MASSACHUSETTS
STOVE COMPANY
Presented by Group 1: Alex Yeung, Jiyeon
Kim, Philip Lee, & Samuel Lee
OVERVIEW
• Introduction
• The Issue
• Analysis
• Recommendations
INTRODUCTION
Company Background
COMPANY BACKGROUND
Massachusetts Stove Company (MSC)
Manufacturer of Wood-burning Stoves
Acquires Parts from Suppliers
(essentially an assembly operation)
Private company with 7 shareholders
• Jane O’Neil, CEO, owns 51% common stock
• Remaining 49% owned by CFO, VP for
manufacturing and 4 independent investors
COMPANY BACKGROUND
Business Strategies
Business Strategies
• Rent a building for manufacturing and
administrative activities
Operations
• Same building as factory showroom
Sales &
Marketing
Sales Channels
• Wholesaling – 20% of sales
• Retail direct marketing – 70%
• Company showroom - 10%
Customer
Payments
• Full payment : check, credit card
• Layaway plan : monthly payment with
period within 1 year, ship the stove after
final payment
• Installment bank loan
COMPANY BACKGROUND
Recent
Industry
Environment
Strict regulations
from government,
Environmental
Protection Agency
(EPA), incurring
additional costs
Number of firms in
the woodstove
industry decreased
from over 200 in
Year 10 to 35 by
Year 11
COMPANY BACKGROUND
Current Business Situation
•
Incurring high operating & investing costs
1
2
Acquire the building
that is currently rented
Retooling & Testing
Cost for EPA approval
• Exercised an option
to purchase for
$608,400 in Year 9
• However, owner
refused to comply
with the option
provisions
Soapstone Stove II:
forecasted additional
$55,000 in Year 12 and
$33,000 in Year 13
3
Legal Cost
• Company sued the
owner of the
building
• Incurred legal cost
of $68,465 in Year
11
THE ISSUE
“To Lend or Not To Lend?”
THE CASE
• Financing Plan of MSC:
• Borrow additional $50,000 loan from bank in Year 12
• Pay back the principle by end of Year 13
• Purpose of Loan:
• Expect to have 25% annual sales growth for next 2 years
• Funding additional working capitals for operations
• The Issue:
• As bankers, to judge and decide whether to lend the money to
MSC, based on the MSC’s financials and projections
THE CASE
Actual Results
Year 8
Projections
Year 12:
Additional
$50,000
Loan
Year 10
Year 9
Year 11
Year 13:
Pay back
the
$50,000
Loan
THE CASE – FORECAST ASSUMPTIONS
• Annual sales projected to increase 25% during Year 12, 13
• Reduction of Cost of Good Sold = 51%, 49% of sales for Year
12, 13 respectively
• Selling and Administrative Expenses = 41% of sales for Year
12, 13
• Legal Expenses = $45,000
• Interest Expense = 6%
• No Income Tax Expenses
• Cash: represent a plug to balance the Balance sheet
• Accounts Receivable: Days Accounts Receivable Outstanding
= 11 days for Year 12, 13
• Inventories: Days Inventory Held = 155 days for Year 12, 13
THE CASE – FORECAST ASSUMPTIONS
• Property, Plant, and Equipment: excludes the cost of acquiring
the building
• Accumulated Depreciation: as per past years
• Other Assets: no amortization of intangibles after Year 11
• Accounts Payable: Days Accounts Payable Outstanding = 97
days, 89 days for Year 12, 13 respectively
• Notes Payable: increase by bank loan in Year 12, pay back in
Year 13
• Other Current Liabilities: Deposits to go back to normal in Year
12, 13
• Long-Term Debt: will not repay in near future
• Retained Earnings: No dividends paid
ANALYSIS
Crunching and Interpreting the Numbers
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
RETURN ON ASSETS (ROA)
30%
3.0
25%
2.5
20%
2.0
15%
1.5
10%
1.0
5%
0.5
0%
-5%
Year 9
Year 10
ROA
Year 11
Year 12
ATOPM
• ROA is expected to be improved due to:
Year 13
-
AT
(ROA = ATOPM x AT)
• Better After-Tax Operating Profit Margin (ATOPM)
• Increased Asset Turnover (AT)
AFTER-TAX OPERATING PROFIT MARGIN
Year 9
Year 10
Year 11
Year 12
Year 13
Revenues
100.0%
100.0%
100.0%
100.0%
100.0%
Cost of Goods Sold
-69.2%
-60.5%
-53.9%
-51.0%
-49.0%
Selling, Gen., & Admin. Expense
-26.7%
-37.1%
-40.9%
-41.0%
-41.0%
Legal
-4.3%
-3.8%
-1.0%
-3.8%
0.0%
Core Operating Profit
-0.2%
-1.4%
4.2%
4.2%
10.0%
Interest Income
0.0%
0.0%
0.0%
0.0%
0.0%
Other Income, Gains, Expenses and
Losses
0.0%
0.0%
0.0%
0.0%
0.0%
-0.2%
-1.4%
4.2%
4.2%
10.0%
0.0%
0.0%
0.0%
0.0%
0.0%
-0.2%
-1.4%
4.2%
4.2%
10.0%
Income Before Tax
Income Tax Expense
After-Tax Operating Profit Margin
AFTER-TAX OPERATING PROFIT MARGIN
Increasing ATOPM is driven by:
• Better cost of goods sold due to:
• Higher proportion of retail sales which has higher gross margins than
•
•
•
•
wholesale sales
More favorable pricing due to less competitors as a result of EPA
regulations
Switch to lower-cost suppliers
More efficient production
Expected to have lower COGS of 51% and 49% for year 12 and year
13 respectively.
• Well maintained legal expenses in Year 12 & no additional legal
expenses in Year 13
• Offset by increased SGA expenses
• Mainly due to a heavier emphasis on retail sales which requires more
aggressive marketing than wholesale sales.
CIRCUMSTANCES
• Loan used to finance operations, working capital
• Better ATOPM, AT, and ROA due to more expected sales
and decreased in COGS
• Low competition - drop from 200 firms to 35 firms in Year
11 due to strict air emission standards
• Expansion and growth - to capitalize on the situation
• Mature, declining business – demand is uncertain
• Developing, testing, and marketing of new designs to
cater to new, more stringent regulations
Risk Level: MEDIUM
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
PAID IN CAPITAL
Year 13
Year 12
Year 11
Paid In Capital
Total Assets
Year 10
Year 9
Year 8
$-
$200,000.00
$400,000.00
$600,000.00
Relatively large amounts of Paid In Capital (PIC) from shareholders
CHARACTER OF MANAGEMENT
• High commitment of shareholders’ personal wealth into
the company, as reflected in equity (Paid In Capital)
• Another example of high commitment is that net income
of firm taxed at the level of individual shareholders
• Shareholders’ property also used to secure loans
• High ability to adapt – came up with a new stove design,
which was approved even in the face of new, stricter
regulations
Risk Level: LOW
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
CONTINGENT LIABILITIES
• A pending lawsuit - the lower courts have ruled in favor of
the company's position on all major issues concerning
building option; Supreme Court is also expected to rule in
company’s favour
• However, if Supreme Court rules against the company,
company may incur additional legal expenses and
liabilities
• Firm is dependent on 8 skilled employees for assembly;
may be difficult to find replacements
Risk Level: MEDIUM
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
COVENANTS
• No covenants were stated
• Company does not have to meet certain conditions or
restrictions on the existing loans
• Company has much freedom in terms decisions,
operations
• Lender cannot ensure that the risk attached to the loan
does not unexpectedly deteriorate prior to maturity
• Lender cannot penalize, call back the loan
Risk Level: HIGH
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
ASSET VALUES
Year
13
Year
12
Year
11
Total Long Term Assets
(after Depreciation)
Year
10
Total Current Assets
Year
9
Year
8
$-
$100,000.00 $200,000.00 $300,000.00 $400,000.00 $500,000.00
Low Levels of Long Term Assets
Most long term assets are already as collaterals for the notes payable.
SHORT TERM LIQUIDITY
Low levels of cash and account receivables
SHORT TERM LIQUIDITY
Acceptable Current Ratio, but Low Quick Ratio (risky if <1)
WORKING CAPITAL TURNOVER
Cash Gap
• Improvements on days receivables held, days inventory held
• Fast decline in days payables held (from around 120 days to below
100 days)  MSC needs to pay back suppliers earlier
• Overall, cash gap is increasing, tighter working capital
INVENTORY
• Parts are purchased from suppliers
• Consists mainly of the following:
• metal castings
• soapstone
• catalytic combusters
• Limited demand for these items
• Hard to find buyers, since they are special parts/materials
use for production of stoves
• Metal castings, soapstone can be scrapped, but re-sale
value will be lower
• Will likely take a loss on re-sale
COLLATERAL
• Low Levels of Long Term Assets
• Low Levels of Cash, Accounts Receivables
• High Levels of Inventory, relatively unsalable
• Existing notes payable to banks are already secured by
existing Long Term Assets, Shareholders’ property
• Not much collateral, low liquidation value
Risk Level: HIGH
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
CREDIT HISTORY
Year 13
Year 12
Year 11
Year 10
Year 9
Year 8
$-
$50,000.00 $100,000.00 $150,000.00 $200,000.00 $250,000.00 $300,000.00 $350,000.00
Long Term Debt
Notes Payable and Short Term Debt
Decreases in Short Term Debt, Increases in Long Term Debt
CREDIT HISTORY
• No bad record on loan repayments
• From Year 8 to Year 11, the short term debt is decreasing,
meaning the company is paying them off
• However, Long Term Liabilities are not being paid off, as
seen from previous years and from projections
Risk Level: MEDIUM
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
DEBT RATIO
High debt ratio (total assets cannot cover total liabilities)
– negative shareholders’ equity
INTEREST COVERAGE RATIO
For financial healthy firm, interest coverage ratio should be above 2
this ratio is currently below 2 but is expected to improve
LONG TERM SOLVENCY
Total Liabilities to Equity (PIC)
800,000.0
180.0%
700,000.0
160.0%
140.0%
600,000.0
120.0%
500,000.0
100.0%
400,000.0
80.0%
300,000.0
60.0%
200,000.0
40.0%
100,000.0
0.0
Total Liabilities
Equity (PIC)
Liabilities to Equity (PIC)
20.0%
Year 9
561,173.0
437,630.0
128.2%
Year 10
607,561.0
437,630.0
138.8%
Year 11
615,186.0
437,630.0
140.6%
Year 12
673,547.4
437,630.0
153.9%
Year 13
609,755.9
437,630.0
139.3%
0.0%
High financial leverage
- Total liabilities : on average 1.4 times of Equity (Paid in Capital)
CAPACITY FOR DEBT
• High Debt Ratios
• Low Interest Coverage Ratios
• Poor Long Term Solvency
• High Financial Leverage
• Negative Shareholders’ Equity – shareholders owe money
• Low capacity to carry additional debt
Risk Level: HIGH
ANALYSIS – LOAN ASSESSMENT
Circumstances
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Credit Risk
Assessment
Credit History
Contingent
Liabilities
Covenants
Collateral
CASH FLOW TO LIABILITIES
Year
Operating Cash Flow to
Current Liabilities
Year 9 Year 10 Year 11 Year 12 Year 13
0.187
0.182
0.142
-0.040
0.270
• Low Operating Cash Flow to Current Liabilities Ratio
• High short-term liquidity risk
• A ratio of 0.40 or more was common for a typical healthy
manufacturing or retailing firm
CASH FLOW TO LIABILITIES
Year
Operating Cash Flow to
Total Liabilities
Year 9 Year 10 Year 11 Year 12 Year 13
0.101
0.098
0.076
-0.022
0.145
• Low Operating Cash Flow to Total Liabilities Ratio
• A ratio of 0.20 or more is common for a financially healthy
company
SENSITIVITY ANALYSIS
• As a preliminary analysis on Cash Flow, 6 Key Forecast
Variables were identified from the assumptions:
• Sales
• Cost of Goods Sold
• Selling and Administration Expenses
• Interest Expenses
• Accounts Receivable
• Inventory
• The original assumptions and projections stated in the
case are treated as the “Best Case” scenario
• “Worst Case” and “Most Likely Case” scenarios were
generated by simultaneously varying all 6 variables
SENSITIVITY ANALYSIS – BEST CASE
• Annual sales projected to increase 25% during Year 12,
13
• Reduction of Cost of Good Sold = 51%, 49% of sales for
Year 12, 13 respectively
• Selling and Administrative Expenses = 41% of sales, for
Year 12, 13
• Interest Expense = 6%
• Accounts Receivable: Days Accounts Receivable
Outstanding = 11 days for Year 12, 13
• Inventories: Days Inventory Held = 155 days for Year 12,
13
Using the ORIGINAL Numbers from projection.
SENSITIVITY ANALYSIS – WORST CASE
• No Sales (Revenue) Growth in Year 12, 13
• COGS increased to previous level, 69.2% of Sales for
Year 12, 13
• Selling, General and Admin Expense increased to 50% of
Sales for Year 12, 13
• Interest Rate increased to 7%
• Accounts Receivable: Days Accounts Receivable
Outstanding = 41 days for Year 12, 13
• Inventories: Days Inventory Held = 177 days for Year 12,
13
Using the WORST Numbers from past years.
SENSITIVITY ANALYSIS – MOST LIKELY CASE
• Sales (Revenue) Growth of 15% in Year 12, 13
• COGS increased to 61.2% (average of the past 3 years)
of Sales for Year 12, 13
• Selling, General and Admin Expense increased to 45% of
Sales for Year 12, 13
• Interest Rate increased to 6.5%
• Accounts Receivable: Days Accounts Receivable
Outstanding = 26 days for Year 12, 13
• Inventories: Days Inventory Held = 164 days for Year 12,
13
Using the AVERAGED Numbers from past years.
SENSITIVITY ANALYSIS
• Comparison of Data from the 3 Scenarios
Best Case
Most Likely
Worst Case
Case
Year
12
Year
13
Year
12
RETURN ON ASSETS (based on reported
amounts):
Profit Margin for ROA
x Asset Turnover
4%
3
10%
3
= Return on Assets
11%
28%
-24% -19% -10% -6%
2
63
3
6
-56% 1214% -26% -34%
ASSET TURNOVER:
Accounts Receivable Turnover
Revenues/ Average Cash
33.18 33.18 8.90
48.74 167.77 -3.94
Year
13
Year Year
12
13
8.90 14.04 14.04
-1.57 -9.32 -3.24
SENSITIVITY ANALYSIS
• Comparison of Data from the 3 Scenarios
Best Case
Current Ratio
Quick Ratio
Operating Cash Flow to Current Liabilities
Cash Gap (= Cash Cycle)
Days Sales Held in Cash
Worst Case
Year Year Year Year
12
13
12
13
0.92 1.24 0.43 -8.50
0.14 0.18 -0.61 -14.69
-0.04 0.27 -1.26 -1.23
69.00 77.00 166.63 165.50
7.49 2.18 -92.62 232.76
Operating Cash Flow to Total Liabilities
-2%
Interest Coverage Ratio (reported amounts) 1.91
Interest Coverage Ratio (recurring
amounts)
1.91
Most Likely
Case
Year
12
0.59
-0.31
-0.75
108.87
Year
13
-0.56
-2.40
-0.59
115.60
-39.18 112.69
14%
5.63
-75%
-7.39
-63%
-7.42
-43%
-3.94
-31%
-2.97
5.63
-7.39
-7.42
-3.94
-2.97
SENSITIVITY ANALYSIS
• From the data seen, that the company will not fare well,
even with relatively small changes in the forecast
variables
• Negative cash flows were observed for both the worst and
most likely scenarios
• It is not immediately clear what variables/assumptions are
having the most effect on the financial projection
• Other assumptions may be affecting the projection
• For a more thorough investigation, analysis should not be
limited to just the 6 key assumptions stated previously
SENSITIVITY ANALYSIS
• To have a better idea of how each of the assumptions
stated in the case affect the financial forecasts, each
assumption was treated as a variable, isolated and
individually varied
• “Goal Seek” was applied on to each variable
• Determine the value of the variable such that the Cash
account is zero for the projected year
• The absolute % error between the original assumed value
and the “Goal Seek” result of the variable will give an
indication of the sensitivity of the variable
• The smaller the absolute % error, the more sensitive
SENSITIVITY ANALYSIS
Sales (%)
COGS (%)
Selling and Administration
Expenses (%)
Interest Expense (%)
Days Account Receivable
Outstanding
Days Inventory Held
Days Account Payable
Outstanding
Legal Expenses ($)
Original Estimate
Year 12
Year 13
25.0
25.0
51.0
49.0
Goal Seek Result
Year 12
Year 13
21.4
22.6
52.1
47.7
Difference
Year 12
Year 13
-3.6
-2.4
1.1
-1.3
Abs % Error
Year 12 Year 13
14.4
9.6
2.2
2.7
41.0
41.0
41.9
40.7
0.9
-0.3
2.2
0.7
6.0
6.0
8.6
4.9
2.6
-1.1
43.3
18.3
11.0
11.0
12.7
13.2
1.7
2.2
15.5
20.0
155.0
155.0
162.2
152.2
7.2
-2.8
4.6
1.8
97.0
89.0
94.0
84.8
-3.0
-4.2
3.1
4.7
56,289
N/A
$
11,289
25.1
N/A
43,220
$
12,060
N/A
$
(4,280)
19.3
9.0
4,057
24.0
8.1
$
(6,512)
33.7
15.9
$
45,000
N/A $
Capital Expenditures ($)
$
62,500 $
Change in Notes Payable ($)
$
50,000
Other Current Liabilities ($)
$
33,500 $
Change in Long Term Debt ($)
$
- $
-
Change in Common Stock ($)
$
- $
-
Change in Additional Paid-in
Capital ($)
$
- $
-
47,500 $
$
$
(50,000)
41,000 $
74,560 $
37,991
22,211 $
$
$
(11,638)
$
$
(11,289)
$
$
(11,289)
$
$
(45,943)
34,488 $
(12,009) $
(11,289)
4,205 $
(11,638) $
4,205
N/A
N/A
4,777 $
(11,289) $
4,777
N/A
N/A
4,777 $
(11,289) $
4,777
N/A
N/A
SENSITIVITY ANALYSIS
• The variables most sensitive to change are:
• Selling and Administration Expenses
• COGS
• For Selling and Administration Expenses, the company
can easily control this cost by scaling down marketing
expenses
• Change company strategy: shift away from retail sales,
back to wholesale sales
SENSITIVITY ANALYSIS
• For COGS, it is very difficult for the company to control
• Company is very dependent on suppliers from various
parts of the world for parts (ie. metal castings, soapstone,
catalytic combusters)
• Company does not have the capability to manufacture
any of these parts
• If any one of the suppliers to raise prices such that cost is
2.2% or more on current sales, the company will run out
of cash (and therefore, cannot pay back interest, loan)
• Sourcing for new suppliers may be difficult, timeconsuming
SENSITIVITY ANALYSIS
• Metal and soapstone are commodities, and may be
subject to price fluctuations
• Fluctuations in exchange rates may also affect costs
• Company only has one revenue stream - the sale of
stoves – no other way to cover potential revenue
shortfalls
• Company had another business selling lawn products, but
it was unsuccessful and was discontinued
• 2.2% is a relatively small difference – makes the company
very risky and susceptible to external factors
CASH FLOW PROJECTION
• Low Cash Flow Ratios
• Original Projection shows that company can pay interest
and repay capital
• However, the projection and assumptions made are very
vulnerable to sensitivity checks
• COGS, the most sensitive variable, cannot be easily
controlled by the company
Risk Level: HIGH
RECOMMENDATIONS
Making a Decision
SUMMARY
Medium Risk
Circumstances
High Risk
High Risk
Medium Risk
Character of
Management
Cash Flow
Projection
Capacity for
Debt
Contingent
Liabilities
Credit Risk
Assessment
Credit History
Low Risk
Covenants
Collateral
High Risk
Medium Risk
High Risk
SUMMARY
• Reasonableness of the company’s projections:
• Projections are too optimistic, sensitive to variations
• Factors affecting industry:
• Uncertainty regarding regulations, enforcement
• Uncertainty regarding demand, expenses on design, tooling,
testing, and compliance
• Factors affecting company:
• High Short-term Liquidity Risk
• High Long-term Solvency Risk
• High Credit Risk
• Ability of company to repay loan:
• Low ability to repay loan
RECOMMENDATIONS
• For this particular case, the main risk faced by the bank
(lender) is credit default risk
• Based on the current and projected financials, MSC is a
very risky company:
• Low cash levels
• Highly leveraged
• Uncertain business environment
• Expenses difficult to control, predict
• The ability of MSC to pay back the loan is low
RECOMMENDATIONS
• There is very little collateral for the bank to hold on to
should MSC default
• The bank should loan the amount to MSC only if it can
charge an interest rate on the loan that is significantly
higher than the market rate
• The bank should also place strict covenants on the loan,
so that it can have more control over the loan conditions
and risks
• The bank can pass the risk to a third party by entering into
a credit default swap
GENERAL RECOMMENDATIONS
• Lenders can protect themselves from a potential credit
risk arising from sensitive ratios by:
• Risk-based pricing: Lenders generally charge a higher interest rate
to borrowers who are likely to default. Higher compensation for
taking higher risk.
• Covenants: Lenders may write into loan agreements certain
stipulations that borrowers must comply with. Protects against
undue deterioration of borrower’s financial condition.
• Credit insurance and credit derivatives: Lenders may hedge their
credit risk by purchasing credit insurance or credit derivatives.
These contracts transfer the risk from the lender to the seller
(insurer) in exchange for payment.
THE END
Thank you for listening!