Question

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 1997. 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 2015, there were twelve Harrod stores producing $5 million in total sales and generating a profit of over $200,000 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 Cornhuskers 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 early 1990s) 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 less 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 Walmart also represented intense competition for the sporting goods dollar. 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.

In January of 2016, 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. It is willing to renew our loan and line of credit, but the bank wants to charge us 2½ 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 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 2½ 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 had 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. In examining the income statement in Figure 1, note that there was an extraordinary loss of $170,000 in 2015. 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 Extraordinary loss .65 (1-tax rate) $110,500 Aftertax addition to profits from eliminating the extraordinary loss from net income The more representative net income number for 2015 would now be: Initially reported (Figure 1) $200,318 Adjustment for extraordinary loss being eliminated +110,500 Adjusted net income $310,818

Based on the adjusted net income figure of $310,818, recompute the profitability ratios for 2015 (include parts a and b for ratios 2 and 3). 4. Now with the adjusted net income numbers as part of the ratios for 2015, write a brief one-paragraph description of trends that appear to have taken place over the three-year time period (refer back to the data in Question 1 for 2013 and 2014). 5. Once again, using the revised profitability ratios for 2015 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 2015, 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 2½ percent over prime instead of one percent over prime? There is no absolute right answer to this question, but use your best judgment.

	Figure 1
			Harrod’s Sporting Goods Income Statement (2013-2015)
					2013		2014		2015
			Sales..............................................................................		$4,269,871		$4,483,360		$5,021,643
			Cost of goods sold..............................................................................		2,991,821		2,981,434		3,242,120
			Gross Profit..............................................................................		$1,278,050		$1,501,926		$1,779,523
			Selling and administrative expense..............................................................................		865,450		1,004,846		1,175,100
			Operating profit..............................................................................		$412,600		$497,080		$604,423
			Interest expense..............................................................................		115,300		122,680		126,241
			Extraordinary loss..............................................................................		__		__		170,000
			Net income before taxes..............................................................................		297,300		374,400		308,182
			Taxes..............................................................................		104,100		131,300		107,864
			Net income..............................................................................		$   193,200		$   243,100		$   200,318
Figure 2
		Harrod’s Sporting Goods Balance Sheet (2013-2015)
				2013		2014		2015
		Cash..............................................................................		$   121,328		$   125,789		$     99,670
		Marketable securities..............................................................................		56,142		66,231		144,090
		Accounts receivable..............................................................................		341,525		216,240		398,200
		Inventory..............................................................................		972,456		1,250,110		1,057,008
		Total current assets..............................................................................		$1,491,451		$1,658,370		$1,698,968
		Net plant and equipment..............................................................................		1,678,749		1,702,280		1,811,142
		Total assets..............................................................................		$3,170,200		$3,360,650		$3,510,110
		Liabilities and Stockholders’ Equity
		Accounts payable..............................................................................		$   539,788		$   576,910		$   601,000
		Notes payable..............................................................................		160,540		180,090		203,070
		Total current liabilities..............................................................................		$700,328		$757,000		$804,070
		Long-term liabilities..............................................................................		1,265,272		1,292,995		1,372,240
		Total liabilities..............................................................................		$1,965,600		$2,049,995		$2,176,310
		Common stock..............................................................................		367,400		368,000		368,000
		Retained earnings[*]..............................................................................		837,200		942,665		965,800
		Total Stockholders’ equity..............................................................................		1,204,600		1,310,655		1,333,800
		Total liabilities and stockholders’ equity..............................................................................		$3,170,200		$3,360,650		$3,510,110

Figure 3
Harrod’s Sporting Goods
Selected Industry Ratios for 2015
1.		Net income/Sales		4.51%
2a.		Net income/Total Assets		5.10%
2b.		Sales/Total Assets		1.33 x
3a.		Net income/Stockholder’s Equity		9.80%
3b.		Debt/Total Assets		0.48
4.		Sales/Receivables		5.75 x
5.		Sales/Inventory		3.01 x
	6.		Sales/Fixed Assets		3.20 x

* This adjustment was made because the $170,000 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 $170,000, based on a 35 percent tax rate. The aftertax benefit of the tax adjustment for the extraordinary loss is $110,500.

[*] Withdrawal of funds in the form of dividends or other means makes the increase in retained earnings less than net income.

Answer 1

First four parts have been answered.

Answer 1:

All ratios are in %

Year	2013	2014	2015
Gross profit ratio
Sales	4269871	4483360	5021643
Gross profit	1278050	1501926	1779523
Gross profit ratio	29.93182	33.50001	35.43707
Operating profit ratio
Sales	4269871	4483360	5021643
Operating profit	412600	497080	604423
Operating profit ratio	9.663055	11.08722	12.03636
Net profit ratio
Sales	4269871	4483360	5021643
Net income	193200	243100	200318
Net profit ratio	4.524727	5.422273	3.989093

Answer 2:

The above table clearly shows that the profitability ratios of the organization have shown a rising trend, i.e. in each of the subsequent year the gross profit ratio and operating profit ratio have increased from the previous years. The net profit ration though seems to have reduced in the year 2015 compare to the net profit ratio of 2014 however, a closer look will help us to note that the reason for the apparent decline in net profit ratio is the adjustment of extra-ordinary loss of the organization in the year 2015. Hence, a clear trend is the increasing profitability of the organization over the years.

Answer 3:

Year	2015
Gross profit ratio
Sales	5021643
Gross profit	1779523
Gross profit ratio	35.43706711
Operating profit ratio
Sales	5021643
Operating profit	604423
Operating profit ratio	12.03635941
Net profit ratio
Sales	5021643
Net income	310818
Net profit ratio	6.189567837

   

Answer 4:

As a result of addition of tax adjusted extra-ordinary loss to the net income of 2015 it is clear that the organization has been quite successful in increasing its overall profitability from the operations of business. The organization has not only been successful in achieving a sustainable growth in business operations but has also been able to achieve significant increase in the rate of gross profit, rate of operating profit and net profit ration wit passing of each year in last three years.