Specialty Metals, Inc., a fast-growing company that makes metals for equipment manufactures, has an $800,000 line of credit at its bank. One section in the credit agreement says that the ratio of cash flows from operations to interest expense must exceed 3.0. If this ration falls below 3.0, the company must reduce the balance outstanding on its line of credit to one-half the total line if the funds borrowed against the line of credit exceed one-half the total line if the funds borrowed against the line of credit exceed one half of the total line.

After the end of the fiscal year, the company€™s controller informs the president; €œwe will not meet the ratio requirements on our line of credit in 2010 because interest expense was $1.2 million and cash flows from operation were $ 3.2 million. Also, we have borrowed 100 percent of our line of credit. We do not have the cash to reduce the credit line by $400,000.€

The president says, €œthis is a serious situation. To pay our ongoing bills, we need our bank to increase our line of credit, not decrease it. What can we do?€

€œDo you recall the $500,000 two-years note payable for equipment?€ replied the controller. €œIt is now classified as €˜Proceeds from Notes Payable€™ in cash flows provided from financing activities in the statement of cash flows. If we move it to cash flows from operations and call it €˜Increase in Payables,€™ it would increase cash flows from operation to $3.7 million and put us over the limit.€

€œWell, do it,€ ordered the president. €œIt surely doesn€™t make any difference where it is on the statement. It is an increase in both places. It would be much worse for our company in the long term if we failed to meet this ratio requirement.€

What is your opinion of the controller and president€™s reasoning? Is the president€™s order ethical? Who benefits and who is harmed if the controller follows the president€™s order? What are management€™s alternatives? What would you do?

Transcribed Image Text:

Enron Corporation Statement of Cash Flows For the Nine Months Ended September 30, 2001 and 2000 (In millions) Cash Flows from Operating Activities Reconciliation of net income to net 2001 2000 cash provided by operating activities Net income Cumulative effect of accounting changes, net of tax Depreciation, depletion and amortization Deferred income taxes Gains on sales of non-trading assets Investment losses Changes in components of working capital $ 225 $ 797 (19) 746 (134) 9 (49) (135) 0 768 Receivables Inventories Payables Other 987 3,363) 339 (1,764) 2,899 464 (455) Trading investments Net margin deposit activity Other trading activities (2,349 541 Other, net Net Cash Provided by (Used in) Operating Activities Cash Flows from Investing Activities 173 (555) 198 (566) 753) $ 127 Capital expenditures Equity investments Proceeds from sales of non-trading investments Acquisition of subsidiary stock Business acquisitions, net of cash acquired Other investing activities $11,584) $(1,539) 1,172) (858) 1,711 0 (485) (82) 773) (239) (147) $11,366) $3,580) Net Cash Used in Investing Activities Cash Flows from Financing Activities Issuance of lona-term debt Repayment of long-term debt $4,060 2,725 3,903) (579) 2,365 1694 182 Net increase in short-term borrowings Issuance of common stock Net redemption of company-obligated 199 preferred securities of subsidiaries Dividends paid Net (acquisition) disposition of treasury stock Other financing activities (95) 394) (396) (398 354 149)(12) $1,880 $ 3,873 (239) s 420 Net Cash Provided by Financing Activities Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Period Cash and Cash Equivalents, End of Periad 1,240 1,001 S 753