INPUT DATA: 1993 1994 Sales growth As a % of sales: CGS Admin expenses Misc expenses ST int rate Federal-plusstate tax rate Dividend payout Target...

MARK X COMPANY (A)Mark X Company manufactures farm and specialty trailers of all types. More than 85 percent ofthe company’s sales come from the western part of the United States, particularly California,although a growing market for custom horse transport vans designed and produced by Mark X isdeveloping nationally and even internationally. Also, several major boat companies in California andWashington have had Mark X design and manufacture trailers for their new models, and theseboat-trailer “packages” are sold through the boat companies’ nationwide dealer networks.Steve Wing, the president of Mark X, recently received a call from Karen Dennison, seniorvice president of Wells Fargo Bank. Karen told Steve that a deficiency report generated by thebank’s computerized analysis system had been filed because of Mark X’s deteriorating financialposition. The bank requires quarterly financial statements from each of its major loan customers.Information from such statements is fed into the computer, which then calculates key ratios foreach customer and charts trends in these ratios. The system also compares the statistics for each companywith the average ratios of other firms in the same industry and against any protective covenantsin the loan agreements. If any ratio is significantly worse than the industry average, reflects a markedadverse trend, or fails to meet contractual requirements, the computer highlights the deficiency.The latest deficiency report on Mark X revealed a number of significant adverse trends andseveral potentially serious problems (see Tables 1 through 6 for Mark X’s historical financial statements).Particularly disturbing were the 1992 current, quick, and debt ratios, all of which failed tomeet the contractual limits of 2.0, 1.0, and 55 percent, respectively. Technically, the bank had a legalright to call all the loans it had extended to Mark X for immediate repayment and, if the loans werenot repaid within ten days, to force the company into bankruptcy.Karen hoped to avoid calling the loans if at all possible, as she knew this would back Mark Xinto a corner from which it might not be able to emerge. Still, her own bank’s examiners had recentlybecome highly sensitive to the issue of problem loans, because the recent spate of bank failures hadforced regulators to become more strict in their examination of bank loan portfolios and to demandearlier identification of potential repayment problems.One measure of the quality of a loan is the Altman Z score, which for Mark X was 2.97 for1992, just below the 2.99 minimum that is used to differentiate strong firms, with little likelihoodof bankruptcy in the next two years, from those deemed likely to go into default. This will put thebank under increased pressure to reclassify Mark X’s loans as “problem loans,” to set up a reserve tocover potential losses, and to take whatever steps are necessary to reduce the bank’s exposure. Settingup the loss reserve would have a negative effect on the bank’s profits and reflect badly onKaren’s performance.Copyright © 1994. The Dryden Press. All rights reserved.To keep Mark X’s loan from being reclassified as a “problem loan,” the Senior Loan Committeewill require strong and convincing evidence that the company’s present difficulties are onlytemporary. Therefore, it must be shown that appropriate actions to overcome the problems have beentaken and that the chances of reversing the adverse trends are realistically good. Karen now has thetask of collecting the necessary information, evaluating its implications, and preparing a recommendationfor action.The recession that plagued the U.S. economy in the early 1990s had caused severe, thoughhopefully temporary, problems for companies like Mark X. Farm commodity prices have remainedlow, thus farmers have held their investments in new equipment to the bare minimum. On top of this,the luxury tax imposed in 1991 has had a disastrous effect on top-of-the-line boat/trailer sales.Finally, the Tax Reform Act of 1986 reduced many of the tax benefits associated with horse breeding,leading to a drastic curtailment of demand for new horse transport vans. In light of the softeningdemand, Mark X had aggressively reduced prices in 1991 and 1992 to stimulate sales. This, thecompany believed, would allow it to realize greater economies of scale in production and to ridethe learning, or experience, curve down to a lower cost position. Mark X’s management had full confidencethat national economic policies would revive the ailing economy and that the downturn indemand would be only a short-term problem. Consequently, production continued unabated, andinventories increased sharply.In a further effort to reduce inventory, Mark X relaxed its credit standards in early 1992 andimproved its already favorable credit terms. As a result, sales growth did remain high by industrystandards through the third quarter of 1992, but not high enough to keep inventories from continuingto rise. Further, the credit policy changes had caused accounts receivable to increase dramaticallyby late 1992.To finance its rising inventories and receivables, Mark X turned to the bank for a long-termloan in 1991 and also increased its short-term credit lines in both 1991 and 1992. However, thisexpanded credit was insufficient to cover the asset expansion, so the company began to delay paymentsof its accounts payable until the second late notice had been received. Management realizedthat this was not a particularly wise decision for the long run, but they did not think it would benecessary to follow the policy for very long. They predicted that the national economy would pullout of the weak growth scenario in late 1992. Also, there has been some talk in Congress of killingthe luxury tax and even giving some tax benefits back to horse breeders. Thus, the company wasoptimistic that its stable and profitable markets of the past would soon reappear.After Karen’s telephone call, and the subsequent receipt of a copy of the bank’s financial analysisof Mark X, Steve began to realize just how precarious his company’s financial position hadbecome. As he started to reflect on what could be done to correct the problems, it suddenly dawnedon him that the company was in even more trouble than the bank imagined. Steve had recentlysigned a firm contract for a plant expansion that would require an additional $6,375,000 of capitalduring the first quarter of 1993, and he had planned to obtain this money with a short-term loan fromthe bank to be repaid from profits expected in the last half of 1993 as a result of the expansion. Inhis view, once the new production facility went on line, the company would be able to increaseoutput in several segments of the trailer market. It might have been possible to cut back on the expansionplans and to retrench, but because of the signed construction contracts and the cancellationcharges that would be imposed if the plans were canceled, Steve correctly regards the $6,375,000of new capital as being essential for Mark X’s very survival.Steve quickly called his senior management team in for a meeting, explained the situation, andasked for their help in formulating a solution. The group concluded that if the company’s currentbusiness plan were carried out, Mark X’s sales would grow by 10 percent from 1992 to 1993 andby another 15 percent from 1993 to 1994. Further, they concluded that Mark X should reverse itsrecent policy of aggressive pricing and easy credit, returning to pricing that fully covered costsplus normal profit margins and to standard industry credit practices. These changes should enable thecompany to reduce the cost of goods sold from over 85 percent of sales in 1992 to about 82.5 percentCase: 35 Financial Analysis and Forecastingin 1993 and then to 80 percent in 1994. Similarly, the management group felt that the company couldreduce administrative and selling expenses from almost 9 percent of sales in 1992 to 8 percent in1993 and then to 7.5 percent in 1994. Significant cuts should also be possible in miscellaneousexpenses, which should fall from 2.92 percent of 1992 sales to approximately 1.75 percent of salesin 1993 and to 1.25 percent in 1994. These cost reductions represented “trimming the fat,” so theywere not expected to degrade the quality of the firm’s products or the effectiveness of its salesefforts. Further, to appease suppliers, future bills would be paid more promptly, and, to convincethe bank how serious management is about correcting the company’s problems, cash dividendswould be eliminated until the firm regains its financial health.Assume that Steve has hired you as a consultant to first verify the bank’s evaluation of thecompany’s current financial situation and then to put together a forecast of Mark X’s expected performancefor 1993 and 1994. Steve asks you to develop some figures that ignore the possibility ofa reduction in the credit lines and that assume the bank will increase the line of credit by the$6,375,000 needed for the expansion and supporting working capital. Also, you and Steve do notexpect the level of interest rates to change substantially over the two-year forecast period; however,you both think that the bank will charge 12 percent on both the additional short-term loan, ifit is granted, and on the existing short-term loans, if they are extended. The assumed 40 percent combinedfederal and state tax rate should also hold for two years. Finally, if the bank cooperates, andif Steve is able to turn the company around, the P/E ratio should be 10 in 1993 and should rise to12 in 1994.Your first task is to construct a set of pro forma financial statements that Steve and the rest ofthe Mark X management team can use to assess the company’s position and also to convince Karenthat her bank’s loan is safe, provided the bank will extend the firm’s line of credit. Then, you mustpresent your projections, with recommendations for future action, to Mark X’s management and toKaren. To prepare for your presentations, answer the following questions, keeping in mind thatboth the Mark X managers and, particularly, Karen and possibly her bosses, could ask you sometough questions about your analysis and recommendations. Put another way, the following questionsare designed to help you focus on the issues, but they are not meant to be a complete and exhaustivelist of all the relevant points.QUESTIONS1. Complete the 1992 columns of Tables 3 through 6, disregarding for now the projected datain the 1993 and 1994 columns. If you are using the Lotus model, use it to complete thetables. Be sure you understand all the numbers, as it would be most embarrassing (and harmfulto your career) if you were asked how you got a particular number and you could notgive a meaningful response.2. Based on the information in the case and on the results of your calculations in Question 1,prepare a list of Mark X’s strengths and weaknesses. In essence, you should look at the commonsize statements and each group of key ratios (for example, the liquidity ratios) and seewhat those ratios indicate about the company’s operations and financial condition. As a partof your answer, use the extended Du Pont equation to highlight the key relationships.3. Recognizing that you might want to revise your opinion later, does it appear, based on youranalysis to this point, that the bank should lend the requested money to Mark X? Explain.4. Now complete the tables to develop pro forma financial statements for 1993 and 1994. Forthese calculations, assume that the bank is willing to maintain the present credit lines and toCase: 35 Financial Analysis and Forecastinggrant an additional $6,375,000 of short-term credit on January 1, 1993. In the analysis, takeaccount of the amounts of inventory and accounts receivable that would be carried if inventoryutilization (based on the cost of goods sold) and days sales outstanding were set atindustry-average levels. Also, assume in your forecast that all of Mark X’s plans and predictionsconcerning sales and expenses materialize, and that the firm pays no cash dividendsduring the forecast period. Finally, in your calculations use the cash and marketable securitiesaccount as the residual balancing figure.In responding to Questions 5 through 8, no Lotus model modifications are required. Answersshould be based solely on the data contained in the financial statements completed in response toQuestion 4.5. Assume Mark X has determined that its optimal cash balance is 5 percent of sales and thatfunds in excess of this amount will be invested in marketable securities, which on averagewill earn 7 percent interest. Based on your forecasted financial statements, will Mark X beable to invest in marketable securities in 1993 and 1994? If so, what is the amount of excessfunds Mark X should invest in marketable securities? Do your financial forecasts reveal anydeveloping conditions that should be corrected?6. Based on the forecasts developed earlier, would Mark X be able to retire all of the outstandingshort-term loans by December 31, 1993?7. If the bank decides to withdraw the entire line of credit and to demand immediate repaymentof the two existing loans, what alternatives would be available to Mark X?8. Under what circumstances might the validity of comparative ratio analysis be questionable?Answer this question in general, not just for Mark X, but use Mark X data to illustrate yourpoints.9. Now revise your pro forma financial statements for 1993 and 1994 assuming the followingconditions:a. Short-term loans will be repaid when sufficient cash is available to do so without reducingthe liquidity of the firm below the minimum requirements set by the bank and whenthe company is able to maintain at least the minimum cash balance (5 percent).b. When the loans are repaid, the repayments will occur at a constant rate throughout theyear. Therefore, on average, the amount of short-term loans outstanding will be half ofthe beginning-of-year amount.c. Mark X will reinstate a 25 percent cash dividend in the year that all short-term loans andcredit lines have been fully cleaned up (paid in full).10. It is apparent that Mark X’s future (and that of the bank loan) is critically dependent on thecompany’s performance in 1993 and 1994. Therefore, it would be useful if you could, aspart of your consulting report, inform management—and the bank—as to how sensitive theresults are to such things as the sales growth rate, the cost of goods sold percentage, and theadministrative expense ratio.If the results would still look fairly good even if those factors were not as favorable asinitially forecasted, the bank would have greater confidence in extending the requestedcredit. On the other hand, if even tiny changes in these variables would lead to a continuationof the past downward trend, then the bank should be leery. If you are using the Lotusmodel, do some sensitivity analyses (using data tables) to shed light on this issue. (Hint:See the bottom part of the model labeled “SENSITIVITY ANALYSES” for some ideas.)Case: 35 Financial Analysis and ForecastingIf you do not have access to the model, describe how one would go about a sensitivity (orscenario) analysis, but do not quantify your answer.11. On the basis of your analyses, do you think Karen should recommend that the bank extendthe existing short- and long-term loans and grant the additional $6,375,000 loan or that thebank demand immediate repayment of all existing loans? If she does recommend continuingto support the company, what conditions (for example, collateral, guarantees, or other safeguards)might the bank impose to help protect against losses should Mark X’s plans go awry?TABLE 1Historical and Pro Forma Balance Sheetsfor Years Ended December 31(in Thousands of Dollars)Proforma1990 1991 1992 1993 1994Assets:Cash and marketablesecurities $ 5,149 $ 4,004 $ 3,906 X XAccounts receivable 17,098 18,462 29,357 X XInventory 18,934 33,029 46,659 X XCurrent assets $41,181 $55,495 $79,922 X XLand, buildings, plant,and equipment $17,761 $20,100 $22,874 $29,249 $30,126Accumulated depreciation (2,996) (4,654) (6,694) (9,117) (10,940)Net fixed assets $14,765 $15,446 $16,180 $20,132 $19,186Total assets $55,946 $70,941 $96,102 X XLiabilities and Equity:Short-term bank loans $3,188 $ 5,100 $18,233 X XAccounts payable 6,764 10,506 19,998 15,995 16,795Accruals 3,443 5,100 7,331 9,301 11,626Current liabilities $13,395 $20,706 $45,562 X XLong-term bank loans $ 6,375 $ 9,563 $ 9,563 $ 9,563 $ 9,563Mortgage 2,869 2,601 2,340 2,104 1,894Long-term debt $ 9,244 $12,164 $11,903 $11,667 $11,457Total liabilities $22,639 $32,870 $57,465 X XCommon stock $23,269 $23,269 $23,269 $23,269 $23,269Retained earnings 10,038 14,802 15,368 X XTotal equity $33,307 $38,071 $38,637 X XTotal liabilities and equity $55,946 $70,941 $96,102 X XNotes:a. 3,500,000 shares of common stock were outstanding throughout the period 1990 through 1992.b. Market price of shares: 1990–$17.78; 1991–$9.71; 1992–$3.67.c. Price/earnings (P/E) ratios: 1990–6.61; 1991–5.35; 1992–17.0. The 1992 P/E ratio is high because of the depressedearnings that year.d. Assume that all changes in interest-bearing loans and gross fixed assets occur at the start of the relevant years.e. The mortgage loan is secured by a first-mortgage bond on land and buildings.Case: 35 Financial Analysis and ForecastingTABLE 2Historical and Pro Forma Income Statementsfor Years Ended December 31(Thousands of Dollars)Pro Forma1990 1991 1992 1993 1994Net sales $170,998 $184,658 $195,732 X XCost of goods sold 187,684 151,761 166,837 X XGross profit $ 33,314 $ 32,897 $ 28,895 $37,678 $49,520Administration and sellingexpenses $ 12,790 $ 15,345 $ 16,881 $17,224 XDepreciation 1,594 1,658 2,040 2,423 1,823Miscellaneous expenses 2,027 3,557 5,725 3,768 XTotal operating expenses $ 16,411 $ 20,560 $ 24,646 X XEBIT $ 16,903 $ 12,337 $ 4,249 $14,263 XInterest on short-term loans $ 319 $ 561 $ 1,823 $ 2,953 $ 2,953Interest on long-term loans 638 956 956 X 956Interest on mortgage 258 234 211 X 170Total interest $ 1,215 $ 1,751 $ 2,990 $ 4,098 $ 4,079Before-tax earnings $ 15,688 $ 10,586 $ 1,259 X $21,953Taxes 6,275 4,234 504 4,066 8,781Net income $ 9,413 $ 6,352 $ 755 X XDividends on stock 2,353 1,588 189 $ 0 XAdditions to retainedearnings $ 7,060 $ 4,764 $ 567 X XNotes:a. Earnings per share (EPS): 1990–$2.69; 1991–$1.81; 1992–$0.22.b. Interest rates on borrowed funds:Short-term loan: 1990–10%; 1991–11%; 1992–10%.Long-term loan: 10% for each year.Mortgage: 9% for each year.c. For purposes of this case, assume that expenses other than depreciation and interest are totally variable with sales.Case: 35 Financial Analysis and ForecastingTABLE 3Common Size Balance Sheetsfor Years Ended December 311990 1991 1992Assets:Cash and marketable securities 9.20% 5.64% 4.06%Accounts receivable 30.56 26.02 XInventory 33.84 46.56 48.55%Current assets 73.61% 78.23% XLand, buildings, plant, and equipment 31.75% 28.33% XAccumulated depreciation (5.36) (6.56) (6.97)Net fixed assets 26.39% 21.77% 16.84%Total assets 100.00% 100.00% 100.00%Liabilities and Equities:Short-term bank loans 5.70% 7.19% 18.97%Accounts payable 12.09 14.81 20.81Accruals 6.15 7.19 7.63Current liabilities 23.94% 29.19% 47.41%Long-term bank loans 11.39% 13.48% XMortgage 5.13 3.67 2.43Long-term debt 16.52% 17.15% XTotal liabilities 40.47% 46.33% 59.80%Common stock 41.59% 32.80% 24.21%Retained earnings 17.94 20.86 XTotal equity 59.53% 53.67% XTotal liabilities and equity 100.00% 100.00% 100.00%Note: Rounding differences occur in this table.Case: 35 Financial Analysis and ForecastingTABLE 4Common-Size Income Statementsfor Years Ended December 311990 1991 1992Net sales 100.00% 100.00% 100.00%Cost of goods sold 80.52 82.18 XGross profit 19.48% 17.82% XAdministrative and selling expenses 7.48% 8.31% 8.62%Depreciation 0.93 0.90 XMiscellaneous expenses 1.19 1.93 2.92Total operating expenses 9.60% 11.13% XEBIT 9.88% 6.68% 2.17%Interest on short-term loans 0.19% 0.30% XInterest on long-term loans 0.37 0.52 XInterest on mortgage 0.15 0.13 0.11Total interest 0.71% 0.95% 1.53%Before-tax earnings 9.17% 5.73% 0.64%Taxes 3.67 2.29 XNet income 5.50% 3.44% 0.39%Dividends on stock 1.38% 0.86% 0.10%Additions to retained earnings 4.13% 2.58% 0.29%Case: 35 Financial Analysis and ForecastingTABLE 5Statement of Cash Flowsfor Years Ended December 31(in Thousands of Dollars)1991 1992Cash Flow from Operations:Sales $ 184,658 $195,732Increase in receivables (1,364) XCash sales $ 183,294 XCost of goods sold (151,761) (166,837)Increase in inventories (14,095) (13,630)Increase in accounts payable 3,742 9,492Increase in accruals 1,657 XCash cost of goods ($160,457) XCash margin $ 22,837 XAdministrative and selling expenses (15,345) ($ 16,881)Miscellaneous expenses (3,557) (5,725)Taxes (4,234) (504)Net cash flow from operations ($ 299) XCash Flow from Fixed Asset Investment:Investment in fixed assets ($ 2,339) ($ 2,774)Cash Flow from Financing Activities:Increase in short-term debt $ 1,912 $ 13,133Increase in long-term debt 3,188 XRepayment of mortgage (268) (261)Interest expense (1,751) (2,990)Common dividends (1,588) (189)Net cash flow from financing activities $ 1,493 $ 9,693Increase (decrease) in cash andmarketable securities ($ 1,145) XCase: 35 Financial Analysis and ForecastingTABLE 6Historical and Pro Forma Ratio Analysisfor Years Ended December 31Pro Forma Industry1990 1991 1992 1993 1994 AverageLiquidity Ratios:Current ratio 3.07 2.68 X X X 2.50Quick ratio 1.66 1.08 0.73 1.10 X 1.00Debt Management Ratios:Debt ratio 40.47% 46.33% X X 52.69% 50.00%TIE coverage 13.91 7.05 1.42 X 6.38 7.70Asset Management Ratios:Inventory turnover (cost)a 7.27 4.59 3.58 5.70 5.70 5.70Inventory turnover (sales)b 9.03 5.59 4.19 X X 7.00Fixed asset turnover 11.58 11.96 12.10 10.69 12.91 12.00Total asset turnover 3.06 2.60 X 2.03 X 3.00Days sales outstanding(ACP)c 36.00 35.99 53.99 X 32.00 32.00Profitability Ratios:Profit margin 5.50% 3.44% 0.39% X X 2.90%Gross profit margin 19.48% 17.82% 14.76% 17.50% 20.00% 18.00%Return on total assets 16.82% 8.95% X 5.74% 10.76% 8.80%ROE 28.26% 16.68% 1.96% X X 17.50%Other Ratios:Altman Z scored 6.55 4.68 X X 5.08 4.65Payout ratio 25.00% 25.00% 25.00% 0.00% X 20.00%Notes:a. Uses cost of goods sold as the numerator.b. Uses net sales as the numerator.c. Assume a 360-day year.d. Altman’s function is calculated asZ = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5Here,X1 = net working capital/total assetsX2 = retained earnings/total assetsX3 = EBIT/total assetsX4 = market value of common and preferred stock/book value of all debtX5 = sales/total assets.The “Altman Z score” range of 1.81–2.99 represents the so-called “zone of ignorance.” Note that the first fourvariables are expressed as percentages. Refer to Chapter 26 of Eugene F. Brigham and Louis C. Gapenski,Intermediate Financial Management, Fourth Edition (Fort Worth: Dryden Press, 1993), for details.e. Year-end balance-sheet values were used throughout in the computation of ratios embodying balance-sheet items.f. Assume constant industry-average ratios throughout the period 1990 through 1994.Case: 35 Financial Analysis and Forecasting" There is a typo in the Case Study: for year 1990 Cost of Goods Sold should be 137,684, not 187,684. Also, Z score formula should be:Z= 1.2X1+1.4X2+3.3X3+0.6X4+0.999X5 if using X1-X4 as shares. Make sure to use total value of debt (liabilities and long term debt) in X4. Note that Market value of stock = market price*number of shares outstanding for current years, and use P/E and EAT or net income to infer the price for the forecast years.