SureCut Shears Case: Corporate Finance Report
An analysis of FCFF and Debt Financing in Recessionary Times
Group 8:
Letizia A. Baronio
Maria Clech Gago
John Duff
Lukas W.T. König
Victoria Manalo
Alexandru Nastasa
Mauricio A. Saenz Zamudio
Word Count: 1944
1. What assumptions did Mr. Fischer make when he prepared the forecasts shown in case Exhibits 1 and
2? Were these assumptions reasonable?
For the Income Statement, Mr. Fischer has made the following assumptions :
Sales will follow the same seasonality pattern as in previous years, increasing in Q3 and Q4,
peaking in October and troughing in May (see annex 1). Additionally, he predicts only a slight decrease in
YOY sales, selling only 135’000 less than in the previous cycle. This seems largely accurate, as seasonal
demands and overall sales for his goods are unlikely to change given that most of his sales are to big
retailers and general stores, whose demands tend to be less volatile than individual smaller players, massive
changes in the products notwithstanding.
Regarding COGS, material and labour costs remain proportional to sales throughout the year,
corresponding with information from previous years. As the business is not being fundamentally altered
and very large changes are not being undertaken, it stands to reason that this is a reasonable projection.
However, the reduction in costs related to the new plant has not been taken into account. Indeed,
optimizations and efficiencies have been ignored and will likely push the COGS down slightly. Although,
as the completion date of the plant as well as the real discount amount are not fully certain, Mr. Fischer has
erred on the side of caution and not included them in his projections. Budgeting with potential discounts of
unspecified amounts in mind is unlikely to yield accurate results and, as such, not applying the efficiency
cost reductions is likely the better decision in this case.
The tax amount is predicted to remain at 36% of EBIT, with a possible tax refund occurring at the
end of the financial year in May, depending on the previous years’ financial performance.
Dividend payments of 300$ remain constant, being paid every quarter. This amount is predicted to
increase to 600$ at the end of 1996 however in order to align more closely with what the dividends from
the previous year were. As the profits and sales are expected to remain proportional and constant, this is
also a reasonable assumption.
Finally, Fischer anticipates relatively similar profits in the upcoming year. However, he has failed to
take into account interest that he will incur for the 3.5m loan, underestimating overall expenses.
Looking at the income statement, we can infer that, for the most part, Mr. Fisher has made rather accurate
assumptions, with most decisions based on previous trends. A reduction in operating expenses, however, has
purposefully not been taken into account in order to keep a conservative approach to the next period. On the
contrary, interest expenses have not been taken into account and will increase overall costs. Nevertheless, these
estimates are rather accurate and grounded, despite the 2 aforementioned outliers.
For the Balance Sheet, Mr. Fischer has made the following assumptions :
The seasonal cycle of business will continue, with most of the cash inflow being after the liquidation
of AR after peak time, with AR themselves increasing proportionally to the seasonal sales (see annex 2).
We can presume that this cycle has been ongoing for a very long time and can be expected to be continued
for the foreseeable future.
This seasonality can also be seen in inventory management, as there is a noticeable increase starting
in January. Current assets, however, only vary 10-15% from low season to high season in tandem with
sales, reflecting their asset management plan. While not outright harmful, the production policy means that
inventory costs can be somewhat higher than necessary during low season.
The costs and timeliness of the new project is considered in the net plant account. As the project is
about half done, approximately 1.5m dollars have been imputed to Net Plant, with the remaining being
imputed later the same year. We can therefore observe a net plant increase of 2.99m, which is in line with
the total 6m cost of the project.
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- Finally, the bank loan payable reflects the need to finish the plant, and once again taking this cost into
consideration is a fairly reasonable assumption to make as it airs on the side of prudency. Indeed, the first
reflects the 3.5m credit line, but no interest incurred is reflected anywhere or shown in the Income
Statement. Secondly, an additional loan of 1.2m has also been predicted to take effect by June 1996.
As with the income statement, we can infer that Mr. Fischer has made educated assumptions that certainly fall
within what could be considered reasonable. When he had the option, he has once again taken the conservative
approach.
2. Why was SureCut Shears unable to repay its bank loan by December 31, 1995 as originally forecasted.
SureCut was unable to pay its loans due to a combination of factors stemming from the looming retail
recession. Looking at the company’s forecasted vs actual cash flows (see annex 3,4) we observe a similar trend
between the two, however the distance between the lines explains why SureCut was unable to pay their loan
back in time. For the FCFF calculations, we assume the following:
- Misc Other includes accounts that aid the daily operations of the business, such as Accrued Expenses,
and hence we used it in our calculations for NWC.
- Taxes payable was also used for NWC as a company must pay its taxes to keep operating.
In the first 3 months (Jul-Sep) of both the forecasted and actual FCFF, we observe a negative value, meaning
the company burned through 2.9m and 3.4m respectively, and required debt financing to support its operations
(this difference may also explain the call for an additional 500k in September). Afterwards, for the next 3
months (Oct-Dec) the company forecasted a positive 3.8m FCFF when in reality it was only 2m. That is why
the company was unable to pay its loans by December as originally agreed.
This difference ties to the retail recession mentioned in the case. There was $1.8m less in sales until December,
meaning their forecasted EBIT was overstated, yet the company continued to produce at a constant pace in line
with their policy. We can deduct this from the drastic increase between the forecasted inventories vs the actual
value
Moreover, the company continued to pay dividends in September and December despite their struggle to meet
their daily financing needs. Therefore, subtracting 600k (300k for Sep and Dec respectively) would result in
an even lower cash flow available to creditors, further strengthening the argument for why SureCut was unable
to pay its bank loan by the end of December.
3. Has SureCut’s financial condition worsened sufficiently to cause Mr. Stewart any great concern?
In order to answer this question effectively we must consider both internal and external factors that
would impact Mr. Stewart’s decision. Primarily, we will focus on the external retail recession and the effects
of SureCut’s financial strategy during this period.
Firstly, the recession alone increases the bank’s risk exposure as we are uncertain how long the recession will
last, and whether it will keep propagating through to next year’s peak sale season. Additionally, with the
recession active, the bank should be concerned about possible bad debt on SureCut’s 2.8m in AR. SureCut
appears to have a very lax policy on collecting payments, which can be seen in its increasing days receivable,
(see annex 7) and this should raise the bank’s awareness over the financial condition of the firm.
Secondly, the company has kept production up constantly and increased their inventory levels. There is a small
risk that the inventories may become outdated, however the product that they are selling isn’t exposed to high
levels of innovation. Still, there is a liquidity problem for the company as a large part of their current assets
(around 70% in March) is held in inventories. Combining this information with the retail recession should
cause Mr. Stewart a high degree of concern.
Additionally, the plant modernisation program doesn’t seem to output the forecasted efficiencies of 900k per
year.. This may be due to a lack of growth in production. We assume that the plant would only start becoming
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more efficient once it needs to generate more products, however it would be unwise to assume that production
would ramp up during a recession, therefore the investment in the plant points towards an untimely investment
of funds, which further raises the concern a bank should have towards extending a further line of credit to
SureCut.
Overall, the increased cash conversion cycle (from increased AR days and inventory days, see annex 4,7) in a
recessionary period should cause great concern to the bank. Further investigation is needed, however some
solutions that the bank may recommend SureCut implement could be:
- Implement a strict policy on AR days and obtain cash quicker.
- Extend their AP days or negotiate a trade discount for early payment.
- The bank can renegotiate its terms such that SureCut stops dividend payment until the loans are repaid.
- Continue with their workforce reduction to lower variable costs.
With these methods, the company will have a higher chance of succeeding through the recession while meeting
the necessary payments to its creditors.
4. Compare the nature of the financial problems faced by SureCut Shears, and Clarkson Lumber.
As a first step in the comparison of SureCut Shears and Clarkson Lumber we’ll be looking at account
receivable and payable days.
To better analyse the company of this case we looked at actual and pro-forma data, to calculate the relevant
metrics for the first one we forecasted the remaining three months in the FY of SureCut Shears by following
the variability in sales used for the pro-forma estimation as well as weighted proportions from the actual
statements. (For the calculations please refer to annex 5,6).
Comparing the actual jul’94-jun’95 (calculations done with the ending balances as there is no info on previous
fiscal years) to the actual and pro-forma jul’95-jun’96 that days payable are pretty low on average with each
one being lower than 30. In terms of days receivable we can say that they are pretty low (25) for the jul’94jun’95 but it’s probably due to the fact that we used the ending balance of AR to calculate the ratio, for the proforma instead AR is pretty high (44) yet lower than for the actual which is the highest at 50. By assuming that
the pro-forma calculations were done in line with historical data, we can say that days payable have lowered
whilst days receivable have increased which along with the decline in sales resulted in the need for liquidity
by SureCut Shears.
Clarkson Lumber’s liquidity problem arises from the rapid growth in sales as well as the desire to exploit trade
discounts to lower COGS which lowers days payable to 10. For days receivable the number (49) is in line with
SureCut Shears’ actual jul’95-’jun’96.
(All data is summarised in annex 7, for ease of comparison)
All in all, both have liquidity problems: Clarkson lumber is growing at a rapid pace and needs debt financing
to achieve this, SureCut Shears instead is experiencing a decline in sales and needs debt to get through tough
times especially now that days receivables have grown and days payable have shortened. Furthermore the
modernization of the plant proved to be a burden at least for times of recession as savings would have been
achieved with increased production, however with the lower production COGS was higher on average (76%
of sales compared to the predicted 72%). This cumulated with maintaining the fixed production policy along
with the dividend payment has generated the need for debt financing.
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Annex
1. Pro Forma Statement (Seasonality Sales)
2. AR Seasonality Variance Calculations.
3. Graphing FCFF Forecast vs. Actual
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4. Monthly Cash Flows Forecasted vs. Actual.
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5.
3 month projections of IS
6. 3 month projections of BS.
7. AR Days, AP Days, Inventory Days, and CCC.
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