Pearson Air Conditioning & Service Managing a Firm\'s Working Capital Bob and Sc

Question

Pearson Air Conditioning & Service

Managing a Firm's Working Capital

Bob and Scott Pearson, father and son, are the owners of Pearson Air Conditioning & Service, based in Dallas, Texas. Scott serves as president, and Bob as general manager. The fi rm sells General Electric, Carrier, and York air-conditioning and heating systems to both commercial and residential customers and services these and other types of systems. Although the business has operated successfully since the Pearson’s purchased it in 2002, it continues to experience working-capital problems.

PEARSON'S FINANCIAL PERFORMANCE

The firm has been profitable under the Pearson’s' ownership. In fact, profits for 2009 were the highest for any year to date. Exhibit C22-1 shows the income statement for the year ending December 31, 2009. The balance sheet as of December 31, 2009, is presented in Exhibit C22-2. Note that the firm's total debt now exceeds the owners' equity. However, $10,737 of the firm's liabilities was a long-term note payable to a stockholder. This note was issued at the time the Pearson’s purchased the business, with payments going to the former owner.

PEARSON'S CASH BALANCE

The Pearson Air Conditioning & Service currently has a cash balance in excess of $28,000. The owners have a policy of maintaining a minimum cash balance of $15,000, which allows them to "sleep well at night." Recently, Bob has thought that they would still be able to "breathe comfortably" as long as they kept a mini- mum balance of $10,000.

PEARSON'S ACCOUNTS RECEIVABLE

The accounts receivable at the end of 2009 were $56,753, but at times during the year, receivables could be twice this amount. These accounts receivable were not aged, so the firm had no specific knowledge of the number of overdue accounts. However, the firm had never experienced any significant loss from bad debts. The accounts receivable were thought, therefore, to be good accounts of a relatively recent nature. Customers were given 30 days from the date of the invoice to pay the net amount. No cash discounts were offered. If payment was not received during the first 30 days, a second statement was mailed to the customer and monthly carrying charges of 1/10 of 1 percent were added. On small residential jobs, the fi rm tried to collect from customers when the work was completed. When a service representative finished repairing an air-conditioning system, for example, he or she presented a bill to the customer and attempted to obtain payment at that time. However, this was not always possible. On major items, such as unit changeouts-- which often ran as high as $2,500--billing was almost always necessary. On new construction projects, the firm sometimes received partial payments prior to completion, which helped to minimize the amount tied up in receivables

PEARSON'S INVENTORY

Inventory accounted for a substantial portion of the firm's working capital. It consisted of the various heating and air-conditioning units, parts, and supplies used in the business. The Pearson’s had no guidelines or industry standards to use in evaluating their overall inventory levels. They believed that there might be some excessive inventory, but, in the absence of a standard, this was basically an opinion. When pressed to estimate the amount that might be eliminated by careful control, Scott pegged it at 15 percent. The firm used an annual physical inventory that coincided with the end of its fiscal year. Since the inventory level was known for only one time in the year, the income statement could be prepared only on an annual the year, the income statement could be prepared only on an annual 670 Case 22 basis. There was no way of knowing how much of the inventory had been used at other points and, thus, no way to calculate profits. As a result, the Pearson’s lacked quarterly or monthly income statements to assist them in managing the business. Scott and Bob had been considering changing from a physical inventory to a perpetual inventory system, which would enable them to know the inventory levels of all items at all times. An inventory total could easily be computed for use in preparing statements. Shifting to a perpetual inventory system would require that they purchase new computer software. However, the cost of such a system would not constitute a major barrier. A greater expense would be involved in the maintenance of the system--entering all incoming materials and all withdrawals. The Pearson’s estimated that this task would necessitate the work of one person on a half-time or three-fourths-time basis.

PEARSON'S NOTE PAYABLE TO THE BANK

Bank borrowing was the most costly form of credit. The firm paid the going rate, slightly above prime, and owed $17,600 on a 90-day renewable note. Usually, some of the principal was paid when the note was renewed. The total borrowing could probably be increased if necessary. There was no obvious pressure from the bank to reduce borrowing to zero. The amount borrowed during the year typically ranged from $10,000 to $25,000. The Pearson’s had never explored the limits the bank might impose on borrowing, and there was no clearly specified line of credit. When additional funds were required, Scott simply dropped by the bank, spoke with a bank officer (who also happened to be a friend), and signed a note for the appropriate amount.

PEARSON'S ACCOUNTS PAYABLE

A significant amount of Pearson's working capital came from its trade accounts payable. Although accounts pay- able at the end of 2009 were $38,585, payables varied over time and might be double this amount at another point in the year. Pearson obtained from various dealers such supplies as expansion valves, copper tubing, sheet metal, electrical wire, and electrical conduit. Some sup- pliers offered a discount for cash (2/10, net 30), but Bob felt that establishing credit was more important than saving a few dollars by taking a cash discount. By giving up the cash discount, the firm obtained the use of the money for 30 days. Although the Pearsons could stretch the payment dates to 45 or even 60 days before being "put on C.O.D.," they found it unpleasant to delay payment more than 45 days because suppliers would begin calling and applying pressure for payment. Their major suppliers (Carrier, General Electric, and York) used different terms of payment. Some large products could be obtained from Carrier on an arrangement known as "floor planning," meaning that the manufacturer would ship the products without requiring immediate payment. The Pearsons made payment only when the product was sold. If still unsold after 90 days, the product had to be returned or paid for. (It was shipped back on a company truck, so no expense was incurred in returning unsold items.) On items that were not floor-planned but were purchased from Carrier, Pearson paid the net amount by the 10th of the month or was charged 18 percent interest on late payments. Shipments from General Electric required payment at the bank soon after receipt of the products. If cash was not available at the time, further borrowing from the bank became necessary. Purchases from York required net payment without discount within 30 days. However, if payment was not made within 30 days, interest at 18 percent per annum was added.

CAN GOOD PROFITS BECOME BETTER?

Although Pearson Air Conditioning & Service had earned a good profit in 2009, the Pearsons wondered whether they were realizing the greatest possible profit. The slowdown in the construction industry during 2009 was currently affecting their business. They wanted to be sure they were meeting the challenging times as prudently as possible.

QUESTIONS.

1. Evaluate the overall performance and financial structure of Pearson Air Conditioning & Service.

2. What are the strengths and weaknesses in this fi rm's management of accounts receivable and inventory?

3. Should the fi rm reduce or expand the amount of its bank borrowing?

4. Evaluate Pearson's management of accounts payable.

5. Calculate Pearson's cash conversion period. Interpret your computation.

6. How could Pearson Air Conditioning & Service improve its working-capital situation?

C22-1 Pearson Air Conditioning & Service Income Statement for the Year Ending December 31,2009 5727,679 466,562 5261,117 189,031 72,086 17,546 54,540 Sales revenue Cost of goods sold Gross profit Selling, general, and administrative expenses (including officers'salaries) Profits before tax Income tax Net profts

Explanation / Answer

QUESTION 1: Evaluate the overall performance and financial structure of Pearson Air Conditioning & Service.

ROE (Return on Equity) = net income/shareholders’ equity

$54540/$126625=0.4307

Current ratio = current assets/current liabilities

$179519/$84980=2.112

Acid test ratio= liquid assets/current liabilities

Liquid assets= cash+ debtors

$85542/$84980 = 1.006

Debt to asset ratio= total liabilities/equity

$136211/$126625= 1.0757

The current ratio and debt to asset ratio are high showing that the company is able to meet its short-term debt obligations. The ROE indicates that the firm is able to make profits with the money shareholders have invested.

QUESTION 2: What are the strengths and weaknesses in this firm’s management of accounts receivable and inventory?

Strengths in managing accounts receivables and inventory

Doubling of the debtors during the year shows the firm’s management improves its impending to raise revenues.

The cases of bad debts being written off which is a loss to the company were reduced. The debtors were not aged because they were given 30 days to pay the net amount failure to which they paid extra charges of 1/10 of 1 percent. An expense of cash discount is not offered which reduces on the firms expenses.

The introduction of perpetual inventory system will enable the firm to know its stock levels throughout the year. The new computer software will reduce the man-hours per person in carrying out a task.

Weaknesses:

The firm lacks precise information on the sum of accounts in arrears; also instant payment by the customer on completion of work was not always possible.

The firm used annual physical control of the stock which made it hard in calculating the profits and hey faced difficulties in determining stock levels in precision. Also the cost of acquisition and maintenance of the system acquired posed a greater challenge the firm.

QUESTION 3: Should the firm reduce or expand the amount of its bank borrowing?

Debt to equity ratio = total liabilities / shareholders’ equity

$136211/$126625 = 1.076

PROS

Since the ratio is high it shows that the firm has been using debt to finance its growth which results in additional interest expense. Bankruptcy can result in cases where the cost of debt financing may be more than the returns the firm generates on the debt through investment. The business activities become a challenge for the firm to handle and the shareholders will not gain.

CONS

The firm however is able to generate more earnings if it uses more debt to finance its improved operations than it would have without this financing. The shareholders will benefit if the earnings exceed the interest expense because the more earnings are divided among the same number of shareholders.

QUESTION 4: Evaluate Pearson’s management of accounts payable.

The firm should use the discount received because it reduces the cost related with the acquisitions and increase the net profit of the firm. Discount received helps the firm regulate its operations and pay their debts within 30 days to avoid pressure from their suppliers.

(2/10, net 30), means that the supplier will offer the firm a 2 percent discount if it pays its bill in 10 days. If the firm doesn’t take that discount, then the bill is due in 30 days.

To get the cost of not taking the discount is:

Discount Percent/100 – Discount percent X 365/Days Credit is outstanding – Discount period = Cost of Not Taking the Discount

2/100 -2 *365/30 – 10 = 37.2%. This is the cost of not taking the discount by the firm and it can get a loan from the bank which is inexpensive.

Paying for the goods once sold will be convenient for the firm since the firm does not incur any extra costs on the good if it is not purchased.

QUESTION 5: Calculate Pearson’s cash conversion period. Interpret your computation.

Cash conversion is the total time that elapses from the time a sale of a good or service is made and time of receipt of cash for the good sold.

Cash conversion period=days in inventory + days in AR – days in AP

Days in inventory = 365/ (COGS/inventory)

365* (466562/89562) = 70 days.

Days in AR= 365/ (sales/AR)

365* (727679/56753) = 28 days

Days in AP = 365/ (COGS/AP)

365* (466562/38585) = 30 days

Cash conversion period is 70+28-30 = 68 days.

This shows that the company will suffer from liquidity risk as they pay suppliers before they collect from a debtor. The company may be increasing its investment in resources to improve on sales, the cash amount drops.

QUESTION 6: How could Pearson Air Conditioning & Service improve its working-capital situation?

To improve the firms’ working capital, the firm should uphold principles to govern their stock levels and a permanent inventory system to ensure production of income statements throughout the year and be able to succeed the business.

The firm should also pay its debts on stipulated time to avoid incurring high interest rates; also they should take advantage of cash discount which releases their expense. Circularization of debtors to minimize bad debts being written off which will reduce working capital. These will ensure there is enough working capital for the company to run its activities. Also by not giving cash discounts to the customers will increase the firms’ working capital .

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