Michael Stewart, Senior Loan officer, Hudson National Bank of New York
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Michael Stewart, Senior loan officer, Hudson National Bank of New York
From:
Date:
February 12, 2006
Subject:
Credit analysis for SureCut Shears, Inc
Introduction
SureCut Shears, Inc. is a manufacturer of household scissors and industrial shears. Because of a policy of level production and a seasonal sales pattern, the company has to borrow funds under a line of credit to cover its seasonal buildup in inventory and receivables. During 1995-96, sales began to fall from projected levels due to a retailing downturn. However, the company may have been slow to react resulting in an accumulation of excess inventory and related inability to repay its bank loan prior to the next seasonal increase in demand. We were given both forecasted and actual financial data.
A diagnosis of why the company cannot repay its bank loan should be made to decide whether to renew the outstanding loan.
The following is the course of loan requests from SureCut during 1995-96:
June 1995 – $3.5 million – Until December 1995
Another $1.2 million by June 1996 (For Plant modernization – finish est. August 1995)
September 1995 – Additional $0.5 million until December 1995 (Total $1.25 million)
January 1996 – Extending loan funds until April 1996 (retailing downturn sales down)
April 1996 – Extending until June 1996 (again, retailing recession)
The plant modernization program is, in essence, a long term investment, and is expected to return $900,000 per year ($75,000 per month) in manufacturing costs.
Pro Forma Assumptions
It is obvious that Mr. Fischer made wrong assumptions when constructing the pro forma financial reports. He assumed that sales would continue to be steady, while actual sales were about 86% of the forecast.
In a retrospective view it was not hard to forecast decrease in sales in 1995 and 1996 as US economy was in a recession. Failing to take this consideration into account led to unrealistic forecast of sales volumes. An example of widely available recession forecast is mentioned in the following example:
“In Octobr [1995], the first month of the fourth quarter, retail sales fell 0.2 percent and industrial production fell 0.3 percent. With relatively high consumer debt loads and weakened consumer spending, early indications are that a somewhat below average Christmas selling season will have resulted. 1996 forecast: look for more of the same.”
Taken at Feb 12 2006 from:
Inventory Management
Another crucial factor that led to the current state of the company was the inability to respond quickly enough to changes in demand. Inventory levels of raw materials, work in progress and finished goods remained more or less steady during the whole period (July 1995 to March 1996). Actually, a careful examination shows that the company ended each month with more inventories that was forecasted when at the same time sales were approximately 86% of the same pro forma forecast. This shows us that inventory-wise the company did not react at all to the recession. This is not a case of slow response, but a case of no response at all.
Cash Budget Analysis
For the cash budget analysis we will forecast SureCuts expected cash requirements for the remainder of 1996. To achieve that, we have assumed the followings:
Due to the continued recession, project sales are at 86% of previous monthly projections. Recession is assumed to begin at Sep 1995 and is calculated as an arithmetic average of previous months beginning in Sep 1995.
Actual materials and labor costs are assumed to be 60% of the sales. Actual overhead costs as well as S&A costs are assumed to be the arithmetic average of previous months since Sep 1995.
On the balance sheets we took cash, accounts receivables, net plant, accounts payable (trade), misc. liabilities, mortgage, and common stocks from the pro forma balance sheets as we did not see any significant differences.
Purchases of raw material for April to June are assumed to be the same as in March because peak season will not start before next month (July).
Bank Loans Payable was calculated as the following: Total Assets – (Accounts Payable + Taxes + Misc. Liabilities + Mortgage + Common Stock + Earned Surplus)
As shown at the expected Income Statement that appears in the first appendix, at the end of June 1996 the company will have $895,000 in retained earnings. This sum is not enough even to liquidate the bank loan which principal is $1,250,000. Appendix 2, concerning the balance sheets, reveals that by the end of June total bank loan payable would be $3,692,000. This liability shows that SureCut would encounter a great deal of difficulty repaying the loan to the bank on time. Also, to keep producing to meet peak season demand, the company would have to borrow an additional loan.
The combination of the retailer recession as well as the timing of the new investment in the plant deteriorated the company to the current condition. Also, the firm faces the prospect of still larger borrowing in the near future as part of its normal seasonal buildup.
Recommendations
As SureCut is in a bad shape and is failing to liquidate its loans on time, it is highly recommended not to pay dividends starting in June 1996 and until the company pays its debt. Not paying dividend in June 1996 will cause cumulative retained earnings to be $1,195,000. Also we will project accrued taxes carefully; if taxes paid exceed the tax liability, we will not make a payment. That happens in June 1996, no tax payment in that month would reduce bank loans payable to $3,149,000.
The current collections lag sales is 45 days while payments paid by the company are 30 days. Reducing collections lag sales to 30 days would improve the companys cash flow.
Although SureCut is experiencing decreasing sales and lower retained earnings recently, we must take into account the following:
The peak season begins next month and sales are expected to go up.
The recession