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 8% 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	$	104.3	$	230.0
Accounts receivable, net		90.0		60.0
Inventory		260.0		155.0
Prepaid expenses		35.0		38.0
Total current assets		489.3		483.0
Property and equipment		410.0		340.0
Total assets	$	899.3	$	823.0
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$	261.0	$	160.0
Accrued liabilities		15.0		60.0
Total current liabilities		276.0		220.0
Long-term liabilities		.0		.0
Total liabilities		276.0		220.0
Stockholders' equity:
Common stock and additional paid-in-capital		150.0		150.0
Retained earnings		473.3		453.0
Total stockholders' equity		623.3		603.0
Total liabilities and stockholders' equity	$	899.3	$	823.0

Venice InLine, Inc. Income Statement For the Year Ended December 31 (dollars in thousands)
	This Year
Sales (all on account)	$	640.0
Cost of goods sold		436.0
Gross margin		204.0
Selling and administrative expenses:
Selling expenses		73.0
Administrative expenses		102.0
Total selling and administrative expenses		175.0
Net operating income		29.0
Interest expense		–
Net income before taxes		29.0
Income taxes (30%)		8.7
Net income	$	20.3

Required:

1a.	Based on the above unaudited financial statement of the current year calculate the following. (Round your answers to 2 decimal places.)

       

1b.	Based on the statement made by the loan officer, would the company qualify for the loan?
	Yes No

2.

Last year Russ purchased and installed new, more efficient equipment to replace an older heat-treating furnace. Russ had originally planned to sell the old equipment, but found that it is still needed whenever the heat-treating 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 $85,000. The bank does not require audited financial statements.

  

a.	Calculate the following if the old machine is considered as inventory. (Round your answers to 2 decimal places.)

           

b.	Based on the 2a above would the company qualify for the loan?
	Yes No

c.	Calculate the following if the old machine is sold off. (Round your answers to 2 decimal places.)

               

d.	Based on the 2c above would the company qualify for the loan?
	Yes No

Answer 1

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

Current Ratio = current assets/current liabilities = 489.3/276 = 1.7728

Acid Test Ratio = (Current assets - Inventory- Prepaid expenses)/Current LIabilities = (489.3-260-35)/276 = 0.70986

Based on the statement made by the loan officer, the company cannot qualify for the loan, because both the above ratios calculated are very low. Hence it will be rejected.

2.If old machinery of $85,000 is considered as inventory:

New Current Ratio = (489.3+85)/276 = 574.30/276 = 2.0808

Acid Test Ratio = (194.3-85)/276 = 109.3/276 = 0.396014

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

The company would still be disqualified for loan, because its acid test ratio is again very low, and doesnt meet the criteria.

2c.. If the machinery is sold off:

The inventory would be reduced, and the cash will increased. hence the current ratio will remain same.

New Current Ratio = 574.3/276 = 2.08079

Acid Test ratio = (574.3-260-35)/276 = 1.01195

d. Yes: In this case both current ratio and acid test ratios are good. Current Ratio is above 2 and acid test ratio is also above 1. Hence the company would now qualify for the laon.