the end of 20Y3, the company was a model customer, meeting the second-quarter 30-day clean-up requirement fairly easily in 20Y1 and 20Y2. At the end of fiscal 20Y3, however, the company was unable to clean up the line. In fact, at the end of June, the outstanding balance was $101,000, the company having been unable to reduce the line significantly below $100,000 at any time during the entire second quarter. The balance outstanding data was on the last day for which you have $153,000. John Holmgren is the lender responsible for the relationship, and he has asked you for assistance in deciding how to handle the loan. When the company could not meet the cleanup requirement, John waived the requirement based on the company's past history and performance. In John's opinion, H and H's management has such high integrity that your organization will be able to recover its money; he believes that the owners would sell their houses if necessary to repay the debt. Having said that, John is also aware that the owning family depends upon dividend income and considers an annual dividend of at least $80,000 to be mandatory. John is feeling the dissatisfaction of credit management, which is unhappy with his decision to waive the clean-up. He needs to come up with a solution to the problem that will meet both the company's and your organization's needs. As you and John discuss the situation, he tells you that H and H's management expects sales to increase significantly in 20Y4 and that part of that increase will be due to additional contracting- mainly repairing older installations by a couple of competitors that have since gone out of business The Wilkinsons have proposed that the limit on the revolving credit be increased to $500,000