To download the complete and accurate content document, go to: https://testbankbell.com/download/solution-manual-for-case-studies-in-finance-manag ing-for-corporate-value-creation-bruner-eades-schill-7th-edition/
Synopsis and Objectives
This case considers the sudden and very large drop in the market value of equity for Krispy Kreme Doughnuts, Inc., associated with a series of announcements made in 2004. Those announcements caused investors to revise their expectations about the future growth of Krispy Kreme, which had been one of the most rapidly growing American corporations in the new millennium. The task for the student is to evaluate the implications of those announcements and to assess the financial health of the company. This case is intended to be introductory as it can provide a first exercise in financial statement analysis and lay the foundation for two important financial themes: the concept of financial health, and the financial-economic definition of value and its determinants.
Suggested complementary cases in financial statement analysis: “The Financial Detective, 2005,” (UVA-F-1486); “Deutsche Brauerei,” (UVA-F-1355); “The Battle for Value, 2004: FedEx Corp. vs. United Parcel Service, Inc.,” (UVA-F-1484)
1. What can the historical income statements (case Exhibit 1) and balance sheets (case Exhibit 2) tell you about the financial health and current condition of Krispy Kreme Doughnuts, Inc.?
2. How can financial ratios extend your understanding of financial statements? What questions do the time series of ratios in case Exhibit 7 raise? What questions do the ratios on peer firms in case Exhibits 8 and 9 raise?
3. Is Krispy Kreme financially healthy at year-end 2004?
4. In light of your answer to question 3, what accounts for the firm’s recent share price decline?
5. What is the source of intrinsic investment value in this company? Does this source appear on the financial statements?
This teaching note was prepared by Robert F. Bruner with the assistance of Sean D. Carr (MBA ’03). It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright © 2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.
This case could be used for the opening class in a sequence of finance and accounting cases in a short executive-education program. Students are expected to have studied an introductory reading on financial statements. Accordingly, this case seeks to exercise and build upon that rudimentary understanding so that students begin (1) to develop a sense of how capital markets consume financial statements and, (2) to explore some of the determinants of value. The following outline pursues those objectives. With a more advanced group of students, the instructor could dispense with the first discussion question and launch directly into the exploration of financial health. In all cases, the instructor will need to exercise careful discipline over time: Although the case seems simple, it raises many issues and can trigger an extensive discussion.
1. What are the definition and purpose of an income statement, as shown in case Exhibit 1? What are the definition and purpose of a balance sheet as shown in case Exhibit 2? How are the two statements related? Are Krispy Kreme’s financial statements exact? Does management have any discretion over how those accounts are estimated?
The goals of this opening are to survey the mechanics of financial statements and to explore how statements are derived. The insights obtained here become a crucial foundation for evaluating the impact of Krispy Kreme’s accounting policies.
2. Is Krispy Kreme financially “healthy”? What do the statements show? What do the ratios show?
This segment of the discussion provides an opportunity to exercise statement and ratio analysis and to lay the foundation for the third question. The instructor should prod students to wring the most out of the comparative ratios, both against peers and against Krispy Kreme’s own performance over time.
3. Given your assessment of Krispy Kreme’s health, why did its stock price drop by 80% between 2003 and 2004?
This final segment of the discussion provides the bridge between accounting and finance that permits the students and the instructor to compare and contrast the two fields. The essence of this comparison must be that accounting is focused on explaining past events, whereas finance (through its attention to market value) is focused on future expectations. Investors pay careful attention to financial statements not only for what they say about the past, but also for any clues they may give about future performance. The surprising revelations about the U.S. Securities and Exchange Commission’s (SEC) investigation into Krispy Kreme and the reports of aggressive accounting for franchises probably caused investors to revise downward their expectations about future cash flows. Thus, financial statements and the choice of accounting policies may be seen as containing signals about future performance.
The instructor could close the discussion with a review of events since the date of the case. The epilogue presented here summarizes the company’s financial performance up to late 2005. Exhibits TN2 and TN3 (on financial statement analysis and financial health) may be distributed to students after the discussion or could be used by the instructor as a foundation for summary comments. See the company’s Web site for updates on its financial information (http://www.krispykreme.com)
The purpose and structure of a firm’s financial statements are well documented in standard texts and will not be repeated here. Novices studying this case, however, may benefit from a slow review of the specific accounts, the choices that managers can make in estimating them, and the possible degree of exactitude. The case presents none of the footnotes to the accounts, which prevents a detailed discussion of accounting policy. Nevertheless, student discussion can highlight some of the following accounting choices and sources of variation in reported results.
Cash and cash equivalents: It is possible to derive a fairly exact estimate of cash. In contrast to some other balance sheet accounts, the cash balance could change dramatically from day to day because cash is fungible.
Accounts receivables: As long as the accountant or analyst agrees that the products have been sold, estimating gross receivables is relatively straightforward. The accounting for sales to “affiliates,” or franchises, was a significant issue for Krispy Kreme. Uncertainty about sales and bad debts can produce an uncertain figure for net receivables.
Inventories: Managerial choices about whether to use the first-in, first-out (FIFO) or lastin, first-out (LIFO) method of inventory valuation and how to treat obsolescence, spoilage, shrinkage, and even outright fraud, affect estimates of inventory values.
Property, plant, and equipment: Managers have choices about depreciation policies and investment basis (for example, property acquired through a purchase-method merger can be written up from its former book value).
Goodwill and other intangibles: The estimation of goodwill and other intangibles, such as the value assigned to recipes, trademarks, and trade names, is a matter of judgment. Reacquired franchise rights result from a company’s acquisition of franchise markets from existing franchisees, and there is considerable room for discretion in how those assets are valued.
Revenues: When do we recognize a sale as revenue? This judgment call is a matter of choice. As indicated in the case, Krispy Kreme generates at least four major streams of incomes for which there are a number of potential revenue recognition choices.
Expenses: Underlying the expense estimates are numerous decisions that involve the allocation of costs across different products and across time.
The instructor can develop an even more detailed list but, at the end of this segment of the discussion, may wish to ask students to speculate on the degree of variation in total assets or earnings that occurs as a result of estimation error and managerial discretion in accounting policy. My experience in discussing this case with managers suggests possible variation from reported figures in the range of plus or minus 10% to 25%.
Financial health of Krispy Kreme Doughnuts, Inc.
Student discussion will uncover a number of concerns about Krispy Kreme’s well-being:
Growth: Case Exhibit 1, for instance, shows rapid growth in revenues and earnings over the past five years, and students may question the long-term sustainability of this pattern. They will note that the company showed a net loss in the first quarter of 2005, and may consider whether that anticipates a trend. A quick examination of case Exhibit 2 shows huge asset growth over the past five years as well. The bulk of this growth, however, has occurred in accounts receivables from affiliates and from reacquired franchise rights, the very item that was the focus of the startling revelations in the Wall Street Journal in May 2004, which described the alleged “aggressive accounting treatment,” whereby the company did not amortize the value of these intangible assets.1 Case Exhibit 3 also illustrates Krispy Kreme’s ambitious expansion strategy for company-owned and franchised factory stores.
DuPont Analysis: The analytical financial ratios in Case Exhibit 7 reveal that returns on assets and equity declined between 2002 and 2004. A simple spreading of the ratios using the DuPont system can help explain why. As Exhibit TN1 shows, in 2002 the firm’s return on assets showed a dramatic improvement, primarily due to solid gains in profit margin. But in 2003 and 2004, even as profit margins continued to improve, the benefit was offset as the firm’s leverage declined and as asset turnover deteriorated, falling to less than half of what it was in 2000. In short, profit margins may be high in an absolute sense, but the reasons for declining asset turnover may warrant careful scrutiny.
Liquidity, leverage, and profitability: Students can mine the ratios in case Exhibits 7, 8, and 9 for additional clues about the company’s financial health. The firm’s liquidity ratios are strong and continued to improve over the five-year period. The leverage ratios show that the firm has been increasing its proportion of debt, but the balance sheet also indicates that the firm’s level of equity has been increasing as well. Times interest earned has dropped dramatically (from 124 in 2002 to 23 in 2004) as a result of a material increase in debt. The stagnant returns on equity, relative to the improving profit margins, appear to be a significant issue. The instructor
1 “Krispy Kreme Franchise Buybacks May Spur New Concerns,” Mark Maremont and Rick Brooks, Wall Street Journal, 25 May 2004.
-5could explore possible reasons for this decline: The case highlights the reacquired franchise rights, which likely have contributed to depressed equity returns and asset turnover.
Peer Comparisons: The detailed information on peers contained in case Exhibit 8 warrants thoughtful consideration by students. The instructor should query the students on the extent to which all 12 firms are really “peers.” Krispy Kreme sells a single product and emphasizes the Krispy Kreme “experience,” so one could argue that Starbucks would be a more apt comparison than the other firms. Counterarguments for using the whole group of 12 firms as a comparison hinge mainly on the assertion of similarity among all quick-service restaurants, regardless of their retail focus. The need to scrutinize the composition of the peer group is a useful learning point that the instructor may make in passing.
In general, a comparison of Krispy Kreme with its peers suggests that Krispy Kreme is significantly more liquid, turns its receivables and inventory more slowly, and has less financial leverage than its peers. Comparing Krispy Kreme’s results to the financial statements of some industry average, common-size companies in case Exhibit 9 reveals that Krispy Kreme has significantly more receivables and intangibles, higher operating expenses, but better profit margins than its peers. In short, analyzing Krispy Kreme’s financial statements alone and in comparison with its peers paints a picture of a company growing aggressively, extending substantial credit to its affiliates, amassing large unamortized assets on its balance sheet in the form of reacquired franchise rights, and yet remaining profitable and competitive with its peers. This does not appear, at this point, to be an image of disaster.
The basic financial health of Krispy Kreme begs the question, “Why did the market react so negatively to the disclosures about adverse results and the revelations in the Wall Street Journal regarding the firm’s accounting methods for the franchise rights?” This reaction is further reflected in case Exhibits 4 and 5, which show a dramatic reappraisal of Krispy Kreme in analysts’ recommendations and earnings per share (EPS) estimates. The quotations in the case that raise the specter of “fundamental problems” question the sustainability of growth, and speculate that “execution and cost discipline were seriously lacking” also yield insight into the market’s behavior: Plainly, the disclosures affected the market’s expectations of future performance. If one thinks of stock prices as equal to the present value of future equity cash flows, then one can rationalize seemingly small adjustments to present earnings and rather large adjustments in stock price: What is actually being adjusted is the future, not present, cash flows.
Novices in finance may benefit from a discussion about the estimation of value. The instructor could compare Krispy Kreme’s book value per common share (about $7.40) with the variety of market prices mentioned in the case ($40.63 at the initial offering in April 2000, $22.51 in May 2004, and less than $10 in January 2005) to generate a discussion about Krispy Kreme’s “true” value and on what it is founded. Based on the previous discussion of accounting policy choices, book value would not seem to be an accurate estimate of value; also, book value deals only with past events. The multiplicity of share prices must be the product of changes in expectations: Reviewing Krispy Kreme’s financial performance over the 2000–2004 period,
-6students might hypothesize that there were periods of both rising and falling investor expectations.
On January 18, 2005, amid an accounting inquiry, shareholder lawsuits, and weakening earnings, Krispy Kreme Doughnuts, Inc., replaced Scott Livengood, the company’s chairperson, president, and chief executive officer, with a leading restructuring expert. The company’s share price rose 10% on the news, and analysts were quoted as saying they believed the company still had a strong enough brand to survive. With the announcement, the company’s lenders agreed to give the beleaguered doughnut chain a three-month extension to deliver its restated financials without triggering a default on its $150-million credit facility.
In subsequent months, as part of a program of cost-cutting and restructuring measures, Krispy Kreme cut its corporate, manufacturing, and distribution workforce by 25% and sold off its corporate airplane for $30.5 million in cash. Even so, the company’s legal woes mounted as the U.S. Attorney’s Office for the Southern District of New York announced its own investigation into Krispy Kreme’s franchise repurchases; separately, plaintiffs in a class-action lawsuit alleged the company’s employees lost millions of dollars in retirement savings because company executives hid evidence of declining sales and profits.
In April 2005, the company announced it would delay the filing of its annual report for the year ended January 30, 2005 as it looked into its accounting practices, and that it expected to report a net loss for the fourth quarter of 2004. In June, six top executives resigned or retired from the company after a special committee of directors investigating the company’s finances concluded they should be fired. Near the end of 2005, the company’s board of directors announced it had initiated a search for a permanent chief executive. On November 2, 2005, Krispy Kreme’s shares closed at an all-time low of $4.45.
Exhibits TN2 and TN3 give summary notes that could be distributed to students after the case discussion to promote student reflection on the lessons of the case. Permission to copy those pages for use solely in connection with the Krispy Kreme case is granted by the copyright holder.
Experience with financial statements eventually teaches caution. No matter how important it is for the general manager to assess financial statements, their interpretation may not be as straightforward as first appears.
For most large corporations, audited financial statements are not exact. Virtually no auditors count every item in inventory or check every sales receipt. The value of oil reserves in the ground or stands of timber is estimated and reported conservatively. Bad debts are a matter of judgment. The key point is that the preparation of financial reports involves a relatively high degree of judgment and estimation.
Managers have relatively wide latitude in choosing accounting policies that underlie financial-statement preparation. When should a sale be recognized? How should inventory or the cost of goods be valued (LIFO or FIFO)? Should a payment be recognized as an expenditure or as an expense? When should asset values be written off to reflect deterioration in value? Which resources should be recognized as assets? At what amount should assets be stated? Even reasonable people can disagree about the choice of policies, which can lead to variations in the value of a firm’s assets of plus or minus 25%.
As accounting looks backward, it does not capture expectations about the future very well. Accountants serve the useful function of explaining the firm’s past activities. As a matter of practice, accountants will explain those activities in a conservative fashion (for instance, they always choose to report the lower of cost or market value of an asset). This backward-looking and conservative view of the firm, however, ignores future prospects and the factors that may affect the future. For instance, most financial statements ignore the value of intangible assets, such as brand names, patents, trademarks, and unique managerial savvy. Statements also fail to capture the death of a talented inventor, or chief executive officer, or the entry of a major new competitor into the firm’s business arena.
Balance sheets are just snapshots in time. In reality, firms are moving targets. Managers need the freshest information about companies, but most companies are audited annually. The older the audit, the more the general manager needs to anticipate possible changes from the audited results.
This note was prepared by Robert F. Bruner as a supplement to the case discussion. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1997 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.
Financial ratios are a useful supplement to financial-statement analysis. Ratios can be used to identify trends in the firm’s financial history or to compare the firm with competing peers. Ratios help focus one’s thinking on six key areas of analysis: profitability, activity, leverage, liquidity, investment returns, and growth. The DuPont system of analytical ratios is especially useful in combining ratios to tell a story about changes in the firm’s investment returns.
Ultimately, financial statement analysis is a basis for asking questions rather than gaining answers. The right approach to financial statements is to use them to trigger inquiries into the kinds of issues that general managers can influence, such as whether to grow rapidly or slowly; how heavily to invest in certain business segments; how large a dividend to pay; whether to adopt a tough stance in labor negotiations; how to price a product. Used in this way, financial statements provide a useful, albeit imperfect, factual foundation for resolving practical problems.
General managers are required to judge the financial condition of companies for many reasons: to evaluate the performance of managers; to assess the robustness of a competitor, supplier, or customer; to identify business risks; and, to illuminate investment or acquisition decisions.
This note summarizes a few key ideas with which a general manager might direct the analytical process. A manager usually wants to know how healthy the company is. Using a medical metaphor, we may characterize a company as being ill, healthy, or fit. What matters is where the firm lies on the spectrum of health. The following questions help expose the company’s condition:
1. Is the company in, or approaching, financial difficulty? Most companies are not in financial distress, but it makes sense to check for this possibility immediately as a way to eliminate at least one end of the spectrum. Firms in financial difficulty display several of the following conditions:
a. Low or negative earnings. Profitability ratios, which are based on net earnings and operating earnings, can reveal difficulties in the firm’s ability to cover its costs.
b. Negative cash flow. Lengthening activity ratios versus the firm’s history and versus its industry, plus changes in the sources-and-uses-of-funds statement, will indicate problems in generating cash internally.
c. High financial leverage, revealed by a high debt-to-equity ratio or a high debt-tocapital ratio and a low EBIT-to-interest ratio relative to the firm’s own history and relative to average ratios for the firm’s industry.
d. Low liquidity, as evidenced by low current ratio, low quick ratio, low cash balance, low turnover of accounts payable, and, generally, difficulty in meeting cash obligations as they come due. Missed dividend or interest payments are strong signals of difficulty.
e. Low stock prices, compared with historical levels and with price-to-earnings ratios of peer companies.
This note was prepared by Robert F. Bruner as a supplement to case discussion. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1997 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.
Exhibit TN3 (continued)
2. If the company is not in financial difficulty, is it financially “fit”? Some companies are healthy in the sense that they survive year after year, but they do not exhibit robustness against the potential challenges of their industry. Those companies often appear in the lower half of their industry peer group in terms of the major categories of financial ratios. Financially fit companies are more profitable, turn their assets faster, are more liquid, and use financial leverage more judiciously than their peers. More importantly, coherence exists between the financial standings and the business strategies of “fit” companies. Management’s statements of goals and policies will seem reasonable in light of the current financial standing of a fit company: Growth appears likely to be sustainable, resources will be applied toward activities that will ultimately strengthen financial standing further, and financial reserves exist to guard against unforeseen troubles.
3. If the company is financially fit, is it excellent? Many companies are fit; few are truly excellent from a financial point of view. The hallmark of an excellent company is its ability to deliver superior returns to its investors consistently over time. Many firms can take actions in the short run that deliver returns for a year or two but, in free markets, competitors rapidly imitate successful strategies. Realizing superior investment returns consistently over time is extremely difficult. The marks of financially excellent firms include high returns on equity and assets, a high price-to-earnings ratio, a high market-tobook ratio, and a steadily rising stock price. Other financial ratios and the DuPont system of ratios can yield insights into the sources of superior returns.
By breaking down the question of financial health into those categories, the general manager will be able to differentiate degrees of performance more effectively. At the end of the day, however, financial analysis based on ratios, financial statements, and stock prices engenders good questions rather than the absolute truth about a company. Financial analysis is an imperfect art because its sources of information are estimates rather than reality. In addition, financial health is a moving target. For those reasons, the best general managers use financial analysis as though it were a lamp shining on a dim landscape, recognizing that it neither shines very far into the future nor does it illuminate current conditions completely.