1. Massachusetts Stove Company
Presented by Group 1: Alex Yeung, Jiyeon Kim, Philip Lee, & Samuel Lee

2. Overview
Introduction
The Issue
Analysis
Recommendations

3. Introduction
Company Background

4. Massachusetts Stove Company (MSC) (essentially an assembly operation)
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

5. COMPANY BACKGROUND Business Strategies Operations Sales & Marketing
Rent a building for manufacturing and administrative activities
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

6. 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

7. COMPANY BACKGROUND Current Business Situation
Incurring high operating & investing costs 1 3
Legal Cost 2
Company sued the owner of the building
Incurred legal cost of $68,465 in Year 11
Retooling & Testing Cost for EPA approval
Soapstone Stove II:
forecasted additional $55,000 in Year 12 and $33,000 in Year 13
Acquire the building that is currently rented
Exercised an option to purchase for $608,400 in Year 9
However, owner refused to comply with the option provisions

8. The ISSUE
“To Lend or Not To Lend?”

9. THE CASE Financing Plan of MSC: Purpose of Loan: The Issue:
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

10. THE CASE Actual Results Projections Year 8 Year 9 Year 10 Year 11
Year 12: Additional $50,000 Loan
Year 13: Pay back the $50,000 Loan
Actual Results
Projections

11. 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

12. 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

13. Analysis
Crunching and Interpreting the Numbers

14. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

15. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

16. Return on Assets (ROA) ROA is expected to be improved due to:
Better After-Tax Operating Profit Margin (ATOPM)
Increased Asset Turnover (AT)
(ROA = ATOPM x AT)

17. After-Tax Operating Profit Margin
Year 9
Year 10
Year 11
Year 12
Year 13
Revenues
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%
Legal
-4.3%
-3.8%
-1.0%
0.0%
Core Operating Profit
-0.2%
-1.4%
4.2%
10.0%
Interest Income
Other Income, Gains, Expenses and Losses
Income Before Tax
Income Tax Expense
After-Tax Operating Profit Margin

18. 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.

19. Circumstances Risk Level: MEDIUM
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

20. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

21. Relatively large amounts of Paid In Capital (PIC) from shareholders

22. 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

23. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

24. 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

25. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

26. Covenants Risk Level: HIGH 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

27. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

28. Low Levels of Long Term Assets
Asset Values
Low Levels of Long Term Assets
Most long term assets are already as collaterals for the notes payable.

29. Low levels of cash and account receivables
Short Term Liquidity
Low levels of cash and account receivables

30. Acceptable Current Ratio, but Low Quick Ratio (risky if <1)
Short Term Liquidity
Acceptable Current Ratio, but Low Quick Ratio (risky if <1)

31. 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

32. 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

33. Collateral Risk Level: HIGH 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

34. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

35. Decreases in Short Term Debt, Increases in Long Term Debt
Credit History
Decreases in Short Term Debt, Increases in Long Term Debt

36. Credit History Risk Level: MEDIUM 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

37. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

38. Debt ratio
High debt ratio (total assets cannot cover total liabilities)
– negative shareholders’ equity

39. 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

40. Long Term Solvency High financial leverage
- Total liabilities : on average 1.4 times of Equity (Paid in Capital)

41. Capacity for Debt Risk Level: HIGH 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

42. Analysis – Loan Assessment
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection

43. Cash Flow to Liabilities
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
Year
Year 9
Year 10
Year 11
Year 12
Year 13
Operating Cash Flow to Current Liabilities
0.187
0.182
0.142
-0.040
0.270

44. Cash Flow to Liabilities
Low Operating Cash Flow to Total Liabilities Ratio
A ratio of 0.20 or more is common for a financially healthy company
Year
Year 9
Year 10
Year 11
Year 12
Year 13
Operating Cash Flow to Total Liabilities
0.101
0.098
0.076
-0.022
0.145

45. 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

46. 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.

47. 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.

48. 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.

49. Sensitivity Analysis Comparison of Data from the 3 Scenarios Best Case
Worst Case
Most Likely Case
Year 12
Year 13
RETURN ON ASSETS (based on reported amounts):
Profit Margin for ROA 4%
10%
-24%
-19%
-10%
-6%
x Asset Turnover 3 2 63 6
= Return on Assets
11%
28%
-56%
-1214%
-26%
-34%
ASSET TURNOVER:
Accounts Receivable Turnover
33.18
8.90
14.04
Revenues/ Average Cash
48.74
167.77
-3.94
-1.57
-9.32
-3.24

50. Sensitivity Analysis Comparison of Data from the 3 Scenarios Best Case
Worst Case
Most Likely Case
Year 12
Year 13
Current Ratio
0.92
1.24
0.43
-8.50
0.59
-0.56
Quick Ratio
0.14
0.18
-0.61
-14.69
-0.31
-2.40
Operating Cash Flow to Current Liabilities
-0.04
0.27
-1.26
-1.23
-0.75
-0.59
Cash Gap (= Cash Cycle)
69.00
77.00
166.63
165.50
108.87
115.60
Days Sales Held in Cash
7.49
2.18
-92.62
-39.18
Operating Cash Flow to Total Liabilities
-2%
14%
-75%
-63%
-43%
-31%
Interest Coverage Ratio (reported amounts)
1.91
5.63
-7.39
-7.42
-3.94
-2.97
Interest Coverage Ratio (recurring amounts)

51. 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

52. 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

53. Sensitivity Analysis Original Estimate Goal Seek Result Difference
Abs % Error
Year 12
Year 13
Sales (%)
25.0
21.4
22.6
-3.6
-2.4
14.4
9.6
COGS (%)
51.0
49.0
52.1
47.7
1.1
-1.3
2.2
2.7
Selling and Administration Expenses (%)
41.0
41.9
40.7
0.9
-0.3
0.7
Interest Expense (%)
6.0
8.6
4.9
2.6
-1.1
43.3
18.3
Days Account Receivable Outstanding
11.0
12.7
13.2
1.7
15.5
20.0
Days Inventory Held
155.0
162.2
152.2
7.2
-2.8
4.6
1.8
Days Account Payable Outstanding
97.0
89.0
94.0
84.8
-3.0
-4.2
3.1
4.7
Legal Expenses ($)
$ ,000
N/A
$ ,289
$ ,289
25.1
Capital Expenditures ($)
$ ,500
$ ,500
$ ,560
$ ,220
$ ,060
$ (4,280)
19.3
9.0
Change in Notes Payable ($)
$ ,000
$ (50,000)
$ ,991
$ (45,943)
$ (12,009)
$ ,057
24.0
8.1
Other Current Liabilities ($)
$ ,500
$ ,000
$ ,211
$ ,488
$ (11,289)
$ (6,512)
33.7
15.9
Change in Long Term Debt ($) $ $
$ (11,638)
$ ,205
$ (11,638)
$ ,205
Change in Common Stock ($)
$ (11,289)
$ ,777
$ ,777
Change in Additional Paid-in Capital ($)

54. 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

55. 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, time-consuming

56. 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

57. Cash Flow Projection Risk Level: HIGH 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

58. Recommendations
Making a Decision

59. Credit Risk Assessment
Summary
Medium Risk
Credit Risk Assessment
Circumstances
Character of Management
Contingent Liabilities
Covenants
Collateral
Credit History
Capacity for Debt
Cash Flow Projection
High Risk
Low Risk
Medium Risk
High Risk
Medium Risk
High Risk
High Risk

60. 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

61. 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

62. 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

63. 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.

64. Thank you for listening!
The End
Thank you for listening!

65. ANALYSIS – RISK ASSESSMENT
Performance Risk
- Profitability
Credit Risk
- 8 ‘Cs’ of Credit
Assessment
Financial Risk
- Financial Structure
Business Risk
- Operating Cycle
Reasonableness
of Projection
Loan
Sensitivity Analysis

66. Company Background Shareholders & Corporate governance 3
Jane O’Neil, CEO, owns 51% common stock
Remaining 49% own by CFO, VP for manufacturing and 4 independent investors
Financial Analysis 3
Repayment Plan
To pay interest for $50,000 new loan monthly
To pay back $50,000 by end Year13

67. Financial Flexibility
Reformulated Balance Sheet

68. Financial Flexibility
Reformulated Income Statement

69. Financial Flexibility
Check the company ability to use creditor financing effectively to increase the returns to shareholders’ equity
Spread measures the return on operating assets
Spread = Operating ROA – Net borrowing rate
Under similar leverage ratio, spread has improvement in Year 11

70. Cash Flows - Projection
CREDIT RISK ASSESSMENT – 8 ’Cs’
Cash Flows - Projection

71. Cash Flows - Projection
CREDIT RISK ASSESSMENT – 8 ’Cs’
Cash Flows - Projection
MSC borrows $50,000 loan at Year 12
Assuming no change in investing and financing cash flow in Year 13
Net cash flow = $104,012 by end of Year 13
Net present value of net cash flow at Year 13
= $104,012 / (1+ 6%) – $50,000
= $48,124.5 > 0
That is, by end of Year 13, MSC will have enough cash to pay back the bank loan under condition of no significant change in investing and financing cash flow

72. Cash + Marketable Securities + Account Receivables
Short-Term Liquidity
Current Ratio =
Current Assets
Current Liabilities
Quick Ratio =
Cash + Marketable Securities + Account Receivables
Current Liabilities
Current Assets of the company includes:
Cash
Account Receivables
Inventories

73. Sensitivity Analysis The variables most sensitive to change are:
Original Estimate
Goal Seek Result
Difference
% Error
Year 12
Year 13
Sales (%)
25.0
21.4
22.6
-3.6
-2.4
-14.4
-9.6
COGS (%)
51.0
49.0
52.1
47.7
1.1
-1.3
2.2
-2.7
Selling and Administration Expenses (%)
41.0
41.9
40.7
0.9
-0.3
-0.7
Interest Expense (%)
6.0
8.6
4.9
2.6
-1.1
43.3
-18.3
Acquisition of Building ($)
608,400
N/A
67,831
-540,569
-88.9
The variables most sensitive to change are:
COGS
Selling and Administration Expenses
Acquisition of the building will affect cash position drastically, unless the company can secure a long-term loan for it
In addition, the assumptions are not very robust and slight changes can drastically alter the company’s performance

74. Return on Equity (ROE) ROE = ROA + (ROA- I*) x (L/E)
Despite improved ROA, ROE has deteriorated a lot due to increased leverage driven by the bank loan, totalling $50,000
ROE is affected by large increase in financial leverage
The decision to borrow money for business expansion will result in a decrease of shareholders’ equity value

75. Asset Turnover
Asset turnover improved due to increased receivable turnover

76. REASONABLENESS OF PROJECTION
The assumptions are not very robust and slight changes can drastically alter the company’s performance
Numbers and assumptions in the projection are not robust
Comparing actual & forecast compound annual growth rate, operating income projection is overestimated by 14.5% (5% % + 23%)