In 2016, after 10 years of public accounting experience, Michelle Tilford, CPA, decided to resign her position with a national accounting firm and started Canada Software Limited (CSL) Michelle had spent almost two years prior to her resignation, developing a financial software program that had now become her signature offerings to small and medium enterprises The last five years has been good for CSL and now she wants to expand software capabilities and increase her market share CSL had losses during the first two years of operation 2016 and 2017 but its profit has increased steadily from 2018 to the present 2022 The profit history, including dividend payments is summarized in Exhibit 1 Michelle started CSL with an initial investment of $100,000 The financing consisted of $50,000 of her own equity and a bank loan of $50,000 She was hoping to maintain 100 ownership of the CSL but had to sell 60 of equity to a group of investors to obtain the needed funds No other common share transaction had taken place since then Although she owns only 40 of CSL, she manages all aspect of the business Investors are inactive in CSL management Operating Results The audited income statement and balance sheet for 2021 and 2022 appear in Exhibits 2 and 3 Michelle also collected the industry average of business ratios that are applicable to both 2021 and 2022, shown in Exhibit 4 She is happy to have achieved record earnings of $48,000 in 2022 But her concerns are now centred on cash flows as she is finding it difficult to pay the firm's bills in a timely manner She has decided to complete all the relevant ratio analysis to evaluate CSL financial position and sustainability of continued operation Marketing Michele is aware that to promote the expanded product offerings, she needs to hire a fulltime software developer Her own market research shows a blockbuster sales potential Her time in the management of the firm is becoming a full time occupation for her and is frustrated by her inability to optimize her time between software development and managing the business She is considering adding this full time position of $80,000 year in salary and benefits She believes that this would lower her earnings per share (EPS) over the next couple of years She also knows that if improvements can be made to software, her earning would significantly increase in the next year and beyond Full time software position would relieve her to devote more time to improve and streamline production and marketing processes Financial Concerns Another concern Michelle has is the firm's interest expenses as CSL relies on short term financing to maintain financial flexibility Due to COVID 19, and financial assistance poured into the economy by the federal government and resulting inflation has forced the Bank of Canada (BoC) to increase the overnight lending rate and to closely monitor the economy The rate increases have created uncertainty to businesses in general Michelle feels that this may elevate business expenses To get a feel for the interest rates, Michelle researched various long term loans that may be available to her See Exhibit 5 Path forward Revision to Business Strategy Michelle certainly wants to have a bright future for CSL as on on going concern She knows that analyzing the 2021 and 2022 financial data would be a crucial step to prepare the financial plan for 2023 She made a set of assumptions that are listed in Exhibit 6 Required Assume the role of an independent business analyst and make your recommendations to Michell Tilford The report should contain the following An Executive Summary listing key issues and conclusions based on your analysis Critical discussion of issues based on your analysis and judgment Quantitative analysis to support your recommendations Your analysis should, as a minimum, address the following Does Michelle have the proper approach to business and monetary management What is she focusing on Could there be a potential agency problem at CSL Analysis of financial statements as they relate to years 2020 and 2021 Examine the following (a) Liquidity, (b) Activity, (c) Leverage and (d) Performance Be sure to evaluate both the cross sectional and time series information Discuss the firm's strengths and weaknesses Suggest where they need to focus Using Exhibit 6, prepare a pro forma income and balance sheet statements as well as any External Financing Needs (EFN) for 2022 Based on the 2022 pro forma statements prepared, complete the ratio analysis, and add it to the analysis made in item 2 above Your overall assessment and recommendations Exhibit 1 Canada Software Limited Profits and Dividends, 2016 to 2022 Year Net Income after Taxes Dividends Paid 2016 $ (50,000) 0 2017 (20,000) 0 2018 15,000 0 2019 35,000 0 2020 40,000 1,000 2021 43,000 3,000 2022 48,000 5,000 Exhibit 2 Canada Software Limited Income Statement ($1,000) for the years ended December 31 2021 2022 Sales Revenue $ 1,434 $ 1,550 Less Cost of Sales 974 1,030 Gross Margin $ 460 $ 520 Less Operating Expenses Selling expense $ 129 $ 150 General and Administrative 242 270 Depreciation Expense 10 $ 11 Total Operating Expenses $ 381 $ 431 Earnings before Interest and Taxes $ 79 $ 89 Less Interest expense $ 26 $ 29 Earnings before Taxes $ 53 $ 60 Less Taxes 20 $ 10 12 Net Income after taxes $ 43 $ 48 Exhibit 3 Balance Sheet CSL ($1,000) As at December 31 Assets 2021 2022 Current Assets Cash $ 31 12 Marketable Securities 82 66 Accounts Receivables 104 152 Inventories 145 191 Total Current Assets $ 362 421 Fixed Assets $ 180 195 Less Accumulated Depreciation 52 63 Net Fixed Assets $ 128 132 Total Assets $ 490 553 Liabilities and Shareholder's Equity Current Liabilities Accounts Payable $ 126 136 Line of Credit 190 200 Accruals 25 27 Total Current Liabilities $ 341 363 Long term Debt $ 40 38 Total Liabilities $ 381 401 Shareholder's Equity Common Shares (100,000 outstanding) $ 50 50 Retained Earnings $ 59 102 Total Liabilities and Owners' Equity $ 490 553 Exhibit 4 Industry Ratio Averages Key Ratios 2022 Net Working Capital $ 96,000 Current Ratio 1 82 Quick Ratio 1 10 Average age of inventory 47 4 days Average collection period 20 5 days Average payment period 38 1 days Total Asset Turn over 3 2 Debt Ratio 55 1 Debt Equity Ratio 51 6 Times Interest Earned Ratio 5 6 Common Size Analysis Percentage Sales 100 0 COS 57 7 Gross margin 42 3 Operating Expenses 29 9 EBIT 12 4 Interest expense s 2 2 EBT 10 2 Taxes 2 0 Net Income (after taxes) 8 2 Performance Ratios Return on Total Assets (ROA) 26 2 Return on Equity 58 4 Exhibit 5 Interest Rates on Various Loan Maturities as of 2022 Loan Maturity Interest Rate 3 Months 12 0 6 months 11 75 1 year 11 5 3 years 11 0 5 years 10 0 10 years 9 5 20 Years 9 0 Exhibit 6 Canadian Software Limited Key Planning Assumptions for 2023 Sales are expected to increase by 20 Cost of Sales to be reduced to 60 of sales Increase in Selling, General and Administrative expenses not to exceed 10 from 2022 A new program developer will be hired at a cost of $80,000 This amount will be part of general and administrative expenses Additional investment in fixed assets will be $145,000 Depreciation expense in 2023 will be $22,000 The interest expense depends on what CSL chooses from Exhibit 5 The $38,000 long term debt can be renegotiated Tax rate will remain the same at 20 Michell would recommend to the Board of Directors not to pay dividend for the year 2023 Recommended minimum cash is at $35,000 and maintain current level of marketable securities Average collection period to be decreased to 35 days in 2023 Average payment period to be at 45 days Accruals will increase at the same rate as sales No changes are anticipated with long term debt and common shares Once the need for the financing is determined, a decision will be made regarding the form of financing Be explicit if you make any other assumptions that are valid

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In 2016, after 10 years of public accounting experience, Michelle Tilford, CPA, decided to resign her position with a national accounting firm and started Canada

In 2016, after 10 years of public accounting experience, Michelle Tilford, CPA, decided to resign her position with a national accounting firm and started Canada Software Limited (CSL). Michelle had spent almost two years prior to her resignation, developing a financial software program that had now become her signature offerings to small and medium enterprises.

The last five years has been good for CSL and now she wants to expand software capabilities and increase her market share. CSL had losses during the first two years of operation - 2016 and 2017 - but its profit has increased steadily from 2018 to the present 2022. The profit history, including dividend payments is summarized in Exhibit 1.

Michelle started CSL with an initial investment of $100,000. The financing consisted of $50,000 of her own equity and a bank loan of $50,000. She was hoping to maintain 100% ownership of the CSL but had to sell 60% of equity to a group of investors to obtain the needed funds. No other common share transaction had taken place since then. Although she owns only 40% of CSL, she manages all aspect of the business. Investors are inactive in CSL management.

Operating Results

The audited income statement and balance sheet for 2021 and 2022 appear in Exhibits 2 and 3: Michelle also collected the industry average of business ratios that are applicable to both 2021 and 2022, shown in Exhibit 4. She is happy to have achieved record earnings of $48,000 in 2022. But her concerns are now centred on cash flows – as she is finding it difficult to pay the firm's bills in a timely manner. She has decided to complete all the relevant ratio analysis to evaluate CSL financial position and sustainability of continued operation.

Marketing

Michele is aware that to promote the expanded product offerings, she needs to hire a fulltime software developer. Her own market research shows a "blockbuster" sales potential! Her time in the management of the firm is becoming a full-time occupation for her and is frustrated by her inability to optimize her time between software development and managing the business. She is considering adding this full-time position of $80,000/year in salary and benefits.

She believes that this would lower her earnings per share (EPS) over the next couple of years. She also knows that if improvements can be made to software, her earning would significantly increase in the next year and beyond. Full time software position would relieve her to devote more time to improve and streamline production and marketing processes.

Financial Concerns

Another concern Michelle has is the firm's interest expenses as CSL relies on short-term financing to maintain financial flexibility. Due to COVID-19, and financial assistance poured into the economy by the federal government and resulting inflation has forced the Bank of Canada (BoC) to increase the overnight lending rate and to closely monitor the economy. The rate increases have created uncertainty to businesses in general. Michelle feels that this may elevate business expenses.

To get a feel for the interest rates, Michelle researched various long-term loans that may be available to her. See Exhibit 5.

Path forward - Revision to Business Strategy

Michelle certainly wants to have a bright future for CSL as on on-going concern. She knows that analyzing the 2021 and 2022 financial data would be a crucial step to prepare the financial plan for 2023. She made a set of assumptions that are listed in Exhibit 6.

Required

Assume the role of an independent business analyst and make your recommendations to Michell Tilford. The report should contain the following:

An Executive Summary listing key issues and conclusions based on your analysis
Critical discussion of issues based on your analysis and judgment
Quantitative analysis to support your recommendations

Your analysis should, as a minimum, address the following:

Does Michelle have the proper approach to business and monetary management? What is she focusing on? Could there be a potential agency problem at CSL?
Analysis of financial statements as they relate to years 2020 and 2021. Examine the following: (a) Liquidity, (b) Activity, (c) Leverage and (d) Performance. Be sure to evaluate both the cross-sectional and time-series information.
Discuss the firm's strengths and weaknesses. Suggest where they need to focus.
Using Exhibit 6, prepare a pro-forma income and balance sheet statements as well as any External Financing Needs (EFN) for 2022.
Based on the 2022 pro-forma statements prepared, complete the ratio analysis, and add it to the analysis made in item 2 above.
Your overall assessment and recommendations.

Exhibit 1

Canada Software Limited - Profits and Dividends, 2016 to 2022

Year Net Income after Taxes Dividends Paid

2016 $ (50,000) 0

2017 (20,000) 0

2018 15,000 0

2019 35,000 0

2020 40,000 1,000

2021 43,000 3,000

2022 48,000 5,000

Exhibit 2 Canada Software Limited

Income Statement ($1,000) for the years ended December 31

2021 2022

Sales Revenue $ 1,434 $ 1,550

Less: Cost of Sales 974 1,030

Gross Margin $ 460 $ 520

Less: Operating Expenses

Selling expense $ 129 $ 150

General and Administrative 242 270

Depreciation Expense 10 $ 11

Total Operating Expenses $ 381 $ 431

Earnings before Interest and Taxes $ 79 $ 89

Less: Interest expense $ 26 $ 29

Earnings before Taxes $ 53 $ 60

Less Taxes @ 20% $ 10 12

Net Income after taxes $ 43 $ 48

Exhibit 3

Balance Sheet CSL ($1,000) – As at December 31

Assets 2021 2022

Current Assets

Cash $ 31 12

Marketable Securities 82 66

Accounts Receivables 104 152

Inventories 145 191

Total Current Assets $ 362 421

Fixed Assets $ 180 195

Less: Accumulated Depreciation 52 63

Net Fixed Assets $ 128 132

Total Assets $ 490 553

Liabilities and Shareholder's Equity

Current Liabilities

Accounts Payable $ 126 136

Line of Credit 190 200

Accruals 25 27

Total Current Liabilities $ 341 363

Long-term Debt $ 40 38

Total Liabilities $ 381 401

Shareholder's Equity

Common Shares (100,000 outstanding) $ 50 50

Retained Earnings $ 59 102

Total Liabilities and Owners' Equity $ 490 553

Exhibit 4 Industry Ratio Averages

Key Ratios 2022

Net Working Capital $ 96,000

Current Ratio 1.82

Quick Ratio 1.10

Average age of inventory 47.4 days

Average collection period 20.5 days

Average payment period 38.1 days

Total Asset Turn over 3.2

Debt Ratio 55.1%

Debt / Equity Ratio 51.6

Times Interest Earned Ratio 5.6

Common Size Analysis Percentage

Sales 100.0

COS 57.7

Gross margin 42.3

Operating Expenses 29.9

EBIT 12.4

Interest expense s 2.2

EBT 10.2

Taxes 2.0

Net Income (after taxes) 8.2

Performance Ratios

Return on Total Assets (ROA) 26.2

Return on Equity 58.4

Exhibit 5

Interest Rates on Various Loan Maturities as of 2022

Loan Maturity Interest Rate %

3 Months 12.0

6 months 11.75

1 year 11.5

3 years 11.0

5 years 10.0

10 years 9.5

20 Years 9.0

Exhibit 6

Canadian Software Limited

Key Planning Assumptions for 2023

Sales are expected to increase by 20%.
Cost of Sales to be reduced to 60% of sales. Increase in Selling, General and Administrative expenses not to exceed 10% from 2022.
A new program developer will be hired at a cost of $80,000. This amount will be part of general and administrative expenses.
Additional investment in fixed assets will be $145,000.
Depreciation expense in 2023 will be $22,000.
The interest expense depends on what CSL chooses from Exhibit 5. The $38,000 long-term debt can be renegotiated.
Tax rate will remain the same at 20%. Michell would recommend to the Board of Directors not to pay dividend for the year 2023.
Recommended minimum cash is at $35,000 and maintain current level of marketable securities
Average collection period to be decreased to 35 days in 2023.
Average payment period to be at 45 days.
Accruals will increase at the same rate as sales.
No changes are anticipated with long-term debt and common shares. Once the need for the financing is determined, a decision will be made regarding the form of financing.
Be explicit if you make any other assumptions that are valid!