The following assumptions pertain to the pro-forma statements. The income before interest and tax is assumed to be 23% of the month’s sales. Accruals and prepaid expenses are assumed to be constant from September to December 31, 1979. Inventories are assumed to equal total liabilities and stockholder’s equity minus total assets (without inventories), as balances for the given data for inventories is insufficient to determine effects of less raw materials purchases, etc.
Areas for consideration
Capacity
Hampton’s cash budget for succeeding months, assuming:
Extension of the $1 Million debt and granting of $350,000 loan, payable on December 31, 1979
Extension of the $1 Million debt and granting of $350,000 loan, with interests on both debts, payable in lump sum on December 31, 1979
Rejection of the extension of $1 Million debt, and granting of $350,000 loan, payable on December 31, 1979
Extension of the $ 1 Million debt, payable on December 31, 1979, and rejection of $350,000 loan
Extension of the $1 Million debt, payable on Dec. 31, 1979, and granting of $350,000 loan, payable on January 31, 1980
Hampton’s liquidity ratios
Hampton’s activity ratios
Hampton’s profitability ratios
Hampton’s cash flow management
Conditions
Economic Condition
Probable reasons why the company would not be able to pay its initial loan
Measures which Hampton plans to take in the next few months
Character
Relationship with Hampton Machine Tool Company
Capital
Hampton’s debt ratios
Collateral
Alternative Courses of Action
Extend the $1 Million debt and grant $350,000 loan, payable on December 31, 1979
Extend the $1 Million debt and grant $350,000 loan, with interests on both debts, payable in lump sum on December 31, 1979
Reject extension of $1 Million debt, and grant $350,000 loan, payable on Dec. 31, 1979
Extend the $ 1 Million debt, payable on December 31, 1979, and reject $350,000 loan
Extend the $1 Million debt, payable on Dec. 31, 1979, and grant $350,000 loan, payable on January 31, 1980
Reject both the extension of $1 Million debt and $350,000 loan application
Analysis using the “5 C’s of Credit”
Capacity
Hampton’s cash budget, assuming:
Extension of the $1 Million debt and granting of $350,000 loan, payable on December 31, 1979 (refer to Exhibit A)
For Hampton to be able to pay both debts on December 31, the interest rate should be less than -5.55% per month. No bank would give a negative interest rate, and thus, payment of both debts on December 31 is very unlikely.
Extension of the $1 Million debt and granting of $350,000 loan, with interests on both debts, payable in lump sum on December 31, 1979 (refer to Exhibit B)
To ensure the payment of both debts on December 31, the interest rate should be less than -5.55% per month. Again, no bank would give a negative interest rate, and consequently, payment of both debts on December 31 is also very unlikely.
Rejection of the extension of $1 Million debt, and granting of $350,000 loan, payable on December 31, 1979 (refer to Exhibit C)
The advantage of this tactic is that bank's losses on this customer would be cut, and it would also keep the bank from throwing more money at a poorly performing customer that is nearing default. The disadvantage of this route is that Hampton is in a poor foreclosure position, as its machines are becoming inefficient. The company’s operations would suffer sooner or later, and Hampton would not be able to raise an amount to cover the bank's existing loan on December. Furthermore, as shown in Exhibit C, the interest rate should be less than -15.35% per month so that Hampton could pay the $1,000,000 debt on September 30 and the $350,000 debt on December 31. A rate like this is impossible, and thus, payment of both debts is also very unlikely.
Extension of the $ 1 Million debt, payable on December 31, 1979, and rejection of $350,000 loan
This alternative would allow Hampton to make capital purchases that would enable it to manufacture at capacity. The problem with this option is that, according to the Pro-Forma statements, Hampton would probably not have the cash to make capital purchases, pay a dividend and still pay the loan back by the end of December. Assuming that the cash budget would be accurate, Hampton would be able to pay the $1,000,000 loan, and it would still have a cash balance of $29,000 on December 31, 1979. The effective interest rate is 6%, and the bank would earn $60,000 in interest from this transaction. This might put the bank and Hampton in a new default situation.
Extension of the $1 Million debt, payable on Dec. 31, 1979, and granting of $350,000 loan, payable on January 31, 1980
Assuming that the cash budget would be accurate, Hampton would be able to pay the $1,000,000 loan on December 31, leaving cash balance of $18,500 on December 31, 1979. The bank would earn $60,000 in interest, and the effective interest rate for this loan is 6%. On January 31, 1980, Hampton would also be able to pay the $350,000, leaving cash balance of $928,250. This is because the amounts due from the strong sales ($2.265.000) during December would be collected in January. The effective interest for this loan is 4.5%, and the bank would earn $15,750 in interest. The net cash inflow from both debts would be $75,750.
Hampton’s liquidity ratios (refer to Exhibit F)
Net working capital increased from Dec 1978 to Aug 1978. Current ratio peaked at June 1979, but recently is falling slightly; nevertheless, the current ratio as of Aug 1979 is still greater than that of Dec 1978. The quick ratio peaked also on June 1979, but since then, it has fell, esp. during August, partly because of the decrease in receivables. The quick ratio as of Aug 1979 is less than that of Dec. 1978. The paradox of increasing current ratio and net working capital but decreasing quick ratio could be attributed to the fact that the company's inventories have almost doubled from its 1978 level.
Hampton’s activity ratios (refer to Exhibit G)
Its average age of inventory slightly improved from its level in 1978. But it hit an all-time low in Aug 1979, becoming almost 7 times slower than its level at Dec 1978. This is a result of an increase in inventories. The company held a buffer stock of raw materials, and also because there are work-in-process inventories awaiting arrival of electronic components from suppliers before completion. This could also be attributed to the fact that the manufacturing of its products takes 5-6 months so goods-in-process comprise a major part of its inventories, and the lack of new equipment may have led to inefficiencies in construction.
Regarding its receivables management, it seemed to improve, but the average collection periods in July and August are causes for concern. This may be partly due to the fact that the company has a backlog of orders, and has a 5-6 months construction period for more complex products. The average collection period would have been longer, if not for the decrease in receivables in August. However, a further study should be undertaken to determine the cause of the problem in collection period (esp. in July and August), as credit terms of the company is n/30. Its asset turnover seems to have decreased slightly. This is because total assets increased.
Hampton’s profitability ratios (refer to Exhibit H)
Sales for the first 8 months of 1979 is greater than the sales during 1978 and selling and administrative expenses were lower; thus, net income was not adversely affected. Gross profit margin fell, due to increase in cost of sales or decrease in markup, despite the increase in sales. However, operating profit and net profit margins increased due to the decrease in selling and administrative expenses. The company's EPS has improved for most of the part in 1979, owing to the effect of treasury shares the company had. The net income's movement directly affected the EPS during 1979, which is why it fell during July and August 1979 (when net income were smaller), and party why it is greater compared to 1978, as net income is higher. ROA and ROE improved from their 1978 levels. ROE’s increase could be attributed to both the financial leverage multiplier and ROA.
The FLM for the 1st 8 months of August (2.2938) is greater than the FLM of 1978 (2.2498). This is both caused by the increase in common stock equity and total assets. However, the decrease in common stock equity during Dec 1978 was caused by the acquisition of treasury shares.
On the other hand, ROA for the 1st 8 months of August (14.11%) was greater than that of 1978 (13.33%). It was caused by the increase in net profit margin, which more than offset the decrease in asset turnover. The increase in net profit margin was due to a higher net income, resulting from lower selling and administrative expenses and higher sales. In fact, the sales and net income for the first 8 months of 1979 has exceeded those of 1978. However, total asset turnover slightly fell, due to increased in total assets which more than offset the increase in sales. One of the culprits is inventories, as inventory turnover fell, and the company's inventories have almost doubled from its 1978 level.
Hampton’s cash flow management (refer to Exhibit I)
Operating cash flow improved from 1978 to the first 8 months of 1979. Thus, the company is generating positive cash flows, and its generated cash flows from operations increased. However, its net current asset investment increased tremendously, partly because the company purchased more raw materials than needed during the first 8 months of 1979, which could have been used for more profitable investments or non-current assets. The company, meanwhile, did not invest in its fixed assets, which made it less risky (since the company became more liquid) but less profitable (as current assets are less profitable than fixed assets). And because of the large increase in net current asset investments, the company has smaller free cash flow compared to its 1978 level, which means that the company has less cash flow to cover all of its operating costs and investments than before. This is also a cause for concern, since the free cash flow has fallen tremendously and the company would have a harder time paying its creditors and stockholders. The company is still in need of more cash (and this is further proven by the fact that the company's cash is less than the customers' advances).
Conditions
Economic Condition
The regional capital goods industry, including Hampton, suffered from the Arab oil embargo which led to higher oil prices. There was also the 1974-1975 recession, which slowed down the US economy. However, Hampton recovered prior to 1979, because of the increase in military aircraft sales, a stable automobile market, and increase in market share of Hampton, as its conservative financial policies aided in its survival amidst economic and financial difficulties. Furthermore, Hampton’s sales forecast shows a significant increase in sales during the succeeding months, showing that Hampton is confident in its future.
Probable reasons why the company would not be able to pay its initial loan
The company has problems on paying its initial $1 million loan due to the fact that their actual sales were less than the forecast sales. This can be attributed to three major factors. First, a major component supplier failed to deliver their part on time. This caused Hampton to have seven machines worth $1.32 million completed except for the inclusion of these parts. Second, the company bought $420,000 worth of components over its normal levels of inventory. This, together with the goods in process worth $1.32 million mentioned above, has caused an excessive investment in inventories. Third, the company's machines have given Hampton problems with maintaining capacity production. Their machines are getting older and less efficient, since the company has tried not to investment in capital expenditures as it wants to conserve cash. It also wants to pay a dividend of $150,000 in December 1979, as goodwill for their stockholders who did not desert the company, and as a means to maintain their loyalty. Thus, the company will have less cash available on December. However, these reasons are mostly temporary, as the company will undertake measures to solve some of these problems.
Measures which Hampton plans to take in the next few months
Hampton plans to use the additional $350,000 to purchase new equipment to maintain production efficiency. This would mean an additional $5,250 interest payment from November to December, and an additional after-tax depreciation expense of $1,895.83 per month. The equipment would also give rise to a deferred tax asset of $35,000, which means that Hampton would have tax savings of $35,000 on March 15, 1980.
Hampton would pay taxes of $181,000 on September 15 and on December 15. It also plans a larger dividend payment, $150,000, on December. However, the electronic components which caused delays in shipment arrived last week, and together with the new equipment, this could lead to increased sales. If Hampton’s forecast turns out accurate, Hampton would earn $7,537,000 from September to December 31, 1979. And on October, the advances of General Aircraft Corporation would become zero since Hampton’s shipments would exceed $1,566,000. This would reduce Hampton’s current liability. Furthermore, selling and administrative expenses is expected to fall to $400,000.
Regarding Hampton’s inventories, the excess in raw materials of $420,000 is expected to be used up by the end of the year. Raw material purchases would fall to about $600,000 per month, and work-in-process goods worth $1,320,000 is expected to be completely constructed and sold in the weeks to come.
The effects could be seen in the pro-forma Income Statements ( exhibit L and N), pro-forma Balance Sheets (exhibit M and O), and the ratios (exhibit P) under both alternatives. The net income for September to December is almost equal to the net income from January to August for both alternatives. Profit margins have also increased, though EPS, ROA and ROE fell slightly due to the slight decrease in asset turnover (but it’s not sign of inefficiency, as net sales are slightly lower during the 4 months than those of previous 8 months). Average Age of Inventory and Average Collection period is significantly better under the 4 months for both alternatives, and debt ratio has fallen (due to payment of $1,000,000 loan). And although operating cash flow is slightly lower, the free cash flow under both alternatives is significantly greater.
Character
Relationship with Hampton Machine Tool Company
Mr. Cowins, Hampton’s President, was known by the bank’s management well, and is widely-respected by the business community. Hampton kept ample cash balances at the St. Louis National Bank. Mr. Cowins also sent Hampton’s financial statements to the bank regularly. Hampton’s market shares also improved, and it has survived the crisis in the mid-1970s. However, during the 10 years prior to December 1978, Hampton had no debt in its balance sheet.
Capital
Hampton’s debt ratios (refer to spreadsheet for solutions)
The company’s debt ratio (57.03%) increased despite the decrease in accruals (excluding taxes payable), due to the increase in accounts payable, taxes payable and customer advances. This is not necessarily bad, since firstly, the company does not have long-term liabilities, secondly, because the company has become relatively more liquid based on the analysis above, and lastly, it has increased financial leverage. The times interest earned ratio has fallen slightly, attributable to lower earnings before interest and taxes from the decrease in sales. From the debt ratio, it could be inferred that the company’s stockholders owns 42.97% of company assets.
Collateral
As seen in Hampton’s Balance Sheet, most of its assets are current assets. Given that the debt of Hampton is a short-term one, Hampton seems to have sufficient current assets which could be used as a collateral or security for its debt.
The bank could choose Hampton’s receivables or inventory as a security for the debt. Hampton’s inventory is more than sufficient to cover the $1,350,000 debt in cases of non-payment. However, Hampton’s inventory is mostly composed of specialized items, as these are usually made to order. It isn’t also marketable, as Hampton’s inventory is mostly raw materials and goods-in-process. Thus, Hampton’s inventory is not desirable collateral.
On the other hand, Hampton’s receivables could be used as collateral, as Hampton’s customer segments are the military aircraft manufacturers and automobile manufacturers. However, Hampton’s receivable ($684,000) is just about half of the $1,350,000 that Hampton wants to borrow. Furthermore, given the assumption that receivables would be collected in full the following month, Hampton will never agree to pledge or factor its receivables, since it will be costly for Hampton.
Evaluation
Hampton’s debt relative to its equity is slightly larger. Hampton stockholders own about half (42.97%) of the company’s assets, which is quite acceptable. Since significant personal financial risks in the part of stockholders are present, the bank would be assured that the management would responsibly manage the company. Thus, Hampton would pass the Capital criterion.
Hampton is rather untested if it is responsible in meeting its obligations, as it had no debt prior to December 1978. However, Mr. Cowins’ seems to be worthy of the loan, as his character is respectable. He diligently complied with the requirements the bank gave him. And he has a good reputation.
Meanwhile, the conditions for Hampton seem favorable. The economic conditions, if they will continue, would enable Hampton to completely recover. As for internal conditions, one root cause of Hampton’s free cash flow and turnover problems is the company's inventory level, which doubled from its 1978 level. This is due to increases in raw material purchases and delays in shipping contributing to increases in goods in process. During July and August, the company purchased excess raw materials, and it also paid off commissions payable to its 3 sales people. However, Hampton’s inventory level is expected to normalize during the next months. The problems mentioned above seem temporary, as the company will reduce its purchases, expenses (except interest expense), and investments in inventory for the succeeding months. The new equipment would also maintain, if not increase, Hampton’s production efficiency, and could aid Hampton in its goal of shipping more products, thus, more sales, if their forecasts would turn out to be accurate. Furthermore, based on the pro-forma statements and ratios under alternatives D and E, it turns out that the liquidity, activity, profitability, and free cash flow would significantly improve, while the debt ratio would be lower. But then, these effects will materialize only if no negative fortuitous event occurs.
The most critical criterion is Capacity to pay. Although Hampton seems to be getting more liquid, it doesn’t necessarily mean that Hampton could easily pay its short-term obligations, since a bulk of its current assets are specialized, not easily marketable inventories. Hampton became more profitable, and its operating cash flow increased, which implies that Hampton has a good chance of meeting its obligations from its operations alone. However, the operation during the months July and August was unimpressive (though these months contributed to increases in profitability ratios despite the decrease in net income), as the company earned less net income and became less inefficient with its asset management. But taking a closer look at Hampton’s cash flow management, its free cash flow, which is the amount available to creditors and stockholders, fell sharply from its 1978 level of $2,025,120 to $161,520, a reduction of $1,863,600. The company’s asset turnover also worsened, and its inventory turnover ratio during July and August were terrible. Thus, Hampton’s capacity to pay its debt without external financing as of the moment is doubtful.
But as mentioned beforehand, the conditions seem favorable to Hampton. Thus, if actual sales would be near the forecasted amounts, Hampton would need less external financing to settle its obligations with the bank, and thus, it would have a greater capacity to pay.
But Hampton’s capacity to pay would also depend on the terms of the obligation to be given to them. As mentioned above, if the bank extends the $ 1 Million debt (payable on December 31, 1979) and reject $350,000 loan, or if the bank extends the $1 Million debt (payable on December 31, 1979), and grants $350,000 loan (payable on January 31, 1980), the company would be able to meet its obligations. This shows that Hampton has no problem in fulfilling the $1 million loan; its problem is the payment of the $350,000 loan. As shown by Exhibits A and B, the company has no capacity to pay both debts on December 31. However, the company would be able to pay the $350,000 loan on January 31, 1980, due to the increase in sales.
Hampton’s most feasible collateral would be its receivables, as its inventory is specialized and isn’t easily marketable. However, the receivable as of August is only half of the debt requested by Hampton. Furthermore, Hampton would probably not agree to pledge or factor its receivables (given the assumptions abovementioned), as it would lead to less cash inflows to the company. Moreover, collateral is unnecessary, since the company would be able to meet its obligations in the both of the feasible proposals discussed above.
Hampton has passed the 5 C’s of Credit. The problem is determining which among the feasible alternatives the bank should undertake. As shown in Exhibits D and E, the latter proposal yields larger net cash inflow. However, the $350,000 loan could be invested to have larger yield. But since the prevailing rate of market interest was not given, and since interest rates for short-term loans are generally larger than interest rates for short-term investments and cash equivalents, it would be reasonable to assume that the returns from lending to Hampton the $350,000 would be greater than investing in short-term investments.
Furthermore, the company would be more apt to face deviations from forecasted sales (esp. lower actual sales) under alternative E than in alternative D. Under alternative E (refer to Exhibit E2), the company would be able to pay both debts unless actual sales on the average drop 13.95% from the forecasted sales. Under alternative D (refer to Exhibit D2), the company would be able to pay the $1,000,000 loan unless actual sales on the average drop 0.66% from forecasted sales. The actual deviations from January to August range from -48.72% to 71.79%, with an average of 22.66% (27.11% if total forecasted and actual sales are used). These figures are closer to the allowable limit under alternative E. Thus, it seems better for the bank to lend an additional $350,000 to Hampton, payable on January 1980. However, those mentioned above are not the only alternatives possible.
Decision Tree
Exhibit Q shows a decision tree about the various alternatives the bank has. The presumed goal is to find the alternative which will maximize the bank’s profit. The basic premise is that if the actual sales’ percentage drop from forecasted sales is greater than the minimum allowable percentage drop, Hampton would not resort to external financing, and instead, default on its loans. (Given the fact that Hampton has a conservative financial policy and has no debt in its balance sheet for 10 years, it seems that Hampton would exhaust all possible means before resorting to external financing, and that Hampton would not want additional obligations from other creditors.) However, interest payments are assumed to be paid, regardless of whether the principal is paid or not. In cases of default, the bank would incur bad debts expense, which is assumed to be equal to 2% of the principal. (The rate of bad debts is probably small, as Hampton’s customers are large companies and would probably not default; besides, an assumption was made that accounts would be paid within 30 days. The effects would be the same until the rate of bad debts exceed 6.34%, in which case, doubling the interest rates would overtake alternative E). The probability that the hypothesized population mean, μ0, (or in this case, the allowable percentage drop in sales) would be greater than the observed sample mean (or in this case, the mean actual deviations in forecasted sales from January to August 1979), which was computed thru the z-test, was used as the probabilities of payment or default in each case. Although the deviations from actual sales would probably be smaller due to seemingly more favorable conditions, the actual sales deviations were used as sample data without adjustments, since this is more reliable and more conservative. Another assumption was that 75% of the time, Hampton would refuse either a shorter credit period or a higher interest rate, which will make Hampton search for banks offering more friendly terms. (75% was set arbitrarily. As long as the probability of refusal is greater than 50.78%, the results would not change.)
The usefulness of decision trees is that, the user has some degree of flexibility in dealing with uncertainties. It could give the steps the company probably should take, when the outcome of uncertain events is resolved. Between granting and rejecting the extension of the $1 Million loan, the bank is better off granting the loan, as the maximum EMV under rejecting the extension is significantly lower. Next, the bank should conduct a more comprehensive study to determine more accurately whether the company would have sufficient cash to retire both obligations or not. If yes, then the company should grant both loans. But if not, the bank has a variety of options aside from agreeing to the terms which Hampton wants, like modifying the credit period, the interest rate, or the payment of interest (as to whether monthly or lump sum). Among these four alternatives, the bank should modify its credit period. And from the decision tree, the extension of the credit period shows a higher EMV than reducing the credit period; thus, the bank should extend the credit period. If the actual sales would insignificantly deviate from the forecast, the bank would earn an interest income of $75,750; otherwise, the company would also incur a bad debts expense of $27,000 aside from the interest income. Another thing to be noticed is that among the alternatives, alternative E appears to be the least risky alternative, since the probability of actual sales percentage drop exceeding the allowable percentage drop in this alternative is the least among the alternatives. Actually, by doubling the interest rates, the company would earn more interest income; however, Hampton would most likely find another bank offering more friendly terms if this alternative is undertaken.
But even if the table effectively shows some of the various means available for the bank, the results are not 100% accurate. Many assumptions were made due to the lack of data. This in turn constrained the list of alternatives which made it non-exhaustive. Other alternatives would involve a mixture of these strategies, or strategies requiring much further data. One possible alternative is to extend the original Hampton loan with increased debt covenants along with a built in extension option with a rate bump to 2% per month. Under this scenario, Hampton would be required to push back the $350,000 purchase of additional equipment, and would also have to indefinitely push back the $150,000 dividend. The loan will have a built-in extension with a rate bump in the event that Hampton is unable to pay down the loan by the December 1979. However, determining the likelihood that Hampton would indeed defer dividend payment (as its stockholders might pressure the company to pay), the incremental rate in case of default, and the amounts and effects of pledges or debt covenants, is very unlikely and reasonable assumptions could not be made without further study and data.
Recommendation
Since the company’s problems are mostly temporary and since the company passed the 5 C’s of Credit, the bank should grant both Hampton’s loan refinancing of the $1,000,000 loan (to be paid on December 31, 1979), and the additional $350,000 that Hampton wants to borrow (payable on January 31, 1980). However, it is very much advisable for St. Louis National Bank to undertake further studies and collect more data, such as industry ratios and data, prevailing interest rates, financial statements from prior years etc., to permit a better and more informed decision.
