Question

A new client, an oil and gas explorer in Western Canada, is currently negotiating a loan worth $3 million to avoid defaulting on its long-term debt that is due in three months. Its latest quarterly earnings report indicate that the entity has a working capital deficiency of $500,000, while its cash balance fell to $250,000, down from $500,000 a year earlier. There is a 0.5:1 current ratio. With little expectation of improved sales, the entity plans to cut back on production to preserve cash. It has also been paying suppliers late consistently, and some suppliers have begun demanding cash on delivery from the client. As a result, the share price has plunged and the entity has lost more than half of its market value in the last week. Which of the following conditions in this case may cast doubt on the client’s ability to continue as a going concern?

A. Declining ratios

B. Long-term loans reaching maturity without alternative financing in place

C. Prolonged losses

D. An inability to pay debts when they fall due

E. Supplier reluctance to provide goods on credit

F. The loss of a major market, key customer, franchise, or licence

G. Overreliance on a few customers or suppliers

H. Shortage of a key input or raw material

I. Rapid growth with insufficient planning

J. Falling behind competitor

Answer 1

Sol:

1. The Client has a fixed long-term borrowings of $3,000,000 is nearing its maturity in 3 months..But the client is negotiating for short-term loan to finance the repayment of long-term debt reaching its maturity. This may cast a doubt on the creditors and suppliers on the financial position of the client to pay their bills for goods supplied.Moreover excessive reliance on short-term debt to finance long-term debt will increase the interest charges to be paid and lowers the liquidity ratio.The most common liquidity ratios are Current ratio, Acid test or Quick ratio and Working capital ratio.. Using short-term borrowing to finance long-term borrowing shows the client's disablity to pay-off his debts.This situation will create a doubt on suppliers to supply goods on credit to the client.

2. There is a working capital deficiency of $500,000 and cash balance has fallen to $250,000 when compared to that of $500,000 in previous year. This shows the mis-management of current assets to that of current liablities. The current ratio which is Current Assets / Current Liabilities = 0.5 : 1, This means current assets are only half of current liabilities indicating that the client does not have enough liquid assets (assets that can be quickly converted in cash such as Bills Receivables, etc.) to pay-off its short term borrowings. The effective current ratio shoul be 1.2 to 2, which means the clent has 1.2 to 2 times of Current assets than curent liablilities to cover its debts. A current ratio below 1 shows the inefficiency of the client to meet its obligations in future.

3. When the share value or market value of the client company is declining continuously, this may have the effect of some creditors or suppliers to draw back their decision to provide goods on credit and they may demand immediate cash payment on delivery of ggods. But here the liquidity position of the client is declinig, so the client will not have enough cash to pay mmediately. This is the indication of withdrawing financial support by creditors or suppliers and there will be loss of important customers or franchise or license as value of the company is plunged in the market due to inability to pay-off debts.

4.The current ratio or liquid ratio is less as there may be shortage of important or key supplies or raw material When key material is in shortage, then Finished Goods may not be produced at the stipulated time..This shortage is due to the fact that the creditors have doubt on the financial position of the client to pay his bills. So the suppliers may reduce the supply of key input to the client on credit terms.

From the above discussions we may anlayse the following factors will cast a doubt on the going concern of the client:

A. Declining ratios -- lower current ratio of 0.5 : 1

B. Fixed or long-term borrowings reaching maturity without alternative financing or excessive reliance on shot-term borrowings to finance long-term debts.

D. Inability to pay debts when they fall due, not able to provide payment of bills payable on time or on demand by creditors.

F. The loss of major market, key customer of franchise or license due to the declining market value of the client

H. Shortage of key input or raw material, as the suppliers or creditors may stop providing supplies when the client is unable to pay for his purchases.