Question
MacGivers Brass has recorded $8 million in sales with $625,000 in profits before taxes. However, upon reviewing the annual report, there was a footnote that
MacGivers Brass has recorded $8 million in sales with $625,000 in profits before taxes. However, upon reviewing the annual report, there was a footnote that stated overhead was under-absorbed. This means that actual overhead was higher than absorbed overheads, meaning they spent more on overhead than allotted, which reduces the profit.
In total, there was $462,000 and an under-absorbed overhead. This was split up with two thirds being assigned to inventory and one third being assigned to cost of goods sold. This will increase the value you inventory, but the inventory is not sold, so this will overstate the profits. It will also affect the income section by reducing reported profits.
That all being said, this would not necessarily make me, as the bank, recall the loan or renew the loan for another year. I would start with questioning how well they are doing their estimates. I would need to consider many other areas during the due diligence period, other than just looking at estimation errors with overhead. Based solely on the information given and considering the company was still profitable even with the under absorption, I would lean towards renewing the loan.
Questions I would also ask are:
Why was there under absorbed overhead? What was the actual cause? Is this the only occupancy or is there a history? Being that there are multiple areas that can be looked at, I would want to know where the issue was and that the company realized there was an issue and was adequately looking into how this could happen.
What will the company do going forward, to fix the under absorption issue? If the company does not have a plan, I would be more hesitant to renew the loan. I would be search for an atmosphere that embraced a continuous improvement culture. If the business is not actively seeking out what the underlying issues are, they will be doomed to repeat the same mistakes.
How is overhead going to be controlled? What plan is put in place to keep cost controls in check. Companies have to be mindful of overhead costs if they want to continue to grow and flourish.
What other debts does the company have and what future debt does the company plan to take on? As a bank, I need to protect my assets. I would need to look into if this company is starting to get over extended or will their plans make them over extended.
I would also look into their current inventory. Are the producing too much? Is there enough demand to justify the loan and the risk that brings to the banks? If there is no turnover in inventory and demand seems to be lowering while output continues to be the same or higher, that would be a red flag.
What are the current contracts? When will those contracts' due dates come up? What is the likelihood of contract renewals? If all contracts are long term and will be in place for years to come, I would then look at if they are adjusted for inflation. Will the long term contracts still be profitable towards the end date based on inflation adjustments.
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