Accounting Quiz

Quiz 3 Cash Flows and Cost Volume Profit Analysis

Part One Cash Flows

Matthew Reedmer owns two Matthew’s Models stores in Florence, South Carolina. He believes that the stores have been successful and he wants to open a new store in Sumter about 30 miles west of Florence. Matt has been in the retail line for over 20 years, and he worked at his uncle’s hobby shop while in high school and college before starting his own store at the age of 25.

Two big secrets to a successful toy store operation are good location and product selection. Matt’s first store is located in downtown Florence. Since Matt had been born and raised in Florence, he attracted a good customer base that remained loyal to his store after some of the giant chain related toy stores began to move into the area. About 10 years ago, Matt saw the change in customer shopping habits and purchased a second store near an interchange to Interstate 95 in a rapidly growing retail area. Lots of new families had moved into the area, and Matt could not totally rely on the “good old boy” market alone to sustain his market share. This second store catered to the younger more mobile generation that shopped at or near malls.

Matt now was looking into other markets. Sumter was not located on the interstate, but the area was growing because of its proximity to the state capital of Columbia, which was just 30 miles to its west. Matt believed that the people of Sumter who commuted to work in Columbia would prefer to limit their driving for shopping activities to the immediate Sumter area. Also, since Matt was a respected citizen of Florence, his reputation as an honest businessman had spread to Sumter. He believed he could quickly build up a new customer base in that location. The big chain type stores also did not seem as interested in the Sumter area, preferring instead to locate in the larger metropolitan areas of Columbia and Florence.

The appropriate toy items to feature in his stores were very important. Matt felt that his area of influence was strictly regional, and he did not have to carry much of the standard inventory of the national chain type of toy stores. His toy lines were more a reflection of local interest; thus NASCAR related items were hot sellers. Matt’s clientele also seemed interested in computer action games and a new line of Ya’ll talking dolls.

Matt went to the Florence National Bank to inquire about funding for the new store location. He had found an abandoned furniture store in downtown Sumter along Main Street that was up for sale for $280,000. The store seemed to be the right size and at a good location. A grocery store was in the same block with ample off street parking. Matt brought his balance sheet for the last two years and an income statement for the last operating year to the bank to support his request for a retail loan of $250,000. (Copies of the financial statements are listed at the end of the quiz).

Nick Tightwad, the local bank loan vice president had been a friend of Matt’s for many years. He was a customer at Matt’s toy store on close out sales, and his bank had underwritten the funding for the second store. Nick was excited about Matt’s expansion goals and the prospect of another business loan with his friend. At the same time, Nick had to live up to his reputation. He was not about to approve a loan unless he was almost 100 percent sure that the borrower would not default. Matt’s past success had alleviated much of Nick’s concern, but he still wanted to complete a detailed analysis of the financial performance of Matthew’s Models during the last calendar year. Upon reviewing the balance sheet, Nick noticed a drop in cash during the last year even though Matt showed a strong profitable performance. The current financial statements did not seem to give enough information to answer Nick’s questions and he asked Matt to prepare a statement of cash flows for the year ending December 31, 20×7.

Matthew’s Models

Balance Sheet

December 31, 20×6

ASSETS
Cash $ 38,500
Accounts Receivable 43,000
Inventory 126,000
Other Current Assets 17,500
Total Current Assets $225,000
Land $100,000
Furnishings, Fixtures & Vehicles $150,000
Less Accumulated Depreciation -30,000
Furnishings, Fixtures & Vehicles (net) 120,000
Building 400,000
Less Accumulated Depreciation 175,000
Building (net) 225,000
Total Long-Term Assets 445,000
Total Assets $670,000
LIABILITIES
Accounts Payable $ 57,500
Short-Term Notes Payable 20,000
Other Current Liabilities 13,000
Total Current Liabilities $ 90,500
Long-Term Notes Payable 400,000
Total Liabilities $490,500
EQUITIES
Capital $100,000
Retained Earnings 79,500
Total Equities $179,500
Total Liabilities and Equity $670,000

Matthew’s Models

Income Statement

For the Year Ended December 31, 20×7

Sales Revenue $600,000
Less Cost of Goods Sold 310,000
Gross Margin 290,000
Less Operating Expenses
Selling and Administrative $106,200
Depreciation Furnishings 5,000
Depreciation Building 15,000
Total Operating Expenses 126,200
Operating Income 163,800
Interest Expense $50,000
Loss on Vehicle Sale 2,500
Total Other Expenses 52,500
Net Income Before Taxes 111,300
Less Income Taxes 29,300
Net Income $82,000

Matthew’s Models

Balance Sheet

December 31, 20×7

ASSETS
Cash $3,600
Accounts Receivable 71,000
Inventory 188,000
Other Current Assets 18,900
Total Current Assets $281,500
Land $100,000
Furnishings, Fixtures & Vehicles $166,000
Less Accumulated Depreciation -28,500
Furnishings, Fixtures & Vehicles (net) 137,500
Building 400,000
Less Accumulated Depreciation 190,000
Building (net) 210,000
Total Long-Term Assets 447,500
Total Assets $729,000
LIABILITIES
Accounts Payable $ 91,500
Short-Term Notes Payable 35,000
Other Current Liabilities 7,000
Total Current Liabilities $133,500
Long-Term Notes Payable 388,000
Total Liabilities $521,500
EQUITIES
Capital $100,000
Retained Earnings 107,500
Total Equities $207,500
Total Liabilities and Equity $729,000

Required:

1. Develop a Statement of Cash Flows for Matthew’s Models for the year ending December 31, 20×7.

2. Analyze the financial performance of Matthew’s Models based on all the financial statements.

3. If you were Matt, how would you explain to Nick the financial situation to help justify the loan request.

4. If you were Nick, would you approve the loan for Matt? Why or why not?

Part Two Cost Volume Profit Analysis

Lily Flowers is President of Lily Recreation which manufactures recreational equipment. One of the company’s products, a skateboard, sells for $40.00. The skateboards are manufactured in an antiquated plant that relies heavily on direct labor workers. The variable costs are high, totaling $24.00 per skateboard of which 60% is direct labor cost.

Over the past year the company sold 40,000 skateboards, with the following operating results:

Sales (40,000 skateboards) $1,600,000

Variable Expenses 960,000

Contribution Margin 640,000

Fixed Expenses 480,000

Net Operating Income 160,000

Management is anxious to maintain and perhaps even improve its present level of income from the skateboards.

Required

1. Compute the Contribution Margin ratio and the break-even point in skateboards.

2. Due to an increase in labor rates, the company estimates that variable costs will increase by $2 per skateboard next year. If this change takes place and the selling price per skateboard remains constant at $40.00, what will be the new Contribution margin ratio and the new break-even point in skateboards?

3. Refer to the data in (2) above. If the expected change in variable costs takes place, how many skateboards will have to be sold next year to earn the same net operating income, $160,000, as last year?

4. Refer again to the data in (2) above. Lily has decided that the company may have to raise the selling price of its skateboards. If Lily Recreation wants to maintain the same Contribution Margin ratio as last year, what selling price per skateboard must it charge next year to cover the increased labor costs?

5. Refer to the original data. Lily is considering the construction of a new, automated plant. The new plant would slash variable costs by 40%, but it would cause fixed cost to increase by 90%. If the new plant is built, what would be the company’s new Contribution Margin ratio and new break-even point in skateboards?

6. Refer to the data in (5) above.

a. If the new plant is built, how many skateboards will have to be sold next year to earn the same net operating income, $160,000, as last year?

b. Assume that the new plant is constructed and that next year the company manufactures and sells 40,000 skateboards (the same number as sold last year). Prepare a contribution format income statement.

c. If you were a member of top management, would you have been in favor of constructing the new plant? Explain.