Wolf Metal Production Company

PART 1

1. BACKGROUND

Mr. Enrique (Harry) Wolff, owner of Wolff Metal Products Company (WMP), had borrowed nearly $250,000 from East Hill State Bank but realized there was a cash shortage again a month or so later. As East Hill Bank had “maxed out” its lending limit, Mr. Wolff was eventually referred to Cheyenne National Bank of New Mexico, and presented a loan request of $650,000. Thereafter, the bank started investigation on Wolff Metal Products Company and Mr. Wolff.

Buying out co-founder Mr. Andrew Murphy, Mr. Wolff became the sole proprietor of WMP in 2010. WMP manufactured and distributed metal products to supply builders, retail outlets and steel yards throughout New Mexico and parts of southern Colorado. WMP gave discounts on quantity purchases and sold on terms of net 30 days.

Without a university degree, Mr. Wolff had installed the latest accounting, billing, and inventory control software. He was also assisted by a woman with a degree in accountancy whom was familiar and also involved in many of the administrative tasks of the company. The other employees appeared to be highly loyal to the firm.

The bank concluded that the firm had a continuous, ready market for its products and that the sales outlook was particularly favorable.

1.1 Why did Mr Wolff require so much money when the business is so profitable?

(Refer to Appendix B on Balance Sheet)

Despite being clearly profitable, WMP had one huge problem – shortage of cash. The business was only left with a balance of $6,598 in cash as at end of Q1 of 2014. This was a fall of $11,554 since 2013, even having borrowed $249,600 from East Hills State Bank in the beginning of 2014. There were 2 major changes in the Balance Sheet that could have contributed to this significant outflow of cash – increase in Inventory and decrease in Accounts Payable.

Inventory went up by more than $300,000 within the first quarter of 2014. Mr. Wolff could have made purchases in quantity more than what the business could sell out in the first quarter to anticipate for the months of April through September, where 55% to 60% of the company’s annual sales would be typically made.

Accounts Payable fell near to $200,000 within the same period. Mr. Wolff might have been trying to pay off the company’s short-term debts through long-term financing. However, despite having a drop of near to $200,000, the forecasted Accounts Payable would still increase to more than $1,000,000. This would then again cause worries to Mr. Wolff as the company would only have less than $100,000 in cash (forecasted at end of 2014). He could have required the additional $650,000 to pay off part of the short-term debts. The company is facing a great risk of default as if the creditors press for payment, he would have insufficient liquid assets to pay off the debts.

1.2 What would the details of WMP’s historic need for funds show?

(Refer to Appendix C on Cash Flow Statement)

From the Statement of Cash Flow for years 2012, 2013 and Q1 of 2014, we can see a significant pattern in the Cash Flows from Operating Activities which could show the need for the business to borrow more money. Despite generating positive net profit for all years and Q1 of 2014, the Cash Flows from Operating Activities fell from a positive $176,128 to $36,920, and finally to a negative $291,880 in from 2012 to 2013 and Q1 2014 respectively. This showed that the operating activities are generating less cash for the business, and in fact bringing about a cash deficit of near to $300,000 in Q1 2014.

Although Inventory level played a significant role in this effect, the main cause of the decline in cash generated through operating activities would be the changes in Accounts Payable, dropping from an increase of $412,168 to $190,222 to a decrease of $182,534 from 2012 to 2013 to Q1 2014 respectively. This may have shown that Mr. Wolff was aware of the staggering amount of Accounts Payable he has in the business, and was trying to control and keep it low.

Likewise as Accounts Payable, Accrued Expenses showed similar pattern in the Statement of Cash Flows. It could be observed that Mr. Wolff might have been putting effort to control the expansion of the business’ current liabilities.

1.3 Though profitable, the firm may have problems in certain aspects of its operations or financing. She concluded that a ratio analysis would help her identify strengths, weaknesses, and trends. (Refer to Appendix D for ratios)

Financial ratios allow users to measure a firm's strengths, weaknesses and even trends. Some of the measures, such as liquidity ratio, are used to measure the firm's ability to meet maturing short term obligations. Efficiency ratios are used to measure how effectively the firm uses its assets. Profitability and leverage ratios are used to measure the company's use of its assets and control of its expenses and measure the ability of the firm to meet its debt obligations respectively. In this section of the report, financial ratios for WMP are measured and analyzed.

Based on the liquidity ratios, WMP is strong in its current ratios, which were held above 1 and it maintained well through years 2011 to 2013. However, there was a significant difference when comparing quick ratio to current ratio for all 3 years. This difference is caused by the company’s excessive holding of inventory. The sub 1 quick ratio signified that WMP was not able to meet its short term obligations with its near cash assets.

Looking at the efficiency ratio, WMP is having good inventory turnover rate. However, it fell slightly in 2012. This might be due to again the holding of more inventories.

In addition, the total asset turnover shows that it is in relatively good state in 2011 (4.6%), and a drop in 2012 (3.7%). This might be affected from the growth in inventory. However, the ratio in 2013 has shown improvement.

The profitability ratio shows that WMP is enjoying considerably comfortable return on assets and equity, except that there seems to be a significant drop from year 2011 to 2012. This is due to increase in the assets, especially in inventory, and the fall in net operating profit, which reflects the high cost of goods sold, affecting the overall profit.

This has also affected the profit margin on sales. Although there is increase in the net sales, the margin percentage fell from 8.84% to 1.92%. It is quite a huge fall which can be seen as a result of the high operating expense, causing a lower net operating profit.

WMP had been increasingly dependent on leveraging through the years.