Custom Tech, Inc., designs and produces computers for a variety of customers. Th
ID: 2813601 • Letter: C
Question
Custom Tech, Inc., designs and produces computers for a variety of customers. The company has encountered a cash shortage resulting from collection problems with several customers. If Custom Tech is unable to collect a significant portion of its receivables relatively soon, the company will not be able to pay suppliers and employees next quarter. As a result, Custom Tech’s president, Don Lardner, began discussions with a local bank about obtaining a short-term loan. Don did not mention the cause of the cash flow shortage other than to say, “This happens the same time every year due to the cyclical nature of our business.”
In a meeting with the bank’s loan officer, Jan Johnson, Don was told the loan should not be a problem as long as Custom Tech maintains a profit margin ratio above 10 percent, quick ratio above 1.0 to 1, and debt to equity ratio below 1.4 to 1. Don indicated this was in line with his company’s performance and agreed to provide financial statements for the most recent year at their next meeting.
The financial statements shown as follows are for Custom Tech’s most recent year ended December 31. This information has not yet been provided to the bank.
Custom Tech, Inc. Income Statement
(In Thousands)
Net Sales
300
Cost of Goods Sold
120
Gross Margin
180
Operating Expenses
135
Income before Taxes
45
Tax Expense
12
Net Income
33
Custom Tech, Inc. Balance Sheet
(In Thousands)
Assets
15
Current Assets
55
Cash and Cash Equivalents
75
Accounts Receivable (net)
40
Other Current Assets
35
Total Current Assets
165
Property, Plant and Equipment (net)
85
Total Assets
250
Liabilities and Shareholders’ Equity
Current Liabilities
Accounts Payable and Accrued Liabilities
100
Total Current Liabilities
100
Noncurrent Liabilities
Long-Term Debt
50
Shareholders’ Equity
Common Stock
60
Retained Earnings
40
Total Liabilities and Shareholders’ Equity
250
Questions:
a. Calculate the ratios required by the bank and determine whether Custom Tech will qualify for the loan.
b. Assume you are the CFO for Custom Tech. Don Lardner asks you to reclassify $30,000 in current liabilities to common stock. Don states, “We owe it to our shareholders and employees to do whatever it takes to get this loan! Without it, we may have to file for bankruptcy and let our employees go. Once we get this loan and collect our outstanding receivables we’ll be in good shape.” Prepare a revised balance sheet after making the $30,000 reclassification, recalculate the ratios required by the bank, and determine whether Custom Tech will qualify for the loan with the revised numbers.
Net Sales
300
Cost of Goods Sold
120
Gross Margin
180
Operating Expenses
135
Income before Taxes
45
Tax Expense
12
Net Income
33
Explanation / Answer
(a) Computation of the ratios required by the bank.We have,
(i) Profit Margin ratio = Net Income / Net Sales
Profit Margin ratio = 33,000 / 300,000 = 0.11 * 100 = 11.00 %
Net profit margin ratio shows the earnings left for shareholders as a percentage of net sales. It measure the overall efficiency of production,administration, selling, financing, pricing and tax managment.Profit margin ratio is 11% for the company and it is favorable for bank to grant laon to the company.
(ii) Quick ratio = ( Current Asset - Inventory) / Current Liabilities
Quick ratio = ( 165 - 15) / 100 = 1.50
Quick ratio is a fairly stringent measure of liquidity.It is based on those current assets which is highly liquid. Higher the ratio is better for the company in the sense of ablity to pay money in short term. Hence, It is favorable for bank to lend short-term loan to the company.
(iii) Debt-to-Equity ratio = Debt / Equity
Debt-to-Equity ratio = 50 / 100
Debt-to-Equity ratio = 0.50
The lower the debt-equity ratio,the higher the degree of protection enjoyed by the creditors.So, Debt-equtiy ratio for this company is favourable to the bank.Debt-equity ratio is favourable for the bank to grant loan to the company.
Conclusion: The profit margin ratio, Quick ratio and Debt-Equity ratio of the company is qualify for bank to senction short-term loan..
(b) Preparation of the revised balance sheet after making the $30,000 reclassification.We have,
Custom Tech, Inc. Balance Sheet
($ In Thousands)
Assets
Current Assets
15.00
Cash and Cash Equivalents
75.00
Accounts Receivable (net)
40.00
Other Current Assets
35.00
Total Current Assets
165.00
Property, Plant and Equipment (net)
85.00
Total Assets
250.00
Liabilities and Shareholders’ Equity
Current Liabilities
Accounts Payable and Accrued Liabilities
70.00
Total Current Liabilities
70.00
Noncurrent Liabilities
Long-Term Debt
50.00
Shareholders’ Equity
Common Stock
60.00
Retained Earnings
70.00
Total Liabilities and Shareholders’ Equity
250.00
Computation of the ratio which is required by the bank.We have,
(i) Profit Margin ratio = Net Income / Net Sales
Profit Margin ratio = 33,000 / 300,000 = 0.11 * 100 = 11.00 %
Net profit margin ratio shows the earnings left for shareholders as a percentage of net sales. It measure the overall efficiency of production,administration, selling, financing, pricing and tax managment.Profit margin ratio is 11% for the company and it is favorable for bank to grant laon to the company.
(ii) Quick ratio = ( Current Asset - Inventory) / Current Liabilities
Quick ratio = ( 165 - 15) / 70 = 2.14
Quick ratio is a fairly stringent measure of liquidity.It is based on those current assets which is highly liquid. Higher the ratio is better for the company in the sense of ablity to pay money in short term. Hence, It is favorable for bank to lend short-term loan to the company.
(iii) Debt-to-Equity ratio = Debt / Equity
Debt-to-Equity ratio = 50 / 130
Debt-to-Equity ratio = 0.38
The lower the debt-equity ratio,the higher the degree of protection enjoyed by the creditors.So, Debt-equtiy ratio for this company is favourable to the bank.Debt-equity ratio is favourable for the bank to grant loan to the company.
Conclusion: The profit margin ratio, Quick ratio and Debt-Equity ratio of the company is qualify for bank to senction short-term loan.
Profit Margin ratio 11.00 %Related Questions
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