Sure Cut Shears

Finance Theory II (15.402) Spring 2009 Carola Frydman

The Big Picture: Part I Financing

A. Identifying Funding Needs Case: Wilson Lumber 1 Case: Wilson Lumber 2 Case: PlayTime Toys Case: Surecut Shears B. Optimal Capital Structure: The Basics Lecture: Capital Structure 1 Case: Massey Ferguson Lecture: Capital Structure 2 Case: Marriott C. Optimal Capital Structure: Information and Agency Lecture: Asymmetric Information and Agency Costs Case: Intel Case: MCI Communications

2 Finance Theory II (15.402) Spring 2009 Carola Frydman

SureCut: Motivation
End of April, Mr. Stewart is going to Savannah. Why?
Whats problem here?
Whats purpose of trip?

3 Finance Theory II (15.402) Spring 2009 Carola Frydman

SureCut: Setup

Complete line of scissors and shears
Severe competition, particularly from overseas
Sales/profits grown steadily, if not dramatically
Level production, seasonal sales pattern
Short term borrowings July Dec
Borrowing for working capital

4 Finance Theory II (15.402) Spring 2009 Carola Frydman

History
6/95: 3.5M line of credit
Anticipated paid off by 12/95 9/95: Call
Need 500K more primarily plant modernization plan 1/96: Call
Havent paid because of sales decrease
Unable to pay until 4/96 4/96: Call
Unable to pay before seasonal requirements startup

5 Finance Theory II (15.402) Spring 2009 Carola Frydman

Why No Repayment?
Why cant they repay as forecast? Compare Exhibit 2 and 4:
Need 500 more in Sept. (3714 vs. 3270 forecast)
Need 1256 more in March (1256 vs. 0 forecast) In Sept. says that its the plant:
Potential Overruns
Is it? Compare PPE:
Forecast 27554 27554 Actual 27848 27812 Difference 294 258

Sept March

So not really just plant

6 Finance Theory II (15.402) Spring 2009 Carola Frydman

Why No Repayment?
Compare differences between actual outcomes and forecasts for:
Start with I/S
Then do B/S
Finally: Quasi Sources and Uses

7 Finance Theory II (15.402) Spring 2009 Carola Frydman

Income Statement: Actual vs. Forecast (2)

Bottom Line:
Sales down by 11%
Gross Profit down by 21%
Is this an indication of poor management?
Operating Leverage!
Overhead constant and sales decrease
Similar in spirit to effect of financial leverage which well get to

8 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet: Actual vs. Forecast

Should compare month by month.
Going to focus here on one point in time: 3/96
Other months calculated in similar manner

9 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet: Actual vs. Forecast

Cash A/R Inventory NetPlant Total Assets Forecast 2371 2850 6588 27,554 39,393 Actual 688 2867 7374 27,812 38,741 Difference -1683 17 786 258 -622

Bank Loan A/P Taxes Payable Misc Mortgage CS NW Liab+NW

0 777 449 270 11,661 11,500 14,706 39,393

1256 514 -127 258 11,661 11,500 13,679 38,741

1256 -263 -576 -12 0 0 -1027 -622

Why is the difference column not a pure Sources/Uses statement?
How should we interpret this table?
10 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis
Inventory (Asset)
In 6/95 Inventory is 8106
Forecast for 3/96 is 6588
Was supposed to be source of 1518 But in 3/96, Inventory was 7374.
So actual source of only 732 1518 732 = 786 less of a source than expected
Asset higher than expected; Didnt go down as much
MUST FUND THIS SHORTFALL!

11 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (2)

Net Plant (Asset)
In 6/95 Net Plant is 24,564
Forecast for 3/96 is 27,554
Was supposed to be use of 2990 But in 3/96, Net Asset was 27,812.
So actual use of 3248! 258 more of a use than expected
Asset higher than expected
MUST FUND THIS SHORTFALL!

12 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (3)

AP (Liability)
In 6/95 AP is 861
Forecast for 3/96 is 777
Was supposed to be use of 84 But in 3/96, AP was 514.
So actual use of 347! 263 more of a use than expected
MUST FUND THIS SHORTFALL!

13 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (4)

Cash (Asset)
In 6/95 Cash is 2121
Forecast for 3/96 is 2371
Was supposed to be use of 250 But in 3/96, Cash was 688.
So actual source of 1433! Supposed to be use of 250 but was actually a source of 1433
ADDITIONAL SOURCE OF 1683!

14 Finance Theory II (15.402) Spring 2009 Carola Frydman

Summary of Funding Shortfall

Funding of Shortfall Cash 1683 Bank 1256 Source of Shortfall AR 17 Inv 786 Plant 258 AP 263 Taxes 576 Misc. 12 NW 1027 2939

TOTAL

2939

Source of Shortfall: Higher Assets and Lower Liabilities Funding Shortfall: Lower Assets and Higher Liabilities
15 Finance Theory II (15.402) Spring 2009 Carola Frydman

Is Management at Fault?
Sales decrease 11%, Profit decrease 21%
Recall operating leverage argument How soon could they have forecasted decrease in sales?
In September sales down only by 7%
By October down by 10% How about purchases?
Purchases forecasted at 777 per month
Actual purchase of raw material greater than forecast until December!
By then sales off by 15% Dont cut labor until February
16 Finance Theory II (15.402) Spring 2009 Carola Frydman

Consequence
Whats the result of all this? Lower sales, even labor, higher purchases
Inventory!
Total Inventory Mar-96 Jan-96 Forecast 6588 5818 Actual 7374 6925 Difference 786 more 1107 more

Finished Goods Mar-96

Forecast 2701

Actual 4171

Difference 1470 more

17 Finance Theory II (15.402) Spring 2009 Carola Frydman

Did Fisher Know? Whats Going On?

9/95: Need 500K more primarily plant modernization plan
Plant 294 more (27,554 vs. 27,848) 1/96: Bank loan supposed to be 0
Actually 1376 (Pay you in April)
(But loan down from 2279 in December) 4/96: Unable to pay before seasonal requirement startup
1256 loan at end of March Whats going on?

18 Finance Theory II (15.402) Spring 2009 Carola Frydman

Response Rate?
Were they slow to respond? Fairly clear that sales decrease by October
But purchases more at first, and decreases purchases below forecast only in Dec.
Maybe getting discounts due to recession deal? Labor decreases in February
Slow?
Layoffs in Christmas
Layoffs of skilled workers in face of temporary fluctuations in demand may not be best idea

19 Finance Theory II (15.402) Spring 2009 Carola Frydman

What do they do now?

Can they get back on track? Currently, as of March:
Sales 83% of forecast
Labor 83% of forecast
Purchases 67% of forecast
Inventory 112% of forecast

CAN THEY REPAY LOAN???

20 Finance Theory II (15.402) Spring 2009 Carola Frydman

Loan Repayment
Going to do an 85% of Proforma analysis
Can they repay the loan if sales are set at 85% Proforma?
Where did we get 85%? Other Assumptions:
AR, AP, Inv at 85% of PF
SGA unchanged
Taxes 36%
Dividend not cut

21 Finance Theory II (15.402) Spring 2009 Carola Frydman

85% Pro Forma Income Statement

Forecast 85% CGS (60%) Overhead SGA PBT Taxes (36%) PAT Dividends Ret. Earnings CumRetEarn April 1500 1275 765 300 270 -60 -22 -38 0 -38 -38 May 1200 1020 612 300 270 -162 -58 -104 0 -104 -142 June 1500 1275 765 300 270 -60 -22 -38 600 -638 -780 July 2100 1785 1071 300 270 144 52 92 0 92 -688 Aug 2700 2295 1377 300 270 348 125 223 0 223 -466 Sept 3300 2805 1683 300 270 552 199 353 300 53 -412 Oct 4500 3825 2295 300 270 960 346 614 0 614 202 Nov 3900 3315 1989 300 270 756 272 484 0 484 686 Dec TOTAL 3300 24000 2805 20400 1683 12240 300 2700 270 2430 552 3030 199 353 300 53 739 1091 1939 1200 739

Taxes Payable 3/96 (-127)

-149

-207

-229

-177

-51

147

493

765

491

22 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet 12/96

Assets Cash AR Inv Plant Plug 4463 4695 27812 Liabilities+NW Bank Loan AP Taxes Payable Misc Mortgage C/S Earned Surplus Plug 660 491 270 11,063 11,500 14,418

36,970 + Cash

38,420 + Bank Loan

Note: Ignored Interest Payments

23 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet 12/96

Assets Cash AR Inv Plant 1432 4463 4695 27812 Liabilities+NW Bank Loan AP Taxes Payable Misc Mortgage C/S Earned Surplus 38,420 + 0 0 660 491 270 11,063 11,500 14,418

36,970 + 1432

Can pay off loan at 85% easily. What did we miss?

24 Finance Theory II (15.402) Spring 2009 Carola Frydman

What did we miss?

Inventory
Assume inventory at 85% of PF, but have all this inventory we need to get rid of!
Actual inventory in 3/96 is 7374, while forecast was 6588 which at 85% is 5600
Actual inventory is 1774 more than 85% forecast

How fast pull inventory down?
Inventory 12/96 @ 85% = 4695
Work of excess by:
Cutting purchases and labor

25 Finance Theory II (15.402) Spring 2009 Carola Frydman

Inventory
End Inv = End Raw Materials + End Work in Process + End Finished Goods End RM. = Beg RM + Purchases Trans. to Work in Process End W in P = Beg W in P + Trans. to W in P + Labor Trans. to Finished Goods End FG = Beg FG + Trans. to Finished Goods - CGS End Inv = Beg RM + Purchases + Beg W in P + Labor + Beg FG CGS End Inv = Beg Inv. + [Monthly Purchases + Labor] - CGS

26 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory

End Inv = Beg Inv. + [Monthly Purchases + Labor] - CGS
Beginning Inventory = 7374
CGS @ 85% Pro Forma 3/96 - 12/96 = 12,240

So End Inv = 7374 + [Purchases + Labor] - 12,240

27 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (2)

Purchases and Labor at 100% forecast are 777 + 778 = 1555
At 85% thats 1322
Production process is about half-half materials and labor Say run production at 85% per month for 9 months
1322 x 9 = 11,898 Therefore
End Inv. at 12/96 = 7374 + 11,898 12,240 = 7032

28 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (3)

At 3/96: Labor at 646 (83%) , Purchases at 518 (67%)
Together at 1164 If run production at current rates (1164) for 9 months
1164 x 9 = 10,476
End Inv. = 7374 + 10,476 12,240 = 5610
That goodbut
But production not balanced at 50-50 between labor and purchases

29 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (4)

Want to get to end inventory of 4695
End Inv = 7374 + [Purchases + Labor] - 12,240
4695 = 7374 + [Purchases + Labor] - 12,240 Purchases + Labor = 9561 over period of 9 months
Per month = 1067
50,50 production implies Purchases and Labor of 531 At 3/96 Purchases are in ballpark of what we need but Labor is at 646 instead of 531.
Lay off workers (skilled employees issue)

30 Finance Theory II (15.402) Spring 2009 Carola Frydman

What about assuming 100% Pro Forma

Show that can still pay off loan! Higher profits but higher AR and Inventory Extra Inventory problem still exists but not as large

31 Finance Theory II (15.402) Spring 2009 Carola Frydman

What Does Banker Do Upon Arrival?

Wants to make sure that they bring production in line with sales. Afterwards, not much:
Especially when sees that theyve done all this analysis

32 Finance Theory II (15.402) Spring 2009 Carola Frydman

Did Banker Make a Mistake?

Make loan in June 1995; Peak in Sept of 3270 (pro forma)

Sep-95 AR Inv AP Tax Pay Loan Cash

Forecast 4650 7878 777 78 3270 736

Actual 4395 7963 843 (79) 3714 702

Only 28% of WC needs financed externally at peak Sept.

33 Finance Theory II (15.402) Spring 2009 Carola Frydman

Is Loan in Danger?

Mar-96 AR Inv AP Mortgage Plant Cash

Actual 2867 4171 514 11,661 27,812 688

Finished

Not really!

34 Finance Theory II (15.402) Spring 2009 Carola Frydman

Bottom Line
SureCut needs to weather downturn and undertake period of inventory readjustment. Purchases and production will be at lower rate than sales in order to bring finished good inventories in line.

After this readjustment, every reason to believe that Surecut will be able to continue with policy of borrowing from bank only for seasonal needs

65 Finance Theory II (15.402) Spring 2009 Carola Frydman

Comparisons
How would you compare Wilson, Playtime, and SureCut? Some ratios:

Wilson Current Ratio 1.6 NW/Assets 40%-45% Nature of Loan long-term Risk of Loan moderate-low

Playtime 3.12 65% seasonal moderate

SureCut 5.7 65% seasonal/cyclical low

This is the safest loan weve made!

36 Finance Theory II (15.402) Spring 2009 Carola Frydman

Summary
Talked about impact of expected case not occurring Mgt response to change in climate Sources and Uses
Look at shortfall
Both source of shortfall and funding of shortfall Pro Forma as forecasting tool
For Firm
For Bank Pro Forma as diagnostic tool
Production calculations
Ratio Analysis
37 Finance Theory II (15.402) Spring 2009 Carola Frydman