FRIENDLY CARDS, INC.

Question # 1: Perform a ratio analysis of FC for 1985-1987 and a pro forma ratio analysis of the FC financials for 1988-1990 to show what is likely to happen to the firm’s bond covenants if the status quo continues. Run a few scenarios by varying the sales growth rate (first try 0%, then 20%) and see what happens to the covenants.

Solution:

LIQUIDITY: The Quick ratio is below 1 which means that the assets which are in the form of cash or can easily be turned into cash are not enough to handle the current debt payment requirements. There is a definite decline in current ratio but the firm's liquidity is relatively good since its current ratio is still above 1.

ACTIVITY: Inventory turnover declined between 1985 and 1987 and is projected to rise slightly from 1988 to 1990. Due to the decline in the inventory turnover the inventory is staying taking longer to be sold.  This is also impacted by the fact that the firm's sales are seasonal.         

DEBT: The proportion of total assets that are financed by debt is 75% and greater.  It rose to above 83% in 1986 but the firm is obviously aiming at bringing it down in 1988 - 1990. Long term debt to equity ratio is a significant ratio because the firm is aiming at keeping the long-term debt to equity ratio to a maximum of two to one. Notice that this ratio was particularly high in 1986 but began declining in 1987 which is good sign for the firm. If the projections for 1988 - 1990 are achieved then the firm would have accomplished its goal of reducing the debt to equity ratio. Friendly's bankers are feeling uneasy about the extent to which the company is depending on debt capital.  As the total liability to equity ratio points out, the firms liability was approximately 3 times its equity in 1985 and that amount grew to over 5 times in   1986.  The firm is attempting to control this amount as indicated in the case. (Exhibit 2 shows this ratio). Friendly's bankers insisted on a few terms, one of them being that the bank loans outstanding at any time should not exceed 85% of the receivables. Based on the performance in 1987 and the projected performance for 1988 - 1990, the firm seems to be in violation of this particular bank request. This may lead to financing problems for the firm.      

PROFITABILITY: Profitability in relation to sales is relatively low from period to period.  However, the firm is projecting an increase Net profit margin.

AFTER 20% INCREASE IN SALES:

LIQUIDITY & DEBT: Liquidity ratios remain unaffected by increase in sales as these are not affected by income statement items. These are totally dependent on balance sheet items.         

ACTIVITY: Inventory turnover declined between 1985 and 1987 but with 20% growth in projected sales remains constant from 1988 to 1990. Due to the stability in the inventory turnover the inventory is taking less time to be sold. Hence, the average age of inventory decreases.

PROFITABILITY: With 20% growth in projected sales the profitability increases as gross profit margin, the net profit margin and return on total assets has increased as compared to 0% growth in projected sales.