Seal-best, Inc.(1) 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. Note, the following tables have been made available to you as an that you can download. The file is Read Only, so you will need to save it as another name after you first open it in Excel. To download, RIGHT-CLICK your mouse on the spreadsheet hot link, and when the menu pops up, choose the "Save Target As" or "Save As" command. When you have the choice, enter where you want the file saved. If your browser does not automatically enter the file extension, make sure you save it with the ".xls" extension for a MS-eXcel file. FIGURE 1 SEAL-BEST, INC. BALANCE SHEET YEAR ENDED DECEMBER 31 2000 2008 2009 2010 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 2008 2009 2010 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 2011. 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 2009 as well as during most of 2010. 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 an increase in 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 2011. 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: o 1) Calculate the key financial ratios for Seal-best, Inc., and plot trends in the firm's ratios against the industry averages. o 2) What strengths and weaknesses are revealed by the ratio analysis? o 3) What amount of internally-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, 2011 to June 30, 2011, 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.) o 4) In 2010, Seal-best's return on equity was 5.38 percent, versus 18 percent for the industry. Use the duPont equation to pinpoint the factors causing Seal-best to fall so far below the industry average. o 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, 2011? o 6) If the credit extension is not made, what alternatives are open to Seal-best? o 7) Under what circumstances is the validity of comparative ratio analysis questionable?