Chapter 14, Problem 18P

Common-Size Statements and Financial Ratios for a Loan Application

Paul Sabin organized Sabin Electronics 10 years ago to produce and sell several electronic devices on which he had secured patents. Although the company has been fairly profitable, it is now experiencing a severe cash shortage. For this reason, it is requesting a $500,000 long-term loan from Gulfport State Bank. $100,000 of which will be used to bolster the Cash account and $400,000 of which will be used to modernize equipment. The company's financial statements for the two most recent years follow:

During the past year, the company introduced several new product lines and raised the selling prices on a number of old product lines in order to improve its profit margin. The company also hired a new sales manager, who has expanded sales into several new territories. Sales terms are 2/10, n/30. All sales are on account.
Required:

1. To assist in approaching the bank about the loan. Paul has asked you to compute the following ratios for both this year and last year:
  a. The amount of working capital.
  b. The current ratio.
  c. The acid-test ratio.
  d. The average collection period. (The accounts receivable at the beginning of last year totaled $250,000.)
  e. The average sale period. (The inventory at the beginning of last year totaled $500,000.)
  f The operating cycle.
  g. The total asset turnover. (The total assets at the beginning of last year were $2,420,000.)
  h. The debt-to-equity ratio.
  i. The times interest earned ratio.
  j. The equity multiplier. (The total stockholders' equity at the beginning of last year totaled $1,420,000.)
2. For both this year and last year:
  a. Present the balance sheet in common-size format.
  b. Present the income statement in common-size format down through net income.
3. Paul Sabin has also gathered the following financial data and ratios that are typical of companies in the electronics industry:

Comment on the results of your analysis in (1) and (2) above and compare Sabin Electronics' performance to the benchmarks from the electronics industry. Do you think that the company is likely to get its loan application approved?

To determine

Financial Ratio Analysis:

The process of evaluating the financial ratios is known as financial ratio analysis

1.

Compute the following ratios for both this year and last year.

a. Working Capital

b. Current Ratio

c. Acid-Test Ratio

d. Average Collection Period

e. Average Sale Period

f. Operating Cycle

g. Total Asset Turnover

h. Debt-to-Equity Ratio

i. Times Interest Earned Ratio

j. Equity Multiplier

2.

Prepare balance sheet and income statement in common-size format for both this year and last year.

3.

Comment on the results of your analysis in (1) and (2) above and compare Sabin Electronics’ performance to the benchmarks from the electronics industry. Do you think that the company is likely to get its loan application approved?

Answer to Problem 18P

Solution:

1.

Ratios	This Year	Last Year
Working Capital	$720,000	$660,000
Current Ratio	1.90	2.53
Acid-Test Ratio	0.69	1.09
Average Collection Period	28 days	23 days
Average Sale Period	73 days	58 days
Average Payable Period	58 days	45 days
Operating Cycle	43 days	36 days
Total Asset Turnover	1.83	1.78
Debt-to-Equity Ratio	0.88	0.72
Times Interest Earned Ratio	6.56	4.89
Equity Multiplier	1.80	1.71

2.

SABIN ELECTRONICS Common Size Balance Sheet
	This Year	Percent	Last Year	Percent
Assets
Current assets:
Cash	$70,000	2.3%	$150,000	6.1%
Marketable securities	0	0.0%	18,000	0.7%
Accounts receivable, net	480,000	16.0%	300,000	12.2%
Inventory	950,000	31.7%	600,000	24.4%
Prepaid expenses	20,000	0.7%	22,000	0.9%
Total current assets	1,520,000	50.7%	1,090,000	44.3%
Plant and equipment, net	1,480,000	49.3%	1,370,000	55.7%
Total Assets	$3,000,000	100%	$2,460,000	100%
Liabilities and Stockholders’ Equity
Liabilities:
Current liabilities	$800,000	26.7%	$430,000	17.5%
Bonds payable, 12%	600,000	20%	600,000	24.4%
Total Liabilities	1,400,000	46.7%	1,030,000	41.9%
Stockholders’ equity
Common stock, $15 par	750,000	25%	750,000	30.5%
Retained Earnings	850,000	28.3%	680,000	27.6%
Total Stockholders’ Equity	1,600,000	53.3%	1,430,000	58.1%
Total liabilities and stockholders’ equity	$3,00,000	100%	$2,460,000	100%

SABIN ELECTRONICS Common Size Income Statement
	This Year	Percent	Last Year	Percent
Sales	$5,000,000	100%	$4,350,000	100%
Cost of goods sold	3,875,000	77.5%	3,450,000	79.3%
Gross margin	1,125,000	22.5%	900,000	20.7%
Selling and administrative expenses	653,000	13.1%	548,000	12.6%
Net operating income	472,000	9.4%	352,000	8.1%
Interest expense	72,000	1.4%	72,000	1.7%
Net income before taxes	400,000	8%	280,000	6.4%
Income taxes (30%)	120,000	2.4%	84,000	1.9%
Net Income	280,000	5.6%	196,000	4.5%

3.

Considering the financial data and ratios of companies in the electronics industry, Sabin Electronics is likely to get its loan approved because the low debt equity ratio and improving times interest earned ratio which are good signs for the bank. In addition to that, the company is planning to invest 80% of the loan amount into modernizing the equipment which increase the productivity and ultimately resulting in higher profitability.

Explanation of Solution

1.

a. Computation of Working Capital
	This Year	Last Year
Current Assets	$1,520,000	$1,090,000
Less: Current Liabilities	$800,000	$430,000
Working Capital	$720,000	$660,000

  $\begin{array}{l}b.CurrentRatio=\frac{CurrentAssets}{CurrentLiabilities}\hfill \\ \hfill \\ ThisYear =\frac{\$1,520,000}{\$800,000}\hfill \\ =1.90\hfill \\ LastYear =\frac{\$1,090,000}{\$430,000}\hfill \\ =2.53\hfill \end{array}$

  $\begin{array}{l}c.Acid-TestRatio=\frac{Cash+MarketableSecurities+AccountsReceivable}{CurrentLiabilities}\hfill \\ \hfill \\ ThisYear=\frac{\$70,000+0+\$480,000}{\$800,000}\hfill \\ =0.69\hfill \\ \hfill \\ LastYear=\frac{\$150,000+\$18,000+\$300,000}{\$430,000}\hfill \\ =1.09\hfill \end{array}$

  $\begin{array}{l}d.AverageCollectionPeriod=\frac{365days}{AccountsReceivableTurnoverRatio}\hfill \\ \hfill \\ *AccountsReceivableTurnoverRatio=\frac{NetCreditSales}{AverageAccountsReceivable}\hfill \\ AverageAccountsReceivable=\frac{BeginningAccountsReceivable+EndingAccountsReceivable}{2}\hfill \end{array}$

  $\begin{array}{l}AveragePayablePeriod=\frac{AverageAccountsPayable }{CostofgoodsSold}X365days\hfill \\ *AverageAccountsPayable=\frac{BeginningAccountsPayable+EndingAccountsPayable}{2}\hfill \\ \hfill \\ ThisYear=\frac{\$615,000}{\$3,875,000}X365days\hfill \\ =58Days\hfill \\ *AverageAccountsPayable=\frac{\$430,000+\$800,000}{2}=\$615,000\hfill \\ \hfill \\ LastYear=\frac{\$430,000}{\$3,450,000}X365days\hfill \\ =45Days\hfill \\ *AverageAccountsPayable=\$430,000\hfill \end{array}$

  $\begin{array}{l}\begin{array}{l}f.OperatingCycle=AverageCollectionPeriod+AverageSalePeriod-AveragePayablePeriod\hfill \\ \hfill \end{array}\\ \begin{array}{l}ThisYear=28days+73days-58days=\text{ 43 }days\hfill \\ LastYear=23days+58days-45days=\text{ 36 }days\hfill \end{array}\end{array}$

  $\begin{array}{l}g.TotalAssetTurnover=\frac{SalesRevenue}{AverageTotalAssets}\hfill \\ *AverageTotalAssets=\frac{BeginningTotalAssets+EndingTotalAssets}{2}\hfill \end{array}$

  $\begin{array}{l}ThisYear=\frac{\$5,000,000}{\$2,730,000}\hfill \\ =1.83\hfill \\ *AverageTotalAssets=\frac{\$2,460,000+\$3,000,000}{2}\hfill \\ =\$2,730,000\hfill \\ \hfill \\ LastYear=\frac{\$4,350,000}{\$2,440,000}\hfill \\ =1.78\hfill \\ \begin{array}{l}*AverageTotalAssets=\frac{\$2,420,000+\$2,460,000}{2}\\ =\$2,440,000\end{array}\hfill \end{array}$

  $\begin{array}{l}h.DebtEquityRatio=\frac{TotalLiabilities}{TotalStockholders’Equity}\hfill \\ \hfill \\ ThisYear=\frac{\$1,400,000}{\$1,600,000}\hfill \\ =0.88\hfill \\ \hfill \\ \text{Last }Year=\frac{\$1,030,000}{\$1,430,000}\hfill \\ =0.72\hfill \end{array}$

  $\begin{array}{l}i.TimesInterestEarnedRatio=\frac{EarningsBeforeInterestandTaxes}{InterestExpense}\hfill \\ \hfill \\ ThisYear =\frac{\$472,000}{\$72,000}\hfill \\ =6.56\hfill \\ \hfill \\ LastYear=\frac{\$352,000}{\$72,000}\hfill \\ =4.89\hfill \end{array}$

Conclusion

With 80% of loan amount being invested in modernizing the equipment, the sales and net income of the company is likely to improve with productivity. The current ratio and acid-test ratio and other relevant ratios will probably improve with this investment. Considering all these factors, the bank is likely to approve the loan of the company.