Reference no: EM133086489
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).
Discussion questions:
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?