ACC 670 GCU Massachusetts Stove Company Financial Statement Review REQUIRED (additional requirements follow on page 723) a. Identify clues from the financ

ACC 670 GCU Massachusetts Stove Company Financial Statement Review REQUIRED (additional requirements follow on page 723)

a. Identify clues from the financial statements and financial statement ratios for Year 3–Year

7 that might suggest that Massachusetts Stove Company is a mature business.

b. Design a spreadsheet for the preparation of projected income statements, balance sheets,

and statements of cash flows for MSC for Year 8–Year 12. Also forecast the financial statements

for each of these years under three scenarios: (1) best case, (2) most likely, and (3)

worst case.

REQUIRED (continued from page 721)

c. Calculate the financial statement ratios listed in Exhibit 10.16 for MSC under each of

the three scenarios for Year 8–Year 12.

Note: You should create a fourth spreadsheet as part of your preparation of the projected

financial statements that will compute the financial ratios.

d. What advice would you give the management of MSC regarding its decision to enter

the gas stove market? Your recommendation should consider the profitability and

risks of this action as well as other factors you deem relevant CASE 10.2
Massachusetts Stove Company: Analyzing Strategic
The Woodstove Market
Since the early 1990s, woodstove sales have declined from 1,200,000 units per year to approximately
100,000 units per year. The decline has occurred because of (1) stringent new federal
EPA regulations, which set maximum limits on stove emissions beginning in 1992; (2) stable
energy prices, which reduced the incentive to switch to woodstoves to save on heating costs;
and (3) changes in consumers’ lifestyles, particularly the growth of two-income families.
During this period of decline in industry sales, the market was flooded with woodstoves at
distressed prices as companies closed their doors or liquidated inventories made obsolete by
the new EPA regulations. Downward pricing pressure forced surviving companies to cut prices,
output, or both. Years of contraction and pricing pressure left many of the surviving manufacturers
in a precarious position financially, with excessive inventory, high debt, little cash, uncollectible
receivables, and low margins.
The shakeout and consolidation among woodstove manufacturers and, to a lesser extent,
woodstove specialty retailers have been dramatic. The number of manufacturers selling more
than 2,000 units a year (characterized in the industry as ‘‘large manufacturers’’) has declined
from approximately 90 to 35 in the prior 10 years. The number of manufacturers selling
less than 2,000 units per year (characterized as ‘‘small manufacturers’’) has declined from
approximately 130 to 6. Because the current woodstove market is not large enough to support
all of the surviving producers, manufacturers have attempted to diversify in order to stay
in business. Seeking relief, nearly all of the survivors have turned to the manufacture of gas
appliances.
The Gas Appliance Market
The gas appliance market includes three segments: (1) gas log sets, (2) gas fireplaces, and
(3) gas stoves. Gas log sets are ‘‘faux fires’’ that can be installed in an existing fireplace. They
are primarily decorative and have little heating value. Gas fireplaces are fully assembled fireboxes that a
builder or contractor can install in new construction or in renovated buildings
and houses. They are mainly decorative and are less expensive and easier to maintain than a
masonry/brick fireplace. Gas stoves are freestanding appliances with a decorative appearance
and efficient heating characteristics.
The first two segments of the gas appliance market (log sets and fireplaces) are large, established,
stable markets. Established manufacturers control these markets, and distribution is primarily
through mass merchandisers. The third segment (gas stoves) is less than five years old.
Although it is growing steadily, it has an annual volume of only about 100,000 units (almost
identical to the annual volume of the woodstove market). This is the market to which woodstove
manufacturers have turned for relief.
The gas stove market is not as heavily regulated as the woodstove market, and there are
currently no EPA regulations governing the emissions of gas heating appliances. Gas stoves are
perceived as being more appropriate for an aging population because they provide heat and
ambiance but require no effort. They can be operated with a wall switch or thermostat or by
remote control. Because actual fuel cost (or cost savings) is not an issue for many buyers, a big
advantage of heating with wood is no longer a consideration for many consumers. Gas stoves
are sold and distributed through mass merchandisers and through natural gas or propane
dealers. The gas industry has the financial, promotional, organizational, and lobbying clout to
support the development of the gas stove market, attributes that the tiny woodstove industry
lacks.
Unfortunately, life has not been rosy for all of the woodstove companies entering this new
market. Development costs and selling costs for new products using a different fuel and different
distribution system have been substantial. Improvements in gas logs and gas burners have
required rapid changes in product design. In contrast, woodstove designs are fairly stable and
slow to change. Competition for market share has renewed pricing pressure on gas stove producers.
Companies trying to maintain their woodstove sales while introducing gas products
must carry large inventories to service both product lines. Failure to forecast demand accurately
has left many companies with inventory shortages during the selling season or with large inventories
of unsold product at the end of the season.
Many surviving manufacturers who looked to gas stoves for salvation are now quietly
looking for suitors to acquire them. A combination of excessive debt and inventory levels, together
with high development and distribution costs, has made financial success highly
uncertain. Continued consolidation will take place in this difficult market during the next five
years.
Massachusetts Stove Company
Massachusetts Stove Company (MSC) is one of the six ‘‘small manufacturers’’ to survive the EPA
regulation and industry meltdown. The company has just completed its sixth consecutive year
of slow but steady growth in revenue and profit since complying with the EPA regulations.
Exhibits 10.13–10.15 present the financial statements of MSC for Year 3–Year 7. Exhibit 10.16
(see page 719) presents selected financial statement ratios.
The success of MSC in recent years is a classic case of a company staying small, marketing
in a specific niche, and vigorously applying a ‘‘stick-to-your-knitting’’ policy. MSC is the only
woodstove producer that has not developed gas products; 100% of its sales currently come
from woodstove sales. MSC is the only woodstove producer that sells by mail order directly to
consumers. The mail-order market has sheltered MSC from some of the pricing pressure that
other manufacturers have had to bear. The combination of high entry costs and high risks make
it unlikely that another competitor will enter the mail-order niche.
Exhibit 10.13
Massachusetts Stove Company
Income Statements
(Case 10.2)
Year Ended December 31
PLESASE FINANCIAL DATA ON THE ATTACHED PHOTOS
MSC’s other competitive advantages are the high efficiency and unique features of its
woodstoves. MSC equips its woodstoves with a catalytic combuster, which reburns gases emitted
from burning wood. This reburning not only increases the heat generated by the stoves,
but also reduces pollutants in the air. MSC offers a woodstove with inlaid soapstone. This soapstone
heats up and provides warmth even after the fire in the stove has dwindled. The soapstone
also adds to the attractiveness of the stove as a piece of furniture. MSC’s customer base
includes many middle- and upper-income individuals.
MSC believes that profitable growth of woodstove sales beyond gross revenues of $3 million
a year in the mail-order niche is unlikely. However, no one is selling gas appliances by mail
order. Many of MSC’s customers and prospects have asked whether MSC plans to produce a
gas stove.
Management of MSC is contemplating the development of several gas appliances to sell by
mail order. There are compelling reasons for MSC to do this, as well as some good reasons to
be cautious.
Availability of Space MSC owns a 25,000-square-foot building but occupies only 15,000
square feet. MSC leases the remaining 10,000 square feet to two tenants. The tenants pay rent
plus their share of insurance, property taxes, and maintenance costs. The addition of gas appliances
to its product line would require MSC to use 5,000 square feet of the space currently
rented to one of its tenants. MSC would have to give the tenant six months’ notice to cancel
its lease.
Availability of Capital MSC has its own internal funds for product development and inventory,
as well as an unused line of credit. But it will lose interest income (or incur interest
expense) if it invests these funds in development and increased inventory.
Existing Demand MSC receives approximately 50,000 requests for catalogs each year and has
a mailing list of approximately 220,000 active prospects and 15,000 recent owners of woodstoves.
There is anecdotal evidence of sufficient demand so that MSC could introduce its gas
stoves with little or no additional marketing expense, other than the cost of printing some additional
catalog pages each year. MSC’s management worries about the risk of the gas stove sales
cannibalizing its existing woodstove sales. Also, if the current base of woodstove sales is eroded
through mismanagement, inattention, or cannibalization, attempts to grow the business
through expansion into gas appliances will be self-defeating.
Vacant Market Niche No other manufacturer is selling gas stoves by mail order. Because the
entry costs are high and the unit volume is small, it is unlikely that another producer will enter
the niche. MSC has had the mail-order market for woodstoves to itself for approximately seven
years. MSC believes that this lack of existing competition will give it additional time to develop
new products. However, management also believes that a timely entry will help solidify its position
in this niche.
Suppliers MSC has existing relationships with many of the suppliers necessary to manufacture
new gas products. The foundry that produces MSC’s woodstove castings is one of the largest
suppliers of gas heating appliances in central Europe. On the other hand, MSC would be a small,
new customer for the vendors that provide the ceramic logs and gas burners. This could lead to
problems with price, delivery, or service for these parts.
Synergies in Marketing and Manufacturing MSC would sell gas appliances through its
existing direct-mail marketing efforts. It would incur additional marketing expenses for photography,
printing, and customer service. MSC’s existing plant is capable of manufacturing the shell
of the gas units. It would require additional expertise to assemble fireboxes for the gas units
(valves, burners, and log sets). MSC would have to increase its space and the number of
employees to process and paint the metal parts of the new gas stoves. The gross margin for the
gas products should be similar to that of the woodstoves.
Lack of Management Experience Managing new product development, larger production
levels and inventories, and a more complex business would require MSC to hire more management
expertise. MSC also would have to institute a new organizational structure for its more
complex business and define responsibilities and accountability more carefully. Up to now, MSC
has operated with a fairly loose organizational philosophy.
REQUIRED (additional requirements follow on page 723)
a. Identify clues from the financial statements and financial statement ratios for Year 3–Year
7 that might suggest that Massachusetts Stove Company is a mature business.
b. Design a spreadsheet for the preparation of projected income statements, balance sheets,
and statements of cash flows for MSC for Year 8–Year 12. Also forecast the financial statements
for each of these years under three scenarios: (1) best case, (2) most likely, and (3)
worst case. The following sections describe the assumptions you can make.
Development Costs MSC plans to develop two gas stove models, but not concurrently. It will
develop the first gas model during Year 8 and begin selling it during Year 9. It will develop the
second gas model during Year 9 and begin selling it during Year 10. MSC will capitalize the development
costs in the year incurred (Year 8 and Year 9) and amortize them straight-line over
five years, beginning with the year the particular stove is initially sold (Year 9 and Year 10). Estimated
development cost for each stove are as follows:
Best Case: $100,000
Most Likely Case: $120,000
Worst Case: $160,000
Capital Expenditures Capital expenditures, other than development costs, will be as follows:
Year 8, $20,000; Year 9, $30,000; Year 10, $30,000; Year 11, $25,000; Year 12, $25,000. Assume a
six-year depreciable life, straight-line depreciation, and a full year of depreciation in the year of
acquisition.
PLEASE SEE SALES GROTH PHOTO ATTACHED
Because sales of gas stoves will start at zero, the projections of sales should use the preceding
growth rates in total sales. The growth rates shown for woodstove sales and gas stove sales
simply indicate the components of the total sales increase.
Cost of Goods Sold Manufacturing costs of the gas stoves will equal 50% of sales, the same
as for woodstoves.
Depreciation Depreciation will increase for the amortization of the product development costs
on the gas stoves and depreciation of additional capital expenditures.
Facilities Rental Income and Facilities Costs Facilities rental income will decrease by 50%
beginning in Year 9 when MSC takes over 5,000 square feet of its building now rented to
another company and will remain at that reduced level for Year 10–Year 12. Facilities costs will
increase by $30,000 beginning in Year 9 for facilities costs now paid by a tenant and for additional
facilities costs required by gas stove manufacturing. These costs will remain at that
increased level for Year 10–Year 12.
Selling Expenses Selling expenses as a percentage of sales are as follows:
Year
Best Case
Most Likely Case
Worst Case
8
34%
34.0%
34%
9
33%
33.5%
35%
10
32%
33.0%
36%
11
31%
32.5%
37%
12
30%
32.0%
38%
Administrative Expenses Administrative expenses will increase by $30,000 in Year 8, $30,000
in Year 9, and $20,000 in Year 10, and then will remain at the Year 10 level in Years 11 and 12.
Interest Income MSC will earn 5% interest on the average balance in cash each year.
Interest Expense The interest rate on interest-bearing debt will be 6.8% on the average
amount of debt outstanding each year.
Income Tax Expense MSC is subject to an income tax rate of 28%.
Accounts Receivable and Inventories Accounts receivable and inventories will increase at
the growth rate in sales.
Property, Plant, and Equipment Property, plant, and equipment at cost will increase each
year by the amounts of capital expenditures and expenditures on development costs. Accumulated
depreciation will increase each year by the amount of depreciation and amortization
expense.
Accounts Payable and Other Current Liabilities Accounts payable will increase with the
growth rate in inventories. Other current liabilities include primarily advances by customers for
stoves manufactured soon after the year-end. Other current liabilities will increase with the
growth rate in sales.
Current Portion of Long-Term Debt Scheduled repayments of long-term debt are as follows:
Year 8, $27,036; Year 9, $29,200; Year 10, $31,400; Year 11, $33,900; Year 12, $36,600; Year 13,
$39,500.
Deferred Income Taxes Deferred income taxes relate to the use of accelerated depreciation
for tax purposes and the straight-line method for financial reporting. Assume that deferred
income taxes will not change.
Shareholders’ Equity Assume that there will be no changes in the contributed capital of
MSC. Retained earnings will change each year in the amount of net income.
REQUIRED (continued from page 721)
c. Calculate the financial statement ratios listed in Exhibit 10.16 for MSC under each of
the three scenarios for Year 8–Year 12.
Note: You should create a fourth spreadsheet as part of your preparation of the projected
financial statements that will compute the financial ratios.
d. What advice would you give the management of MSC regarding its decision to enter
the gas stove market? Your recommendation should consider the profitability and
risks of this action as well as other factors you deem relevant
10.13
Exhibit
Massachusetts Stove Company
Income Statements
(Case 10.2)
Year Ended December 31
Year 3
Sales
Cost of goods sold
Depreciation
Facilities costs
Facilities rental income
Selling expenses
Administrative expenses
Operating Income
Interest income
Interest expense
Income Before
Income Taxes
Income taxes
Net Income
Year 4
(727,259)
(56,557)
(59,329)
25,856
(452,032)
(36,967)
174,211
712
(48,437)
(759,156)
(73,416)
(47,122)
37,727
(563,661)
(39,057)
192,443
2,242
(44,551 )
126,486
150,134
(35,416)
(42,259)
107,875
91
Year 5
Year 6
$ 2,225,745
$ 2,376,673
35)
(64,320)
(66,226)
38,702
(776,940)
(46,444)
(l 59,466)
247,382
222,384
9,209
(52,633)
(1
9,541
(47,535)
209,388
(64, 142)
145,246
(66,829)
42,142
(874,000)
(48,046)
178,960
(45,794)
133,166
Year 7
s 2,734,986
(72,321)
(45,309)
41 ,004
(926,175)
(1
99)
240,166
16,665
(42,108)
214,723
(60,122)
154,601
Exhibit
10.14
Massachusetts Stove Company
Balance Sheets
(Case 10.2)
December 31
Year 2
Year 3
Year 4
19,687
56,706
327,627
145,930
30,934
347,883
Year 5
Year 6
Year 7
ASSETS
Cash
$
50,794
Accounts receivable
12,571
Inventories
Other current assets
251,112
1,368
Total Current Assets
$ 315,845 $ 404,020
PP&E, at cost
Accumulated depreciation
Other assets
Total Assets
524,747
1 , 164,884
(296,683)
121 ,483
$1,196,802
(353,240)
94,000
(426,656)
61 ,500
104,383
41 , 748
375,258
258,148
30,989
409,673
$ 351,588
5,997
452,709
521,389
698,810 $ 810,294
1,184,132 1,234,752
1,257,673
(490,975) (557,804)
(630,125)
12,200
$1,375,758
Exhibit
IC.14 (Continued)
December 31
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
LIABILITIES AND SHAREHOLDERS’
EQUITY
Accounts payable
Notes payable
Current portion of
long-term debt
Other current liabilities
Total Current Liabilities
Long-term debt
Deferred income taxes
Total Liabilities
Common stock
Additional paid-in capital
Retained earnings (deficit)
Treasury stock
Total Shareholders’ Equity
Total Liabilities and
Shareholders’ Equity
137,104
25,000
112,815
12,000
43,229
27,600
39,530
229,234
972,446
29,000
100,088
253,903
953,491
21,570
2,000
435,630
(442,508)
(4,878) $
2,000
435,630
(351 ,438)
60,036
3,257
1 84, 194
189,732
248,993 s 363,025
881,415
599,408
2,000
435,630
(243,563)
86,192 $ 194,067
962,433
2,000
435,630
(98,317)
(75,000)
264,313
1226,746
39,170
47,809
27,036
257,252
398,487 s 332,097
547,296
574,332
5,460
6,369
978,279 s 885,762
2,000
2,000
435,630
435,630
189,450
(75,000)
(75,000)
397,479 s 552,080
115,076
244,241
Exhibit
10.15
MassachusettsStove Company
Statements of Cash Flows
(Case 10.2)
Year Ended December 31
OPERATIONS
Net income
Depreciation and amortization
Other addbacks
(Increase) Decrease in receivables
(Increase) Decrease in inventories
Decrease in other current assets
Increase (Decrease) in payables
Increase in other current liabilities
Cash Flow from Operations
Year 3
Year 4
$ 91,070
$107,875
73,416
32,500
25,772
(20,256)
56,557
27,483
(44, 135)
(76,515)
1,368
(24,289)
60,558
$ 92,097
Year 6
Year 7
145,246
64,320
49,300
(10,814)
(27,375)
$133,166
66,829
17,660
10,759
(34,415)
s 154,601
$233,827
$ 243,022
(20,866)
54,509
$227,642
8,639
84, 106
16,807
5,538
(69,586)
Year 5
72,321
909
24,992
(43,036)
13,011
s 231,437
Exhibit
10.15 (Continued)
Year Ended December 31
INVESTING
Capital expenditures
Cash Flow from Investing
FINANCING
Increase in long-term debt
Decrease in short-term debt
Decrease in long-term debt
Acquisition of common stock
Cash Flow from Financing
Change in Cash
Cash—Beginning of year
Cash—End of Year
Year 3
Year 4
$ (92,649)
$ (92,649)
$ (16,078)
$ (16,078)
Year 6
Year 7
(19,249)
(19,249)
$ (50,620)
$ (50,620)
$ (22,921)
$ (22,921)
(190,320)
(75,000)
(23,J57)
(115,076)
$ (23,257)
$153,765
104,383
$258,148
15,076)
Year 5
$ 10,000
(13,000)
(27,555)
50,794
$ 19,687
(12,000)
(79,506)
$ (91,506)
$126,243
19,687
$145,930
$ (41,547)
145,930
$ 104,383
$ 93,440
258,148
$ 351,588
Exhibit
10.16
Massachusetts Stove Company
Financial Statement Ratios
(Case 10.2)
Year 4
Year 5
Year 6
Year 7
8.5%
8.5%
8.1%
7.2%
6.8%
1.2
1.3
1.8
1.9
10.1%
6.2%
30.6
224.0%
49.1%
3.8%
2.3%
30.5%
2.5%
10.7…
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