Sure Cut

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

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
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
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
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

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

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)
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
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
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.
Is Loan in Danger?
Mar-96 AR Inv AP Mortgage Plant Cash
Actual 2867 4171 514 11,661 27,812 688
Finished
Not really!
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
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!

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

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Finance Theory II (15.402) Spring 2009 Carola Frydman

The Big Picture: Part I Financing

2 Finance Theory II (15.402) Spring 2009 Carola Frydman

3 Finance Theory II (15.402) Spring 2009 Carola Frydman

4 Finance Theory II (15.402) Spring 2009 Carola Frydman

5 Finance Theory II (15.402) Spring 2009 Carola Frydman

So not really just plant

6 Finance Theory II (15.402) Spring 2009 Carola Frydman

7 Finance Theory II (15.402) Spring 2009 Carola Frydman

Income Statement: Actual vs. Forecast (2)

8 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet: Actual vs. Forecast

9 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet: Actual vs. Forecast

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

11 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (2)

12 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (3)

13 Finance Theory II (15.402) Spring 2009 Carola Frydman

Some analysis (4)

14 Finance Theory II (15.402) Spring 2009 Carola Frydman

Summary of Funding Shortfall

Finished Goods Mar-96

Difference 1470 more

17 Finance Theory II (15.402) Spring 2009 Carola Frydman

Did Fisher Know? Whats Going On?

18 Finance Theory II (15.402) Spring 2009 Carola Frydman

19 Finance Theory II (15.402) Spring 2009 Carola Frydman

What do they do now?

CAN THEY REPAY LOAN???

20 Finance Theory II (15.402) Spring 2009 Carola Frydman

21 Finance Theory II (15.402) Spring 2009 Carola Frydman

85% Pro Forma Income Statement

Taxes Payable 3/96 (-127)

22 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet 12/96

38,420 + Bank Loan

Note: Ignored Interest Payments

23 Finance Theory II (15.402) Spring 2009 Carola Frydman

Balance Sheet 12/96

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

What did we miss?

25 Finance Theory II (15.402) Spring 2009 Carola Frydman

26 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory

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

27 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (2)

28 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (3)

29 Finance Theory II (15.402) Spring 2009 Carola Frydman

Pulling down Inventory (4)

30 Finance Theory II (15.402) Spring 2009 Carola Frydman

What about assuming 100% Pro Forma

31 Finance Theory II (15.402) Spring 2009 Carola Frydman

What Does Banker Do Upon Arrival?

32 Finance Theory II (15.402) Spring 2009 Carola Frydman

Did Banker Make a Mistake?

Sep-95 AR Inv AP Tax Pay Loan Cash