Question

Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had designed for doing aerial tricks. Up to this point, Russ has financed the company with his own savings and with cash generated by his business. However, Russ now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bearings developed just as the company was beginning production for the Christmas season. Russ had been assured by his suppliers that the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and was unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Russ does not have enough cash to pay his creditors.

Well before the accounts payable were due, Russ visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Russ promised to return later with a copy of his financial statements.

Russ would like to apply for a $100,000 six-month loan bearing an interest rate of 8% per year. The unaudited financial reports of the company appear below:

Venice InLine, Inc. Comparative Balance Sheet As of December 31 (dollars in thousands)
	This Year		Last Year
Assets
Current assets:
Cash	$	60.1	$	260.0
Accounts receivable, net		85.0		95.0
Inventory		275.0		170.0
Prepaid expenses		60.0		48.0
Total current assets		480.1		573.0
Property and equipment		400.0		210.0
Total assets	$	880.1	$	783.0
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$	246.0	$	170.0
Accrued liabilities		35.0		30.0
Total current liabilities		281.0		200.0
Long-term liabilities		-		-
Total liabilities		281.0		200.0
Stockholders' equity:
Common stock and additional paid-in capital		150.0		150.0
Retained earnings		449.1		433.0
Total stockholders' equity		599.1		583.0
Total liabilities and stockholders' equity	$	880.1	$	783.0

Venice InLine, Inc. Income Statement For the Year Ended December 31 (dollars in thousands)
	This Year
Sales (all on account)	$	635.0
Cost of goods sold		372.0
Gross margin		263.0
Selling and administrative expenses:
Selling expenses		98.0
Administrative expenses		142.0
Total selling and administrative expenses		240.0
Net operating income		23.0
Interest expense		–
Net income before taxes		23.0
Income taxes (30%)		6.9
Net income	$	16.1

Required:

Last year Russ purchased and installed new, more efficient equipment to replace an older plastic injection molding machine. Russ had originally planned to sell the old equipment, but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $145,000. The bank does not require audited financial statements.

a. Calculate the following if the old machine is considered as inventory.

Current Ratio

Acid-test ratio

b. Calculate the following if the old machine is sold off.

Current Ratio

Acid-test ratio

Answer 1