Silver River Full Report

Financial Management

INTRODUCTION

Silver River Manufacturing Company (SRM) owned by Greg White is a large regional producer of farm and utility trailers, specialized live stock carriers and mobile home chassis. It depends on farmers for roughly 45 to 50 percent of its total sales. More than 85% of its sales come from the southeastern part of US. Several major boat companies in Florida work closely with SRM in designing trailers for their new offerings. The products manufactured by SRM are not subject to technological obsolesces or to deterioration and in those instances where technology is to be considered, SRM holds several patents with which it can partially offset some of the risk.

In the decade prior to 2003, SRM had experienced high and relatively steady growth in sales, assets and profits. Toward the end of 2003, the demand for new field trailers in the citrus and vegetable industries started to fall off. The recession that had been plaguing the nation’s farm economy and disastrous freezes for two straight winters resulted in high curtailment of demand for grove retailer and citrus transport carriers; SRM was not immune to this. Though SRM had shown high and steady growth in sales, assets and profits prior to 2003, however, towards the end of 2003 the demand for new field trailers in citrus and vegetable industries started for fall off. In order to sustain profits and superior market performance Mr. White aggressively reduced prices to stimulate further sales. He had full confidence that national economic policies would revive the ailing farm sector so; the downturn in demand would be short-term. Consequently, production continued unabated and inventories started increasing. Mr. White’s next step was to relax credit terms and standard to maintain preciously high growth and to reduce the ever expanding inventory. This effort of Mr. White increased sales through the third quarter of 2005, but inventories also increased steadily and particularly short-term credits and accounts receivable grew up dramatically.

Hence, to finance these increase in assets, SRM turned to Marion Country National Bank, (MCNB) for long term loan in 2004 and increase in its short term credit loan in both 2004 and 2005. MCNB had been a major banker of SRM for a long time. In the start, Lesa Nix, the vice-president of MCNB, had handled the case of SRM. Later, she got promoted and was no longer responsible for handling SRM’s account. However, as Mr. White was a close friend, she still took keen interest on SRM. Even this was insufficient to cover the aggressive expansion on the asset side. Consequently, Greg White who always made prompt payments, started to delay payments. This resulted substantial increase in accounts payable and other short term loans.

Upon analyzing SRM’s financial conditions, Lesa Nix found that the bank’s computer analysis system revealed a number of significant adverse trends and highlighted several potentially serious problems. Its 2005 current, quick and debt ratios failed to meet the contractual limits of 2, 1.0 and 55percent respectively. Technically, the bank had a legal right to call for immediate repayment of both long and short-term loans, and, if they were not repaid within ten days, could force the company into bankruptcy.

Despite such adverse conditions Nix considered the company to have good long run prospects, assuming, of course that management reacted immediately and appropriately to the current situation. Hence, Nix looked upon the threat of accelerating the loan repayment primarily as a means to get Greg White’s undivided attention and to force him to think about corrective actions that must be taken at once to reverse the deterioration and to correct SRM’s

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near-term problems. Even though she hoped to avoid calling the loans if at all possible because that action would back SRM into a corner from which it might not be able to emerge intact, Nix realized that the bank’s examiners, due to the recent spate of bank failures, were very sensitive to the issue of problem loans. SRM’s Altman Z factor (2.88) for 2005 was below 2.99 which indicated that SRM was likely to get bankrupt in two years. Because of this deficiency, MCNB was under increased pressure from the regulators to reclassify SRM’s loan as ‘problem category’ and take whatever steps needed to collect the money due and reduce the bank’s exposure as quickly as practicable. In order to avoid reclassification, SRM required strong and convincing evidence to prove that its problems were temporary in nature and it had good chance of reversing the trend.

The current financial problems were not the only problem Mr. White faced. He had recently signed a contract for a plant expansion that would require another $6375000 of the capital during the first quarter of 2006. He had planned to obtain this money by a short term loan from MCNB to be repaid from the profit generated in the first quarter of 2006. He believed that new facilities would enhance the production capabilities in a very lucrative area of custom horse van.

According to Mr. White’s analysis, the financial position of the company could improve significantly over the next two years if the bank maintained or even extended the credit lines. Once the new facility is added, the company would be able to increase output in rapidly growing segments of market (horse van and home chain) and also reduce the dependency on farm and light utility sales to 35% or less. He also projected that the sales growth would be 6% and 9.5% in an average for 2006 and 2007 respectively, assuming there is no significant improvement in either national or farm economy. He also assumed that SRM would change its policy of aggressive marketing and sales promotion and return to full margin prices, standard industry credit term and tighter credit standards. These changes would reduce cost of goods sold to 82.5% in 2006 and 80% in 2007. Similarly administrative and selling expenses are likely to decrease from 9% to 8% in 2006 and 7.5% in 2007. Also, the miscellaneous expense would reduce to 1.75% and 1.25% of sales in 2006 and 2007 respectively.

Regarding the financial data provided in the case and the projected income statement and balance sheet, we have to analyze whether SRM is eligible to obtain the bank loan. Now, the question is whether the bank should extend the existing short and long-term loans or should rather demand immediate repayment of both existing loans. Also we have to propose alternatives available to SRM if the bank were to decide to withdraw the entire line of credit and to demand immediate repayment of the two existing loans.

In support of the answers provided to the questions, we have included the key financial statements and financial ratios of SRM.

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Question 1

(a) Prepare a statement of changes in financial position for 2005 (sources and uses of funds statement) or complete Table 6.

Solution:

Table 6: Silver River Manufacturing Company Statement of Changes in Financial Position Year Ended December 31st(thousands of dollars) Particulars 2004 2005 Sources of funds Net income after taxes 6,351.70 755.02 Depreciation 1,657.50 2040 Funds from operation 8,009.20 2795.02 Long term loan 3,187.50 0 Net decrease in working capital 428.26 Total sources 11,196.70 3223.26 Application of funds

Mortgage change

267.75 261.38 Fixed assets change 2,339.62 2773.13 Dividends on stock 1,587.93 188.76 Net increase in working capital 7,001.40 0 Total uses 11,196.70 3223.27 Analysis of changes in working capital Increase (decrease) in current assets Cash change -1,145.83 -9671 AR change 1,364.25 10894.86 INV change 14,095.12 13629.75 CA change 14,313.54 24427.9

Increase(decrease) in current liabilities AP change 3,742.13 9492.38 NP change 1,912.50 13132.5 ACC change 1,657.50 2231.28

CL change 7,312.13 24856.16 Net increase(decrease) in working capital 7,001.41 -428.26

The table shows the sources and uses of fund of Silver Manufacturing Company. The major sources of fund are net income after tax, depreciation, long term loan and net decrease in working capital. The major applications of fund are changes in fixed assets, mortgages, dividend on stock and net increase in working capital.

As long as there are more short term assets than liabilities, the firm is said to be in a relatively liquid position. From the analysis of change in working capital, the company is in a relatively liquid position in 2004 but the current assets are less than current liabilities in the year 2005 showing that it is not relatively liquid. Hence the company cannot pay off all of its short term obligations without having to liquidate any long term assets in 2005.

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Particulars 20042005

(Calculated)Difference

Sources of fundsNet income after taxes 6,351.70 755.02 Given

Depreciation 1,657.50 2040 Given

Funds from operation 8,009.20 2795.02 755.02+2040

Long term loan 3,187.50 0 9562.50-9562.50Net decrease in working capital 428.26

CA change –CL change

Total sources 11,196.70 3223.26 2795.02+428.26

Application of fundsMortgage change 267.75 261.38 2601-2339.62

Fixed assets change 2,339.62 2773.13 20100.37-22873.5

Dividends on stock 1,587.93 188.76 GivenNet increase in working capital 7,001.40 0

Total uses 11,196.70 3223.27261.38+2773.13+1

88.76Analysis of changes in working capitalIncrease (decrease) in current assetsCash change -1,145.83 -96.71 3905.77-4002.48

AR change 1,364.25 10894.86 29356.86-18462.00

INV change 14,095.12 13629.75 46658.62-33028.87

CA change 14,313.54 24427.9

-96.71+10894.86+1

3629.75

Increase(decrease) in current liabilitiesAP change 3,742.13 9492.38 19998.39-10506.01

NP change 1,912.50 13132.5 18232.50-5100.00

ACC change 1,657.50 2231.28 7331.28-5100

CL change 7,312.13 24856.16 45562.17-20706.01

Net increase(decrease) in working capital 7,001.41 -428.26

CA change – CL change

24427.9 - 24856.16

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Table 7: Silver River Manufacturing CompanyRatio Analysis Year Ended December 31

Particulars 2003 2004 2005Industry Average

Liquidity ratios

Current ratio 3.07 2.68 1.75 2.50

Quick ratio 1.66 1.08 0.73 1.00

Leverage ratios

Debt ratio(%) 40.46 46.33 59.796 50.00

Times interest earned 15.89 7.97 1.49 7.70

Asset management ratios

Inventory turnover(cost) 7.14 4.55 3.57 5.70

Inventory turnover(selling) 9.03 5.59 4.19 7.00

Fixed assets turnover 11.58 11.95 12.097 12.00

Total asset turnover 3.06 2.60 2.04 3.00

Average collection period 36.00 35.99 53.99 32.00

Profitability ratios

Profit margin(%) 5.50 3.44 0.386 2.90

Gross profit margin(%) 20.89 18.70 14.86 18.00

Return on total assets 16.83 8.95 0.786 8.80

Return on owner's equity 28.26 16.68 1.95 17.50

Potential failure indicator

Altman Z factor 6.69 4.75 2.88 1.89/2.99

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Notes:

a) Uses cost of goods sold as the numerator.

b) Uses net sales as the numerator.

c) The Altman Z factor range of 1.81-2.99 represents the so-called “zone of ignorance".

d) Year-end balance sheet values were used throughout in the computation of rations embodying balance sheet items

e) Assume constant industry-average ratios throughout the period 2003-2007.

(b) Calculate SRM’s key financial ratios for 2005 and compare them with those of 2003, 2004, industry average, and contract requirement or complete Table 7.

Solution:

Liquidity Ratios:

Current Ratio

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The Current ratio has decreased in 2005 as compared to 2003, 2004 and industry average. The company’s ability to fulfill short term obligations with current assets has decreased.

Quick Ratio

The quick ratio is also showing declining trend. The Company is showing less liquidity in 2005 as the ratio is less than that of the years 2003, 2004 and industry average.

Leverage Ratios:

Debt Ratio

7

Quick Ratio

00.20.40.60.8

11.21.41.61.8

2003 2004 2005

Years

Rat

io Quick Ratio

Industry Average

Debt Ratio

0

10

20

30

40

50

60

70

2003 2004 2005

Years

Rat

io Debt Ratio

Industry Average


The debt ratio of the company is in increasing trend showing that it is becoming riskier. The company has been able to finance about more than half of its assets by borrowing in 2005. In 2005, its debt ratio surpassed the industry average by 9.796%.

Times Interest Earned Ratio

It is better to have a higher times interest earned ratio. The industry average is 7.70. The ratio is more in the years 2003 and 2004 as compared to 2005. The ratio has drastically gone down to 1.49 in 2005 and is less than the industry average showing its inability to cover the necessary interest expenses.

8

02468

1012141618

2003 2004 2005

Rat

io

Years

Times Interest Earned


Industry Average


Asset Management Ratios:

Inventory Turnover Ratio (Cost)

Inventory Turnover Ratio (Selling)

The company has not been efficient in managing its inventories in 2005 with respect to 2003 and 2004 as the inventory turnover ratio is less in the year. In both cases, when inventory turnover ratio is calculated based on cost of goods sold and net sales, the ratio is less than the industry average in 2005.

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Inventory Turnover

0

1

2

3

4

5

6

7

8

2003 2004 2005

Years

Rat

io Inventory Turnover

Industry Average

Inventory Turnover

0

2

4

6

8

10

2003 2004 2005

Years

Rat

io Inventory Turnover

Industry Average


Fixed Asset Turnover Ratio

The fixed asset turnover ratio is greater than the industry average in 2005. The ratio in 2005 is also higher than the ratios in 2003 and 2004. The number of times the fixed assets are turned over 2005 is higher.

Total Assets Turnover Ratio

The number of times the total assets have turned over has decreased from 2003. The ratio has slightly declined from 2004 and is less than the industry average.

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Total Asset Turnover

0

0.5

1

1.5

2

2.5

3

3.5

2003 2004 2005

Years

Rat

io Total Asset Turnover

Industry Average

Fixed Asset Turnover

11.311.411.511.611.711.811.9

1212.112.2

2003 2004 2005

Years

Rat

io Fixed Asset Turnover

Industry Average


Average Collection Period

The number of days tied up in accounts receivables has increased in 2005. The collection period is less in 2003 and 2004. Also, the industry average is lower. The company is not able to appraise accounts receivables in a timely manner.

Profitability Ratios

Net Profit Margin

The profit margin is expected to be higher for the company to earn profit. However, the company is facing constant decrease in profit margin since the percentage is less in 2005 than in 2003 and 2004. The industry average is also more than the margin obtained in 2005.

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Profit Margin

0

1

2

3

4

5

6

2003 2004 2005

Years

Rat

io Profit Margin

Industry Average


0

10

20

30

40

50

60

2003 2004 2005

Years

Rat

io

Average CollectionPeriod

Industry Average


Gross Profit Margin

The company’s gross profit has decreased 2005 as compared to 2003 and 2004. The gross profit margin of 2005 is also less than the industry average which shows the less proportion of sales revenues going towards paying for cost of goods sold.

Return on Total Assets

The Return on total assets shows the return on total assets after interest and taxes. The operating management is inefficient in 2005 as the return is less as compared to the returns in the year 2003 and 2004. Also this return is less than the required industry average.

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Return On Total Assets

02468

1012141618

2003 2004 2005

Years

Rat

io Return On Total Asset

Industry Average

Gross Profit Margin

0

5

10

15

20

25

2003 2004 2005

Years

Rat

io Gross Profit Margin

Industry Average


Return on Owners’ Equity

The efficiency of the company with respect to its operating and financing decisions is based on the return on owners’ equity. The company is also inefficient in this regard as the return is lower than the returns in 2003 and 2004 as well as the industry average.

Potential Failure Indicator

Altman Z factor

The Altman Z factor indicates that the company falls in the gray zone which shows that there is no possibility of predicting whether the firm will or will not fail. The firm is in less safe zone as compared to the Altman Z factor given in 2003 and 2004.

Comparison of SRM’s 2005 ratios with the contractual requirements

The 2005 current, quick and debt ratios are below the contractual limits. From the calculation of the ratios above, the company is facing serious problems. All the ratios show negative trend apart from the fixed asset turnover ratio. The liquidity ratios are decreasing showing that the company is not able to meet its short term obligations with its current assets. The company is facing higher risks as the company is has financed its assets with higher borrowed funds. All the asset management ratios apart from fixed asset turnover ratios are decreasing. This shows the firm is not effectively utilizing its assets to generate sales. Profitability ratios are used as overall measures of the efficiency and effectiveness of a firm’s management. The company is facing decreased profitability ratios over the years. Also the Altman z factor shows that the company has moved from non failure zone to gray zone.

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Particulars Contractual requirement SRM 2005

Current Ratio 2.0% 1.75%

Quick Ratio 1.0% 0.73%

Debt Ratio 55% 59.796%

Return On Owners' Equity

0

5

10

15

20

25

30

2003 2004 2005

Years

Rat

io

Return On Owners'Equity

Industry Average


Working notes of Table 7

Particulars Formula Computation

Current ratioCurrent assets / current liabilities 79,921.26 / 45,462.17 1.75

Quick ratio

(Current assets - inventories) / Current liabilities

(79,921.26 - 46,658.62) / 45,562.17 0.73

Debt ratioTotal debt / Total asset 57,464.29 / 96,101.01 59.796

Times interest earned EBIT / Interest 4,443.25 / 2,991.4 1.49

Inventory turnover(cost) COGS / Inventory 166,642.58 / 46,658.62 3.57

Inventory turnover(selling) Sales / Inventory 195,731.63 / 46,658.62 4.19

Fixed assets turnover Sales / Fixed asset 195,731.63 / 16,179.75 12.097

Total asset turnover Sales / Total asset 195,731.63 / 96,101.01 2.04

Average collection periodReceivables / Sales per day

29,356.86 / (195,731.63 / 360) 53.99

Profit margin (%)(Net income / Sales) * 100 (755.02 / 195,731.63)*100 0.386

Gross profit margin (%)(Gross profit / Sales) * 100

(29,089.05 / 195,731.63)*100 14.86

Return on total assets(Net income / Total asset) * 100 (755.02 / 96,101.01)*100 0.786

Return on owner's equity(Net income / Total equity) * 100 (755.02 / 38,636.72)*100 1.95

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Question 2.Based on the case data and the results of your analysis in Question 1, what are the SRM’s strengths and weaknesses? What are the causes thereof? (Use of the DU Pont system and Altman Z factor would facilitate analysis and strengthen your answer.)

Solution:

DU Pont System:

Particulars Return on Equity (ROE)

= Net Profit margin

× Asset Turnover × Equity Multiplier

= Net IncomeSales

× Sales______ Total Assets

× AssetEquity

2003 28.26 = 5.50 × 3.06 × 1.682004 16.68 = 3.44 × 2.66 × 1.862005 1.95 = 0.39 × 2.04 × 2.49Industry Average

17.50 = 2.90 × 3.00 × 2.00

DU Pont System:Du Pont system decomposes ROE into its component parts. This decomposition helps us to find out exactly where the strengths and weaknesses lie. Management can use this system to analyze ways of improving the firm’s performance.

If ROE goes up due to an increase in net profit margin or asset turnover, it is beneficial for the company because it shows the operating efficiency and asset use efficiency. But if the equity multiplier is the source, it means that company is taking excessive debt and making it very risky.

Altman Z factorThe Z-Score Bankruptcy-Predictor combines several of the most significant variables in a statistically derived combination.

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

Where,X1 = working capital / total assets (working capital is current assets less current liabilities)X2 = retained earnings / total assetsX3 = earnings before interest and taxes / total assetsX4 = market value of equity / book value of total debt (market value of equity includes both preferred and common shares, and debt includes current and long-term liabilities)X5 = sales / total assets

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

We have, for the year 2005, Working capital = Current assets – Current liabilities

= $ (79921.26 – 45562.17) = $ 34359.09Total Assets = $ 96101.01

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Retained Earnings = $ 15367.72EBIT = $ 4443.25Market value of equity = $ 3500.54Book value of debt (Total Liability) = $ 57464.29Sales = $ 195731.63

Altman Z factor = 1.2×Working capital + 1.4×Retained earnings + 3.3×EBIT Total Assets Total Assets Total Assets

+ 0.6×Market value of equity + 0.999×Sales Book Value of debt Total Assets

= 1.2 × 34359.09 + 1.4 × 15367.72 + 3.3 × 4443.25 + 96101.01 96101.01 96101.01 0. 6 × 3500.54 + 0.999 × 195731.63

57464.29 96101.01= 1.2 × 0.357531 + 1.4 × 0.159912 + 3.3 × 0.046235 + 0.6 × 0.060917 + 0.999 × 2.036728= 2.88

SRM’s Altman Z Score = 2.88Industry Average = 1.81 - 2.99

The Interpretation of Altman Z-Score:

Altman provides multivariate analysis of bankruptcy utilizing financial ratios. It allows combining several financial ratios into a single predictive equation.

Z score below 1.8: High probability of failure

Z score above 3.0: High probability of non failure

Z score between 1.8 and 3.00: hard to predict with confidence whether the firm will or will not fail. This range is also known as gray zone

Strengths

1. Favorable fixed asset turnover ratio: The fixed asset turnover ratio is increasing in 2005. The number of times that SRM has been able to turn its fixed assets is high. This shows that the fixed assets are used effectively.

2. Altman Z score: SRM’s Altman Z score is compatible with the industry average (i.e. 2.88 against the industry average of 1.81/2.99). Even though, the factor is compatible with the industry average, it is not a good sign for the company. The company falls under gray zone and needs to be more careful about going bankrupt.

Weaknesses

1. Declining profitability ratios: All the profitability ratios are in declining trend in 2005. The net profit margin has drastically reduced from 2003 to 2005 and is less than the industry average in 2005. From Du Pont analysis, it can be seen that the net profit margin is below the industry average of 2.90 reflecting the operating inefficiency.

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2. Inefficiency in major asset management ratios: The major asset management ratios are showing declining trend from 2003 to 2005. The Du Pont analysis also shows that the asset turnover ratio has decreased from 3.06 in 2003 to 2.04 in 2005. The industry average is 3. The assets have not been efficiently utilized to generate sales.

3. Deteriorating financial leverage: The Company has financed about more than half of its assets by borrowing as can be seen from the debt ratio in 2005. The Du Pont analysis also show that the equity multiplier is higher in 2005 as compared to 2003, 2004 and industry average. This reflects that SRM is using more debt to finance its assets than its competitors. This indicates that the company has high chances of being bankrupt.

4. Liquidity position: The Company is not in a relatively liquid position. The company has fewer current assets than the current liabilities thereby showing negative net working capital. The current ratio and quick ratio also reflect the less liquid position of SRM.

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Question 3.If the bank were to maintain the present credit lines and grant an additional $6,375,000 short-term loan at a 16 percent rate of interest effective from January 1, 2006, would the company be able to retire all short-term loans existing on December 31, 2006? (Assume that all of White’s plans and predictions concerning sales and expenses materialize. In these calculations cash is the residual balancing figure, and SRM’s tax rate is 48%. Assume that SRM pays no cash dividends during the year.) Complete tables 9 and 10 included as worksheets to facilitate analysis.

Solution: Table 9: Silver River Manufacturing Company

Pro Forma Income Statements (Projected)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Projected 2007 ProjectedNet sales 1,95,731.63 207475.5278 227185.7029Cost of goods sold 1,66,642.58 171167.3104 181748.5624 Gross profit 29,089.05 36308.21737 45437.14059Administrative and selling 16,880.96 16598.04222 17038.92772Depreciation 2,040.00 2,422.50 1,823.00Miscellaneous expenses 5,724.72 3630.821737 2839.821287 Total operating expenses 24,645.68 22651.36396 21701.74901 EBIT 4,443.25 13656.8534 23735.39158Interest on short-term loans 1,823.25 3,937.20 3,937.20Interest on long-term loans 956.25 956.25 956.25Interest on mortgage 211.90 190.54 171.52 Net income before tax 1,451.94 8,572.86 18,670.42Taxes 696.94 4114.974434 8961.802359 Net income 755.02 4,457.89 9,708.62Dividends on stock 188.76 0 0Additions to retained earnings 566.27 4,457.89 9,708.62

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Table 10: Silver River Manufacturing Company

Pro Forma Balance sheets (Projected)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Projected 2007 ProjectedAssets Cash 3,905.77 36,450.24 45,451.62Accounts receivable 29,356.86 18,442.27 20,194.28Inventory 46,658.62 29,639.36 32,455.10 Current assets 79,921.26 84,531.87 98,101.00Land, buildings, plant, and equipment 22,873.50 29,248.50 30,125.96Accumulated Depreciation -6,693.75 -9,116.25 -10,939.20 Net fixed assets 16,179.75 20,132.25 19,186.76Total assets 96,101.01 1,04,664.12 1,17,287.76Liabilities and equities Short-term bank loans 18,232.50 24,607.50 24,607.50Accounts payable 19,998.39 15,994.88 16,794.62Accruals 7,331.28 9,301.13 11,626.41 Current liabilities 45,562.17 49,903.51 53,028.53Long-term bank loans 9,562.50 9,562.50 9,562.50Mortgage 2,339.62 2,103.75 1,893.75 Long-term debt 11,902.12 11,666.25 11,456.25 Total liabilities 57,464.29 61,569.76 64,484.78Common stock 23,269.00 23,268.75 23,268.75Retained earnings 15,367.72 19,825.610 29,534.23 Owners' equity 38,636.72 43,094.36 52,802.98Total capital 96,101.01 1,04,664.12 1,17,287.76

Working notes of Table 9:

Particulars 2006 2007

Projected sales 195,731.63 * 1.06 2,07,475.52207475.52 * 1.095 2,27,185.70

Cost of goods sold82.5% of 207,475.52 1,71,167.31

80% of 227,185.7 1,81,748.56

Administrative and selling expenses 8% of 207,475.52 16,598.04

7.5% of 227,185.7 17,038.93

Miscellaneous expenses1.75% of 207,475.52 3,630.82

1.25% of 227,185.7 2,839.82

Taxes 48% of 8,572.87 4,114.9748% of 18,670.42 8,961.80

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Working of Table 10:

1. Retained Earnings

For 2006: Retained earnings (2005) + Additions in 2006 i.e. 15,367.72 + 4,457.89 = 19,825.61

For 2007: Retained earnings (2006) + Additions in 2007 i.e. 19,825.61 + 9,708.62 = 29,534.23

2. Accounts Receivables

For 2006: Average collection period = Receivables / Sales per dayi.e. 32 = Receivables / (207,475.53 / 360)Therefore, receivables = 18,442.27


3. Inventory

For 2006: Inventory turnover = Sales / Inventoryi.e. 7 = 207,475.53 / Inventory

Therefore, inventory = 29,639.36



Notes:1. Cash is the balancing figure.2. Accounts receivables and inventory has been calculated by using the industry average

ratios.

In 2006, the company has total cash balance of 36,450.24 thousands and during the same year the short-term bank loan to be retired is 24607.50. = $(36450240 – 24607500)= $11842740

The company should maintain cash balance of 5% of sales. Minimum cash balance = $ (207475527 * 0.05)

= $ 10373776.35From the calculation we can see that the company is able to maintain the minimum cash balance. Hence, it has enough cash balance to retire the short-term bank loans.

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Question 4.Compute projected financial ratios for 2006 and 2007 (or complete Table 11). Compare these ratios with 2005 along with industry averages and analyze improvement or deterioration in financial condition.

Solution:Table 11: Silver River Manufacturing Company

Ratio Analysis Year Ended December 31, 2007 (Projected)

Particulars 20052006

Projected2007

ProjectedIndustry average

Liquidity ratios Current ratio 1.754 1.69 1.85 2.50Quick ratio 0.73 1.10 1.24 1.00 Leverage ratios Debt ratio (%) 59.79 58.83 54.98 50.00Times interest earned 1.48 2.69 4.69 7.70 Asset management ratios Inventory turnover (Cost)* 3.57 5.77 5.60 5.70Inventory turnover (Selling)* 4.19 7.00 7.00 7.00Fixed asset turnover 12.09 10.30 11.84 12.00Total asset turnover 2.04 1.98 1.94 3.00Average collection period 53.99 32.00 32.00 32.00 Profitability ratios Profit margin (%) 0.39 2.15 4.27 2.90Gross profit margin (%) 14.86 17.50 20.00 18.00Return on total assets 0.79 4.26 8.28 8.80Return on owners' equity 1.95 10.34 18.39 17.50

Working notes of Table 11:

Particulars Formula 2006 2007

Current ratioCurrent assets / current liabilities 84,531.87 / 49,903.51 1.69

98,101 / 53,028.53 1.85

Quick ratio


(84,531.87 - 29,639.36) / 49,903.51 1.1

(98,101 - 32,455.10) / 53,028.53 1.24

Debt ratioTotal debt / Total asset 61,569.76 / 104,664.12

58.83

64,484.78 / 117,287.76 54.98

Times interest earned EBIT / Interest 13,656.86 / 5,083.99 2.69

23,735.39 / 5,064.97 4.69

Inventory turnover(cost) COGS / Inventory 171,167.31 / 29,639.36 5.77

181,748.56 / 32,455.10 5.6

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Inventory turnover(selling) Sales / Inventory 207,475.53 / 29,639.36 7

227,185.70 / 32,455.10 7

Fixed assets turnover Sales / Fixed asset 207475.53 / 20,132.25 10.3

227,185.70 / 19,186.76 11.84

Total asset turnover Sales / Total asset 207475.53 / 104,664.12 1.98

227,185.70 / 117,287.76 1.94

Average collection period

Receivables / Sales per day

18,442.27 / (207,475.53 / 360) 32

20,194.28 / (227,185.70 / 360) 32

Profit margin (%)(Net income / Sales) * 100

(4,457.89 / 207,475.53)*100 2.15

(9,708.62 / 227,185.70)*100 4.27

Gross profit margin (%)

(Gross profit / Sales) * 100

(36,308.22 / 207,475.53)*100 17.5

(45,437.14 / 227,185.70)*100 20

Return on total assets

(Net income / Total asset) * 100

(4,457.89 / 104,664.12)*100 4.26

(9,708.62 / 227,185.70)*100 8.28

Return on owner's equity

(Net income / Total equity) * 100

(4,457.89 / 43,094.36)*100

10.34

(9,708.62 / 52,802.98)*100 18.39

Notes: Figures for 2005 have been taken from table 7.

In 2006, the projected current ratio is lower than that of 2005 and Industry average. This shows that the firm’s ability to meet its short term obligations has decreased in the year 2006. In 2007, the projected current ratio is slightly higher than that of 2005 and lower than the industry average. This shows that the firm’s ability to meet short term obligations has improved but it is still poor in comparison to industry average.

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In 2006, the projected quick ratio is higher than that of 2005 and industry average. This shows that the ability of firm to meet short term obligations has improved. In 2007, the projected quick ratio is much higher than that of 2005 and industry average. This shows that the firm has substantially improved its ability to meet the short term obligations.

In 2006, the projected debt ratio is lower than that of 2005 and much higher than the industry average. This shows that the company has decreased its assets financing from debts but it is much higher in comparison to industry average. In 2007, the projected debt ratio has decreased than that of 2005 and higher than the industrial average. The improved debt ratio indicates that the company has lowered its risk level.

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It is better to have a higher times interest earned ratio. The industry average is 7.70. In 2006 the ratio has increased than 2005 and is significantly lower than the industry average. This shows that the company is still unable to cover the necessary interest expenses. In 2007, the ratio has gone up but is still below the industrial average showing improvement in ability of the company to cover the necessary interest expenses.

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0

5

10

15

20

25

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average


Higher inventory turnover ratio indicates efficient management of inventories. In 2006, there has been increase in inventory turnover ratio (in costs) in comparison to 2005 and is also above the industry average. In 2007, this ratio is higher than that of 2005 but is below the industry average showing deterioration in the company’s capacity in efficiently managing the inventory. If we evaluate the inventory turnover in terms of sales we see in both the years 2006 and 2007 there have been significant improvement in inventory turnover in comparison to the year 2005 and both the years have inventory turnover equal to that of industry average. However, a better measure of inventory turnover is inventory turnover in terms of cost rather than in terms of sales.

Fixed Assets Turnover

9

10

11

12

13

2005 2006 2007

Years

Rati

o

Projected

Revised

Industry Average

Fixed assets turnover ratio shows how efficiently the firm is utilizing fixed assets to generate the largest possible level of sales revenues. The utilization of fixed assets seems to be less efficient in the year 2006, in comparison to that of the year 2005 and industry average. However, there is some progress in utilization of fixed assets in the year 2007 but it is still below in comparison to 2005 and industry average. This shows the deterioration in the capacity of the company to efficiently utilize fixed assets to generate revenue.

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Total assets turnover shows how efficiently the overall assets of the company are utilized to generate sales revenues. The total assets turnover ratios in the year 2006 and 2007 are lower in comparison to the year 2005 and industry average. This ratio in the year 2005, 2006 and 2007 shows the decreasing trend. The company has not been able to match this ratio with industrial average in all three years i.e. in all these cases the ratio is below the industry average. Thus, the capacity of the company to utilize its overall assets efficiently is in decreasing trend.

Average collection period (ACP) shows the number of days’ sales that are tied up in the receivables. Lower ACP frees up funds, which can be invested somewhere else and earn some return. In both the year 2006 and 2007 ACP is equal to industry average. The firm is projected to have significant improvement in ACP in comparison to the year 2005. The decreased ACP has improved the financial condition.

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0

10

20

30

40

50

60

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average

Total Asset Turnover

0

0.5

1

1.5

2

2.5

3

3.5

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average


Profit margin ratio measures the overall efficiency and effectiveness of the company’s management. It shows how much a company is able to earn of each sales after paying all the necessary expenses. In 2006, the projected profit margin has improved in comparison to the year 2005 but is still below the industry average. However, in the year 2007 the projected profit margin has improved significantly and is higher than industry average. This shows that there will be considerable improvement in financial condition of the company in the year 2007.

Gross profit margin shows the proportion of firm’s sales revenue going toward paying for cost of goods sold. In the year 2006 and 2007 the projected gross profit margin has increased in comparison to the year 2005. In the year 2006 it is below industry average but in 2007 it is above industry average showing the improvement in financial condition

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Profit Margin

0

1

2

3

4

5

6

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average

Gross Profit Margin

0

5

10

15

20

25

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average


Return of total assets (ROA) measures the return on total assets after interest and taxes. It is important for assessing the effectiveness of the operating management of the firm. This ratio has increased in the year 2006 and 2007 in comparison to the year 2005 but is still below the industry average showing the necessity for the company to bring improvement in the operating management.

Return on owner’s equity helps to assess the effectiveness of the management with respect to both its operating and financial decisions. In the year 2006, there has been great improvement in ROE in comparison to the year 2005 but is still below the industry average. However, in 2007 it is above the industry average showing the improvement in both operating and financial decisions of the company.

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Return On Total Asset

0

2

4

6

8

10

12

14

2005 2006 2007

Years

Rat

io

Projected

Revised

Industry Average


Question 5.If all short-term bank loans are repaid towards the end of the first half of 2006, do you think that company is still able to pay regular dividends and maintain minimum cash balance? Revise the tables 9, 10, 11 (or complete the tables 12, 13 and 14). Do you find any situations developing that may indicate poor financial policy? What should be the impact of such situations on the ratios for the company, and are such impacts necessarily either good or bad? Why?

Solution:Note: The figures for the revised data are shown in question no 4.


Pro Forma Income Statements (Revised)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Revised 2007 RevisedNet Sales 1,95,731.63 2,07,475.52 2,27,185.70Cost of Goods Sold 1,66,642.58 1,71,167.30 1,81,748.56 Gross Profit 29,089.05 36,308.22 45437.13Administrative and Selling 16,880.96 16,598.00 17,038.90Depreciation 2,040.00 2,422.50 1,823.00Miscellaneous expenses 5,724.72 3,631.00 2,840.00 Total operating expenses 24,645.68 22,651.50 21,702.00 EBIT 4,443.25 13,656.71 23,735.13Interest on short-term loans 1,823.25 1,968.20 0Interest on long-term loans 956.25 956.25 956.25Interest on mortgage 211.90 190.54 171.52 Net income before tax 1,451.94 10,541.72 22,607.36Taxes 696.94 5,060.03 10,851.53 Net income 755.02 5,481.69 11,755.83Dividends on stock 188.76 1,370.42 2,938.96Additions to retained earnings 566.27 4,111.27 8,816.87


Pro Forma Balance Sheets (Revised)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Revised 2007 RevisedAssets Cash 3,905.77 11,495.86 19,605.72Accounts Receivable 29,356.86 18,442.27 20,194.28Inventory 46,658.62 29,639.36 32,455.10 Current Assets 79,921.26 59,577.49 72,255.10Land, Buildings, Plant and Equipment 22,873.50 29,248.50 30,125.96Accumulated Depreciation -6,693.75 -9,116.25 -10,939.20 Net Fixed Assets 16,179.75 20,132.25 19,186.76Total Assets 96,101.01 79,709.74 91,441.86Liabilities and Equities Short-term bank loans 18,232.50 0.00 0.00Account payable 19,998.39 15,994.88 16,794.62Accruals 7,331.28 9,301.13 11,626.41 Current liabilities 45,562.17 25,296.01 28,421.03

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Long-term bank loans 9,562.50 9,562.50 9,562.50Mortgage 2,339.62 2,103.75 1,893.75 Long-term debt 11,902.12 11,666.25 11,456.25 Total liabilities 57,464.29 36,962.00 39,877Common stock 23,269.00 23,268.75 23,269Retained earnings 15,367.72 19,478.99 28,295.86 Owners' equity 38,636.72 42,747.74 51,564.86Total Capital 96,101.01 79,709.74 91,441.86


Ratio Analysis Year Ended December 31 (Revised)Particulars 2005 2006 Revised 2007 Revised Industry averageLiquidity Ratios Current ratio 1.75 2.36 2.54 2.5Quick Ratio 0.73 1.18 1.4 1 Leverage Ratios Debt ratio (%) 59.79 46.37 43.61 50Times interest earned 1.48 4.38 21.04 7.7 Asset Management Ratios Inventory turnover (Cost) 3.57 5.77 5.6 5.7Inventory turnover (Selling) 4.19 7 7 7Fixed asset turnover 12.09 10.3 11.84 12Total asset turnover 2.04 2.6 2.48 3Average collection period 53.99 32 32 32 Profitability Ratios Profit margin (%) 0.39 2.64 5.17 2.9Gross profit margin (%) 14.86 17.5 20 18Return on total assets 0.79 6.88 12.86 8.8Return on owners' equity 1.95 12.82 22.79 17.5

Working notes of Table 12Particulars 2006 2007

Projected sales 195,731.63 * 1.06 2,07,475.52 207475.52 * 1.095 2,27,185.70

Cost of goods sold82.5% of 207,475.52 1,71,167.31 80% of 227,185.7 1,81,748.56

Administrative and selling expenses 8% of 207,475.52 16,598.04 7.5% of 227,185.7 17,038.93

Miscellaneous expenses1.75% of 207,475.52 3,630.82 1.25% of 227,185.7 2,839.82

Taxes 48% of 10,541.72 5,060.03 48% of 22,607.36 10,851.53

Working notes of Table 13

1. Retained earningsFor 2006: Retained earnings (2005) + Additions in 2006

i.e., 15,367.72 + 4,111.27 = 19,478.99 For 2007: Retained earnings (2006) + Additions in 2007

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i.e., 19,478.99 + 8,816.87 = 28,295.86

2. Accounts receivablesFor 2006: Average collection period = Receivables / Sales per day

i.e. 32 = Receivables / (207,475.53 / 360)Therefore, receivables = 18,442.27


3. InventoryFor 2006: Inventory turnover = Sales / Inventory

i.e. 7 = 207,475.53 / Inventory Therefore, inventory = 29,639.36



Notes:3. Cash is the balancing figure.4. Accounts receivables and inventory has been calculated by using the industry average

ratios.

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Working notes of Table 14Particulars Formula 2006 2007

Current ratioCurrent assets / current liabilities

59,577.49 / 25,296.01 2.36

72,255.10 / 28,421.03 2.54

Quick ratio


(59,577.49 - 29,639.36) / 25,296.01 1.18

(72,255.10 - 32,455.10) / 28,421.03 1.4

Debt ratioTotal debt / Total asset

36,962 / 79,709.74 46.37

39,877 / 91,441.86 43.61

Times interest earned EBIT / Interest13,656.86 / 3,114.99 4.38

23,735.39 / 1,127.77 21.04

Inventory turnover(cost) COGS / Inventory171,167.31 / 29,639.36 5.77

181,748.56 / 32,455.10 5.6

Inventory turnover(selling) Sales / Inventory207,475.53 / 29,639.36 7

227,185.70 / 32,455.10 7

Fixed assets turnover Sales / Fixed asset207475.53 / 20,132.25 10.3

227,185.70 / 19,186.76 11.84

Total asset turnover Sales / Total asset207475.53 / 79,709.74 2.6

227,185.70 / 91,441.86 2.48

Average collection periodReceivables / Sales per day

18,442.27 / (207,475.53 / 360) 32

20,194.28 / (227,185.70 / 360) 32

Profit margin(%)(Net income / Sales) * 100

(5,481.69 / 207,475.53)*100 2.64

(11,755.83/ 227,185.70)*100 5.17

Gross profit margin(%)(Gross profit / Sales) * 100

(36,308.22 / 207,475.53)*100 17.5

(45,437.13 / 227,185.70)*100 20

Return on total assets(Net income / Total asset) * 100

(5,481.69 / 79,709.74)*100 6.88

(11,755.83 / 91,441.86)*100 12.86

Return on owner's equity(Net income / Total equity) * 100

(5,481.69 / 42,747.74)*100 12.82

(11,755.83/ 51,564.86)*100 22.79

If all short term loans are repaid by end of first half of 2006, the company would obviously be able to pay regular dividends in 2006 as well as in 2007. This is because the interest on short term is being decreased in 2006 and is nil by 2007.

The minimum cash balance required at the end of 2006 is 10373.76 (5% of 207475.520). The company after paying the dividend of 25% during the year 2006 has the cash balance of $11,495.88. So, the company will be able to maintain the minimum cash balance of $10373.76.

The following table shows the changes in the ratios of the company after the payment of short term bank loans in the first half of year 2006.

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Since, after the payment of short term loan all the ratios of the company are improving we find that there is no situation that indicates poor financial policy. The impacts on the ratios after the payment of short term bank loans are as follows:Liquidity ratios

a. Current ratio: The improvement in the current ratios of the company shows better ability of the company to meet its current obligations.

b. Quick ratio: the increase in quick ratio indicates improvement of the company’s ability to meet its short term obligations.

Leverage ratios:a. Debt ratio: The decrease in debt ratio of the company shows the less involvement of

debt to finance fixed assets of the company.b. Times interest earned: The improvement in the TIE ratio shows the increase in the

operating earnings to pay interest.

Asset management ratio:a. Total asset turnover: The increase in the ratios shows that the company has more

efficiently utilized the overall assets to generate sales revenue.

Profitability ratios:a. Profit margin: The increase in the profit margin ratio shows the improvement in the

company’s ability to earn of each sale after paying all the necessary expenses.b. Return on total assets: The improvement in return on total assets ratio indicates the

enhancement in the effectiveness of the operating management of the firm.c. Return on owner’s equity: the increase in the ratio shows the improvement in both

operating and financial decisions of the company.

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RatiosNot Revised 2006

Not revised 2007

Revised2006

Revised2007

Liquidity ratiosCurrent ratio 1.69 1.85 2.36 2.54Quick ratio 1.10 1.24 1.18 1.4 Leverage ratios Debt ratio (%) 58.83 54.98 46.37 43.61Times interest earned 2.69 4.69 4.38 21.04 Asset management ratios Inventory turnover (Cost)* 5.77 5.60 5.77 5.6Inventory turnover (Selling)* 7.00 7.00 7 7Fixed asset turnover 10.30 11.84 10.3 11.84Total asset turnover 1.98 1.94 2.6 2.48Average collection period 32.00 32.00 32 32 Profitability ratios Profit margin (%) 2.15 4.27 2.64 5.17Gross profit margin (%) 17.50 20.00 17.5 20Return on total assets 4.26 8.28 6.88 12.86Return on owners' equity 10.34 18.39 12.82 22.79


Question 6.On the basis of your analyses, do you think that the bank should:

a. Extend the existing short and long-term loans and grant the additional $6,375,000 loans, or

b. Extend the existing short and long-term loans without granting the additional loan, or

c. Demand immediate repayment of both existing loans?

If you favor (a) or (b) above, what conditions (collateral, guarantees, or other safeguards) should the bank impose to protect itself on the loans?

Solution:On the basis of our analysis, bank should

Extend the existing short and long- term loans and grant the additional $6,375,000 loans. SRM was a good client of MCNB as they were prompt in making payments when it was due, and had a reputation of unquestioned integrity in its business dealings. The current problem faced by SRM is temporary in nature. The problem occurred due to financial downturn which was not the only problem faced by Mr. White.

Recently, Mr. White had signed a contract for a plant expansion. He believed that new facilities would enhance the production capabilities in a very lucrative area of custom horse van. According to Mr. White’s analysis, the financial position of the company could improve significantly over the next two years. Once the new facility is added, the company would be able to increase output in rapidly growing segments of market (horse van and home chain) and also reduce the dependency on farm and light utility sales to 35% or less. He also projected that the sales growth would be 6% and 9.5% in an average for 2006 and 2007 respectively, assuming there is no significant improvement in either national or farm economy. He also assumed that SRM would change its policy of aggressive marketing and sales promotion and return to full margin prices, standard industry credit term and tighter credit standards. These changes would reduce cost of goods sold to 82.5% in 2006 and 80% in 2007. Similarly administrative and selling expenses are likely to decrease from 9% to 8% in 2006 and 7.5% in 2007. Also, the miscellaneous expense would reduce to 1.75% and 1.25% of sales in 2006 and 2007 respectively. Hence, on the basis of our analysis we can be assured that if SRM will undertake new facilities then within two year period SRM will be able to generate enough profit to meet the entire obligation owed to the bank.

In addition for the purpose of safety, bank should impose collaterals, guarantees and other safeguards. The collaterals will serve as a value given or pledged as security for payment of loan. In this case, the bank may charge SRM following collaterals:

Financial collaterals: Stocks, bonds and negotiable paper assuming SRM possess these securities.

Merchandise collaterals: Warehouse receipts, trust receipts, rights in real estates, bills of sale of movable goods such as crops, machineries, furniture, livestock.

The most promising collateral option for the bank to charge SRM would be the new operation which is going to start. Above mentioned collaterals may also be charged by the bank in securing itself from default. In case of default, the bank may sell the collateral pledged by SRM and apply the money thus acquired to payment of the debt.

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Question 7.If the bank decides to withdraw the entire line of credit and to demand immediate repayment of the two existing loans, what alternatives would be open to SRM?

Solution:Though SRM had shown high and steady growth in sales, assets and profits prior to 2003, however, towards the end of 2003 the demand for new field trailers in citrus and vegetable industries started to fall. In order to sustain profits and superior market performance Mr. White aggressively reduced prices to stimulate further sales. Consequently, production continued unabated and inventories started increasing. Mr. White’s next step was to relax credit terms and standard to maintain preciously high growth and to reduce the ever expanding inventory. This effort of Mr. White increased sales through the third quarter of 2005, but inventories also increased steadily and particularly short-term credits and accounts receivable grew up dramatically.

In, case if the bank withdraws the entire line of credit and demands immediate repayment of the two existing loans, SRM can adopt following actions:

Take mortgage loan from bank: SRM has land, buildings, plant and equipment worth of $ 22873500 and it has mortgage worth of $ 2339620. This reflects that SRM has the capacity to mortgage its land and buildings. Hence, it can request loan with another bank mortgaging its land and buildings.

Sell accounts receivables and liquidate inventory: SRM has accounts receivables of $ 29356860 and inventory worth $ 46658620. It can sell its receivables and liquidate the inventory in order to repay the loan.

Make strict collection policies: The average collection period of SRM is 54 days in 2005. The company has to make its collection policies stricter so that the creditors will pay in time. Here, SRM is adopting liberal collection policies.

Increase the minimum cash balance:The current minimum cash balance is 5% of net sales. SRM has to increase the percentage so that it has more cash reserve and can utilize it when necessary.

SRM has to take immediate actions as well as gradual steps to stabilize its condition. It can mix the above mentioned actions at once.

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CONCLUSION & LESSON LEARNT

Silver River Manufacturing company (SRM), a large regional producer of agricultural utility such as grove trailers, citrus transport carrier, is being hit hard by deteriorating nation’s farm economy. This company has been a good customer of Marion country National Bank (MCNB) however, due to inability to meet the contractual financial ratio by the company, Lesa Nix, Vice-president of MCNB had made a alerting phone call to the Greg White, founder and president of SRM.

Due to ensuing loss of public trust the regulators of MCNB are becoming strict in their examination of bank loan portfolios and lending practice, because of which SRM might have to suffer.

Greg White, an optimistic person, after attending seminar on executive development convinced that the key to sustained profit and superior performance was sales growth and the achievement of higher share of the market so; he started producing all his products relentlessly and relaxed the credit term to capture more market share. Until the third quarter of 2005 indeed, the sales was high but during fourth quarter inventories as well as receivable started rocketing.

Over optimist White had always taken it for granted that MCNB would increase his line of credit and when he was about to turn to MCNB to finance increase of assets , MCNB was considering reducing or even eliminating such loan. Knowing this ground reality, White realized, for the sales growth and sustainable profit is possible only when reasonable profit margins at every sale are made which was the crux point. Failing this point to notice early was the main cause of his company to be in such deteriorating condition.

White, Knew he focused much on marketing and production issues without paying adequate attention to their financial attention, started to switch his production form volatile farm sector to more stable medium-to-high growth markets of Horse Vans, Mobile home chassis etc. Likewise, SRM will change its policy of aggressive marketing and sales promotion and return to full-margin pricing, standard industry credit terms and tighter credit standards; remaining within the periphery of industry average.

Also a manager must not be over optimistic and also should be prepared for a situation when forecasts go wrong.

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Silver River Full Report

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