Question

Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had designed for doing aerial tricks. Up to this point, Russ has financed the company with his own savings and with cash generated by his business. However, Russ now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bearings developed just as the company was beginning production for the Christmas season. Russ had been assured by his suppliers that the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and was unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Russ does not have enough cash to pay his creditors.

Well before the accounts payable were due, Russ visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Russ promised to return later with a copy of his financial statements.

Russ would like to apply for a $120,000 six-month loan bearing an interest rate of 3% per year. The unaudited financial reports of the company appear below:

Venice InLine, Inc. Comparative Balance Sheet As of December 31 (dollars in thousands)
	This Year		Last Year
Assets
Current assets:
Cash	$	112.4	$	245.0
Accounts receivable, net		125.0		80.0
Inventory		250.0		150.0
Prepaid expenses		40.0		28.0
Total current assets		527.4		503.0
Property and equipment		380.0		270.0
Total assets	$	907.4	$	773.0
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$	276.0	$	145.0
Accrued liabilities		25.0		30.0
Total current liabilities		301.0		175.0
Long-term liabilities		-		-
Total liabilities		301.0		175.0
Stockholders' equity:
Common stock and additional paid-in capital		150.0		150.0
Retained earnings		456.4		448.0
Total stockholders' equity		606.4		598.0
Total liabilities and stockholders' equity	$	907.4	$	773.0

Venice InLine, Inc. Income Statement For the Year Ended December 31 (dollars in thousands)
	This Year
Sales (all on account)	$	635.0
Cost of goods sold		403.0
Gross margin		232.0
Selling and administrative expenses:
Selling expenses		93.0
Administrative expenses		127.0
Total selling and administrative expenses		220.0
Net operating income		12.0
Interest expense		–
Net income before taxes		12.0
Income taxes (30%)		3.6
Net income	$	8.4

Required:

1-a. Based on the above unaudited financial statement of the current year calculate the following.

Current ratio

Acid-test ratio

Ratio of net operating income to loan interest

1-b. Based on the statement made by the loan officer, would the company qualify for the loan?

2. Last year Russ purchased and installed new, more efficient equipment to replace an older plastic injection molding machine. Russ had originally planned to sell the old machine but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $79,000. The bank does not require audited financial statements.

a. Calculate the following if the old machine is considered as inventory.

b. Based on the 2a answer would the company qualify for the loan?

c. Calculate the following if the old machine is sold off.

d. Based on the 2c answer would the company qualify for the loan?

Complete this question by entering your answers in the tabs below.

• Req 1A
• Req 1B
• Req 2A
• Req 2B
• Req 2C
• Req 2D

Based on the above unaudited financial statement of the current year calculate the following:

Current ratio

Acid-test ratio

Ratio of net operating income to loan interest

(Round your answers to 2 decimal places.)

Show less

	Current ratio Acid-test ratio Ratio of net operating income to loan interest

Last year Russ purchased and installed new, more efficient equipment to replace an older plastic injection molding machine. Russ had originally planned to sell the old machine but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $79,000. The bank does not require audited financial statements. Calculate the following if the old machine is considered as inventory. (Round your answers to 2 decimal places.)

Show less

	Current ratio Acid-test ratio

Last year Russ purchased and installed new, more efficient equipment to replace an older plastic injection molding machine. Russ had originally planned to sell the old machine but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $79,000. The bank does not require audited financial statements. Calculate the following if the old machine is sold off. (Round your answers to 1 decimal place.)

Show less

	Current ratio Acid-test ratio

Answer 1

Ans.

1A.

Current Ratio = Current Asset / Current Liabilities

= $ 527.40 / $ 301.0 = 1.75

Acid Test Ratio = Current Asset - Inventory / Current Liabilities

= $ 527.40 - $ 250 / $ 301.0 = 0.92

Ratio of net operating income to loan interest = EBIT / Interest Expense

Interest Expense on proposed loan = $ 120,000 * 3% * 6/12 = $ 1,800

Net Operating Income = $ 12,000

Ratio of net operating income to loan interest = $ 12,000 / $ 1,800 = 6.67

1B)

	This Year	Required for loan	Condition Satisfy
Current Ratio	1.75	2	No
Acid Test Ratio	0.92	1	No
Time Interest Ratio	6.67	4	Yes

As the company's statements does not satisfy two of the conditions required for loan, company would not qualify for the loan.

2A.

If the old machine is considered as inventory.

Current Ratio = $ 527.40 + $ 79 / $ 301 = 2.01

Acid Test Ratio = $ 527.40 - ( $ 250 + $ 79) / $ 301 = 0.66

Ratio of net operating income to loan interest = $ 12,000 / $ 1,800 = 6.67

2B.

	This Year	Required for loan	Condition Satisfy
Current Ratio	2.01	2	Yes
Acid Test Ratio	0.66	1	No
Time Interest Ratio	6.67	4	Yes

As the company's statements does not satisfy one condition required for loan, company would not qualify for the loan.

2C.

If the old machine is sold off

Current Assets ( i.e cash or debtor) will increase.

Current Ratio = Current Ratio = $ 527.40 + $ 79 / $ 301 = 2.01

Acid Test Ratio = ( $ 527.40 + $ 79 ) - $ 250 / $ 301 = 1.18

Ratio of net operating income to loan interest = $ 12,000 / $ 1,800 = 6.67

2D.

	This Year	Required for loan	Condition Satisfy
Current Ratio	2.01	2	Yes
Acid Test Ratio	1.18	1	Yes
Time Interest Ratio	6.67	4	Yes

As the company's statements satisfy all the three conditions required for loan, company would now qualify for the loan.