FRIENDLY CARDS, INC.

Question # 2: Perform an NPV analysis to see if Friendly Cards should purchase the envelope machine (you will need to come up with a reasonable WACC).

Solution:

Purchase of envelop machine:

Friendly Card is bearing millions of cost every year on envelops purchasing. So it is considering the option of purchasing an envelope machine rather than envelops. As the NPV calculated by discounting the cash flows of 8 years at a wacc of 7.9% is positive, so I think it’s a good investment to purchase an envelope machine. Positive negative value is an indicator that cash inflows by purchasing envelope machine exceeds

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.

Analysis of Financial Ratios

Financial statement analysis seeks to evaluate management performance in several important areas including profitability, efficiency, and risk. Analysts use financial ratios because numbers in isolation typically convey little meaning. For example, knowing that a firm earned a net income of $100,000 is not very informative unless we also know the sales figure that generated this income and the assets or capital committed to the enterprise. The ratios are intended to provide meaningful relationships between individual values in the financial statements.

Internal liquidity ratios:

current ratio:

                       it exams the relationship between current assets and current liabilities as follows

current ration = current assets/current liabilities

Quick ratio:

                      some believes that inventories and some other current assets might not be very liquid, so they prefer the quick ration which is as follows

quick ratio = cash + marketable securities + receivables / current liabilities

Cash ratio:

cash ratio = cash and marketable securities / current liabilities

Receivable turnover:

receivables turnover = net annual sales / average receivables

it is useful to analysis the quality (liquidity) of the  accounts receivables by calculating how often the firm's receivables turn over, which implies an average collection period.