Question

BORROWING ISSUESTessa’s personality compels her to make virtually all major operating decisions. Owen is concerned that firms the size of KF have had difficulty maintaining a stable bank relationship. Due to increasingly strict federal regulations, some lenders have called in loans, and most are scrutinizing new business loans very carefully. Consequently, Tessa views bank debt financing as unreliable, a potential problem should business become slow, and thinks that loan officers are capable of wasting her time.Owen isn’t sure what to make of these arguments, but he is concerned that avoiding debt has significantly reduced KF’s financial flexibility because it means that all projects will have to be equity financed. In fact, over the past five years there have been no dividends because all earnings have been reinvested. And three years ago each of the partners had to contribute $20,000 of capital in order to meet the company’s needs.Another infusion of capital may be necessary since the firm’s present cash position is low by historical standards. More important, however, Owen feels that the company is not benefiting from the leverage effect of debt financing, and that this hurts the profitability of the firm to the two owners.

Owen suspects that KF’s inventory is excessive. He stated, “Capital is unneces- sarily tied up in inventory.” Tessa’s position is that a large inventory is necessary to provide speedy delivery to customers. She replied, “Our customers expect quick service when a game is in demand, and a large inventory helps us to provide it.” Owen is skeptical of this argument and wonders if there isn’t a more efficient way of providing good service.He also questions Tessa’s credit standards and collection procedures, and believes that Tessa has been quite generous in granting payment extensions to customers. At one point, nearly 45 percent of the company’s receivables were more than 90 days overdue. Furthermore, Tessa would continue to accept and ship orders to these resellers even when it was clear that their ability to pay was marginal. Tessa’s position is that she doesn’t want to lose sales and that the difficult times are only temporary.Owen wonders about the wisdom of passing up trade discounts. Vendors frequently offer KF terms of 11⁄2/10, net 30. That is, KF receives a 11⁄2 percent discount if a bill is paid in 10 days and in any event full payment is expected within 30 days. Tessa rarely takes these discounts because she “wants to hold onto our cash as long as possible.” She also notes that “the discount isn’t espe- cially generous and 981⁄2 percent of the bill must still be paid.”

Despite all of Owen’s concerns, however, the relationship between the two partners has been relatively smooth over the years. And he admits that he may be unduly critical of Tessa’s management decisions. “After all,” he concedes, “she seems to have reasons for what she does, and we have never lost money since we started, which is an impressive record, really, for a firm in our business.”Owen has discussed with two advisors the possibility of selling his half of the firm. Since KF is not publicly traded, the market value of the company’s stock must be estimated. The consultants believe that KF is worth between $35 and $40 per share, figures that appear reasonable to Owen.

1.Using the data in Exhibits C2.1 and C2.2, calculate and analyze the firm’s 2012 and 2013 ratios.

2. Part of Owen’s evaluation will consist of comparing the firm’s ratios to the industry as shown in Exhibit C3.3. Discuss the limitations of such a comparative financial analysis. In view of these limitations, why are such industry comparisons so frequently made? (Note: Sales are forecast to be $8.25 million in 2014.)

3.Owen thinks that the profitability of the firm has been hurt by Tessa’s reluc- tance to use much interest‐bearing debt. Is this a reasonable position? Explain.

4. The case mentions that Tessar arely takes trade discounts,which are typically 11⁄2/10, net 30. Does this seem like a wise financial move? Explain.

5.Is the estimate of $35 to $40 for Owen’s shares a fair evaluation?

6.What do you recommend that Owen and Tessa do to improve their company?

	2012	2013
Sales	6,572,800	7,811,500
Cost of goods sold	4,896,700	5,866,200
Gross Margin	1,676,100	1,945,300
Administrative	1,281,700	1,492,200
Depreciation	72,000	86,000
Earnings before interest	322,400	367,100
Interest	37,900	31,600
Earnings before taxes	284,500	335,500
taxes (at 40%)	113,800	134,200
Net income	170,700	201,300

	2012	2013
Cash	328,000	244,000
Accounts receivable	1,004,200	1,106,600
Inventory	765,400	1,222,300
Other current	39,200	46,800
current assets	2,136,800	2,619,700
Gross fixed assets	372,200	493,600
Accmlated depreciation	-147,900	-233,800
net fixed assets	224,300	259,800
total assets	2,361,100	2,879,500
Liabilities and net worth
accounts payable	345,700	544,800
notes payable	63,200	63,200
accruals	164,300	156,100
current liabilities	573,200	764,100
Long-term debt	316,000	252,800
common stock (62,000 shares outstanding)	948,000	1,137,600
Retained earnings	524,000	725,000
Total liabilities and net worth	2,361,200	2,879,500

	Industry averages
current (times)	2.6/1.7/1.3
quick (times)	1.6/0.8/0.6
Debt%	41/57/71
Times interest earned (times)	7.4/3.9/1.3
Inventory turnover (times)	8.1/6.0/3.5
Total asset turnover (times)	3.5/2.8/2.0
Average collection period (days)	41/50/68
return on equity %	27.3/19.5/7.8

Answer 1

Solution:

1. Using the data in exhibits C2.1 and C3.3, calculate and analyze the firm’s 2012 and 2013 ratios.

2. The firm's current ratio is greater than the average that indicates they are capabale of paying short-term and long-term obligations. The firm's quick ratio is greater than the average indicates that they have quick assets to pay off the current liabilities. The firm has lower debt indicates their lower debt and lower debt burden. The firm's times interest earned ratio is greater than the average indicates they earn enough income to pay the interest expense. The inventory turnover ratio is within industry average with 2013 which is lower than the industry average. The total asset turnover is within the industry average indicates the firm is efficient with the assets in generating revenue. The average collection period is within average. The firm’s return on equity is below the industry average.

The limitations of financial analysis consist of historical, historical versus the current cost, inflation, aggregation, operational changes, accounting policies, business conditions,interpretations, company strategy. Industry comparisons are made to analyze the financial ratios to determine profitability and solvency.

3. I do not think it is reasonable position to think Tessa's reluctant to use interest bearing debt that affects the firm's profitability. There should be constant sales production in paying the debts. The firm involves cyclicality in which customers move on to other products as they grow older. The firm would need to reinvent the products and services to maintain their sales production to pay the debts.

4. The decision to take trade discounts rarely is not a wise financial move. The discount taken to receive full payment in 10 days and full payment expected in 30 days will reduce their accounts receivable and increase their cash flows. Their firm struggle at a time in which 40% of the accounts receivable were over 90 days overdue. Tessa should accept discounts to reduce the risk of losing money because of non-payment and high accounts receivable balances.

5. The firm is not traded publicly. To determine if $35 to $40 for owen's share is fair evaluation you would require to compare the companies of similar industry and size in making a fair evaluation. The financial analysis can be compared and with industry averages once the similar companies have been identified.