Holly Fashion

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cASE 6 HOLLY FASHIONS RAT I O A N A LYSI S Billion-dollal a pparel c ompanies s uch a s C alvin K lein a nd L iz C laiborne a re unusual i n t he g arment i ndustry, w hich c onsists p rimarily o f m uch s malier apparel m akers. O ne s uch f irm i s H olly F ashions ( HF), l ocated i n C herry F lill, New J eriey. H F w as s tarted 1 4 y ears a go b y W illiam H amilton a nd J ohn W hite, who b etween t hem h ad o ver 2 5:yearso f e xperiencew ith a m ajor g arment m anufacturer.

A nd t he p artnership i nitially b lended v ery w ell. H amilton, r eserved and i ntrospective, i s e xtremely c reative w ith a r eal f lair f or m erchandising a nd trend s potting. M ainly a s a r esult o f h is g enius, t he H F l abel i s s ynonymous with q uality a nd " tn" f ashions. ' h ite, o Utgoing a nd f orceful, h as c ontributed important m erchandising a nd m arketing i deas, b ut h as m ainly a ssumed t he duties o f t he f irm's c hief o perating o fficer.

Hamilton h as h ad l ittle i nterest i n t he f inancial a spectso f t he c ompany, m uch preferring t o w ork o n d esigning n ew f ashions a nd t he d evelopment o f m arketing s trategies. A f ew m onths a go, h owever', h e d ecided t hat h e h ad b etter' become m ore i nvolved w ith t hd c ompany's f inancials. His m otivation i s t wofold. F irst, h e i s c onsidering t he s ale o f h is 5 0 p ercent interest i n H F. T hough h e m joys t he c reative s ide o f t he b usiness,h e i s t ired o f the c ash c runches t hat t he f irm h as e xperiencedi n r ecent y ears.

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P eriodically, t he retailers H F d eals w ith h ave e ncountered f inancial p loblems a nd h ave s tlung out t heir p ayments, w hich o ften c aused a m ad s cramble f or c ash a t H F A nd i f Hamilton d ecides t o s ell, h e k nows t hat h e i s l ikely t o b e i nvolved i n s ome stressful n egotiations s urrounding t he c ompany's v a1ue. T hough h e w ould h ire a c onsultant t o a id h im i n a ny,negotiations,h e d ecides i t i s a g ood i dea t o e ducate h imself a bout H F's f inancials.

Another r eason t hat H amilton i s i nterested i n t he f irm's f inancials i s s o h e can b etter j udge t he m anagerial c ompetence o f l Alhite. Ahen I IF w as s mall Hamilton t hought W hite d id a f ine j ob, b ut n ow h e w onders w hether / hite i s capable o f r unning a f irm a s l arge a s H F. A ctually, i f H amilton w ere c onvinced that W hite i s a c ompetent m anager, h e w ould n ot c onsider s elling o ut s ince h e 36 PARTI I F INANCIALA NALYSIS genuinely e ntoys b eing a n o wner o f a n a pparel f irm.

B ut h e t hinks t he a pparel industry w ill f ace e ven t ougher t imes i n t he n ext f ew y ears, a nd w onders i f ltrhite i s t alented e nough t o s uccessfullym eet t hese c hallenges. BORROWING CONCEB. NS A4rite's p ersonality i s s uch t hat h e m akes v irtually a ll m ajor o perating a nd financial d ecisions. A n i mportant e xample o f t his w as h is d ecision t hree y ears ago t o r etire a ll l ong-term d ebt/ a m ove t riggered b y W hite's f ear t hat H F's b usiness r isk w as i ncreasing.

H e c ited t he d ifficulties o f s eemingly r ock-solid r etailers l ike B loomingdale's a nd C ampeau t o s upport h is c laim. I M-Lite i s a lso concerned t hat f irms t he s ize o f H F h ave h ad d ifficulty m aintaining s table b ank relationships. D ue t o i ncreasingly s trict f ederal r egulations, s ome b anks h ave called i n l oans a t t he s lightest t echnicality, a nd m ost a re s crutinizing n ew b usiness l oans v ery c arefully. C onsequently W hite v iews b ank d ebt f inancing a s "unreliable" a nd t hinks t hat l oan o fficers a re c apable o f " chewing u p m y t ime. Harnilton isn't sure what to make of these arguments, but he is concerned that this debt avoidance has significantly reduced FIF's financial flexibility because it means that all protects will have to be equity financed. In fact, over the past five years t here h ave b een n o d ividends b ecausea ll e arnings h ave b een r einvested. And two years ago each of the partners had to contribute $15,000of capital in order to m eet t he c ompany's c ashn eeds. A nother i nfusion o f c apital m ay b e n ecessary sincet he f irm's p resentc ashp osition i s l ow b y h istorical s tandards. ( See xhibit 2 . E More j mportantly, h owever, H amilton f eels t hat t he c ompany i s n ot b enefiting f rom t he l everage e ffect o f d ebt f inancing, a nd t hat t his h urts t he p rofitabiiity o f t he f lrm t o t he t wo o whers. WORKING CAPITAL CONCERNS Hamilton s uspectst hat F {F'si nventory i s " excessive" a nd t hat " capital i s u nnecessarily t ied u p i n i nventory. " n/hite's p osition i s t hat a l arge i nventory i s n ecessary t o p rovide s peedy d elivery t o c ustomers. H e a rgues t hat " our c ustomers expect q uick s ervice a nd a l arge i nventory h elps u s t o p rovide i t. Hamilton is skeptical of this argument and wonders if there isn't a mole efficient w ay o f p roviding q uicker s ewice. H e k nows t hat a c onsultant r ecommended t hat H I " very s eriously" c onsiderb uilding a s tate-of-the-artd istribution center. T he p roposed f acility w ould a liow F {F t o r educe i nventory a ld a lso handle big orders from retailers such as Kmart and Wal-Mart. VVhite rejected the suggestion a rguing t hat t he e sttnated $ S-million t o $ 8-mi11ion ost i s e xcessive. c Hamiiton a lso q uestions / hite's c redit s tandards a nd c ollection p rocedures.

Hamilton t hinks t hat / hite h as b een q uite g enerous i n g ranting p ayment extensions t o c ustomers, a nd a t o ne p oint n early 4 0 p ercent o f t he c ompany's receivablesw ere m ore t han 9 0'davs o verdue. F urther. / hite w ould c ontinue t o . C ASE6 H OLLYF ASHIONS 37 accept and ship orders to these qetailers eyen when it was clear that their ability t o p ay w as m arginal. l hite's p osition i s t hat. he d oesn't w ant t o l ose s ales 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 ol 1. 1. 0, 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. ffiite rarely takes these discounts because he "wants t o h old o nto o ur c ash a s l ong a s p ossible. " H e a lso n otes t hat " the d iscount isn't especially generous emd 99 percent of the bill must still be paid. " FINAL THOUGHTS Despite ill of Hamilton's concems, however, the retationship between the two partners has been relatively smooth over the years. And Hamilton admits that he may be unduly critical of y'hite's management decisions. After al1,"he concedes, " the m an s eems t o h ave r easonsf or w hat h e d oes, a rd w e h ave b een i n the black every year since we started, which is an impressive record, really, for a f um i n o ur b usiness. " Further, Hamilton has discussed with two condultants the possibility of selling his half of the firm. Since FIF is not publicly traded, the market value of the company's s tock m ust b e e stimated. T hesec onsultants b elieve t hat H F i s w orth between $55 and $55 per share, figures that "seem quite good" to Hamilton. QUESTIONS 1 Calculate the firm's 1995ratios listed in Exhibit 3. . P art o f H amilton's e valuationw ill c onsisto f c omparingt he f irm's r atios t o . 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 frequentlym ade? 3, Hamilton thinks thai the profitability of the firm to the owners hasbeenhurt by White's reluctanceto use ftuch inteiest-bearing debt. Is this a reasonable position? E xplain. 4. The case mentions that {hite rarely takes trade discounts, which are typically 1 /10, n et 3 0.

D oest his s eeml ike a w ise f inancialm ove? E xplain. 5. C alculatet he c ompany'sm arket-to-book dV/BV) r atio. ( Therea re 5 ,000 O shares f c ommons tock. ) o 6. Hamilton's position is that White has not competently managed the firm. Defend this position using your previous an. swers nd other information in a the c ase. 38 PARTII FINANCIAL ANALYSIS 7. Vy'hite'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 arbitratoi.

Is it possible based on an examination of the firm's r atios a nd o ther i nformation i n t he c aset o a ssessW hite's m anagerial competmce? Defend your position. 9. ( a) A re t he r atios y ou c alcul:ited b ased o n m arket o r b ook v alues? E xplain. (b) W ould y ou p refer r atios b ased o n m arket c ir b ook v alues? E xplain. EXHIBIT 1 Holly F ashions'I ncome S tatements:1 993-1996 ( 000s) 1993 Sales Costo f g oods Grossmargin Adrrinistrative Dq)reciation EBIT lnterest EBT Taxes Net income 1994 1995 1996 $985. 0 748. 6 236. 4 169. 4 10. 8 56. 1 7. O 49. 1 19. 7 $1,040. 0 n4. $1,236. 0 $1,305. 0 978. 8 202. 8 1 14 51. 0 4t. 0 18. 0 $27. 0 a7a', 307. 8 236,I 13. 6 58. 1 53. 1 21. 7 _-$3L9 249. 3 '14 4 62. 6 58. 5 23. 5 ___$99! EXHIBIT 2 BalanceS heetso { t he H olly F ashionsC ompany: f 993-1996 ( 000s) 1993 ASSETS Cash $40. 4 Receivables r53. 2 Inventory 117. 0 5. 9 Other cwrent Current assets 'u. 8 Grossf ixed Accumulaied depreciation (12. 0) 32. 8 Net fixed Totala ssets $349. 3 1994 1995 1996 $s1. 9 158. 9 121. 1 6. 2 338. 0 58. 9 (23. 4) __35t $38. 6 't75. 1 $10. 6 224. 8 19L. 9 7. 8 435. 1 96. 4' (s1. 4) 45. 0 $480. 1 193. 4 7. 4 414. 5 78. 1. _a;l continued) C ASE6 H OLLYF ASHIONS 39 EXHIBIT 2 (Contirwed) t993 LIAB]LITIES & NET WORTH Accounts payable Debt due Accruals Current liabilities Long-term debt Common s tock Retained e arnings Total L &NW $53. 8 10. 0 | 1 9. 7 , 8 3. 5 60. 0 150_0 1994 1995 r996 $v. f $85. 2 10. 0 24. 7 120. 9 40. 0 180. 0 114. 6 $u. 2 10. 0 26. L 120. 3 30. 0 180. 0 149. 8 $48q. 1 10. 0 26. 0 90. 7 50. 0 150. 0 82. 8 $349. 3 $455t EXHIBIT 3 Financial R atios { ot t hb H olly F ashionsC ompany: 1 993-1996 Ind*r11 (Presen] r993 r994 1995. 3. 7 3. 4 2. 6 'L7 1. 8 1. 3 1. 6 .8 r996 1993-19961. Liquidity Ratios

Curlent Quick Leverage atios R Deb(%) 41.. 1 37. 7 35. 3 8. 0 8. 5 11. 6 6. 4 6. 4 4. 8 FixedA sset Turnover 30. 0 29. 3 30. 1 TotalA sset Turnovet 2. 8 2. 8 2. 7 Timesinterest eamed Activity Ratios lnventory Tulnover (CGS) 47 57 71 3. 9 1. 3 8. 1 6. 0 40 25 72 3. 5 2. 8 2. 0 (continued) P ARTI I F INANCIALA NALYSIS DGIIBIT 3 (Conrinued) Ifld - r) 1993 1994 1995 AverageCollection Period Days Pulchases Outstanding** (Present) 1996 1993-1996+ 50 68 18 31 25 32 ProfitabilityR atios M Gross argin ( %) 24. 0 25. 5 24. 9 Net Profit Margin (%) 3. 0 2. 6 2. 6 Return on Equity (%) 14. 3 11. 6 0. 8 8. 4 7. 2 7. 0 5. 8 6. 0 6. L Retum on Total ( Assets %) Operating Margin*** (%) 26 3. 1 '1. 2 27. 3 19. 5 7. 8 11. 8 8. 7 9. 9 7. 2 3. 1 iThe thr€e numbers for each ratio arc comPuted in the following wsy. Ratios for all firms in dre indushy are arranged in what is consider€d a strontest-to-weakest order' The middle number rePl€senis the median ratioj that is, half the firms in the industry had mtios better than the median ratio and half had ratios that wer€ worse The top nunlber represents the uPPer qua4ile figure; meaning 25 Pelcent of the firms had ratios befter tlran this.

The lower number represents the lowest quaftile, that is, 25 Percent of the firms had ratios worse than this. *"This shows the average lentth of time that trade debt is ouhtandint. AIso caled the averate Paymeni Period. Calculated ; is A /P - ( CGS/360). 1**Calculateda s ( EBIT + D ep)/Sales.

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