CAS E

6

HOLLY RATIO

FASHIONS ANALYSIS

Billion-dollar apparel companies such as Calvin Klein and Liz Claiborne are unusual in the garment industry, which consists primarily of much smaller apparel makers. One such firm is Holly Fashions (HF), located in Cherry Hill, New Jersey. HF was started 14 years ago by William Hamilton and John White, who between them had over 25 years of experience with a major garment manufacturer. And the partnership initially blended very well. Hamilton, reserved and introspective, is extremely creative with a real flair for merchandising and trend spotting. Mainly as a result of his genius, the HF label is synonymous with quality and "in" fashions. White, outgoing and forceful, has contributed important merchandising and marketing ideas, but has mainly assumed the duties of the firm's chief operating officer.

Hamilton has had little interest in the financial aspects of the company, much preferring to work on designing new fashions and the development of marketing strategies. A few months ago, however, he decided that he had better become more involved with the company's financials.

His motivation is twofold. First, he is considering the sale of his 50 percent interest in HF. Though he enjoys the creative side of the business, he is tired of the cash crunches that the firm has experienced in recent years. Periodically, the retailers HF deals with have encountered financial problems and have strung out their payments, which often caused a mad scramble for cash at HF. And if Hamilton decides to sell, he knows that he is likely to be involved in some stressful negotiations surrounding the company's value. Though he would hire a consultant to aid him in any negotiations, he decides it is a good idea to educate himself about HF's financials.

Another reason that Hamilton is interested in the firm's financials is so he can better judge the managerial competence of White. When HF was small Hamilton thought White did a fine job, but now he wonders whether White is capable of running a firm as large as HF. Actually, if Hamilton were convinced that White is a competent manager, he would not consider selling out since he

36 PART II FINANCIAL ANALYSIS

genuinely enjoys being an owner of an apparel firm. But he thinks the apparel industry will face even tougher times in the next few years, and wonders if White is talented enough to successfully meet these challenges.

BORROWING CONCERNS

White's personality is such that he makes virtually all major operating and financial decisions. An important example of this was his decision three years ago to retire all long-term debt, a move triggered by White's fear that HF's business risk was increasing. He cited the difficulties of seemingly rock-solid retailers like Bloomingdale's and Campeau to support his claim. White is also concerned that firms the size of HF have had difficulty maintaining stable bank relationships. Due to increasingly strict federal regulations, some banks have called in loans at the slightest technicality, and most are scrutinizing new business loans very carefully. Consequently White views bank debt financing as "unreliable" and thinks that loan officers are capable of "chewing up my time."

Hamilton isn't sure what to make of these arguments, but he is concerned that this debt avoidance has significantly reduced HF's financial flexibility because it means that all projects will have to be equity financed. In fact, over the past five years there have been no dividends because all earnings have been reinvested. And two years ago each of the partners had to contribute $15,000 of capital in order to meet the company's cash needs. Another infusion of capital may be necessary since the firm's present cash position is low by historical standards. (See Exhibit 2.)

More importantly, however, Hamilton feels that the company is not benefiting from the leverage effect of debt financing, and that this hurts the profitability of the firm to the two owners.

WORKING CAPITAL CONCERNS

Hamilton suspects that HF's inventory is "excessive" and that "capital is unnecessarily tied up in inventory." White's position is that a large inventory is necessary to provide speedy delivery to customers. He argues that "our customers expect quick service and a large inventory helps us to provide it."

Hamilton is skeptical of this argument and wonders if there isn't a more efficient way of providing quicker service. He knows that a consultant recommended that HF "very seriously" consider building a state-of-the-art distribution center. The proposed facility would allow HF to reduce inventory and also handle big orders from retailers such as Kmart and Wal-Mart. White rejected the suggestion arguing that the estimated $5-million to $8-million cost is excessive.

Hamilton also questions White's credit standards and collection procedures.

Hamilton thinks that White has been quite generous in granting payment extensions to customers, and at one point nearly 40 percent of the company's receivables were more than 90 days overdue. Further, White would continue to

CASE 6 HOLLY FASHIONS 37

accept and ship orders to these retailers even when it was clear that their ability to pay was marginal. White's position is that he doesn't want to lose sales and that the rough times these retailers face are only temporary.

Hamilton also wonders about the wisdom of passing up trade discounts. HF is frequently offered terms of 1/10, net 30. That is, the company receives a l-percent discount if a bill is paid in ten days and in any event full payment is expected within 30 days. White rarely takes these discounts because he "wants to hold onto our cash as long as possible." He also notes that "the discount isn't especially generous and 99 percent of the bill must still be paid."

FINAL THOUGHTS

Despite all of Hamilton's concerns, however, the relationship between the two partners has been relatively smooth over the years. And Hamilton admits that he may be unduly critical of White's management decisions. "After all, "he concedes, "the man seems to have reasons for what he does, and we have been in the black every year since we started, which is an impressive record, really, for a firm in our business."

Further, Hamilton has discussed with two consultants the possibility of selling his half of the firm. Since HF is not publicly traded, the market value of the company's stock must be estimated. These consultants believe that HF is worth between $55 and $65 per share, figures that "seem quite good" to Hamilton.

QUESTIONS

1. Calculate the firm's 1996 ratios listed in Exhibit 3.

2. Part of Hamilton's evaluation will consist of comparing the firm's ratios to the industry numbers shown in Exhibit 3.

(a) Discuss the limitations of such a comparative financial analysis.

(b) In view of these limitations, why are such industry comparisons so frequently made?

3. Hamilton thinks that the profitability of the firm to the owners has been hurt by White's reluctance to use much interest-bearing debt. Is this a reasonable position? Explain.

4. The case mentions that White rarely takes trade discounts, which are typically 1/10, net 30. Does this seem like a wise financial move? Explain.

5. Calculate the company's market-to-book (MV /BV) ratio. (There are 5,000 shares of common stock.)

6. Hamilton's position is that White has not competently managed the firm.

Defend this position using your previous answers and other information in the case.

38 PART II FINANCIAL ANALYSIS

7. White's position is that he has effectively managed the firm. Defend this position using your previous answers and other information in the case.

8. Play the role of an arbitrator. Is it possible based on an examination of the firm's ratios and other information in the case to assess White's managerial competence? Defend your position.

9. (a) Are the ratios you calculated based on market or book values? Explain. (b) Would you prefer ratios based on market or book values? Explain.

EXHIBIT 1
Holly Fashions' Income Statements: 1993-1996 (OOOs)
1993 1994 1995 1996
Sales $985.0 $1,040.0 $1,236.0 $1,305.0
Cost of goods 748.6 774.8 928.2 978.8
Gross margin 236.4 265.2 307.8 326.3
Administrative 169.4 202.8 236.1 249.3
Depreciation ___lO1l 11.4 13.6 14.4
EBIT 56.1 51.0 58.1 62.6
Interest _____2Q 6.0 5.0 4.0
EBT 49.1 45.0 53.1 58.6
Taxes 19.7 18.0 21.2 23.5
Net income $29.5 $27.0 $31.9 $35.2 EXHIBIT 2

Balance Sheets of the Holly Fashions Company: 1993-1996 (OOOs)

1993 1994 1995 1996
ASSETS
Cash $40.4 $51.9 $38.6 $10.6
Receivables 153.2 158.9 175.1 224.8
Inventory 117.0 121.1 193.4 191.9
Other current _____5,_2 ______62 ____2A _____L8
Current assets 316.5 338.0 414.5 435.1
Gross fixed 44.8 58.9 78.1 96.4
Accumulated depreciation (12.0) (23.4) (37.0) (51.4)
Net fixed 32.8 35.5 ___All 45.0
Total assets $349.3 $373.5 $455.5 $480.1
(continued) LIABILITIES & NET WORTH Accounts payable

Debt due

Accruals

Current liabilities Long-term debt Common stock Retained earnings Total L&NW

CASE 6 HOLLY FASHIONS 39
EXHIBIT 2
( Continued)
1993 1994 1995 1996
$53.8 $54.7 $86.2 $84.2
10.0 10.0 10.0 10.0
19.7 26.0 24.7 26.1
83.5 90.7 120.9 120.3
60.0 50.0 40.0 30.0
150.0 150.0 180.0 180.0
55.8 82.8 114.6 149.8
$349.3 $373.5 $455.5 $480.1 EXHIBIT 3

Financial Ratios for the Holly Fashions Company: 1993-1996

1993

1994

1995

(Present) 1996

Industry Average 1993-1996*

Liquidity Ratios

Current

Quick

Leverage Ratios

Debt(%)

41.1

Times interest earned

Activity Ratios Inventory Turnover

(CGS)

Fixed Asset Turnover

30.0

Total Asset Turnover

3.8

2.6 1.7 1.3 1.6

.8 .6

3.7

3.4

2.4

2.4

1.8

37.7

41 57 71

7.4 3.9 1.3

35.3

8.0

8.5

11.6

6.4

8.1 6.0 3.5

40 25 12

3.5 2.8 2.0

6.4

4.8

29.3

30.1

2.8

2.8

2.7

(continued)

40 PART II FINANCIAL ANALYSIS
EXHIBIT 3
(Continued)
Industry
(Present) Average
1993 1994 1995 1996 1993-1996*
Average Collection 41
Period 56 55 51 50
68
Days Purchases 18
Ou tstanding** 25 22 31 25
32
Profitability Ratios 28
Gross Margin (%) 24.0 25.5 24.9 26
24
4.2
Net Profit Margin (%) 3.0 2.6 2.6 3.1
1.2
27.3
Return on Equity (%) 14.3 11.6 10.8 19.5
7.8
Return on Total 11.8
Assets (%) 8.4 7.2 7.0 8.7
3.4
9.9
Operating Margin*** (%) 6.8 6.0 6.1 7.2
3.1 *The three numbers for each ratio are computed in the following way. Ratios for all firms in the industry are arranged in what is considered a strongest-to-weakest order. The middle number represents the median ratio; that is, half the firms in the industry had ratios better than the median ratio and half had ratios that were worse. The top number represents the upper quartile figure, meaning 25 percent of the firms had ratios better than this. The lower number represents the lowest quartile, that is, 25 percent of the firms had ratios worse than this. **This shows the average length of time that trade debt is outstanding. Also called the average payment period. Calculated as AlP -7 (CGS/360).

***Calculated as (EBIT + Dep)/Sales.