Working Capital Management
Prof. Johnson
Case Project
Josh Hunt, Travis Krimbill, Matthew Hester, Zhang Zheming
Credit Analysis Case for Y. Guess Jeans
Y. Guess Jeans is presently one of the County Seat’s largest suppliers of jeans and casual
tops. The first County Seat store opened in Minneapolis in 1973. Beginning as an offspring of
the grocery store chain Super Value Stores, County Seat was intended as a budget-priced chain
of stores offering casual clothes for the entire family. County Seat is one of the nation's largest
mall-based specialty retailers of casual wear for teens and young adults. With more than 630
jean stores in 46 states, it is the seventh largest "single concept" retailer. Jeans and jean jackets
account for more than 50 percent of the company's sales in 1993, with shirts, shorts, t-shirts,
socks, belts, fashion jewelry, and other accessories accounting for the rest.
As we see the background and history of Count Seat INC and American economics in the
1990s, the company was in the period of booming. However, the huge volume of business
required more cash flow and a request for an increased credit limit. In this case, we will
analyze the data of County Seat INC and come up with a recommendation for Y. Guess Jeans
whether or not the 20% credit limit increase should be approved for County Seat INC. The
analysis will begin with the organization of County Seat, credit agreement; company’s
operating results, and liquidity and capital resources including financing and operating
activities.
The County Seat is already borrowing money from a syndicate of commercial banks in
what is termed the Credit Agreement. Under this preexisting Credit Agreement, County Seat
must meet certain financial benchmarks established by the banks. If County Seat does not
meet these benchmarks, the banks may elect to prevent the County Seat from making their
semi-annual interest payments on their 12 percent Senior Subordinated Notes. If County Seat
fails to make the semi-annual interest payment, the company will be considered to have
defaulted and the company may be liquidated.
The Credit Agreement requires County Seat to maintain the following ratios or measures
of business activity or else the company faces the threat of liquidation. County Seat must
maintain a Current Ratio of 1.10:1.0, or have $1.10 in current assets for each $1.00 in current
liabilities. While County Seat was meeting that requirement at this same time last year, their
current ratio has dropped considerably in the past year. The company must maintain a
minimum Interest Coverage Ratio, a measure of how well a company can meet its current
debt payments, of 0.90:1.0. The company is also required to maintain a Fixed Charge
Coverage Ratio of 1.15:1.0. This measure indicates how prepared a company is to meet its
financing obligations. Since the company has been losing money by staying open, both these
ratios are negative. The next covenant is a minimum company Adjusted Net Worth of $30
million (including its redeemable preferred stocks). In 1995, the company’s value was
estimated at just over $39 million but due to the heavy losses it experienced during the year,
losses which were absorbed by Shareholder Equity, the company is now values at nearly -$69
million. Finally, the company must maintain an EBITDA, or gross profit with interest, taxes,
depreciation, and amortization payments added back, of $24.8 million. The company reported
an EBITDA of $2.14 million in 1995 but, again due to the heavy losses, the company is
reporting negative returns of -$7.47 million. The covenant requirements and evaluations of
the company at August 3, 1996 and July 29, 1995 are summarized in Figure 1 and a more
detailed look at how these ratios are calculated can be found in the Calculations section at the
end of the report.
To determine whether or not to increase our credit line to County Seat we need to look at
several ratios and measurements to see how they are performing and which direction they are
heading. Most importantly since we are lending them credit the liquidity ratios are vital in
figuring out if County Seat would be able to make their payments to Y. Guess Jeans.
Looking at figure 2 we can see that the current ratio has dropped significantly in the course of
a year. From 1.361 to 1.036 which is a poor sign that they will continue to be able to cover
their payables. Net working capital in another measure of liquidity and that has dropped
severally from $47,102 to $5,536. Again this is another sign that they will struggle to cover
their payables at this rate. To further show the poor situation that has occurred with County
Seat the Quick ratio on figure 2 has fallen from .262 to .170. The quick ratio has dropped
almost a whole .1 in a year, a bad sign for people that lend and extend credit to County Seat.
The Net liquid balance was a negative $(35,575) the year before On June 29th 1995 and has
gone further negative to $ (71,197) as of August 3rd 1996. This shows that the financial
flexibility of County Seat is non-existent. The last “Time to Ruin” measurement of liquidity
on figure 2 is the number of days that the company would be able to pay its bills if it has
some sort of break in revenue stream. The number of days went up from roughly 7 days to 10
days. An average “safe” length of time is roughly 30-90 days for that ratio.
After looking at the liquidity ratios and measurements, the debt management and
coverage analysis is the next step in the decision making process. The Interest coverage ratio
has decreased from an already negative -.399 to -1.206 as shown in figure 2. Higher is better
in this ratio, showing how many times interest could be paid from funds available. The fact
that this number is negative is very worrisome to creditors. The long-term debt to capital ratio
was dramatically decreased from 1.633 to -2.081 and that was mainly influenced from a big
drop in shareholder equity. The final DM&C measurement is the Total Liabilities to Total
Assets which is self explanatory. The lower the better, the more liabilities you have the
riskier a borrower you become. In this case the ratio has increase from 1.179 to 1.830
showing a drastic increase in debt.
The last measurements that are important to look at are the Performance ratios. They
show the growth or lack there of over time. The Return on Equity is the most important of
these because it is the number the stockholders are most interested in, it shows the companies
ability to generate shareholder wealth. In June of 1995 the ROE was .408 and roughly a year
later dropped to .151. This proves that County Seat is a much less lucrative investment from a
shareholder point of view which will lower the price of the stock. The Profit Margin on Sales
fell further from -.114 to -.136 which shows that they are earning even less profit per $1 of
sales. Finally the Return on Total Assets is similar to profit margin on sales but shows ability
to make profit on every $1 of assets. This has also decreased further from -.088 to -.151 as
seen in figure 2.
Figure 3 can be used to consider how a 20% credit extension would affect the County
Seat’s Income Statement. Certain assumptions were made for this Figure. First, there is no
mention of County Seat’s bad debt ratio or collection expense, so Figure 3 assumes that these
values are 0.0% since it will only hurt the company’s Income Statement. County Seat was also
assumed to have a tax rate of 40.0% since the company is dealing in values of millions of
dollars. The rest of the values were either collected from the County Seat’s financial statements
or ratios.
The first section considers the state of the company in 1995 and without the credit
extension and only the goods received from Y Guess Jeans. The $2.5 million in credit sales is
the company’s variable costs as it is the cost of goods sold. Since the variable cost ratio is given
at 74.7%, this suggests that the sale of these goods will generate nearly $3.45 million in sales
($2.5 million / 0.0747 = approx. $3.45 million), which suggests a profit of nearly $0.85 million.
With an SG&A ratio of 24.4% and tax rate of 40.0%, County Seat would generate an estimated
earnings after taxes of just over $18,000. This suggests a return of 0.72% on their initial $2.5
million dollar investment.
The second section considers the state of County Seat in 1996 with the 20% credit
extension. A 20% increase of $2.5 million indicates County Seat will purchase $3.0 million
worth of goods from Y Guess Jeans. A variable cost ratio of 76.4% suggests Count Seat will
generate just under $3.93 million in sales which results in a gross profit of nearly $0.93 million.
Despite the increase in profit, the company’s SG&A ratio has increased to 26.7% which gives
fixed costs of over $1.0 million. This suggests Count Seat would lose approximate $0.12
million, or a -4.0% return on the initial $3.0 million dollar investment.
These numbers suggest that Y Guess Jeans should not extend the 20% increase in
credit to County Seat because it does not appear that County Seat will be able to generate
enough in sales to cover all of the obligations. This appears to be due mostly to high and
growing costs, both fixed and variable. Figure 4 shows the same evaluation as Figure 3, the
only difference being that Figure 4 shows the situation in which no additional credit is
extended. This means County Seat will again have a variable cost of $2.5 million. Figure 4
confirms that rising costs are what is really hurting the company because while the company
made a slim profit on the $2.5 million investment in 1995, the company is now losing money
on the investment.
All of these evaluations suggest that County Seat is a failing company. With regards to
the financial covenants of the Credit Agreement, County Seat is moving further away from
fulfilling these obligations as they were at the same time last year, as shown in Figure 1. An
inability to fulfill these covenants may result in the company being liquidated. Considering
key financial ratio for credit analysis of a company, County Seats ratios for the current year are
deteriorating when compared to the ratios from last year, as seen in Figure 2. Figures 3 and 4
evaluate the County Seat’s single account with regards to their purchase from Y Guess Jeans.
Figure 3 considers the situation where the 20% credit extension is approved while Figure 4
considers the situation where the extension is denied and Y Guess Jean continues to sell $2.5
million. In both situations, County Seat is expected to lose money on their jean purchase due
to their high costs.
Given all the data and analysis, our firm recommends that Y Guess Jeans definitely
not extend the 20% credit extension. We feel that County Seat is a quickly dying company
which is under the real threat of liquidation. Y Guess Jeans does not want to find itself in the
situation where County Seat is liquidated without the funds to pay for their jeans purchases.
We recommend that Y Guess Jeans reevaluates its relationship with County Seat and would
even suggest that you consider decreasing the amount of goods you sell to Y. Guess Jeans in an
attempt to hedge against loss should the company fail.
Figure 1
Most Restrictive Financial Covenants
As of August 3, 1996
(Amounts in Thousands)
August 3, 1996
July 29, 1995
Minimum Requirement
1.036
1.361
1.10 to 1.0
-1.206
-0.399
0.90 to 1.0
-0.749
-0.130
1.15 to 1.0
Current Ratio
Interest Coverage
Ratio
Fixed Charge
Coverage Ratio
Adjusted Net Worth
EBITDA
$
$
(68,847.00)
$
39,005.00
(7,471.00) $
2,144.00
$30,000 (including
redeemable preferred stock)
$24,800
Figure 2
Key Financial Ratios and Measurements for Credit Analysis
As of August 3, 1996 and July 29, 1995
(Amounts in Thousands)
Liquidity Ratios
Current ratio =
Net working capital = $
Quick ratio =
Net liquid balance = $
"Time to Ruin" =
August 3, 1996
1.036
July 29, 1995
1.361
5,536.00 $
0.170
47,102.00
0.262
(71,197.00)
10.441
(35,575.00)
7.861
$
Debt Management & Coverage
Interest Coverage Ratio =
Long-term debt to capital =
Total Liabilities to Total Assets =
-1.206
-2.081
1.830
-0.399
1.633
1.179
Performance Ratios
Return on Equity =
Profit Margin on Sales =
Return on Total Assets =
0.151
-0.136
-0.151
0.408
-0.114
-0.088
Figure 3
Evaluation of the County Seat
With the 20% Credit Extension
BEFORE CREDIT EXTENSION - July 29, 1995
Income Statement
Credit Sales $
3,346,720.21
Variable Cost $
2,500,000.00
Gross Profit $
846,720.21
Fixed Cost $
816,599.73
Bad Debt Expense $
EBIT $
Taxes $
EBIT (1-t) $
30,120.48
12,048.19
18,072.29
AFTER CREDIT EXTENSION - August 3, 1996
Income Statement
Credit Sales $
3,926,701.57
Variable Cost $
3,000,000.00
Gross Profit $
926,701.57
Fixed Cost $
1,048,429.32
Bad Debt Expense $
EBIT $
Taxes $
EBIT (1-t) $
Incremental EBIT =
Incremental NPATBI =
$
$
(121,727.75)
(48,691.10)
(73,036.65)
(151,848.23)
(91,108.94)
Figure 4
Evaluation of the County Seat
Without the 20% Credit Extension
BEFORE EXTENSION DECISION - July 29, 1995
Income Statement
Credit Sales $
3,346,720.21
Variable Cost $
2,500,000.00
Gross Profit $
846,720.21
Fixed Cost $
816,599.73
Bad Debt Expense $
EBIT $
Taxes $
EBIT (1-t) $
30,120.48
12,048.19
18,072.29
WITHOUT CREDIT EXTENSION - August 3, 1996
Income Statement
Credit Sales $
3,272,251.31
Variable Cost $
2,500,000.00
Gross Profit $
772,251.31
Fixed Cost $
873,691.10
Bad Debt Expense $
EBIT $
Taxes $
EBIT (1-t) $
Incremental EBIT =
Incremental NPATBI =
$
$
(101,439.79)
(40,575.92)
(60,863.87)
(131,560.27)
(78,936.16)
Calculations – Formulas and Ratios
Liquidity Ratios–
Current Ratio = Current Assets / Current Liabilities
Net Working Capital = Current Assets – Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Cash Flow to Total Debt = (Net Income + Depreciation)/ (Short-term debt +Long-term debt)
Net Liquid Balance = (Cash + Short-term investments) – (Notes Payable + Long-term debt)
“Time to Ruin” = (Cash + Short-term investments) / (Daily operating expenses)
Debt Management and Coverage-
Times Interest Earned or “Interest coverage ratio” = EBIT/ interest expense
Long-term Debt to Capital = Long-term debt/(long-term debt + equity)
Total Liabilities to Total Assets = Total Liabilities / Total Assets
Performance Ratios-
Return on Equity = Earnings available to shareholders / Common equity
Profit Margin on Sales = Net Income / Revenues
Return on Total Assets = Net Income / Total Assets
Financial Covenants –
Current Ratio – above
Interest Coverage Ratio – above
EBITDA = EBIT + Depreciation and Amortization
Fixed Charge Coverage Ratio = (EBIT + SG&A) / (SG&A + Interest expense)
Adjusted Net Worth = Total Shareholders’ Equity + Redeemable Preferred stock CSI + Minority
Interest of Stores
References
"Earnings Before Interest, Taxes, Depreciation and Amortization - EBITDA." Earnings Before
Interest, Taxes, Depreciation and Amortization (EBITDA) Definition. Web. 11 Nov. 2012.
<http://www.investopedia.com/terms/e/ebitda.asp>.
"Fixed-Charge Coverage Ratio." Definition. Web. 11 Nov. 2012.
<http://www.investopedia.com/terms/f/fixed-chargecoverageratio.asp>.
"Interest Coverage Ratio." Definition. Web. 11 Nov. 2012.
<http://www.investopedia.com/terms/i/interestcoverageratio.asp>.
Johnson, Larry. "Solvency, Liquidity, Growth." Lecture.
Maness, Terry S., and John T. Zietlow. Short-term Financial Management. Mason, OH:
South-Western/Thomson Learning, 2005. Print.