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

Overview Introduction The Issue Analysis Recommendations

Introduction Company Background

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

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

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 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

The ISSUE “To Lend or Not To Lend?”

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

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

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 Credit Risk Assessment Circumstances Character of Management Contingent Liabilities Covenants Collateral Credit History Capacity for Debt Cash Flow Projection

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

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)

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

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 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

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

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 Credit Risk Assessment Circumstances Character of Management Contingent Liabilities Covenants Collateral Credit History Capacity for Debt Cash Flow Projection

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 Credit Risk Assessment Circumstances Character of Management Contingent Liabilities Covenants Collateral Credit History Capacity for Debt Cash Flow Projection

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

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

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.

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

Acceptable Current Ratio, but Low Quick Ratio (risky if <1) 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 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

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

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

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

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

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 High financial leverage - Total liabilities : on average 1.4 times of Equity (Paid in Capital)

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

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

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

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

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 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

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 -232.76 -39.18 -112.69 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)

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 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 ($) $ 45,000 N/A $ 56,289 $ 11,289 25.1 Capital Expenditures ($) $ 62,500 $ 47,500 $ 74,560 $ 43,220 $ 12,060 $ (4,280) 19.3 9.0 Change in Notes Payable ($) $ 50,000 $ (50,000) $ 37,991 $ (45,943) $ (12,009) $ 4,057 24.0 8.1 Other Current Liabilities ($) $ 33,500 $ 41,000 $ 22,211 $ 34,488 $ (11,289) $ (6,512) 33.7 15.9 Change in Long Term Debt ($) $ - $ - $ (11,638) $ 4,205 $ (11,638) $ 4,205 Change in Common Stock ($) $ (11,289) $ 4,777 $ 4,777 Change in Additional Paid-in Capital ($)

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, time-consuming

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 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

Recommendations Making a Decision

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

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.

Thank you for listening! The End Thank you for listening!

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

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

Financial Flexibility Reformulated Balance Sheet

Financial Flexibility Reformulated Income Statement

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

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

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

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

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

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

Asset Turnover Asset turnover improved due to increased receivable turnover

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% - 13.5% + 23%)