Cases Study on

Holly Fashions Ratio Analysis and Palmetto Soups

Break-Even Analysis
FNB-509: Cases in Finance and Banking

Prepared for:
Dr. Sheikh Abu Taher
Associate Professor
Course Teacher of
FNB-509: Cases in Finance and Banking

Prepared by:
Kamrun Nahar (958)
Tanjinur (959)
Prodip Chandra Bishwas (971)
MBA Program (4th Batch)

Department of Finance and Banking

Jahangirnagar University
Savar, Dhaka-1342

07 May 2018
 Case Study
On
Holly Fashions Ratio Analysis
Overview of the case
Holly Fashion is a famous garments company located in Cherry Hill, New Jersey Holly Fashion
(HF) was stated 14 years ago by William Hamilton and John White, who had over 25 years of
experience with a major garments manufacture. Their partnership blended very well. Hamilton,
reserved, is extremely creative with a rear flair for merchandising. As a result of his genius the HF
level is synonymous with quality. White, outgoing and forceful, has contributed important
merchandising and marketing ideas. Hamilton has had little interest in financial aspect of the
company. He preferred to work on designing new fashions and the development of marketing
strategies. But a few month ago he decide that he involved with the company's financials. His
motivation is twofold, and these are-
-First his considering the sale of 50% interest in HF.
-He thought that he can better judge the managerial competence of white.
When Hamilton got involved in company's financial decision, some arguments between White and
Hamilton got differ as Hamilton was in company's creative site and White was in chief operating
officer. When HF was small Hamilton thought White did a fine job but now he wonders whether
White is capable of running a large firm or not, as company will face tougher time in next few
year. On the other hand as White was dealing virtually all major operating and financial decision
he decided 3 years ago to retire all long term debt as business risk was increasing. He also concerns
the firm size and difficulty maintaining stable bank relationship due to increasingly strict federal
regulations of some banks.
Hamilton suspect that HF inventory is "excessive" while White position is that a large inventory
is necessary to provide speedy delivery to customer. Hamilton always interested in giving trade
discount while White rarely takes these discount decision because he wants to hold onto their cash
as long as possible.

However, the relationship between the two partners has been relatively smooth over the years.
Hamilton admits that he may be unduly critical oh White's management decision.

Question and Answer:

1. Calculate the firm’s 1996 ratios listed in Exhibit 3.
Answer:
Financial Ratios for the year 1993-1996 are bellow:-
A. Liquidity Ratios:-
Liquidity ratios are used to determine a company’s ability to pay off its short-terms debts
obligations.
Formula:
Current ratio: Current assets/Current liabilities
Quick ratio: Current assets- inventory/ Current liabilities
Years 1993 1994 1995 1996

Current 3.8 3.7 3.4 3.6

Quick 2.4 2.4 1.6 2.0

B. Leverage Ratios:
A leverage ratio is any one of several financial measurements that look at how much capital
comes in the form of debt (loans), or assesses the ability of accompany to meet financial
obligations.
Formula:
Debt ratio: Total Liabilities/ Total Assets
Time interest earned ratio: EBIT/Interest expense
Years 1993 1994 1995 1996
Debt Ratios (%) 41.1 37.7 35.3 31.1
Time interest 8.0 8.5 11.6 15.7
earned

C. Activity Ratios/ Efficient Ratios:

Activity ratios are accounting ratios that measure a firm’s ability to covert different
accounts within its balance sheets into cash or sales. Activity ratios are used to measure the
relative efficiency of a firm based on its use of its assets, leverage or other such balance
sheet items. These ratios are important in determining whether a company’s management
is doing a good enough job of generating revenues, cash etc. from its resources.
Formula:
Inventory turnover: COGS/ Average inventory
Fixed assets turnover: Net sales/Fixed assets- accumulated depreciation
Total assets turnover: Sales/Total assets
Average collection period: (Average receivable/Sales) × 360
Days purchase outstanding: (Accounts payable/COGS) ×360
 Year 1993 1994 1995 1996
Inventory 6.4 6.4 4.8 5.1
turnover
Fixed asset 30.0 29.3 30.1 29.0
turnover
Total asset 2.8 2.8 2.7 2.7
turnover
Average 55 55 51 62
collection period
Days purchase 25 32 31 31
outstanding

D. Profitability Ratio:
Profitability ratios are used to asses a business’s ability to generate earnings as compare to
its expenses and other relevant costs incurred during a specific period of time.
Formula:
Gross margin: (Gross profit/ Sales) ×100
Net profit margin: (Net income/Sale) ×100
Return on equity: (Net income/Shareholders equity) ×100
Return on total assets: (Net income/ Total assets) ×100
Operating margin: (EBIT+ Depreciation) ×100
Year 1993 1994 1995 1996
Gross margin % 24 23.5 24.9 25
Net profit 3.0 2.6 2.6 2.7
margin %
Return on 14.3 11.6 10.8 10.7
equity %
Return on total 8.4 7.2 7.0 7.3
assets %
Operating 6.8 6.0 6.1 5.9
margin %

2. Part of Hamilton’s evaluation will consist of comparing the firm’s ratios to the industry
numbers shown in Exhibit 3.
a. Discus the limitations of such a comparative financial analysis.
b. In view of these limitations, why are such industry comparisons so frequently made?
Answer:
a) The limitations of comparative financial analysis are
 I. It is wrongly believe that as long as the firm being analyzed with a value better than
the industry average, it can be viewed favorable, it’s therefore important to investigate
significant deviation either side of the industry standard.
II. Industry average is not particularly useful for analyzing firms with multiproduct lines.
In the case of multiproduct firms, it’s difficult to select the appropriate benchmark
industry.
III. Ratios with large deviations from the norm only indicate symptoms of a problem.
Additional analysis is typically needed to isolate the cases of the problem, the
fundamental point is: ratio analysis merely directs attendance to potential area of
concern, it does not provide conclusive evidence as to the existence of a problem.
IV. The ratios being compared should be calculated using financial statements that
published in the same date and year. Otherwise it will provide wrong output.

b) Industry comparison are made for following reasons

I. A single ratio does not generally provide sufficient information for which the judge the
overall performance of the firm, only when a group of ratios is used can reasonable
judgment can be used, however, if an analysis is considered only with citrine specific
aspects of a firm’s financial position, one ratio can be sufficient.
II. Cross sectional analysis involve the comparison of different firms financial ratio at the
same point in time, analysts are often interested in how will a firm has performed in
relation to the other firms in its industry. Frequently, a firm will compare its ratio value
to those of key competitors to it.

3. Hamilton thinks that the profitability of the firm to the owners has been hurt by White’s
reluctant to use much interest bearing debt. Is this a reasonable position? Explain.
Answer:
White’s reluctance to use much interest bearing debt has no effect and will not hurt the firm’s
profitability. The firm’s interest bearing debts major the forms ability to make contractual interest
payment or to fulfill its interest obligations and have no relation to its profitability.
4. The case mentions that White rarely takes trade discounts, which are typically 1/10, made
30. Dose this seems like a wise financial move? Explain.
Answer:
The company is usually offered terms of 1/10, net 30, that is, the company’s 1% discount if it is
paid within 10 days and in any event full payment is expected within 30 days. White takes this
discounts and he wants the liquidity or cash as soon as possible, in addition, the discount is not
especially generous and 99% of the bill must be paid. The decision is considered a wise financial
move.
 5. Calculate the company’s market-to-book (MV/BV) ratio. (There are 5000 shares of
common stock).
Answer:
Book value per share for common stock:
Total equity/Number of share outstanding
$329,800/5000 share =$65.96 per share.
Market to book value ratio (MV/BV)
=$55/65.96=$0.833 per share
=$65/65.96=$0.985 per share
This means that the investors are paying $0.833 to $0.985 for each $1 of book value of holly
fashions stocks.

6. Hamilton’s position is that White has not competently manage the firm. Defend this
position using your previous answers and other information in the case.
Answer:
 Hamilton thinks that’s the profitability of the firms to the owners has been hurt by White’s
reluctance to use much interest bearing debt.
 Hamilton suspect that HF’s inventory is to excessive and that capital is unnecessarily tied
again inventory.
 Hamilton thinks that white has been generous is granting payment extensions to customers,
and at one point nearly 40 percent of company’s receivables were more than 90 days
overdue.
 Hamilton wonders about the wisdom of passing up trade discount. HF is frequently offered
terms of 1/10, net 30. That is, the company receives a one percent discount if bill is paid in
10 days and in any payment is expected within 30 days.

7. White’s position is that he has effectively manage the firm. Defend this position using your
previous answer and other information in the case.
Answer:
 White’s position in a large inventory is necessary to provide speedy delivery to customers.
He argues that their customers expect quick service and a large inventory to them to provide
that.
 White has been generous in granting payment extensions to customers because he doesn’t
want to lose sales and that the rough time these retailers face is only temporary.
  White rarely takes cash discount because he wants to hold onto their cash as long as
possible. Hamilton notes that the discount isn't especially generous and 99 percent of the
bill must be paid.

8. Play the role of an arbitrator. Is it possible based on examination of the firm’s ratios and
other information in the case to asses White’s managerial competence? Defend your
position.
Answer:
Looking at the comparison and analysis of the ratios with the different years the Holly Fashions
has experienced a lot of ups and downs within four years. There is increase and decrease in all
ratios one can't identify and realize any stable financial position, for example there is increase in
inventory turnover and average collection period has been extended almost to 62 which is more
and is not a good sign of sound cash cycle and this can cause poor liquidity. On the other hand, the
firm's interest bearing debts measure the firm's ability to make contractual interest payment or to
fulfil its interest obligations and have no relation to its profitability. White gave discount on the
faster repayment which will be motivate the borrowers to pay their liabilities on time and fast
which will help them decrease the 62 days of collection and then they can pay the HF account
payables.

9. (a) Are the ratios you calculated based on market or book values? Explain.
(b) Would you prefer rations based on market or book values? Explain.
Answer:
(a) All the calculated ratios are based on book values which are recorded it the books of the firm.
(b) The calculation either to be Book value or Market value depends on the firms companies with
lots of machinery, like railroads, or lots of financial instruments, like banks, tend to have a large
book values. In contrast, video game companies, fashion designers or trading firms may have little
or no book value because they are only as good as the people who work there. Book value is not
very useful in the latter case, but for companies with solid asset it's often the No. 1 figure for
investors. The following difference about the relationships between book value and market value
can highlight which one to apply:
1. Book Value Greater than Market Value:
The financial market values the company for less than its stated value or net worth. When this is
the case, it’s usually because the market has lost confidence in the ability of company's assets to
generate future profits and cash flows. In other words, the market doesn’t believe that the company
is worth the value on its book. Values investor often like to seek out companies in this category in
hopes that the market perception turn out to be incorrect. After all, the market is giving you the
opportunity to buy a business for less than its stated net worth.
2. Market Value Greater than Book Value:
The market assigns a higher value to the company due to the earnings power of the company's
asset. Nearly all consistently profitable companies will have market values greater than book
values.

3. Book Value Equals Market Value:

The market sees no compelling reason to believe the company's assets are better or worse than
what is stated on the balance sheet.

Recommendations:
Throughout the case we find that Hamilton and White have two different professional background
and both wanted to take part in decision making so they differ in some argument. So we can say
that-
 Since the company is going through tough times, Hamilton should reduce the risk of not
selling the company share.
 As Hamilton was from creative site so he should generate new idea to diversify their
product.
 White always working with customers, he has the opportunity to maintain customers’
satisfaction so he should focus more on that site.
 Hamilton and White working together since 14 years, if they want to run their firm in a
proper way they should keep their personal conflict aside.
 Case Study
On
Palmetto Soups Break-Even
Analysis
Overview of the Case
Palmetto Soups is a well-known company on the market, which has experienced an impressive
increase in sales and profits and which expects to have even better results in the future.
Robert Rivera, the founder of the company is now facing an issue concerning the sources of
financing the switch to a highly capital-intensive method of production which the board of
directors agreed upon.
Even though 1996 will be a transition year for the company, the change will be very profitable on
the long term so now the question is whether to finance the change through debt or equity.
Robert Rivera is inclined to use as source of financing debt, because he doesn’t want to share his
creation with outsiders, nor the profits that are about to take off, and he considers that given the
fact that the demand for the company’s products is stable, there is only a minimal risk for Palmetto
Soups.
On the other hand, Theodore Tipps’s, a financial officer, strongly recommends equity as a method
of financing because debt could “embarrass” the company and there’s the threat of bankruptcy and
its effects on the customers to be considered. He would also recommend lengthening the loan term
to lower the yearly payments but he is against liquidating assets as those will be needed to support
future sales projections.
The company’s investment banking firm, Smith, Peabody and Associates, thinks that debt would
be a good source of financing as Palmetto Soups has a strong net working capital, competitive debt
ratio and low business risk.

Questions and Answers

1. Q: Projects the 1996 income statement assuming the firm uses debt. (Assume sales will
increase by 10%).
Answer:
The 1996 Income Statement projection – assuming the firm uses debt and that sales will
increase by 10%.
1995 1996
Sales 25500000 28050000
Cost of Goods Sold * 20400000 17671500
Gross Profit 5100000 10378500
Administrative exp 1275000 3000000
Depreciation 850000 3750000
Other fixed exp 425000 1000000
EBIT 2550000 2628500
Interest 400000 1400000
 EBT 2150000 1228500
Tax(40%) 860000 491400
Net Income 1290000 737100
* Cost of Goods Sold = (28050000 - X) / 2805000 = 0.37 => X = 17671500

2. Q: Compute the company’s EBT break-even sales volume and DOL for 1996. Express
the break-even sales volume as a percent of sales. (In 1995, this break-even sales volume
was $14,750,000 and 57.8% of sales. The firm’s DOL was 2.)
Answer:
The company’s EBT break-even sales volume (expressed as percentage of sales) and DOL for
1996.
Cost of Goods Sold / Sales = 17671500 / 28050000 = 0.63
For every 1$ of sales, profits before tax would be 1 - 0.63 = 0.37$
Break Even Revenues = (Fixed Costs + Depreciation) / 0.37
= (3000000 + 1000000 + 3750000) / 0.37
= 20946000
DOL = ((delta Income / Income (95)) / ((delta Sales / Sales (95))
= ((737100 - 1290000) / 1290000))/ ((28050000 - 25500000) / 25500000))
= -0.43 / 0.1 = -4.3

3. Q: If sales are 10 percent below the 1996 estimate, predict the firm’s net operating
income (EBIT). Would it be sufficient to cover the interest due?
Answer:
The predicted EBIT for 1996 if sales are 10% below the 1996 estimate:
Sales 25500000
Cost of Goods Sold * 16065000
Gross Profit 9435000
Administrative exp 3000000
Depreciation 3750000
Other fixed exp 1000000
EBIT 1685000
Interest 1400000

EBIT (96) = 1685000 which will be enough to cover the 1400000 interest due that year.
4. Q: After reviewing the answers to 1 to 3, Rivera says, ”What we’re really after is the level
of sales that generates sufficient cash flow to pay the principal and interest due on our
debt. What is that sales amount?” (Principal due will be $1,900,000 in 1996 if the
company borrows.) Use S* = {(FC – Dep) + Prin}/(1-V/S)
Answer:
The level of sales that generates sufficient cash flow to pay the principal and interest due
on the debt.
S* = ((FC - Depreciation) + Principal) / (1 – V/S)
GM = 1 – V/S
FC = Administrative exp + depreciation + other fixed exp
S* = (Administrative ext + other fixed expenses + principal) / GM
= (3000000 + 100000 + 1900000) / 0.37
= 5900000 / 0.37
= 15945945

5. Q: The correct use of the break-even formulas in questions 2 and 4 rests on certain
assumptions. What are they? Do these assumptions appear to hold for Palmetto?
Explain.
Answer:
The break-even formulas in questions 2 and 4 are based on the assumption that sales and profit
are expected to increase for the next 3 years and there will be enough profit to cover the debt.
The assumption appears to hold for Palmetto taking into account that Rivera thinks that the
risk in minimal as the demand for the company's product will be stable for the next 3 years.
This assumption is based on the previous sales forecasts which as Rivera said: "we've never
been more than 10 percent off in any of our sales forecasts". More over the profit is expected
to increase in the next 3 years, as for 1996 they predict an increase in sales with 10% and all
this may attract investors.

6. Q: Based on your answers to 1 to 5 and information provided in the case, would you
recommend the use of debt to finance the new production methods? Explain.
Answer:
Although it appears that based on these predictions mentioned above the company may be able
to pay the debt but it should be considered the advices of the financial officer, Theodor Tipps’s,
who thinks that is advisable to take into consideration that the NOI in 1996 may be not enough
to pay the firms interest also to be careful not to lose employees because of the rumors that
may emerge, because of them the company may have problems with the supplies which could
affect the sales. He also thinks that the term of the loan should be lengthen in order to lower
the yearly payment if Rivera want to make the debt after all even if this means that the interest
rate would be higher and the payment would take longer which doesn’t suits Rivera.
We think that the best alternative in order to avoid complications the borrowing should be
made entirely from Palmetto’s yearly operation we believe that this alternative may minimize
the other threats mentioned before. In this way Palmetto will have enough money to cover the
expectation without risking ruining its image.

7. Q: What additional information would you like to have to make a more informed
decision?
Answer:
The additional information I would like to have to make a more informed decision are:
 The cost of debt is unknown to us.
 The period of the loan is unknown.
 There would be a comparative analysis loan and internal assets. Only after then we can
say about whether there is a bankruptcy threat lies or not.
 What would be source of paying the debt early?
 We need to know about future sales forecast.

8. Q: One of Rivera’s arguments for using debt is that Palmetto expects increases in both
sales and profits in the coming years. Apparently, he believes that the larger expected
profits will generate sufficient cash to pay any debt due. Is there a fallacy in this
reasoning? That is, is it possible that larger profits resulting from higher sales could
actually be associated with less cash available for debt service? Explain.
Answer:
No. There is no fallacy in this reasoning that the larger expected profits will generate sufficient
cash to pay any debt due. Because there is an argument that Palmetto expects increases in both
sales and profits in the coming years. When the sales increases, the profits will also increase.
And with the larger amount of profit, Palmetto can able to repay its debt. So we can say that,
it is possible for Palmetto that larger profits resulting from higher sales could actually be
associated with less cash available for debt service.
9. Q: Robert Rivera, the company president and major stockholder, feels pretty good at this
point about the decision to borrow all the funds needed to finance the new production
techniques. Still, he is taking very seriously the objections of Theodore Tipp’s, a
financial officer. Rivera doesn’t want to be bothered with any cash flow problems,
especially over the next few years during the production changes. He decides to “think
pessimistically” regarding the future, and analyze the firm’s ability to meet the debt due
under adverse circumstances. The scenarios Rivera will investigate are shown below,
and the debt due is $1,900(000) in both 1996 and 1997. Interest expense will be
$1,400(000) in 1996 and $1,210(000) in 1997.
NOTE: The large increase in the gross margin from 1996 and 1997 in all scenarios is a
result of the implementation of the new production techniques. Perform the appropriate
analysis. How do the results affect your answer to question 6?

Answer:
According to question number 6, we suggested for the debt financing. And in this question
number 9, we can see that there is a large increase in the gross margin from 1996 to 1997
because of the implementation of the new production techniques. Theodore Tipps, a
financial officer was worried about the repayment of the debt and also for the bankruptcy
threat. But in this case, as the gross margin increases (35% in 1996 and 47% in 1997,
Robert Rivera thinks in a pessimistic way) the board of directors can easily repay the debt
and remove the bankruptcy threat. In the above scenario, we can see that Palmetto Soup’s
sales growth also increases in the year 1996 and 1997. With the increasing sales growth
and gross margin, Palmetto Soup’s can easily pay out their overhead cost, interest expense
and debt due. So, this results help us to take the decision regarding debt financing and it
supports the debt financing for the implementation of the new production techniques.