Question
MARK X COMPANY (A) Mark X Company manufactures farm and specialty trailers of all types. More than 85 percent of the companys sales come from
MARK X COMPANY (A)
Mark X Company manufactures farm and specialty trailers of all types. More than 85 percent of
the companys sales come from the western part of the United States, particularly California,
although a growing market for custom horse transport vans designed and produced by Mark X is
developing nationally and even internationally. Also, several major boat companies in California and
Washington have had Mark X design and manufacture trailers for their new models, and these
boat-trailer packages are sold through the boat companies nationwide dealer networks.
Steve Wing, the president of Mark X, recently received a call from Karen Dennison, senior
vice president of Wells Fargo Bank. Karen told Steve that a deficiency report generated by the
banks computerized analysis system had been filed because of Mark Xs deteriorating financial
position. The bank requires quarterly financial statements from each of its major loan customers.
Information from such 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 deficiency report on Mark X revealed a number of significant adverse trends and
several potentially serious problems (see Tables 1 through 6 for Mark Xs 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 Mark X for immediate repayment and, if the loans were
not repaid within ten days, to force the company into bankruptcy.
Karen hoped to avoid calling the loans if at all possible, as she knew this would back Mark X
into a corner from which it might not be able to emerge. Still, her own banks 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 Mark X was 2.97 for
1992, just below the 2.99 minimum that is used 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 Mark Xs loans as problem loans, to set up a reserve to
cover potential losses, and to take whatever steps are necessary to reduce the banks exposure. Setting
up the loss reserve would have a negative effect on the banks profits and reflect badly on
Karens performance.
Copyright 1994. The Dryden Press. All rights reserved.
To keep Mark Xs loan from being reclassified as a problem loan, the Senior Loan Committee
will require strong and convincing evidence that the companys 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. Karen 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 had caused severe, though
hopefully temporary, problems for companies like Mark X. Farm commodity prices have remained
low, thus farmers have held their investments in new equipment to the bare minimum. On top of this,
the luxury tax imposed in 1991 has had a disastrous effect on top-of-the-line boat/trailer sales.
Finally, the Tax Reform Act of 1986 reduced many of the tax benefits associated with horse breeding,
leading to a drastic curtailment of demand for new horse transport vans. In light of the softening
demand, Mark X had aggressively reduced prices in 1991 and 1992 to stimulate sales. This, 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. Mark Xs management had full confidence
that 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, Mark X relaxed its credit standards in early 1992 and
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, Mark X 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. They predicted that the national economy would pull
out of the weak growth scenario in late 1992. Also, there has been some talk in Congress of killing
the luxury tax and even giving some tax benefits back to horse breeders. Thus, the company was
optimistic that its stable and profitable markets of the past would soon reappear.
After Karens telephone call, and the subsequent receipt of a copy of the banks financial analysis
of Mark X, Steve began to realize just how precarious his companys 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. Steve had recently
signed a firm contract for a plant expansion that would require an additional $6,375,000 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. In
his view, once the new production facility went on line, the company would be able to increase
output in several segments of the trailer 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, Steve correctly regards the $6,375,000
of new capital as being essential for Mark Xs very survival.
Steve 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 companys current
business plan were carried out, Mark Xs sales would grow by 10 percent from 1992 to 1993 and
by another 15 percent from 1993 to 1994. Further, they concluded that Mark X 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 82.5 percent
Case: 35 Financial Analysis and Forecasting
in 1993 and then to 80 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 firms 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 companys problems, cash dividends
would be eliminated until the firm regains its financial health.
Assume that Steve has hired you as a consultant to first verify the banks evaluation of the
companys current financial situation and then to put together a forecast of Mark Xs expected performance
for 1993 and 1994. Steve 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
$6,375,000 needed for the expansion and supporting working capital. Also, you and Steve do not
expect the level of interest rates to change substantially over the two-year forecast period; however,
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 Steve is able to turn the company around, the P/E ratio should be 10 in 1993 and should rise to
12 in 1994.
Your first task is to construct a set of pro forma financial statements that Steve and the rest of
the Mark X management team can use to assess the companys position and also to convince Karen
that her banks loan is safe, provided the bank will extend the firms line of credit. Then, you must
present your projections, with recommendations for future action, to Mark Xs management and to
Karen. To prepare for your presentations, answer the following questions, keeping in mind that
both the Mark X managers and, particularly, Karen and possibly 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, but they are not meant to be a complete and exhaustive
list of all the relevant points.
QUESTIONS
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,
prepare a list of Mark Xs 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 companys 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 Mark X? 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
Case: 35 Financial Analysis and Forecasting
grant an additional $6,375,000 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 Mark Xs 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.
In responding to Questions 5 through 8, no Lotus model modifications are required. Answers
should be based solely on the data contained in the financial statements completed in response to
Question 4.
5. Assume Mark X 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 average
will earn 7 percent interest. Based on your forecasted financial statements, will Mark X be
able to invest in marketable securities in 1993 and 1994? If so, what is the amount of excess
funds Mark X should invest in marketable securities? Do your financial forecasts reveal any
developing conditions that should be corrected?
6. Based on the forecasts developed earlier, would Mark X be able to retire all of the outstanding
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, what alternatives would be available to Mark X?
8. Under what circumstances might the validity of comparative ratio analysis be questionable?
Answer this question in general, not just for Mark X, but use Mark X data to illustrate your
points.
9. Now revise your pro forma financial statements for 1993 and 1994 assuming the following
conditions:
a. Short-term loans will be repaid when sufficient cash is available to do so without reducing
the liquidity of the firm below the minimum requirements set by the bank and when
the company is able to maintain at least the minimum cash balance (5 percent).
b. When the loans are repaid, the repayments will occur at a constant rate throughout the
year. Therefore, on average, the amount of short-term loans outstanding will be half of
the beginning-of-year amount.
c. Mark X will reinstate a 25 percent cash dividend in the year that all short-term loans and
credit lines have been fully cleaned up (paid in full).
10. It is apparent that Mark Xs future (and that of the bank loan) is critically dependent on the
companys performance in 1993 and 1994. Therefore, it would be useful if you could, as
part of your consulting report, inform managementand the bankas to how sensitive the
results are to such things as the sales growth rate, the cost of goods sold percentage, and the
administrative expense ratio.
If the results would still look fairly good even if those factors were not as favorable as
initially forecasted, the bank would have greater confidence in extending the requested
credit. On the other hand, if even tiny changes in these variables would lead to a continuation
of the past downward trend, then the bank should be leery. If you are using the Lotus
model, do some sensitivity analyses (using data tables) to shed light on this issue. (Hint:
See the bottom part of the model labeled SENSITIVITY ANALYSES for some ideas.)
Case: 35 Financial Analysis and Forecasting
If you do not have access to the model, describe how one would go about a sensitivity (or
scenario) analysis, but do not quantify your answer.
11. On the basis of your analyses, do you think Karen should recommend that the bank extend
the existing short- and long-term loans and grant the additional $6,375,000 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 Mark Xs 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 $ 5,149 $ 4,004 $ 3,906 X X
Accounts receivable 17,098 18,462 29,357 X X
Inventory 18,934 33,029 46,659 X X
Current assets $41,181 $55,495 $79,922 X X
Land, buildings, plant,
and equipment $17,761 $20,100 $22,874 $29,249 $30,126
Accumulated depreciation (2,996) (4,654) (6,694) (9,117) (10,940)
Net fixed assets $14,765 $15,446 $16,180 $20,132 $19,186
Total assets $55,946 $70,941 $96,102 X X
Liabilities and Equity:
Short-term bank loans $3,188 $ 5,100 $18,233 X X
Accounts payable 6,764 10,506 19,998 15,995 16,795
Accruals 3,443 5,100 7,331 9,301 11,626
Current liabilities $13,395 $20,706 $45,562 X X
Long-term bank loans $ 6,375 $ 9,563 $ 9,563 $ 9,563 $ 9,563
Mortgage 2,869 2,601 2,340 2,104 1,894
Long-term debt $ 9,244 $12,164 $11,903 $11,667 $11,457
Total liabilities $22,639 $32,870 $57,465 X X
Common stock $23,269 $23,269 $23,269 $23,269 $23,269
Retained earnings 10,038 14,802 15,368 X X
Total equity $33,307 $38,071 $38,637 X X
Total liabilities and equity $55,946 $70,941 $96,102 X X
Notes:
a. 3,500,000 shares of common stock were outstanding throughout the period 1990 through 1992.
b. Market price of shares: 1990$17.78; 1991$9.71; 1992$3.67.
c. Price/earnings (P/E) ratios: 19906.61; 19915.35; 199217.0. The 1992 P/E ratio is high because of the depressed
earnings 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.
Case: 35 Financial Analysis and Forecasting
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 $170,998 $184,658 $195,732 X X
Cost of goods sold 187,684 151,761 166,837 X X
Gross profit $ 33,314 $ 32,897 $ 28,895 $37,678 $49,520
Administration and selling
expenses $ 12,790 $ 15,345 $ 16,881 $17,224 X
Depreciation 1,594 1,658 2,040 2,423 1,823
Miscellaneous expenses 2,027 3,557 5,725 3,768 X
Total operating expenses $ 16,411 $ 20,560 $ 24,646 X X
EBIT $ 16,903 $ 12,337 $ 4,249 $14,263 X
Interest on short-term loans $ 319 $ 561 $ 1,823 $ 2,953 $ 2,953
Interest on long-term loans 638 956 956 X 956
Interest on mortgage 258 234 211 X 170
Total interest $ 1,215 $ 1,751 $ 2,990 $ 4,098 $ 4,079
Before-tax earnings $ 15,688 $ 10,586 $ 1,259 X $21,953
Taxes 6,275 4,234 504 4,066 8,781
Net income $ 9,413 $ 6,352 $ 755 X X
Dividends on stock 2,353 1,588 189 $ 0 X
Additions to retained
earnings $ 7,060 $ 4,764 $ 567 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: 199010%; 199111%; 199210%.
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.
Case: 35 Financial Analysis and Forecasting
TABLE 3
Common Size Balance Sheets
for Years Ended December 31
1990 1991 1992
Assets:
Cash and marketable securities 9.20% 5.64% 4.06%
Accounts receivable 30.56 26.02 X
Inventory 33.84 46.56 48.55%
Current assets 73.61% 78.23% X
Land, buildings, plant, and equipment 31.75% 28.33% X
Accumulated depreciation (5.36) (6.56) (6.97)
Net fixed assets 26.39% 21.77% 16.84%
Total assets 100.00% 100.00% 100.00%
Liabilities and Equities:
Short-term bank loans 5.70% 7.19% 18.97%
Accounts payable 12.09 14.81 20.81
Accruals 6.15 7.19 7.63
Current liabilities 23.94% 29.19% 47.41%
Long-term bank loans 11.39% 13.48% X
Mortgage 5.13 3.67 2.43
Long-term debt 16.52% 17.15% X
Total liabilities 40.47% 46.33% 59.80%
Common stock 41.59% 32.80% 24.21%
Retained earnings 17.94 20.86 X
Total equity 59.53% 53.67% X
Total liabilities and equity 100.00% 100.00% 100.00%
Note: Rounding differences occur in this table.
Case: 35 Financial Analysis and Forecasting
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% X
Administrative and selling expenses 7.48% 8.31% 8.62%
Depreciation 0.93 0.90 X
Miscellaneous expenses 1.19 1.93 2.92
Total operating expenses 9.60% 11.13% X
EBIT 9.88% 6.68% 2.17%
Interest on short-term loans 0.19% 0.30% X
Interest on long-term loans 0.37 0.52 X
Interest on mortgage 0.15 0.13 0.11
Total interest 0.71% 0.95% 1.53%
Before-tax earnings 9.17% 5.73% 0.64%
Taxes 3.67 2.29 X
Net income 5.50% 3.44% 0.39%
Dividends on stock 1.38% 0.86% 0.10%
Additions to retained earnings 4.13% 2.58% 0.29%
Case: 35 Financial Analysis and Forecasting
TABLE 5
Statement of Cash Flows
for Years Ended December 31
(in Thousands of Dollars)
1991 1992
Cash Flow from Operations:
Sales $ 184,658 $195,732
Increase in receivables (1,364) X
Cash sales $ 183,294 X
Cost of goods sold (151,761) (166,837)
Increase in inventories (14,095) (13,630)
Increase in accounts payable 3,742 9,492
Increase in accruals 1,657 X
Cash cost of goods ($160,457) X
Cash margin $ 22,837 X
Administrative and selling expenses (15,345) ($ 16,881)
Miscellaneous expenses (3,557) (5,725)
Taxes (4,234) (504)
Net cash flow from operations ($ 299) X
Cash Flow from Fixed Asset Investment:
Investment in fixed assets ($ 2,339) ($ 2,774)
Cash Flow from Financing Activities:
Increase in short-term debt $ 1,912 $ 13,133
Increase in long-term debt 3,188 X
Repayment of mortgage (268) (261)
Interest expense (1,751) (2,990)
Common dividends (1,588) (189)
Net cash flow from financing activities $ 1,493 $ 9,693
Increase (decrease) in cash and
marketable securities ($ 1,145) X
Case: 35 Financial Analysis and Forecasting
TABLE 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 3.07 2.68 X X X 2.50
Quick ratio 1.66 1.08 0.73 1.10 X 1.00
Debt Management Ratios:
Debt ratio 40.47% 46.33% X X 52.69% 50.00%
TIE coverage 13.91 7.05 1.42 X 6.38 7.70
Asset Management Ratios:
Inventory turnover (cost)a 7.27 4.59 3.58 5.70 5.70 5.70
Inventory turnover (sales)b 9.03 5.59 4.19 X X 7.00
Fixed asset turnover 11.58 11.96 12.10 10.69 12.91 12.00
Total asset turnover 3.06 2.60 X 2.03 X 3.00
Days sales outstanding
(ACP)c 36.00 35.99 53.99 X 32.00 32.00
Profitability Ratios:
Profit margin 5.50% 3.44% 0.39% X X 2.90%
Gross profit margin 19.48% 17.82% 14.76% 17.50% 20.00% 18.00%
Return on total assets 16.82% 8.95% X 5.74% 10.76% 8.80%
ROE 28.26% 16.68% 1.96% X X 17.50%
Other Ratios:
Altman Z scored 6.55 4.68 X X 5.08 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. Altmans function is calculated as
Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5
Here,
X1 = net working capital/total assets
X2 = retained earnings/total assets
X3 = EBIT/total assets
X4 = market value of common and preferred stock/book value of all debt
X5 = sales/total assets.
The Altman Z score range of 1.812.99 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.
Case: 35 Financial Analysis and Forecasting"
There is a typo in the Case Study: for year 1990 Cost of Goods Sold should be 137,684, not 187,684. Also, Z score formula should be:
Z= 1.2X1+1.4X2+3.3X3+0.6X4+0.999X5 if using X1-X4 as shares. Make sure to use total value of debt (liabilities and long term debt) in X4. Note that Market value of stock = market price*number of shares outstanding for current years, and use P/E and EAT or net income to infer the price for the forecast years.MARK X COMPANY (A) Mark X Company manufactures farm and specialty trailers of all types. More than 85 percent of the companys sales come from the western part of the United States, particularly California, although a growing market for custom horse transport vans designed and produced by Mark X is developing nationally and even internationally. Also, several major boat companies in California and Washington have had Mark X design and manufacture trailers for their new models, and these boat-trailer packages are sold through the boat companies nationwide dealer networks. Steve Wing, the president of Mark X, recently received a call from Karen Dennison, senior vice president of Wells Fargo Bank. Karen told Steve that a deficiency report generated by the banks computerized analysis system had been filed because of Mark Xs deteriorating financial position. The bank requires quarterly financial statements from each of its major loan customers. Information from such 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 deficiency report on Mark X revealed a number of significant adverse trends and several potentially serious problems (see Tables 1 through 6 for Mark Xs 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 Mark X for immediate repayment and, if the loans were not repaid within ten days, to force the company into bankruptcy. Karen hoped to avoid calling the loans if at all possible, as she knew this would back Mark X into a corner from which it might not be able to emerge. Still, her own banks 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 Mark X was 2.97 for 1992, just below the 2.99 minimum that is used 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 Mark Xs loans as problem loans, to set up a reserve to cover potential losses, and to take whatever steps are necessary to reduce the banks exposure. Setting up the loss reserve would have a negative effect on the banks profits and reflect badly on Karens performance. Copyright 1994. The Dryden Press. All rights reserved. To keep Mark Xs loan from being reclassified as a problem loan, the Senior Loan Committee will require strong and convincing evidence that the companys 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. Karen 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 had caused severe, though hopefully temporary, problems for companies like Mark X. Farm commodity prices have remained low, thus farmers have held their investments in new equipment to the bare minimum. On top of this, the luxury tax imposed in 1991 has had a disastrous effect on top-of-the-line boat/trailer sales. Finally, the Tax Reform Act of 1986 reduced many of the tax benefits associated with horse breeding, leading to a drastic curtailment of demand for new horse transport vans. In light of the softening demand, Mark X had aggressively reduced prices in 1991 and 1992 to stimulate sales. This, 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. Mark Xs management had full confidence that 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, Mark X relaxed its credit standards in early 1992 and 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, Mark X 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. They predicted that the national economy would pull out of the weak growth scenario in late 1992. Also, there has been some talk in Congress of killing the luxury tax and even giving some tax benefits back to horse breeders. Thus, the company was optimistic that its stable and profitable markets of the past would soon reappear. After Karens telephone call, and the subsequent receipt of a copy of the banks financial analysis of Mark X, Steve began to realize just how precarious his companys 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. Steve had recently signed a firm contract for a plant expansion that would require an additional $6,375,000 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. In his view, once the new production facility went on line, the company would be able to increase output in several segments of the trailer 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, Steve correctly regards the $6,375,000 of new capital as being essential for Mark Xs very survival. Steve 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 companys current business plan were carried out, Mark Xs sales would grow by 10 percent from 1992 to 1993 and by another 15 percent from 1993 to 1994. Further, they concluded that Mark X 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 82.5 percent Case: 35 Financial Analysis and Forecasting in 1993 and then to 80 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 firms 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 companys problems, cash dividends would be eliminated until the firm regains its financial health. Assume that Steve has hired you as a consultant to first verify the banks evaluation of the companys current financial situation and then to put together a forecast of Mark Xs expected performance for 1993 and 1994. Steve 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 $6,375,000 needed for the expansion and supporting working capital. Also, you and Steve do not expect the level of interest rates to change substantially over the two-year forecast period; however, 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 Steve is able to turn the company around, the P/E ratio should be 10 in 1993 and should rise to 12 in 1994. Your first task is to construct a set of pro forma financial statements that Steve and the rest of the Mark X management team can use to assess the companys position and also to convince Karen that her banks loan is safe, provided the bank will extend the firms line of credit. Then, you must present your projections, with recommendations for future action, to Mark Xs management and to Karen. To prepare for your presentations, answer the following questions, keeping in mind that both the Mark X managers and, particularly, Karen and possibly 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, but they are not meant to be a complete and exhaustive list of all the relevant points. QUESTIONS 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, prepare a list of Mark Xs 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 companys 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 Mark X? 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 Case: 35 Financial Analysis and Forecasting grant an additional $6,375,000 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 Mark Xs 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. In responding to Questions 5 through 8, no Lotus model modifications are required. Answers should be based solely on the data contained in the financial statements completed in response to Question 4. 5. Assume Mark X 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 average will earn 7 percent interest. Based on your forecasted financial statements, will Mark X be able to invest in marketable securities in 1993 and 1994? If so, what is the amount of excess funds Mark X should invest in marketable securities? Do your financial forecasts reveal any developing conditions that should be corrected? 6. Based on the forecasts developed earlier, would Mark X be able to retire all of the outstanding 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, what alternatives would be available to Mark X? 8. Under what circumstances might the validity of comparative ratio analysis be questionable? Answer this question in general, not just for Mark X, but use Mark X data to illustrate your points. 9. Now revise your pro forma financial statements for 1993 and 1994 assuming the following conditions: a. Short-term loans will be repaid when sufficient cash is available to do so without reducing the liquidity of the firm below the minimum requirements set by the bank and when the company is able to maintain at least the minimum cash balance (5 percent). b. When the loans are repaid, the repayments will occur at a constant rate throughout the year. Therefore, on average, the amount of short-term loans outstanding will be half of the beginning-of-year amount. c. Mark X will reinstate a 25 percent cash dividend in the year that all short-term loans and credit lines have been fully cleaned up (paid in full). 10. It is apparent that Mark Xs future (and that of the bank loan) is critically dependent on the companys performance in 1993 and 1994. Therefore, it would be useful if you could, as part of your consulting report, inform managementand the bankas to how sensitive the results are to such things as the sales growth rate, the cost of goods sold percentage, and the administrative expense ratio. If the results would still look fairly good even if those factors were not as favorable as initially forecasted, the bank would have greater confidence in extending the requested credit. On the other hand, if even tiny changes in these variables would lead to a continuation of the past downward trend, then the bank should be leery. If you are using the Lotus model, do some sensitivity analyses (using data tables) to shed light on this issue. (Hint: See the bottom part of the model labeled SENSITIVITY ANALYSES for some ideas.) Case: 35 Financial Analysis and Forecasting If you do not have access to the model, describe how one would go about a sensitivity (or scenario) analysis, but do not quantify your answer. 11. On the basis of your analyses, do you think Karen should recommend that the bank extend the existing short- and long-term loans and grant the additional $6,375,000 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 Mark Xs 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 $ 5,149 $ 4,004 $ 3,906 X X Accounts receivable 17,098 18,462 29,357 X X Inventory 18,934 33,029 46,659 X X Current assets $41,181 $55,495 $79,922 X X Land, buildings, plant, and equipment $17,761 $20,100 $22,874 $29,249 $30,126 Accumulated depreciation (2,996) (4,654) (6,694) (9,117) (10,940) Net fixed assets $14,765 $15,446 $16,180 $20,132 $19,186 Total assets $55,946 $70,941 $96,102 X X Liabilities and Equity: Short-term bank loans $3,188 $ 5,100 $18,233 X X Accounts payable 6,764 10,506 19,998 15,995 16,795 Accruals 3,443 5,100 7,331 9,301 11,626 Current liabilities $13,395 $20,706 $45,562 X X Long-term bank loans $ 6,375 $ 9,563 $ 9,563 $ 9,563 $ 9,563 Mortgage 2,869 2,601 2,340 2,104 1,894 Long-term debt $ 9,244 $12,164 $11,903 $11,667 $11,457 Total liabilities $22,639 $32,870 $57,465 X X Common stock $23,269 $23,269 $23,269 $23,269 $23,269 Retained earnings 10,038 14,802 15,368 X X Total equity $33,307 $38,071 $38,637 X X Total liabilities and equity $55,946 $70,941 $96,102 X X Notes: a. 3,500,000 shares of common stock were outstanding throughout the period 1990 through 1992. b. Market price of shares: 1990$17.78; 1991$9.71; 1992$3.67. c. Price/earnings (P/E) ratios: 19906.61; 19915.35; 199217.0. The 1992 P/E ratio is high because of the depressed earnings 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. Case: 35 Financial Analysis and Forecasting 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 $170,998 $184,658 $195,732 X X Cost of goods sold 187,684 151,761 166,837 X X Gross profit $ 33,314 $ 32,897 $ 28,895 $37,678 $49,520 Administration and selling expenses $ 12,790 $ 15,345 $ 16,881 $17,224 X Depreciation 1,594 1,658 2,040 2,423 1,823 Miscellaneous expenses 2,027 3,557 5,725 3,768 X Total operating expenses $ 16,411 $ 20,560 $ 24,646 X X EBIT $ 16,903 $ 12,337 $ 4,249 $14,263 X Interest on short-term loans $ 319 $ 561 $ 1,823 $ 2,953 $ 2,953 Interest on long-term loans 638 956 956 X 956 Interest on mortgage 258 234 211 X 170 Total interest $ 1,215 $ 1,751 $ 2,990 $ 4,098 $ 4,079 Before-tax earnings $ 15,688 $ 10,586 $ 1,259 X $21,953 Taxes 6,275 4,234 504 4,066 8,781 Net income $ 9,413 $ 6,352 $ 755 X X Dividends on stock 2,353 1,588 189 $ 0 X Additions to retained earnings $ 7,060 $ 4,764 $ 567 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: 199010%; 199111%; 199210%. 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. Case: 35 Financial Analysis and Forecasting TABLE 3 Common Size Balance Sheets for Years Ended December 31 1990 1991 1992 Assets: Cash and marketable securities 9.20% 5.64% 4.06% Accounts receivable 30.56 26.02 X Inventory 33.84 46.56 48.55% Current assets 73.61% 78.23% X Land, buildings, plant, and equipment 31.75% 28.33% X Accumulated depreciation (5.36) (6.56) (6.97) Net fixed assets 26.39% 21.77% 16.84% Total assets 100.00% 100.00% 100.00% Liabilities and Equities: Short-term bank loans 5.70% 7.19% 18.97% Accounts payable 12.09 14.81 20.81 Accruals 6.15 7.19 7.63 Current liabilities 23.94% 29.19% 47.41% Long-term bank loans 11.39% 13.48% X Mortgage 5.13 3.67 2.43 Long-term debt 16.52% 17.15% X Total liabilities 40.47% 46.33% 59.80% Common stock 41.59% 32.80% 24.21% Retained earnings 17.94 20.86 X Total equity 59.53% 53.67% X Total liabilities and equity 100.00% 100.00% 100.00% Note: Rounding differences occur in this table. Case: 35 Financial Analysis and Forecasting 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% X Administrative and selling expenses 7.48% 8.31% 8.62% Depreciation 0.93 0.90 X Miscellaneous expenses 1.19 1.93 2.92 Total operating expenses 9.60% 11.13% X EBIT 9.88% 6.68% 2.17% Interest on short-term loans 0.19% 0.30% X Interest on long-term loans 0.37 0.52 X Interest on mortgage 0.15 0.13 0.11 Total interest 0.71% 0.95% 1.53% Before-tax earnings 9.17% 5.73% 0.64% Taxes 3.67 2.29 X Net income 5.50% 3.44% 0.39% Dividends on stock 1.38% 0.86% 0.10% Additions to retained earnings 4.13% 2.58% 0.29% Case: 35 Financial Analysis and Forecasting TABLE 5 Statement of Cash Flows for Years Ended December 31 (in Thousands of Dollars) 1991 1992 Cash Flow from Operations: Sales $ 184,658 $195,732 Increase in receivables (1,364) X Cash sales $ 183,294 X Cost of goods sold (151,761) (166,837) Increase in inventories (14,095) (13,630) Increase in accounts payable 3,742 9,492 Increase in accruals 1,657 X Cash cost of goods ($160,457) X Cash margin $ 22,837 X Administrative and selling expenses (15,345) ($ 16,881) Miscellaneous expenses (3,557) (5,725) Taxes (4,234) (504) Net cash flow from operations ($ 299) X Cash Flow from Fixed Asset Investment: Investment in fixed assets ($ 2,339) ($ 2,774) Cash Flow from Financing Activities: Increase in short-term debt $ 1,912 $ 13,133 Increase in long-term debt 3,188 X Repayment of mortgage (268) (261) Interest expense (1,751) (2,990) Common dividends (1,588) (189) Net cash flow from financing activities $ 1,493 $ 9,693 Increase (decrease) in cash and marketable securities ($ 1,145) X Case: 35 Financial Analysis and Forecasting TABLE 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 3.07 2.68 X X X 2.50 Quick ratio 1.66 1.08 0.73 1.10 X 1.00 Debt Management Ratios: Debt ratio 40.47% 46.33% X X 52.69% 50.00% TIE coverage 13.91 7.05 1.42 X 6.38 7.70 Asset Management Ratios: Inventory turnover (cost)a 7.27 4.59 3.58 5.70 5.70 5.70 Inventory turnover (sales)b 9.03 5.59 4.19 X X 7.00 Fixed asset turnover 11.58 11.96 12.10 10.69 12.91 12.00 Total asset turnover 3.06 2.60 X 2.03 X 3.00 Days sales outstanding (ACP)c 36.00 35.99 53.99 X 32.00 32.00 Profitability Ratios: Profit margin 5.50% 3.44% 0.39% X X 2.90% Gross profit margin 19.48% 17.82% 14.76% 17.50% 20.00% 18.00% Return on total assets 16.82% 8.95% X 5.74% 10.76% 8.80% ROE 28.26% 16.68% 1.96% X X 17.50% Other Ratios: Altman Z scored 6.55 4.68 X X 5.08 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. Altmans function is calculated as Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5 Here, X1 = net working capital/total assets X2 = retained earnings/total assets X3 = EBIT/total assets X4 = market value of common and preferred stock/book value of all debt X5 = sales/total assets. The Altman Z score range of 1.812.99 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. Case: 35 Financial Analysis and Forecasting" There is a typo in the Case Study: for year 1990 Cost of Goods Sold should be 137,684, not 187,684. Also, Z score formula should be: Z= 1.2X1+1.4X2+3.3X3+0.6X4+0.999X5 if using X1-X4 as shares. Make sure to use total value of debt (liabilities and long term debt) in X4. Note that Market value of stock = market price*number of shares outstanding for current years, and use P/E and EAT or net income to infer the price for the forecast years.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-text-image.webp)
Get Instant Access with AI-Powered Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-subtext-image.webp)
Step: 3
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-subtext-image.webp)
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started