Hatfield medical supplies mini case

1. Mini Case

11/21/18

Chapter 12 Mini Case

Hatfield Medical Supply’s stock price had been lagging its industry averages, so its board of directors brought in a new CEO, Jaiden Lee. Lee had brought in Ashley Novak, a finance MBA who had been working for a consulting company, to replace the old CFO, and Lee asked Ashley to develop the financial planning section of the strategic plan. In her previous job, Novak’s primary task had been to help clients develop financial forecasts, and that was one reason Lee hired her.

Novak began as she always did, by comparing Hatfield’s financial ratios to the industry averages. If any ratio was substandard, she discussed it with the responsible manager to see what could be done to improve the situation. The following data shows Hatfield’s latest financial statements plus some ratios and other data that Novak plans to use in her analysis.

Hatfield Medical Supply: Balance Sheet (Millions of Dollars), December 31 Hatfield Medical Supply: Income Statement (Millions of Dollars Except per Share)

2018 2018

Cash $90 Sales $9,000.9

Accts. rec. 1,260 Op. costs (excl. depr.) 8,100.9

Inventories 1,440 Depreciation 360.0

Total CA $2,790 EBIT $540.0

Net fixed assets 3,600 Interest 144.0

Total assets $6,390 Pretax earnings $396.0

Taxes (25%) 99.0

Accts. pay. & accruals $1,620 Net income $297.0

Line of credit 0

Total CL $1,620 Dividends $100

Long-term debt 1,800 Add. to RE $197

Total liabilities $3,420 Common shares 50

Common stock 2,100 EPS $5.94

Retained earnings 870 DPS $2.00

Total common equ. $2,970 Ending stock price $41.00

Total liab. & equity $6,390

Selected Ratios, Calculations, and Other Data, 2018

Operating Ratios and Data Hatfield Industry Other Ratios Hatfield Industry

(Op. costs)/Sales 90% 88% Profit margin (M) 3.30% 5.60%

Depr./FA 10% 12% Return on assets (ROA) 4.6% 9.5%

Cash/Sales 1% 1% Return on equity (ROE) 10.0% 15.1%

Receivables/Sales 14% 11% Sales/Assets 1.41 1.69

Inventories/Sales 16% 15% Asset/Equity 2.15 1.59

Fixed assets/Sales 40% 32% Debt/TA 28.2% 16.9%

(Acc. pay. & accr.)/Sales 18% 12% (Total liabilities)/(Total assets) 53.5% 37.3%

Tax rate 25% 25% Times interest earned 3.8 11.7

Target WACC 10% 11% P/E ratio 6.9 16.0

Interest rate on debt 8% 7% OP ratio: NOPAT/Sales 4.5% 6.1%

CR ratio: (Total op. capital)/Sales 53.0% 47.0%

ROIC 8.5% 13.0%

a. Using Hatfield’s data and its industry averages, how well run would you say Hatfield appears to be in comparison with other firms in its industry? What are its primary strengths and weaknesses? Be specific in your answer, and point to various ratios that support your position. Also, use the DuPont equation (see Chapter 3) as one part of your analysis.

Hatfield has lower operating profitability as shown by operating profitability (OP) ratio: 4.5% vs. 6.1%. Hatfield utilizes operating capital less efficiently, as shown by capital requirement (CR) ratio: 53% vs. 47%. As a consequence, Hatfield has a lower ROIC: 8.5% vs. 13%. In fact, Hatfield’s ROIC is less than its 10% WACC.

The debt/TA ratio and the TL/TA ratio indicate that Hatfield has more leverage than its industry competitors. The combination of higher interest payments and lower operating profitability cause Hatfield's times interest earned ratio to be much lower than the industry average.

Du Pont ROE M x Sales/Assets x Assets/Equity = ROE

Hatfield 3.30% 1.41 2.15 = 10.0%

Industry 5.60% 1.69 1.59 = 15.1%

The DuPont analysis confirms the conclusions.

b. Use the AFN equation to estimate Hatfield’s required new external capital for 2019 if the sale growth rate is 11.1%. Assume that the firm’s 2018 ratios will remain the same in 2019. (Hint: Hatfield was operating at full capacity in 2018.)

Data for AFN Method

Growth rate in sales (g) 11.1%

Sales (S0) $9,001

Required assets (A0*) $6,390

Spontaneous liabilities (L0*) $1,620

Forecasted sales (S1) $10,000

Increase in sales (ΔS = gS0) $999

Profit margin (M) 3.30%

Assets/Sales (A0*/S0) 71.0%

Payout ratio (POR) 33.7%

Spont. Liab./Sales (L0*/S0) 18.0%

AFNHatfield = Required increase in assets − Increase in spontaneous liabilities − Increase in retained earnings

= (A0*/S0)∆S − (L0*/S0)∆S − M ×S1 × (1–POR)

= (0.7099)(999.1) − (0.18)(999.1) − (0.033)(10000)(0.6633)

= $709.3 − $179.8 − $218.9

AFNHatfield = $310.60 million

c. Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant: the growth rate, the amount of accounts payable, the profit margin, and the payout ratio. Answer: See PowerPoint Show

d. Define the term self-supporting growth rate. What is Hatfield’s self-supporting growth rate? Would the self-supporting growth rate be affected by a change in the capital intensity ratio or the other factors mentioned in the previous question? Other things held constant, would the calculated capital intensity ratio change over time if the company were growing and were also subject to economies of scale and/or lumpy assets? Answer: See PowerPoint Show

Self-Supporting Growth Rate. This is the maximum growth rate that can be attained without raising external funds, i.e., the value of g that forces AFN = 0, holding other things constant. We found this rate, ith Excel's Goal Seek function and also algebraically, as explained below.

1. Using algebra. The self-supporting growth rate can also be found by setting the AFN equation to zero and then solving for g.

M(1 – POR)(S0)

Self-Supporting g = = ───────────────────────

A0* – L0* – M(1 – POR)S0

M = 3.30% 3 3.300%

POR = 33.7% 3 33.700%

1-POR = 66.3% 66.300%

S0 = $9,000.9 0 $9,001.0

A* = $6,390 0 $6,390.0

L* = $1,620 0 $1,620.0

M(1 – POR)(S0) $197.00

Self-Supporting g = ─────────────────── = ──────── = 4.3%

A0* – L0* – M(1 – POR)S0 $4,573.00

2. Using Goal Seek. To find the self-supporting growth rate with Goal Seek, select Data, What-If Analysis, and Goal Seek; then choose cell with the AFN (B96) as the value for the "Set Cell" area of the Goal Seek dialog box, choose 0 as the value for the "To Value" area of the dialog box, and choose the cell with the growth rate (C54) as the value for the "By Changing Cell" area of the dialog box. Then hit OK.