Managing Financial Resources & Decisions

Case Study: Fortune Bike Inc.

Fortune Bike Inc. was a small publicly-owned corporation that has been in the retail business selling bicycles for the last six years. It has only one big store. Its founder, president and CEO was and is Mr. Jackson Black who also owns 20% of the company's common shares. Sales and profits have been growing at approximately 10% a year. In March this year (2002), a super-discount sport store opened its business only two blocks away from Fortune Bike. Since this opening, Fortune Bike has been losing many of its customers to this new store because its competitor, a chain store owned by a big corporation, has been able to offer bicycles at much lower prices. This competitor has also let customers lease bicycles with an option to buy. Fortune Bike did not provide this alternative for its customers.

Mr. Black was quite concerned that this year profit growth would not be as high as prior years. In July 2002, he requested his staff to prepare the projected income statement and balance sheet for 2002 to compare to those for 2001. These financial statements are in Exhibits 1 and 2 (shown in page 2).

Mr. Black was really upset by a large decline in projected sales (-20%) and in projected net income (-41%) for the current year. He has three major concerns. First, he will not receive a bonus in 2002 because the bonus was given only if there was an increase in net income. Second, Fortune Bike's return on assets (7.5%) will not meet the bank loan requirement (10%). Per the loan agreement, the loan will be due immediately if the return on assets falls below 10%. Mr. Black was wondering whether the company would have enough cash to pay off the loan. The third and most serious concern for Mr. Black was that the other 80% of stockholders would be so angry about this profit decline that they might try to replace him as the president and CEO.

To cope with this profitability problem, Mr. Black planned to ask his family and friends to make several large credit purchases in November and December, then to return these purchases early next year. His family and friends would not have to pay for these purchases because Fortune Bike gave credit customers 60 days to make payments. The company had the policy of accepting sales returns only if bicycles were defective. Mr. Black, however, had the power to waive this policy and to authorize any returns given that there was a justified reason and bicycles were in the same good condition as when purchased. Return shipment charges were paid by Fortune Bike. Mr. Black planned to pay his family and friends' storage costs for the bicycles.

Additional information

1. An average selling price of a bicycle was $480 which was the same as last year's average price. The majority of sales were on credit, terms n/60, FOB destination. Fortune Bike sold 2,500 bicycles last year and expected to sell 2,000 bicycles this year.

2. The cost of a bicycle has been gradually rising from $270 last year to $290 this last month. The number of bicycles purchased between January and July 2002 was only slightly lower than that during the same period in 2001. Inventory cost was determined by the average-cost method. Fortune Bike's average inventory turnover was 130 days. The industry average was 80 days. The only supplier for Fortune Bike was Mr. Black's long-time friend, Mr. Jordan White, who offered credit purchase terms n/45, FOB shipping point. Fortune Bike never took any purchase discounts. There were a few other suppliers who offered the same terms with a lower price, FOB destination.

3. All cash was deposited in a non-interest-bearing checking account.

4. The company used the straight-line method of depreciation. The equipment had an estimated useful life of 10 years and a $5,000 estimated salvage value.

5. Bad debt expense was estimated to be 2% of gross credit sales which were $1,000,000 in 2001 and expected to be $720,000 in 2002. Fortune Bike had never re-estimated the percentage of uncollectible accounts for the last four years. It took the company about 98 days to collect cash from credit sales. The industry average was 60 days.

6. The interest rate on the bank loan was 12%.

7. Fortune Bike's board of directors had declared and paid a $30,000 cash dividend ($0.60 per common share) in each of the past three years. It planned to do the same in 2002.

Mr. Black has asked for your comments on his planned action. What advice can you give him? What needs to be done at Fortune Bike Inc. to deal with the competitor?

Requirements:

a) Managers and stockholders are always concerned about the net income. What is net income? Why is net income so important?

b) Identify other alternatives to increase Fortune Bike's 2002 and future net income.

c) Evaluate Fortune Bike's cash position. Is the company likely to face any cash flow problem? Which answers to requirement (c) also increase Fortune Bike's cash?

d) Identify additional ways to increase cash and their effects on net income.

Instructions:

1. The assignment should be at least 1,500 or above words in length, hence or otherwise, marks will be deducted accordingly.