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There were many compounding factors that caused SureCut Shears to be unable to pay its bank loan by March 31, 1996. When looking at the pro forma income statement as compared to the actual income statement we see the following inconsistencies, which are contributing to SureCut’s financial problems: AnticipatedActualDollar Loss Contributed
COGS (% to Sls)70.5%73.8% 768
Gross Profit (% to Sls)29.5%26.2%
SG&A Expenses (% to Sls)9.4%10.6% 269
Total dollar loss contributed by increase in expenses 1,037 Total dollar loss contributed by decrease in sales 2,813
As expenses increase, profits are squeezed and SureCut continues to pay dividends at the same rate and amount, further squeezing the retained earnings, and thus net income of the company. In total over the nine months, the percentage increase in COGS and SG&A expenses contributed to over a $1 million loss based on the actual sales during that time.
In addition the case refers to a plant modernization program, which is claimed to be the reason for an increase in needed funds. However, when examined more closely, the plant modernization project was supposed to create efficiencies that would save $900K in manufacturing costs (to show up in COGS). If we look at the overall increase in actual COGS through March vs. the anticipated amount, we find that this savings of 3% is not realized and the process has actually reduced in efficiency.
By looking at the pro forma balance sheet compared to actuals through March we see this play out – actual cash on hand in March is $1.68 million lower than anticipated. Since SureCut did not make financial adjustments to their payables or receivables period to increase cash flow, this loss directly contributed to their inability to pay the $1.25 million loan at the end of March.
To assess the financial situation of SureCut Shears we examined a few
financial ratios. Based on our assessment, SureCut Shears’ financial situation has definitely declined and Mr. Stewart should be concerned.
Before discussing ratios, we looked at the trend over time of sales and inventory, as seen in Exhibit 1.
As you can see, sales drop off of forecast in September/October, but it doesn’t appear that SureCut dynamically changes their production and inventory strategy. Instead of the difference of actual vs. anticipated inventory dropping with sales, it increases. As a result, inventory continues to build and sales soften, causing cash to be tied up, and preventing SureCut from paying off their seasonal loans. This is seen in the financial ratios listed in the chart below as well.
ROE9.2%5.5%(Common Stock + Earned Surplus)/Net Income
Asset Turnover24.3%23.4%Average Sales/Current Assets
Inventory Turnover30.7%25.6%Average COGS/Ending Inventory Current Ratio 7.89 5.75 Current Assets/Current Liabilities Acid Test 3.49 1.87 (Current Assets – Inventory)/Current Liabilities Days Sales in Cash 28.85 8.74 Cash in March/(Annual Sales/365)
Together these ratios reinforce the issues discussed above. Without making changes to financial policy, SureCut Shears continues to increase liabilities while sales decline, inventory grows, and cash dwindles down to only 8.74 days sales in cash in March 1996. If Mr. Stewart were paying close attention to these ratios compared he would be concerned that SureCut hasn’t changed its financial policy to accommodate, other than requesting to borrow more money. In short, Mr. Stewart should not lend additional dollars to SureCut given the financial situation.
All three cases, SureCut, Play Time Toys, and Wilson Lumber had cash flow problems that contributed to the financial trouble our protagonists found themselves in. As a result of the cash flow problems, the owner of the company in each of the cases requested a loan from the bank in order to support the continued operations of his business. However, the reasoning behind the requested funding and the risks and returns associated with its fulfillment varied in each of the cases examined. For Wilson Lumber, the company was experiencing rapid growth and the nature of the business (long cash cycles and low profit margins) necessitated that Mr. Wilson secure outside funding to finance its growth. Wilson Lumber is an established business with 10 years of profitable returns in a non-seasonal industry that has little volatility in sales and is relatively unaffected by swings in the economic state of the nation. These characteristics differentiate Wilson Lumber from the other cases discussed and impact the options available to Mr. Wilson in terms of outside funding. Mr. Wilson had previously been relying on extended trade credits as a means of financing. However, by extending the life of the trade credits, Mr. Wilson was not only increasing his cash cycle but also running the risk of financing his payables at a much higher rate than obtaining a bank loan. Mr. Wilson was therefore left to decide how to finance his growing company, something his narrow profit margins left him unable to do on his own. The tradeoff between the two sources, bank loans and extended trade credits, ultimately depended on the rate of borrowing and the impact this decision would have on his business and supplier/customer relationships.
Both Play Time Toys and SureCut have seasonal sales periods which greatly affect the cash flow cycle of the business. Mr. King from Play Time Toys is trying to find a way to increase profit by maintaining a level production throughout the year. For Play Time Toys, the seasonality of the manufacturing and production process meant that equipment was left idle or underutilized during the off-seasons while labor expenses and wages spiked during peak seasons. In order to level production, Mr. King needs outside funding because the dismal sales during the off-season are not enough to finance level production during this time. In order to obtain this outside funding from the bank, Mr. King needs to forecast future sales and purchases to demonstrate reasonable need and recovery of the requested loan amount. However, forecasts in a seasonal industry carry great risk of volatile returns especially when stockpiling inventory for goods largely dependent on the state of the economy and consumer trends. Play Time Toys must consider this risk in terms of the company’s investment because in addition to the bank loan the company will need to partially finance the increases to inventory by using its excess cash. Mr. King needs to consider the trade-off between the savings (increased profit) from level production and the interest payments, reduction in marketable securities income and increase in storage costs resulting from its implementation. While the financial tradeoff between these scenarios can be estimated given the forecasted sales and expenses the greater risk lies in the forecasted numbers themselves. SureCut Shears is an example of how the inability to meet forecasted totals can have disastrous effects on the long term profitability and viability of the company as a whole well beyond any anticipated savings.
The nature of the financial problems SureCut Shears is facing stem from a failure to meet the sales and profit forecasts that it submitted to the bank and its resulting inability to pay back the loan amounts. Similar to Play Time Toys, SureCut Shears operates in a seasonal industry and its forecasted sales fell short of expectations. However, in addition to decreased revenue SureCut Shears also failed to maintain its profit margins and control costs in the face of declining sales. The impact of the sales forecast on SureCut Shears financials was extensive because the company decided to maintain a level production throughout the year. To finance this decision the company increased its liability by taking out bank loans to fund the production of inventory during months when revenues were low and future earnings were uncertain. The original choice to maintain level production, a risky move in itself for a company in a seasonal industry, was compounded as SureCut increased borrowing amounts and inventory levels (above the “level limit”) despite the repeated inability of the company to meet its sales targets month after month. As a result, the company has been left with a stockpile of inventory (its largest current asset), decreasing profit margins and unreliable forecasts. SureCut Shears has been made riskier in the eyes of the lending bank and is therefore not expected to be able to maintain its current borrowing limits.