New Consolidated Friendly Cards Inc Ratios example essay topic

Friendly Cards, Inc. Statement of the problem: Amy McConville, a friend and financial consultant of Wendy Beaumont, the president of Friendly Cards Inc., needs to come up with some suggestions concerning the financing of Friendly's expansion. Amy has been doing research on the firm and money is tight right now. The cost of financing growth right now is high and Friendly Card's is projecting 20% growth in sales next year and even more the following year.

The company has never been without financing problems. The business is capital intensive and has had to rely on its good relations with its banks and suppliers to achieve success. Friendly's bankers have begun to feel uneasy about how much the company is relying on debt capital to finance its operations. They have suggested that they agreed to help finance their growth in the past with the assumption that sales would decrease substantially in the future. The firm's liabilities / equity ratio had peaked to 5.2 in 1986, and was still a couple of years away from returning to historically lower ratios. This scenario has prompted Friendly's bankers to insist on the firm adhering to some new restrictions.

The two restrictions, which would apply by the end of 1988, were the following: 1. The bank loans outstanding at any time could not exceed 85% of Friendly's accounts receivable. 2. Friendly's total liabilities could not exceed three times the book value of the company's net worth.

In addition to these restrictions, Wendy has decided to impose an all interest bearing debt / equity ratio of a maximum of 2 to 1 for the firm. This should help with planning and provide some margin of safety for the firm. Wendy has also asked Amy to analyze three other scenarios: 1. Should Friendly Cards purchase an envelope machine that will enable them make their own envelopes?

2. Should Friendly Cards acquire Creative Designs, a small manufacturer of cards? 3. Should Friendly Cards accept the West Coast investors offer and issue new equity? Relevant facts: o Money is tight right now for Friendly Cards and they are predicted a 20% sales increase with more the following years Distribution costs are very important to the firms overall profitability o The seasonal nature of the business provides peaks and lows for borrowing from the bank so The company borrows at 2 1/2% above a prime rate of 8 1/2% currently o Friendly Cards had spent $1.5 million to purchase envelopes in 1987 and could save $218,000 per year for the next 8 years if it purchased the envelope machine Wendy believed she could reduce CD's cost of goods sold by 5% and their expenses by 10%o CD's principals were willing to accept Friendly common at $9.50 a share for 198,000 shares to buy their company Due to the stock market crash and low trading volume of Friendly Cards, it would be hard to take their stock to the market at more than $8.00 a share A west coast group of investors were willing to buy 200,000 shares at $8.00 a share; this deal included a finder's fee of $80,000 or 10,000 shares in addition to the 200,000 shares. Envelope Machine option: Friendly Cards would purchase the machine for $500,000 and when it was operated at full capacity, it would produce all the envelopes that the firm had used in 1987.

The machine was estimated to have an economic life of about eight years and that it would cost around $91,000 a year to operate the machine. In addition, they would need to purchase some additional warehouse space to store the envelopes the machine produced at a level rate during the year. After estimating the following savings and expenses, it was determined that Friendly Cards could save $218,000 a year by purchasing the machine. Savings: $1,500 Expenses: Materials: $902 Warehouse: $94 Labor: $91 Depreciation: $62 Total exp: $1,149 Increase in Profit before tax: $331 Increase in income tax @. 38: 133 Increase in profit after tax: $218 Purchasing the machine would not cost the firm any additional funds then it had spent on envelopes the year before, and it would start saving them money this year. I have included the firm's original income statement and balance sheet without the purchase and then with the machine purchase.

I have assumed that the firm would use the $218,000 to reduce the bank loans balance for each year. This reduction of the bank loan balance will lower their three restrictive financial ratios. Acquisition of Creative Designs: Friendly Cards would acquire Creative Designs for 198,000 shares of Friendly's common stock valued at $9.50 a share. The exchange of shares would be considered a tax free transaction; this meant that both companies' financial statements could be consolidated by adding them together. This made the CD acquisition more attractive to Friendly Cards because of CD's strong balance sheet. Their low financial ratios would help lower Friendly's ratios and possibly provide them with consolidated ratios that would fall under the bank's restrictions.

I have made the following assumptions for the consolidated statements: o Friendly Cards bought the envelope machine and is using the saving to retire the bank loan balance I used the 1987 CD balance sheet numbers based on flat the flat sales for the 1988 o I added the 1987 CD numbers to the projected Friendly number so Friendly issued the new 198,000 shares of common stock to the principals of CDo CD's common stock par value is. They should be able to maintain these ratios going forward as they consolidate and streamline both businesses to reduce redundancies in operations. The C / D acquisition would increase their Earnings per share and enable them to achieve their growth rates. Common stock sale option: Friendly Cards has the option to sell 200,000 shares of its common stock at $8.00 a share to a group of west coast investors. They would have to pay a finder's fee of $80,000 to the individual who located the group.

The firm would be able to generate $1,520,000, net the finder's fee to use to reduce their bank loan balance. This option would create more shares as in option two, and Wendy needed to consider the EPS effect of the equity financing. The reduction of the bank loan balance should decrease their debt financial ratios, but once the money was allocated to the debt, it would not be reoccurring and the ratios could end up increasing again if sales growth continued at this rate in the future. I have made the following assumptions for the common stock sale: o C / S increased by 20,000, APIC by 1,580,000, and they used the 1,520,000 net to reduce the bank loan balance Friendly bought the envelope machine and used the $218,000 to reduce the loan o Sale @ 8.00 per share for 200,000 shares. As the firm continues to grow, they would need to increase their borrowing again to finance the growth. The EPS decreases under this option because of the new shares issued.

Friendly Cards would be diluting each stockholder's earnings and valuation per share. I do not think this is a good time to raise equity with the market crash and the discount to market value that they have to sell at. Recommendation / Conclusion: Friendly Cards should purchase the envelope machine. It will generate a positive cash flow of $218,000 a year for the next eight years. They can use this money to reduce the bank loan balance and help decrease their debt financial ratios.

The purchase of the machine will not require any additional funds in respect to last year's 1.5 million dollar expense for envelopes and will generate a profit the first year. The firm should acquire Creative Designs Inc with a stock merger. Creative Design's strong balance sheet and low debt / equity will decrease the new consolidated Friendly Cards Inc ratios. The new ratios would meet the restrictions applied by the banks and allow Friendly Cards to continue to grow at the current rate. The acquisition should be sustainable based on the pooling of interest accounting of both company's financial statements. It is expected that Friendly Cards will be able to reduce the cost of goods sold and overall expenses of Creative Design by eliminating duplication.

The Creative Designs merger will increase the EPS and should generate a larger net income and additional retained earnings. The common stock sale is not a good option for Friendly Cards to pursue at this time. They have to sell the shares at a discount and pay a finder's fee on top of the discount. The equity market has just crashed within the year and they have been told it would be hard to raise money through an equity issue currently.

While this option would create a sizeable amount of money that they could decrease the bank loan balance with, it is not a reoccurring event. The merger is the better option for long-term growth and success of the company.