Lecture 7-Toy World

COMM 371, Lecture 7

COMM 371, Lecture 7

Lecture 7: Financing Seasonal Needs - Toy World, Inc. • Objectives:

Case Facts • Highly seasonal sales (80% of sales between August and November)

• To understand the pattern of current assets and cash flows in a company with seasonal sales, and how these are affected by the choice of production plan

• Current production follows sales, and thus is highly seasonal.

• To understand the trade-off between profitability versus risk and liquidity in choosing between level and seasonal production

• Question: should the company smooth production over the year? • Examine pro-forma monthly statement of cash flows for 1994, constructed with base on pro-forma tables reported by company

• To practice the mechanics of basic financial analysis What is it that we are trying to help Mr. McClintock with?

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COMM 371, Lecture 7

What we will do

COMM 371, Lecture 7

The Current (Seasonal) Production Plan

• Assess Toy World’s need for external financing under its current (seasonal) production plan. Discuss the timing, magnitude, and duration of borrowing needs, and risk. • Assess Toy World’s need for external financing under the proposed level production plan • Conceptual discussion

Production is approximately equal to sales (production in response to customer orders). Cost and benefit of the seasonal production plan: • Inventory • Inventory is minimized and the funds necessary to finance inventory is minimized. • Inventory risk is minimized. • Costs • Overtime premiums in high season (reduces profits) • Difficulty in scheduling production runs & shorter production runs • Fixed capital is underused part of the year and then run to capacity

• The mechanics of preparing the pro forma income statement and balance sheet • Would a bank be likely to provide the financing necessary under the smooth production plan?

• Seasonal financing requirements • Primarily receivables financing during the collection lag after the months of peak sales (lag is 60 days) • The firm stays comfortably within its current credit line (it is owing $752 thousands at the end of 1993, and the bank is willing to extend a credit line of up to $2 million in 1994) • Cash balance stays at a minimum required to finance operations

• Would you recommend adoption of the level production plan? • Cost savings versus risks

See pro-forma IS and BS for seasonal production plan

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COMM 371, Lecture 7

COMM 371, Lecture 7

Level Production Plan Analysis of pro-forma financial statements

• Benefit o Eliminates overtime premiums

• Net income is much higher under level production ($519 vs. $351)

o Other direct labor costs savings

• Level production dramatically increases financing needs

• Cost o Higher inventory and handling cost o Need to commit funds to finance inventory accumulation in the off season

• The required financing exceeds the maximum credit available ($2 million) for all months in the period June-November. • Maximum financing needed in September doubles the available credit

• Main issues: • Actually, most critical month is July

o What is the financing need under level production?

o Current assets are mostly inventory in July, whereas for September accounts receivable increase substantially. o The risk of not collecting is less than the risk of not selling!

o Is the current credit limit enough to cover this need? o Are there any risks involved in level production?

• Examine inventory cycle • So level production is more risky (can end up with unsold inventories) and requires more financing (now yet available)

Construct MONTHLY Pro-forma Financial Statements

• Look more in detail at the advantages of level production!

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COMM 371, Lecture 7

• Cost Savings of Level Production

COMM 371, Lecture 7

Under level production:

(compare pro-forma statements level vs. seasonal production plans)

• If estimates are right, net income increases by almost 48% • Requires much more bank financing

Overtime Premiums Other labor savings Net labor savings COGS

225,000 265,000 490,000

Increase in interest expense Reduction in interest income Increase in storage costs Op. Exp. Combined cost

105,000 = 200-95 17,000 = 28-11 115,000 = 2515-2400 in

Net pre-tax savings

253,000

= 7000-6510 cut in

• Required bank borrowing from June to November is above the $2 million limit set by the bank. • So loan renegotiation is needed. Need to convince the bank that the firm can repay the loans.

237,000

Taxes (34%)

86,020

Net savings

166,980

• Higher risk: if sales forecasts were not accurate, then the firm may end up with unsold inventory (dollar sales of particular products can vary 30-35% from year to year), while having to repay a larger loan. • From the bank’s perspective, the firm becomes riskier. • However, Toy World is approaching full capacity during seasonal production peak. The adoption of level production postpones the need for additional investment in fixed assets.

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COMM 371, Lecture 7

COMM 371, Lecture 7

• Are there any alternatives? • Should the bank extend the loan?

• Sell receivables or offer them as collateral for a bank loan. Also tighten credit policy to customers to induce quick repayment.

• The firm needs a credit line of up to $4 million in order to finance level production

• However, in July when financing needs are highest, accounts receivable are only $300, so not much collateral can be offered.

• Plus: firm financially healthy. Even if the firm absorbs inventory losses for one year, it can repay early in the next year.

• Tighter credit to customers can reduce sales….

• Minus: substantial increase in firm risk. If sales forecast is not correct, the accumulation of inventories can wipe out the cost savings

• How about asking suppliers for an extension of payment time?

• Trade-off between profitability and liquidity o Level production increases profitability o But involves the risk of committing funds to inventory in an amount that exceeds the firm equity!

• However, AP are $250 per month, so even if credit is extended to 90 days, this would only generate payables of $750. Would suppliers extend credit? • A production plan half way between seasonal and level production.

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