Financial Planning for East Coast
Yachts
Prepared for East Coast Yachts
Prepared by Dan Ervin, Mary-Ann Lawrence,
Kevin Klepacki, Katie Wilson, Andrew Wright
January 1, 2010
Table of Contents
iii
Table of Contents
Executive Summary ............................................................................................................................................. v
Introduction .......................................................................................................................................................... 1
Methods for Evaluating ECY’s Growth Potential .......................................................................................... 3
Results of Financial Evaluations ........................................................................................................................ 5
Ratio Calculations ................................................................................................................................... 5
Pro Forma Statements Based on the Sustainable Growth Rate ...................................................... 6
Pro Forma Statements Based on ECY’s Desired Growth Rate ...................................................... 7
Balance Sheet Statement Adjusted for Net Plant and Equipment Investments ........................... 8
Analysis .................................................................................................................................................................. 9
Analysis for the Sustainable Growth Rate .......................................................................................... 9
Analysis for the 20% Growth Rate...................................................................................................... 10
Recommendations ............................................................................................................................................... 13
Reduce the Planned Growth Rate to 10% ......................................................................................... 13
Consider Suspending Dividend Payments to Finance Additional Growth ................................... 13
Executive Summary
v
Executive Summary
We have evaluated East Coast Yachts’ (ECY) financial performance and the rate that ECY can
expect to grow with and without raising external equity capital. After calculating ratios, comparing
ECY’s ratios to the industry, creating pro forma financial statements, and calculating external funds
needed (EFN), we have decided that ECY will grow in the coming years, but if they want to grow at
a rate of 20%, they risk having unfavorable debt ratios. We recommend reducing the planned
growth rate to 10% and potentially suspending dividends. These recommendations will allow ECY
to grow and avoid the inherent risk of taking on substantial debt.
Introduction
1
Introduction
ECY hired Dan Ervin and Company to assist with ECY’s short-term financial planning and to
evaluate its performance. ECY provided their income and balance sheet statements for 2009. We
researched industry ratios and conditions, created pro forma income and balance sheet statements,
and calculated the EFN needed for ECY to grow at its planned rate.
From our research on the yacht industry, we discovered that while overall forecasts are good, the
industry as a whole must still be cautious with its growth plans. IBISWorld predicted the following
for the yacht industry:
Over the five years to 2012, the industry’s revenue is expected to decline at an average
annual rate of 8.6%. The decline is largely attributable to a significant downturn in 2008 and
2009, resulting from the recession and the global financial crisis. In the five years to 2017,
industry revenue is projected to continue increasing at an average annual rate of 6.9%. 1
We must evaluate ECY’s growth potential with caution since revenues for the entire industry are
expected to drop by 8.6%. We would also recommend watching the growth rate to see if it does
start growing again after 2012. We must also consider that the yacht industry caters to a select group
of customers and that ECY performs meticulous production on each yacht it produces. ECY “caters
to some of the world’s wealthiest individuals, building new yachts that feature advanced nautical
technologies, precision engineering, and top-of-the-line style and amenities1.” We must also consider
how ECY is performing compared to the industry and the competition it might face from trade
shows that will sell yachts to the same individuals for a cheaper price. This is especially important to
consider in the midst of the recession.
To assist ECY with its financial planning, we did the following:
•
•
•
•
Created ratios for ECY and compared them to industry averages.
Created pro forma income and balance sheet statements.
Calculated the sustainable growth rate and external financing needed (EFN).
Evaluated how much ECY will grow with and without equity financing.
Our methods and conclusions are explained in the following sections of this report.
1 Reference Information: Smith, Gavin. (January 12, 2012). Luxury and Mega Yacht Manufacturing in the US Industry
Market Research Report Now Available from IBISWorld. New Technologies and Wealthy Consumers Propel Revenue.
IBISWorld [On-line]. Available: http://www.prweb.com/releases/2012/1/prweb9097660.htm
Methods
3
Methods for Evaluating ECY’s Growth Potential
As mentioned, we evaluated ECY’s growth potential based on:
•
•
•
•
Ratios compared to industry averages
Pro forma income and balance sheet statements
Sustainable Growth Rate
External Financing Needed
To calculate ECY’s ratios, we used the following ratios and equations. (We are elaborating on the
equations we used because we know different methods can be used from industry to industry.):
•
Current Ratio = Current Assets / Current Liabilities
•
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
•
Total Asset Turnover = Sales / Total Assets
•
Inventory Turnover = Cost of Goods Sold / Inventory
•
Days' Sales in Inventory = 365/ Inventory Turnover
•
Receivables Turnover = Sales / Accounts Receivable
•
Days' Sales in Receivables = 365 / Receivables Turnover
•
Debt Ratio = Total Debt / Total Assets
•
Debt Equity Ratio = Total Liabilities / Total Equity
•
Equity Multiplier = Total Assets / Total Equity
•
Interest Coverage = EBIT / Interest
•
Profit Margin = Net Income / Sales
•
Return on Assets = Net Income / Total Assets
•
Return on Equity = Net Income / Total Equity
•
Inventory / Liabilities
To prepare the pro forma statements we calculated the sustainable growth rate using the following
equation:
ROE x b
1-ROE x b
We then created the pro forma statements based on that sustainable growth rate and assumed that
everything would grow at that rate. From there, we were able to determine the EFN required.
We then calculated a new EFN under the assumption that ECY would grow at the 20% they have
planned, and we created new pro forma statements for that scenario.
The results of our calculations are shown in the following section.
Results
5
Results of Financial Evaluations
The following sections show the results for our ratio calculations and pro forma statements.
Result 1: Ratio Calculations
The ratio calculations revealed that ECY is competitive in the industry. Several of its ratios were
better than its competitors. The results for the significant ratios are shown below:
Ratios Lower Quartile Median ECY 1.43 Upper Quartile 1.89 Current Ratio 0.50 Quick Ratio 0.21 0.38 0.62 0.44 Total Asset Turnover 0.68 0.85 1.38 1.54 Inventory Turnover 4.89 6.15 10.89 19.22 Days' Sales in Inventory 74.64 59.35 33.52 18.99 Receivables Turnover 6.27 9.82 14.11 30.57 Days' Sales in Receivables Debt Ratio 58.21 37.17 25.87 11.94 0.44 0.52 0.61 0.49 Debt Equity Ratio 0.79 1.08 1.56 0.96 Equity Multiplier 1.79 2.08 2.56 1.96 Interest Coverage 5.18 8.06 9.83 7.96 Profit Margin 4.05% 6.98% 9.87% 7.51% Return on Assets 6.05% 10.53% 13.21% 11.57% Return on Equity 9.93% 16.54% 26.15% 22.70% 1.05 1.27 0.31 Inventory Over Liabilities 0.29 0.75 Results
6
Result 2: Pro Forma Statements Based on the Sustainable Growth
Rate
The following show the income and balance sheet statements based on ECY’s sustainable growth
rate of 10%.
East Coast Yachts 2010 Pro Forma Income Statement Sales COGS Other Expenses Depreciation EBIT Interest Taxable Income Taxes Net Income $ 184,018,615 129,685,224 21,990,725 6,005,269 $ 26,337,396 3,309,497 $ 23,027,899 9,211,160 $ 13,816,739 Dividends $ 8,290,044* Addition to RE 5,526,696 Tax Rate 40 % *Assumed same dividend payout as previous year. East Coast Yachts 2010 Pro Forma Balance Sheet Assets Current Assets Cash Accounts Receivable Inventory Total Fixed Assets Net Plant and Equipment $ 3,345,793 6,019,568 6,748,779 $ 16,114,140 $ 103,347,828 Liabilities & Equity Current Liabilities Accounts Payable Notes Payable Total Long Term Debt Shareholder's Equity Total Assets $ 119,461,968 Retained Earnings Total Equity Total Liabilities and Equity 55,667,696 $ 60,867,696 $ 116,092,981 EFN = $3,368,986 Common Stock $ 7,106,236 14,384,050 $ 21,490,286 $ 33,735,000 5,200,000 Results
7
Result 3: Pro Forma Statements Based on ECY’s Desired Growth Rate
The following pro forma statements represent what ECY could expect to see in terms of income,
assets, and liabilities based on a 20% growth rate.
East Coast Yachts 2010 Pro Forma Income Statement (20% growth) Sales $ 200,772,000 COGS 141,492,000 Other Expenses 23,992,800 Depreciation 6,552,000 EBIT $ 28,735,200 Interest 3,610,800 Taxable Income $ 25,124,400 Taxes 10,049,760 Net Income $ 15,074,640 Dividends $ 9,044,784 Addition to RE 6,029,856 Tax Rate 40 % *Assumed same dividend payout as previous year. East Coast Yachts 2010 Pro Forma Balance Sheet Assets Current Assets Cash Accounts Receivable Inventory Total Fixed Assets Net Plant and Equipment 6,567,600 7,363,200 $ 17,581,200 $ 112,756,800 Liabilities & Equity Current Liabilities Accounts Payable Notes Payable Total Long Term Debt Shareholder's Equity $ 7,753,200 15,693,600 $ 23,446,800 $ 33,735,000 Common Stock 5,200,000 Total Assets $ 130,338,000 Retained Earnings Total Equity Total Liabilities and Equity 56,170,856 $ 61,370,856 $ 118,552,656 EFN = $11,785,344 $ 3,650,400 Results
8
Result 4: Balance Sheet Statement Adjusted for Net Plant and
Equipment Investments
From our calculations, we realized that ECY is operating at 100% capacity. We also calculated that
ECY would need to invest $30.0M in fixed assets (including a new plant and new equipment) to
grow the company. We created a new pro forma balance sheet which shows the new investment in
fixed assets with the sustainable growth rate of 10%.
East Coast Yachts 2010 Pro Forma Balance Sheet ($30.0M Fixed Asset Investment) Assets Current Assets Cash Accounts Receivable Inventory Total Fixed Assets Net Plant and Equipment $ 3,345,793 6,019,568 6,748,779 $ 16,114,140 $ 123,964,000 Total Assets $ 140,078,140 Retained Earnings Total Equity Total Liabilities and Equity 55,667,696 $ 60,867,696 $ 116,092,981 EFN = $23,985,158 Liabilities & Equity Current Liabilities Accounts Payable Notes Payable Total Long Term Debt Shareholder's Equity Common Stock $ 7,106,236 14,384,050 $ 21,490,286 $ 33,735,000 5,200,000 Analysis
9
Analysis
Our analyses are divided into two parts:
•
•
“Analysis for the Sustainable Growth Rate” explains what ECY can expect if they grow at
the rate we calculated for the sustainable growth rate.
“Analysis for the 20% Growth Rate” explains what ECY can expect if they try to grow at a
rate of 20%, which would require additional external financing.
Analysis for the Sustainable Growth Rate
In 2009, ECY’s financial performance was slightly above average when compared to the industry.
We believe these ratios show that ECY is competitive when compared to the industry. When
analyzing the company’s 2009 financial ratios, several key ratios show the financial status of ECY
and how they are positioned for the future. These are analyzed in the following sections.
Current Ratio and Quick Ratio Analysis
The Current Ratio was less than one, which is below the median of the industry. At first glance, this
ratio is cause for concern because it suggests the company has more bills due within the year than
assets to pay them. However, we need to consider the total picture before drawing any conclusions.
When we compare the Quick Ratio, which removes inventory from the asset base, with the Current
Ratio and the other industry averages, we are able to determine that ECY’s inventory levels are
lower than most competitors. We then look at the Inventory Turnover and Days’ Sales in Inventory
ratios, which show that once ECY produces a yacht, they are very effective at selling the yacht in the
near future.
ECY leads in its ability to turnover its inventory. This is important for this industry, especially when
we consider the Current Ratio. Current ratios where inventory represents a significant portion of the
assets combined with low turnover and high day’s sales in inventory are cause for concern in an
industry where products are highly customized to specific tastes. ECY’s ratios imply a different,
more assuring story than the median and lower quartile firms because ECY is able to efficiently
manage its inventory levels. Because ECY manages its inventory better, they have a lower risk of
liquidity than some of the other firms. This is important for this industry because it caters to
customers who want custom yachts. It is important for a custom yacht company to quickly turn over
its inventory because they expect customers who order customized yachts to pick them up soon
after they are ready. These ratios show that ECY turns over its inventory better than its peers.
In addition to the efficient management of inventory, ECY leads in its ability to manage and collect
its receivables. Having industry leading numbers here shows that the company is efficient at
managing its assets and lessens the concern about the Current Ratio being low; however, we would
recommend that ECY take steps to improve its Current Ratio by keeping a slightly higher balance of
cash on hand to meet short-term obligations.
Analysis
10
ROE, ROA, and Profit Margin Analysis
Looking further into the financial ratios, ECY is above average on important ratios such as Profit
Margin, Return on Assets, and Return on Equity, but there is still room to improve when compared
to the upper quartile. ECY’s profit margin is 7.51%, but the upper quartile is 9.87%. ECY generates
$0.12 in income per dollar invested in assets where the upper quartile earns $0.13 per dollar. Lastly,
ECY generates $0.23 for every dollar invested in equity where the upper quartile is earning $0.26 per
dollar. Given these ratios, we feel that ECY is performing well against its competitors and is a
healthy company overall; however, ECY could also improve these ratios. To improve its
performance and accelerate growth, ECY could explore cost improvement programs to improve
their profit margins. These could be investigated for both COGS and other expenses.
Debt Ratio Analysis
ECY is strong in several ratios, which puts it in a good position to grow in the future. The
company’s Debt Ratio and Debt to Equity Ratio are both low, which means ECY does not rely as
heavily on debt as its peers do, and that the company’s creditors have less money in the company
than its equity holders. This means that ECY is already experiencing strong performance without
leveraging itself to the extent that other companies in the industry are. Should the company decide
to grow and finance this growth with long-term debt, the future gain prospects are encouraging.
The Pro Forma Financial statements for 2010 in the “Results” section above (page 6) show a model
for how much the company can grow. It shows that for a projected sustainable growth of 10%, the
company will require only $3.4M of external financing. This will result in an increase of roughly
$0.75M in dividends and $0.5M in additions to retained earnings for 2010, assuming the dividend
payouts and retention ratios are held constant.
This growth rate of 10% was calculated to be the maximum sustainable growth rate. Ten percent is
the highest level of growth the firm can achieve without using external equity financing, while still
maintaining a constant Debt to Equity ratio. Should ECY plan to grow larger than 10%, equity
financing, such as issuing additional shares of stock, will be required, or ECY will have to increase its
leverage. If ECY wants to avoid diluting its ownership or increasing its leverage, they should plan to
grow at the maximum sustainable growth rate of 10%.
Analysis for the 20% Growth Rate
The following analysis shows why ECY will need external equity financing or another option if it
wants to grow at 20%.
Debt to Equity Ratio Analysis for a 20% Growth Rate
ECY’s original Debt to Equity ratio was .96. This ratio indicates that the company is borrowing
against its equity almost 1-1 and is close to saturation of the equity of the company. ECY does not
want to issue additional equity to finance its growth. We showed above that the maximum
sustainable growth rate for the company is less than 20%. If ECY grows at 20% and uses debt
financing, the Debt to Equity ratio will be 1.12. This increases the leverage of the company and
Analysis
11
means that creditors will have a higher stake in the company than equity holders. Sales would have
to increase by more than 20% to absorb the debt. ECY should consider financing a portion of this
growth with equity and keeping its Debt to Equity ratio in the existing ideal position.
Recommendations
13
Recommendations
Based on our analyses, we can offer two recommendations to ECY.
Recommendation 1: Reduce the Planned Growth Rate to 10%
Overall, ECY is in a strong position to grow the company. However, given the current economic
climate, the estimate that industry wide sales will drop by 8.6% for the next few years, and
management’s preference to not finance growth with equity, we recommend reducing the desired
growth rate from 20% to 10%, which is the sustainable growth rate of the firm.
If ECY plans to grow by 10%, they will not have to use equity to finance their investments (which is
consistent with management’s objectives) and they will be better prepared for an uncertain market.
Recommendation 2: Consider Suspending Dividend Payments to
Finance Additional Growth
For ECY to support any growth, we learned that they will need to make an investment of $30.0M in
fixed assets because they are currently operating at 100% capacity. At the 10% growth rate, we
calculated an EFN of $24.0M to support this investment. Since ECY will not seek equity financing
to support the fixed asset expansion, we recommend ECY reduce or suspend the dividend payment
during the planned growth period. Suspending the dividend payment would create an additional
retention of $8.3M to use towards the expansion. This approach would reduce the amount of debt
financing required and mitigate the risk of becoming overly leveraged.
Suspending the dividend payment also increases ECY’s retention ratio, which provides a higher
sustainable growth rate. This is important because the expansion in fixed assets, which is an increase
of 31.9% over existing levels, would result in ECY operating under 100% capacity. Suspending the
dividend payment increases the retention ratio to 1.0 and the sustainable growth rate to 29.3%. By
altering how much money is retained in the business, ECY can position itself to reinvest its earnings
in the expansion and will be able to pursue growth rates that enable a greater utilization of the
existing capacity (i.e., above the original sustainable growth rate of 10%). ECY should consider
adjusting its dividend policy in the short term so it can better position itself for the long term.
If ECY accepts these recommendations, we believe that ECY will grow significantly and avoid the
inherent risk of taking on substantial debt.