Module 3 Answer Key – Financial Management

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Home Read Sign in Want to create or adapt books like this? Learn more about how Pressbooks supports open publishing practices. FINANCIAL MANAGEMENT CONTENTS Search in book … Module 3 Answer Key 3.5 Exercises A. Problem: Short-term Financial Planning Section 3.5 Exercise Answer Key – Short-term Financial Planning and Growth Spreadsheet 1. https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 1 of 18

Budgeted Income Statement Quarter 1 Quarter 2 Quarter 3 Quarter 4 Year Sales CAD 170,775 CAD 314,550 CAD 251,325 CAD 111,375 CAD 848,025 Cost of sales 109,568 198,450 161,700 75,075 544,793 Gross profit CAD 61,207 CAD 116,100 CAD 89,625 CAD 36,300 CAD 303,232 Operating expenses – Selling 10,583 12,021 11,388 9,989 43,980 Distribution 2,079 3,558 3,076 1,617 10,330 Administration 9,550 9,550 9,550 9,550 38,200 Depreciation 1,750 3,050 3,538 3,538 11,875 Operating income CAD 37,245 CAD 87,922 CAD 62,073 CAD 11,607 CAD 198,847 Interest income – – – 250 250 Interest expense 1,500 2,506 2,340 1,781 8,126 Income before tax CAD 35,745 CAD 85,416 CAD 59,733 CAD 10,076 CAD 190,970 Income tax 16,085 38,437 26,880 4,534 85,937 Net income CAD 19,660 CAD 46,979 CAD 32,853 CAD 5,542 CAD 105,034 Cash Budget Quarter 1 Quarter 2 Quarter 3 Quarter 4 Year Cash balance, beginning CAD 21,483 CAD 20,000 CAD 20,000 CAD 20,000 CAD 21,483 Cash receipts Sales Last quarter 26,700 40,986 75,492 60,318 203,496 129,789 239,058 191,007 84,645 644,499 – – – 250 250 Total cash receipts CAD 156,489 CAD 280,044 CAD 266,499 CAD 145,213 CAD 848,245 Cash disbursements Purchases 1 2 3 4 5 5 6 7 Previous: Module 2 Answer Key Next: Module 4 Answer Key https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 2 of 18

Last quarter CAD 27,563 CAD 40,856 CAD 56,228 CAD 40,714 CAD 165,360 This quarter 95,330 131,198 94,999 64,349 385,875 Selling expenses 10,583 12,021 11,388 9,989 43,980 Distribution expenses 2,079 3,558 3,076 1,617 10,330 Administrative expenses 9,550 9,550 9,550 9,550 38,200 Interest expense 1,500 2,506 2,340 1,781 8,126 Income tax 16,085 38,437 26,880 4,534 85,937 Regular dividend 15,000 15,000 15,000 15,000 60,000 Capital purchase 26,000 19,500 – – 45,500 Total cash disbursements CAD 203,690 CAD 272,624 CAD 219,460 CAD 147,533 CAD 843,308 Sub-total -CAD 25,718 CAD 27,420 CAD 67,039 CAD 17,679 CAD 26,420 Financing Borrowing/repayment Line of credit CAD 27,418 – – – CAD 27,418 Term loan 20,800 – – – 20,800 Repayment – Line of credit – -3,880 -23,538 – -27,418 Term loan -2,500 -3,540 -3,540 -3,540 -13,120 Special dividends – – – – – Issue/repurchase of shares – – – – – Total financing CAD 45,718 -CAD 7,420 -CAD 27,078 -CAD 3,540 CAD 7,680 Temporary investment – – -CAD 19,961 CAD 5,861 -CAD 14,100 Cash balance, ending CAD 20,000 CAD 20,000 CAD 20,000 CAD 20,000 CAD 20,000 9 10 11 12 https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 3 of 18

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Budgeted Balance Sheet Quarter 1 Quarter 2 Quarter 3 Quarter 4 Assets Current assets Cash CAD 20,000 CAD 20,000 CAD 20,000 CAD 20,000 Temporary investments – – 19,961 14,100 Accounts receivable 40,986 75,492 60,318 26,730 Inventory 59,535 48,510 22,523 39,375 Total current assets CAD 120,521 CAD 144,002 CAD 122,801 CAD 100,205 Fixed assets Equipment, net CAD 116,038 CAD 132,488 CAD 128,951 CAD 125,413 Total Assets CAD 236,559 CAD 276,490 CAD 251,752 CAD 225,618 Liabilities Current liabilities Accounts payable CAD 40,856 CAD 56,228 CAD 40,714 CAD 27,578 Line of credit 27,418 23,538 – – Current portion of long-term debt 14,160 14,160 14,160 14,160 Total current liabilities CAD 82,434 CAD 93,926 CAD 54,874 CAD 41,738 Long-term liabilities Term loan CAD 64,140 CAD 60,600 CAD 57,060 CAD 53,520 Shareholders’ equity Common shares CAD 53,000 CAD 53,000 CAD 53,000 CAD 53,000 Retained earnings 36,986 68,964 86,818 77,360 Total liabilities and equities CAD 236,559 CAD 276,490 CAD 251,752 CAD 225,618 13 14 15 16 17 18 19 https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 4 of 18

Key Financial Ratios Quarter 1 Quarter 2 Quarter 3 Quarter 4 Current ratio – 1.520 1.46 1.53 2.24 2.40 Line of credit / (Accounts receivable + Inventory)21 89.0% 42.0% – – Line of credit financing – CAD 35,000 CAD 27,418 CAD 23,538 – – Long-term Debt / Total Capitalization – 40.0%22 47.0% 38.0% 34.0% 34.0% 12-Month cash flow coverage ratio23 4.58 Purchases Budget Quarter 1 Quarter 2 Quarter 3 Quarter 4 Sales 209 378 308 143 Add: Ending inventory 113 (378 X .3) 92 (308 X .3) 43 (143 X .3) 75 (250 X .3) Subtotal 322 470 351 218 Less: Beginning inventory 63 113 92 43 Purchases 259 357 259 175 1 (132x900) + (77x675) 2 32, 198 + (132 + 77 − 63)(525) 3 ( ) + (.01)(170, 775) 4 (7)(132) + (15)(77) 5 ( ) 6 7 (.45)(35, 745) 8 (180, 775)(.76), .20 + (.8)(.7) = .76 9 (259)(525)(.7) 35,500 4 (45,200 − 7,000) , 7,000 4 (60,000)(.10) 4 (45,200 − 7,000) https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 5 of 18

2. Wind’n Wave experienced a cash shortage in Q1 because: Quarter 1 is the second slowest sales period so less cash is generated In Quarter 1, they are building up inventory for Quarter 2 which is the busiest quarter – In Quarter 1, 30.0% of Quarter 2’s inventory is purchased in advance and 70.0% of that must be paid for in Quarter 1 A major acquisition took place in Quarter 1 and a down payment of no less than 20.0% had to be made Quarter 1 follows the slowest period Quarter 4 so there a fewer accounts receivable from Quarter 4 being collected – 80.0% of sales in Quarter 4 are on credit and 30.0% of the credit sales from Quarter 4 are collected in Quarter 1 3. Wind’n Wave could increase its cash flows in Q1 by: Delaying the capital purchase – but the company may need the equipment now Offering early payment discounts to customers – but this is very expensive Selling accounts receivable to a factor – but this is very expensive Stretching payables – but it could hurt your credit rating and supplier relationships Reducing level of inventory buildup for the next quarter – but the stock buildup may be 10 11 (26, 000)(.8) 12 13 (.24)(170, 775) 14 (.3)(378)(525) 15 91, 788 − ( ) + 26, 000 16 (259)(525)(.3) 17 (( ) + ( ))(4) = 14, 160 18 60, 000 + 20, 800 − 2, 500 − 14, 160 19 32, 326 + 19, 660 − 15, 000 20 21 22 (45,200 − 7,000) 4 10,000 4 7,000 4 10,000 4 20,800 5 4 120,521 82,434 27,418 ((.75)(40,986)+(.0)(59,535)) (198,847+11,875+18,000) (8,126+18,000+( )) 13,120 (1 − .45) https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 6 of 18

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justified Reducing selling and administration expenses – but the company may already be very lean and reducing hours may alienate staff Reducing the dividend paid – but the owner may have personal financial obligations that makes this difficult 4. Wind’n Wave could increase its current ratio in Q1 by: Reducing receivables and using the cash to pay down the line of credit Reducing inventories and using the cash to pay down the line of credit Delaying capital purchases and using the cash to pay down the line of credit Reducing selling and administrative costs and using the cash to pay down the line of credit Reducing dividends and using the cash to pay down the line of credit The general rule is that if a ratio is above 1.0 and the numerator and denominator are re- duced by the same amount, the ratio will rise. For example: If .5 in accounts receivable or inventory are liquidated and the cash is used to pay down the line of credit, the current ratio would rise. Stretching payables to save cash will lower and not raise the current ratio. If payment of .5 in accounts payments is delayed to save cash, the current ratio will fall. 5. Wind’n Wave could reduce its long-term debt to total capitalization ratio in Q1 by: Delaying capital purchases to reduce debt Reducing operating expenses in order to increase net income and equity Reducing dividends to increase equity Issuing additional shares to increase equity Current ratio = = 1.5 1.5 1.0 Current ratio = = = 2.0 1.5 − .5 1.0 − .5 1.0 .5 Current ratio = = 1.5 1.5 1.0 Current ratio = = = 1.3 1.5+.5 1.0+.5 2.0 1.5 https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 7 of 18

6. Wind’n Wave determined it line of credit limit by: Current Assets Current Liabilities Net Working Capital Quarter 4, 2017 Cash – CAD 21,483 A/R – CAD 26,700 Inventory – CAD 32,918 A/P – CAD 27,563 CAD 53,538 Quarter 1, 2018 Cash – CAD 20,000 A/R – CAD 40,986 Inventory – CAD 59,535 A/P – CAD 40,856 CAD 79,665 Quarter 2, 2018 Cash – CAD 20,000 A/R – CAD 75,492 Inventory – CAD 48,510 A/P – CAD 56,228 CAD 87,774 Quarter 3, 2018 Cash – CAD 20,000 A/R – CAD 60,318 Inventory – CAD 22,523 A/P -CAD 40,714 CAD 62,127 Quarter 4, 2018 Cash – CAD 20,000 A/R – CAD 26,700 Inventory – CAD 39,375 A/P – CAD 27,578 CAD 58,497 Recommended borrowing on the line of credit: A line of credit of approximately CAD 35,000 will be sufficient to meet the company’s working capital needs throughout the year. 7. There are mathematical models for estimating optimal cash balances, but companies nor- Average quarterly growth in NWC − = 1, 240 (58,497 − 53,538) 4 Quarter 179, 665 − 53, 538 − 1, 240(1) = 24, 887 Quarter 287, 774 − 53, 538 − 1, 240(2) = 31, 756 Quarter 362, 127 − 53, 538 − 1, 240(3) = 4, 869 Quarter 458, 497 − 53, 538 − 1, 240(4) = 0 https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 8 of 18

mally apply a general rule of thumb based on past experience as to what amount of cash on hand is sufficient. Wind’n Wave’s rule is that they maintain a cash balance equal to ap- proximately 10.0% of quarterly cash disbursements at all times. Wind’n Wave is a season- al business, so it could have varied this amount by quarter. 8. See part 1 for the Q2, Q3, and Q4 pro forma financial statements. 9. As stated in Part 2, Q1 is a very difficult quarter from a cash flow perspective (sub-total - CAD 25,718) because Q1 is the second slowest sales quarter and Q4 is the slowest sales quarter. Also, inventory in Q1 is increased for the busiest quarter in Q2 and a capital pur- chase with a large down payment requirement is made. The company generates the cash needed in Q1 by borrowing nearly the maximum amount on its line of credit and the maximum amount on a term loan. The current ratio is slightly below the loan requirement of 1.5 (actual 1.46) though and the long-term debt to total capitalization ratio is above the goal of 40.0% (actual 47.0%). The company plans to go forward with its decisions in Q1 despite failing the current ratio requirement because it feels it can convince lenders that the problems are tempo- rary. In Q2, cash flows should improve significantly (sub-total CAD 27,420) as Q2 is the strongest sales quarter. With these funds, it is able to pay cash for the capital purchase and make a modest payment on its line of credit. In Q3, cash flows will improve again (sub-total CAD 67,039) due to Q3 being the sec- ond strongest sales quarter and the large accounts receivable collections from Q2. Inven- tory purchases also fall as the company reduces its inventory purchases for Q4 which is the slowest sales quarter. With its greatly improved cash flows, it is able to pay off its line of credit and invest in a temporary investment (CAD 19,961). The line of credit has to be paid off once a year (usually just before the seasonal low) to meet its loan requirements and the temporary investment will serve as cash buffer for Q4 and Q1, so the difficulties experienced in Q1 do not re-occur in future years. The temporary investment should not be allowed to become excessive though and the long-term debt to total capitalization ra- tio should be maintained at the optimal level of 40.0% on average. Surplus cash should be used to finance profitable growth opportunities or paid out to the owners. B. Problem: Percen t age of Sales Method https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 9 of 18

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Section 3.5 Exercise Answer Key – Percentage of Sales Method Spreadsheet 1. https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 10 of 18

2014 ($) 2015 ($) 2016($) Operations 182,315 191,430 201,002 Net income 133,116 139,772 146,760 Depreciation -27,517.25 -28,893.11 -30,337.77 Change in accounts receivable -19,717.80 -20,704 -21,739 Change in inventories -1,517.25 -1,.592 -1,673 Change in prepaids 26,645 27,977 29,376 Change in accounts payable 12,191 12,801 13,441 Change in accrued payroll 310 326 342 Change in income tax payables 305,825 321,116 337,172 Net operations Investment Change in property, plant, and equipment -199,133 -209,089 -219,544 Change in other assets -12,882.70 -13,527 -14,203 Net investment -212,015 -222,616 -233,747 Financing Change in long-term liabilities 67,010 33,243 34,905 Sale of shares – – – Dividends -143,792 -113,863 -119,556 Net financing -76,782 -80,620 -84,651 Change in cash/cash equivalents 17,027 17,880 18,774 Beginning cash/cash equivalents 340,571 357,600 375,480 Ending cash/cash equivalents 357,598 375,480 394,254 Yes, it can meet its goal of 5.0% growth without issuing any new equity. It will even be https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 11 of 18

able to issue a large special dividend in each of the next three years and should consider raising its regular dividend as a higher dividend would be sustainable. 2. No, it cannot meet its goal of 20.0% growth over the next three years without issuing new equity even after increasing the long-term debt to total capitalization ratio to 40.0%. The amount of new equity needed could be reduced by not paying the special dividend in 2014 and instead retaining the funds to finance 2015’s growth, but new equity will still be need- ed by 2016. Reducing the growth rate after 2015 is likely the best action given the negative effect that a dividend cut would have on the share price and that issuing new equity would create control problems for the founder and CEO. The founder and CEO should consider issu- ing new equity though. They many lose control but they could end up owning a smaller percentage of a much larger company which may be worth more to them and the other shareholders in the long run. This is a common problem faced by the founders of many new ventures – they need to give up control to access the funding needed to maximize their wealth. https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 12 of 18

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C. Problem: Adjusting Asset Requirements for Excess Capacity 1. Meta’s capacity utilization is: 2. Sales are expected to increase by 10.0% from CAD 150 million to CAD 165 million next year. Current capacity of CAD 170 million should be sufficient to meet demand so no fixed asset expenditures will be required next year. 3. = = .882 or 88.2% 150 170 https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 13 of 18

If sales increase by 20.0% from CAD 150 million to CAD 180 million, current capacity of CAD 170 million will be insufficient. Additional capacity of CAD 20 million will have to be purchased next year at a cost of CAD 8 million. D. Problem: Analyzing Sus t ainable Growth at Wicker Company 1. 2011 2012 2013 2014 2015 Retention ratio 1.00 0.90 0.85 0.74 0.65 Net profit margin (%) 7.90 8.10 8.10 8.20 8.40 Asset turnover 1.34 1.22 1.17 1.14 1.07 Assets/equity 2.49 2.15 1.81 1.61 1.31 SGR (%) 35.79 23.64 17.07 12.53 8.29 Actual growth rate (%) 5.67 8.95 10.10 9.45 8.73 2. Actual growth has been fairly stable over the last five years. Sustainable growth exceeded actual growth in 2011 through 2014, but the difference de- clined rapidly and by 2015 the two rates were approximately the same. The sustainable growth rate fell due to a decrease in the retention ratio – the sharehold- ers are likely better off receiving higher dividends and investing in more successful com- panies. Funds were also used to reduce borrowing which contributed substantially to the reduc- tion in the sustainable growth rate – paying down debt was not wise if the company was already at its optimal capital structure though. Surplus cash may also have been used to do one or both of the following: Purchase additional temporary investments with low returns that do not earn the cost of capital Invest in unsuccessful new expansion projects Both these actions would have resulted in lower profitability and asset turnover. https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 14 of 18

Wicker has reduced its sustainable growth rate to match the actual growth rate. It has correctly done so by reducing the retention ratio. This got funds out of the company where shareholders could reinvest in other companies with better growth prospects. Mistakenly, Wicker may also have reduced borrowing to below optimal levels and invest- ed in short-term investments and unsuccessful new projects thus lowering its profitabili- ty and asset turnover ratios. This can be corrected in the future by lowering the retention ratio further; returning cash balances to what is only needed for the normal operation of the business; and discontinu- ing to invest in unprofitable projects. E. Problem: Analyzing Sus t ainable Growth at Telsa Fashions 1. 2011 2012 2013 2014 2015 Retention ratio 1.00 1.00 1.00 1.00 1.00 Profit margin (%) 0.45 0.52 2.85 3.72 3.81 Asset turnover 2.24 2.41 2.48 2.51 2.53 Assets/equity 1.85 1.85 2.01 2.19 2.39 SGR (%) 1.90 2.37 16.56 25.70 29.93 Actual growth rate (%) 8.90 10.30 18.90 28.90 29.85 2. Actual growth rates have risen rapidly over the last five years. Sustainable growth rate has been less than actual growth rate in 2011 through 2014, but the gap decreased quickly and the sustainable growth rate now approximates the actual growth rate. Increased profitability, asset turnover and borrowing were used to increase the sustain- able growth rate. The level of borrowing cannot be increased indefinitely to increase the sustainable growth rate due to bankruptcy risk and it should be at the optimal capital structure level. Telsa should: https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 15 of 18

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Continue efforts to improve profit margins Continue to increase asset turnover Return borrowing to the optimal capital structure level Issue more new equity or slow growth if sustainable growth rates are insufficient F. Problem: Analyzing Sus t ainable Growth at Caribou Manu f acturing 1. Cartlidge has grown her company without issuing new equity or refusing new business by: Increasing the net profit margin from 2011 to 2014 with a small declined in 2015 Increasing the total asset turnover ratio from 2011 to 2015 but at a declining rate Increasing the debt ratio considerably from 2011 to 2015 with the largest increases coming in 2014 and 2015 Cartlidge has reduced the sustainable growth rate by taking considerably more money out of the business for personal use. Cartlidge’s borrowing is excessive. Recommendations Cartlidge should: Reduce the debt ratio to a level the bank is comfortable with Increase the retention ratio to better support company growth while still ensur- ing Cartlidge has sufficient income to support her family – small business people must always remember to put the financial needs of their business ahead of their own Take further steps to increase the net profit margin and total asset turnover ra- tios, although it appears the company has limited potential for further improve- ment given the decline in the net profit margin and the declining rate of growth in the total asset turnover ratio https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 16 of 18

LICENSE Financial Management Copyright © by Dan Thompson is licensed under a Creative Commons Attribution 4.0 International SHARE THIS BOOK If these steps prove to be insufficient to fund future growth, Cartlidge may have to raise new equity by bringing in a partner or slowing her rate of growth by refusing new busi- ness. Successfully financing rapid growth is a major problem for small businesses. G. Problem: Analyzing Sus t ainable Growth at Beluga Manu f acturing 1. Vincenten had to slow Beluga’s growth due to a lack of bank financing because of a major reduction in the company’s retention ratio. He withdrew excessive amounts of cash from the business to finance his home construction. Growth was further limited by a reduc- tion in the net profit margin and total asset turnover ratio over the last two years. Both these ratios are well below the industry average. Borrowing has also become excessive as this was used as a substitute for retained earnings in financing the business. The bank was hesitant to lend what was needed last year and will likely be hesitant again this year. Recommendations Vincenten should: Reduce the borrowing level to the industry average for safety reasons and to ad- dress the concerns of the bank Increase the retention ratio to the industry average or higher to fund growth Increase the net profit margin to the industry average by raising prices or lower- ing costs – higher prices will also reduce capital expenditures and borrowing re- quirements Turnover ratio should be raised to the industry average through greater efforts to increase sales and eliminate unneeded assets https://financialmanagement.pressbooks.tru.ca/chapter/module-3-answer-key/ 5/31/24, 6 : 18 AM Page 17 of 18

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