Question

Modern Services sells various components to maintain on-shore rigs and derricks. The company has just approached Linden State Bank requesting a $300,000 loan to strengthen the Cash account and to pay certain pressing short-term obligations. The company’s financial statements for the most recent two years follow:
MODERN SERVICES
Comparative Balance Sheet
Assets This Year       Last Year
Current assets:
   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . .    $ 90,000       $ 200,000
   Marketable Securities . . . . . . . . . . . . . . . . . .     0       50,000
   Accounts Receivable, net . . . . . . . . . . . . . . . .     650,000       400,000
   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000       800,000
   Prepaid Expenses . . . . . . . . . . . . . . . . . . . . 20,000       20,000
Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . 2,060,000       1,470,000
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . 1,940,000       1,830,000
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000,000       3,300,000

Liabilities and Stockholders’ Equity
Liabilities:
   Current Liabilities . . . . . . . . . . . . . . . . . . . . $ 1,100,000       $ 600,000
   Bonds Payable, 12% . . . . . . . . . . . . . . . . . . 750,000       750,000
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 1,850,000       1,350,000  
Stockholders’ Equity:
   Preferred Stock, $50 par, 8% . . . . . . . . . . . . . 200,000       200,000
   Common Stock, $10 par . . . . . . . . . . . . . . . .    500,000       500,000
   Retained Earnings . . . . . . . . . . . . . . . . . . . 1,450,000       1,250,000
Total Stockholders’ Equity . . . . . . . . . . . . . . . . . . . 2,150,000       1,950,000
Total Liabilities and Stockholders’ Equity . . . . . . . . . . . 4,000,000       3,300,000

MODERN SERVICES
Comparative Income Statement
Assets This Year       Last Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000,000   $ 6,000,000
Less cost of goods sold . . . . . . . . . . . . . . . . . . . . . .   5,400,000       4,800,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . .   1,600,000       1,200,000
Less operating expenses . . . . . . . . . . . . . . . . . . . . .     970,000       710,000
Net Operating income . . . . . . . . . . . . . . . . . . . . . .     630,000       490,000
Less interest expense . . . . . . . . . . . . . . . . . . . . . . .     90,000       90,000
Net income before taxes . . . . . . . . . . . . . . . . . . . . .     540,000       400,000
Less income taxes (40%) . . . . . . . . . . . . . . . . . . . . .     216,000       160,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .     324,000       240,000
Dividends paid:
   Preferred dividends . . . . . . . . . . . . . . . . . . .     16,000       16,000
   Common dividends . . . . . . . . . . . . . . . . . . . .   108,000       60,000
Total dividends paid . . . . . . . . . . . . . . . . . . . . . . . .     124,000       76,000
Net income retained . . . . . . . . . . . . . . . . . . . . . . . .     200,000       164,000
Retained earnings, beginning of year . . . . . . . . . . . . . . .   1,250,000       1,086,000
Retained earnings, end of year . . . . . . . . . . . . . . . . . . $ 1,450,000   $ 1,250,000

During the past year, the company has explained the number of lines that is carries in order to stimulate sales and increase profits. It has also moved aggressively to acquire new customers. Sales terms are 2/10, n/30/. All sales are on account.

                Assume that the following ratios are typical of firms in the building supply industry:

                                Current ratio . . . . . . . . . . . . . . . . . . .       2.5 to 1

                                Acid-test ratio . . . . . . . . . . . . . . . . . .      1.2 to 1

                                Average age of receivables . . . . . . . . . . .     18 days

                                Inventory turnover in days . . . . . . . . . . .     50 days

                                Debt-to-equity ratio . . . . . . . . . . . . . . .     0.75 to 1

                                Times interest earned . . . . . . . . . . . . . .    6.0 times

                                Return on total assets . . . . . . . . . . . . . .    10%

                                Price-earnings ratio . . . . . . . . . . . . . . .      9

                                Net income as a percentage of sales . . . . . . 4%

1. Linden State Bank is uncertain whether the loan should be made. To assist it in making a decision, you have been asked to compute the following ratios for both this year and last year:
   1. The amount of working capital
   2. The current ratio
   3. The acid-test ratio
   4. The average age of receivables. (The accounts receivable at the beginning of last year totaled $350,000)
   5. The inventory turnover in days. (The inventory at the beginning of last year totaled $720,000)
   6. The debt-to-equity ratio
   7. The number of times interest was earned
2. For both this year and last year (carry computations to one decimal place)
   1. Present the balance sheet in common-size form              
   2. Present the income statement in common-size form down through net income
3. From your analysis in (1) and (2) above, what problems or strengths do you see existing in Modern Services? Make a recommendation as to whether the loan should be approved.

Answer 1

a)	Working Capital = Current Assets - Current Liabilities
	Current Assets	2,060,000	1,470,000
	Current Liabilities	1,100,000	600,000
	Working Capital	960,000	870,000
b)	Current Ratio = Current Assets/Current liabilities
	Current Assets	2,060,000	1,470,000
	Current Liabilities	1,100,000	600,000
	Current Ratio	1.9	2.5
c)	Acid Test Ratio = Quick Assets/Current liabilities
	Quick Assets = Cash (+) Marketable Securities (+) Accounts Receivable, net	740,000	650,000
	Current Liabilities	1,100,000	600,000
	Acid Test Ratio	0.7	1.1
d)	Average age of receivables = Accounts receivable in an accounting period x 365 ÷ sales revenue in that period
	Accounts receivable in an accounting period	650,000	400,000
	sales revenue in that period	7,000,000	6,000,000
	Average age of receivables (in days)	33.9	24.3
e)	Inventory Turnover = Average inventory*365/Cost of Goods Sold
	Cost of Goods sold	5,400,000	4,800,000
	Opening Inventory	800,000	720,000
	Closing Inventory	1,300,000	800,000
	Average inventory = (Opening Inventory+Closing Inventory)/2	1,050,000	760,000
	Inventory Turnover	71.0	57.8
f)	Debt to equity = Debt/Equity
	Debt	750,000	750,000
	Equity	1,950,000	1,750,000
	Debt Equity	0.4	0.4
g)	number of times interest was earned = Earning before Interest & Tax/Interest
	Earning before Interest & Tax	630,000	490,000
	Interest	90,000	90,000
	number of times interest was earned	7.0	5.4
h)	Common Size Balance Sheet			=Asset/Total Asset
	Current assets:	This Year	Last Year	This Year	Last Year
	Cash	90,000	200,000	2.3%	6.1%
	Marketable Securities	-	50,000	0.0%	1.5%
	Accounts Receivable, net	650,000	400,000	16.3%	12.1%
	Inventory	1,300,000	800,000	32.5%	24.2%
	Prepaid Expenses	20,000	20,000	0.5%	0.6%
	Total Current Assets	2,060,000	1,470,000	51.5%	44.5%
	Plant and equipment, net	1,940,000	1,830,000	48.5%	55.5%
	Total Assets	4,000,000	3,300,000	100.0%	100.0%
	Liabilities and Stockholders’ Equity
	Liabilities:			=Liability/Total Liability
	Current Liabilities	1,100,000	600,000	27.5%	18.2%
	Bonds Payable, 12%	750,000	750,000	18.8%	22.7%
	Total Liabilities	1,850,000	1,350,000	46.3%	40.9%
	Stockholders’ Equity:
	Preferred Stock, $50 par, 8%	200,000	200,000	5.0%	6.1%
	Common Stock, $10 par	500,000	500,000	12.5%	15.2%
	Retained Earnings	1,450,000	1,250,000	36.3%	37.9%
	Total Stockholders’ Equity	2,150,000	1,950,000	53.8%	59.1%
	Total Liabilities and Stockholders’ Equity	4,000,000	3,300,000	100.0%	100.0%
	Sales	7,000,000	6,000,000	100.0%	100.0%
	Less cost of goods sold	5,400,000	4,800,000	77.1%	80.0%
	Gross margin	1,600,000	1,200,000	22.9%	20.0%
	Less operating expenses	970,000	710,000	13.9%	11.8%
	Net Operating income	630,000	490,000	9.0%	8.2%
	Less interest expense	90,000	90,000	1.3%	1.5%
	Net income before taxes	540,000	400,000	7.7%	6.7%
	Less income taxes (40%)	216,000	160,000	3.1%	2.7%
	Net income	324,000	240,000	4.6%	4.0%
	Dividends paid:
	Preferred dividends	16,000	16,000	0.2%	0.3%
	Common dividends	108,000	60,000	1.5%	1.0%
	Total dividends paid	124,000	76,000	1.8%	1.3%
	Net income retained	200,000	164,000	2.9%	2.7%
	Retained earnings, beginning of year	1,250,000	1,086,000
	Retained earnings, end of year	1,450,000	1,250,000
	Recommendations:
	1. The company has current ratio in between 2.5 to 1 in both the years and hence meeting the industry standard and should continue to maintain the same.
	2. The company acid test ratio has decreased below the industry standard from 1.2 to 0.7 and should struggle to maintain the same.
	3. The company's receivables ageing has increased leading to blockage of funds and hence company should try to stiffen its credit policy.
	4. A increase in inventory turnover implies decreasing efficency and hence the company should maintain a policy to maintain its inventory effectively.