Question

Sparky’s Electrical Supply

Frank Newman had been an electrician for over twenty years and was anxious to do something where he didn’t have to work in attics or crawl spaces any more. He had worked for both big and small firms and one thing that he had noticed was that large firms always had their own inventory of supplies, but small firms were always having to go out and buy things because they couldn’t afford, and didn’t want, to have a lot of extra things laying around that they weren’t using. Essentially, the small firms were buying supplies as they were needed for each job. And Frank (whose nickname was Sparky due to an unfortunate accident very early in his training) wanted to be the one to sell the supplies to these small electrical contractors. The town where Frank lived and worked was a moderate size (about 90,000) that was on a steady growth rate with new businesses coming in and housing being built. There were two of the big DIY-type stores, but Frank knew that the average small electrical contractor didn’t use them that much for supplies. Even though the prices for materials was good, the process of buying could take a long time and the purchase had to be paid for right away rather than on a trade account which could be paid once a month. There was only one electrical supply store in town currently, and it was on the west side, while a lot of growth has been on the east side. Frank had saved up $50,000 in a retirement account which he could use to start his own business. He has been talking to a bank about getting a loan to open his new store and the loan officer was quite positive about the possibility of a loan, but she told Frank the bank would need a pro forma income statement and balance sheet to see what his loan needs would be and whether it looked like the business would be successful enough to pay back the loan. The loan officer also reminded Frank that even though the bank wanted this information, the loan would still be one made to Frank personally, so he would be responsible for the payments, even if the business were not successful. Income Statement The SBA office in Frank’s town helped him find some information online that would help Frank develop the two statements that the bank needed in order to review a loan application. Based on the size of the store that Frank was considering opening the annual sales should be about $525,000. The cost of good sold (COGS) for these sales would be 59% and the turnover rate for the inventory should be about 4.5 times a year. So now Frank had enough information to get to the Gross Margin line on the income statement (Sales — COGS = Gross Margin), but the bank was going to want to see the bottom line, or Net Profit Margin, before it would approve a loan. The Operating Expenses would include things like rent, utilities, labor, phone, marketing, insurance, repairs and maintenance, licenses, everything that Frank would have to pay for in order to run the business. He got estimates for everything and it came up to $137,500. So now he could complete the income statement. Balance Sheet For the balance sheet, Frank estimated that the furniture and fixtures for the store would only be $25,000. Add another $5,000 in for a computer system and $1,000 for a software system for billing. The sign out front would be about $3,000, and there was probably going to be about $1,000 in miscellaneous other fixed assets he would have to purchase. The current assets would only be his inventory and cash. The inventory would be easy since it is just the COGS from the income statement divided by his turnover rate. For the cash level the bank had suggested taking his annual operating expenses and dividing that figure by his turnover rate also. It made good sense to him since that way there would be enough cash to cover all the expenses until the inventory had turned over at least once. The other half of the balance sheet was where Frank was struggling a little to figure it out. He knew that the owner’s equity would be the $50,000 that he was investing. And he knew that he was only going to be able to get 50% of his opening inventory level on credit, so that amount would be his initial accounts payable. This essentially meant that whatever value was necessary to make the liabilities and owner’s equity balance will the total assets would be the loan value he would have to ask for.

   •   Prepare both the pro forma income statement and the pro forma balance sheet for Sparky.

   •   What is the amount of a loan that Frank will need from the bank?

   •   Assume that the bank says Frank can have the money and would like to work with him on the type of debt that he will be incurring. The bank says he can have it as a line of credit (see footnote) at 5% interest, a short term loan of two years at 7% interest, or a five year loan at 10% interest, or a combination of these types of loans. What would you suggest and why? And remember that since Frank is a sole proprietor, he does not get a paycheck but is instead pay from the profits of the store, which also has to be used to pay back the loan.

Answer 1

Pro-forma income statement
Sales	525000
COGS	309750
Gross Profit	215250
Operating Expenses	137500
Net Income	77750
Proforma Balance Sheet
Assets
Cash	30600
Inventory	68800
Current Assets	99400
Furniture and fixtures	25000
Comuter system	6000
Other assets	4000
Total fixed assets	35000
Total Assets	134400
Acounts Payable	34400
Loan (Balancing amount)	50000
Total liabilities	84400
Equity	50000
Total liabilities and equity	134400
COGS = 59% of sales = 59% of 525,000
= 309,750
Cash = Operating expenses / turnover ratio
=137,500 / 4.5 = 305,555 say 305,600
Inventory = COGS / turnover ratio
= 309,750 / 4.5 = 68,833 say 68,800

b. The loan from the bank is $50,000.

c. It is better for Frank, to go for a line of credit, as this will enable him to have the lowest interest payment.

This will also help him to draw for his services and also enable him to be repaying the in small amounts so that the operations are not affected.

For the above , the business is generating sufficient net income.