A Case Study onO.M.

Scott and Sons Company

CASE CONTEXT The company is facing a good economy as evidenced by the increase in sales. Industry is investing in research and development of products. Competitors are slowly entering the market. O.M. Scott and Sons Company is a business in the lawn care and garden product industry. Currently, the company is reviewing the results of 1961 and preparing plans for the 1962 selling season. Sales were increasing and so is net income except for the year 1960 to 1961. Presently, the company is using a combination of traditional seasonal dating plan and trust receipt plan to encourage and enable as many dealers as possible to be well stocked in advance of seasonal sales peaks. Also, this combination was used to retain security interest in merchandise shipped.

PROBLEM DEFINITION With the current internal complications, what must O.M. Scott and Sons Company do to be able to decrease cost of sales and operating expenses? How will the company keep up with its goal of a 25% annual growth rate in sales and profit considering the current policies? How should the company finance its current policy of combination of seasonal dating and trust receipt plan?

FRAMEWORK FOR ANALYSIS

To assess the current financial position of O.M Scott & Sons Company, key ratios are computed and a Dupont analysis is prepared.

A proforma income statement is prepared to project the companys target sales that will conform to the companys 25% annual growth rate goal.

A further analysis of the financial statements and the notes is made to evaluate the companys condition and the needed financing for the current policies of seasonal dating and trust receipt plan.

ANALYSIS Financial Ratio Analysis Liquidity

The overall liquidity of the company seems to exhibit an inconsistent trend. The companys liquidity seems to be okay since the recent ratios are not too large from that of the past. Also, the company is a business with relatively predictable cash flow so its current ratio is quite acceptable. With regards to its quick ratio, its inventory is typically sold on credit which means that it becomes an account receivable before being converted into cash so the quick ratio of the company is relatively high.

Activity The companys inventory appears to be in poor shape. Its inventory management seems to have not improved because from 1960 to 1961, its inventory turnover deteriorated. The company may be experiencing some problems with accounts receivable. The average collection period crept up over the past few years. O.M. Scott and Sons Company appear to be slow in paying its bills; it pays nearly 32 days slower compared to that of 1960. Although overall liquidity appears to be okay, the management of receivables and payables should be examined. Total asset turnover reflects a decline in the efficiency of total asset utilization. This means that the companys operation have been financially inefficient.

Debt Indebtedness increased over the 1958-1961 period and this increase in the debt ratio could be cause for alarm. The companys ability to meet interest payment obligations deteriorated from 19581961. The companys indebtedness in these periods apparently caused the deterioration in its ability to pay debt adequately. In summary, it appears that periods 1958-1961 were off years showing that the companys inability to pay debts does not compensate its increased degree of indebtedness.

Profitability O.M. Scott and Sons Companys profitability relative to sales was increasing. Although the gross profit margin was better in recent years than those in the past, higher levels of operating and interest expenses appear to have caused the recent years net profit margin to fall below that of the past. The companys earnings per share deteriorated in 1961 which probably is because of the decrease in net profits. The value of the ROA indicates a poorly managed or ineffective management in generating profits with its available assets. The company appears to have a rapid expansion in its assets during 1958 to 1961 which caused the drop or deterioration in ROA. The low 1961 level of ROE suggests that the company is performing poorly. The return earned on the common stockholders investment in the firm was not better for the owners.

DuPont System of Analysis Doing the DuPont System of Analysis in Exhibit 2, we can trace the possible problem back to its cause: O.M. Scott and Sons Companys ROE is primarily the consequence of slow collections of accounts receivable and poorly managed inventory which resulted in high levels of receivables and inventories and therefore high levels of total assets. The high total assets slowed the companys total asset turnover, driving down its ROA, which then drove down its ROE. By using the DuPont system of analysis to dissect the companys overall returns as measured by its ROE, we found that slow collections of receivable and poor management of inventories caused ROE to drive down. Clearly, the firm needs to better manage its credit and inventory operations. Also, the company is financed primarily through the use of debt as shown by the high value indicated by the leverage ratio.

In Exhibit 3, the projected sales for 1962 are based on O.M Scott & Sons Companys goal of up to 25% annual growth rate of sales and profits. Through the years, the company has increased its sales but during the year 1961, profits decreased by 12% even if sales increased at the same rate. It can be observed that even though there is an increase in annual sales and profits, the profit remains to be only 2-5% of sales. This shows that the companys costs and expenses are very large resulting to a small profit. To increase profit, the company could probably cut cost. The projected sales for the next years should be the companys target to keep up with their goal.

Financing Plan Both the seasonal dating plan and trust receipt plan implemented by the company produces high outstanding receivables to finance their dealers in maintaining appropriate levels if inventory. In addition, an increase in expenses and cost of sales is expected in order to sustain the 25% growth in profit and sales and this will also require the company to finance it. The following year of 1962 requires an additional financing of $ 9,976,080 dollars as projected in the proforma income statement. The company is currently financing its long-term debt by subordinated promissory notes which have restrictions attached to it. According to the Financial Statement Analysis, the company is now having a hard time paying its interests. In addition, the company just exchanged the outstanding notes with new ones with same terms to extend the due date of principal payment. They can no longer use this option because of the restriction that limits the allowed subordinated debt by the company.

DECISION AND OPERATIONALIZATION To effectively manage its inventories, the firm must increase its sales of at least $53,925,130 For the year 1962, the company should cut cost of about $657,775 to increase the ratio of profit to sales. Our group suggests that in order to finance the additional needs of the company is to exhaust the other options. Top priority is to ask for additional investment from stockholders for they are the ones who will benefit from the 25% increase in sales and profit. Secondly, the company can offer shares publicly to take advantage of their very competitive market price of shares. These internal financing saves the company from additional interest payments made to creditors. It was also mentioned that the company is able to stretch accounts payable and it will still be useful to ease payments. The remaining financing, if ever still needed, can be obtained from the revolving credit line from the commercial banks but his entails interest payment.

JUSTIFICATION According to the analysis, both the seasonal dating plan and trust receipt plan implemented by the company produces high outstanding receivables to finance their dealers in maintaining appropriate levels if inventory. In addition, an increase in expenses and cost of sales is expected in order to sustain the 25% growth in profit and sales and this will also require the company to finance it.

Based on industry norms, the short-run level of inventories varies inversely with sales. As shown in Exhibit 4, during the year 1959, the companys profit is about 4.86% of net sales. For 5 years, this is the highest ratio of profit and sales. For 1962, projected sales are $5,392,513,000, and net profit after taxes is $1,963,170. The ratio of profit to sales is only 3.6%. To keep up with a good year where the ratio of profit to sales is 4.86%, the company should target a net profit after taxes of at least, $ 2,620,945.10 (a 66.86% increase in profit from the previous year). To do this, the company should cut cost of about $657,775($2,620,945.10-$1,963,170) for the year 1962.

APPENDICES

Exhibit 1 The O.M. Company Scott & Sons Company and Subsidiary Companies Summary of Financial Ratios Year RATIO Liquidity Current Ratio Quick Ratio Activity Inventory Turnover Average Collection Period Average Payment Period Total Asset Turnover Debt Debt Ratio Times Interest Earned Ratio Profitability Gross Profit Margin Operating Profit Margin Net Profit Margin Earnings Per Share (EPS) Return on Total Assets (ROA) Return on Common Equity (ROE) 1957 2.13 1.22 6.62 50.89 51.83 2.1 53.83% 5.48 17.00% 5.86% 2.42% 5.08% 19.27% 1958 2.48 1.58 5.60 72.10 58.04 2.04 50.52% 10.18 19.17% 9.25% 3.85% $0.69 7.84% 27.68% 1959 1.97 1.02 3.45 68.18 88.28 1.41 65.80% 8.69 10.33% 11.67% 4.86% $1.15 6.83% 29.45% 1960 4.30 3.53 7.77 147.67 47.19 1.28 62.75% 5.15 20.78% 11.83% 4.65% $1.21 5.97% 20.30% 1961 3.59 2.88 6.14 179.42 93.46 1.21 67.52% 3.86 20.42% 10.13% 3.64% $0.99 4.39% 16.79% Evaluation Time-series 1957 - 1961 OK OK POOR POOR POOR POOR GOOD POOR OK OK POOR OK POOR POOR

Exhibit 2 DuPont System of Analysis

= 3.64% x 1.21 x 3.82

= 16.8%

Exhibit 3 THE O.M SCOTT AND SONS AND SUBSIDIARY COMPANIES Pro-Forma Income Statements for the Year Ending September 30, 1962-1963 (Dollar amounts in thousands) 1962 Net sales Cost of sales and operating expenses General and administrative, research and development expenses Depreciation and amortization Interest Charges Total Cost of Sales Earnings before taxes on income Federal and state taxes on income Net income after taxes (42,914.69) (4,813.36) (737.16) (1,414.37) (49,879.58) $ 4,045.54 (2,082.37) $ 1,963.17 $53,925.13* (53,643.37) (6,016.70) (921.45) (1,767.97) (62,349.48) $ 5,056.93 (2,602.97) $ 2,453.96 1963 $67,406.41*

* The forecast sales are based on the companys goal of 25% increase in sales every year. The expenses are based on a percent of sales method.

Exhibit 4 1957 Net sales Net income after taxes % of profit over sales 2.42 3.85 4.86 4.65 3.64 18675.9 451.3 1958 23400.2 901.1 1959 30563.7 1485.5 1960 38396.4 1785 1961 43140.1 1570.7