Question

Nancy Corporation is suffering from financial distress as it can be seen from its balance sheet:

YEAR O YEAR 1 YEAR 2 Current assets Fixed assets Total assets $100,000 100,000 $200,000 $100,000 100,000 $200,000 $100,000 100,000 $200,000 $ 0 $100,000 $250,000 Total debt Equity Common stock Retained earnings Total equity Total debt and equity 200,000 0 200,000 $200,000 200,000 -100,000 100,000 $200,000 200,000 -250,000 -50,000 $200,000

Two scenarios are possible for Nancy in Year 3: In scenario 1, Year 3 for Nancy is expected to result in an additional $150,000 operating loss. In scenario 2, Year 3 is expected to be a “breakout” year for Nancy when higher sales and lower costs owing to economies of scale are forecasted to produce operating profits of $250,000 in Year 3. Total assets are expected to remain at $200,000 under either scenario. Total debt will be increased to finance additional operating losses. Operating profits will be used to reduce total debt.

Instructions:

a. Show Nancy’s balance sheets under both scenarios. (10 points)

b. Based on your analysis, will Nancy Corporation still be balance sheet insolvent in Year 3 under scenario 1? If this trend continues, would you describe Nancy’s financial distress as a temporary or a permanent problem? (5 points)

c. Based on your analysis, will Nancy Corporation still be balance sheet insolvent in Year 3 under scenario 2? If this trend continues, would you describe Nancy’s financial distress as a temporary or a permanent problem? (5 points)

d. There are two basic options in the situation of financial distress: liquidation or reorganization. Explain them. (5 points)

Answer 1

(a)

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Scenario I scenamo2 $100,000 $ 100 000 $100,000 $100,000 $200,000 $200,000 $400,000 0 Current assets fixed assets Cotal assets Total debt Equity Cornnon stock Rebaines cernings Total dest & equity $ 200 000 $ 200,000 $-400,000 о $ 200,000 $200000 Scanned with CamScanner

b)

Balance sheet insolvency means the Total outside liabilities exceeding the Total assets. In other terms the Networth becoming negative (less than zero).

In Scenario 1, the Total debt ($400,000) is higher than the total assets ($200,000). The entity is balance sheet insolvent.

If the trend continues, the financial distress of entity is a permanent one and it will lead to liquidation or bankruptcy.

c)

In Scenario 2, the Total Debt is 0 and the total assets are $200,000. The total assets is higher than the outside liabilities and the entity is solvent.

As the company has turned into profit making current year and made recovered all its losses and paid the outside debt, we can see bright future and set aside the financial distress as a temporary affair.

d)

Two options in financial distress are

1. Liquidation : It is a set of processes that brings the existent of an entity to end and distributes the assets to creditors and shareholders. This means winding up of the company by appointing a liquidator, who will takeover the management of entity and carryon the liquidation process of realising the assets and distribution of assets to creditors and share holders.

2. Reorganization : It is also called as Business Restructuring. It involves overhauling the entity's strategy, operations, management etc inorder to turnround the entity into profit making from loss making. This may be done by selling certain divisions, laying off employees and agreement with creditors, debt holders, share holders etc where they agree to forgo certain portion and help in reorganization and thus come out of financial crisis.