Principals of Finance

Case Study #1 – HiTop Toys, Inc.
Financial Ratio Analysis

Charles Stevens, vice president for investment analysis at First National Bank of Florida, is looking for a company to recommend to the bank’s portfolio committee for inclusion in its “buy list” for the various trust funds managed by First National’s trust department. Steven’s criteria for recommending a company were that it be a good, fundamentally sound, long term prospect and not a hot stock. Since the stock market crash, portfolio returns had been rather weak. Stevens hoped to convince the portfolio committee to take a long term view of the market rather than focus on short term price changes.

Stevens had recently read an article in the Wall Street Journal concerning HiTop Toys, Inc., a toy manufacturer. HiTop had posted a six month pretax profit margin of 10 percent. While this was far below the 15% profit margins enjoyed before the market decline, it was far ahead of other companies in the industry. Perhaps HiTop was a good long term investment.

The toy industry depended on three main factors for growth: the economy, demographics, and new product innovations on a regular basis. The average life for new products in the toy industry was only one or two Christmas seasons. Companies had two choices to maintain their sales strengths. Either they came up with regular product innovations or they relied on strong standby toys.

HiTop had changed its marketing strategy during the past two years. Management was concentrating on its solid performing toys and moving away from the highly risky (yet potentially very profitable) promotional, faddish toys that had dominated the toy market over the most of the past decade. However, for the past two years, shipments of the blockbuster toys had steadily declined, leaving the manufacturers with obsolete inventory and machinery. Two of HiTop’s three primary competitors had put too much emphasis on blockbuster toys. One was in Chapter 11 bankruptcy and the other had been forced to borrow to stay afloat. Its debt was now 88% of its total capital.

In contrast HiTop and the other major competitor had bitten the bullet. They had trimmed overhead, written down inventories, and closed plants with excess capacity. HiTop was focusing on its traditional toy line of stable toys, board games, and preschool games.

Today HiTop has three new hot prospects for the future. First, the company recently announced the purchase of two operations that produced ride-on toys and outdoor furniture for children. These were expected to compliment HiTop’s solid array of preschool items. Second, HiTop had just signed the toy license on what was expected to be this summers hottest children’s movie. Third HiTop was rumored to be planning to enter the video game segment of the industry.

In preparation for the necessary analysis, Stevens had collected his financial statements and industry data for the past five years. Exhibit 1 contains company income statements for the five years xx01 through xx05. Exhibit 2 provides comparable balance sheets. Exhibit 3 contains industry average percentage income statements, balance sheets, and ratios as reported by Robert Morris and Associates.

Prepare a report/memo, with attached schedules that addresses the following questions:

1. Prepare a common size income statement and balance sheet for HiTop for each of the years.

2. Calculate five years of relevant financial ratios for HiTop (including profitability ratios, efficiency ratios, liquidity ratios, debt ratios, dividend ratios, and growth rates) and identify the relevant financial strengths, weaknesses, and trends of the company.

3. Compare the financial results of HiTop with the industry and identify and discuss the areas where HiTop is stronger or weaker than the industry.

4. Using the DuPont model analyze the return on equity for the past five years. Comment on the strengths and weaknesses uncovered by this analysis.

5. Given this analysis would you recommend HiTop be included in First National Bank’s “buy list”? Explain why?

Exhibit 1
HiTop Toys, Inc.
Income Statements
(thousands)
xx01 xx02 xx03 xx04 xx05

Revenue       221,522    714,392    1,220,352    1,329,631    1,345,089
Cost of Goods Sold   107,136    340,007    556,192    605,071    647,342
Gross Profit       114,386    374,385    664,160    724,560    697,747

Operating Expense
General, Administrative,
and Selling Expenses   71,871    206,652    382,271    437,221    443,713
Research & Development   8,794    21,924    40,345    57,701    69,472
Depreciation       5,100    14,100    19,467    34,009    52,077
Total Operating Expenses   85,765    242,676    442,083    528,931    565,262

Operating Profit       28,621    131,709    222,077    195,629    132,485
Other Income       3,343    6,048    10,499    25,828    171
Earnings Before Interest & Taxes   31,964    137,757    232,576    221,457    132,656
Interest Expense   2,400    27,546    37,661    29,619    33,021

Earnings Before Taxes   29,564    110,211    194,915    191,838    99,635
Income Taxes       14,334    57,823    95,946    92,679    51,412
Net Income       15,230    52,388    98,969    99,159    48,223

Preferred Dividends 0 0 2,769 2,559 2,817

Earnings Available to Common 15,230 52,388 96,200 96,600 45,406
Common Dividend 1,628 2,774 3,858 4,740 4,757

Retained Earnings 13,602 49,614 92,342 91,860 40,649

Outstanding Shares 32,550 46,230 48,220 52,663 52,850
Earnings Per Share $ 0.47 $ 1.13 $ 2.00 $ 1.83 $ 0.86

Average Price Per Share $ 3.85 $ 8.55 $ 15.55 $ 23.75 $ 18.25

Exhibit 2
HiTop Toys, Inc.
Balance Sheets
(thousands)

xx01 xx02 xx03 xx04 xx05
Assets

Current Assets
Cash       $    40,972    $    62,786    $   182,385    $   116,061    $   161,770
Accounts Receivable   48,726    200,797    241,786    305,489    339,556
Inventory       9,797    76,753    67,856    122,902    133,585
Other Current Assets   7,906    23,757    38,407    57,010    57,721
Total Current Assets   107,401    364,093    530,434    601,462    692,632

Gross Fixed Assets   28,240    107,755    146,553    231,508    297,900
Accum. Depreciation   13,850    18,136    37,233    70,038    121,647
Net Fixed Assets   14,390    89,619    109,320    161,470    176,253

Other Assets 9,468 211,810 205,879 218,928 207,107

Total Assets 131,259 665,522 845,633 981,860 1,075,992

Liabilities and Stockholders Equity

Current Liabilities
Accounts Payable   $    20,122    $    30,349    $     45,856    $     91,142    $     88,239
Accrued Expenses   18,995    105,742    142,685    107,950    115,089
Accrued Taxes   10,956    23,991    24,486    30,853    26,183
Short Term Debt   1,303    83,404    26,687    42,475    74,397
Total Current Liabilities   51,376    243,486    239,714    272,420    303,908

Long Term Liabilities
Long Term Debt   3,063    127,537    185,746    124,977    127,127
Other Liabilities   1,035    1,524    2,240    4,191    3,414
Total Long Term Liabilities   4,098    129,061    187,986    129,168    130,541

Stockholders Equity
Preferred Stock   2,051    35,728    3,517    3,517    3,517
Common Stock   36,443    170,342    235,169    305,648    326,269
Retained Earnings   37,291    86,905    179,247    271,107    311,757
Total Stockholders Equity   75,785    292,975    417,933    580,272    641,543

Total Liabilities and
Stockholders Equity 131,259 665,522 845,633 981,860 1,075,992
Exhibit 3

Industry Averages and Ratios
Toy Manufacturers
(Robert Morris & Associates, Annual Statement Studies)

xx01 xx02 xx03 xx04 xx05

Percentage Income Statements
Revenue       100.0%   100.0%   100.0%   100.0%   100.0%
Gross Profit       34.7%   35.0%   34.6%   35.1%   35.0%
Operating Expenses   29.8%   28.2%   29.9%   28.3%   29.6%
Operating Profit   4.8%   6.8%   4.7%   6.8%   5.4%
All Other Expenses   3.0%   2.7%   2.1%   3.1%   2.0%
Profit Before Taxes   1.8%   4.1%   2.7%   3.7%   3.4%

Percentage Balance Sheet
Cash       9.5%   8.3%   7.4%   8.9%   8.5%
Accounts Receivable   29.0%   30.4%   28.7%   31.0%   28.0%
Inventory       34.1%   31.2%   33.7%   29.7%   33.1%
Other Current Assets   2.3%   3.2%   1.9%   3.4%   2.6%
Total Current Assets   74.9%   73.4%   71.7%   73.0%   72.2%
Net Fixed Assets   19.0%   19.7%   20.5%   19.1%   18.4%
Other Assets   6.1%   7.4%   7.7%   7.8%   9.3%
Total Assets   100.0%   100.0%   100.0%   100.0%   100.0%

Notes Payable   14.3%   12.2%   18.6%   14.5%   15.1%
Current Maturity – Long Debt   2.8%   2.8%   2.8%   4.6%   4.0%
Accounts Payable   13.0%   13.5%   14.6%   13.0%   13.3%
Accrued Taxes   0.0%   0.0%   0.7%   1.6%   1.7%
Other Current Liabilities   10.2%   11.6%   11.2%   8.7%   8.2%
Total Current Liabilities   40.3%   40.1%   47.9%   42.4%   42.3%
Long Term Debt   14.7%   16.2%   13.9%   13.5%   13.4%
Other Long Term Debt   4.7%   3.5%   3.4%   2.8%   3.1%
Stockholders Equity   40.5%   40.4%   34.0%   41.3%   41.0%
Total Liabilities and Equity   100.0%   100.0%   100.0%   100.0%   100.0%

Ratios
Current       1.9   1.9   1.6   1.8   1.8
Quick       0.9   1.0   0.8   1.0   1.0
Sales/Receivables   6.9   6.1   6.5   5.7   5.9
Cost of Sales/Inventory   3.7   3.4   3.8   4.5   4.1
Sales/Working Capital   6.0   5.1   6.7   5.3   5.5
EBIT/Interest   1.8   2.2   2.0   1.9   3.6
Total Debt/Net Worth   160.0%   150.0%   190.0%   150.0%   170.0%
% EBT/Equity   14.8%   20.2%   18.5%   17.1%   28.9%
%EBT/Total Assets   6.5%   5.9%   4.9%   6.7%   7.8%
Sales/Total Assets                1.9                 1.6                 1.7                 1.7                 1.6

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