Lecture 7: Financing Seasonal Needs - Toy World, Inc.
• Objectives:
• 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
• To understand the trade-off between profitability versus risk and liquidity in choosing between level and seasonal production
• To practice the mechanics of basic financial analysis
What is it that we are trying to help Mr. McClintock with?
Case Facts
• Highly seasonal sales (80% of sales between August and November)
• Current production follows sales, and thus is highly seasonal. • Question: should the company smooth production over the year? • Examine pro-forma monthly statement of cash flows for 1994,
What we will do
• 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
• 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?
• Would you recommend adoption of the level production plan? • Cost savings versus risks
The Current (Seasonal) Production Plan
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
• 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
Level Production Plan
• Benefit
o Eliminates overtime premiums o Other direct labor costs savings
• Cost
o Higher inventory and handling cost
o Need to commit funds to finance inventory accumulation in the off season
• Main issues:
o What is the financing need under level production? o Is the current credit limit enough to cover this need? o Are there any risks involved in level production?
Construct MONTHLY Pro-forma Financial Statements
Analysis of pro-forma financial statements
• Net income is much higher under level production ($519 vs. $351)
• Level production dramatically increases financing needs • 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
• Actually, most critical month is July
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! • Examine inventory cycle
• So level production is more risky (can end up with unsold inventories) and requires more financing (now yet available)
• Cost Savings of Level Production
(compare pro-forma statements level vs. seasonal production plans)
Overtime Premiums 225,000
Other labor savings 265,000
Net labor savings 490,000 = 7000-6510 cut in COGS
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 Op. Exp.
Combined cost 237,000
Net pre-tax savings 253,000
Taxes (34%) 86,020
Net savings 166,980
Under level production:
• If estimates are right, net income increases by almost 48% • Requires much more bank financing
• 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.
• 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.
• Are there any alternatives?
• Sell receivables or offer them as collateral for a bank loan. Also tighten credit policy to customers to induce quick repayment.
• However, in July when financing needs are highest, accounts receivable are only $300, so not much collateral can be offered.
• Tighter credit to customers can reduce sales….
• How about asking suppliers for an extension of payment time?
• 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.
• Should the bank extend the loan?
• The firm needs a credit line of up to $4 million in order to finance level production
• Plus: firm financially healthy. Even if the firm absorbs inventory losses for one year, it can repay early in the next year.
• Minus: substantial increase in firm risk. If sales forecast is not correct, the accumulation of inventories can wipe out the cost savings
• 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!
