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COMM 371, Lecture 7 COMM 371, Lecture 7

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

• Objectives: Case Facts

• To understand the pattern of current assets and cash flows • Highly seasonal sales (80% of sales between August and
in a company with seasonal sales, and how these are November)
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 • Question: should the company smooth production over the year?
production
• Examine pro-forma monthly statement of cash flows for 1994,
• To practice the mechanics of basic financial analysis constructed with base on pro-forma tables reported by company

What is it that we are trying to help Mr. McClintock with?

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COMM 371, Lecture 7 COMM 371, Lecture 7

What we will do The Current (Seasonal) Production Plan

Production is approximately equal to sales (production in response


• Assess Toy World’s need for external financing under its current to customer orders). Cost and benefit of the seasonal production
(seasonal) production plan. Discuss the timing, magnitude, and plan:
duration of borrowing needs, and risk.
• Inventory
• Inventory is minimized and the funds necessary to finance
• Assess Toy World’s need for external financing under the inventory is minimized.
proposed level production plan • Inventory risk is minimized.

• Conceptual discussion • Costs


• Overtime premiums in high season (reduces profits)
• The mechanics of preparing the pro forma income • Difficulty in scheduling production runs & shorter
statement and balance sheet production runs
• Fixed capital is underused part of the year and then run to
capacity
• 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)
• Would you recommend adoption of the level production plan? • The firm stays comfortably within its current credit line (it
is owing $752 thousands at the end of 1993, and the bank
• Cost savings versus risks is willing to extend a credit line of up to $2 million in
1994)
• Cash balance stays at a minimum required to finance
operations

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

• Benefit Analysis of pro-forma financial statements

o Eliminates overtime premiums


• Net income is much higher under level production ($519 vs.
o Other direct labor costs savings $351)

• Cost • Level production dramatically increases financing needs

o Higher inventory and handling cost


• The required financing exceeds the maximum credit available
o Need to commit funds to finance inventory accumulation in ($2 million) for all months in the period June-November.
the off season

• Maximum financing needed in September doubles the available


credit
• Main issues:

o What is the financing need under level production? • Actually, most critical month is July

o Is the current credit limit enough to cover this need? o Current assets are mostly inventory in July, whereas for
September accounts receivable increase substantially.
o Are there any risks involved in level production? o The risk of not collecting is less than the risk of not selling!

• Examine inventory cycle

Construct MONTHLY Pro-forma Financial Statements • So level production is more risky (can end up with unsold
inventories) and requires more financing (now yet available)

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

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COMM 371, Lecture 7 COMM 371, Lecture 7

• Cost Savings of Level Production Under level production:

(compare pro-forma statements level vs. seasonal production


plans) • If estimates are right, net income increases by almost 48%

Overtime Premiums 225,000 • Requires much more bank financing


Other labor savings 265,000
Net labor savings 490,000 = 7000-6510 cut in
COGS • Required bank borrowing from June to November is above
the $2 million limit set by the bank.
Increase in interest expense 105,000 = 200-95
Reduction in interest income 17,000 = 28-11
Increase in storage costs 115,000 = 2515-2400 in • So loan renegotiation is needed. Need to convince the bank
Op. Exp. that the firm can repay the loans.
Combined cost 237,000

Net pre-tax savings 253,000 • Higher risk: if sales forecasts were not accurate, then the firm
may end up with unsold inventory (dollar sales of particular
Taxes (34%) 86,020 products can vary 30-35% from year to year), while having to
repay a larger loan.
Net savings 166,980

• 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 • Plus: firm financially healthy. Even if the firm absorbs
offered. 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
• How about asking suppliers for an extension of payment correct, the accumulation of inventories can wipe out the cost
time? savings

• However, AP are $250 per month, so even if credit is • Trade-off between profitability and liquidity
extended to 90 days, this would only generate payables of o Level production increases profitability
$750. Would suppliers extend credit? o But involves the risk of committing funds to inventory
in an amount that exceeds the firm equity!
• A production plan half way between seasonal and level
production.

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