Reference no: EM132964867
Case Study 1:
How you report revenues on the income statement makes a big difference in how profitable a company looks. The problem is that stockholders are often fooled into investing in a firm that is not nearly as profitable as they think. A good example is that of Thousand Trails of Seattle. It sold campground memberships for owners of recreation vehicles. It used the usual expensive promotions to get potential buyers to come to the campgrounds. Once a potential customer was at the site, there was much pressure to buy now, and the campgrounds were quite attractive. Once a customer got home and reconsidered the investment, though, some backed out of the commitment and that is where Thousand Trails got into difficulty.
The company recorded the full price of a membership (about $7,500) as revenue, even though members paid only 40% down on average. Marketing expenses were running higher than payments, so more cash flowed out than flowed in. To get cash, Thousand Trails sold its receivables.
In one year, Thousand Trails used $52 million more cash than it produced, a definite cash flow problem. Nevertheless, it reported record earnings of $19.1 million, and the stock price went up to over $29.
Two years later, the stock had fallen to less than $5, reflecting a 90% drop in earnings reported (from $19 million to less than $2 million). What happened was that a lot of campground members dropped out before paying in full. So Thousand Trails had to write off $11 million in paper revenues. Marketing expenses were two times greater than down payments. Debt reached a horrendous 244% of stockholders' equity.
Meanwhile, stockholders were left wondering what happened to the company that was growing so fast and making such good profits (at least on the income statement).
- Thousand Trails did nothing illegal in its reporting of revenues and profits. What does that tell you about the need to carefully read and analyze income statements before you invest?
- Can you see how cash flow problems can grow to unbelievable proportions in just a short time, even when profits look good?
Case Study 2:
Katherine Potter knew a good thing when she saw it. At least, it seemed so at first. She was traveling in Italy when she spotted pottery shops that made beautiful products ranging from ashtrays to lamps. Some of the pottery was stunning in design.
Katherine began importing the products to the United States, and sales took off. Customers immediately realized the quality of the items and were willing to pay top price. Katherine decided to keep prices moderate to expand rapidly, and she did. Sales in the second three months were double those of the first few months. Sales in the second year were double those of the first year.
Every few months, Katherine had to run to the bank to borrow more money. She didn't really discuss her financial situation with her banker because she had no problems getting larger loans. You see, she always paid promptly. To save on the cost of buying goods, Katherine always took trade discounts. That is, she paid all bills within 10 days to save the 2% offered by her suppliers for paying so quickly.
Most customers bought Katherine's products on credit. They would buy a couple of lamps and a pot, and Katherine would allow them to pay over time. Some were very slow in paying her, taking six months or more.
After three years, Katherine noticed a small drop in her business. The local economy was not doing well, and many people were being laid off from their jobs. Nonetheless, Katherine's business stayed level. One day, the bank called Katherine and told her she was late in her payments. She told them she had been so busy that she didn't notice the bills. The problem was that Katherine had no cash available to pay the bank. She frantically called several customers for payment, but they were not able to pay her, either. Katherine was in a classic cash flow bind.
Katherine immediately raised her prices and refused to make sales on credit. She started delaying payment on her bills and paid the extra costs. Then she went to the bank and went over her financial condition with the banker. The banker noted her accounts receivable and assets. He then prepared a cash budget and loaned Katherine more money. Her import business grew much more slowly thereafter, but her financial condition improved greatly. Katherine had nearly gone bankrupt, but she recovered at the last minute.
- How is it possible to have high sales and high profits and run out of cash?
- Why did Katherine do better when she raised her prices and refused to sell on credit?
- What was the nature of Katherine's problem? Was she correct to go to the banker for help, even though she owed the bank money? How could she have prevented some of the problems she eventually found herself faced with?
Case Study 3:
After Tom and Elise Ryan finished veterinary school in the early 2000s, they spent several years working for other veterinary clinics. By 2007, they felt it was time for them to start their own practice. They considered several towns in the south-central United States, visiting local chambers of commerce and studying each town's demographics. They finally settled in Wardston, a small city in Arkansas. Wardston is a regional center for the surrounding counties, located at the intersection of a two major cross-state highways. The industry rule of thumb is that it takes a population of 1,500 pet owners to support one veterinarian. Wardston appeared to be an underserved area, and no other veterinarian in the area was treating large animals. A big factor in their decision also was the fact that Elise's parents and three brothers lived in Wardston. "If we failed, at least we knew we could get a good homemade meal," said Tom.
They bought an abandoned veterinary clinic with a three-quarter-acre plot of land on the major thoroughfare. The clinic, a sturdy 2,000-square-foot cinderblock structure, had been constructed in 1950 and needed major renovations. Tom and Elise were still paying off $45,000 in student loans and had no savings to draw on. However, Elise's parents agreed to deed them a house and tract of land to get started. Now a property owner, Tom was able to borrow $165,000 from a local bank. Tom's family took out a home equity loan to help them complete the renovations. When the clinic opened in the summer of 2008, the small concrete building had been transformed into the Wardston Animal Hospital, a 4,000-square-foot veterinary clinic, complete with treatment room, surgery, kennels, and offices.
As they had anticipated, the area badly needed another vet clinic, and business began to boom. They were able to pay off the loan from Tom's parents and make improvements to the clinic's parking area. By 2010, the Wardston Animal Hospital had grown large enough to need another vet, and Dr. Laura Hyde joined the practice. She soon became an equal partner with Tom and Elise.
The clinic building, while adequate for a small practice, was still half a century old with an inconvenient traffic flow. The building was designed around a single center hallway going from north to south. Clients going to exam rooms, animals being weighed, vets heading to treatment rooms, staff going to the break room all had to go down same central hallway. The partners always knew that they eventually wanted to build a new "ideal" clinic. Elise kept a notebook full of ideas and possible floor plans that they dubbed their "five-year plan."
Then in April 2015 a line of severe thunderstorms passed through the city. It was a Wednesday afternoon, the clinic's early closure day, and the staff-with the exception of the office manager-had left the building. At 3:00 p.m., a tornado dropped out of the squall line and plowed through the northern part of the city, tearing the roof off the Wardston clinic and wrapping it around several nearby pine trees. For three hours, a steady downpour flooded the damaged building, leaving six inches of water on the treatment room floor. Worse still, the rainwater soaked into the insulation in the walls, the sheetrock on the walls, and the ceiling tiles. Volunteers, staff, even other veterinarians flocked to the clinic to help ferry the boarded animals to temporary homes and clean up the shredded interior. None of the animals was hurt, and no one was injured, although the clinic office manager was in shock for a few days.
Within two weeks, the partners were back in business, operating out of a doublewide trailer set up on the north side of the parking lot. They hired a cleanup service to start the long process of recovery. The cleaning crew soon realized the extent of the damage and told the partners that the cleanup would be very costly. They also warned that the soggy walls and ceiling would probably have mildew problems in the future no matter how thoroughly the building was cleaned.
Tom, Elise, and Laura had to make a decision about how to proceed. As Tom saw it, there were four options to consider:
Plan A: Restore the building to its existing condition before the tornado. The $150,000 insurance settlement would just cover the renovation costs. This option would be the least costly, but they would still have the same 55-year-old building with the same bad traffic flow.
Plan B: Gut the old building and create the "ideal" building within the old shell, total cost approximately $400,000.
Plan C: Level the old building and rebuild on the site. This option was almost immediately eliminated for several reasons. First, the cost just to demolish the building would be $50,000. Also, the clinic staff was using undamaged parts of the old building for kennel space and storage. The doublewide trailer alone would be inadequate to support the practice if the old building were immediately demolished.
Plan D: Build the clinic of their dreams on land the partners owned adjacent to the clinic. The clinic would take almost a year to complete at a cost of $650,000.
- Are there other options that have not been considered? Explain.
- How should the renovations or rebuilding be financed-debt or equity financing? Why?
- What would you advise the veterinary partners to do? Why?
- If the Wardston area suffered a major economic blow, what risks would the partnership face?