Ratio analysis is a method used to analyze the financial reports of a company and interpret trends in the company's performance. As a nonaccounting manager, you use numerous ratios to analyze your com

Case study 7.2: Carrington Printers – an accounting critique

Carrington Printers was a privately owned, 100-year-old printing company employing about 100 people and operating out of its own premises in a medium-sized town. Although the company was heavily indebted and had been operating with a small loss for the past three years, it had a fairly strong Balance Sheet and a good customer base spread over a wide geographical area. Carrington’s simplified Balance Sheet is shown in Table 7.13. Although the case study is several years old (the organization was real, but the name has been changed), the data has been presented in the format of current accounting standards.

Table 7.13 Carrington Printers’ Balance Sheet.

The nature of the printing industry at the time the financial statements were prepared was one of excess production capacity and over the previous year a price war had been fought between competitors in order to retain existing customers and win new business. The effect of this had been that selling prices (and consequently profit margins) had fallen throughout the industry. Carrington’s plant and equipment were, in the main, quite old and not suited to some of the work that it was winning. Consequently, some work was being produced inefficiently, with a detrimental impact on profit margins. Before the end of the year the sales director had left the company and had influenced many of Carrington’s customers, with whom he had established a good relationship, to move to his new employer. Over several months, Carrington’s sales began to drop significantly.

Lost sales and deteriorating margins affected cash flow. Printing companies at that time typically carried a large stock of paper in a range of weights, sizes, and colours, while customers often took more than 60 days to pay their accounts. Because payment of taxes and employees takes priority, suppliers are often the last group to be paid. The major suppliers of printers are paper merchants, who stop supply when their customers do not pay on time. The consequence of Carrington’s cash flow difficulties was that suppliers limited the supply of paper that Carrington needed to satisfy customer orders.

None of these events was reflected in the financial statements and the auditors, largely unaware of changing market conditions and the increased level of competition, had little understanding of the gradual detrimental impact on Carrington that had taken place at the time of the audit. Although aware of the cash flow tightening experienced by the company, the auditors signed the accounts, being satisfied that the business could be treated as a going concern.

As a result of the problems identified above, Carrington approached its bankers for additional loans. However, the bankers declined, believing that existing loans had reached the maximum percentage of the asset values against which they were prepared to lend. The company attempted a sale and leaseback of its land and buildings (through which a purchaser pays a market price for the property, with Carrington becoming a tenant on a long-term lease). However, investors interested in the property were not satisfied that Carrington was a viable tenant and the property was unable to be sold on that basis.

Cash flow pressures continued and the shareholders were approached to contribute additional capital. They were unable to do so and six months after the Balance Sheet was produced the company collapsed, and was placed into receivership and subsequently liquidation by its bankers.

The liquidators found, as is common in failed companies, that the values in the Balance Sheet were substantially higher than what the assets could be sold for. In particular:

• Land and buildings were sold for far less than an independent valuation had suggested, as the property would now be vacant.

• Plant and machinery were almost worthless given their age and condition and the excess capacity in the industry.

• Receivables were collected with substantial amounts being written off as bad debts. Customers often refuse to pay accounts giving spurious reasons and it is often not cost-effective for the liquidator to pursue a collection action through the courts.

• Inventory was discovered to be largely worthless. Substantial stocks of paper were found to have been held for long periods with little likelihood of ever being used and other printers were unwilling to pay more than a fraction of its cost.

As the bankers had security over most of Carrington’s assets, there were virtually no funds remaining after repaying bank loans to pay the unsecured creditors.

This case raises some important issues about the value of audited financial statements:

1. The importance of understanding the context of the business, that is how its market conditions and its mix of products or services are changing over time, the impact of key members of staff on business viability, and how well (or in this case badly) the business is able to adapt to these changes.

2. The preparation of financial statements assumes a going concern, but the circumstances facing a business can change quickly and the Balance Sheet can become a meaningless document.

3. The auditors rely on information from the directors about significant risks affecting the company. The directors did not intentionally deceive the auditors, but genuinely believed that the business could be turned around and become profitable by winning back customers. They also believed that the large inventory would satisfy future customer orders. The directors also genuinely believed that