Dunham Cosmetics – Financial Evaluation

1.Calculate Dunham’s 1995 financial rations. (See Exhibits 1,2, and 3).

Current Ratio = (current assets/current liabilities) = (16,268/7,600) = 2.1405%

Inventory Turnover = (sales/inventory) = (26,671/6,133) = 4.3487%

receivable____ = 5,920___ = 81.01 Days

DSO = annual sales/365 26,671/365

Fixed Asset Turnover = (sales/net fixed assets) = (26,671/3,336) = 7.9949%

Total Turnover Asset = (sales/total assets) = (26,671/16,268) = 1.6394%

Total Debt to Total Assets = (total debt/total assets) = (9,666/16,268) = 0.5941%

Time Interest Earned = (earnings before interest taxes/interest charge)

= (1,331/578)

= 2.3027%

EBITDA Coverage = (EBITDA + Lease Payment)/( Interest + Principal payment + Lease Payment)

Profit margin on sales = (net income available to common stock)/(sales)

= (376/ 26,671)

= 0.01409%

Basic Earning Power = (EBIT/ Total Assets) = (753/16,268) = 0.0462%

Return on Total Assets = (Net income available to common stock/Total Assets)

= (376/16,268)

= 0.02311%

Return on common equity = (Net income available to common stockholders/Common Equity)

= (376/6,602)

= 0.05695%

2.Does a trend analysis indicate Dunham’s position has been deteriorating? (See Exhibit 3)

A trend analysis indicates that Dunham’s position has been deteriorating.

3.Is the bank justifiably concerned? Justify your answer.

The bank is justifiably concerned because the debt ratio increases and creditors prefer low debt rates due to the reason that the greater cushion against creditor losses in the event of liquidation.

4.Nineteen ninety-four was a “down” year for Dunham. Do you think that CBG had a responsibility to express concern in 1994, especially since the current ratio was close to 1.85, the number that could trigger a call of the loan? Explain.

GCB had the responsibility to express concern in 1994, especially since the current ratio was close to 1.85. The current ratio is calculated dividing current assets by current liabilities. Current assets normally include cash, marketable securities, accounts receivables, and inventories. In the meantime, current liabilities consist of accounts payable, short term notes payable, current maturities of long term debt, accrued taxes and other accrued expenses (principally wages.) If a company is getting into financial difficulty, it begins paying its bills more slowly, borrowing from its bank, and so on. If current liabilities are using faster than current assets, the current ratio will fall, and this could enhance trouble. Because the current ratio provides the best single indicators of the extent to which assets cover the claims of short-term creditors, then they expect to be converted to cash. As a result, it is the most commonly used measured of short-term solvency.

5.Suppose Dunham had followed Jensen’s 1993 recommendation to lower its payout ratio. Recalculate the firm’s debt and current ratios for 1995 assuming that the payout ratio was 20 percent from 1993 to 1995. (Assume that the extra money was used to reduce the firm’s notes payable)

Dividends = (Net income – Retained earnings required to help finance new investments)

= Net income – [(Target equity ratio)(Total capital budget)]

1993 1994 1995

New POR and funds available to lower CL

(558 * 20)/50 = 223.2 (475 *20)/50 = 190 (188 * 20)/50 = 75.2

558-223.2 = 334.8 475-190 = 285 188-75.2 = 112.8

New current liability

3788-334.8 = 3453.2 5940-285 = 5655 7600-112.8 = 7487.2

CR= CA/CL

1993 1994 1995

9095/3453.2 = 2.634 11543/5655 = 2.041 12932/7487.2 = 1.727

6.A. Jensen discussed Dunham’s situation with Paula Robinson, an accounting friend. Robinson said that, in her opinion, Dunham has “too little long-term capital, especially considering your receivables and inventory needs.” Why is it frequently appropriate to use a long-term capital source like bonds or equity to finance items like inventory and receivables that appear on a balance sheet as short-term assets?

It is frequently appropriate to use a long-term capital source like bonds or equity to finance items like inventory and receivables that appear on a balance sheet as short-term assets because according on the conservative approach philosophy, long-term financing is used to finance all of the firm’s long-term assets, and of all of its permanent current assets, in which the needs are higher when does the firm use any short-term financing.

B. What advantages are there to using short-term debt to finance long-term assets? What are the disadvantages?

The advantage in using short-term debt to finance long-term assets is that a short loan can be obtained much faster. If the firm needs funds, are seasonal or cyclical. A firm may not want to commit itself to long-term debt for three reasons:

1.Flotation costs are higher for long-term debt than short-term credit,

2.Although long-term debt can repay early, providing the loan agreement includes a prepayment provision, in which prepayment penalties can be expensive, and

3.Long-term loan agreements always contain provisions and convenience, or may be inconvenient, constraining the firm’s future actions. Short-term credit agreements are generally less restricted.

By the time the funds are obtained, interest costs will be lower if the firm borrows on a short-term rather than a long-term basis. Even though short-term rates are often lower than long-term rates, short-term credit is riskier for two reasons:

1.f a firm borrows on a long-term basis, its interest costs will be relatively stable overtime, but if it were short-term credit, its interest expense will fluctuate widely, at times going quite high. Many firms that had borrowed heavily on a short-term basis simply could not meet their using interest costs, and as a result, bankruptcies hit record levels during that period.

2.If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak financial position, the lender may not extend the loan, which could force the firm to bankruptcy.

The disadvantage is that short-term, due to its very nature, must be repaid or rolled over more often, and so it increase the possibility that the firm’s financial condition might deteriorate to a point where the needed funds might not be available. A short-term debt is the uncertainly of interest cost from year to year.

A. Project Dunham’s income and balance sheet for 1996 (see Exhibit 4) assuming the bank grants Dunham a $675K note payable at 12 percent and no existing interest-bearing debt is retired. (Dividends will be 50 percent of net income.) Cash will be the residual or balancing item in the forecast.

Because the loan was granted, we assume Mr. Jensen’s recommendations were successfully implemented for 1996. These are: Increase gross profit margin to 31%, reduce selling and administrative expenses to 21.5% of sales, increase sales by 10%, and reduce payables (a/p) to 9% of sales. Since no time period for the note payable was given, we assume it was a loan, guaranteed with a note, extended for five years.

B.Estimate the firm’s 1996 minimum cash balance assuming that on average during 1993 to 1995 its cash situation was normal.

Minimum cash balance = (1264 + 1237 + 879 / 3) = 1126

Extra cash available to amortize notes payable

2238 – 1126 = 1112

C.Use any excess cash at the end of 1996 to retire note payable.

3075 – 1111 = 1964