A liquidity crisis occurs whenever a firm is unable to pay its bills on time or lacks sufficient cash to expand inventory and production or violates some term of an agreement by letting some of its financial ratios exceed limits. It is the financial manager's job to ensure that this never happens. But it happens and all interests involved start to scramble to protect their positions.
Consider the following example:
SITUATION This company has received a call from its bank informing it that the company has violated some terms of its loan agreement, specifically, that debt ratio exceeded 55% and that the current ratio has fallen below 2.0. These ratios are highlighted in the table of ratios below.
Technically the bank could call the loan for the complete amount outstanding . If the company cannot repay in ten days then it could be forced into bankruptcy. You are surprised at this turn of events since you were going to the bank tomorrow anyway to ask for for an additional $1,000,000 to meet a payment due to the construction company working on the expansion of your facilities.
You will have to calculate whether you would be able to repay the existing loans to the bank and the additional money you want to borrow within six months if you could get your average collection period in line with the industry average and also do the same with your inventory turnover. Assume that you will generate cash from operations and depreciation at the same rate that you did last year for one half year.
|
FOREST RESOURCES CORP. BALANCE SHEETS |
||||
| amounts in thousands of dollars |
1993 |
1994 |
1995 |
|
|
CASH |
807 |
628 |
612 |
|
|
ACCOUNTS RECEIVABLE |
2682 |
2896 |
4605 |
|
|
INVENTORY |
2970 |
5181 |
7319 |
|
|
LAND BUILDINGS PLANT & EQUIP |
2786 |
3153 |
3558 |
|
|
ACCUMULATED DEPRECIATION |
470 |
730 |
1050 |
|
|
TOTAL ASSETS |
8775 |
11128 |
15074 |
|
|
SHORT TERM LOANS |
500 |
800 |
2860 |
|
|
ACCOUNTS PAYABLE |
1061 |
1648 |
3137 |
|
|
ACCRUALS |
540 |
800 |
1150 |
|
|
LONG TERM BANK LOAN |
1000 |
1500 |
1500 |
|
|
MORTGAGE |
450 |
408 |
367 |
|
|
COMMON STOCK[3.65 MILL.SHS] |
3650 |
3650 |
3650 |
|
|
RETAINED EARNINGS |
1574 |
2322 |
2410 |
|
|
TOTAL LIABILITIES AND CAP |
8775 |
11128 |
15074 |
|
|
- |
- |
- |
- |
|
|
INCOME STATEMENTS |
||||
|
1993 |
1994 |
1995 |
||
|
NET SALES |
26820 |
28996 |
30703 |
|
|
COST OF GOODS SOLD |
21216 |
23550 |
26140 |
|
|
GROSS PROFIT |
5604 |
5416 |
4563 |
|
|
AMN AND SELLING EX |
2006 |
2407 |
2648 |
|
|
DEPRECIATION |
250 |
260 |
320 |
|
|
MISC EX |
318 |
558 |
898 |
|
|
EBIT |
3030 |
2191 |
697 |
|
|
INTEREST SHORT TERM |
50 |
88 |
286 |
|
|
INTEREST LONG TERM |
0 |
150 |
150 |
|
|
INTEREST MORTGAGE |
41 |
37 |
33 |
|
|
NET INCOME BEFORE TAXES |
2939 |
1916 |
228 |
|
|
TAXES |
1411 |
919 |
110 |
|
|
NET INCOME AFTER TAXES |
1528 |
997 |
118 |
|
|
DIVIDENDS |
382 |
249 |
30 |
|
|
INCREASE IN RETAINED EARNINGS |
1146 |
748 |
88 |
|
|
Ratio Analysis |
||||
|
1993 |
1994 |
1995 |
INDUSTRY AVG | |
|
- |
- |
- |
- |
- |
|
CURRENT RATIO |
3.07 |
2.68 |
2.5 | |
|
QUICK RATIO |
1.66 |
1.08 |
0.73 |
1 |
|
DEBT RATIO % |
0.4 |
0.46 |
50 | |
|
TIMES INTEREST EARNED |
16.79 |
3.63 |
0.25 |
7.7 |
|
7.14 |
4.55 |
3.57 |
4.7 | |
|
INVENTORY TURNOVER[SELLING] |
9.03 |
5.6 |
4.19 |
7 |
|
FIXED ASSET TURNOVER |
11.58 |
11.97 |
12.24 |
12 |
|
TOTAL ASSETS TURNOVER |
3.06 |
2.61 |
2.04 |
3 |
|
36 |
36 |
54 |
25 | |
|
PROFIT MARGIN % |
5.7% |
3.4% |
0.4% |
2.9 |
|
GROSS PROFIT MARGIN % |
20.9% |
18.7% |
14.9% |
18 |
|
RETURN ON TOTAL ASSETS % |
17.4% |
9% |
0.8% |
8.8 |
|
RETURN ON OWNERS EQUITY % |
29.2% |
16.7% |
1.9% |
17.5 |
|
DIVIDEND PAYOUT RATIO |
25% |
25% |
25.4% |
20% |
This situation is a problem for the company and the bank:
What are the alternatives?
If the bank calls the loan the company has ten days to come up with the money. There is not enough cash so they might seek another bank to arrange financing. However with the lousy financial ratios they have at the present time, no sane banker would lend them the money. The company would default [not be able to pay], and bankruptcy would start. The bank may have to wait years and only recover a small percentage of what is owed.
If the bank does not call the loan the company will still be unable to meet the progress payment to the contractor who will then probably start the bankruptcy proceedings anyway. So alternative #2 really is not viable in this case.
If the bank lends the additional money, the crises will be averted for the moment, but how will the bank be able to protect its interest? And, is it really throwing good money after bad.
The bank is in the driver's seat and will have to make a quick determination if the company is
The important thing to realize is that the existing
management is much worse than the industry average. If the company were managed
at the industry average level there would be a lot less receivables and
inventory. Inventory would be sold off and old account balances would be
collected.
| Amount of Cash Available from Receivables | ||
| Actual Accounts Receivable | [from the balance sheet] | 4605 |
| Ideal Accounts Receivable | [ind ACP times avg. daily sales | 2132 |
| Cash potential | 2473 | |
| Amount of Cash Available from Inventory | ||
| Actual Inventory | [from the balance sheet] | 7319 |
| Ideal Inventory | [Sales divided by ind Inventory turnover | 6533 |
| Cash Potential | 786 | |
| Amount of Cash Available from Operations | ||
| Estimated net income | [one half of last year's] | 59 |
| Depreciation | [one half of last year's] | 160 |
| Cash Potential | 219 | |
| Decision Table | ||
| Total Cash Available | [sum of above three tables] | 3478 |
| Total Cash required | [sum of bank loans + amount due contractor] | 3860 |
| Decision | ||
If the decision is made to go with bankruptcy it is basically a legal process to protect the rights of all the creditors.
If the decision is made to continue in operation the bank must do something to insure that the old way of managing inventory and receivables stops.
Comments and Suggestions should may be sent togramborw@tiger.uofs.edu