Exercise V

Problem 1 What is the test to differentiate current from long term assets and liabilities?
Some loans have what is called a "balloon payment", i.e. for the term of the loan interest only
is paid, and at the end of the loan term the entire principal is repaid (the "balloon payment").
This kind of financing is rare, because it does not reflect the depreciation of assets, but it
sometimes occurs if there is an excess of assets to secure the loan. Imagine that a company
has a loan for $25 million. What is the current liability of this loan in year one if it is a
five-year term with straight line repayment of principal? What is the current liability of this
loan in year one if principal is recovered by a full balloon payment at the end of year five?
What is the current liability of this loan in year one if it is a levelized (mortgage) type annual
repayment with a 20-year term and 8% interest?

Problem 2 You are considering buying 123Co, a manufacturing company. The president and
CFO are traveling and won't be back for two weeks, and the financial statements cannot be
released until then. However, you have talked to the daughter of the owner, and have written
down the following comments. Try to do up a balance sheet for the company, making
reasonable assumptions where necessary.

1. "We started 123Co two years ago with $3.3 million that dad had inherited."
2. "Our sales have done well, and if we can keep them at last month's performance we
would reach $4.2 million a year. We hope to do even better than that."
3. "We bought four and half million dollars of equipment at an auction. It was used
equipment but had been completely rebuilt, so dad decided on a ten year depreciation
period."
4. "We just rent the space we are in."
5. "We never have any cash or notes in the bank. Dad set up a credit line and we float on
that. The bank didn't want to give us long term financing until we were in operation
for two years. We are trying to decide right now whether to take out some long term
financing and really expand the business, or sell it to you and stay on as operators."
6. "At first our draw on our credit line was over 3 million, and the only way we could
get it was to have a personal guarantee from my uncle. Lucky for us, the business has
gone well and the draw from the bank has dropped over the two years we have been
in business. Dad thinks we can get the requirement for a personal guarantee lifted."
7. "When we set up the business, we decided to leave the depreciation in the business.
We also decided to set up an objective for ourselves of leaving a quarter million
dollars of net income per year in the company, and treating ourselves to a dividend on
everything else. So far we have met our objective."
8. "We play it safe on inventory. It is running 35 days of sales, which is a lot considering
our materials cost is only 50% of sales. We could probably bring it down, but we have
just been too busy filling orders."

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 9. "We have been stringing our suppliers out 50 days. We have to talk to them every
month to assure them we are doing ok, but it has worked so far. Because our sales
grew to $350,000 last month and we have stayed with the same suppliers, they haven't
minded our slow pay."
10. "Our prepaids are so small we ignore them. Our accountant said that they weren't
material, and that we could just expense this stuff as we spent it."
11. "We are current on taxes. Dad knew a guy that lost his business because of unpaid
taxes, so he has insisted on a monthly payment to keep us current."
12. "Our payroll is two weeks behind, but it isn't a big deal because our staff is only 22
with an average salary of $4,000 per month. Otherwise we are current on all our
expenses."
13. "Our customers are large companies, and they are sure slow to pay. Our receivables
are running 55 days."
14. "We are still getting by on the original equipment we bought."

Do you need the income statement to prepare the balance sheet in this case? Would you be
able to make an intelligent decision about whether to buy the business without looking at the
income statement? Why?

What percentage of the total assets is tied up in inventory and receivables?

Problem 3 Take the following information on a company and say what the company has (its
assets) and where the money came from to own those assets (its liabilities and equity) at the
end of two years of operation (assume the principal repayment on debt has been made for
year 2):
1. The company has gross sales of $48 million per year, and the pattern of sales is even,
i.e. there is no cyclical pattern to sales.
2. Customers are large firms with a typical large firm payment pattern, making payment
at 45 days.
3. COGS for the business is 60% and is material only; all labor costs are in SG&A.
4. Monthly payroll is $200,000 (Salary is paid every two weeks).
5. There is enough raw material on hand to support one month of manufacturing, and
two months of actual production of finished goods is in the warehouse. (Remember
that finished goods in inventory are carried on the books at COGS, not expected sale
price).
6. The company pays its suppliers 30 days after goods are received.
7. The owners started the business with an initial capital injection of $5.6 million 25
months ago.
8. The company borrowed $3 million of long term debt, with the principal repayable in
10 equal annual payments.
9. The company bought $8 million in assets at startup and picked a depreciation period
of 10 years. No additional assets have been purchased.
10. In the first two years of the business, the company had a cumulative net income of
$1,800,000, and paid dividends of $300,000 ($150,000 per year) to the owners.

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 11. The business has a short term credit line that runs positive or negative based on the
fluctuations of the business (just like a personal checking account).

Balance sheets help us do "what ifs" and think about the financial health of the business. Use
the balance sheet to answer the following questions:

1. What assets does the business have? Which is larger, "current" assets or fixed?
2. How much short term debt does the business have?
3. 3 How much working capital does the business have?
4. If the cumulative dividend over two years had been $1,800,000 instead of $300,000
5. (i.e. if all of the profits had been taken out of the business as dividends), what would
the short term debt be? Would working capital still be positive?
6. If you cut the inventory in half by a vigorous program of "Just in time" manufacturing
and shipping, by how much would your bank borrowings drop? Would working
capital change?

Problems 4 Shown below is the balance sheet of XYZCo for End of Year 1998.

XYZCo Balance Sheet 1998 ($000)

Assets Liabilities
Current Asset: Current Liabilities:
Cash 15 Short Term Credit Line 96
Receivables 123 Accounts Payable 66
Short Term Investments 0 Accrued Expenses 16
Inventory 98 Taxes Payable 0
Prepaid Expenses 26 Current Portion of Long Term Debt 20
262 198
Fixed Assets: Long Term Debt:
Land, Bld & Equip at Cost 800 Repayable Grants 0
Less Accumulated Depreciation 160 Long Term Debt 140
640
Shareholders Equity:
Long Term Investments 0 Capital Shares 500
Goodwill 0 Retained Earnings 64
Total Assets 902 Total Liability and Equity 902

For fiscal 1999, you have the following information:

1. Inventory, receivables and payables are each up 35%, reflecting an improvement in sales.
2. Net Income for the year 1999 is $142,000.
3. XYZCo starts the year with three owners, one of whom wants to retire. The owners agree
that the retiring owner will have his shares bought back by XYZCo for $100,000. The
two remaining shareholders each receive a dividend of $50,000 in late 1999. Other than
leaving some retained earnings in the business in 1999, they don't inject any capital.

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4. A new piece of equipment is purchased for $120,000, very early in 1999. Its depreciation
period is ten years (all depreciation is straight-line).
5. Other than the extra depreciation on the new piece of equipment, depreciation on the
balance of equipment is unchanged from 1998 at $80,000 per year.
6. Accrued wages are up 25% compared to 1998's year-end, i.e. there are 25% more hours
worked but unpaid at year-end.
7. Cash in the bank and prepaid expenses are the same at year-end 1999 as in year-end 1998.
8. The long term financing is a loan of $200,000 with a ten-year straight-line retirement.
1999 is the third year of this financing, i.e. at the end of 1998 two years of financing had
been completed.

Complete XYZCo's balance sheet for 1999. What fraction of XYZCo's assets is tied up in
Inventory and receivables in 1999? Is XYZCo in good shape? If not, are the problems due to
operational management or financial management? What could XYZCo have done
differently?