FINAN204 – 21A

Tutorial 6 – Week starting 12th April 2021

Q1: Bike-With-Us Corporation, a specialty bicycle parts replacement venture, was started
last year by two former professional bicycle riders who had substantial competitive racing
experience including competing in the Tour de France. The two entrepreneurs borrowed
$50,000 from members of their families and each put up $30,000 in equity capital. Retail
space was rented and $60,000 was spent for fixtures and store equipment. Following are
the abbreviated income statement and balance sheet information for the Bike-With-Us
Corporation after one complete year of operation.

Prepare an income statement and a balance sheet for the Bike-With-Us Corporation using
only the information provided above.

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 MINI CASE: SCANDI HOME FURNISHINGS, INC.
Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2016. Sales
during the first full year (2017) of operation reached $1.3 million. Sales increased by 15
percent in 2018 and another 20 percent in 2019. However, profits after increasing in 2018
over 2017 fell sharply in 2019 causing Kaj to wonder what was happening to his “pride and
joy” business venture. After all, Kaj has continued to work as close as possible to a 24/7 pace
beginning with the startup of Scandi and through the first three full years of operation.
Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures,
and sells Scandinavian-designed furniture and accessories to home furnishings retailers. The
modern Scandinavian design has a streamlined and uncluttered look. While this furniture
style is primarily associated with Denmark, both Norway and Sweden designers have
contributed to the allure of Scandinavian home furnishings. Some say that the inspiration for
the Scandinavian design can be traced to the “elegant curves” of art nouveau from which
designers were able to produce aesthetically pleasing, structurally strong modern furniture.
Danish furnishings and the home furnishings produced by the other Scandinavian countries—
Sweden, Norway, and Finland—are made using wood (primarily oak, maple, and ash),
aluminum, steel, and high-grade plastics.
Kaj grew up in Copenhagen, Denmark and received a college degree from a technical
university in Sweden. As is typically in Europe, Kaj began his business career as an
apprentice at a major home furnishings manufacturer in Copenhagen. After “learning the
trade,” he quickly moved into a management position in the firm. However, after a few
years, Kaj realized that what he really wanted to do was to start and operate his own
Scandinavian home furnishings business. At the same time, after traveling throughout the
world including the U.S., he was sure that he wanted to be an entrepreneur in the United
States. Thus, while it was hard to give up the Tivoli Gardens with its many entertainment
and dining activities, as well as the other attractions in Copenhagen, Kaj moved to the U.S. in
early 2016. With $140,000 of his personal assets, and $210,000 from venture investors, he
began operations in mid-2016. Kaj, with a 40 percent ownership interest and industry-related
management expertise, was allowed to operate the venture in a way that he thought was best
for Scandi. Four years later, Kaj is sure he did the right thing.
Following are the three years of income statements and balance sheets for the Scandi
Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive
advantage that he would need to continue to expand sales. After first concentrating on selling
Scandinavian home furnishings in the northeast in 2017 and 2018, he decided to enter the
west coast market. An increase in expenses associated with identifying, contacting, and
selling to home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen
was hoping that you could help him better understand what has been happening to Scandi
Home Furnishings both from operating and financial standpoints.

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Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture
investors when Scandi Home Furnishings was incorporated in mid-2016.

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Part A
Your first challenge is to advise Kaj on what has been happening with Scandi Home
Furnishings from a liquidity perspective.

A. Kaj was particularly concerned by the drop in cash from $50,000 in 2017 to $10,000
in 2019. Calculate the average current ratio, the quick ratio, and the networking
capital to total assets ratio for 2017-2018 and 2018-2019. What has happened to
Scandi’s liquidity position?

Note: ratio calculations involving asset items on the balance sheet are averages of the
prior and current years. For example, the ratios for 2018 use average balance sheet
account amounts for 2017 and 2018. Likewise, ratios for 2019 use average balance
sheet account amounts for 2018 and 2019.

Current Ratio = Average Current assets / Average current Liabilities

Current Ratio (2018) = ((700,000 + 800,000)/2) / ((270,000 + 330,000)/2) = 2.5
Quick Ratio = (Average Current assets – Average Inventories) / Average current
Liabilities
Quick Ratio (2018) = ((700,000 + 800,000)/2) – ((450,000 + 500,000) / 2) / ((270,000
+ 330,000)/2) = 0.917
NWC – to – Total – Asset Ratio = (Average Current assets - Average current
Liabilities) / Average total Assets
NWC – to – Total – Asset Ratio (2018) = (((700,000 + 800,000)/2) - ((270,000 +
330,000)/2)) / ((1,000,000 + 1,200,000)/2) = 0.409

All three liquidity ratios declined.

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B. Kaj should be interested in knowing whether Scandi has been building or burning
cash. Compare the cash build, cash burn, and the net cash build/burn positions for
2018 and 2019. What, if any, changes have occurred?

The venture had a $36,000 net cash burn in 2018 and a larger $274,000 net cash burn
in 2019. Operating expenses and interest expenses increased resulting in lower cash
from operations. The net cash burn also increased due to the increase in accounts
receivable and in inventories.

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Part B
Your second challenge is to advise Kaj on what has been happening to Scandi from a financial
leverage, profitability, and efficiency perspective.

C. Creditors, as well as management, are also concerned about the ability of the venture
to meet its debt obligations as they come due, the proportion of current liabilities to
total debt, the availability of assets to meet debt obligations in the event of financial
distress, and the relative size of equity investments to debt levels. Calculate average
ratios in each of these areas for the 2017-2018 and 2018-2019 periods. Interpret
your results and explain what has happened to Scandi.
Total Debt to total Asset ratio = Average total debt / average total assets
Total Debt to total Asset ratio(2018) = (570,000 + 730,000)/2) / (1,000,000 + 1,200,000)/2)
= 0.5909
Equity Multiplier = (Average Total Assets / Average Equity)
Equity Multiplier (2018) = ((1,000,000 + 1,200,000)/2) / ((300,000+50,000+80,000) +
(300,000+50,000+120,000))/2) = 2.444
Debt to equity Ratio = Total Liabilities / Total Shareholder’s Equity
Debt to equity Ratio (2018) = (570,000 + 730,000)/2) / ((300,000+50,000+80,000) +
(300,000+50,000+120,000))/2) = 1.444
Current Liability to Total Debt = Current Liabilities / Total Debt
Current Liability to Total Debt (2018) = (270,000 + 330,000)/2) / (570,000 + 730,000)/2) =
0.4615
Interest Coverage Ratio = EBITDA / Interest
Interest Coverage Ratio (2018) = (240,000 + 300,000)/2) / (45,000 + 57,000)/2) = 5.263

Financial Leverage:
2018 2019 Change
Total-Debt-to-Total-Assets 0.5909 0.6457 Higher
Equity Multiplier 2.444 2.822 Higher
Debt-to-Equity Ratio 1.444 1.822 Higher
Current-Liab.-to-Total Debt 0.4615 0.4490 Lower
Interest Coverage 5.263 2.000 Lower

Financial leverage (as measured by the total-debt-to-total-assets ratio, the equity

multiplier, and the debt-to-equity ratio) increased in 2019 versus 2018. This indicates
that financial risk also increased. The current-liabilities-to-total debt ratio improved
(was lower in 2019) indicating a more than proportional use of long-term debt relative
to short-term debt to meet financing needs in 2019. The interest coverage dropped
substantially due to an increase in the amount of interest and a drop in EBITDA.

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 D. Of importance to Kaj and the venture investors is the efficiency of the operations of
the venture. Several profit margin ratios relating to the income statement are
available to help analyze Scandi’s performance. Calculate average profit margin
ratios for 2017-2018 and 2018-2019 and describe what is happening to the
profitability of Scandi Home Furnishings.
Gross profit Margin = Net sales – COGS / Net Sales
Gross profit Margin (2018) = 1,500,000 – 900,000 / 1,300,000 = 0.4
Operating Profit Margin = EBIT / Net Sales
Operating Profit Margin (2018)= ((200,000 + 247,000)/2) / (1,300,000 + 1,500,000)/2) =
0.1593
Net Profit Margin = Net Profit / Net Sales
Net Profit Margin (2018) = (93,000 + 114,000)/2) / (1,300,000 + 1,500,000)/2) = 0.0738
NOPAT = EBIT (1-Tax Rate) / Net Sales
NOPAT (2018) = ((200,000 + 247,000)/2) (1-0.4) / (1,300,000 + 1,500,000)/2) = 0.0956

Profitability Ratios:
2018 2019 Change
Gross Profit Margin 0.4000 0.3500 Lower
Operating Profit Margin 0.1593 0.1046 Lower
Net Profit Margin 0.0738 0.0397 Lower
NOPAT Margin 0.0956 0.0627 Lower

All profitability ratios decreased in 2019 versus 2018. For example, the gross profit
margin decreased from 40.00% to 35.00% and the net profit margin decreased from
7.38% to 3.97%.

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 E. Kaj and the venture investors are also interested in how efficiently Scandi is able to
convert their equity investment, as well as the venture’s total assets, into sales.
Calculate several ratios that combine data from the income statements and balance
sheets and compare what has happened between the 2017-2018 and 2018-2019
periods.
Sales to total assets ratio = Net sales / Average Total Assets
Sales to total assets ratio(2018) = 1,500,000 / (1,000,000 + 1,200,000)/2) = 1.3636
Operating Return on Assets = EBIT / Average Total Assets
Operating Return on Assets (2018) = 247,000 / (1,000,000 + 1,200,000)/2) = 0.2245
Return on Assets = Net Profit / Average Total Assets
Return on Assets (2018) = 114,000 / (1,000,000 + 1,200,000)/2) = 0.1036
Return on Equity = Net Income / Average Owner’s Equity
Return on Equity (2018) = 114,000 /
((300,000+50,000+80,000)+(300,000+50,000+120,000))/2) = 0.2533

Efficiency and Return Ratios:

2018 2019 Change
Sales-to-Total-Assets 1.3636 1.3483 Same
Operating Return on Assets 0.2245 0.0599 Lower
Return on Assets (ROA) 0.1036 0.0045 Lower
Return on Equity (ROE) 0.2533 0.0127 Lower

The sales-to-total-assets ratio remained about the same at 1.3636 in 2018 to 1.3483 in
2019. Profitability was sharply lower in terms of the ROA results (from 10.36% to .
45%) and the ROE results (from 25.33% to 1.27%).

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 F. A ROA model consisting of the product of two ratios provides an overview of a
venture’s efficiency and profitability at the same time. A ROE model consists of the
product of three ratios and simultaneously shows an overview of a venture’s
efficiency, profitability, and leverage performance. Calculate ROA and ROE models
for the 2017-2018 and 2018-2019 periods. Provide an interpretation of your
findings.
ROA Model = (Net Profit / Sales) x (Net Sales / Average Total Assets)
ROA Model (2018) = 10.36% = (114,000 / 1,500,000) x (1,500,000 / (1,000,000 +
1,200,000)/2))
ROE Model = (Net Profit / Sales) x (Net Sales / Average Total Assets) x (Average Total
Assets / Average Equity)
ROE Model (2018) = (114,000 / 1,500,000) x (1,500,000 / (1,000,000 + 1,200,000)/2)) x
((1,000,000 + 1,200,000)/2) / (((300,000+50,000+80,000)+(300,000+50,000+120,000))/2)

ROA 2018: 10.36% = 7.60% x 1.3636

ROA 2019: 0.45% = 0.33% x 1.3483
ROE 2018: 25.33% = 7.60% x 1.3636 x 2.444
ROE 2019: 1.27% = 0.33% x 1.3483 x 2.822

Both the ROA and ROE model results show declining performance due to a large
decline in the net profit margin combined with a relatively unchanged (slight decline)
sales-to-assets ratio. The financial leverage (as measured by the equity multiplier)
increased from 2018 to 2019 during this period of declining operating performance.

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Part C
Your third challenge is to advise Kaj on what has been happening to Scandi relative to
financial developments in the home furnishings industry.

G. Kaj has been able to obtain some industry ratio data from the home furnishings
industry trade association of which he is a member. The industry association collects
proprietary financial information from members of the association, compiles
averages to protect the proprietary nature of the information, and provides averages
for use by individual trade association members.
Trade association data for the home furnishings industry shows an average net
profit margin of 6.5 percent, a sales-to-assets ratio of 1.3 times, and a total-debt-to-
total-assets ratio of 55 percent over the 2017-2018 and 2018-2019 time periods.
Compare and contrast Scandi’s results with the industry average in terms of the ROA
and ROE models. Make sure you compare the components of each model as well as
the product of the components.

ROE Model = (Net Profit / Sales) x (Net Sales / Average Total Assets) x (Average Total
Assets / Average Equity)

If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1

- .55). If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for
the industry of 2.222. Thus, the industry ROE model is:

ROE Industry: 18.78% = 6.50% x 1.300 x 2.222

From Part G:
ROA 2018: 10.36% = 7.60% x 1.3636
ROA 2019: 0.45% = 0.33% x 1.3483
ROE 2018: 25.33% = 7.60% x 1.3636 x 2.444
ROE 2019: 1.27% = 0.33% x 1.3483 x 2.822

Scandi’s ROE declined from above the industry average in 2018 to well below the industry
average in 2019. The firm’s net profit margin also declined from above the industry average
to below the industry average. Also, while the turnover of assets declined slightly for the
firm, the ratio remained above the industry average. Scandi’s use of debt to finance its assets
was above the industry average in 2018 and even more so in 2019.

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