Seal-best, Inc.⁽¹⁾(2019)

Roger Elliot, vice president and loan officer of the First National Bank of Cincinnati, was recently alerted to the deteriorating financial position of one of his clients, Seal-best, Inc., by his bank's newly instituted computer loan-analysis program. The bank requires quarterly financial statements - balance sheets and income statements - from each of its major loan customers. This information is fed into the computer, which then calculates the key ratios for each customer, charts trends in these ratios, and compares the statistics of each company with the average ratios and trends of other firms in the same industry. If any ratio of any company is significantly poorer than the industry average, the computer output makes note of this fact. If the terms of a loan require that certain ratios be maintained at specified minimum levels and these minimums are not being met by a company, the computer output notes the deficiency.

When an analysis was run on Seal-best three months earlier, Elliot noticed that some of the company's ratios were showing downward trends, dipping below the averages for the dairy products industry. Elliot sent a copy of the computer output, together with a note voicing his concern, to Eric Swenson, president of Seal-best. Although Swenson acknowledged receipt of the material, he took no action to correct the situation.

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FIGURE 1

SEAL-BEST, INC. BALANCE SHEET

YEAR ENDED DECEMBER 31

2015

2016

2017

2018

Cash

$ 34,000

$ 51,000

$ 23,800

$ 17,000

Accounts Receivable

136,000

204,000

231,200

323,000

Inventory

170,000

255,000

425,000

688,500

Total Current Assets

$ 340,000

$ 510,000

$ 680,000

$ 1,028,500

Land and Building

51,000

40,800

108,800

102,000

Machinery

68,000

125,800

98,600

85,000

Other Fixed Assets

40,800

23,800

6,800

5,100

Total Assets

$ 499,800

$ 700,400

$ 894,200

$ 1,220,600

Notes Payable, bank

---

---

85,000

238,000

Accounts and Notes Payable

74,800

81,600

129,200

255,000

Accruals

34,000

40,800

47,600

64,600

Total Current Liabilities

108,800

122,400

261,800

557,600

Mortgage

51,000

37,400

34,000

30,600

Common Stock

306,000

306,000

306,000

306,000

Retained Earnings

34,000

234,600

292,400

326,400

Total Liabilities & Equity

$ 499,800

$ 700,400

$ 894,200

$ 1,220,600

The first financial analysis indicated that some problems were developing, but no ratio was below the level specified in the loan agreement between the bank and Seal-best. However, the second analysis, which was based on the data given in Figures 1, 2, and 3, showed that the current ratio was below the 2.0 times specified in the loan agreement. According to the loan agreement, the Cincinnati Bank could legally call upon the dairy for immediate payment of the entire bank loan, and if payment was not forthcoming within 10 days, the bank could force Seal-best into bankruptcy. Elliot had no intention of actually enforcing the contract to the full extent that he legally could, but he did intend to use the loan agreement provision to prompt Seal-best to take some decisive action to improve its financial picture.

Figure 2

SEAL-BEST, INC. INCOME STATEMENT

2016

2017

2018

Net Sales

$ 2,210,000

$2,295,000

$2,380,000

Cost of Goods Sold

1,768,000

1,836,000

1,904,000

Gross Operating Profit

442,000

459,000

476,000

General, Administrative, Selling

170,000

187,000

204,000

Depreciation

68,000

85,000

102,000

Miscellaneous

34,000

71,400

102,000

EBT

170,000

115,600

68,000

Taxes (50%)

85,000

57,800

34,000

Net Income

$ 85,000

$ 57,800

$ 34,000

Seal-best is a company that handles a full line of dairy products in central and southern Ohio. It produces both fresh dairy products and such storable products as powdered milk and cheese. Seasonal working capital needs have been financed primarily by loans from the Cincinnati Bank, and the current line of credit permits the dairy to borrow up to $240,000. In accordance with standard banking practices, however, the loan agreement requires that the bank loan be repaid in full at some time during the year, in this case by February 2019.

A limitation on dairy products prices, coupled with higher costs, caused a decline in Seal-best's profit margin and net income during the last half of 2017 as well as during most of 2018. Sales increased during both of these years, however, due to the dairy's aggressive marketing program.

When Swenson received a copy of Elliot's latest computer analysis and the blunt statement that the bank would insist on immediate repayment of the entire loan unless the firm presented a program showing how the poor current financial picture could be improved, he began trying to determine what could be done. He rapidly concluded that the present level of sales could not be continued without anincreasein the bank loan from $240,000 to $340,000, since payments of $100,000 for construction of a plant addition would have to be made in February 2019. Even though the dairy has been a good customer of the Cincinnati Bank for over 50 years, Swenson began to question whether the bank would continue to supply the present line of credit, let alone increase the loan outstanding. Swenson was especially troubled by the fact that the Federal Reserve recently tightened bank credit, forcing the Cincinnati Bank to ration credit even to its best customers.

Questions:

• 1) Calculate the key financial ratios for Seal-best, Inc., and plot trends in the firm's ratios against the industry averages.
• 2) What strengths and weaknesses are revealed by the ratio analysis?
• 3) What amount ofinternally-generated funds would be available for the retirement of the loan? If the bank were to grant the additional credit and extend the increased loan from a due date of February 1 to June 30, would the company be able to retire the loan on June 30? (Hint: To answer this question, consider profits and depreciation as well as the amount of inventories and receivables that would be carried if Seal-best's inventory turnover and average collection period (Days Sales Outstanding) were at industry average levels, that is, generating funds by reducing inventories and receivables to industry averages.)
• 4) In 2018, Seal-best's return on equity was 5.38 percent, versus 18 percent for the industry. Use theduPontequation to pinpoint the factors causing Seal-best to fall so far below the industry average.
• 5) On the basis of your financial analysis, do you believe that the bank should grant the additional loan and extend the entire line of credit to June 30?
• 6) If the credit extension is not made, what alternatives are open to Seal-best?
• 7) Under what circumstances is the validity of comparative ratio analysis questionable?

Dairy Products Industry Ratios (2018) (a)

Quick Ratio

1.0

Current Ratio

2.7

Inventory Turnover

7 times

Average Collection Period

32 days

Fixed Asset Turnover (b)

13.0 times

Total Asset Turnover (b)

2.6 times

Return on Total Assets

9%

Return on Equity

18%

Debt (Total) Ratio

50%

Profit Margin on Sales

3.5%

(a) Industry average ratios have been constant for the past three years.

(b) Based on year-end balance sheet figures.