1) You are to prepare the following ratio analysis calculations for the two years 2006 AND 2005 based on the following ratios listed below:
Inventory Turnover in Days
Account Receivable turnover in Days
Accounts Payable Turnover in Days
Fixed Assets Turnover
Total Assets Turnover
Times Interest Earned
Cost of Borrowing (do your best on this one!)
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
2) Prepare Common-size financials for the Balance Sheet and Income Statement for the two years.
3) 3-Factor Dupont Method for two years (Return on Equity)
4) Prepare a two-page memo that analyzes the financial health of the organization and make recommendations. The memo should address the following: a) liquidity, b) efficiency (aka turnover), c) debt, and d) profitability. What do you think about the health of the organization and its future? Remember, you are telling a story!
GLOBAL AUTO PARTS, LTD.
Global Auto Parts (GAP), Ltd. is a retail car parts chain with a network of company-owned
stores in Texas. The company was formed by Jack Hardwick in 1973. In 2004, Jack decided to
retire and transferred the company’s management and the responsibilities for the day to day
operations to his son John Hardwick.
By early 2007, GAP was having difficulties and Jack Hardwick decided to become actively
involved again in the company to turn things around. His first action was to hire Kathy
Rutkowski, CPA, CGMA, CFA from one of the Big 4 accounting firms to review current
operations and make recommendations.
John Hardwick’s Tenure
John had led a privileged life and his father did not feel that he would be able to operate the
business successfully, but he had little choice if he wanted to keep the business under family
control. Despite his MBA degree, Jack Hardwick did not feel that his son had the patience and
the general business acumen to operate the business. He was also fearful that he would recklessly
try to expand the business and lose interest if things did not go as planned.
Upon taking over operations in the beginning of 2004, John began to put a major expansion plan
into effect that he had worked on as project in his MBA. This plan had two major focal points.
One was to expand the number of retail auto parts outlets in smaller communities and the other
was to diversify the products provided at each of the outlets to include automotive maintenance
services such as tire changes, battery changes and fluids changes. A number of auto parts retail
chains in Texas had allowed a similar strategy of diversification and were successful.
In 2004, all the outlets were expanded to include bays for maintenance work. Sales of these new
services were poor over the next two years. To have their fluids or their tires changed, customers
had to leave the vehicle and wait for a considerable period of time in the reception area. An
appointment was also required. This was not as convenient as other stores where patrons did not
need to schedule an appointment or to get out of their vehicles and generally could have the work
done in less than thirty minutes. For more complicated maintenance work, GAP mechanics had a
reputation in the community of not being highly qualified. There had been a number of cases that
received extensive coverage in the local news, where GAP mechanics had made mistakes that
caused major damage to the vehicles they were working on. Instead of admitting they were at
fault and keeping damage to a minimum, GAP was taken to court a number of times and forced
to pay the repair costs.
In addition to its sales outlets in nine cities, in 2004 additional stores were opened in five other
cities. By early 2007, all outlets were underutilized. Local service stations with strong ties to the
community, lowered their prices and improved their customer service which increased
Prior to 2004, GAP’s workforce was composed of a number of experienced professionals who
had been with the company for years. When John Hardwick took over operations, he decided to
try to increase profitability by cutting wages and benefits. The result was that most of the
employees left and were replaced by less experienced staff. The sales staff was taken off salary
and put on straight commission as a means of increasing sales. The sales staff did become
“hungrier,” but the more aggressive practices alienated many customers.
In order to increase gross profits, GAP began buying more no-name car parts from overseas
suppliers. These sales generated a higher gross profit margin for the retailer initially and the
customers did receive a lower price, but quality concerns due to the parts’ durability,
performance and safety features soon caused sales and margins to fall.
A new accounting system was purchased in 2005 in order to better automate the record keeping,
payroll, billing and inventory functions of the company. The low-cost vendor was selected to
save cash to help expansion. This vendor provided very poor software installation and training
and then went bankrupt. GAP’s staff struggled with the new system and matters were made
worse by high employee turnover due to low wages and John’s disorganized management style.
A lot of overtime had been used to clear the backlog of clerical work, while customers, staff and
suppliers were becoming alienated over delays and errors.
In the first quarter of 2006, Jack Hardwick suspended all dividend payments. John had been
drawing too much from the company to fund his personal expenses.
For the Year Ended December 31
2006 2005 2004
Sales 6,500,000 5,550,000 4,050,000
Cost of Goods Sold 3,965,000 3,385,500 2,430,000
Gross Profit 2,535,000 2,164,500 1,620,000
Depreciation 485,600 287,200 158,500
Other Operating Expenses 1,690,000 1,387,500 1,012,500
Earnings Before Interest and Tax 359,400 489,800 449,000
Interest Expense 331,956 160,125 50,645
Earnings Before Tax 27,444 329,675 398,355
Income Tax Expense 10,978 131,870 159,342
Net Income 16,467 197,805 239,013
As of December 31
2006 2005 2004
Cash 57,000 110,000 155,000
Accounts Receivable 95,000 59,000 45,000
Inventory 1,050,000 723,000 540,000
Prepaid Expenses 42,000 36,000 25,000
Total Current Assets 1,244,000 928,000 765,000
Property, Plant and Equipment 7,288,800 4,819,200 3,245,000
Less: Accumulated Depreciation 2,432,800 1,947,200 1,660,000
Property, Plant and Equipment, net 4,856,000 2,872,000 1,585,000
Total Assets 6,100,000 3,800,000 2,350,000
Accounts Payable 440,556 165,000 99,000
Line of Credit 570,638 353,000 267,435
Current Portion of Long-term Debt 325,346 162,000 41,461
Total Current Liabilities 1,336,540 680,000 407,895
Long-term Debt 3,253,460 1,620,000 414,605
Equity 1,510,000 1,500,000 1,527,500
Total Liabilities and Equity 6,100,000 3,800,000 2,350,00
GAP has a $600,000 line-of-credit with Texas Investment Bank. The limit could be extended,
but only if the bank has sufficient loanable funds and the company is in a good financial
condition. The company must maintain a current ratio of 1.5, a times interest earned ratio of 5.0,
and can only borrow up to 50 per cent of the value of its accounts receivable and inventory. The
company negotiates separate term loans and mortgages to finance its capital purchases. Under
Jack’s leadership, GAP had an excellent relationship with its bank, but John’s poor management
and interpersonal skills had put this relationship in jeopardy.
Retail sales were paid for in cash or by credit card so there were no accounts receivable. Sales to
businesses made up to 40 per cent of sales and were on terms 2/10, net 30 with negligible bad
debts. GAP bought its auto parts from the manufacturers on terms 2/15, net 30, which was the
norm in the industry. Interest was charged on overdue accounts at 12 per cent per annum and
many retailers who got too far in arrears were put on a cash-and-carry basis.
A slowdown was forecasted in the local economy in 2007 due to the corn fields fires that took
place in the summer of 2006 and the collapse of the beef industry caused by the discovery of
mad cow decease in more than half of the farms in Texas.
The following industry average ratios (based on year-end figures) were available for companies
that sold both tires and automotive maintenance services:
Current Ratio 1.90
Quick Ratio 0.51
Inventory Turnover in Days 60 days
Account Receivable turnover in Days 30 days
Accounts Payable Turnover in Days 15 days
Fixed Assets Turnover 3.19
Total Assets Turnover 2.00
Debt Ratio 30.00%
Times Interest Earned 14.63
Cost of Borrowing 6.50%
Gross Profit Margin 42.00%
Operating Profit Margin 12.00%
Net Profit Margin 6.71%
Return on Assets 13.42%
Return on Equity 19.17%
GAP’s marginal tax rate was 40 percent.
Kathy Rutkowski had just returned to her office at the Big 4 accounting firm from a meeting
with Jack Hardwick in 2007. Jack asked her to prepare a comprehensive review of GAP’s
operations with a focus on why things have deteriorated and what can be done to improve
operations. Also, she was asked to make further recommendations on the future management of