Longs Jewelers Introduction Bob Longs of Longs Jewelers returned to his store in

Question

Longs Jewelers Introduction Bob Longs of Longs Jewelers returned to his store in the spring of 20x5 angry and depressed. “We just lost our lease; I don’t see how we can make it now.” It had been seven years since Bob and his wife, Bonnie, moved their business to Spartanburg, South Carolina. They had struggled, and sometimes excelled. But primarily, through sheer determination, they just survived in the jewelry business to this point. The loss of their lease and prime location could be the final blow that would destroy their business. Bob needed to decide, and quickly, either to fold the tent or give it one more shot. York Operations Longs Jewelers originally started in 1978 as Able Jewelry and Music—a pawnshop in York, South Carolina, purchased by Bob’s parents from other family members. Bob helped his mom in the business after his graduation from the University of South Carolina with a major in business in 1989. Wanting to gain more business experience, Bob earned his MBA from Regent University in 1993 and, with Bonnie, assumed ownership of the store on July 1, 1993. Bob and Bonnie met at the University of South Carolina. She graduated in three years with a major in foreign politics and a minor in Spanish. After college she was also able to get a Para-legal degree in business and real estate law and bankruptcy. Her legal training made it easy for her to find work with a law firm while Bob completed his MBA. Even though the store was a well-recognized landmark in York, it initially had trouble earning a reasonable profit. After about three years, Bob saw the 80-20 rule in action. The pawnshop generated 80% of the headaches and 20% of the revenue. Bob wanted the store to be more upscale; he eliminated the electronics and musical equipment inventory associated with the pawnshop and changed the name of the store to Longs Jewelers. Over the next four years, sales and profits grew. Bob and Bonnie lived in Spartanburg where Bonnie grew up, about 30 miles west of York on I-85. Through their associations and church activities, they established a loyal clientele in their hometown who would travel to York to shop at Longs Jewelers. Many of these customers often encouraged Bob and Bonnie to open a store in Spartanburg. In York, however, Bob had the only jewelry store that catered to a middle-class market. Unlike in Spartanburg, where there were several similar jewelry stores already established, he did not have to worry about competition. The store’s roots were in York with a long history and a devoted following. Even though the drive to work sometimes seemed long, the York site was doing well. This situation changed about ten years ago. Video poker was the new craze, and numerous people in the York seemed addicted to it. While illegal in South Carolina, it was legal in North Carolina. Many York citizens frequently drove north a mere 10 miles to the next state to spend their discretionary income on these games. Bob saw a change in his customer spending habits as they bought less jewelry, and some even said they or their spouse used the money instead to gamble and “hit it big.” At the same time, York’s Main Street was going the way of many small towns without a strong economic base. Downtown businesses were shutting their doors as shoppers drove to new malls or superstores like Wal-Mart. The only stores that seemed to be opening on Main Street were loan companies, which offered high interest rate loans to consumers and businesses. Within two years, this combination of events took Bob’s operation from being profitable to barely surviving. Relocating to Spartanburg Bob and Bonnie had to decide if it was worthwhile to continue their jewelry business. They had two young children and roots in Spartanburg. With Bob’s MBA and business experience, the possibility of a job at a company in Spartanburg was attractive. Bonnie could stay home and raise the kids, and they would be free of the pressure of ownership and the worry over cash flow. It was evident that Longs Jewelers in York would not survive. Persuaded by friends and motivated by his entrepreneurial spirit, Bob developed a business plan and sought financial assistance to move his operation to Spartanburg. To his surprise, local banks were not as supportive as Bob thought they would be. Longs Jewelers’ current financial condition did not help to qualify for a loan; it seemed too risky. The financial institutions denied funding. Bob liked the idea of being his own boss, enjoyed the jewelry business, and felt he had some expertise in the area. So he kept looking for financial assistance. Eventually, he returned to his old bank in York. Even though he was leaving town, based on the relationship he had established with the bank and with their assistance, he qualified for a Small Business Administration loan of $60,000. Bob and Bonnie sold their house in Spartanburg and used the equity to add another $20,000 to start over in Spartanburg. Upon the sale of their house in Spartanburg, Bob and Bonnie and their two children, Hannah and Jonathan, moved from a 3,200-square-foot home into a 1,200-square-foot apartment. Spartanburg Operations Bob secured a lease for almost 3,000 square feet in a prime location in west Spartanburg on a busy main street across from a large shopping center. This section of Spartanburg was experiencing sustained consumer consumption since it had easy access to I-85, and new upper-income home developments were opening on a regular basis. The rent for the store was $3,000 per month. The strip shopping center included some other fine stores, including an upscale women’s fashion store and a quality shoe store. Unexpectedly, Bob learned that the landlord charged him an additional $40,000 to “up fit” the store before the first sale was even made. In some of the other lease contracts they considered, “up fitting” was already provided, and he wrongly assumed those lease stipulations were included in this current lease. Bob learned the importance of “buyer beware.” He regretted not getting professional guidance before signing the lease, but he was trying to save money and time. On top of that, Bob later learned that his share of the property tax for the facility was also charged to him at the end of the year as an additional expense versus being part of the monthly rent. Already cash poor, Bob used his remaining $40,000 in funds to acquire inventory. With limited working capital, a discretionary income type product with low turnover, and a seasonal business, Bob continually had cash flow problems. Jewelry was expensive, and the store needed significant inventory to display in showcases in order to attract customers. He bought lots of silver, which was relatively inexpensive, to supplement gold and diamonds. Bob maintained a credit purchasing relationship with many of his suppliers, but when sales did not achieve anticipated levels, Bob quickly found himself past due on many accounts. It was not long before some of these suppliers wanted cash up front for purchases. Conditions seemed to go from bad to worse as debt mounted. In the first year, the business lost over $108,000. Bonnie and Bob both needed to work in the store because at least two people had to be around to prevent theft. With their responsibilities as parents, family activities, commitments at church, working six days a week at the store was demanding and there was little down time. They even had to give up attending or watching the games of their beloved University of South Carolina football team—an activity that in the past often gave them much-needed relaxation from the stress of running your own business. Fortunately, the clientele from Spartanburg remained loyal and frequented the store even more now that the business was more conveniently located in Spartanburg. Store hours were 10:00 a.m. to 5:30 p.m., Monday through Saturday. Bob believed that the customers he was trying to reach, primarily non-working women who enjoyed shopping and socializing would shop during the day. These women generally entertained, wanted quality family time, and had other obligations in the evening. Also, this was more of a destination location as opposed to a mall location where there would be more walk by traffic in the evening. Bob and Bonnie practiced a high moral and ethical standard and understood the importance of trust and honesty. They were fair in valuing stones for both buying and selling purposes, which was often a concern by less knowledgeable customers. They were also friendly and got to know their customers on a first-name basis. Customer service was highly regarded in all of their business dealings. As it turned out, many customers bought jewelry exclusively from Longs Jewelers. With over 15 years of experience, plus his educational training, Bob felt he knew the jewelry business and how to make it successful. Additionally, Bonnie, who was completely self-taught in the jewelry business, had a knack for picking the right products. She had always had an interest in colors and texture and was good at determining what looked good on fashion conscious women. As a teenager, Bonnie was paid commercial art work for the Governor of New Jersey. Since their market was primarily women in a middle- to upper-middle income bracket, it was important for Bonnie to recognize trends and styles when purchasing inventory. She believed in her products and her enthusiasm translated into sales to satisfied customers. Bonnie also learned to make jewelry. She bought older jewelry from estate sales and other secondary sources at a discounted price and used the materials to make new and more appealing jewelry items. Customers adored these unique items. Even though competition from other jewelry stores in the immediate vicinity was fierce, Longs Jewelers effectively used good marketing strategy with ads in popular publications, radio, store specials, and especially word of mouth primarily catered to middle-income earners. They became active in the community and supported charitable events, which helped to give the business credibility. Also their products were more fashion forward and seemed to have a unique appeal to their customers. Their target customers were women who looked for something better than a run-of-the-mill Kmart or Wal-Mart type of product, but not the exorbitantly priced products found at the really upscale jewelry stores. Of course, many of the other individually-owned stores were trying to capture the same market. As with many owner-run businesses, Bob and Bonnie focused on little, but significant, services. They did engraving, cleaning, and elaborate gift-wrapping at no extra charge. Their best promotion was word of mouth and personal friendly service. Still with all the positive factors that Bob and Bonnie had going for them, maintaining the financial viability of the business was still a struggle in a very competitive market. There were any number of factors that seemed to impact their potential for success including the seasonal nature of sales, high carrying cost of inventory, high overhead costs, low sales volume, and even sometimes surprisingly low margins on items sold. At times Bob had trouble making the monthly lease payment on the store. This last year he was four months behind. Like many businesses, the jewelry business was seasonal. The majority of sales were made during the Christmas season with other peaks in February, May, and June. Months like July and August were extremely slow. In the past, Bob caught up on the rent payments in December when he had a better cash flow. Over the years, Bob and Bonnie had no choice but to rely on credit card debt, which had amounted to over $50,000. Once they were unable to make even the minimum payment, their credit scores tumbled—and they no longer qualified for any personal loans or other credit cards. Nevertheless, they worked hard to repay suppliers and establish a better relationship with those companies to hopefully get more favorable terms for future purchases. Even with their best efforts, the Spartanburg store did not live up to their expectations. It had been seven years. What did Bob and Bonnie have to show for their effort? They had already worked nine years in York with limited success and now another seven years in Spartanburg. There were good days, but then there were also days when Bob wished just to sell a watch battery. With a $3,000-plus monthly rent, it was easy for Bob to determine that he needed over $200 in sales (assuming a 100% markup) every day just to pay the rent. Sometimes Bob felt he was working for his landlord. However, Bob and Bonnie both gained much joy selling a quality product, like an engagement ring to a satisfied customer, knowing they played a role in a special event. Bob and Bonnie enjoyed working the store together and had complementary skills and a strong marriage even though they were together almost 24-7. Bob surveyed what he had. His $100,000 of inventory could neatly fit into a couple of shoeboxes! There was the large safe, showcases, fixtures and some office furniture. Of course, there also was the $250,000 debt. He felt fortunate that some of the debt was still interest-free and that his average cost of debt was around 11%. He had worked very hard to reduce the level of debt over the past few years. While the total company debt had decreased, his interest expenses increased as his credit rating went down and his perceived riskiness by creditors went up. If he left the store he asked himself: how was he going to make good on this debt? Because of their high ethical values and integrity, Bob and Bonnie felt badly that they had created such a bad debt situation, and they felt morally obligated to make good on all of the outstanding debt. Suppliers and others had placed faith in them and given the store favorable credit terms and assumed they would fulfill these obligations. Future Operations If Bob wanted to begin again, could he, especially now that his lease was terminated by his landlord? Seven years ago, he had a house with some equity that he sold to raise capital for the business. Now, he did not even have that. It was doubtful that he could arrange for debt financing, given his history. If he brought in a partner, that partner would probably want 51% ownership or more of the business, and he would lose control. Furthermore, could he even find a suitable location for his store close to where he had become established? He was aware of another location that had recently become available. It was just three blocks away, but it was only 1,250 square feet, 40% of the size of his current store. Bob surmised that the monthly lease rate would be about half of his current rate. What kind of other lease terms would he face with a new landlord? Bob did not want to be surprised again with hidden charges in another lease agreement. Also, could he afford the cost of a move, especially transporting the large and very heavy safe? There was also the issue of employees. Because of the need to always have at least two employees on site, Bob had often hired extra help at various times during the year. Currently, two additional employees had come to depend on Bob and the job for their source of income. They too, would have to seek other employment. And there were his loyal customers. Many had stuck with him since his early days back in York. He had spent years developing this relationship and market. Did he want to give up this valuable but intangible resource? If he folded the business, what would he do? For 20 years he had been in the jewelry business. Working for another company in jewelry, like a competitor, seemed like such a step down. He wanted to stay in Spartanburg, and he had plenty of connections. But after being an entrepreneur, could he work for someone else? What would Bonnie do? Their children were now 12 and 16. How would they react to this situation? They had already been through a lot. Bob pulled out his last three years of financial data to try to determine if they even had resources or the financial viability available to make the store viable at a new location. From Bob’s understanding of the jewelry business, successful operations have a gross margin of around 50 percent and a profit margin of at least five to ten percent. Maybe it was time to consider another direction. He had an MBA and years of retail experience, surely he could find a job in the Spartanburg area in the $50,000 to $60,000 range. Plus Bonnie, with her talents and skills in the jewelry business, could easily find a part-time or maybe full time job and earn up to $30,000. Also, with some catching up on the latest laws in the legal field, she could probably get a much higher paying job as a Para-legal with a law firm in the area. The thought of using her legal bankruptcy training on their own store was not amusing. But was it or should it be just about the money? They really enjoyed the jewelry business and the relationships established with their clientele. Their faith had remained strong, but this was going to be a test, or was it an opportunity? Longs Jewelers Income Statement For the Years Ending June 30, 20x2, 20x3 and 20x4 20x2 20x3 20x4 Sales $419,779 $419,667 $432,206 Cost of Goods Sold 232,869 297,161 228,743 Gross Margin 186,910 122,506 203,463 Operating Expenses Salaries and Wages 50,374 31,909 44,891 Rent 36,284 38,639 40,523 Taxes and Licenses 19,772 18,804 26,391 Advertising 13,895 15,515 11,599 Insurance 7,829 7,683 7,658 Utilities 6,506 7,412 6,504 Depreciation 19,047 16,672 16,738 Other General and Administration 3,087 11,767 19,762 Total Operating Expenses 156,794 148,401 174,066 Interest Expense 7,670 3,812 11,696 Total Expenses 164,464 152,213 185,762 Net Income Before Tax* $22,446 $-29,707 $17,701 *Due to significant losses from prior years, no taxes have been paid over the three years because of net operating loss carryforwards. The marginal federal plus state tax rate, if taxes had been paid, would be 15%. Longs Jewelers Balance Sheet For the Years Ending June 30, 20x1, 20x2, 20x3 and 20x4 20x1 20x2 20x3 20x4 Current Assets Cash $-4,824 $413 $-4,150 $7,637 Accounts Receivable 7,886 6,100 5,000 4,368 Inventory 186,450 188,237 111,455 99,351 Total Current Assets 189,512 194,750 112,305 111,356 Long-Term Assets Equipment 139,497 150,790 149,332 152,942 Less Accumulated Depreciation -63,592 -82,639 -99,311 -116,049 Equipment (net) 75,905 68,151 50,021 36,893 Other Assets 1,458 1,458 Total Long-Term Assets 75,905 68,151 51,479 38,351 Total Assets $265,417 $262,901 $163,784 $149,707 Current Liabilities Accounts Payable $151,743 $140,000 $140,000 $141,328 Long-Term Liabilities Loans from Shareholders 19,471 17,200 16,200 44,177 Notes Payable 206,377 201,846 133,436 70,684 Total Long-Term Liabilities 225,848 219,046 149,636 114,861 Total Liabilities 377,591 359,046 289,636 256,189 Common Equity Common Stock 1,000 1,000 1,000 1,000 Retained Earnings* -113,174 -97,145 -126,852 -107,482 Total Equity -112,174 -96,145 -125,852 -106,482 Total Liabilities and Equity $265,417 $262,901 $163,784 $149,707 *Prior period adjustments made to balance in retained earnings -6,417 1,669 Longs Jewelers Discussion Questions 1. Complete a financial analysis of Longs Jewelers including a cash flow statement and ratio analysis and discuss your findings. 2. Identify critical non-quantitative issues that should be considered in the decision process. 3. What risk factors should Bob be most concerned about regarding his decision? 4. Identify possible ethical or values-based issues that could impact any decision. 5. What should Bob and Bonnie do? Longs Jewelers Discussion Questions 1. Complete a financial analysis of Longs Jewelers including a cash flow statement and ratio analysis and discuss your findings. 2. Identify critical non-quantitative issues that should be considered in the decision process. 3. What risk factors should Bob be most concerned about regarding his decision? 4. Identify possible ethical or values-based issues that could impact any decision. 5. What should Bob and Bonnie do?

Explanation / Answer

Cash Flow Analysis

Given three years of income statement data, along with four years of balance sheet data,it is possible to develop three years of cash flow statements. Given the critical nature of cash flow for James Jewelers, it is very important to understand how the business is operating from a cash flow perspective. Exhibit IM 1 illustrates the cash flow for James Jewelers for the years ending June 30, 2000, 2001, and 2002.

Cash Flow Statement

For the Years Ending June 30, 2000, 2001, and 2002

7,637

*Interest Expense is more appropriately classified as a finance activity versus an operation activity, so the amount of annual interest was transferred from the operation section to the finance section of the cash flow statement.

Analysis of Exhibit IM 1

Cash flow is a very important aspect of a small business. A critical analysis and understanding on the impact of cash for James Jewelers is important.The statement of cash flows shows a positive increase in cash flow coming from operating activities. Specifically in 2000 and 2002, this cash flow came mostly from income statement activities. While net income was not particularly high, the add-back of noncash depreciation helped in the cash flow. Also, interest expense activities weremoved to the finance section for evaluation.

In 2001, a large reduction in inventory helped to offset a negative cash flow from income statement activities. JamesJewelers may be taking a more aggressive working capital strategy by reducing levels of Inventory while trying to maintain or grow sales. This may be a risky strategy, as the store needs to maintain a certain critical mass of inventory to appeal to the typical walk-in customer who wants to view a variety of produc

The cash flow from investing activities wasrelatively insignificant, especially over the last two years. James Jewelers is at least not making significant investments in fixed assets and has relatively few fixed assets, which is good given its critical cash flow position.

The cash flow from financing activities has shown a significant outflow over the past three years, especially in the last two years. In addition to paying interest, Bob has beenstriving to reduce debt. Someof the debt in 2002 was also transferred from third parties to the shareholders as Bob probably used personal loans to pay off creditors.

Even though a fair amount of debt is being paid off in 2001 and 2002 there was asubstantial increase in interest expense in 2002. It is possible that creditors were demanding higher rates of interest on the outstanding debt because the company was being perceived as a greater credit risk, making it even harder to improve the cash flow position.

There is no evidence of any payment of dividends to the shareholders (Bob and Bonnie) and the salary expense from the income statement was for other employees. One might question how Bob and Bonnie are surviving financially and providing for basic familyneeds during this period.More than likely they areaccumulating large amounts of consumer debt.

Overall, the cash flow position is very precarious. Bob seems to be doing his best toefficiently manage cash flow, reduce debt, and maintain a minimum level of inventory, but he has little margin for error

Financial Statement (Ratio) Analysis

Financial statement analysis (r

atios) will also provide valuable information regarding the

current financial condition of James Jewelers.

Exhibit IM 2 summarizes several critical

financial ratios for the company.

Exhibit IM 2

James Jewelers

Financial Statement Analysis

For the Years Ending June 30, 1999, 2000, 2001, and 2002

1999 2000 2001 2002

Liquidity Ratios

Current Ratio 1.249 1.391 0.802 0.788

Quick Ratio 0.020 0.047 0.006 0.085

Activity Ratios

Inventory Turnover 1.243 1.983 2.170

Days in Inventory 293.6 184.1 168.2

Accounts Receivable Turnover 60.03 75.62 92.27

Days in Receivables 6.08 4.83 3.96

Accounts Payable Turnover 1.596 2.123 1.626

Days in Payables 228.6 172.0 224.5

Fixed Asset Turnover 5.83 7.02 9.62

Total Asset Turnover 1.59 1.97 2.76

Debt Ratios

Debt to Asset Ratio 1.423 1.366 1.768 1.711

Debt to Equity Ratio NMF NMF NMF NMF

Times Interest Earned 3.93 -6.79 2.51

Profitability Ratios

Gross Margin 0.445 0.292 0.471

Profit Margin 0.053 -0.071 0.041

Basic Earning Power 0.114 -0.121 0.188

Return on Assets 0.0850 -0.1392 0.1129

Return on Equity -0.215 0.268 -0.152

Analysis of Exhibit IM 2

To aid the discussion, ratios are divided into

four categories: liquidi

ty, activity, debt and

profitability.

Liquidity Ratios

– James Jewelers is clearly in a da

ngerous situation regarding liquidity.

Both the current and quick ratios are extr

emely low, and the trend is in the wrong

direction. Even a slight dow

nturn in sales or other crit

ical operating activities could

create an irrevocable situation leadi

ng to termination of James Jewelers.

Activity Ratios

– Turnover measures of inventory and accounts payable are poor, while

fixed asset and total asset tur

nover are very good. If one

only looked at the total asset

turnover, one would not get a

correct evaluation of James Je

welers because of the low

amounts of long-term assets. The more correc

t measure of activity

is reflected in the

inventory and accounts payable turnover. Je

welry, by its nature, is

a low-turnover and

relatively high-margin product. The inventor

y turnover ratio for James Jeweler certainly

reflects the low turnover. Hopefully, this is

being offset by high margins. At least the

inventory turnover is improving. This improveme

nt is probably the result of a scale-back

in the level of inventory. It would be even

better if sales levels are also increasing to

improve the inventory turnover

The accounts payable turnover indi

cates a serious problem in

credit relationships with

suppliers. It is easy to see

where suppliers will not want to do business with James

Jewelers for fear of not receiving payment fo

r product for more than 200 days. If terms

are net 30 or even 60 days, there is a

critical problem with accounts payable.

The accounts receivable turnover is not a fact

or in this analysis, as James Jewelers

apparently does not carry accounts receivable

balances with its customers. One can

probably assume that customers are either

paying in cash or most likely with a

commercial credit card. James Jewelers is fortunate that payment for retail sales is in this

format, as any additional delays in the rece

ipt of cash for sales would further jeopardize

an already unhealthy

cash flow situation.

Debt Ratios

– James Jewelers is literally off the

chart regarding its debt ratios as the

level of debt far exceeds the level of assets.

Additionally, the trend

is getting worse as

total debt is almost twice the level of total a

ssets. Fortunately, much

of this debt must be

at low or no interest as the

interest expense is relatively

low for the amount of debt and

risk of the company as reflected in a pos

itive times interest earned ratio for 2000 and

2002. The debt to equity ratio gives results th

at are not meaningful figures (NMF) due to

the negative equity amounts.

Profitability Ratios

– Gross margins have been under 50% and even under 30% for

2001. This ratio is below the industry aver

age of around 50% for a successful jewelry

business. Given a high-margin item like jewelr

y, this appears to be a low margin, which

when accompanied by low turnover will result in

low profitability. James Jewelers could

be under pricing their merchandise to try to

generate sales or it is being forced by

competition to reduce prices. The inability to make satisfactory margins could easily

result in unsuccessful operations. The pr

ofit margin and basic earning power may be

typical numbers for 2000 and 2002, but both we

re negative in 2001. Again, even when

the profit margin was positive, it was at the low end, around 5 percent, of an industry

norm of 5 to 10 percent for a su

ccessful operation.

With all the other difficulties of the

company, James Jewelers needs to have highe

r margins to begin to turn things around.

Summary Comments on Financial Statement Analysis

There is not much positive to say about Jame

s Jewelers. Liquidity is in real danger,

turnover of critical inventor

y is low, and payment policie

s with suppliers are extended

well beyond normal credit terms. The debt

situation makes conventional measures of

performance almost irrelevant. Profitability beginning with gross margin is too low and

leading to marginal levels of performance.

About the only positive results is that there is

a relatively low amount of capital tied up in fixe

d assets and interest

levels on debt appear

to be fairly reasonable give

n the risk of the operation.

Growth Analysis

Another measure of financial performance c

ould be related to growth. Exhibit IM 3

looks at the growth of some cr

itical areas of James Jewelers.

Summary Comments on Financial Statement Analysis

There is not much positive to say about Jame

s Jewelers. Liquidity is in real danger,

turnover of critical inventor

y is low, and payment policie

s with suppliers are extended

well beyond normal credit terms. The debt

situation makes conventional measures of

performance almost irrelevant. Profitability beginning with gross margin is too low and

leading to marginal levels of performance.

About the only positive results is that there is

a relatively low amount of capital tied up in fixe

d assets and interest

levels on debt appear

to be fairly reasonable give

n the risk of the operation.

Growth Analysis

Another measure of financial performance c

ould be related to growth. Exhibit IM 3

looks at the growth of some cr

itical areas of James Jewelers.

James Jewelers

Growth Analysis

For the Years Ending June 30, 2000, 2001, and 2002

2000 2001 2002

Growth in Sales 0.000 0.030

Growth in Gross Margin -0.345 0.661

Growth in Net Income Before Tax -2.323 NMF

Growth in Total Assets -0.009 -0.377 -0.086

Growth in Total Liabilities -0.030 -0.317 -0.232

Analysis of Exhibit IM 3

There has been no growth in sales over th

e three-year period from 2000 through 2002. In

spite of discussions regarding customer l

oyalty and various marketing techniques, the

efforts have not translated

into increased sales.

Because of the poor performance of 2001 with

a negative net income before tax, the

growth percentages in 2001 and 2002 for gross

margin and profitability do not represent

meaningful figures.

James Jewelers has shown reductions in the gr

owth of its total assets with a rather

significant reduction in size in 2001. There has

also been a corresponding decrease in the

growth rate for total liabilities. One might

conclude that the company was too large in

the beginning and is trying to become more ef

ficient, and/or they are being forced to

downsize because of unpr

ofitable operations.

Common Sized Income Statement Analysis

A common sized income statement analysis

can help to determine which expense

categories consume the greatest

proportion of revenue for Jame

s Jewelers and any trends

over the three year period.

Exhibit IM 4 highlights the re

venue, expense and income

categories in the common sized analysis.

Exhibit IM 4

James Jewelers

Common Sized Income Statement Analysis

For the Years Ending June 30, 2000, 2001, and 2002

Sales 419,779 1.00 419,667 1.00 432,206 1.00

Cost of Goods Sold 232,869

0.55 297,161

0.71 228,743

0.53

Gross Margin 186,910 0.45 122,506 0.29 203,463 0.47

Operating Expenses

Salaries and Wages 50,374 0.12 31,909 0.08 44,891 0.10

Rent 36,284 0.09 38,639 0.09 40,523 0.09

Taxes and Licenses 19,772 0.05 18,804 0.04 26,391 0.06

Advertising 13,895 0.03 15,515 0.04 11,599 0.03

Insurance 7,829 0.02 7,683 0.02 7,658 0.02

Utilities 6,506 0.02 7,412 0.02 6,504 0.02

Depreciation 19,047 0.05 16,672 0.04 16,738 0.04

General & Administration 3,087

0.01 11,767

0.03 19,762

0.05

Total Operating Expenses 156,794 0.37 148,401 0.35 174,066 0.40

Interest Expense 7,670

0.02 3,812

0.01 11,696

0.03

Total Expenses 164,464 0.39 152,213 0.36 185,762 0.43

Net Income Before Tax 22,446 0.05 -29,707 -0.07 17,701 0.04

Analysis of Exhibit IM 4

Cost of goods sold as a percentage of reve

nue was much higher in 2001 at 71% than the

55% in 2000 and 53% in 2002. That resulted

in a lower gross margin rate of 29% and

probably led to the negative

net income before tax.

The total operating expense as

a percent of sales remained

relatively consistent between

35 and 40 percent over the three year time pe

riod and the individual operating expenses

also remained relatively constant during this

time period. This consistency should give

credibility to expected levels of expe

nses in these areas in future years.

Interest expense as a percent or revenue rema

ined at a very insignificant 1 to 3 percent

over the three years. Given the concern over de

bt load, Bob should be thankful that these

expenses were not a lot higher.

Overall, if James Jewelers can work towa

rd a gross margin of around 50 percent and

maintain a relatively consistent level of ot

her operating expenses, they have a chance to

earn a positive net income before taxes of between 5 and 10 percent which will be at the

low end of the industry standard

for their jewelry business.

Common Sized Balance Sheet Analysis

A common sized balance sheet analysis can help

to determine the size of various asset,

liability and equity accounts in relation to total assets for James Jewelers and any trends

over the four year period. Exhibit IM 5 hi

ghlights the balance sheet in the common sized

analysis.

Exhibit IM 5

James Jewelers

Common Sized Balance Sheet Analysis

For the Years Ending June 30, 1999, 2000, 2001, and 2002

1999 % 2000 % 2001 % 2002 %

Current Assets

Cash -4,824 -0.02 413 0.00 -4,150 -0.03 7,637 0.05

Accounts Receivable 7,886 0.03 6,100 0.02 5,000 0.03 4,368 0.03

Inventory 186,450

0.70

188,237

0.72

111,455

0.68

99,351

0.66

Total Current Assets 189,512 0.71 194,750 0.74 112,305 0.69 111,356 0.74

Long-Term Assets

Equipment 139,497 0.53 150,790 0.57 149,332 0.91 152,942 1.02

Less Accumulated

Depreciation -63,592

-0.24

-82,639

-0.31

-99,311

-0.61

-116,049

-0.78

Equipment (net) 75,905 0.29 68,151 0.26 50,021 0.31 36,893 0.25

Other Assets 1,458 0.01 1,458 0.01

Long-Term Assets 75,905 0.29 68,151 0.26 51,479 0.31 38,351 0.26

Total Assets

265,417 1.00 262,901 1.00 163,784 1.00 149,707 1.00

Current Liabilities

Accounts Payable 151,743 0.57 140,000 0.53 140,000 0.85 141,328 0.94

Long-Term

Liabilities

Loans Shareholders 19,471 0.07 17,200 0.07 16,200 0.10 44,177 0.30

Notes Payable 206,377

0.78

201,846

0.77

133,436

0.81

70,684

0.47

Total Long-Term

Liabilities 225,848 0.85 219,046 0.83 149,636 0.91 114,861 0.77

Total Liabilities 377,591 1.42 359,046 1.37 289,636 1.77 256,189 1.71

Common Equity

Common Stock 1,000 0.00 1,000 0.00 1,000 0.01 1,000 0.01

Retained Earnings -113,174

-0.43

-97,145

-0.37

-126,852

-0.77

-107,482

-0.72

Total Equity -112,174 -0.42 -96,145 -0.37 -125,852 -0.77 -106,482 -0.71

Liabilities & Equity

265,417 1.00 262,901 1.00 163,784 1.00 149,707 1.00

Analysis of Exhibit IM 5

When looking at the various asset categories, it

is evident that inventory is the key asset

for James Jewelers which should not be surpri

sing. Inventory repr

esents about 70% of

the total assets. However, there is a slight

downward trend to the

most recent inventory

level of 66%. This trend may be an indication

that Bob is doing a better job of efficiently

managing inventory.

Accounts receivable is a rela

tively insignificant amount as

retail customers generally

either pay with a check or cash or most lik

ely use a credit card.

Bob at least does not

seem to have any problem with the collecti

on of accounts receivable or the accumulation

of bad debts. There is some concern rega

rding cash which is sometimes even a negative

balance, and never at a very high percentage

of total assets. While Bob does not need to

have a large amount of availa

ble cash, he has obviously be

en experiencing some cash

flow difficulties and this low percentage leav

es him with little margin for error.

Net equipment is around 25% of total assets

and that proportion will probably continue to

decline as the assets are depreciated. The

case indicated that the fixed assets include

showcases and fixtures along with some offi

ce furniture and a large safe. Assuming the

safe has a long useful life and showcases,

fixtures and office furnishings can be

maintained reasonable inexpensively there s

hould not be a need for any significant

increase in fixed assets in the near future.

The liability and equity common sized analys

is is a little unusual because of the

increasing negative equity position. Total liabil

ities for the last two

years have been at

177 and 171 percent of total assets up

from around 140 percent in 1999 and 2000.

However, long-term liabilities have been

reduced by about half from 1999 to 2002 and

the other major category, accounts payable

in absolute dollar terms has remained

relatively constant. Also, th

e negative equity position has

been relatively constant in

absolute dollar terms. The change in pr

oportions has come about primarily from the

reduction in the total asset of approxi

mately $100,000 in three years which roughly

coincides with the reduction in long-term lia

bilities of just over $100,000 in the same

three year period. Bob appears to be improvi

ng his asset efficiencies along with making

a concerted effort to reduce debt.

Return on Equity (DuPont) Analysis

Additional information regarding financial pe

rformance can sometime

be gained through

a decomposition of the return on equity into se

veral related ratios. In this analysis the

return on equity (ROE) is divi

ded into five specific ratios.

•

Return on Equity = Tax Burden x Intere

st Burden x Operating Profit Margin x

Total Asset Turnover

x Leverage Ratio

•

Net Income/Average Total Equity =

Net Income/Earnings Before Tax x

Earnings Before Tax/Earnings Before

Interest and Tax x Earnings Before

Interest and Tax/Sales x Sales/Average Total Assets x Average Total

Assets/Average Total Equity

NI = NI x EBT x EBIT x Sales x Avg Assets

Avg Equity EBT EBIT Sales Avg Assets Avg Equity

Specific information regarding each ratio can

help to analyze the overall performance of

James Jewelers. Exhibit IM 6 highlights results

for each of the five ratios over the 2000

to 2002 time period. When the five ratios are

multiplied together they equal the return on

equity.

Exhibit IM 6

James Jewelers

Decomposition of Return on Equity Analysis

For the Years Ending June 30, 2000, 2001, and 2002

2000 2001 2002

Return on Equity -0.215 0.268 -0.152

Tax Burden 1.00 1.00 1.00

Interest Burden 0.75 1.15 0.60

Operating Profit Margin 0.07 -0.06 0.07

Total Asset Turnover 1.59 1.97 2.76

Leverage Ratio -2.54 -1.92 -1.35

Analysis of Exhibit IM 6

Tax Burden Ratio

•

Equals 1- Tax Rate or NI/EBT

•

EBT is greater than or equal to NI

•

Reported as a percentage figure

less than or equal to 100%.

•

Zero taxes would give a

burden ratio of 100%.

•

The higher the tax rate, the lo

wer the tax burden ratio.

•

The lower the tax burden ratio, the lower the ROE.

•

If the tax burden ratio

is 100% there are no taxes

and NI = EBT and taxes

have no effect on ROE.

•

A very high tax rate has the gr

eatest reduction impact on ROE.

Since James Jewelers has not had to pay taxes

for the last several years because of prior

operating and current operating losses, the ta

x burden ratio, which is 100%, has had no

impact on the overall return on equity.

Interest Burden Ratio

•

Equals (EBIT - Interest

Expense)/EBIT = EBT/EBIT

•

EBIT is greater than or equal to EBT

•

Reported as a percentage figure

less than or equal to 100%

23

•

Zero interest would give

a burden ratio of 100%.

•

The higher the interest, the lower

the interest burden ratio.

•

The lower the interest burden ratio, the lower the ROE.

•

If the interest burden ratio is 100% th

ere is no interest expense and EBT =

EBIT and there is no effect on ROE.

•

A very high interest expense has th

e greatest reduction impact on ROE

The interest burden for 2001 is not a meaningful

figure since both the earnings before tax

and the earnings before interest and taxes

are negative. In 2000 and 2002 this ratio is

75% and 60% respectively. The greatest

impact on reducing ROE occurs in 2002 with

the lower interest burden ratio. Also, the tr

end is in the less favorable direction; which

could be an indication that th

e amount of debt is starting

to have a greater detrimental

impact on the return on equity for James Jewelers.

Operating Profit Margin Ratio

•

Equals EBIT/Sales.

•

EBIT could also be classifi

ed as Operating Income

•

Differs from the typical profit margin ra

tio of NI/Sales to account for the tax

burden and interest burden.

•

Profit Margin Ratio = Tax Burden x

Interest Burden x Operating Profit

Margin

•

Reported as a percentage

figure less than 100%.

•

Generally a low percentage amount as

EBIT is a relatively small component

of sales.

•

The higher the operating expenses relative

to sales, the lower the EBIT and

the lower the operating

profit margin ratio.

•

The lower the operating profit margin ra

tio, the greater th

e reduction to ROE

The first question should be is 2001 with

a negative operating prof

it margin of around -

6.0% the norm or are the years 2000 and 2002

with a positive operati

ng profit margin of

around 7.0 percent more the norm. In either

situation the ratio is

low and is probably

leading to lower levels of retu

rn on equity. If 2001 is more the norm, than the financial

situation is much more serious.

Total Asset Turnover Ratio

•

Equals Sales/Average Total Assets

•

Better to use average total assets vers

us ending assets since balance sheet

numbers (assets) are being compared to

an income statement number (sales)

•

Reported as a times figure from 0 to any positive number

•

Generally the ratio has a value of 1 to 2 times

•

The higher the ratio value, the more efficient the utilization of assets in

generating sales.

•

The higher the average total assets rela

tive to sales, the lower the turnover

ratio and the greater the reduction in ROE

The total asset turnover ratios ar

e quite high as James Jewelers are efficiently using their

assets. The company requires a relatively lo

w amount of long-term assets, and there is

essentially no accounts receivable

or cash balances. In recent

years, inventory levels, the

most significant asset category, have been d

ecreased by almost 50 percent. Since sales

levels have remained relatively constant, th

e improvement in the a

sset turnover ratio has

been due to maintaining a consistent sales vo

lume with fewer resources. The issue of

concern could be the reduction in inventor

y. If inventory levels continue to drop,

customers may see empty shelves with less qu

antity and quality and sales levels could

drop. There is probably a critical mass of i

nventory that needs to be maintained to

positively impact the customer perception of the jewelry store operations. While the high

asset turnover numbers indicat

e a large positive impact on the

return on equity, in reality,

there could be a more l

ong-term negative result.

Leverage Ratio

•

Average Total Assets/Average Total Equity

•

Equals (Average Total Equity + Average Total Debt)/Average Total Equity

•

= 1 + Debt/Equity Ratio

•

Better to use average assets and average e

quity to be consistent with the other

ratios and because some of the ratios in the ROE decomposition involve

income statement numbers

•

Reported as a times figure from 1.0 and higher

•

If a company has zero debt than aver

age total assets equal average total

equity, the leverage ratio equals 1.0 a

nd there is no leverage impact on ROE.

•

The higher the leverage ratio value, the gr

eater the use of fina

ncial leverage in

increasing ROE

•

Increased financial leverage also brings

about increased risk

of debt funding

•

Higher levels of financial leverage w

ill also bring about higher levels of

interest burden which will somewhat offset the overall impact on ROE

The leverage ratio is negative due to the nega

tive equity position for James Jewelers over

the three year time period. Since the ratio

is negative the figures are not especially

meaningful, other than the fact

that the relative debt levels were much higher in 2002

when the ratio was -2.54 than in 2002 when th

e ratio was just -1.35. The very fact that

the ratio is negative means that there is more debt in the company than assets. Lenders,

suppliers and various creditors

have evidently been willi

ng to support the operation even

beyond its financially reported valu

e. With this favorable fi

nancial leverage, Bob has the

potential to gain a significant multiplicative

impact on return on equity if the company

can become profitable.

Overall Conclusions. The return on equity

figure for 2001 is not meaningful since both

the net income and total equity numbers

are negative. The 2000 and 2002 return on

equity figures are also not very useful because the amounts are negative. The

decomposition of ROE into the five ratios does

not clarify the situation much better other

than recognizing the precarious debt and a

sset situation, but the potential for great

improvement if Bob can start earnin

g a profit on a consistent basis.

2.

Identify critical non-quantita

tive issues that should be

considered in the decision

process.

There are many non-quantitative (non

-financial) issues that need

to be considered in the

decision-making process. Some of these issu

es support starting over for a third time, and

some argue for discontinuing the operation.

Non-quantitative issues that support contin

uing the operation include the following:

•

Almost 20 years in the busine

ss including 16 years as owner

•

Strong values, integrity, and trust, which

are important in a bu

siness line such as

jewelry

•

Past history of periods of good growth

•

Total family commitment to the business

•

Entrepreneurial mindset

•

Extremely loyal customers

•

Strong customer service

•

Bonnie’s knack for buying the right products

•

Bonnie’s talent designing

and marketing jewelry

•

There does not appear to be an alternative plan

Non-quantitative issues that support disconti

nuing the operation include the following:

•

Will have to move from

their current location

•

Sales often dependent on discretionary income

•

Strong competition

•

No financial reserves to

absorb downturns in sales

•

Sales have been stagnate over the last three years

•

Running your own business is stressful

•

Poor credit rating

•

Seems to be working for his landlord

•

Will have to renegotiate new lease

terms from a position of weakness

•

Does not appear to ha

ve other skill sets

•

There does not appear to be an alternative plan

3.

What risk factors should Bob be most

concerned about regarding his decision?

Entrepreneurs constantly deal with risk. Pa

rt of their make-up is having a higher than

normal tolerance for risk. Entrepreneurs are

often willing to trade the risk and potential

of bankruptcy for the reward of being your

own boss and the possibility of significantly

above normal returns.

There are several significant ri

sks that Bob is dealing with

in his decision regarding

continuing to operate James Jewelers.

•

People often make jewelry purchases with

discretionary income; this soft money

is the first to go in times of need or economic downturn.

•

The community’s culture can pose a risk. If

you are not from an area, and there is

history and a sense of family first,

an “outsider” or someone new may be

perceived as a threat to

established operations.

•

The entrepreneurial mindset

that believes one can make

every situation into a

successful despite the odds and evidence.

•

Escalation of commitment

•

A “David versus Goliath” setting with th

e small retail “mom and pop” type of

operation going up against a superstore like Wal-Mart.

•

Location, location, location.

•

The need to raise funds primarily through debt.

4.

Identify possible ethical or at least valu

es-based issues that could impact any

decision.

Bob and Bonnie maintain a strong sense of valu

es and have moral beliefs that influence

their decision-making. Some of th

eir concerns include the following:

•

Making good on their debt obligations

•

Sticking with suppliers who have st

uck with them through difficult times

•

Providing support and service to loyal customers

•

Providing employment for their employees

•

They are a source of expertise in the jewelry business

•

As parents they want to be a good exam

ple for their childre

n and other family

members

5.

What should Bob and Bonnie do?

Financial evidence certainly poi

nts to discontinuing operations.

Even if Bob and Bonnie

wanted to start over a third tim

e, they may not get the fina

ncial backing and support they

need to cover necessary start-up costs.

The problem with closing the business is ther

e appears to be no alte

rnative strategy. Bob

and Bonnie’s expertise is all a

ssociated with running a retail

jewelry operation. If they

are serious about turning around

their financial situation, co

ntinuing the business may be

the only viable option. Either they could b

ecome extremely successful or collapse.

Given the education, skills, and talents both

Bob and Bonnie possess, there may be more

attractive options than they

are aware of. They both have become known in their

community and recognized for their honesty and in

tegrity. If either is willing to work for

27

someone else, they could easily begin again in

either the retail industry or for a more

financially secure company with the possibili

ty for promotion. The stress of running a

store would be eliminated; that peace of mi

nd alone might be worth making a change.

Regarding their obligation to other employ

ees, customers, and suppliers, most would

probably be understanding and work with

them through a transition. The biggest

obligation would be the debt repayment. A

pparently many suppliers have already been

willing to develop repayment programs. These plans could be maintained and/or

modified as long as Bob continued to

make the effort to repay his debt.

Sometimes it is just as important

to know when to fold as it is to continue to bet more

chips on a losing hand. The weakness of the fina

ncials strongly indicat

es that it would be

best to terminate operations. There does not

appear to be enough ar

guments in terms of

favorable non-quantitative informa

tion to change that decision.

Epilogue

Bob and Bonnie decided to begi

n again at a new location. Th

ey were able to secure

leased space just three blocks from their ex

isting location. While the new facilities were

only 1,250 square feet, less than ha

lf the size of their current

location, that turned out to

be a blessing as overhead was cut significantl

y. They sold enough of their inventory to

pay for a move and get reestablished. They

moved during July and August, traditionally

the slowest time of the year for sales, so th

ey probably did not lose much business in the

transition.

The goodwill and customer serv

ice that was built up during th

e seven years of operation

in Spartanburg paid off. Customers remain

ed loyal and supported

Exhibit IM 1 James Jewelers

Cash Flow Statement

For the Years Ending June 30, 2000, 2001, and 2002

2000 2001 2002 Cash Flow from Operating Activities Net Income Before Tax 22,446 -29,707 17,701 Depreciation 19,047 16672 16738 Interest Expense* 7670 3812 11696 Cash Flow from Income Statement Acct 49,163 -9,223 46,135 Change in Current Accounts Accounts Receivable 1786 1100 632 Inventor -1787 76782 12104 Accounts Payable -11743 0 1328 Cash Flow form Changes in Current Acct -11744 77882 14064 Cash Flow from Operating Activities 37,419 68,659 60,199 Cash Flow from Operating Activities Change in Equipment -11293 1458 -3610 Change in Other Assets 0 -1458 0 Cash Flow from Investing Activities -11293 0 -3610 Cash Flow from Financing Activities Interest Expense* -7670 -3812 -11696 Change in Loans from Shareholders -2271 -1000 27977 Change in Notes Payable -4531 -68410 -62752 Change in Common Stock 0 0 0 Divide 0 0 0 Prior Period Adjustments -6417 0 1669 Cash Flow from Financing Activities -20889 -73222 -44802 Net Cash Flow 5,237 -4,563 11,787 Beginning Cash Balance -4824 413 -4150 Ending Cash Balance 413 -4,150

7,637

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