November 17, 1997

To: Engagement Partner

From: Audit Staff (Group 3: Michael Cohen, Alon Doitch, & Gavin Green)

Re: TCC, Inc.’s Financial Condition

This memorandum will address in detail the financial condition of Troubled Computer Company, Inc. (TCC). This memo will accomplish this goal by identifying significant trends, addressing the effectiveness of management’s corrective actions, and reviewing the alternative courses of action available to management.

Troubled Computer Company has been displaying several trends that should evoke ample concern regarding the immediate survival of the company. These disturbing trends can most clearly be highlighted by analyzing TCC’s liquidity ratios. Both the current and the quick ratios have been dropping steadily from what was a minimal level of working capital to a level that is now completely unacceptable. TCC’s 1992 current and quick ratio are both below one. That means that TCC actually has negative working capital. Its current liabilities are now greater than its current assets. These ratios demonstrate that TCC is in serious danger of either technical or actual insolvency within the new fiscal year (1993). The trend in these ratios is displayed in the following graph.

Whereas, the trends in the ratio between the current assets and current liabilities signal a danger for the company’s short-term operations, the trend in the ratio between its total assets and total liabilities signals a severe structural weakness under which no company can survive in the long run. Currently, TCC has total liabilities in excess of its total assets. In other words, a liquidation of all of TCC’s assets at book value would not yield enough cash to pay off its creditors. In light of TCC’s many recent write-downs of manufacturing assets, the sale of assets for much over book value is unlikely. Under these circumstances, it is needless to say that the stockholders would receive nothing. This is a situation that would not only raise the cost of additional capital, but rather, it is a situation that we believe would make additional procurements of capital either impossible or nearly impossible. The trend in the ratio of total liabilities to total assets can be viewed in the following graph.

The liabilities for TCC are now so great that its times interest earned ratio is now negative. Clearly TCC is a company that is in serious immediate danger. To answer the question of how much time TCC would have in a worse case scenario, we can turn our attention to its defensive interval ratio. This ratio has in fact been improving over the recent years as management has been decreasing TCC’s operating expenses. TCC now has a margin of safety of about 99 days in which it can pay its operating expenses without additional outside cash.

An analysis of the previous responses of TCC’s management to the crisis shows that they have in fact improved TCC’s inventory turnover ratio, improved its total asset turnover (because of its smaller asset base), and improved its collection of receivables (see the attached spreadsheet). Unfortunately, management has been unable to do anything about TCC’s underlying problems. The result has been that management has become more efficient at losing money! The main problem is that TCC has no products that are strengthening in the marketplace. We are in a period where mini-computers and the software that runs on them are becoming increasingly obsolete, and management’s decision to cut R&D expenses makes it impossible for TCC to get off of its sinking platform and onto another growth trend. The result has been continual restructuring of the company resulting in a severe decay in its total assets. Management’s retreat has been complicated by the fact that asset liquidations have not been successful at paying down liabilities, but rather, it has just been diminishing its equity. It can be seen on the attached spreadsheet that total assets have been diminishing at a far greater pace than has total liabilities.

This section will address the options available to TCC in light of its precarious position. These options are severely limited, because of TCC’s difficulties in obtaining additional financing. In order to make any meaningful turnaround for the company, TCC would need funds to discover and develop new products unrelated to the mini-computer. We believe that the only way that this would be possible would be with the cooperation of its existing creditors. Accordingly, an option for TCC is to go into negotiations with its current creditors in order to obtain a relaxation in credit terms, the avoidance of its current portion of long-term debt, and possible additional cash infusions if the creditors believe in management’s recovery plans. Another option would be to file for protection under Chapter 11 of the Bankruptcy Code. This would provide similar benefits to option number one, but it would make the process court supervised. It could also prevent minority creditors from blocking a potentially promising recovery plan. A final proposal of ours is to restructure one last time. This restructuring would end TCC’s product sales and only continue as a service organization. We believe that this option would return TCC back into a profitable but smaller company. All of these options would need much further analysis. Further analysis should also be directed at discovering additional options; however, we believe that in light of the severity of TCC’s financial condition, Chapter 11 bankruptcy protection will probably be the best option for TCC to take some time in the new fiscal year.

Thank you for the opportunity to let us be of service, and if you have any additional questions, then feel free to contact us at your convenience.

Sincerely,

The Audit Staff from Group #3.

What really happened:

A reorganization plan was confirmed by the Court about 13 month after the company entreed Chapter 11. The plan was developed with the help of the Creditor's Committee and had the following components:

1. The company restructured its business, electing to focus on networking, integrsted imaging and related office software. Abandoning proprietary systems, the company exited nonstrategic and unprofitable operations and formed alliances with other major hardware and software manufacturers.
2. The company was freed from a substantial portion of its leases and reduced its debt. $64 mil. Was saved by renegotiating or rejecting almost 200 leases. Corporate headquarters and other facilities were turned over to the mortgage holders. The company emerged smaller, more focused and more competitive. Employement was targeted at 6,000.
3. 30 million new shares were issued to holders of corporate debt.
4. Creditors controlled and selected the Board of Directors
5. Virtually all pre-petition creditors (trade, bondholders) converted to equity. Old banks were replaced by new banks.
6. The company became one of the least leveraged firms in the industry. This allowed other banks and new preferred lenders to step in and also made the stock more exciting.
7. Management and employees received about 10% of new equity. Significant financial incentives were provided to management.
8. All existing common stock was extinguished. 7.5 mil warrants were issued to former shareholders. The warrants, with a term of 7 years, 9 months, have an exercise price equal to 95% of the total allowed claim divided by the number of new shares issued in connection with the unsecured claims.
9. A private placement of $40 mil of preferred stock was issued to raise additional capital.
10. New working capital lines of credit equalling $60 mil. Were established in connection with the reorganization.
11. Certain priority claims were paid in cash, such as administrative expense (attorneys, accountants, advisors) and certain tax payments.
12. In accordance with the provisions of AICPA Statement of Position 90-7, Financial Reporting for Entities in Reorganization under the Bankruptcy Code, the company adopted fresh start reporting following confirmation of the plan. Under this reporting, the pre-petition debt was extinguished, the retained deficit was set to zero and a reorganization value credit representing fresh-start intangibles was recorded on the balance sheet. This amount will be amortized to expense in the years following confirmation of the plan.
13. The reorganization plan permitted the company to change its core business. It eliminated the mini-computer segment and concentrates on imaging and office systems.

The company's plan of reorganization was approved by the Court in September 1993. The company has continued to pursue its new business strategy. Emphasizing acquisition of companies in the netweork support industry. The company spent almost $68 mil to acquire companies in the networking, imaging and data storage industries in 1995. In July 1996, it announced plans to acquire a networking company for $206 mil.

For the nine month period following confirmation of its plan the company and positive cashflow of $34 mil. (after restructuring expenditures of $84 mil.) and operating income before amortization of the fresh start intangibles of almost $45 mil. Although it reported revenues of almost $1.1 bil. for the year ended June 30, 1996 (a 15 % increase over the prior year), the company continued to report net losses. The 1996 net loss, however, was only $600 000, compared to a loss of $61.3 mil. In 1995. The company reported that the losses are now primarily due to costs of acquisitions and it remains optimistic as revenues continue to grow.

For the year ended 6/30/1997, the company reported revenue of $1,268 mil., net income of $69.9 mil (EPS: $1.44 ). Unfortunately, $76.6 mil of net income were attributable to a gain on discontinued operations. However, for the third quarter (9/97) revenues of $312.2 mil. Resulted in net income of $11.1 mil. Things do seem to be improving.