Suggested questions for advance assignment to students 1.

What can historical income statement ( case exhibit 1 ) and balance sheets ( case exhibit 2 ) tell you abou the financial health and current condition of krispy kreme doughnuts, inc. ? 2. How can financial ratio extend your understanding of financial statement ? what questions do the time series of ratio in case exhibit 7 raise ? what question do the the ratios on peer firms case exhibit 8 and 9 raise? 3. Is krispy kreme financially healthy at year-end 2004 ? 4. In light of your answer to question 3, what acoounts for the firms recent share price decline ?

What is the source of intrinsic investment value in this company? Does this source appear on the financial statements ? Hypothetical teaching plan This case could be used for the opening class in a sequence of finance and accounting cases I a short executive-education program. Student are expected to have studied an introductory reading on financial statements. Accordingly,

Case analysis Preparation and exactness of financial statement The purpose and structure of a firms financial statement are well document In standart texts and will not be repated here. Novices studying this case, however, may benefit from a slow review of a specific accouts, the choices that managers can make in estimating them, and the possible degree of exactitude. The case present none of 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 repored result. Cash nad cash equivalent : ot is possible to derive a fairly exact estimate of cash. In contrast to some other ba;ance sheet accounts, the cash balance could change rdamatically from day to day because cash is fungible. Account receivables : as long as the accountant or analysist agrees that the product have been sold, estimating grodd receivables is relatively straightforward. The accounting for sales to affiliates, or franchises as a significant issues for krispy kreme. Uncertainty about sales and bad debts can produce an uncertain figure for ne receivables. Inventories : managerial choices about whether to use the first-in, first-out (FIFO) or last-in, firstout (LIFO) method of inventory valuatin and how to treat obsolescence, spoilage, shrinkage, and even outright fraud, of inventory values.

Property, plant and equipment : managers have chices 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 intagibles : the estimation of goodwill and other intangibles, such as the value assigned to recipes, trademarks, and trade names, is a matter of judgement. Reacquired franchises rights result from a companys acquisition of franchise markets from existing franchises, and there is considerable room for discretion in ho those assets are valued. Revenues : when do we recognize a sale as revenue ? this judgement call is a matter of choice, as indicated in the case, krispy kreme generates at least four major streams of income for which there are a number of potential revenues recognition choices. Expenses : underlying the expense estimates are numerous decisions that involve theallocation of costs across different products and across time The instructor can develop an even more detaiked list but, at the end of segment of thediscussion, may wih to ask student to speculate on the degree of variation in total asset or ernings that occurs as a result of estimation error and managerial discretion in acccounting policy. My experience in discussing this case with managers suggest possible variation from ted 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 concern about krispy kremes well-being : Growth : case exibhit 1, for instance, shows rapid growth in revenues and earnings over the past five company showed a net loss in the first quarter of 2005, and may consider whether that anticipates a trend. A quick eximination of case exhibit 2 shows huge asset growth over the past five years as well. The bulk of this growth, howevwe, has occurred in accounts receivabes from affiliates and from reacquired franchises rights, the very item that was the focus of the starting 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. case exhibit 3 also illustrates krispy kremes ambitious expansion strategy for companyowned and franchised factory stores. Du point analysis : the analytical ratios in case exhibit 7 reveal that returns on asset and equity declined between 2002 and 2004. A simple spreading of the DuPont system can help explain why. As exhibit TN1 shows, in 2002 the firms 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 firms leverage declined and asset turnover deteriorated, falling to less than half of what is was in 2000. In short, profit margin may be high in an absolute sense, but the reasons for declining asset turnover may warrant careful scrutiny.

Liquidity, leverage, and profitability : student can mine the ratios in case exhibit 7, 8, and 9 for additional clues about the companys financial health. The firms liquidity ratios are strong and continued to improve over the five-year period. The leverage ratiios show that the firm has been increasing its proportion of debt, but the balance sheet also indicates that the firms level of equity has been increasing as well. Times interested 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 besignificant issue. The instructor coud 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 warrant thoughtful consideration by students. The instructor should query the student 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 similiarity 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 suggest that kripsy kreme is significantly more liquid, turns its receivables and inventory more slowly, and has less financial leverage than its peers. Comparison kripy kremes results to the financial statement of some industry average, commonsize 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 kremes financial statement alone and comparison with its peers paints a picture of a company growing aggresively, 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.

INVESTORS REACTIONS TO THE NEWS The basic financial health of krispy kreme begs the questiom, why did the market react so negaively to the disclosures about adverse result and revelations in the wall street journal regarding the firms accounting methods for the franchise rights? this reaction is further reflected in case exhibit 4 and 5, which show a dramatic reappraisal of krispy kreme in analysist recommendations and earnings per share ( EPS) estimates. The quotations in the case that raise the specter of fundamental problems questions the sustainability of growth, and speculate that execution and cost discipline were seriously lacking also yield insight into the markets behavior : plainly, the disclosures affected the markets expectations of future performnce. If one thinks of stock prices as equal to the present value of future equity cash flows, the one can rationalize seemingly small adjusment to present earnings and rather large adjusment in stock price: what is actually being adjusted is the future, not present, cash flows.