Corporate finance

Weekend Adventures

Weekend Adventures (WA) Inc. is a retailer of recreational vehicles (RVs) located in Kamloops, British Columba. WA was founded in 2011 by Betty Zelanko with the plan of selling quality, used RVs to middle income families at reasonable prices. The company bought products at various auctions across B.C. and Alberta or directly from owners. It then conducted a thorough overhaul of an RV’s mechanics, upgraded the interior and exterior, and did a major cleaning before putting the unit on sale. The refurbished products were warrantied by WA at no additional cost to the owner for one year and all maintenance work after that was completed at very reasonable rates.

Customers were very happy with the RVs and repair services offered by WA. Quality was considered excellent and WA had a reputation of “standing behind” its work with “no questions asked.” Zelanko was pleased with the company’s growth over this time, but felt profitability could have been higher.

In 2015, Zelanko changed her business plan and decided to focus solely on selling new, high-margin RVs to wealthier clients. She arranged to become the exclusive dealer for Great Plains RV, an up-scale manufacturer, in the Kamloops market. This was not only an attempt to improve profitability, but Zelanko had always dreamt of becoming a luxury RV distributor. To comply with the dealership agreement, WA was required to complete a major renovation and expansion of its sales facility near the Kamloops Airport. The refurbished building was quite large and luxurious and the display lot was expanded and paved. The sales facility included a new, 4-bay service area that provided warranty work and regular maintenance for Great Plains products. Only two bays are currently needed, but Zelanko hopes to expand service work as the business grows. WA also has a 50-unit, RV storage facility in an adjacent lot.

At the end of 2016, WA’s balance sheet was as follows:

Weekend Adventures Inc. Balance Sheet December 31, 2016
Current assets
Cash	$612,000
Temporary investment	35,700
Accounts receivable	2,386,800
Inventory	1,783,368
Total current assets	$4,817,868
Fixed assets, net	4,033,386
Total assets	$8,851,254
Current liabilities
Accounts payable	$1,453,500
Line of credit	–
Current portion of long-term debt	470,526
Total current liabilities	$1,924,026
Long-term liabilities
Term loan	2,352,630
Shareholders’ equity
Share capital	1,227,570
Retained earnings	3,347,028
Total liabilities and equity	$8,851,254

Sales

The RV industry is very seasonal with most sales occurring in the second and third quarters. The second quarter is the busiest season as families get ready for summer holidays, but the third quarter remains strong as “snowbirds migrate” to their winter “nests” in California, Arizona, and Florida.

Zelanko has prepared the following sales estimates for 2017:

	Quarter 1 (January-March)	Quarter 2 (April-June)	Quarter 3 (July-September)	Quarter 4 (October-December)
Models
Freedom	5	11	9	3
Independence	16	33	25	13
Autonomy	18	81	65	16
Total	39	125	99	32
Service hours	590	910	920	530
Storage units	50	30	25	50

Great Plains’ three RV models cater to different price segments. Retail prices for 2017 are:

Freedom	$168,504
Independence	$140,556
Autonomy	$87,210

Unit sales are expected to increase by 6 per cent in 2018 but WA has not raised its prices since adopting its new strategy in 2015. The dealer relations representative from Great Plains estimates that WA could raise its prices by 2 per cent with no change to the units sold.

WA’s shop rate is $70 per hour, which is low compared to the industry standard of $85. All parts are resold at cost. Service work is paid for immediately by the customer.

Twenty-five per cent of all sales are for cash, but the remainder require financing. WA offers customers three- and five-year financing plans, but these sales agreements are immediately resold to Great Plains’ financing unit that repackages them and sells them as asset-backed securities. This process takes approximately 60 days, and WA is paid in full at that time. The dealers have been lobbying Great Plains to reduce this payment period to 30 days through faster processing.

WA’s 50 covered storage lots are rented at $300 per unit per quarter, which WA promotes as the “best rate in town.” In the Kamloops market, rates for similar units average $450 per unit and the customer must commit to a one-year lease. Payment is received electronically from customers on the last day of each quarter.

Cost of Sales

The 2017 wholesale prices for Great Plains RVs are:

Freedom	$146,982
Independence	$126,276
Autonomy	$75,684

The company’s two mechanics are paid on piece rate and receive $40 per service hour. Both mechanics are fully employed in quarters 2 and 3, but are underutilized the rest of the year. WA has been exploring ways to improve efficiency in the service area.

As engines in all three RV models are standard General Motors designs, parts can be sourced locally on a just-in-time basis, therefore, negligible parts inventories are required. Supply inventories are also minimal. For planning purposes, WA finds that parts and supplies average 80 per cent and 15 per cent of service revenue.

WA purchases all of its RVs on terms net 30 from Great Plains. WA maintains inventory levels at 40 per cent of next quarter’s sales for each model of RV. The dealer relations representative from Great Plains says other dealers maintain inventory of approximately 30 per cent of next quarter’s sales on average. The representative also indicates that Great Plains’ credit terms are sometimes extended to net 60 to aid struggling dealers or help finance expansions.

Beginning inventory consists of two Freedom models, seven Independence models, and eight Autonomy models. Wholesale prices were the same as in 2016.

Other Expenses

Category	Details
Selling	Five sales staff at $32,650 per employee per year plus a commission equal to 6.25 per cent of RV sales
Administration and storage	$988,380 per year
Depreciation	$296,514 per year

Other than inventory purchases and depreciation, all expenses are paid as incurred.

WA has been considering paying its sales staff on a straight commission basis to improve results. The number of salespeople will likely decline as poorer performers see their incomes drop, but the remaining sales people should be able to maintain their earnings.

Capital Budget

WA has prepared a list of capital acquisitions that it plans to make in 2017:

Item	Estimated Cost	Acquisition Date
Service bay equipment – 10-year life	$855,000	Quarter 1
Sales facility furniture – 3-year life	$78,000	Quarter 1

The equipment is needed to open the remaining two service bays and additional furniture is required for the sales offices. The equipment purchases can be delayed if necessary. All assets are depreciated on a straight-line basis and the residual value is assumed to be negligible.

Financing

WA has negotiated a $5,750,000, 5.70 per cent line of credit with the Royal Bank. The loan is secured by the company’s current assets – it can borrow no more than 40 per cent of the value of its inventory and 80 per cent of its accounts receivable. Interest is paid at the end of each quarter and all repayments or drawdowns are made at that time.

Purchases of fixed assets can be financed with a term or mortgage loan with the Royal Bank. The bank is willing to lend 60 per cent of the value of equipment and 75 per cent of the value of real estate. Loans are paid down monthly on a straight-line basis over the life of the asset and generally cannot be paid early. Asset acquisitions and interest and principal payments are made at the end of the quarter only. The term loan currently has a fixed interest rate of 7.35 per cent per annum. The Royal Bank allows the company to make an additional principal payment equal to 15 per cent of the balance of any term and mortgage loan at the end of the fourth quarter each year.

The Royal Bank requires that WA maintain a current ratio of 1.50 each quarter and an annual times interest earned ratio of 5.00 (i.e. it is only calculated in the fourth quarter based the yearly totals) as well as submit audited quarterly and annual financial statements for review. Also, the line of credit must be paid down to zero once per year to ensure the company only uses its line of credit to finance its seasonal build up in net working capital.

WA attempts to maintain a long-term debt to total-capitalization ratio of 25.00 per cent although it is not a condition of any of its bank loans.

Company policy is to maintain a cash balance of $575,000 at the end of each quarter. Surplus cash balances can be invested in a 3-month term deposit at 1.35 per cent per annum. Funds are invested or withdrawn at the end of the quarter only and income is paid out at this time. Based on past experience, the company was studying whether a cash balance of $500,000 could be sufficient.

Income Taxes

The corporate tax rate is 16 per cent.

Distributions to Owner

Current loan agreements limit Zelanko’s dividends to $300,000 per year. WA currently pays this amount to Zelanko in four equal monthly installments, but she indicated it could be reduced to $150,000 per year if necessary.

Potential Expansion

Great Plains approached Zelanko about opening another dealership in Kelowna in 2019. She thinks this is a tremendous opportunity given that city’s high average income and its emergence as a major Canadian retirement destination. Based on her experience in Kamloops, Zelanko feels a net investment of $6,750,000 would be needed and that 55.0 per cent could be financed through the Royal Bank.

Zelanko was very anxious to pursue the Kelowna expansion so she immediately met with her accountant. Ali McPherson, CPA, stressed that the economy in B.C. was currently doing well but that continuing low oil prices and rising interest rates may lead to a decline in consumer confidence next year that could significantly affect RV sales. She also indicated that WA did not meet all its loan conditions last year, its profitability ratios were significantly below industry averages and it was over leveraged. Recent data from Statistics Canada indicated an industry average net profit margin of 2.85 per cent, total assets turnover of 3.75, rate of return on assets of 10.67 per cent, rate of return on equity of 25.55 per cent, long-term debt to total capitalization ratio of 25.00 per cent, and times interest earned ratio of 5.00 – all ratios are calculated for the year and are based on year end information.

Despite McPherson’s cautious tone, Zelanko still wants to somehow purse the expansion. She knows that other new Great Plains dealers can be found quickly if she hesitates, so being able to open a new location by 2019 is imperative. How can she address McPherson’s concerns about profitability and over borrowing? Will she be able to find the equity for the proposed expansion or should she pursue a more prudent growth strategy given the current economic outlook?

Page 2

Memorandum

To:

Drew Pearson, Senior Account Manager, Royal Bank of Canada

From:

Jenna Jones, Owner, JAS Ltd.

Subject:
Budget 2006

Date:

March 25, 2006

(Brief introduction)

Decision Making

Quarter 1

Cash flows prior to financing are at their lowest point in Quarter 1. Not only is this quarter the slowest period for sales due to the seasonal nature of aerial spraying operations, but there are also minimal accounts receivable collections from Quarter 4 (also a slow quarter) and chemical inventories must be built up for Quarter 2 – this is the busiest quarter of the year. With the acquisition of the radios, JAS’s current ratio will fall to 1.3, which is below the bank requirement of 1.5. Since the new radios are important for the safety and efficiency of company operations, it is felt that their acquisition should not be delayed. As the proforma financial statements indicate, the current ratio will rise to well above the bank requirement in Quarters 2, 3, and 4, so it is requested that RBC waive this financial covenant for this period only. The debt ratio will also rise to well above the optimal level of 35% with this acquisition, but it is expected financial leverage will fall naturally over the year as the company retains all profits and limits capital expenditures to modest office renovations in the coming period.

Quarter 2

Cash flows prior to financing increased dramatically this period with only modest capital expenditures and a dramatic increase in revenues from both aerial spraying and flight instruction. Surplus cash was used to pay the line of credit down to zero and the remainder was placed into a temporary investment to fund the possible acquisition of a new plane in the coming periods and to maintain financial flexibility so the company never again has to ask the bank to waive its current ratio requirement. The current ratio will be well above the minimum bank requirement and the debt ratio will begin to decline.

Quarter 3

Cash flows prior to financing are at their highest level due to continued strong sales, the collection of large accounts receivable balances from the previous period, no major capital expenditures, and greatly reduced purchases of chemicals as large inventories are drawn down to zero as the busy summer season comes to an end. Surplus cash is again placed in a temporary investment to fund the acquisition of a new plane – enough has been now saved to make the required down payment assuming 60% financing by the bank. The current ratio also continues to rise and the debt ratio to fall.

Quarter 4

Cash flows prior to financing continue to be high despite a dramatic decrease in sales due to the collection of large accounts receivable balances from the previous period, no major capital purchases, and no need to build up chemical inventories for Quarter 1. Another large contribution was made to the plane purchase fund and the company has approximately 2/3rds of the cost of the new plane. Purchasing the plane at this time would result in a dramatic deterioration in the company’s financial ratios. Also, the plane is not needed as the company is in a seasonal low when no aerial spraying is taking place. The plan is to patiently wait till the company has accumulated sufficient funds so the acquisition does not expose it to significant financial risks.

Recommended Changes

Case Study 2: Weekend Adventures

Student Instructions

1. Prepare pro forma income statements, cash budgets, and balance sheets for Quarter 1, 2, 3 and 4 of 2017 that attempt to address McPherson’s concerns about profitability and overuse of financial leverage while helping Zelanko meet her goal of opening a new dealership in Kelowna. A fully automated spreadsheet should be prepared.

2. Prepare a 3.0 page memorandum (12-point Calibri font, .7 inch margins) that discusses the changes in cash flows, the financial decisions made, and whether the company is meeting it financial goals and lending conditions in Quarter 1, 2, 3 and 4. A final recommendation section should discuss whether this plan will address McPherson’s concerns about profitability and overuse of financial leverage and whether Zelanko should proceed with her expansion in Kelowna.

Submit both the Excel and Word files through the course Moodle site using the drop box in Module 6.

Recommended Templates

Budgeted Income Statement
	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Year
Sales
RV
Freedom
Independence
Autonomy
Total
Service
Parts
Storage
Total sales
Expenses
RV
Freedom
Independence
Autonomy
Total
Service
Parts
Supplies
Selling
Administration and storage
Depreciation
Total expenses
Operating profit
Interest income
Interest expense
Income before tax
Income tax
Net income

Cash Budget
	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Year
Cash balance, beginning
Cash receipts
RV
Last quarter
This quarter
Service
Parts
Storage
Interest income
Total cash receipts
Cash disbursements
Purchases
Last quarter
This quarter
Service technicians
Parts
Supplies
Selling
Administration and storage
Interest expense
Income tax
Regular dividends
Capital purchase
Total cash disbursements
Sub-total
Financing
Repayment
Line-of-credit
Term loan – Regular loan payment
Term loan – Extra loan payment
Borrowing
Line-of-credit
Term loan
Special dividends
Issuance and repurchase of shares
Total financing
Temporary investment
Cash balance, ending

Budgeted Balance Sheet
	Quarter 1	Quarter 2	Quarter 3	Quarter 4
Current assets
Cash
Temporary investments
Accounts receivable
Inventory
Total current assets
Fixed assets, net
Total assets
Current liabilities
Accounts payable
Line of credit
Income taxes payable
Current portion of long-term debt
Total current liabilities
Term loan
Shareholders’ equity
Common shares
Retained earnings
Total liabilities and equities

Key Financial Ratios
	Quarter 1	Quarter 2	Quarter 3	Quarter 4
Current ratio (> 1.50)	XX	XX	XX	XX
Net profit margin	–	–	–	XX
Total asset turnover	–	–	–	XX
Return on assets	–	–	–	XX
Return on equity	–	–	–	XX
Line of credit / A/R + Inventory (< 1.0)	XX	XX	XX	XX
Times interest earned (> 5.00)	–	–	–	XX
Long-term debt / Total capitalization (= 25%)	XX	XX	XX	XX
Line of credit financing (maximum $5,750,000)	XX	XX	XX	XX

Note: A dash means that the ratio is only calculated on an annual basis.

Evaluation Rubric

Total: _________ / 100

Letter Grade: _________

Quality of Spreadsheet: 20%

Physical Appearance	/5
Input Section	/5
Automation	/10

Thoroughness of Analysis: 60%

Quarter 1	/10
Quarter 2	/10
Quarter 3	/10
Quarter 4	/10
Recommendations	/20

Memo Layout and Writing Quality: 20%

Layout	/5
Grammatical and Spelling Errors	/5
Writing Style	/10

Comments

________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Page 5

Case 2 Weekend Adventure

Remember the goal in the case is to recommend ways to address the problems the company is experiencing relating to profitability and the overuse of financial leverage. Also, the owner wants to see if the business can accumulate enough cash in the next year to open a new dealership.

In this case, a number of potential business improvements were recommended. These included:

• Raise RV prices by 2%
• Increase the shop rate to $85
• Collect receivables in 30 days instead of 60 days
• Raise storage lot prices to $450
• Lower inventory level to 30%
• Pay accounts payable in 60 days, not 30 days
• Move salespeople to a straight commission of 6.25%
• Delay the capital purchases
• Lower the minimum cash level to $500,000
• Make the additional term loan payment in Q4 to reduce the debt ratio
• Reduce dividends to $150,000 per year

Make all these changes when preparing your proformas assuming Great Plains will agree.

When writing Q1, Q2, Q3, and Q4 of the memo discuss the changes in cash flows, why they occurred, the financial decisions made, and whether the company is meeting its financial goals and lending conditions. The answer key for
Wind ’n Wave and the sample memo give examples of what you should include. Be sure to read them.

In the recommendation section, describe the improvements made and whether they were successful in addressing the company’s financial problems. Also, discuss whether the company will be able to accumulate enough cash to open the new dealership – cost data for the new dealership is provided. Even if they can accumulate enough funds, it might not be a good idea given the company’s current financial condition. Can a more prudent growth strategy be recommended? There is not a right or wrong answer to the case, just make sure whatever you recommend is well-supported.

Please be very thorough in your analysis. Remember to always say why.

Wind ’n Wave

Budgeted Income Statement
	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Year
Sales1	CAD 170,775	CAD 314,550	CAD 251,325	CAD 111,375	CAD 848,025
Cost of sales2	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					–
Selling3	10,583	12,021	11,388	9,989	43,980
Distribution4	2,079	3,558	3,076	1,617	10,330
Administration5	9,550	9,550	9,550	9,550	38,200
Depreciation5	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 expense6	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 tax7	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
This quarter8	129,789	239,058	191,007	84,645	644,499
Interest income	–	–	–	250	250
Total cash receipts	CAD 156,489	CAD 280,044	CAD 266,499	CAD 145,213	CAD 848,245
Cash disbursements
Purchases
Last quarter	CAD 27,563	CAD 40,856	CAD 56,228	CAD 40,714	CAD 165,360
This quarter9	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 expenses10	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 loan11	20,800	–	–	–	20,800
Repayment					–
Line of credit	–	-3,880	-23,538	–	-27,418
Term loan12	-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

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 receivable13	40,986	75,492	60,318	26,730
Inventory14	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, net15	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 payable16	CAD 40,856	CAD 56,228	CAD 40,714	CAD 27,578
Line of credit	27,418	23,538	–	–
Current portion of long-term debt17	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 loan18	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 earnings19	36,986	68,964	86,818	77,360
Total liabilities and equities	CAD 236,559	CAD 276,490	CAD 251,752	CAD 225,618

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

1 (132 x 900) + (77 x 675)

2 32,198 + (132 + 77 – 63) (525)

3 (35,500 / 4) + (.01) (170,775)

4 (7) (132) + (15) (77)

5 (45,200 – 7,000) / 4, (7,000 / 4)

6 (60,000) (.10) / 4

7 (.45) (35,745)

8 (170,775) (.76), .20 + (.8) (.7) = .76

9 (259) (525) (.7)

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

10 (45,200 – 7,000) / 4

11 (26,000) (.8)

12 (10,000) / 4)

13 (.24) (170,775)

14 (.3) (378) (525)

15 91,788 – (7,000 / 4) + 26,000

16 (259) (525) (.3)

17 ((10,000 / 4) + (20,800 / 5 / 4)) (4) = 14,160

18 60,000 + 20,800 – 2,500 – 14,160

19 32,326 + 19,660 – 15,000

20 120,521 / 82,434

21 27,418 / ((.75) (40,986) + (.0) (59,535))

22 (14,160 + 64,140) / (14,160 + 64,140 + 53,000 + 36,986)

23 (198,847 + 11,875 + 18,000) / (8,126 + 18,000 + (13,120 / (1 – .45))

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 are fewer accounts receivable from Quarter 4 being collected. Approximately 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 the company’s credit rating and supplier relationships.

· Reducing the level of inventory buildup for the next quarter, but the stock buildup may be 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 make 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 the 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 reduced by the same amount, the ratio will rise. For example:

Current ratio = = 1.5

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.

Current ratio = = = 2.0

Stretching payables to save cash will lower and not increase the current ratio.

Current ratio = = 1.5

If payment of .5 in accounts payable is delayed saving cash, the current ratio will fall.

Current ratio = = = 1.3

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 to increase net income and equity.

· Reducing dividends to increase equity.

· Issuing additional shares to increase equity.

6. Wind’n Wave determined its 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 is:

Average quarterly growth in NWC – (58,497 – 53,538) / 4 = 1,240

Quarter 1 79,665 – 53,538 – 1,240 (1) = 24,887

Quarter 2 87,774 – 53,538 – 1,240 (2) = 31,756

Quarter 3 62,127 – 53,538 – 1,240 (3) = 4,869

Quarter 4 58,497 – 53,538 – 1,240 (4) = 0

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 normally apply a general rule of thumb based on 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 approximately 10.0% of quarterly cash disbursements at all times. Wind’n Wave is a seasonal business, so this amount could vary 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 must increase for the busiest quarter in Q2 and a capital purchase 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) 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 temporary. In Q2, cash flows should improve significantly (sub-total CAD 27,420) as Q2 is the strongest sales quarter. With these funds, it can 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 second strongest sales quarter and the large accounts receivable collections from Q2. Inventory 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 can 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 a cash buffer for Q4 and Q1, so the difficulties experienced in Q1 do not re-occur. The temporary investment should not be allowed to become excessive though and the long-term debt to total capitalization ratio 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.