Company Financial Analysis the First

Company Financial Analysis The first step in analyzing Harnischfeger's performance in 1984 is to identify the key accounting policies. In the course of restructuring the company, several changes were made to the accounting policies. The first major accounting policy change was with respect to the treatment of the firm's debt load. The company restructured its debts through the two debenture issues. This had the effect of reducing the current portion of the debt.

In 1983, all of the debt was due on demand as a result of the company failing to meet its covenants. The new debentures allowed the firm to stretch its debt obligations out until 1994 and 2004. This has the effect of reducing current liabilities, improving the current ratio. The debt restructuring did, however, increase the interest expense recorded in 1984. Harnischfeger has also deferred a significant portion of its pension obligations. In 1983, accrued pension costs were $19 million. This ballooned to $57.6 million in 1984.

Most likely, this occurred as a result of the massive cuts to the company's workforce. The difference year over year was $38.513 million; $39.307 million is listed as a salaried pension assets reversion on the statement of cash flows. The company will need to pay this obligation at some point in the future. This qualifies as a red flag, since the obligation has only been deferred. Had it been paid in cash, it would have reduced the 1984 operating profit.

Pension expenses are typically recorded as Administrative expenses, so this deferral directly impacted the profit for the year. The impact was essentially dollar for dollar, meaning that net income was increased in the $38-39 million range as a result of this deferral. There was a change in the method of depreciation. The Statement of Cash Flows shows that this adds $11 million to the net income. This change therefore has the result of reducing net income.

It can reasonably be surmised that this change in depreciation method was necessary rather than voluntary. This can be deduced from the highly visible way in which this policy change was noted in the annual report, on the Income Statement and on the Statement of Cash Flows. There were other policy changes as well. For example, the company stretched its payables. Trade payables in 1983 were 6.6% of revenues; in 1984 payables were 9.45% of revenues. This increases the current liabilities and it increases the net income.

The impact of this change on net income is estimated to be $11.4 million. This represents a significant portion of the company's profit for 1984. It also signals financial distress. In particular, it raises a red flag because the company is supposed to be coming out of its restructuring woes. Indeed, the cash flow from operations is down for 1984, despite the stretching of payables. The $11.4 million of payables would completely wipe out all of the firm's $10 million in positive cash flow from operations.

Thus, this payment stretching was necessary to avert both a cash crunch and a glaring red mark on their cash flow statement. There were also changes to the company's collection policy. Receivables increased from 19.6% of revenues in 1983 to 21.8% of revenues in 1984. This change could indicate that the company is either less efficient with respect to their collection or that the credit quality of their customers has deteriorated.

Note that this could have occurred as the result of the company's shift in business direction -- slower receivables turn could be the standard in the lines they are now emphasizing. Another new policy for 1984 was that Harnischfeger began to record the full sales price of construction and mining equipment purchased from Kobe Steel and sold by H. These sales amounted to $28 million in 1984. Given that Construction Equipment sales were essentially flat, this change essentially masked as $28 million decline in this business.

Declines in this sector are an ongoing problem for Harnischfeger. The firm's move with Kobe may assist in improving their competitiveness but there is some question as to the value of maintaining a presence in this sector. The deal with Kobe also impacted the accounting of research and development expenses. The firm appears to have offloaded some of its R&D expense onto Kobe rather than recording it on their own books. It is difficult to quantify with external information the precise impact this had on the 1984 profit figures.

The company's profits were inflated $1.4 million by a previous unrecorded income tax benefit at Harnischfeger Credit. Were it not for this benefit, the Credit company would have lost $200,000 for the year. In the company's defense, they may not have had any flexibility with respect to this income tax. They may have been obligated by law to record it when it was discovered. Thus, although it has the impact of making an unprofitable subsidiary profitable, there may not have been any managerial flexibility on the matter.

Overall, these changes made a significant contribution to the company's profit for the year. The change to the depreciation method added $11 million to the firm's bottom line. The pension deferral was worth $38-39 million in expenses that have been put off until a future date. Stretching the payables did not affect the profit but did add $11.4 million to the company's operating cash flows for the year, which would otherwise have been negative. Thus, the impact of the accounting policy changes was in the range of $60 million.

The firm's operating results support his. While revenues increased, cash flow from operations was down in 1984, from $37 million to $10 million. 2. In the annual report, the company trumpeted its success on the basis of improved operating results. While is some divisions sales did improve, the overall operating results for the company did not. Operating activities contributed less cash flow to the firm than either of the two prior years, both of which saw steep losses.

While on the surface these myriad changes to accounting policy could rationally be explained as part of the firm's overall restructuring process, there are two other motivating factors that could have contributed to management making these changes. The first is the bonus for senior managers. In December 1984, the company instituted an incentive plan for its senior managers. It had scrapped its previous incentive plan in 1982 as a result of its financial strife. The note in the annual report regarding this plan is worded in a somewhat confusing manner.

The note alludes to the plan being in effect for fiscal 1985, but states that the table of executive compensation, Exhibit 2, reflects bonuses for fiscal 1984. This confusing wording could be for the purpose of obfuscating the amount of bonuses paid out to the company's executives in 1984.

Regardless of whether or not such bonuses are paid in 1984 or 1985, if indeed they are awarded on the basis of fiscal 1984 performance, then the executives would have had strong motivation to increase profits for the year to a level that would permit them to receive their bonus payments. Another potential reason for the accounting changes is that the firm intends to raise more capital. The company was able to raise sufficient capital in 1984 to restructure its debt and get it out of the financial jam it was in.

The annual report hints that the company is looking to add further financing 1985 and possible beyond. In order to achieve this, the company must have strong financials, in particular with respect to profits. Following a credit crunch, it is understandable that management may wish to place the firm in a position to acquire capital again. Likewise, the new capital that was acquired still has restrictive covenants placed on it. The company's restructuring efforts not only boosted profits but improved working capital, as a result of restructuring the debt.

The increase in payables damages the working capital position, but if the company has access to capital they will be able to rectify that problem quickly by paying down those payables quickly. The restructuring therefore improves the current ratio and the working capital situation. Improved financial performance was likely necessary for a variety of other reasons. The firm's business is likely dependent on long-term relationships with key customers. During the crisis, there was considerable cause to speculate about the very survival of the firm.

By showing profits and improved performance, management not only retains its key customers but places itself in a strong position to acquire more. Growing the business requires stability, and the profits shown in 1984 are a demonstration that the company has returned to stability. Lastly, there is also the matter of pride. The company has some new management, in particular new financial management. The restructuring and changing of policies to increase profits and working capital makes the new financial management team look good to the shareholders.

The matter of pride extends to the company as well. They are in their centennial year, and it would look bad for the company to show heavy losses during and appear to be on death's door during such a critical year. Investors, however, are likely to see through these changes. The company's turnaround is striking, but many of the changes are listed in the annual report, the depreciation change in particular.

The listing of that change on the statements was undoubtedly mandated by law, but the other changes were buried a little bit more. However, the investment community can reasonably determine that increasing payables is a sign of the company remaining in a precarious position, as is the deferral of pension obligations. 3. The company's future prospects are reasonable. They have a strong customer base and for the most part the restructuring effort was successful.

The acquisition of new capital may have served a useful short-term purpose on the balance sheet, but it also allows Harnischfeger greater financial flexibility. The company's immediate future is no longer in doubt.