Harry’s Hamburgers Ltd. (HHL) is a chain of fast-food restaurants. A few years ago, the company decided it didn’t want to own any new restaurants. Rather, when a new restaurant opened up, it is owned by a franchisee rather than the company. A franchisee is an individual investor who owns the land, building, furniture, and other assets and operates the restaurant. In return, the franchisee pays HHL a royalty fee, based on a percentage of sales, for the right to use the HHL name and products under a franchise agreement. If the franchisee needs funds to help build the restaurant, they can borrow money from HHL for a one-year period by signing a note receivable to HHL. Selected items from the 2021 HHL financial statements along with comparative amounts from 2020 are shown below (in thousands of dollars):

2021 2020
Cash $ 1,300 $ 2,900
Accounts receivable $6,000 $5,000
Less: Allowance for doubtful accounts 400 5,600 500 4,500
Notes receivable 2,700 2,000
Inventory at company-operated stores 1,000 1,100
Total current assets 10,600 10,500
Current liabilities 6,800 5,100
Net credit sales 60,000 50,000

Accounts receivables consist only of royalties receivable from franchisees. During 2021, accounts receivable amounting to $100,000 was written off.

The notes receivable are from franchisees, and are due within one year. During 2021, notes amounting to $1.5 million were received from new franchise operators and these are still outstanding. Also during 2021, notes of $800,000 were collected in full. A number of notes were dishonoured during the year, but the company’s new vice-president of finance believes that all of these are recoverable, so no allowance for doubtful notes was set up. In the past, no dishonoured note has ever been collected.

The Company’s bank requires HHL to maintain a current ratio of 1.5:1.

ROUND 1

(a) Based on the above information, calculate the company’s current ratio for 2021 and 2020. Does it currently meet the bank’s requirement?

(b) Reconstruct the Allowance for Doubtful Accounts and Notes Receivable accounts for the year 2021.

(c) Do you believe the allowance is adequate for accounts receivable? Explain.

ROUND 2
(d) Do you think that an allowance should be recorded for notes receivable? Why or why not? If you believe that an allowance should be set up, what amount should be recorded? (Hint: Calculate the amount of dishonoured notes)

ROUND 3
(e) Based on the above information, calculate the company’s current ratio for 2021 and 2020. Does it currently meet the bank’s requirement?

(f) If an allowance for doubtful notes was to be recorded based on your answer in Round 2, what would be the new current ratio? How do you think the bank would react to this?

ROUND 4
(g) Based on the information provided, as well as your answers in the previous rounds, do you think the liquidity of HHL has improved or deteriorated in 2021? Explain.