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Topeka Case Study
While it may be true that the retained earnings of the company provide a large amount of cash for future endeavors, there are several issues with using this cash to fund the necessary expansion efforts. First, this cash might simply be inadequate when it comes to funding the entire expansion, second, such a use would significantly impair the company's ability to operate if a supplier disruption or major payment issue arose, and third, this cash represents the only return on investment for the company's owners and stakeholders. All of these reasons make the securing of at least some external funding preferable.
1996 Pro-Form Income Statement
Cost of sales (assumes 31% gross margin)
income Before Taxes
Income from Operations
It is assumed 40% of sales will be collected on a net 30 basis, with 80% on-time payment, and that 60% of sales will be made on a net 45 basis with 90% on-time payment. The average collection period for on time payments can thus be calculated as (.4x.8x30)+ (.6x.9x45)=33.9. Assuming that late payments are made within thirty days of the payment due date, late payment schedules can be calculated as (.4x.2x60)+(.6x.1x75)=9.3, bring the total average expected accounts receivable period to 43.2.
With an expected average receivables period of 43.2 days on $1,933,100 receivables at the end of a 360-day year, total receivables at the end of the year could be estimated as $214,789.
The purchase estimate for 1996 is based on the cost of goods ($1,333,839) plus beginning inventory ($149,500) less ending inventory (which has been a fairly consistent 13.9% of cost of goods, and can be estimated at $185,404), for a total of $1,297,935.
Assuming 1/3 of all payments are made on a 2/10 net 30 basis and the remaining 2/3 will be made on a net 30 basis, the average payment period will be (.33x10)+(.66x30)=23.1.
In a 360-day year with $1,333,839 in purchases and an average payment period of 23.1 days, the average level of payables would be $57,742.
1996 Pro Forma Balance Sheet
Total Current Assets
Gross fixed assets
Liabilities and equity
Total Liability & Equity
It is possible that no additional funds (form external sources) will be necessary in 1996, as projected sales are not hugely different from 1995's actual sales. It is in 1997 and 1998 that funds will be required to expand operations. Funding that equals the cost of goods sold, other operational costs, and debt payments (in the neighborhood of $1,600,000) should be sufficient
While reducing the cost of goods sold/inventory ratio would provide for a freer cash flow and thus ease concerns regarding operating capital, it would not present a significant cost savings and is thus not a point of essential consideration in the projection of these pro forma documents.
In 1995, approximately 95% of sales revenue was needed to cover all operating expenses and debt payments. 95% of 1996's expected sales revenue ($1,933,100) is $1,836,445.
The answers in 6(b) and & ought to be (and are) fairly similar; some discrepancy exists as it was not possible to adequately project administrative costs with the information given, and this expense is thus left out of the pro forma cash flow statement for 1996.
Saving money tends to make sound financial sense in the long run for any company, and as long as operational expenses can be met with early payments the discount received is certainly worthwhile. If the company has to borrow at a rate of higher than 2% on a regular basis in order to make payments within 10 days to its suppliers, however, then this does not make financial sense during the growth period. For 1996, continuing to make 10 day payments and receive the discount is definitely sensible.
Extending 15 days of extra credit makes sense at the current time, though after expanding (when a sale of this size will make up a smaller percentage of total revenue), establishing a stricter credit scheme would be advantageous.
Repeat of Bank Analysis
Current Ratio: 1.9 (contractual obligation=2.0)
Quick Ratio: .77 (contractual obligation=1.0)
Debt Ratio: 68.2% (contractual obligation=5.5)
The banks analysis of SDI's current position is quite accurate, and the huge debt ratio is especially disturbing.
If the company can secure the financing for its expansion project and meet projected sales increases and cost savings, sales revenue will increase to $330,386 in 1996 at a cost of goods of $274,200, and in 1997 to $371,684 at a cost of $297,347. The rise in short-term interest rates will not significantly affect earnings figures as long as administrative and selling expenses are reigned in over this period; there is not much room for these to grow proportionately with sales if the company wishes to achieve a better financial position, however.
Historical Analysis and Current Position
Though it is true that the company currently carries far more debt and other liabilities than it ought to for its own health and for the bank loan, owner's equity in the firm has risen considerably in the past few years despite economic troubles, meaning that the company is still profitable if precarious. The price cutting and credit extensions the company has been offering are largely responsible for the position SDI currently finds itself in, and as an elimination of these policies is included in the expansion plan it seems that a turnaround is quite possible.
Sales have been rising during this period as well, but administrative/selling and miscellaneous expenses have also risen considerably and interest payments have climbed far more so, reducing profitability significantly. Borrowing as a means of solving this problem might be seen as throwing good money after bad for the bank; the increase in loa acquisition has not demonstrably been used by the company to generate greater revenue and cash flow, but has actually arguably been detrimental to the company. From a historical financial analysis, the new loan request is likely to be denied; SDI will need to present a very clear line of reasoning as to why this loan is different and how it will help reshape the company into a more solvent and financially reliable business entity and potential debtor.
Pro Forma Balance Sheet (in thousands)
Total Current Assets
Gross fixed assets
Liabilities and equity
Total Liability & Equity
Unfortunately, the projected amounts are very sensitive to changes in line items such as the administrative expense rate, the cost of good sold, and the sales growth rate. Previous years have shown that there is no a great elasticity in demand, and thus it is unclear that the ability to increase production would actually increase sales revenue at the rate of growth projected -- it is possible that sales can only continue to grow at or slightly higher than the current growth rate, and any disturbance in the industry could lead to a reduction in sales rather than an increase regardless of increased production capacity. This greatly affects the cost of goods sold, as well; the projected numbers take into account not only the efficiency of the new processes available following the planned expansion of SDi's production facilities, but also (presumable) take into account…[continue]
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