fact, over the past five years there have been no dividends because a capital in order to meet the QUESTION TWO KF was started seven years ago by Owen and Tessa, who between them had over 15 years of experience with various computer systems design companies. The partnership initially blended very well Owen, reserved and introspective, is creative with a flair for designing games and spotting trends. Mainly as a result of his genius, the KF brand is synonymous with intriguing electronics with high graphic appeal Tessa, more outgoing with a strong marketing focus, has assumed the role of the firm's chief operating officer The first successful product the two partners developed was a game called Koala Fun, which they used as the company name. The game uses a cute image of a koala bear cub chasing treasure and villains around the coast while helping rescue heroes and animals. The game was so successful that various spinoff products were licensed, including stuffed toys and a movie. The Chinese even picked up on the idea and joint-ventured games with KF using a giant panda as the theme. A problem with this industry is that it experiences cyclicality, as players (usually children and teens) move on to other activities. The company enjoyed initial success, showing profits by its second year. Owen and Tessa preferred to work on designing new games and the development of marketing strategies over the administrative aspects of the business. As the result, new games and products were in development and production costs escalated, but sales were somewhat slow to be realized Tessa's personality compels her to make virtually all major operating decisions. Owen is concemed that firms the size of KF have had difficulty maintaining a stable bank relationship. Due to increasingly strict regulations, some lenders have called in loans, and most are scrutinizing new business loans very carefully. Consequently, Tessa views bank debt financing as unreliable, a potential problem should business become slow, and thinks that loan officers are capable of wasting her time. Owen isn't sure what to make of these arguments, but he is concerned that avoiding debt has significantly reduced KF's financial flexibility because it means that all projects will have to be equity financed. In been . And three years ago each of the partners had to contribute sh200,000 of company's needs. Another infusion of capital may be necessary since the firm's present cash position is low by historical standards. More important, however, Owen feels that the company is not benefiting from the leverage effect of debt financing, and that this hurts the profitability of the firm to the two owners. Owen and Tessa loved their company but were inexperienced in business matters. Owen asked his mother, Amy, an accountant, for assistance. After studying the ledgers and other records, she reported that there was a significant working capital problem with declining cash, unsold inventory (mostly old Koala Fun games), and vendors who had not been paid. Owen and Tessa still needs additional expert advice and they have approached you with the financial statements below; Page 2 of 3 KF Income Statements: 2020-2019 Sales Cost of goods sold Gross margin Administrative Depreciation Earnings before interest and taxes Interest Earnings before taxes Taxes (at 40% Net income 2020 6,572,800 4,896,700 1,676.100 1.281.700 72.000 322,400 37.900 284,500 113.800 170,700 2019 7,811,500 5.866.200 1,945,300 1,492,200 86,000 367,100 31.600 335,500 134,200 201.300 2019 Cash 244,000 1,106,600 1,222 300 46.800 2,619,700 493,600 = (233,800) KF Balance Sheets: 2020-2019 2020 Assets 300,000 Accounts receivable 915,000 Inventory 700,000 Other current 36.200 Current assets 1,951,200 Gross fixed assets 340,000 Accumulated depreciation (135,000) Net fixed assets 205,000 Total assets 2.361,200 Liabilities and Net Worth Accounts payable 345,700 Notes payable 63,200 Accruals 164.300 Current liabilities 573,200 Long-term debt 316,000 Common stock (62,000 shares outstanding) 948,000 Retained eamings 524.000 Total liabilities and net worth 2.361.200 259.800 2.879.500 544,800 63.200 156,100 764,100 252,800 1,137,600 725.000 2.879.500 Required Using common size financial analysis and focusing on both the income statements and the balance sheets, evaluate the business and advice Owen and Tessa accordingly. (20 marks)