Posted: May 28th, 2021
Part I. c – Summary of Observations Including Assessment of Business Risk Based on the financial ratios calculated, it appears that Pinnacle Manufacturing (the “Company”) is both using up cash assets and increasing its debt. The Cash Ratio has declined each of the past three years indicating that the Company has a decreasing ability to pay its current liabilities from cash and will be required to liquidate assets to pay off current liabilities. The Current Ratio has also declined each of the last three years. In 2009, it was 218. % or 2. 186. This means that for every dollar of current liabilities the Company had $2. 18 in current assets with which to pay those liabilities. Inventory Turnover has declined from 4. 04 times per year in 2009 to 3. 78 times per year in 2011. This would seem to indicate that sales are slowing and inventory is not being sold as quickly as in prior years. This is further supported by the increasing Days to Sell Inventory number. In 2009 Days to Sell Inventory was 90. 44 and had grown to 96. 48 days in 2011.
This makes it important to assess inventory obsolescence in light of these numbers. Debt to Equity has increased significantly from 2009 to 2011. In 2009, the Debt to Equity Ratio was 70. 81%. In 2011, it had grown to 96. 48%. This might indicate that the Company does not have room to continue to borrow should it need cash to operate. If borrowing is not available as a financing tool, it is likely that the Company might need to look to its stockholders for additional cash or resort to more costly forms for financing. Gross Profit Margins have declined from 29. 1% in 2009 to 27. 5% in 2011. This ratio is helpful analytically to indicate that possible misstatements might exist in the areas of sales, COGS, A/R and inventory. As noted above there is already a negative trend in inventory for the Company. Similarly, Profit Margin for the Company has declined from 3. 77% to 2. 84% between 2009 and 2011. A decline in profit margin can signal misstatements in various operating expense accounts and balance sheet items. It can also simply signal a declining business trend for the Company.
Return on Assets shows the Company’s ability to generate a profit based on assets and equity. In 2009, the Company’s profit margin was 3. 07% and in 2011 it had fallen to 1. 91%. Overall, the Company appears to have slowing sales leading to growing inventory. The Company is increasing its debt burden to help cash flow since sales seem to be declining and inventory is growing. The profitability of the Company is declining steadily. Finally, if the Company finds itself in default of any loan covenants it will have to liquidate assets to pay its debts.
Forced asset sales are never beneficial to the seller and would only exacerbate the already declining business trends of the Company. Part I. f – What Data is More Useful in Evaluating the Potential for Misrepresentations? We believe that each set of data has its strengths and weakness. The balance sheet data available for Pinnacle Manufacturing is extremely helpful in evaluating whether certain income statement items could be misstated. As an example, to know the trend in the asset Accounts Receivable: Trade made evaluating the income statement item Bad Debt expense easier.
As a result, the financial data for the parent Pinnacle could be cross-referenced more easily. However, the subsidiary income statements allow greater detail into the business components that make up Pinnacle. A possible overstatement in one account for one of the subsidiaries could be cancelled out by a similar understatement in the in the same account for another subsidiary. When the numbers are rolled-up to the parent company, there might not be a noticeable problem in the account. As a result possible insufficient planning would result.
With the subsidiary information, an audit of each corresponding account could result in a more accurate number for the parent company. This would appear to help acceptable audit risk for the audit firm. ? Part I. g – Observations based on Accounts Receivable, Inventory and Short/Current Long-term Debt Accounts Receivable: Trade has grown in absolute dollar amount from just under $9. 6 Million in 2010 to over $14 Million in 2011. As a result, we believe it is important to look at the reasonableness of the allowance for bad debts and bad debt expense.
Confirmation of balances with customers will help to uncover any discrepancies between Pinnacle and its customers about amounts owed and paid. This could impact the internal control over posting of payments at Pinnacle and whether the money is being diverted through fraud. Inventory has grown from slightly over $25 Million at year-end in both 2009 and 2010 to more than $32 Million in 2011. Growing inventory could be indicative of inventory obsolescence. Obsolete inventory would be subject to a write-down in value. We would want to explore these areas.
We have identified Inventory as an area of possible misstatement for Pinnacle. Short/Current Long-term debt has increased from 2009 and 2010 levels in 2011. In 2009 and 2010, the short/current portion of long-term debt was only $41,070. In 2011 it had increased to almost $4 Million. We are concerned that a misstatement has occurred. If the amount is correct, we would want to ascertain why the sudden increase. If it is due to a scheduled one-time balloon payment being due it is less of a concern than if a loan has been accelerated due to default or failure to meet certain loan covenants.
The long-term solvency of Pinnacle depends on the success of its operations to raise capital for future growth and expansion as well as its ability to make payments on its debts. If Pinnacle is in default and a loan has been called or accelerated it would negatively impact the Company’s ability to borrow in the future. ? Part I. h – Going Concern Issue We assess the likelihood that Pinnacle is likely to fail financially in the next twelve months as low. While many of the items discussed indicate that Pinnacle has some financial problems, its current ratio is still well over 1.
It might be holding some obsolete inventory but even obsolete inventory has some value to generate cash. In twelve months, if the Company does not resolve its growing inventory issues and possibly rework some of its debt deals, the decision might be different. Currently, sales are growing as is Income from operations and net income. The Company has a positive cash flow which buys it time to try to fix its underlying problems. Inattention to these details could cause us to revisit this question next year with a more dire answer.
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