silver river manufacturing company

Current AssetCurrent Liabilities

Current Asset – Inventory Current Liabilities

X 100 %Total Debt Total Asset

EBITInterest Expenses

Cost of Goods SoldAverage Inventory

Net Sales Inventory

Net SalesNet Fixed Assets

Net SalesTotal Assets

Receivable Net Sales per Day

Net Income Net Sales X 100 %

Gross Profit Net Sales X 100 %

Net Income Common Equity X 100 %

Financial ratio used in case

1) Current Ratio :

2) Quick Ratio:

3) Debt Ratio:

4) Times interest Earned:

5) Inventory Turnover Ratio(Cost):

6) Inventory Turnover Ratio(Selling):

7) Fixed Asset Turnover:

8) Total Asset Turnover:

9) Average Collection Period:

10) Profit Margin:

11) Gross Profit Margin:

12) Return on Owner's Equity:

13) Price Earnings Ratio:MarketPrice Per share ( MPS )

Earnings Per Share ( EPS )

14) Earnings Per Share: Net Income

No .of Common Shares Outstanding

15) Market Price Per Share (MPS) PEratioXEPS

16) Dividend Pay Out RatioDividend Per Share (DPS)Earnings Per Share(EPS )

17) Altman Z score, Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5

Where, X1 = Current Assets−Current Liabilities

Total Assets x 100

X2 = Retained Earnings

Total Assets x 100

X3 = Earnings Before Interest∧Tax(EBIT )Total Assets

X4 = Market Value of Equity

Book Valueof Total Debt

X5 = Net Sales

Total Assets

18) Du-Pont identity

Returns on Equity = Total Assets Turnover X Net Profit Margin x Equity Multiplier

=Net Sales

Total AssetsxNet IncomeNet Sales x Total Assets

Owners Equity

General Background

Silver River Manufacturing Company (SRM) is a US based large regional producer of farm and utility trailers specialized lives stock carriers and mobile home chassis owned by Greg White. More than 85% of SRM’S sales come from the south eastern part of the United States. Several major boat companies in Florida work closely with SRM in designing trailers for their new offerings. SRM is a major client of Marion Country National Bank (MCNB). Due to the recession that had been plaguing the nation’s farm economy since 2000s caused problem for agriculture for the SRM who depends on farmers for roughly 45 to 50 percent of total sales. SRM whose products are totally based on latest technology and SRM hold several patents with which it can partially offsets some of the risk.

In the decade prior to 2003, SRM had experienced high and relatively steady growth in sales, assets and profits. Toward the end of 2003, the demand for new field trailers in the citrus and vegetable industries started to fall off. The recession that had been plaguing the nation’s farm economy and disastrous freezes for two straight winters resulted in high curtailment of demand for grove retailer and citrus transport carriers; SRM was not immune to this. Though SRM had shown high and steady growth in sales, assets and profits prior to 2003, however, towards the end of 2003 the demand for new field trailers in citrus and vegetable industries started for fall off.

SRM in designing trailers for their new offerings, and these boat-trailer packages are sold through the nationwide dealer networks of the boat companies. With few exceptions, the products manufactured by SRM are not subject to technological obsolescence or to deterioration, and in those instances where technology is a factor to be considered, SRM holds several patents with which it can partially offset some of the risks. Marion County National Bank (MCNB) is the official banker of SRM that has sanctioned short and long term credit facilities. MCNB considered SRM to be a financially sound and efficiently managed firm until the symptoms of illness of SRM surfaced. Being a close friend and a well-wisher, Ms. Lesa Nix, Vice President of MCNB, informs Mr. White that the financial health of SRM worsened from 2004 through 2005 such that MCNB might consider calling back the credit facilities while SRM has made a commitment to expand its facility requiring an additional fund of $7,012,500 . Mr. White Had planned to obtain this additional money by a short term loan from MCNB.

Hence, to finance these increase in assets, SRM turned to Marion Country National Bank, (MCNB) for long term loan in 2004 and increase in its short term credit loan in both 2004 and 2005.MCNB had been a major banker of SRM for a long time. In the start, Lesa Nix, the vice-president of MCNB, had handled the case of SRM. Later, she got promoted and was no longer responsible for handling SRM’s account. However, as Mr. White was a close friend, she still took keen interest on SRM. Even this was insufficient to cover the aggressive expansion on the

asset side. Consequently, Greg White who always made prompt payments, started to delay payments. This resulted substantial increase in accounts payable and other short term loans.

Upon analyzing SRM’s financial conditions, Lesa Nix found that the bank’s computer analysis system revealed a number of significant adverse trends and highlighted several potentially serious problems. Its 2005 current, quick and debt ratios failed to meet the contractual limits of 2, 1.0 and 55percent respectively. Technically, the bank had a legal right to call for immediate repayment of both long and short-term loans, and, if they were not repaid within ten days, could force the company into bankruptcy.

Despite such adverse conditions Nix considered the company to have good long run prospects, assuming, of course that management reacted immediately and appropriately to the current situation. Hence, Nix had looked upon the threat of accelerating the loan repayment primarily as a means to get Greg White’s undivided attention and as well to force him to think about corrective actions that must be taken to mitigate SRM’s short-term problems. Even though she hoped to avoid calling the loans if at all possible because that action would back SRM into a corner from which it might not be able to emerge intact, Nix realized that the bank’s examiners, due to the recent spate of bank failures, were very sensitive to the issue of problem loans. SRM’s Altman Z factor (2.88) for 2005 was below 2.99 which indicated that SRM was likely to get bankrupt in two years. Because of this deficiency, MCNB was under increased pressure from the regulators to reclassify SRM’s loan as ‘problem category’ and take whatever steps needed to collect the money due and reduce the bank’s exposure as quickly as practicable. In order to avoid reclassification, SRM required strong and convincing evidence to prove that its problems were temporary in nature and it had good chance of reversing the trend.

The current financial problems were not the only problem Mr. White faced. He had recently signed a contract for a plant expansion that would require another $7012500 of the capital during the first quarter of 2006. He had planned to obtain this money by a short term loan from MCNB to be repaid from the profit generated in the first half of 2006. He believed that new facilities would enhance the production capabilities in a very lucrative area of custom horse van.

According to Mr. White’s analysis, the financial position of the company could improve significantly over the next two years if the bank maintained or even increase the credit lines. Once the new facility is goes online, the company would be able to increase output in rapidly growing(and particularly profitable) horse van and home chassis segment of the market and also reduce the dependency on farm and light utility trailer sales to 35% or less. He also projected that the sales growth would be 6% and 9.5% in an average for 2006 and 2007 respectively, assuming there is no significant improvement in either national or farm economy. He also assumed that SRM would change its policy of aggressive marketing and sales promotion and return to full margin prices, standard industry credit term and tighter credit standards. These changes would reduce cost of goods sold to 85% in 2005 and 82.5% in 2006 and 80 % in 2007. Similarly administrative and selling expenses are likely to decrease from 9% to 8% in 2006 and

7.5% in 2007. Also, the miscellaneous expense would reduce to 1.75% and 1.25% of sales in 2006 and 2007 respectively. Average collection period and inventory turnover will be maintained at average industry level.

Regarding the financial data provided in the case and the projected income statement and balance sheet, we have to analyze whether SRM is eligible to obtain the bank loan. Now, the question is whether the bank should extend the existing short and long-term loans or should rather demand immediate repayment of both existing loans. Also we have to propose alternatives available to SRM if the bank were to decide to withdraw the entire line of credit and to demand immediate repayment of the two existing loans.

Question 1(a): Prepare a statement of changes in financial position for 2005 (sources and uses of funds statement) or complete Table 6.

Solution:

Silver River Manufacturing Company

Statement of Changes in Financial Position

For The Year Ended December 31st (thousands of dollar)

Particulars 2004 2005Sources of fundsNet income after taxesDepreciation Funds from operationsLong-term loanNet decrease in working capital Total sourcesApplication of fundsMortgage changeFixed assets changeDividends on stock Net increase in working capital Total uses

6,987.001,823.008,810.003,506.00 -12,316.00

295.002,574.001,747.007,702.0012,316.00

831.002,244.003,075.000.000472.003,546.00

287.003,051.00+208.000.00003,546.00

Analysis of changes in working CapitalIncrease (decrease) in current assetsCash changeAR changeINV change CA change

Increase (decrease) in current liabilitiesNP changeAP changeACC change CL changeNet increase (decrease) in working capital

(1,260.00)1,500.0015,505.0015,745.00

2,104.004,117.001,823.008,044.007,702.00

(107.00)11,985.0014,992.0026,870.00

10,441.0014446.002,454.0027,341.00(471.00)

It can be seen from the above calculated table that the sources of funds have decreased due to decrease in net income as there is no change in long term loan. The decrease in working capital is due to the sources of fund to the firm but it is in little amount in comparison to other applications of fund.

Question 1(b): Calculate SRM’s key financial ratios for 2005 and compare them with those of 2003, 2004, industry average, and contract requirement or complete Table 7.

Solution:

Table 7: Silver River Manufacturing Company

Ratio Analysis Year Ended December 31

Particulars 2003 2004 2005 Industry averageLiquidity ratiosCurrent ratioQuick ratio

Leverage ratiosDebt ratio (%)Times interest earned

Asset management ratiosInventory turnover (Cost)aInventory turnover (Selling)bFixed asset turnoverTotal asset turnoverAverage collection period

Profitability ratiosProfit margin (%)Gross profit margin (%)Return on total assetsReturn on owners’ equity

Potential failure indicatorAltman Z factor

3.071.66

40.4615.89

7.149.0311.583.0636.00

5.5020.8916.8328.26

3.06

2.681.08

46.337.97

4.555.5911.952.6035.99

3.4418.708.9516.68

2.64

1.7540.73

59.7961.49

3.574.19512.0972.0453.99

0.38614.860.7861.955

2.04

2.501.00

50.007.70

5.707.0012.003.0032.00

2.9018.008.8017.50

1.81/2.99

Notes:

a) Uses cost of goods sold as the numerator.

b) Uses net sales as the numerator.

c) The Altman Z factor range of 1.81-2.99 represents the so-called “zone of ignorance".

d) Year-end balance sheet values were used throughout in the computation of rations embodying balance sheet items

e) Assume constant industry-average ratios throughout the period 2003-2007.

1. Liquidity Ratio: Fig. 1.1 Current ratio:

2003 2004 20050

0.5

1

1.5

2

2.5

3

3.5

SRM CompanyIndustry Average

The current ratios of a firm measure its short-term solvency, i.e. its ability to meet short-term obligations. Higher the current ratio higher will be the amount available to meet its current liability.

The Current ratio of SRM has decreased in 2005 as compared to 2003, 2004 and industry average.ie. 1.75 < 3.07, 2.68 & 2.50.So, we can conclude that the company’s ability to fulfill short term obligations with current assets has decreased.

Fig. 1.2 Quick ratio:

2003 2004 20050

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8


The Quick ratio is used to measure the liquidity to overcome the defect of current ratio. The quick ratio is used to know the liquidity position of a firm.

The quick ratio of SRM’s is also showing declining trend. The Company is showing less liquidity in 2005 as the ratio is less than that of the years 2003, 2004 and industry average, i.e. 0.73 < 1.66, 1.08 & 1.00.

2. Leverage ratios :

Fig. 2.1 Debt ratio:

2003 2004 20050.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%


The debt ratio is increasing as it was 40.46% in 2003 and 46.33% in 2004 and 59.796% in 2005. In 2005 the company was more dependent on leverage which means compared to previous year it has taken more risk in 2005. In comparison to the industry average, SRM is taking more risk than the competitors where industry average is 50% and that of the SRM are 59.796%.

Fig. 2.2 Time interest earned ratio:

2003 2004 20050

2

4

6

8

10

12

14

16

18


The time interest earned ratio is declined from 2003 to 2005 but is not below 1 so it is still able to meet its interest obligations. So from this we can easily see the decreasing interest paying capacity of SRM over the years. And in the year 2005 SRM has failed to maintain the ratio as off industry.

Fig. 3 Asset management ratio:

Inventory turnover ratio (cost):

2003 2004 20050

1

2

3

4

5

6

7

8


Inventory turnover (selling)

2003 2004 20050

1

2

3

4

5

6

7

8

9

10


The inventory turnover ratio decreased from 7.14 times to 3.57 times from 2003 to 2005 on the basis of cost and decreased from 9.03 to 5.59 on the basis of sales. This means the sales getting poorer from 2003 to 2005. In comparison to the industry average, SRM is not efficient compared to its competitors in turning or managing its inventory over the years. So the efficiency of SRM in Inventory management does not seems much better than that of Industry.

Fixed asset turnover ratio:

2003 2004 200511.3

11.4

11.5

11.6

11.7

11.8

11.9

12

12.1

12.2


SRM is effectively utilizing its fixed assets because the turnover generated from fixed assets is increasing from $11.58 in 2003 to $12.097 in 2005. In comparison to the industry average, SRM with turnover of $12.097 greater than its competitor of $12 is using its fixed assets effectively to increase the productivity of the company with respect to generating sales.

Total asset turnover ratio:

2003 2004 20050

0.5

1

1.5

2

2.5

3

3.5


In case of SRM the total assets turnover has declined from $3.06 in 2003 to $ 2.04 in 2005 which means the company is not capable to utilize its total assets. In comparison to the industry average of $ 3, SRM with turnover of 2.04 is not using its assets effectively to increase the productivity of the company with respect to generating sales.

Average collection period:

2003 2004 20050

10

20

30

40

50

60


This ratio measures the average number of days customers take to pay their bills, indicating the effectiveness of credit and collection policies of the business. This ratio also determines if the credit terms are realistic.

In case of SRM it takes 36 days to collect its receivable in 2003 which increased to 53.99 in 2005. When compared to the industry average, the competitors are more capable of collecting the receivables then SRM.

Profitability ratios:

Profit margin (%)

2003 2004 20050

1

2

3

4

5

6


SRM the profit margin ratio has been decreasing rapidly from 5.5 in 2003 to 0.386 in 2005. The industry average is 2.9 which means other companies have greater profit margin for each dollar of sales than SRM.

Gross profit margin (%)

2003 2004 20050

5

10

15

20

25


The gross profit margin is in declining trend from 20.89% in 2003 to 14.86% in 2005 which means that SRM is not able to make profit by using its raw materials, labor and manufacturing. Compared to industry average which is 18% it shows that other companies are more efficient in making profit

Return on total asset:

2003 2004 20050

2

4

6

8

10

12

14

16

18


The return on assets of SRM has been declining from 16.83% to 0.786% from 2003 to 2005. Compared to industry average of 8.8% other companies are more efficient in generating profit using its assets

Return on owner’s equity

2003 2004 20050

5

10

15

20

25

30


The ROE of SRM is declining rapidly from 28.26% in 2003 to 1.95% in 2005 which means that company is incapable of generating profit from the shareholders money. Compared to the industry average of 17.5%, the competitors are more capable of generating profit from shareholders money.

Question no. 2.Based on the case data and the results of your analysis in Question 1, what are the SRM’s strengths and weaknesses? What are the causes thereof? (Use of the Du Pont system and Altman Z factor would facilitate analysis and strengthen your answer.)

Answer Table 7: Silver River Manufacturing Company Ratio Analysis Year Ended December 31

Particulars 2003 2004 2005 Industry average

Contractual limits

Liquidity ratiosCurrent ratioQuick ratio

Leverage ratiosDebt ratio (%)Times interest earned

Asset management ratioInventory turnover (Cost)Inventory turnover (sell)Fixed asset turnoverTotal asset turnoverAverage collection period

Profitability ratiosProfit margin (%)Gross profit margin (%)Return on total assetsReturn on owners equity

Potential failure indicator Altman Z factor

3.071.66

40.4615.89

7.149.0311.583.0636.00

5.5020.8916.8328.26

3.06

2.681.08

46.337.97

4.555.5911.952.6035.99

3.4418.708.9516.68

2.62

1.7540.73

59.791.485

3.574.19512.0972.036753.99

0.38614.860.7861.955

2.04

2.501.00

50.007.70

5.707.0012.003.0032.00

2.9018.008.8017.50

1.81/2.99

2.001.00

55.00

Working Note.Calculation of Altman Z factorFor 2003

For 2004

X1=CA-CL/TA= (45,298.00-14,733.00)/61,539.00 = 0.4967 = 49.66%

X2 = Retained Earnings/ Total Assets = 11,041.00/61,539.00 = 17.94%

X3 = EBIT / Total Assets = 21,251.00/61,539.00 = 0.3453 times

No. of shares = NI/ EPS = 10,355.00/2.69 = 3,849 shares

ME = No. of shares * MPPS = 3,849.44 * 17.79 =68,481.5

X4 = ME / Book Value of Total Debt = 68,481.57/24,901.00 = 2.75 times

X5 = sales/total assets = 188,097.00/61,539.00 = 3.06 times

Altman Z factor = 0.012 X1 +0.014 X 2 +0.033 X3+0.006 X4+0.999 X5

=0.012(0.4966) +0.014 (0.1794)+0.033 (0.3453)+0.006 (2.75) +0.999 (3.06)

= 3.093

X1=CA-CL/TA= (61,043.00 – 22,777.00)/78,034.00=0.4904 = 49.04%


X3 = EBIT / Total Assets = 15,364.00/78,034.00 =0.1969 times

No. of shares = NI/ EPS = 6,987.00/1.81 = 3,860.22 shares

ME = No. of shares * MPPS = 3,860.22* 9.69 = 37,405.54

X4 = ME / Book Value of Total Debt = 37,405.54/36,156.00 = 1.02 times



= 0.012 (0.4904) +0.014 (0.2086)+0.033 (0.1969) +0.006 (1.02) +0.999 (2.60) = 2.62

For 2005

Almond Z Factor:

2003 2004 20050.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

Z Factor

Z Factor

Du Pont Analysis of SRMFor 2003

X1=CA-CL/TA= (87,913.00–50,118.00)/105,711.00 =0.3575= 35.75%


X3 = EBIT / Total Assets = 4,888.00/105,711.00 =0.0462 times

No. of shares = NI/ EPS =830.00/0.22 = 3,772.72 shares

ME = No. of shares * MPPS = 3,772.72* 1.02 = 3,848.18

X4 = ME / Book Value of Total Debt =3,848.18/63,211.00 = 0.061 times



= 0.012 (0.3575) +0.014 (0.1599)+0.033 (0.0462) +0.006 (0.061) +0.999 (2.04) = 2.04

ROE = NI/Sales * Sales/Total Assets * Total Assets/Total Equity

ROE = 10,355.00/188,097.00 * 188,097.00/61,539.00 * 61,539.00/36,637.00

ROE = 0.0550 * 3.0565 * 1.6796 = 0.2824 =28.24%

ROE = NPM * TAT * EM

For 2004

For 2005

Du Pont Analysis:

2003 2004 20050.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

ROE

ROE


ROE =6,987.00/203,124.00* 203,124.00/78,034.00* 78,034.00/41,877.0

ROE = 0.0344 * 2.6030 * 1.8633 = 0.1668 = 16.68%



ROE = 830.00/215,305.00* 215,305.00/105,711.00 * 105,711 /42,500.00

ROE = 0.0038 * 2.0367 * 2.4873= 0.0195 = 1.95%


Based on the case data and the results of ratio analysis SRM’s the strengths and weaknesses and the causes thereof are listed below:

Strengths:

The fixed asset turnover ratio is increasing in 2005. The number of times that SRM has been able to turn its fixed assets is high. This shows that the fixed assets are used effectively.

SRM’s Altman Z score is compatible with the industry average (i.e. 2.04) against the industry average of 1.81/2.99). Even though, the factor is compatible with the industry average, it is not a good sign for the company. The company falls under gray zone and needs to be more careful about going bankrupt.

Weakness:

All the profitability ratios are in declining trend in 2005. The net profit margin has drastically reduced from 2003 to 2005 and is less than the industry average in 2005. From Du Pont analysis, it can be seen that the net profit margin is below the industry average of 2.99 reflecting the operating inefficiency.

The Company is not in a relatively liquid position. The company has fewer current assets than the current liabilities thereby showing negative net working capital. The current ratio and quick ratio also reflect the less liquid position of SRM.

The price earnings (PE) ratios are also declining from 6.61 in 2003 to 5.35 in 2004 and finally 4.63 in 2005.

Earnings per share (EPS) are declining from the year 2003: $2.69 to $1.81 in year 2004 and $0.22 in year 2005.

Inventories increased steadily and accounts receivable shot up dramatically.

Delay in payment of accounts payable.

The firm’s equity multiplier is increasing from 1.68 times in 2003 to 1.86 times in 2004 and finally 2.49 times in 2005.

Question No.3.If the bank were to maintain the present credit lines and grant an additional $7,012,500.00 short-term loan at a 16 percent rate of interest effective from January 1, 2006, would the company be able to retire all short-term loans existing on December 31, 2006? (Assume that all of White’s plans and predictions concerning sales and expenses materialize. In these calculations cash is the residual balancing figure, and SRM’s tax rate is 48%. Assume that SRM pays no cash dividends during the year.) Complete tables 9 and 10 included as worksheets to facilitate analysis.

Table 9: Silver River Manufacturing Company Pro Forma Income Statements (Projected) Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Projected

2007 Projected

Net salesCost of goods soldGross profitAdministrative and selling expensesDepreciationMiscellaneous expenses Total operating expenses EBITInterest on short term loanInterest on long-term loansInterest on mortgage Net income before taxTaxes

215,305183,30731,99818,5692,2446,29727,1104,8882,0061,0522331,597767

22822318828439939182582665399424,917150224331105221094294525

249904199923499811874320063124238732610843311052189205369857

Net incomeDividends on stockAdditions to retained earnings

831208623

49030.0004903

106790.00010679

Working Note:

Particulars

Calculations

2006 2007

Projected sales 215,305 *1.06 228223228223.3* 1.095 2,49904

Cost of goods sold82.5% of 228223.3 188284

80% of 249904.5 1,99923

Administrative and selling expenses

8% of 228223.3 18258

7.5% of 249904.5 18743

Miscellaneous expenses1.75% of 228223.3 3994

1.25% of 249904.5 3124

Taxes48% of 9429.23 4,526

48% of 20536.24 9857


Pro Forma Balance sheets (Projected)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Projected 2007 ProjectedAssetsCashAccounts receivableInventoryCurrent assetsLand, Building, plant and equipmentAccumulated depreciationNet fixed assets

429632293513248791325161

(7363)17798

3966720286330329298532173

(10028)22145

49529222133507410681633139

(10939)22199

Total assets 105711 115130 129015Liabilities and equitiesShort term bank loansAccount payableAccruals

20056219988064

270681759410231

270681847412789

Current liabilitiesLong term bank loansMortgageLong term debtTotal LiabilitiesCommon stockRetained earningsOwners equity

501181051925741309263211255961690442500

548941051923141283367727255962180747403

583311051920831260270933255963248658082

Total Capital 105711 115130 129015

Working Note for table 10:

1. 2. Retained Earnings For 2006: Retained earnings (2005) + Addition in 2006

i.e. 16904+4903.19 = 21807

For 2007: Retained earnings (2006) + Addition in 2007

i.e. 21807 +10679 = 32486

3. Accounts ReceivablesFor 2006: Average collection period = Receivables / Sales per day

i.e. 32= Receivables / (228223.3 / 360

Therefore, receivables = 20286

For 2007: Average collection period = Receivables / Sales per day

i.e. 32 = Receivables / (249904.5 / 360)

Therefore, receivables = 22213.

Notes:

1. Cash is the balancing figure.

2. Accounts receivables and inventory has been calculated by using the industry average ratios.

In 2006, the company has total cash balance of 39667 thousands and during the same year the short-term bank loan to be retired is 27068

= $(39667 – 27068)

= $12599

5% of sales. is maintain by the company

Minimum cash balance = $ (228223* 0.05)

= $ 11411.15

From the calculation we can see that the company is able to maintain the minimum cash balance. Hence, it has enough cash balance to retire the short-term bank loans i.e. SRM will be able to retire its short term bank loan if the prediction made were materialized.

Question No.4.Compute projected financial ratios for 2006 and 2007 (or complete Table 11). Compare these ratios with 2005 along with industry averages and analyze improvement or deterioration in financial condition.

Table 11: Silver River Manufacturing CompanyRatio Analysis Year Ended December 31, 2007 (Projected)

Particulars Formula 2005 2006 Projected

2007 Projected

Industry Average

Liquidity ratiosCurrent ratioQuick ratio

Leverage ratiosDebt ratio (%)Time interest earned

Asset management ratiosInventory turnover (cost)Inventory turnover

CA/CL(CA-Inventory)/CL

Total debt/TAEBIT/Interest charge

COGS/InventorySales/Inventory

1.750.73

59.801.48

3.574.19

1.691.09

59.002.68

5.706.9

1.831.23

55.004.68

5.707.1

2.501.00

50.007.70

5.707.00

(Selling)Fixed asset turnover

Total asset turnoverAverage collection period

Profitability ratiosProfit margin (%)Gross profit margin (%)Return on total assetsReturn on owners equity

Sales/Net fixed assetsSales/Total assetsReceivables/(annual sales/360)

Net income/SalesGross Income/SalesNet Income/TANet Income/equity

12.10

2.0454.00

0.3814.860.781.95

10.3

1.9832.00

2.1517.54.2610.34

11.26

1.9432.00

4.2720.008.218.38

12.00

3.0032.00

2.9018.008.8017.50

Working notes for Table 11

Particulars FormulaComputation2006 2007

Current ratioCurrent assets / current liabilities 92984/ 54894 1.69 106815/58331 1.83

Quick ratio

(Current assets - inventories) / Current liabilities

(92984-33032)/ 54894 1.09

(106815-31074) /58331 1.23

Debt ratioTotal debt / Total asset

67727/ 115130 58.8 70933/ 1290151 54.98

Times interest earned EBIT / Interest 15022/5593 2.69 26108 /5572 4.69

Inventory turnover(cost) COGS / Inventory 18824/ 33032 5.70 199904 / 35074 5.70

Inventory Sales / Inventory 228223 / 7 227,185.70 / 7

turnover(selling) 233032 32,455.10

Fixed assets turnover Sales / Fixed asset207475.53 / 20,132.25 10.3

227,185.70 / 19,186.76 11.84

Total asset turnover Sales / Total asset207475.53 / 104,664.12 1.98

227,185.70 / 117,287.76 1.94

Average collection periodReceivables / Sales per day

18,442.27 / (207,475.53 / 360) 32

20,194.28 / (227,185.70 / 360) 32

Profit margin(%)(Net income / Sales) * 100

(4,457.89 / 207,475.53)*100 2.15

(9,708.62 / 227,185.70)*100 4.27

Gross profit margin(%)(Gross profit / Sales) * 100

(36,308.22 / 207,475.53)*100 17.5

(45,437.14 / 227,185.70)*100 20

Return on total assets(Net income / Total asset) * 100

(4,457.89 / 104,664.12)*100 4.26

(9,708.62 / 227,185.70)*100 8.28

Return on owner's equity(Net income / Total equity) * 100

(4,457.89 / 43,094.36)*100

10.34

(9,708.62 / 52,802.98)*100 18.39

Notes: Figures for 2005 have been taken from table 7.

Liquidity Ratios:

Current ratio:

2005 2006 20070

0.5

1

1.5

2

2.5

3


In 2006, the projected current ratio is lower than 2005 and Industry average. This shows that the firm’s ability to meet its short term obligations has decreased in 2006. In 2007, the projected current ratio is quite higher than 2005 and lower than the industry average. This shows that the

firm’s ability to meet its short term obligations has improved but is still poor in comparison to industry average.

Quick ratio:

2005 2006 20070

0.2

0.4

0.6

0.8

1

1.2

1.4


In 2006, the projected quick ratio is higher than 2005 and industry average. This shows that the ability of firm to meet its short term obligations has improved. In 2007, the projected quick ratio is quite higher than 2005 and industry average. This shows that the firm has improved its ability to meet its short term obligations.

Leverage Ratios:

Debt ratio:

2005 2006 200644

46

48

50

52

54

56

58

60

62


In 2006, the projected debt ratio is lower than 2005 and quite higher than industry average. This shows that company has decreased its assets which is financing from debts but it is quite higher in comparison to industry average. In 2007, the projected debt ratio has decreased than 2005 and

also higher than industrial average. The debt ratio indicates that the company has minimized its risk level.

Time interest earned ratio:

2005 2006 20070

1

2

3

4

5

6

7

8

9


In 2006 the time interest earned ratio has increased than 2005 and is lower than the industry average. This shows that the company is still unable to cover the interest expenses. In 2007, the ratio is improved but still below the industrial average line which shows the improvement in ability to cover the necessary interest expenses.

Asset Management Ratios:

Inventory turnover ratio(cost):

2005 2006 20070

1

2

3

4

5

6


Inventory turnover ratio has been improved in the years 2006 and 2007 then in 2005 and is equal to industrial average. From this we can conclude that the company’s inventory are producing sales as that industry average.

Inventory turnover ratio(Sales):

2005 2006 20070

1

2

3

4

5

6

7

8


In 2006, there has been increase in inventory turnover ratio (in costs) in comparison to 2005 and is above the industry average. In 2007, this ratio is higher than 2005 but is below the industry average showing deterioration in the company’s capacity in efficiently managing the inventory. If we analyze the inventory turnover in terms of sales we see in both the years 2006 and 2007 there have been significant improvement in inventory turnover in comparison to the year 2005 and both the years have inventory turnover equal to that of industry average. However, a better measure of inventory turnover is the inventory turnover in terms of cost rather than in terms of sales.

Fixed assets turnover ratio:

2005 2006 20079

9.5

10

10.5

11

11.5

12

12.5


The fixed assets turnover ratio in2006is low in comparison to that of the year 2005 and industry average. However, there is some progress in utilization of fixed assets in the year 2007 but it is still below in comparison to 2005 and industry average.

Total assets turnover ratio:

2005 2006 20060

0.5

1

1.5

2

2.5

3

3.5


The total assets turnover ratios in the year 2006 and 2007 are lower in comparison to the year 2005 and industry average. This ratio in the year 2005, 2006 and 2007 shows the decreasing trend. This ratio is below the industry average line.

Average collection period (ACP):

2005 2006 20070

10

20

30

40

50

60


In year 2006 and 2007 average collection period is equal to industry average. The firm is projected to have sufficient improvement in Average collection period in comparison to 2005.

Profitability Ratios:

Profit margin ratio:

2005 2006 20070

0.5

1

1.5

2

2.5

3

3.5

4

4.5


In 2006, the projected profit margin has improved in comparison to the year 2005 but is still below the industry average. However, in the year 2007 the projected profit margin has improved

and is higher than industry average. This shows that there will be improvement in financial condition of the company in the year 2007.

Gross profit margin:

2005 2006 20070

5

10

15

20

25


In year 2006 and 2007 the projected gross profit margin has increased in comparison to 2005. In 2006 it is below industry average but in 2007 it is above industry average showing the improvement in financial condition.

Return on Total Assets:

2005 2006 20070

1

2

3

4

5

6

7

8

9

10


Return on assets is also been increased in the year 2006 and 2007 from 2005. In the year 2006 and 2007 SRM has failed to maintain the industry average but it has improved dramatically in

the year 2007 and has able to maintain better return that of industry. Even With the increase in ROA which is a good sign of progress.

Return on owner’s equity:

2005 2006 20070

2

4

6

8

10

12

14

16

18

20


In 2006, there has been great improvement in ROE in comparison to the year 2005 but is still below the industry average. But, in 2007 it is above the industry average showing the improvement in both operating and financial decisions of the company.

Question No.5. If all short-term bank loans are repaid towards the end of the first half of 2006, do you think that company is still able to pay regular dividends and maintain minimum cash balance? Revise the tables 9, 10, 11 (or complete the tables 12, 13 and 14). Do you find any situations developing that may indicate poor financial policy? What should be the impact of such situations on the ratios for the company, and are such impacts necessarily either good or bad? Why?

Solution: If all the short term loans are repaid at the end of first half of 2006, the company would be able to pay its regular dividends in 2006 as well as in 2007. This is because the interest on short term loan is being decreased in 2006 and is being zero by 2007.

The minimum cash balance required at the end of 2006 is 11411.165 (5% of 228223.3). The company after paying the dividend of 25% during the year 2006 has the cash balance of

$10125440. So, the company will not be able to maintain the minimum cash balance of $10387276.

Since, after the payment of short term loan all the ratios of the company are improving. We can find that there is no any situation that indicates poor financial status.

The impacts on the ratios after the payment of short term bank loans are:

Liquidity ratios

a. Current ratio: The improvement in the current ratios of the company shows better ability of the company to meet its current obligations.

b. Quick ratio: The improvement in quick ratio of the company shows better ability to meet its short term obligations.

Leverage ratios

a. Debt ratio: The decrease in debt ratio of the company shows its less involvement of debt to finance fixed assets of the company.

b. Time’s interest earned ratio: The improvement in the Time interest earned ratio shows is ability to pay interest.

Asset management ratio

a. Total asset turnover: The increase in total asset turnover ratios shows the company has more efficiently utilized the overall assets to generate more sales revenue.

Profitability ratios

a. Profit margin: The increase in the profit margin ratio shows the improvement in the company’s ability to earn by its sale after paying all the necessary expenses.

b. Return on total assets: The improvement in return on total assets ratio shows the good effectiveness of the operating management of the firm.

c. Return on owner’s equity: The increase in return on owners equity shows the improvement in both operating and financial decisions of the company.

Table 12: Silver River Manufacturing CompanyPro Forma Income Statements (Revised)Worksheet for Year End 2007 (Thousands of Dollars)

Particulars 2005 2006 Revised 2007 Revised

Net Sales 215305 228223 249904

Cost of Goods Sold 183307 188284 199923

Gross Profit 31998 39939 49981

Administrative and Selling 18569 18258 18743

Depreciation 2244 2665 1823

Miscellaneous expenses 6297 3994 3124

Total operating expenses 27110 24917 23691

EBIT 4888 15022 26291

Interest on short-term loans 2006 2165 -

Interest on long-term loans 1052 1052 1052

Interest on mortgage 233 210 189

Net income before tax 1597 11595 25050

Taxes 767 5565.6 12024

Net income 831 6029.4 13026

Dividends on stock 208 1507.35 3256.5

Additions to retained earnings 623 4522.05 9769.5


Pro Forma Balance Sheets (Revised)

Worksheet for Year End 2007 (Thousands of Dollars)Particulars 2005 2006 Revised 2007 Revised

Assets

Cash 4296 12217 22265

Accounts Receivable 32293 20286 22213

Inventory 51324 33032 35074

Current Assets 87913 65535 79552

Land, Buildings, Plant and Equipment 25161 32173 33139

Accumulated Depreciation (7363) (10028) (12033)

Net Fixed Assets 17798 22145 21105

Total Assets 105711 87680 100657

Liabilities and Equities

Short-term bank loans 20056 0.00 0.00

Account payable 21998 17594 18474

Accruals 8064 10231 12789

Current liabilities 50118 27826 31263

Long-term bank loans 10519 10519 10519

Mortgage 2574 2314 2083

Long-term debt 13092 12833 12602

Total liabilities 63211 40658 43865

Common stock 25596 25596 25596

Retained earnings 16904 21426 31196

Owners' equity 42500 47022 56792

Total Capital 105711 87680 100657

Working notes of Table 12

Particulars

Calculations that affect changes

2006 2007

Projected sales 215305 * 1.06 228223.3 228223.3* 1.095 249904.5

Cost of goods sold82.5% of 228223.3 188284.2 80% 249904.5 199923.6

Administrative and selling expenses 8% of 228223.3 18258.76 7.5% of 249904.5 18743

Miscellaneous expenses 1.75% of 3,993.9 1.25% of 3123.81

228223.3 249904.5

Taxes 48% of 11595 5565.60 48% of 25050 12024

Working Notes on Table 13

Particulars2006 2007Retained earnings (2005)

Additions in 2006

Total Retained earnings (2006)

Additions in 2007

Total

Retained Earnings

16904 4522 21426 21426 9770 31196

Particulars 2006 2007Formula Calculations Total Calculations Total

AccountsReceivables

Average collection period = Receivables / Sales per day

32

=Receivables / (228223.3 / 360)

20286 32= Receivables / (249904.5 / 360)

22213

Inventory Inventory turnover = Sales / Inventory

5.7 =188284 / Inventory

33032 5.7= 199923 / Inventory 35074

Notes:

1. Cash is the balancing figure.2. Accounts receivables and inventory has been calculated by using the industry average

ratios.3. Major changes have been observed in ratios like current, quick, debt ratio, interest

earned, total assets turnover, profit margin, ROA and ROE.

Table 14: Silver River Manufacturing CompanyRatio Analysis Year Ended December 31 (Revised)Particulars 2005 2006 2007 Revised Industry average

Revised

Liquidity Ratios

Current ratio 1.75 2.35 2.54 2.50Quick Ratio 0.73 1.17 1.04 1.00

Leverage Ratios

Debt ratio (%) 60 46 43.57 50.00Times interest earned 1.48 4.38 21.19 7.70

Asset Management Ratios

Inventory turnover (Cost) 3.57 5.70 5.70 5.70Inventory turnover (Selling) 4.19 6.9 7.12 7.00Fixed asset turnover 12.1 10.3 11.84 12.00Total asset turnover 2.04 2.6 2.48 3.00Average collection period 54 32 32 32.00

ProfitabilityRatios

Profit margin (%) 0.39 2.64 5.21 2.90Gross profit margin (%) 14.86 17.5 20 18.00Return on total assets 0.78 6.87 12.94 8.80Return on owners' equity 1.95 12.82 22.94 17.50

Comparison of forecasted and revised financial ratios of 2006 and 2007:

Particulars2005 Forecasted

2006Revised 2006

Forecasted 2007

Revised 2007

Current ratio 1.75 1.69 2.35 1.83 2.54

Quick ratio 0.73 1.092 1.16 1.23 1.42

Debt ratio(%) 6.0 59.0 46.37 55.0 43.58

Times interest earned 1.48 2.68 4.38 4.68 21.18

Inventory turnover(cost) 3.57 5.70 5.70 5.70 5.70

Inventory turnover(selling) 4.20 6.9 6.91 7.1 7.13

Fixed assets turnover 12.1 10.3 10.31 11.26 11.84

Total asset turnover 2.04 1.98 2.6 1.94 2.48

Average collection period 54 32 32 32 32

Profit margin (%) 0.39 2.15 2.64 4.27 5.21

Gross profit margin (%) 14.86 17.5 17.5 20 20

Return on total assets 0.79 4.26 6.88 8.20 12.94

Return on owner's equity 1.96 10.34 12.82 18.38 22.91

1. Liquidity ratioSince all short term loans would have been met by the end of 2006, current and quick ratios would increase. It shows the company’s ability to meet its short term obligation in coming year will be better.

2. Leverage ratio Debt ratio has declined as we can see in the trend above which reduces the risk of bank as there would be lower debt in comparison to assets. With new policy, SRM will have 46.37% of debt financing in 2006 as compared to previous 58.83%. Similarly in 2007, SRM will have 54.98% of debt financing and after the repayment the SRM will have 43.61%.

Significant increase in times interest earned ratio is observed in 2007 as EBIT is in increasing trend which indicate the lower risk of interest default.

3. Profitability ratioProfit margin has also increased as income is in an increasing trend with decrease in interest expenses. The return from the total assets of SRM will be improved after the repayment of all loans. The profit generated from shareholders equity will also be improved if all the short-term loans are repaid. As major ratios would have been improved by implementing new policy of repayment of short term loan by 2006, financial situation of the company would be better off.

Working notes of Table 14

Particulars FormulaComputation2006 2007

Current ratio

Current assets/ current liabilities 65535 / 27826 2.35 79552/ 31263 2.54

Quick ratio

(Current assets - inventories) Current liabilities

(65535-33032) / 27826 1.16

(79552-35074)/ 31263 1.42

Debt ratio(%)Total debt / Total asset 40658 / 87680 46 43865 / 100657 43.57

Times interest earnedEBIT / Interest 15022 / 3427 4.38 26292 / 5572 21.19

Inventory turnover(cost)COGS / Inventory 188284 / 33032 5.70 199923 / 35074 5.70

Inventory turnover(selling)Sales / Inventory 228223 / 33032 6.90 249904 / 35074 7.12

Fixed assets turnoverSales / Fixed asset 228223 / 22145 10.3 249904 / 21105 11.84

Total asset turnoverSales / Total asset 228223/ 87680 2.6 249904 / 100657 2.48

Average collection periodReceivables / Sales per day

20286 / (228223 / 360) 32

22214 / (249904 / 360) 32

Profit margin (%)(Net income / Sales) * 100 (6030/228223)*100 2.64 (13027/249904)*100 5.21

Gross profit margin (%)(Gross profit / Sales) * 100

(39939 / 228223)*100 17.5

(49981/ 249904)*100 20

Return on total assets(%)

(Net income / Total asset) * 100 (6030 / 87680)*100 6.87

(13027 / 100657)*100 12.94

Return on owner's equity(%)

(Net income / Total equity) * 100 (6030 / 47022)*100 12.82 (13027/ 56792)*100 22.94

Question No. 6: On the basis of your analyses, do you think that the bank should:a) Extend the existing short and long-term loans and grant the additional $6,375,000

loans, orb) Extend the existing short and long-term loans without granting the additional loan,

orc) Demand immediate repayment of both existing loans?

If you favor (a) or (b) above, what conditions (collateral, guarantees, or other safeguards) should the bank impose to protect itself on the loans?Based on our analysis we think that the bank should in fact extend the existing short and long-term loans and grant the additional $6,375,000 loan. We have following reasons to support our recommendation:

1. The past performance of SRM has been observed to be quite impressive. For the past years, SRM has depicted the characteristics of being a good client of the bank by making due payments within the time line. It also has a good reputation in the market.

2. The current problems faced by SRM are not solely because of its operational failure. Rather, it is due to unavoidable circumstances like financial downturn (recession) in the market and the unexpected change in the climatic conditions that reduced the demand of its products in the market.

3. SRM is also committed to repay its loan. In fact the analyses made by Mr. White suggest that the financial position of the company could improve significantly over the next two years. Shifting from policy of aggressive marketing and sales promotion to full margin prices, standard industry credit term and tighter credit standards would reduce the cost of goods sold. Similarly, he is also planning to minimize administrative and selling expense and miscellaneous expenses in the coming two years.

4. There is a projected growth rate of 6% and 9.5% in sales on an average for 2006 and 2007 respectively, assuming there is no significant improvement in either national or farm economy. This condition is also likely to strengthen their chances of making the debt payments.

5. The company is also likely to enter in the horse van and mobile chassis segments of the market that are rapidly growing with significant profit prospective. Such an investment is likely to reduce the dependency of the company on farm and light utility trailer segment that is presently causing the firm’s poor performance.

6. Assuming that the projected ratios hold true in future, these ratios exceed the contractual requirement of the bank. Hence, it is very likely that SRM will eventually succeed in fulfilling its financial obligations.

7. SRM’s projected Altman Z factor is increasing and is above 3 for the years 2006 and 2007 which shows the less chances of company going bankrupt in future.

Analyzing the condition of SRM we can find that they seems quite able to repay their short term loan

Question No.7: If the bank decides to withdraw the entire line of credit and to demand immediate repayment of the two existing loans, what alternatives would be open to SRM?

Solution:Though SRM had shown high and steady growth in sales, assets and profits prior to 2003, however, towards the end of 2003 the demand for new field trailers in citrus and vegetable industries started to fall. In order to sustain profits and superior market performance Mr. White aggressively reduced prices to stimulate further sales. Consequently, production continued unabated and inventories started increasing. Mr. White’s next step was to relax credit terms and standard to maintain preciously high growth and to reduce the ever expanding inventory. This effort of Mr. White increased sales through the third quarter of 2005, but inventories also increased steadily and particularly short-term credits and accounts receivable grew up dramatically.

In case if the bank withdraws the entire line of credit and demands immediate repayment of the two existing loans, SRM can adopt following actions:

Take mortgage loan from bank: SRM has land, buildings, plant and equipment worth of $ 22873.5 and it has mortgage worth of $ 2339.62. This reflects that SRM has the capacity to mortgage its land and buildings. Hence, it can request loan with another bank mortgaging its land and buildings.

Sell accounts receivables and liquidate inventory: SRM has accounts receivables of $ 29356.86 and inventory worth $ 46658.62. It can sell its receivables and liquidate the inventory in order to repay the loan.

Make strict collection policies: The average collection period of SRM is 57 days in 2005. The company has to make its collection policies stricter so that the debtors will pay in time. Here, SRM is adopting liberal collection policies.

In the same way SRM can liquidate its fixed assets, stop payment of dividend payment and can delay its trade payable to deal with this circumstance.

SRM has to take immediate actions as well as gradual steps to stabilize its condition. It can mix the above mentioned actions as a response to the bank’s decision of withdrawing entire line of credit and demanding immediate repayment of existing loans..

8. Lessons Learnt:

Silver River Manufacturing company (SRM), a large regional producer of agricultural utility such as grove trailers, citrus transport carrier, is being hit hard by deteriorating nation’s farm economy. This company has been a good customer of Marion country National Bank (MCNB) however, due to inability to meet the contractual financial ratio by the company, Lesa Nix; Vice-president of MCNB had made a alerting phone call to the Greg White, founder and president of SRM.

Due to ensuing loss of public trust the regulators of MCNB are becoming strict in their examination of bank loan portfolios and lending practice, because of which SRM might have to suffer.

Greg White, an optimistic person, after attending seminar on executive development convinced that the key to sustained profit and superior performance was sales growth and the achievement of higher share of the market so; he started producing all his products relentlessly and relaxed the

credit term to capture more market share. Until the third quarter of 2005 indeed, the sales was high but during fourth quarter inventories as well as receivable started rocketing.

Over optimist White had always taken it for granted that MCNB would increase his line of credit and when he was about to turn to MCNB to finance increase of assets , MCNB was considering reducing or even eliminating such loan. Knowing this ground reality, White realized, for the sales growth and sustainable profit is possible only when reasonable profit margins at every sale are made which was the crux point. Failing this point to notice early was the main cause of his company to be in such deteriorating condition.

White, Knew he had focused much on marketing and production issues without paying adequate attention to their financial implications and started to switch his production form volatile farm sector to more stable medium-to-high growth markets of Horse Vans, Mobile home chassis etc. Likewise, SRM will change its policy of aggressive marketing and sales promotion and return to full-margin pricing, standard industry credit terms and tighter credit standards; remaining within the periphery of industry average.

What learning we can gain from the case of SRM is that as being manager one shouldn’t apply any policies without analyzing the effect of decision on company’s financial position. One should always consider the future environment to make sure that the decision made by manager is going to rock in future. Major things learned from this case study can be summarized below:

How to look at the strength and weakness of a company. How to analyze the company’s financial condition based on different kinds of ratios. How to look at the different corner of the financial statements.

silver river manufacturing company

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