Previously, you were introduced to Dry Supply, Inc., as a case study. Dry Supply is a wholesaler of dry cleaning equipment, cleaning supplies, and laundry soap. The company, which is located in central Kansas, has been in business over 50 years. Anne Schippel is a business banker and, in conjunction with her manager, has determined that this business is consistent with the industries targeted by her bank, as well as being within the bank's designated market area. She has made a couple of introductory calls and knows chat Dry Supply was founded in 1949 by the father, who sold it 20 years later to his daughters, who are the current owners and managers of the company. Four grandchildren also are employed by the company. In shore, this is a family-run business and likely to remain so in the foreseeable future. Dry Supply began as a wholesaler of powdered laundry produces. Twenty years later, the operation changed its focus co dry cleaning supplies, such as liquid cleaners, plastic bags, and metal hangers. The company continues in chat capacity today. Historically, the company has had a very good operating and credit record, and a review of its dealings with suppliers and customers reveals no notable problems. Instructions Review the Risk Rating Grid for Qualitative Factors and Schippel's financial review findings for Dry Supply in Appendix A and Appendix B in this chapter. Then answer these questions. What are some initial risk rating conclusions you can make for the following: Industry risk? Market risk? Management risk?

What are some questions Anne Schippel can ask Dry supply or be thinking about to better understand these risks?

APPENDIX A: RISK RATING GRID FOR QUALITATIVE FACTORS 1 2 4 Risk Rating Label Minimal Risk (superior) Modest Risk (exceptional) 3 Average Risk Acceptable Risk Area Industry Risk Minimal cyclicality. Modest cyclicality . Not capital . Modest capital (Industry intensive needs industry - Favorable legal Neutral legal segment) regulatory, labor regulatory labor outlook outlook Market Risk Leader with large. Reasonable share in stablo market share (Position industry nationally or within industry Pricing leader and strong regional and level of low-cost producer presence competition) Performance May dominate ratios rank high local market Competitive pricing with good margins Above average performance ratios Average cyclicality. Intensely cyclical . Serious industry industry downturn not likely Uncartain industry Neutral legal, outlook regulatory, labor Low barriers to outlook entry Demanding legal. regulatory, labor Outlook Price follower with Position within average market industry weak or share deteriorating Stable demand Maintenance of Established and market share loyal customers difficult and Smaller firm expensive with strong local Customer supplier position relations price- driven Performance ratios generally Smaller firm with better than peers average local presence Reasonable Limited industry industry experience with experience with littie depth modest depth at Actual or potential key positions friction between Good Internal owners or potential controls successors Proven character Internal controls and ability to deal marginal with some with adversity manual processes Principals' ability + Acceptable and willingness to character Inject capital Higher litigation Good labor risk relations High owner . Low litigation compensation polential relative to revenues and earnings Management Highly Risk experienced management with (Management continuity and and controls) depth Excellent internal controls and reporting Broad industry experience with good continuity Depth in key positions High level of internal controls with quality reporting + American Bankers Association Credit Investigation and Assessing Industry Market and Management Risk 45 APPENDIX B: INITIAL RESEARCH FINDINGS FOR DRY SUPPLY, INC. The following are Schippel's initial research findings on wholesalers of cleaning equip- ment and supplies: As a wholesaler, Dry Supply's operating cycle involves purchasing finished products for sale to retailers such as laundries and dry cleaners For this industry, the largest asser is inventory, closely followed by accounts receivable. The largest liability is accounts payable, which tends to follow or mirror inventory As a wholesaler, the following are risks that may disrupe the operating cycle: Quality of product Inability to market products Credit approval policies Collection of accounts receivable Relationship with vendors (accounts payable) As Schippel obtained more detailed financial information, she conducted a thorough financial analysis of Dry Supply. The chart below shows the most recent three years of summary financial ratios compared with the wholesale dry cleaning equipment industry, plus excerpts from Schippel's comparative analysis. Comparative analysis involves evalu- ating the performance of a business against other companies in the industry. Dry Supply Comparative Analysis Ratio Dry Supply, Inc Trend Analysis 20xy 1.5x % 20xx Oxz 1.3x 1.8% 0.8x 1 Ox 12x Wholesale Dry Cleaning Equipment Industry Quartiles 20xz Higher Modian Lower 2. 4x 1 5x 1.2x 1.2x 0.8x 0.5x 0.9x 2.5x 5 1x 5.5x 2 1x 1. Ox n/a 2. 1x n/a 10.7x 3. 2x 10.3x) Current Quick Tangible leverage Interest coverage Pretax profit margin Return on assets 3.3x 2.7% 4.7x 4 3x 1 9x 4.6% 43x 14.8x 2. 2x 2.8x 10.0x 8. 2x Dry Supply's 20xz current ratio is in the second quartile and above the median for the industry. Firms in the industry with a current ratio above 2.4x are in the highest or first quartile. Firms with a current ratio between 2.4x and 1.5x are in the second quartile, with 1.5x also being the median. Firms with a current ratio between 1.5x and 1.2.x are below the median and in the third quartile. Finally, firms with a current ratio below 1.2x are in the lowest or fourth quartile. The three numbers shown in the chart on the next page are the breakpoints between the quartiles. 46 Commercial Lending American Bankers Association Interpreting Industry Data Using the Current Ratio From Dry Supply Comparative Analysis Breakpoint Second Quartile Breakpoint First or Highest Quartile Third Quartile Breakpoint Fourth or Lowest Quartile 2.4x 1.5x 1 2x The current ratio of 1.8x suggests that, in liquidation, Dry Supply's current assets, cven after discounts of almost 45 percent, would be sufficient to current liabilities, Moreover, its 20xz quick ratio is in the top quartile for its industry. An experienced business banker would recognize that Dry Supply's liquidity compares favorably to the industry. However, because the primary purpose of a ratio is to reflect trends, it is dif- ficult to be conclusive about any single ratio in isolation. This is why a business banker needs to underscand the business and its industry. Dry Supply's tangible leverage ratio of 1.9x at 12/31/20xz indicates that creditors continue to have more risk than its owners. While this ratio has improved over the three years, it is still fairly high and may limit the company's ability to borrow addi- tional funds. At 12/31/20xz, this ratio is better than (lower than the median, since it is below 2.5x, which means that, in general, Dry Supply has a lower (more favorable) tangible leverage ratio than most of its competitors. The coverage ratio available for the industry is interest coverage, which shows Dry Supply to be higher than the median for the industry. This is the result of having a lower leverage position than its peers, which likely includes having fewer borrowed funds to generate interest expense, together with favorable levels of profits as compared to the industry. Dry Supply's pretax profit margin for 20xz is well above the median for the in- dustry, with full quartiles not available from the industry data. A business banker should look further at the common-size income statement data for the industry to see which components cause the favorable position relative to the industry. Dry Supply could have a higher gross profit margin, lower operating expense levels, or a combination of both. The relatively high levels of profits contribute to Dry Supply being in the highest or first quartile for the return on assets (ROA) ratio for 20x2. This is because Dry Supply's ROA of 14.8 percent exceeds the 10.7 percent breakpoint between the first and second quartile. It is possible that Dry Supply uses its assets more efficiently than others in the industry to produce profits, but perhaps Dry Supply does not have as much new equipment as its competitors. If industry data for the sales to assets ratio is available, as well as the other efficiency ratios, a business banker can make better conclusions about this ratio. American Bankers Association Credit Investigation and Assessing Industry, Market, and Management Risk 47 APPENDIX A: RISK RATING GRID FOR QUALITATIVE FACTORS 1 2 4 Risk Rating Label Minimal Risk (superior) Modest Risk (exceptional) 3 Average Risk Acceptable Risk Area Industry Risk Minimal cyclicality. Modest cyclicality . Not capital . Modest capital (Industry intensive needs industry - Favorable legal Neutral legal segment) regulatory, labor regulatory labor outlook outlook Market Risk Leader with large. Reasonable share in stablo market share (Position industry nationally or within industry Pricing leader and strong regional and level of low-cost producer presence competition) Performance May dominate ratios rank high local market Competitive pricing with good margins Above average performance ratios Average cyclicality. Intensely cyclical . Serious industry industry downturn not likely Uncartain industry Neutral legal, outlook regulatory, labor Low barriers to outlook entry Demanding legal. regulatory, labor Outlook Price follower with Position within average market industry weak or share deteriorating Stable demand Maintenance of Established and market share loyal customers difficult and Smaller firm expensive with strong local Customer supplier position relations price- driven Performance ratios generally Smaller firm with better than peers average local presence Reasonable Limited industry industry experience with experience with littie depth modest depth at Actual or potential key positions friction between Good Internal owners or potential controls successors Proven character Internal controls and ability to deal marginal with some with adversity manual processes Principals' ability + Acceptable and willingness to character Inject capital Higher litigation Good labor risk relations High owner . Low litigation compensation polential relative to revenues and earnings Management Highly Risk experienced management with (Management continuity and and controls) depth Excellent internal controls and reporting Broad industry experience with good continuity Depth in key positions High level of internal controls with quality reporting + American Bankers Association Credit Investigation and Assessing Industry Market and Management Risk 45 APPENDIX B: INITIAL RESEARCH FINDINGS FOR DRY SUPPLY, INC. The following are Schippel's initial research findings on wholesalers of cleaning equip- ment and supplies: As a wholesaler, Dry Supply's operating cycle involves purchasing finished products for sale to retailers such as laundries and dry cleaners For this industry, the largest asser is inventory, closely followed by accounts receivable. The largest liability is accounts payable, which tends to follow or mirror inventory As a wholesaler, the following are risks that may disrupe the operating cycle: Quality of product Inability to market products Credit approval policies Collection of accounts receivable Relationship with vendors (accounts payable) As Schippel obtained more detailed financial information, she conducted a thorough financial analysis of Dry Supply. The chart below shows the most recent three years of summary financial ratios compared with the wholesale dry cleaning equipment industry, plus excerpts from Schippel's comparative analysis. Comparative analysis involves evalu- ating the performance of a business against other companies in the industry. Dry Supply Comparative Analysis Ratio Dry Supply, Inc Trend Analysis 20xy 1.5x % 20xx Oxz 1.3x 1.8% 0.8x 1 Ox 12x Wholesale Dry Cleaning Equipment Industry Quartiles 20xz Higher Modian Lower 2. 4x 1 5x 1.2x 1.2x 0.8x 0.5x 0.9x 2.5x 5 1x 5.5x 2 1x 1. Ox n/a 2. 1x n/a 10.7x 3. 2x 10.3x) Current Quick Tangible leverage Interest coverage Pretax profit margin Return on assets 3.3x 2.7% 4.7x 4 3x 1 9x 4.6% 43x 14.8x 2. 2x 2.8x 10.0x 8. 2x Dry Supply's 20xz current ratio is in the second quartile and above the median for the industry. Firms in the industry with a current ratio above 2.4x are in the highest or first quartile. Firms with a current ratio between 2.4x and 1.5x are in the second quartile, with 1.5x also being the median. Firms with a current ratio between 1.5x and 1.2.x are below the median and in the third quartile. Finally, firms with a current ratio below 1.2x are in the lowest or fourth quartile. The three numbers shown in the chart on the next page are the breakpoints between the quartiles. 46 Commercial Lending American Bankers Association Interpreting Industry Data Using the Current Ratio From Dry Supply Comparative Analysis Breakpoint Second Quartile Breakpoint First or Highest Quartile Third Quartile Breakpoint Fourth or Lowest Quartile 2.4x 1.5x 1 2x The current ratio of 1.8x suggests that, in liquidation, Dry Supply's current assets, cven after discounts of almost 45 percent, would be sufficient to current liabilities, Moreover, its 20xz quick ratio is in the top quartile for its industry. An experienced business banker would recognize that Dry Supply's liquidity compares favorably to the industry. However, because the primary purpose of a ratio is to reflect trends, it is dif- ficult to be conclusive about any single ratio in isolation. This is why a business banker needs to underscand the business and its industry. Dry Supply's tangible leverage ratio of 1.9x at 12/31/20xz indicates that creditors continue to have more risk than its owners. While this ratio has improved over the three years, it is still fairly high and may limit the company's ability to borrow addi- tional funds. At 12/31/20xz, this ratio is better than (lower than the median, since it is below 2.5x, which means that, in general, Dry Supply has a lower (more favorable) tangible leverage ratio than most of its competitors. The coverage ratio available for the industry is interest coverage, which shows Dry Supply to be higher than the median for the industry. This is the result of having a lower leverage position than its peers, which likely includes having fewer borrowed funds to generate interest expense, together with favorable levels of profits as compared to the industry. Dry Supply's pretax profit margin for 20xz is well above the median for the in- dustry, with full quartiles not available from the industry data. A business banker should look further at the common-size income statement data for the industry to see which components cause the favorable position relative to the industry. Dry Supply could have a higher gross profit margin, lower operating expense levels, or a combination of both. The relatively high levels of profits contribute to Dry Supply being in the highest or first quartile for the return on assets (ROA) ratio for 20x2. This is because Dry Supply's ROA of 14.8 percent exceeds the 10.7 percent breakpoint between the first and second quartile. It is possible that Dry Supply uses its assets more efficiently than others in the industry to produce profits, but perhaps Dry Supply does not have as much new equipment as its competitors. If industry data for the sales to assets ratio is available, as well as the other efficiency ratios, a business banker can make better conclusions about this ratio. American Bankers Association Credit Investigation and Assessing Industry, Market, and Management Risk 47