Quality of Earnings Case:Avery Corporation Accounting 301 – Winter 2004 Heather Bowers, Bruce Phillips, Sarah Renfro, Mert Topcu
Key Points from Management Letter • Total revenue increased almost 8% • Profits increased 30% • Management chose to write off $5 million in obsolescent inventory • Avery has grown without relying on debt financing • Avery is extremely solvent with great earning power potential
1. Why did 2002 earnings-per-share decrease when net income seems to have increased? • EPS for 2002 reflects a loss of $1.30 due to the $5 million write-down for inventory obsolescence. • Additionally, EPS decreased due to outstanding share dilution (outstanding shares increased by 2,350,000 in 2002)see table on next slide
2. How many shares of stock were issued in the 2002 stock dividend and how did this affect the assets & liabilities? • 350,000 shares of stock at $15 per share • The issuance of stock did not affect the assets and liabilities because only accounts within the stockholder’s equity section are adjusted.(Pratt, pg. 535)
3. Is it likely the company will exercise its option to call outstanding bonds in the near future? Why? • No, at the current market rates, present value of the future cash payments is less than the call back value. ($4.99M < $5.1M respectively) • Additionally, the company does not have necessary cash flow to pay back the bonds.
4.The debt/equity ratio is .65 (on 12/31/02). Is that ratio an accurate measure of the company’s actual debt position? • No, the issuance of preferred stock (1M at $50/share) has created hidden debt not reflected in liabilities; however it has increased stockholder’s equity. • This makes company more attractive to creditors because issuing preferred stock as a method of financing maintains the debt/equity ratio. (Pratt, pg. 524)
5. a. Is the 2002 sales number a measure of cash collected from customers in 2002?b. If not, how much cash was actually collected from customers? • No, all company sales are made on credit. Also, the company recognizes revenue when goods are shipped. $104,550* cash collected from customers*cash in $1000s
5. c. How much cash was paid to suppliers for inventory purchases? • $45,000 (beginning inventory from 2001)+ ? (purchases) - $5,000 (inventory write off) - $55,000 (ending inventory from 2002) $60,500 (COGS from 2002) $75,500 cash or accounts payable to suppliers • Assuming all accounts payable were to inventory suppliers since accounts payable increased by $7,800 actual cash paid to suppliers is $67,700*amounts in $1000s
6. Inventory and accounts receivable have increased dramatically over the past 2 years. Is that a positive sign? • No, while inventory and accounts receivable have increased, revenue from sales has actually decreased • Inventory Turnaround = COGS/Avg. Inventory = 1.21 (2002), 1.6 (2001) • Avery did not move inventory as quickly in 2002 • Accts. Rec. Turnaround = Sales/Accts. Rec. = 2.59 (2002), 3.48 (2001) • The company is having problems collecting receivables
7. Are the elements that make up the increase in profits from 2001 to 2002 likely to persist in future years? • No, operating revenues for 2002 included a one time gain from sale of equipment and special services revenue • Without these entries, operating revenue would have decreased • Sales as % of Revenue =.88 (2002), .98 (2001)
8. What was the value of Buckeye’s PP&E when acquired by Avery in 2002? • Avery had $50M in PP&E In 2002 it acquired Buckeye’s PP&E In 2002 it sold 20M of equipment and bought $14M • 2002 PP&E = $94M • Buckeye’s PP&E = $94-$50+$20-$14 = $50 M • Acquisition of Buckeye was $50 million cash and 1 million shares of common stock valued at $15/share. This is consistent with $50M PP&E + $15M Goodwill
9. What was the book value of the equipment sold in 12/02? • $10 million • Equipment was part of original $50M, depreciating at $5M per year • In 2002, the $50M was depreciated to $25M. Avery sold 2/5 of the original equipment, so the book value is 2/5 of $25M = $10M
10. How much cash did Avery contribute to its pension fund in 2001? • $5 million • Decrease of $8M in accrued pension expense • Increase of $3M in pension on cash flow • Actual amount spent was $5M
Conclusions concerning Management Letter • The $5 million inventory write-off will significantly inflate earnings next period • Avery’s issue of preferred stock contradicts claim that they are not relying on debt financing. • Avery claims company is extremely solvent but we see a large decline in liquidity Current Ratio = 3.79 (2002), 6.22 (2001) Quick Ratio = 1.96 (2002), 4.20 (2001) • Management letter is not telling the whole story. Definite lack of transparency!