COMM 371, Lecture 7 COMM 371, Lecture 7

Lecture 7: Financing Seasonal Needs - Toy World, Inc.

• Objectives: Case Facts

• To understand the pattern of current assets and cash flows
in a company with seasonal sales, and how these are
affected by the choice of production plan
• To understand the trade-off between profitability versus
risk and liquidity in choosing between level and seasonal
production
• To practice the mechanics of basic financial analysis
• Highly seasonal sales (80% of sales between August and
November)
• Current production follows sales, and thus is highly seasonal.
• Question: should the company smooth production over the year?
• Examine pro-forma monthly statement of cash flows for 1994,
constructed with base on pro-forma tables reported by company

What is it that we are trying to help Mr. McClintock with?

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 COMM 371, Lecture 7 COMM 371, Lecture 7

What we will do The Current (Seasonal) Production Plan

Production is approximately equal to sales (production in response

• Assess Toy World’s need for external financing under its current to customer orders). Cost and benefit of the seasonal production
(seasonal) production plan. Discuss the timing, magnitude, and plan:
duration of borrowing needs, and risk.
• Inventory
• Inventory is minimized and the funds necessary to finance
• Assess Toy World’s need for external financing under the inventory is minimized.
proposed level production plan • Inventory risk is minimized.

• Conceptual discussion • Costs

• The mechanics of preparing the pro forma income
statement and balance sheet
• Would a bank be likely to provide the financing necessary under
the smooth production plan?
• Would you recommend adoption of the level production plan?
• Cost savings versus risks
• Overtime premiums in high season (reduces profits)
• Difficulty in scheduling production runs & shorter
production runs
• Fixed capital is underused part of the year and then run to
capacity
• Seasonal financing requirements
• Primarily receivables financing during the collection lag
after the months of peak sales (lag is 60 days)
• The firm stays comfortably within its current credit line (it
is owing $752 thousands at the end of 1993, and the bank
is willing to extend a credit line of up to $2 million in
1994)
• Cash balance stays at a minimum required to finance
operations

See pro-forma IS and BS for seasonal production plan

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 COMM 371, Lecture 7 COMM 371, Lecture 7

Level Production Plan

• Benefit Analysis of pro-forma financial statements

o Eliminates overtime premiums

• Net income is much higher under level production ($519 vs.
o Other direct labor costs savings $351)

• Cost • Level production dramatically increases financing needs

o Higher inventory and handling cost

• The required financing exceeds the maximum credit available
o Need to commit funds to finance inventory accumulation in ($2 million) for all months in the period June-November.
the off season

• Maximum financing needed in September doubles the available

credit
• Main issues:

o What is the financing need under level production? • Actually, most critical month is July

o Is the current credit limit enough to cover this need? o Current assets are mostly inventory in July, whereas for
September accounts receivable increase substantially.
o Are there any risks involved in level production? o The risk of not collecting is less than the risk of not selling!

• Examine inventory cycle

Construct MONTHLY Pro-forma Financial Statements • So level production is more risky (can end up with unsold
inventories) and requires more financing (now yet available)

• Look more in detail at the advantages of level production!

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• Cost Savings of Level Production
(compare pro-forma statements level vs. seasonal production
plans)
Overtime Premiums
Other labor savings
Net labor savings
COGS
Increase in interest expense
Reduction in interest income
Increase in storage costs
Op. Exp.
Combined cost
Net pre-tax savings
Taxes (34%)
Net savings
COMM 371, Lecture 7 COMM 371, Lecture 7
Under level production:
• If estimates are right, net income increases by almost 48%
225,000 • Requires much more bank financing
265,000
490,000 = 7000-6510 cut in
• Required bank borrowing from June to November is above
the $2 million limit set by the bank.
105,000 = 200-95
17,000 = 28-11
115,000 = 2515-2400 in • So loan renegotiation is needed. Need to convince the bank
that the firm can repay the loans.
237,000
253,000 • Higher risk: if sales forecasts were not accurate, then the firm
may end up with unsold inventory (dollar sales of particular
86,020 products can vary 30-35% from year to year), while having to
repay a larger loan.
166,980
• From the bank’s perspective, the firm becomes riskier.
• However, Toy World is approaching full capacity during
seasonal production peak. The adoption of level production
postpones the need for additional investment in fixed assets.
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 COMM 371, Lecture 7
• Are there any alternatives?
• Sell receivables or offer them as collateral for a bank loan.
Also tighten credit policy to customers to induce quick
repayment.
• However, in July when financing needs are highest, accounts
receivable are only $300, so not much collateral can be
offered.
• Tighter credit to customers can reduce sales….
• How about asking suppliers for an extension of payment
time?
• However, AP are $250 per month, so even if credit is
extended to 90 days, this would only generate payables of
$750. Would suppliers extend credit?
• A production plan half way between seasonal and level
production.
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COMM 371, Lecture 7
• Should the bank extend the loan?
• The firm needs a credit line of up to $4 million in order to
finance level production
• Plus: firm financially healthy. Even if the firm absorbs
inventory losses for one year, it can repay early in the next
year.
• Minus: substantial increase in firm risk. If sales forecast is not
correct, the accumulation of inventories can wipe out the cost
savings
• Trade-off between profitability and liquidity
o Level production increases profitability
o But involves the risk of committing funds to inventory
in an amount that exceeds the firm equity!