Question 5: Once again, using the revised profitability ratios for 2006 that you developed in Question 3, write a complete one paragraph analysis of the company's profitability ratios compared to the industry ratios (figure 3). Make sure to include asset turnover and debt to total assets as supplemental material in your analysis.

CASE [iJ Harrod's Sporting Goods Jim Harrod knew that service, above all, was important to his customers. Jim and Becky Harrod had opened their first store in Omaha, Nebraska in 1991. Harrod's carried a full line of sporting goods including everything from baseball bats and uniforms to fishing gear and hunting equipment. By the year 2006, there were twelve Harrod stores producing $5 million in total sales and generating a profit of over S200,000 per year. On the positive side, there was an increasing demand for sporting goods as leisure time activities continued to grow. Also, the state of Nebraska, where all twelve stores were located, was experiencing moderate growth. Finally, there had been a sharp upturn in the last decade for women's sporting goods equipment. This was particularly true of softball uniforms for high school, college, and city league women's teams. Jim's wife Becky was one of the top softball players in the city of Omaha and her extensive contacts throughout the state help to bring in new business. While Nebraska is primarily known as a football state, Omaha actually hosts the college baseball . world series each year in June and this generates a lot of interest in baseball (and softball as well). Jim, who had been a walk-on third string offensive tackle at the University of Nebraska (the Comhuskers in Lincoln, Nebraska), took great pride in his stores as well as his prior university affiliation. He and Becky (also a University of Nebraska graduate in the mid- l 980s) contributed $2,000 annually to the University of Nebraska athletic program. The growth in the stores was the good news for Jim and Becky. The Jess than good news was the intense competition that they faced. Not only were they forced to compete with nationally established sporting good stores such as Oshman's and the Academy, but Wal-Mart and Lowe's also represented intense competition for the sporting goods dollar. It appeared that every time Wal-Mart opened a new store near one of its locations, Lowe's put up one of its "big-boxes" nearby. The national stores were extremely competitive in terms of pricing. However, Jim, Becky and their employees offered great personal service, and they hoped this would allow them to continue with their specialty niche. 1n January of 2007, Becky, who served as the company's chief financial officer, walked into Jim's office and said, "I've had it with the First National Bank of Omaha. lt is willing to renew our loan and line of credit, but the bank wants to charge us 2 Y2 percentage points over prime. The prime rate is the rate at which banks make loans to their most creditworthy customers. It was 4.75 percent at the time Becky had visited 2 Required Case 1 the bank, so that the total rate on the loan would be 7 .25 percent. It was not so much the total rate that Becky objected to, as the fact that Harrod's was being asked to pay 2Yz percent over prime. She felt that Harrod's was a strong enough company that one percent over prime should be all that the bank required. Her banker told her he would review the firm's financial statements with her next week and reconsider the premium Harrod's was being asked to pay over prime. While Becky knew the bank "crunched all the numbers," she decided to do some additional financial analysis on her own. She bad a bachelor's degree in finance with a 3.3 GPA. She began by examining Figures 1, 2, and 3. 1. Compute the profitability ratios, including the a and b components (DuPont Methods) of ratios 2 and 3 as shown in the textbook. The profitability ratios should be shown for all three years. 2. Write a brief one-paragraph description of any trends that appear to have taken place over the three-year time period. 3. Jn examining the income statement in Figure 1, note that there was an extraordinary loss of $170,000 in 2006. This might have represented uninsured losses from a fire, a lawsuit settlement, etc. It probably does not represent a recurring event or affect the earnings capability of the firm. For that reason, the astute financial analyst might add back in the extraordinary loss to gauge the true operating earnings of the firm. Since it was a tax-deductible item, we must first multiply by (1 -tax rate) before adding it back in.* The tax rate was 35 percent for the year: $170,000 .65 Extraordinary loss ( 1-tax rate) $1 10,500 Aftertax addition to profits from eliminating the extraordinary loss from net income The more representative net income number for 2003 would now be: lnitially reported (Figure 1) Adjustment for extraordinary loss being eliminated Adjusted net income $200,318 +110,500 $310,818 Based on the adjusted net income figure of $310,818, recompute the profitability ratios for 2006 (include part a and b for ratios 2 and 3). 4. Now with the adjusted net income numbers as part of the ratios for 2006, write a brief one-paragraph description of trends that appear to have taken plac~ over the three-year time period (refer back to the data in Question 1 for 2004 and 2005). This adjustment was made because the SI 70,000 deduction saved 35 percent of this amount in taxes. If we eliminate the $170,000, the tax benefit would also be eliminated. Thus, the firm would only benefit by 65 percent of $ I 70,000, based on a 35 percent tax rate. The aftertax benefit of the tax adjustment for the extraordinary loss is $110,500. e .a Harrod's Sporting Goods Required Figure 1 5. Once again, using the revised profitability ratios for 2006 that you developed in Question 3, write a complete one paragraph analysis of the company's profitability ratios compared to the industry ratios (figure 3). Make sure to include asset turnover and debt to total assets as supplemental material in your analysis. 6. Harrod's has a superior sales to total assets ratio compared to the industry. For 2006, compute ratios 4, 6 and 7 as described in the text and compare them to industry data to see why this is so. Write a brief one-paragraph description of the results. Note: for ratio 4, only half the sales are on credit terms. 7. Conclusion: Based on your analysis in answering Questions 4 and 5, do you think that Becky Harrod has a legitimate complaint about being charged 2 Y2 percent over prime instead of one percent over prime? There is no absolute right answer to this question, but use your best judgment. Harrod's Sporting Goods Income Statement (2004-2006) 2004 Sales......................................................... $4,269,871 Cost of goods sold ....................... ,............ 2.99 L82 l Gross Profit .. .. .......................................... 1,278,050 Selling and administrative expense .......... 865,450 Operating profit ........................................ 4 12,000 Interest expense ............... ......... ................ 115,300 Extraordinary loss ........................... ......... Net income before taxes ........................... 297,100 Taxes ... .................................... .. ............... 104,100 2005 $4,483,360 2,981.434 1,501,926 1,004,846 497,080 122,680 374,400 131,300 2006 $5,021,643 3.242.120 1,779,100 1.175.1 00 604,423 126,241 170,000 308,182 107,864 Net income............................................... $ 193,200 $ 243,100 $ 200,318 3 4 Figure 2 Figure 3 1. 2a. 2b. 3a. 3b. 4. 5. 6. Harrod's Sporting Goods Balance Sheet (2004-2006) 2004 Cash.................... .... .............. ...... ......... ..... $ 121,328 Marketable securities ............................... . Accounts receivable ................................. . Inventory ........ .......................................... . Total current assets .................... ........ . Net plant and equipment... ....................... . Total assets ................ ........ ..................... .. Liabilities and Stockholders' Equity Accounts payable ..................................... . Notes payable .......................................... . Total current liabilities ....................... . Long-term liabilities ......................... ....... . Total liabilities .... ............. .................. . Common stock ................................ ...... ... . Retained earnings ................................... . Total Stockholders' equity ......... ........ . Total liabilities and stockholders' equity .. 56,142 341,525 972,456 1,491,451 1,678.749 $3,170,200 $ 539,788 160.540 700,328 1.265.272 1,965,600 367,400 837,200 1.204.600 $3,170,200 Harrod's Sporting Goods 2005 $ 125,7&9 66,231 216,240 1,250,110 1,658,370 1.702.280 $3,360,650 $ 576,910 180.090 757,000 1,292.995 2,049,995 368,000 942,665 1,310,655 $3,360,650 Selected Industry Ratios for 2006 Net income/Sales 4.51% 5.10% 1.33 X 9.80% 0.48 5.75 X 3.01 X 3.20 X Net income/Total Assets Sales/I otal Assets Net income/Stockholder's Equity Debt/I otal Assets Sales/Receivables Sales/Inventory Sales/Fixed Assets Case 1 2006 $ 99,670 144,090 398,200 1,057.008 1,698,968 1.811.142 $3,510,110 $ 601,000 203.070 804,070 1.372.240 2,176,310 368,000 965,800 1,333,800 $3,510,110 ' Withdrawal of finds in the form of dividends or other means makes the increase in retained earnings less than net income. 0