To answer this problem, assume it is August Financial Statement Analysis Case Cash Flow Analysis. A $7 Million Credit Request

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1 To answer this problem, assume it is August Financial Statement Analysis Case Cash Flow Analysis A $7 Million Credit Request Mr. Jerry Poe, the Director of Credit for Needham Food Company, wondered what to do about a $7 million line of credit request by Manhatton Corporation. The credit department received the request while Poe was traveling on business. During his absence, his secretary forwarded the request to Stan DeGroot, Vice President of Credit and Collections. Bruce Devlin, the national accounts sales manager for Needham, met with DeGroot to persuade him to approve the line of credit. He stated that Needham had been selling to Manhatton for two years and felt that there was little risk associated with the requested line of credit. After considering Devlin s information, DeGroot sent the request to Roberta Cook, a senior credit analyst who worked for Poe. He told her to read the file and construct a cash flow statement. She noted that the company was acquired via a leveraged buyout about two years ago. A Dun & Bradstreet report indicated that the firm has about $500 million in equity and a debt-equity ratio of less than 2 to 1. The report also indicated a consistent quarterly profit record. A major Fortune 100 company and a large investment-banking firm have significant investments in Manhatton. Although Cook was receiving much pressure from Devlin to increase the credit line, she did not want to do so until Poe had an opportunity to review the request. In an effort to get more current information, she asked Manhatton to send its financial information. The finance manager at Manhatton faxed Cook a cover letter from Gallinger and Healey, Manhatton s independent audit firm, and a consolidated balance sheet for the periods ending March 31, 1994, and Using the available information, Cook carried out a ratio analysis of the financial statements. Her report to Poe indicated that Manhatton had a current ratio in excess of 2:1, working capital turnover of about 5 times, and a long-term debt-to-net worth ratio of about 0.7:1. The consolidated financial statements for June 30, 1994, indicated receivable turnover of 20 times and inventory turnover of 2.9 times. The report went on to state that, Overall, the financial ratios appear positive. Although the account has always paid, there have been periods of slow paying. Cook s recommendation was to increase the credit line from $3 million to $4 million far less than the amount requested. The sales manager became aware of Cook s recommendation about the same time that Poe returned to the office from his business travels. The recommendation of a $4 million credit line incensed Devlin. He expressed to Poe that Needham would lose the account to a competitor if Manhatton's request for a $7 million credit line were denied. He stated that Manhatton needed the credit line in order to stock its stores with candies for the upcoming summer selling season. In an effort to get another perspective on the account, Poe asks you to calculate quarterly cash flow statements, inventory turnovers, and receivable turnovers for the period March 1994 through March Additionally, he wants you to comment about any items that you think are relevant to the decision. Case prepared by George W. Gallinger Page 1

2 Gallinger & Healey, LLP Certified Public Accountants Independent Auditor s Report The Board of Directors and Shareholders Manhatton Corporation We have audited the accompanying consolidated balance sheets of Manhatton Corporation and Subsidiaries as of March 31, 1994 and 1995, and the related consolidated statements of income and retained earnings and cash flows for each of the three fiscal years for the period ended March 31, These consolidated financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Manhatton Corporation and Subsidiaries as of March 31, 1994 and 1995, and the consolidated results of their operations and their cash flows for each of the three fiscal years for the period ended March 31, 1995, in conformity with generally accepted accounting principles. Gallinger & Healey LLP June 15, 1995 Case prepared by George W. Gallinger Page 2

3 Manhatton Corporation and Subsidiaries Consolidated Balance Sheets March 31, 1994 and 1995 (in thousands) Assets Current Assets Cash 3,911 9,892 Accounts receivable 120, ,959 Merchandise inventories 678, ,053 Prepaid expenses 32,225 29,139 Total current assets 835,145 1,054,043 Property and equipment, net 241, ,102 Other assets 71,389 94,375 Total assets 1,148,071 1,459,520 Liabilities & Shareholders Equity Current liabilities Accounts payable 246, ,536 Accrued expenses 23,491 19,927 Income taxes payable 7,056 1,930 Current portion of term debt and capital lease obligations 27,890 40,502 Total current liabilities 304, ,895 Term debt 483, ,512 Capital lease obligations 50,674 85,002 Deferred income taxes 10,159 9,850 Accrued rent 9,415 4,111 Total liabilities 858, ,370 Shareholders equity Common stock, authorized shares, 200,000; issued and outstanding shares, 39,170 in 1994 and 48,250 in ,917 4,825 Paid-in capital 241, ,081 Retained earnings 43,956 70,244 Total shareholders equity 289, ,150 Total liabilities and shareholders equity 1,148,071 1,459,520 Case prepared by George W. Gallinger Page 3

4 D&B Inc. Report DUNS: DATE PRINTED SUMMARY JUNE 7, 1995 RATING 5A3 MANHATTON CORP UNIVERSITY SQUARE DISCOUNT STORES STARTED 1994 TEMPE AZ SIC NO. PAYMENTS SLOW SALES $2,492,000,000 WORTH $550,150,000 EMPLOYS 12,000 (500 HERE) HISTORY CLEAR FINANCING SEC-UNSEC CHIEF EXECUTIVE: TERRY W. LAMBERT, PRES FINANCIAL CONDITION FAIR TREND UP SPECIAL EVENTS 03/30/95 Effective March 26, 1995, the Company purchased from Lemmon Inc. its 50% ownership interest in Cesta Distributors Company, a wholesaler of personal care aids, for an undisclosed consideration. As a result, Cesta continues its operations as a wholly owned subsidiary of the Company with the Company being Cesta s only customer. In connection with this transaction, the Company obtained a $600 million bank revolving credit facility and $155 million in senior notes from various institutional lenders to provide the necessary foundation to insure Cesta s and the Company s continued growth. 11/07/94 According to a published report, the Company said it raised $112 million through a private placement of four million shares of stock. The Company said it would use the money to expand its distribution system and to construct new stores. UPDATE 05/15/95 On April 21, 1995 management submitted the following figures dated March 31, Cash $9,892,000 Accounts payable $204,536,000 Accounts receivable 193,959,000 Inventory 821,053,000 Total current assets 1,054,043,000 Total current liabilities 266,895,000 Sales for the latest 3 months: $779,321,000 Net earnings before taxes for the quarter: approximately $5,263,000 Total assets: $1,459,520,000 Total liabilities: $909,370,000 Net worth: $550,150,000 Case prepared by George W. Gallinger Page 4

5 03/03/95 On Feb. 25, 1995, management submitted the following figures dated Dec. 30, Cash $6,474,000 Accounts payable $265,010,000 Accounts receivable 160,629,000 Inventory 780,077,000 Total current assets 958,466,000 Total current liabilities 337,045,000 Sales for latest 3 months $857,000,000 Net income before taxes for the quarter: approximately $23,000,000 Total assets: $1,352,399,000. Long-term debt: $467,697,000. Total liabilities: $804,742,000. The Company opened 19 new stores during the quarter. 12/03/94 On Nov. 21, 1994, management submitted the following figures dated Sep. 30, Cash $4,442,000 Accounts payable $253,574,000 Accounts receivable 140,830,000 Inventory 755,971,000 Total current assets 918,306,000 Total current liabilities 317,107,000 Sales for the latest 3 months: $705,000,000. Net income before taxes: approximately $10,000,000. Total assets: $1,308,302,000. Total liabilities: $882,864,000. Tangible net worth: $425,438,000. On Oct. 28, 1994, the Company completed the sale of 4 million shares of common stock, bringing tangible net worth in excess of $500 million. Sales increased 36.9% and profits before taxes increased $5.165 million over the previous quarter ending June new stores were opened during the quarter ended Sep. 30, /10/94 Twelve Months Ended Twelve Months Ended Twelve Months Ended June 30, 1992 June 30, 1993 June 30, 1994 Current assets 363,121, ,783, ,618,000 Current liabilities 150,761, ,917, ,212,000 Current ratio Working capital 212,360, ,866, ,406,000 Other assets 127,523, ,601, ,911,000 Long-term debt 209,004, ,533, ,587,000 Worth 105,763, ,589, ,374,000 Sales 1,040,000,000 1,652,000,000 2,492,000,000 Case prepared by George W. Gallinger Page 5

6 Balance Sheet Dated June 30, 1994 Cash 2,768,000 Accounts payable 133,847,000 Accounts receivable 103,218,000 Accts payable-affiliates 101,973,000 Inventory 718,379,000 Accruals 27,542,000 Prepaid 7,253,000 Taxes 3,154,000 Current LT debt and capital leases 31,742,000 Stock redemption payable 72,954,000 Current assets 831,618,000 Current liabilities 371,212,000 Fixtures and 282,913,000 Long-term debt 303,587,000 equipment Other assets 70,998,000 Capital leases 72,693,000 LT liabilties-other 19,663,000 Common stock 4,425,000 Additional paid-in capital 367,802,000 Retained earnings 47,147,000 Total assets 1,186,529,000 Total 1,186,529,000 Prepared from statement(s) by accountant: Gallinger & Healey, LLP. ACCOUNTANTS OPINION: A review of the accountant s opinion indicates the financial statements meet generally accepted accounting principles and that the audit contains no qualifications. FINANCIAL STATEMENT EXPLANATIONS (000 s omitted) ACCOUNTS RECEIVABLE: Consist principally of receivables from vendors (advertising and promotional rebates, etc); receivables from affiliate transactions; and vendor coupons. OTHER ASSETS: Consist of rental equipment, lease acquisition costs and investment in Cesta Distributors Company. ACCOUNTS PAYABLE - AFFILIATES: Consist of payments for merchandise and administrative services. LONG-TERM DEBT: Revolving credit loan $201,424 Sr. subordinated notes, unsecured ($50 million face value) 45,956 Term loans due through ,853 Installment loans due through ,822 Less current portion 16,468 At June 30, 1993, the Company had a revolving credit agreement with a group of commercial banks providing for borrowings of up to $350 million through September 30, Borrowings were limited to 55% of the Company s eligible inventory as defined. The facility was subsequently increased to provide borrowings up to $450 million. Borrowings are collateralized by substantially all merchandise inventories. The credit agreement contains restrictive financial covenants. Term and installment loans are at prime plus 1/2%; and collaterized by substantially all of the Company s fixtures and equipment. Case prepared by George W. Gallinger Page 6

7 Aggregate annual maturities : $16,468; $15,683; $23,521; $22,226; and $18,995. LEASES: Aggregate future obligations under capital and operating leases and after, $119,971 and $1,435,159, respectively. CONTINGENCIES: None indicated. NET WORKING CAPITAL RECONCILIATION (000 s omitted) Balance June 30, 1993 $414,866; increase fixed assets ($115,202); increase other noncurrent assets ($8,108); decrease long-term debt ($105,946); increase long-term capital lease obligations $47,033; increase other long-term liabilities $7,978; increase tangible worth $219,785. Balance June 30, 1994, $460,406; increase in net working capital, $45,540. INTERIM UPDATE Management submitted the following interim figures dated June 30, Sales for 12 months ended June 30, 1994 were $2,492,000,000. Management reported as of October 9, 1994 the Company had 273 stores operating. 60 new stores are expected to be opened in fiscal 1995; and 70 new stores are expected to be opened in fiscal OPERATING TRENDS The company continues an exceptionally rapid expansion program: Operating Stores Sales (millions) June 30, $2,492.0 December 31, 1993 (6 months) 235 1,200.0 June 30, ,652.0 June 30, ,040.0 June 30, June 30, June 30, Sales have continued to increase in correlation with new stores opened along with increased sales from comparable stores from year to year and the contributions of stores remodeled and expanded. Management has reported that operations have continued to be profitable since 1989 with earnings on an upward trend. ANALYST S COMMENTS Management has reported that the Company s inventories have continued to turn at expected rates and that operations have continued to generate cash flows as anticipated during the Company s store expansion. Case prepared by George W. Gallinger Page 7

8 In addition, management has reported that the Company s bank revolving credit agreement was increased in June 1993 to provide a borrowing capacity up to approximately $450 million, up from $350 million. In October 1993, the Company raised equity through the private placement to existing shareholders of additional shares of common stock resulting in proceeds of about $72 million. And in June 1994, the company received another $200 million equity investment. Management has acknowledged slowness in payments to vendors due to negotiated payments and aggressive store expansion. Management has also commented that it is the Company s practice to set off its accounts payable with accounts receivable for the same vendors. 06/04/94 On May 28, 1994, management submitted the following figures dated March 31, Cash $3,911,000 Accounts payable $246,463,000 Accounts receivable 120,075,000 Inventory 678,934,000 Total current assets 835,145,000 Total current liabilities 304,900,000 Sales for latest 3 months: $777,000,000. Net income before taxes for the quarter: approximately $5,062,000. The company reported that five new stores were opened during the quarter. BANKING 03/95 Account averages high 4 figures. Account open over 5 years. (Same bank) Account averages medium 3 figures. Account open over 3 years. Account averages low 5 figures. Account open 1-3 years. 10/94 Account averages medium 6 figures. Account open over 5 years. Account satisfactory. Line of credit extended to medium 9 figures on a secured basis. Now owing moderate 9 figures. Collateral consists of accounts receivable and inventory. Matures in 1 to 5 years. Borrowing account is as agreed. Overall relations are satisfactory. 09/94 Account open 1-3 years. Case prepared by George W. Gallinger Page 8

9 HISTORY BACKGROUND/OWNERSHIP Business started in 1985 by Lemmon, Inc. as a division. Present control succeeded As of June 1994, principal holders of the Company s outstanding common stock were Lemmon Inc, 41%; Venture Investors, 15%; Besco Corp, 3%; and a number of other individuals including the officers and directors. RECENT EVENTS June 1994, the Company received a $200 million equity investment from Venture Investors. According to published reports, Besco Corp. also held $50 million of the Company s subordinated debt and had an $8 million indirect investment in the Company s stock through a limited partnership interest in Venture Investors. As a result of the equity financing, the ownership interest of Lemmon Inc. in the Company was diluted from 52% to 41%. MANAGEMENT BACKGROUND TERRY LAMBERT, born 1947; married. Graduated Babson University present: Toronto Company Inc, Chandler, AZ vice president also president of subject. RODGER NAU, born 1943; married University of Michigan BBA, MBA and LB present Toronto Co., Chandler, AZ senior vice president HB Service Co, Mesa, AZ, former affiliate of parent Allied Supermarkets, Detroit, MI also vice president and corporate secretary of the Company. DONALD SHARPE, born 1942; married Oberlin College BA Stanford University MBA Lemmon Inc vice president president present also president, Toronto Company Inc present also treasurer of subject present Chairman and Chief Executive Officer, Cesta Distributors Company, Phoenix, AZ. ALBERT DIBBLE, born 1968; married BSBA Young State University Certified Public Accountant Arthur Andersen, Dallas, TX joined subject, senior vice president-chief Financial Officer. AFFILIATED BUSINESSES Businesses affiliated with the Company through ownership interest, or common officers: Lemmon, Inc., Phoenix, AZ, started Operates as a retailer and distributor of groceries and personal care products. Inter-company relations include participation in the Cesta Distributors Company joint venture with the Company. Toronto Company, Inc., Chandler, AZ, started Wholesales groceries. No significant intercompany relations reported. Venture Investors, LP, San Francisco, CA. Started in 1991, operates as an institutional investment fund. No inter-company relations reported. Case prepared by George W. Gallinger Page 9