Memo
To:
Winston Winchester III, CEO
Digital Online Holdings, Inc.
From: Cassie Knox, Jeffrey Blaker, Frank J. Bruno, David Zawitkowski
CC: Robert McParland
Date: April 13, 2020
Re: Default of Revolving Line of Credit Agreement with Vulture Bancorp
A year ago, Digital Online Holdings, Inc. (“the Company”) signed a revolving line of credit agreement with Vulture Bancorp (“the Bank”). Since then, several Negative Covenants described in Section 7 of the agreement were breached. According to Section 8 of the agreement, “In the event that any covenant in Section 7 of this agreement is breached, the
Bank may suspend all future borrowings under this Revolving Credit Agreement and all amounts outstanding due the Bank shall become due and payable.” The breach of contract can be seen when analyzing certain financial ratio requirements described in Section 7 of the agreement and discussed in the following section.
Section 7, part 2 states that certain financial ratio tests applied to the consolidated financial statements must be met. The requirements not met and explanations are as follows:
§7, 2a Tangible net worth greater than $20 million at 12/31/02; and $35 million at all times thereafter.
At 12/31/02 tangible net worth was as follows:
Equity 30,920,000
Less goodwill and intangibles: 10,000,000
Tangible net worth 20,920,000
At 12/31/03 tangible net worth was as follows:
Equity
Less goodwill and intangible:
40,000,000
10,000,000
Tangible net worth 30,000,000
The tangible net worth requirement was met in 2002 but was under the required $35 million in 2003 by 5,000.
§7,2b Debt to equity ratio lower than 6 to 1 for year ended December 31, 2002 and lower than 5 to 1 for all periods thereafter.
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Debt to equity ratio
12/31/02:
12/31/03
6.063%
5.113%
The debt to equity ratio requirement was not met in either 2002 or 2003.
§7, 2c Interest coverage ratio (Pretax income plus interest expense divided by interest expense) greater than 1.5 to 1 for 12/31/02, 2.5 to 1 for 12/31/03 and 3 to 1 for all periods thereafter.
Interest coverage ratio
12/31/02: 1.66%
12/31/03: 2.41%
The interest coverage ratio was acceptable in 2003 but not in 2002.
After reviewing the current situation of DOH and the break in covenant agreements by the company, seve ral major flaws in the company’s approach to managing the capital have become apparent. The first major flaw is the policy of DOH to not charge interest on loans made to the two subsidiaries (WOO and HOO). From an accounting standpoint, the policy appears to be arrived at from a logical basis. This is due to the fact that interest income reported by the parent would cancel out the interest expense reported by the subsidiary resulting in no net effect on the consolidated financial statements. However, from a business standpoint it is unrealistic not to charge interest. If there is no cost of money, the subsidiaries will borrow at will and not willfully cut down on spending.
At this point in time, the CEO’s of the subsidiaries have unlimited access to funds, with no cost of capital implications. This results in poor business decisions because there are no financial consequences for drawing too much cash from the funds. In 2003, WOO has
$15 million in cash and HOO has $13 million. This is a considerable amount of cash to be holding on the balance sheet. If interest charges are implemented, managers for the subsidiaries will be forced to make smarter decisions and greatly reduce the amount of cash wasted on unprofitable activity or sitting idly on the balance sheet.
Other red flags that came up when analyzing the financials of the Company are commonly used metrics applied to the consolidating statements, including Days Sales
Outstanding (DSO) and Inventory Turnover. With respect to DSO, in 2002 it was 72 days. In
2003, this number increased by 24% to 89 days. These numbers represent the average collection period for accounts receivable and are needlessly high. If it takes three months or longer to collect the receivables of the company, there is a major problem billing and/or collections. To improve the cash position of the company, this number must be greatly reduced. Another alarming metric is Inventory Turnover, which represents the number of times a company goes through its inventory each year. In 2002 it was 4.5 versus 3.9 in
2003. Inventory Turnover decreased by 14% from 2002 to 2003 illustrating that not only are these numbers low for the industry they are involved in, they are also heading in the wrong direction for financial prosperity.
Lastly, Return On Investment (ROI) for 2003 has increased 49.89% from 2002’s ROI of 9.14% to 13.7%. This percentage reflects the real return on DOH’s investments used in its subsidiaries, WOO and HOO. It is important to keep close track of the investments made in subsidiaries because the investments come in different forms. These forms include:
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advances made to subsidiaries, any direct borrowing of the subsidiaries from the parent, the debt of the subsidiary where the parent is ultimately responsible for, and the equity of the subsidiary. It is important to establish a required return on investment in order to set a minimum level of return for an investment. This will allow for better cash management and more efficient use of cash.
DOH’s estimated WACC for 2003 is 6.25%, which leaves an expected 12.5% of ROI
(WACC x2) for the year. This year DOH has produced an overall 13.7% ROI and has exceeded its estimated level.
A different area of the Company which exhibits weak strategy is the compensation key management personnel receive in the form of their yearly bonus. As it stands right now, the CEO of each subsidiary receives 80% of their salary if key targets are reached. The two targets are revenue levels and EBITDA. While these two metrics are mediocre measurements of how the CEO is performing at their given position, the numbers are skewed because of the process of how their unit obtains capital. This again goes back to the policy of
0% interest on all loans given to the subsidiary by the parent ’s company. Not only are poor decisions made because of the policy, as was mentioned previously, but it leaves the door open for self-serving decisions on the part of the CEO. Certain managerial decisions involving allocation of resources could be determined solely on what would get us the highest
EBITDA, which in reality might not result in higher Net Income. For instance, if the CEO of a company is faced with the decision of investing in new equipment that will increase output
(given there is a demand for more of the product), and he chooses to invest in the equipment, revenues rise, and EBITDA is well above the target level. This is good for the CEO, however, without taking depreciation into account, the effect on Net Income might be greatly diminished or wiped out completely. Because of examples like this, the bonus compensation of the management should be altered.
The biggest modification to company policy that can be made is for DOH to start charging interest to both of its subsidiaries. There are several reasons for this, which have already been explained, but to review; it would change the mentality of the subsidiaries from thinking they have unlimited capital at their disposal, to the attitude that decisions made concerning the direction of the unit need to make perfect financial sense before projects are taken on and the subsidiaries will pay cash off to the subsidiaries so they are not sitting on it for free. At a very minimum, DOH should charge the rate that the bank is currently charging them. However, it is the recommendation of our firm that they charge an even higher rate.
This hopefully will reduce borrowing by the subsidiaries even more, with the possibility of repayment of loans to the bank. These transactions would help the overall financial health of the company by reducing its long term outstanding debt.
The second change that should be made is a reconsideration of the metrics used as the basis of management’s bonuses. For the CEO’s of the subsidiaries, one of two metrics would be better suited for their bonuses. The first metric is using pretax income instead of
EBITDA. This would be a better choice for two reasons. The first is that it would incorporate more of the financial results of managerial decisions into the bonuses. The second is that using pretax instead of Operating Income is that it would again make the CEO conscious of the amount he is borrowing from the parent. The less borrowed, the better the decisions and the minimization of corporate debt. The second metric that would be better for judging the performance of the CEO’s would be ROI. Looking at the return the CEO can provide for the capital they borrow from DOH would directly show the management of DOH if the capital being granted is being put to use to help the business as a whole. Target levels should be set
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at least a few points above the interest rate the bank is charging DOH. Achieving an ROI on the amount loaned by DOH to the subsidiaries would contribute to positive financial growth as well as better management of capital.
Lastly, the Company should negotiate better covenants so that in the course of reforming their cash management approach, they will have more realistic ratios to meet.
They are not in a good position right now to meet the current covenants any time soon. They should also decrease the amount of revolving credit line by as much as 50% to $100 million because they do no need so much cash for their current operations.
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