Garden State Container Corporation manufactures boxes and other containers primarily for farm products. More than 85 percent of the company's sales come from the northeastern part of the United States, especially Pennsylvania, New Jersey, New York, and Maryland, although the company's patented egg cartons are distributed throughout the United States. Jim Jackson, the founder and president, recently received a call from Martha Menendez, vice president of Atlantic First National Bank. Menendez told him that a negative report had been generated by the bank's computerized analysis system; the report showed that Garden State's financial position was bad and getting worse.

The bank requires quarterly financial statements from each of its major loan customers. Information from these statements is fed into the computer, which then calculates key ratios for each customer and charts trends in these ratios. The system also compares the statistics for each company with the average ratios of other firms in the same industry and against any protective covenants in the loan agreements. If any ratio is significantly worse than the industry average, reflects a marked adverse trend, or fails to meet contractual requirements, the computer highlights the deficiency.

The latest report on Garden State revealed a number of adverse trends and several potentially serious problems (see Tables 1 through 6 for Garden State's historical financial statements). Particularly disturbing were the 1992 current, quick, and debt ratios, all of which failed to meet the contractual limits of 2.0, 1.0, and 55 percent, respectively. Technically, the bank had a legal right to call all the loans it had extended to Garden State for immediate repayment and, if the loans were not repaid within ten days, to force the company into bankruptcy.

Martha hoped to avoid calling the loans if at all possible, as she knew this would back Gar-den State into a corner from which it might not be able to emerge. Still, her own bank's examiners had recently become highly sensitive to the issue of problem loans, because the recent spate of bank failures had forced regulators to become more strict in their examination of bank loan portfolios and to demand earlier identification of potential repayment problems.

One measure of the quality of a loan is the Altman Z score, which for Garden State was 3.04 for 1992, slightly below the 3.20 minimum that Martha's bank uses to differentiate strong firms with little likelihood of bankruptcy in the next two years from those deemed likely to go into default. This will put the bank under increased pressure to reclassify Garden State's loans as "problem loans," to set up a reserve to cover potential losses, and to take whatever steps are necessary to reduce the bank's exposure. Setting up the loss reserve would have a negative effect on the bank's profits and reflect badly on Martha's performance.

To keep Garden State's loan from being reclassified as a "problem loan," the Senior Loan Committee will require strong and convincing evidence that the company's present difficulties are only temporary. Therefore, it must be shown that appropriate actions to overcome the problems have been taken and that the chances of reversing the adverse trends are realistically good. Martha now has the task of collecting the necessary information, evaluating its implications, and preparing a recommendation for action.

The recession that plagued the U.S. economy in the early 1990s caused severe, though hopefully temporary, problems for companies like Garden State. On top of this, disastrous droughts for two straight summers had devastated vegetable crops in the area, leading to a drastic curtailment of demand for produce shipping containers. In light of the softening demand, Garden State had aggressively reduced prices in 1991 and 1992 to stimulate sales. Higher sales, the company believed, would allow it to realize greater economies of scale in production and to ride the learning, or experience, curve down to a lower cost position. Garden State's management had full confidence that normal weather and national economic policies would revive the ailing economy and that the downturn in demand would be only a short-term problem. Consequently, production continued unabated, and inventories increased sharply.

In a further effort to reduce inventory, Garden State relaxed its credit standards in early 1992and improved its already favorable credit terms. As a result, sales growth did remain high by industry standards through the third quarter of 1992, but not high enough to keep inventories from continuing to rise. Further, the credit policy changes had caused accounts receivable to increase dramatically by late 1992.

To finance its rising inventories and receivables, Garden State turned to the bank for a long-term loan in 1991 and also increased its short-term credit lines in both 1991 and 1992. However, this expanded credit was insufficient to cover the asset expansion, so the company began to delay payments of its accounts payable until the second late notice had been received. Management realized that this was not a particularly wise decision for the long run, but they did not think it would be necessary to follow the policy for very long?the 1992 summer vegetable crop looked like a record breaker, and it was unlikely that a severe drought would again hurt the crop. They also predicted that the national economy would pull out of the weak growth scenario in late 1992. Thus, the company was optimistic that its stable and profitable markets of the past would soon reappear.

After Martha's telephone call, and the subsequent receipt of a copy of the bank's financial analysis of Garden State, Jim began to realize just how precarious his company's financial position had become. As he started to reflect on what could be done to correct the problems, it suddenly dawned on him that the company was in even more trouble than the bank imagined. Jim had recently signed a firm contract for a plant expansion that would require an additional $12,750,000 of capital during the first quarter of 1993, and he had planned to obtain this money with a short-term loan from the bank to be repaid from profits expected in the last half of 1993 as a result of the expansion. Innis view, once the new production facility went online, the company would be able to increase output in several segments of the shipping container market. It might have been possible to cut back on the expansion plans and to retrench, but because of the signed construction contracts and the cancellation charges that would be imposed if the plans were canceled, Jim correctly regards the$12,750,000 of new capital as being essential for Garden State's very survival.

Jim quickly called his senior management team in for a meeting, explained the situation, and asked for their help in formulating a solution. The group concluded that if the company's current business plan were carried out, Garden State's sales would grow by 10 percent from 1992 to 1993 and by another 15 percent from 1993 to 1994. Further, they concluded that Garden State should reverse its recent policy of aggressive pricing and easy credit, returning to pricing that fully covered costs plus normal profit margins and to standard industry credit practices. These changes should enable the company to reduce the cost of goods sold from over 85 percent of sales in 1992 to about 70 percent in 1993 and then to 60 percent in 1994. Similarly, the management group felt that the company could reduce administrative and selling expenses from almost 9 percent of sales in 1992 to 8 percent in 1993 and then to 7.5 percent in 1994. Significant cuts should also be possible in miscellaneous expenses, which should fall from 2.92 percent of 1992 sales to approximately 1.75 percent of sales in 1993 and to 1.25 percent in 1994. These cost reductions represented "trimming the fat," so they were not expected to degrade the quality of the firm's products or the effectiveness of its sales efforts. Further, to appease suppliers, future bills would be paid more promptly, and to convince the bank how serious management is about correcting the company's problems, cash dividends would be eliminated until the firm regains its financial health.

Assume that Jim has hired you as a consultant to first verify the bank's evaluation of the company's current financial situation and then to put together a forecast of Garden State's expected performance for 1993 and 1994. Jim asks you to develop some figures that ignore the possibility of a reduction in the credit lines and that assume the bank will increase the line of credit by the$12,750,000 needed for the expansion and supporting working capital. Also, you and Jim do not expect the level of interest rates to change substantially over the two-year forecast period; how-ever, you both think that the bank will charge 12 percent on both the additional short-term loan, if it is granted, and on the existing short-term loans, if they are extended. The assumed 40 percent combined federal and state tax rate should also hold for two years. Finally, if the bank cooperates, and if Jim is able to turn the company around, the P/E ratio should be 12 in 1993 and should rise to 14in 1994.

Your first task is to construct a set of pro forma financial statements that Jim and the rest of the Garden State management team can use to assess the company's position and also to convince Martha that her bank's loan is safe, provided the bank will extend the firm's line of credit. Then, you must present your projections, with recommendations for future action, to Garden State's management and to Martha. To prepare for your presentations, answer the following questions, keeping in mind that the Garden State managers and, particularly, Martha and her bosses, could ask you some tough questions about your analysis and recommendations. Put another way, the following questions are designed to help you focus on the issues.

1.Complete the 1992 columns of Tables 3 through 6, disregarding for now the projected data in the 1993 and 1994 columns. If you are using the Lotus model, use it to complete the tables. Be sure you understand all the numbers, as it would be most embarrassing (and harmful to your career) if you were asked how you got a particular number, and you could not give a meaningful response.

2.Based on the information in the case and on the results of your calculations in Question 1, list Garden State's strengths and weaknesses. In essence, you should look at the common-size statements and each group of key ratios (for example, the liquidity ratios) and see what those ratios indicate about the company's operations and financial condition. As a part of your answer, use the extended Du Pont equation to highlight the key relationships.

3.Recognizing that you might want to revise your opinion later, does it appear, based on your analysis to this point, that the bank should lend the requested money to Garden State? Explain.

4.Now complete the tables to develop pro forma financial statements for 1993 and 1994. For these calculations, assume that the bank is willing to maintain the present credit lines and to grant an additional $12,750,000 of short-term credit on January 1, 1993. In the analysis, take account of the amounts of inventory and accounts receivable that would be carried if inventory utilization (based on the cost of goods sold) and days sales outstanding were set at industry-average levels. Also, assume in your forecast that all of Garden State's plans and predictions concerning sales and expenses materialize and that the firm pays no cash dividends during the forecast period. Finally, in your calculations use the cash and marketable securities account as the residual balancing figure.

5.Assume Garden State has determined that its optimal cash balance is 5 percent of sales and that funds in excess of this amount will be invested in marketable securities which, on aver-age, will earn 7 percent interest. Based on your forecasted financial statements, will Garden State be able to invest in marketable securities in 1993 and 1994? If so, what is the amount of excess funds Garden State should invest in marketable securities? Do financial forecasts reveal any developing conditions that should be corrected?

6.Based on the forecasts developed earlier, would Garden State be able to retire all of the out-standing short-term loans by December 31, 1993?

7.If the bank decides to withdraw the entire line of credit and to demand immediate repayment of the two existing loans (the short-term and long-term loans) extended to Garden State, what alternatives would be available to Garden State?

8.Under what circumstances might the validity of comparative ratio analysis be questionable?Answer this question in general, not just for Garden State, but use Garden State data to illustrate your points.

9.On the basis of these analyses, should Martha recommend that the bank extend the existing short- and long-term loans and grant the additional $12,750,000 loan or that the bank demand immediate repayment of all existing loans? If she does recommend continuing to support the company, what conditions (for example, collateral, guarantees, or other safeguards) might the bank impose to help protect against losses should Garden State's plans go awry?

TABLE 1 Historical and Pro Forma Balance Sheets for Years Ended December 31 (in Thousands of Dollars) Proforma 1990 1991 1992 1993 1994 Assets: Cash and marketable securities $ 9,930 $ 7,363 6,550 X Accounts receivable 34,196 36,924 58,714 X Inventory 39,791 69.361 97,984 X Current assets $ 83,888 $113.647 $163,249 X X Land, buildings, plant, and equipment $ 34,634 $ 39,19 $ 44,604 $ 57,036 $58,746 Accumulated depreciation (5,992) (9,308) (13,388) (18.234) (21,880) Net fixed assets $ 28.642 $ 29.887 $ 31.216 $ 38.802 $36.866 Total assets $112,530 $143,534 $194,465 $215,375 X Liabilities and Equity: Short-term bank loans 6,376 $ 10,200 $ 36,466 X X Accounts payable 13,528 21,012 39,996 31,990 $33,590 Accruals 6,886 10,200 14,662 18,602 23,252 Current liabilities $ 26.790 $ 41.412 $ 91,124 X X Long-term bank loans $ 13,388 $ 20,082 $20,082 20,082 $20,082 Mortgage 5,738 5,202 4.680 4,208 3,788 Long-term debt $ 19,126 $ 25,284 $ 24.762 $ 24,290 $23,870 Total liabilities $ 45,916 $ 66,696 $115,886 X X Common stock $ 46,538 $ 46,538 $ 46,538 $ 46,538 $46,538 Retained earnings 20,076 30,300 32,041 X Total equity $ 66.614 $ 76.838 $ 78.579 X X $112,530 $143,534 $194,465 X X Total liabilities and equity X Notes: a. 7,000,000 shares of common stock were outstanding throughout the period 1990 through 1992. b. Market price of shares: 1990-$17.78; 1991-$9.70; 1992-$3.74. c. Price/earnings (P/E) ratios: 1990-6.29: 1991-4.98; 1992-11.28. The 1992 P/E ratio is high because of the depressed carnings that year. d. Assume that all changes in interest-bearing loans and gross fixed assets occur at the start of the relevant years. e. The mortgage loan is secured by a first-mortgage bond on land and buildings.TABLE 2 Historical and Pro Forma Income Statements for Years Ended December 31 (Thousands of Dollars) Pro Forma 1990 1991 1992 1993 1994 Net sales $350,546 $378,549 $401,251 $441,376 $507,583 Cost of goods sold 282,252 311,110 342,016 364,135 X Gross profit $ 68.294 $ 67,439 $ 59,235 $ 77,24 $101,517 Administration and selling expenses $ 25,580 $ 30,690 $ 33,762 X X Depreciation 3,188 3,316 4,080 4,846 3,646 Miscellaneous expenses 4.054 7,114 11,450 X 6,345 Total operating expenses $ 32,822 $ 41,120 49.292 X X EBIT $ 35,472 $ 26,319 9.943 $ 29,361 X Interest on short-term loans $ 638 $ 1,122 $ 3,647 $ 5,906 $ 5,906 Interest on long-term loans 1,339 2,008 2,008 1,912 1,912 Interest on mortgage 516 468 421 379 341 Total interest $ 2,493 3,598 6,076 8,197 $ 8,159 Before-tax earnings $ 32,979 $ 22.721 $ 3,867 X $ 45,298 Taxes 13,192 9.088 1,547 X 18,119 Net income $ 19,787 $ 13,632 2,320 X X Dividends on stock 4,947 3,408 580 0 X Additions to retained earnings $ 14,841 $ 10,224 1,740 X X Notes: a. Earnings per share (EPS): 1990-$2.69; 1991-$1.81; 1992-$0.22. b. Interest rates on borrowed funds: Short-term loan: 1990-10%; 1991-11%; 1992-10%. Long-term loan: 10% for each year. Mortgage: 9% for each year. c. For purposes of this case, assume that expenses other than depreciation and interest are totally variable with sales.TABLE 3 Common-Size Balance Sheets for Years Ended December 31 1990 1991 1992 Assets: Cash and marketable securities 8.82% 5.13% 3.37% Accounts receivable 30.39 25.72 X Inventory 35.36 48.32 50.39 Current assets 74.55% 79.18% X Land, buildings, plant, and equipment 30.78% 27.31% X Accumulated depreciation (5.32) (6.48) (6.88) Net fixed assets 25.45% 20.82% 16.05% Total assets 100.00% 100.00% 100.00% Liabilities and Equities: Short-term bank loans 5.67% 7.11% 18.75% Accounts payable 12.02 14.64 20.57 Accruals 6.12 7.11 7.54 Current liabilities 23.81% 28.85% 46.86% Long-term bank loans 11.90% 13.99% X Mortgage 5.10 3.62 2.41 Long-term debt 17.00% 17.62% Total liabilities 40.80% 46.47% 59.59% Common stock 41.36% 32.42% 23.93% Retained earnings 17.84 21.11 X Total equity 59.20% 53.53% 40.41% Total liabilities and equity 100.00% 100.00% 100.00% Note: Rounding differences occur in this table.TABLE 4 Common-Size Income Statements for Years Ended December 31 1990 1991 1992 Net sales 100.00% 100.00% 100.00% Cost of goods sold 80.52 82.18 X Gross profit 19.48% 17.82% 14.76% Administrative and selling expenses 7.30% 8.11% 8.41% Depreciation 0.91 0.88 X Miscellaneous expenses 1.16 1.88 2.85 Total operating expenses 9.36% 10.86% 2.28% EBIT 10.12% 6.95% 2.48% Interest on short-term loans 0.18% 0.30% X Interest on long-term loans 0.38 0.53 X Interest on mortgage 0.15 0.12 0.10 Total interest 0.71% 0.95% 1.51% Before-tax earnings 9.41% 6.00% 0.96% Taxes 3.76 2.40 X Net income 5.64% 3.60% 0.58% Dividends on stock 1.41% 0.90% 0.14% Additions to retained earnings 4.23% 2.70% 0.43%TABLE 5 Statement of Cash Flows for Years Ended December 31 (in Thousands of Dollars) 1991 1992 Cash Flow from Operations: Sales $378,549 $401,251 Increase in receivables (2,728) X Cash sales $375.821 $379,461 Cost of goods sold (311,110) (342,016) Increase in inventories (29,570) (28,623) Increase in accts payable 7,484 18,984 Increase in accruals 3,314 X Cash cost of goods ($329.882 X Cash margin $45,939 X Administrative and selling expenses (30,690) ($33,762) Miscellaneous expenses (7,114) (11,450) Taxes (9,088) (1,547) Net Cash Flow from operations $953 X Cash Flow from Fixed Asset Investment: Investment in fixed assets ($4,561) ($5.409) Cash Flow from Financing Activities: Increase in short-term debt $3,824 $26,266 Increase in long-term debt 6,694 X Repayment of mortgage (536) (522) Interest expense (3,598) (6,076) Common dividends (3,408) (580) Net Cash Flow from financing activities $2,976 $19.088 Increase (decrease) in cash and marketable securities ($2,539) XTABLE 6 Historical and Pro Forma Ratio Analysis for Years Ended December 31 Pro Forma Industry 1990 1991 1992 1993 1994 Average Liquidity Ratios: Current ratio 3.13 2.74 X X Quick ratio X 2.50 1.65 1.07 0.72 1.13 X 1.00 Leverage Ratios: Debt ratio 40.80% 46.47% X TIE coverage 14.23 X 52.31% 50.00% 7.31 1.64 X 6.55 7.70 Asset Managment Ratios: Inventory turnover (cost) 7.09 4.49 3.49 5.70 5.70 5.70 Inventory turnover (sale)b 8.81 5.46 4.10 X X 7.00 Fixed asset turnover 12.24 12.67 12.85 11.38 13.77 12.00 Total asset turnover 3.12 2.64 X 2.05 X 3,00 Days sale outstanding (ACP) 35.12 35.11 52.68 X 32.00 32.00 Profitability Ratios: Profit margin 5.64% 3.60% 0.58% X X 2.90% Gross profit margin 19.48% 17.82% 14.76% 17.50% 20.00% 18.00% Return on total assets 17.58% 9.50% X 5.90% 10.94% 8.80% ROE 29.70% 17.74% 2.95% X X 17.50% Other Ratios Altman Z. scored 6.64 4.75 X 3.95 5.42 4.65 Payout ratio 25.00% 25.00% 25.00% 0.00% X 20.00% Notes: a. Uses cost of goods sold as the numerator. b. Uses net sales as the numerator. C. Assume a 360-day year. d. Altman's function is calculated as Z=0.012X, + 0.014X, + 0.033X, + 0.006X4 + 0.9995 Here, X1 = net working capital/total assets X, = retained earnings/total assets X, = EBIT/total assets X4 = market value of common and preferred stock/book value of all debt Xs = sales/total assets. The "Altman Z score" range of 1.81-2.99 represents the so-called "zone of ignorance." Note that the first four variables are expressed as percentages. Refer to Chapter 26 of Eugene F. Brigham and Louis C. Gapenski, Intermediate Financial Management, Fourth Edition (Fort Worth: Dryden Press, 1993), for details. e. Year-end balance-sheet values were used throughout in the computation of ratios embodying balance-sheet items. f. Assume constant industry-average ratios throughout the period 1990 through 1994