Corporate finance

Case 2 Weekend Adventure

Remember the goal in the case is to recommend ways to address the problems the company is experiencing relating to profitability and the overuse of financial leverage. Also, the owner wants to see if the business can accumulate enough cash in the next year to open a new dealership. In this case, a number of potential business improvements were recommended. These included: • Raise RV prices by 2% • Increase the shop rate to $85 • Collect receivables in 30 days instead of 60 days • Raise storage lot prices to $450 • Lower inventory level to 30% • Pay accounts payable in 60 days, not 30 days • Move salespeople to a straight commission of 6.25% • Delay the capital purchases • Lower the minimum cash level to $500,000 • Make the additional term loan payment in Q4 to reduce the debt ratio • Reduce dividends to $150,000 per year Make all these changes when preparing your proformas assuming Great Plains will agree. When writing Q1, Q2, Q3, and Q4 of the memo discuss the changes in cash flows, why they occurred, the financial decisions made, and whether the company is meeting its financial goals and lending conditions. The answer key for Wind ’n Wave and the sample memo give examples of what you should include. Be sure to read them. In the recommendation section, describe the improvements made and whether they were successful in addressing the company’s financial problems. Also, discuss whether the company will be able to accumulate enough cash to open the new dealership – cost data for the new dealership is provided. Even if they can accumulate enough funds, it might not be a good idea given the company’s current financial condition. Can a more prudent growth strategy be recommended? There is not a right or wrong answer to the case, just make sure whatever you recommend is well-supported. Please be very thorough in your analysis. Remember to always say why.

Wind ’n Wave

Budgeted Income Statement
	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Year
Sales1	CAD 170,775	CAD 314,550	CAD 251,325	CAD 111,375	CAD 848,025
Cost of sales2	109,568	198,450	161,700	75,075	544,793
Gross profit	CAD 61,207	CAD 116,100	CAD 89,625	CAD 36,300	CAD 303,232
Operating expenses					-
Selling3	10,583	12,021	11,388	9,989	43,980
Distribution4	2,079	3,558	3,076	1,617	10,330
Administration5	9,550	9,550	9,550	9,550	38,200
Depreciation5	1,750	3,050	3,538	3,538	11,875
Operating income	CAD 37,245	CAD 87,922	CAD 62,073	CAD 11,607	CAD 198,847
Interest income	-	-	-	250	250
Interest expense6	1,500	2,506	2,340	1,781	8,126
Income before tax	CAD 35,745	CAD 85,416	CAD 59,733	CAD 10,076	CAD 190,970
Income tax7	16,085	38,437	26,880	4,534	85,937
Net income	CAD 19,660	CAD 46,979	CAD 32,853	CAD 5,542	CAD 105,034

Cash Budget
	Quarter 1	Quarter 2	Quarter 3	Quarter 4	Year
Cash balance, beginning	CAD 21,483	CAD 20,000	CAD 20,000	CAD 20,000	CAD 21,483
Cash receipts
Sales
Last quarter	26,700	40,986	75,492	60,318	203,496
This quarter8	129,789	239,058	191,007	84,645	644,499
Interest income	-	-	-	250	250
Total cash receipts	CAD 156,489	CAD 280,044	CAD 266,499	CAD 145,213	CAD 848,245
Cash disbursements
Purchases
Last quarter	CAD 27,563	CAD 40,856	CAD 56,228	CAD 40,714	CAD 165,360
This quarter9	95,330	131,198	94,999	64,349	385,875
Selling expenses	10,583	12,021	11,388	9,989	43,980
Distribution expenses	2,079	3,558	3,076	1,617	10,330
Administrative expenses10	9,550	9,550	9,550	9,550	38,200
Interest expense	1,500	2,506	2,340	1,781	8,126
Income tax	16,085	38,437	26,880	4,534	85,937
Regular dividend	15,000	15,000	15,000	15,000	60,000
Capital purchase	26,000	19,500	-	-	45,500
Total cash disbursements	CAD 203,690	CAD 272,624	CAD 219,460	CAD 147,533	CAD 843,308
Sub-total	-CAD 25,718	CAD 27,420	CAD 67,039	CAD 17,679	CAD 26,420
Financing
Borrowing/repayment
Line of credit	CAD 27,418	-	-	-	CAD 27,418
Term loan11	20,800	-	-	-	20,800
Repayment					-
Line of credit	-	-3,880	-23,538	-	-27,418
Term loan12	-2,500	-3,540	-3,540	-3,540	-13,120
Special dividends	-	-	-	-	-
Issue/repurchase of shares	-	-	-	-	-
Total financing	CAD 45,718	-CAD 7,420	-CAD 27,078	-CAD 3,540	CAD 7,680
Temporary investment	-	-	-CAD 19,961	CAD 5,861	-CAD 14,100
Cash balance, ending	CAD 20,000	CAD 20,000	CAD 20,000	CAD 20,000	CAD 20,000

Budgeted Balance Sheet
	Quarter 1	Quarter 2	Quarter 3	Quarter 4
Assets
Current assets
Cash	CAD 20,000	CAD 20,000	CAD 20,000	CAD 20,000
Temporary investments	-	-	19,961	14,100
Accounts receivable13	40,986	75,492	60,318	26,730
Inventory14	59,535	48,510	22,523	39,375
Total current assets	CAD 120,521	CAD 144,002	CAD 122,801	CAD 100,205
Fixed assets
Equipment, net15	CAD 116,038	CAD 132,488	CAD 128,951	CAD 125,413
Total Assets	CAD 236,559	CAD 276,490	CAD 251,752	CAD 225,618
Liabilities
Current liabilities
Accounts payable16	CAD 40,856	CAD 56,228	CAD 40,714	CAD 27,578
Line of credit	27,418	23,538	-	-
Current portion of long-term debt17	14,160	14,160	14,160	14,160
Total current liabilities	CAD 82,434	CAD 93,926	CAD 54,874	CAD 41,738
Long-term liabilities
Term loan18	CAD 64,140	CAD 60,600	CAD 57,060	CAD 53,520
Shareholders’ equity
Common shares	CAD 53,000	CAD 53,000	CAD 53,000	CAD 53,000
Retained earnings19	36,986	68,964	86,818	77,360
Total liabilities and equities	CAD 236,559	CAD 276,490	CAD 251,752	CAD 225,618

Key Financial Ratios
	Quarter 1	Quarter 2	Quarter 3	Quarter 4
Current ratio - 1.520	1.46	1.53	2.24	2.40
Line of credit / (Accounts receivable + Inventory)21	89.0%	42.0%	-	-
Line of credit financing - CAD 35,000	CAD 27,418	CAD 23,538	-	-
Long-term Debt / Total Capitalization – 40.0%22	47.0%	38.0%	34.0%	34.0%
12-Month cash flow coverage ratio23				4.58

1 (132 x 900) + (77 x 675)

2 32,198 + (132 + 77 – 63) (525)

3 (35,500 / 4) + (.01) (170,775)

4 (7) (132) + (15) (77)

5 (45,200 – 7,000) / 4, (7,000 / 4)

6 (60,000) (.10) / 4

7 (.45) (35,745)

8 (170,775) (.76), .20 + (.8) (.7) = .76

9 (259) (525) (.7)

Purchases Budget
	Quarter 1	Quarter 2	Quarter 3	Quarter 4
Sales	209	378	308	143
Add: Ending inventory	113 (378 X .3)	92 (308 X .3)	43 (143 X .3)	75 (250 X .3)
Subtotal	322	470	351	218
Less: Beginning inventory	63	113	92	43
Purchases	259	357	259	175

10 (45,200 – 7,000) / 4

11 (26,000) (.8)

12 (10,000) / 4)

13 (.24) (170,775)

14 (.3) (378) (525)

15 91,788 – (7,000 / 4) + 26,000

16 (259) (525) (.3)

17 ((10,000 / 4) + (20,800 / 5 / 4)) (4) = 14,160

18 60,000 + 20,800 - 2,500 – 14,160

19 32,326 + 19,660 – 15,000

20 120,521 / 82,434

21 27,418 / ((.75) (40,986) + (.0) (59,535))

22 (14,160 + 64,140) / (14,160 + 64,140 + 53,000 + 36,986)

23 (198,847 + 11,875 + 18,000) / (8,126 + 18,000 + (13,120 / (1 - .45))

2. Wind’n Wave experienced a cash shortage in Q1 because:

· Quarter 1 is the second slowest sales period, so less cash is generated.

· In Quarter 1, they are building up inventory for Quarter 2 which is the busiest quarter. In Quarter 1, 30.0% of Quarter 2’s inventory is purchased in advance and 70.0% of that must be paid for in Quarter 1.

· A major acquisition took place in Quarter 1 and a down payment of no less than 20.0% had to be made.

· Quarter 1 follows the slowest period Quarter 4 so there are fewer accounts receivable from Quarter 4 being collected. Approximately 80.0% of sales in Quarter 4 are on credit and 30.0% of the credit sales from Quarter 4 are collected in Quarter 1.

3. Wind’n Wave could increase its cash flows in Q1 by:

· Delaying the capital purchase, but the company may need the equipment now.

· Offering early payment discounts to customers, but this is very expensive.

· Selling accounts receivable to a factor, but this is very expensive.

· Stretching payables, but it could hurt the company’s credit rating and supplier relationships.

· Reducing the level of inventory buildup for the next quarter, but the stock buildup may be justified.

· Reducing selling and administration expenses, but the company may already be very lean and reducing hours may alienate staff.

· Reducing the dividend paid, but the owner may have personal financial obligations that make this difficult.

4. Wind’n Wave could increase its current ratio in Q1 by:

· Reducing receivables and using the cash to pay down the line of credit.

· Reducing inventories and using the cash to pay down the line of credit.

· Delaying capital purchases and using the cash to pay down the line of credit.

· Reducing the selling and administrative costs and using the cash to pay down the line of credit.

· Reducing dividends and using the cash to pay down the line of credit.

The general rule is that if a ratio is above 1.0 and the numerator and denominator are reduced by the same amount, the ratio will rise. For example:

Current ratio = = 1.5

If .5 in accounts receivable or inventory are liquidated and the cash is used to pay down the line of credit, the current ratio would rise.

Current ratio = = = 2.0

Stretching payables to save cash will lower and not increase the current ratio.

Current ratio = = 1.5

If payment of .5 in accounts payable is delayed saving cash, the current ratio will fall.

Current ratio = = = 1.3

5. Wind’n Wave could reduce its long-term debt to total capitalization ratio in Q1 by:

· Delaying capital purchases to reduce debt.

· Reducing operating expenses to increase net income and equity.

· Reducing dividends to increase equity.

· Issuing additional shares to increase equity.

6. Wind’n Wave determined its line of credit limit by:

	Current Assets	Current Liabilities	Net Working Capital
Quarter 4, 2017	Cash – CAD 21,483 A/R – CAD 26,700 Inventory - CAD 32,918	A/P - CAD 27,563	CAD 53,538
Quarter 1, 2018	Cash – CAD 20,000 A/R – CAD 40,986 Inventory - CAD 59,535	A/P - CAD 40,856	CAD 79,665
Quarter 2, 2018	Cash – CAD 20,000 A/R – CAD 75,492 Inventory - CAD 48,510	A/P - CAD 56,228	CAD 87,774
Quarter 3, 2018	Cash – CAD 20,000 A/R – CAD 60,318 Inventory - CAD 22,523	A/P -CAD 40,714	CAD 62,127
Quarter 4, 2018	Cash – CAD 20,000 A/R – CAD 26,700 Inventory - CAD 39,375	A/P - CAD 27,578	CAD 58,497

Recommended borrowing on the line of credit is:

Average quarterly growth in NWC - (58,497 – 53,538) / 4 = 1,240

Quarter 1 79,665 – 53,538 – 1,240 (1) = 24,887

Quarter 2 87,774 – 53,538 – 1,240 (2) = 31,756

Quarter 3 62,127 – 53,538 – 1,240 (3) = 4,869

Quarter 4 58,497 – 53,538 – 1,240 (4) = 0

A line of credit of approximately CAD 35,000 will be sufficient to meet the company’s working capital needs throughout the year.

7. There are mathematical models for estimating optimal cash balances, but companies normally apply a general rule of thumb based on experience as to what amount of cash on hand is sufficient. Wind’n Wave’s rule is that they maintain a cash balance equal to approximately 10.0% of quarterly cash disbursements at all times. Wind’n Wave is a seasonal business, so this amount could vary by quarter.

8. See part 1 for the Q2, Q3, and Q4 pro forma financial statements.

9. As stated in Part 2, Q1 is a very difficult quarter from a cash flow perspective (sub-total -CAD 25,718) because Q1 is the second slowest sales quarter and Q4 is the slowest sales quarter. Also, inventory in Q1 must increase for the busiest quarter in Q2 and a capital purchase with a large down payment requirement is made.

The company generates the cash needed in Q1 by borrowing nearly the maximum amount on its line of credit and the maximum amount on a term loan. The current ratio is slightly below the loan requirement of 1.5 (actual 1.46) and the long-term debt to total capitalization ratio is above the goal of 40.0% (actual 47.0%).

The company plans to go forward with its decisions in Q1 despite failing the current ratio requirement because it feels it can convince lenders that the problems are temporary. In Q2, cash flows should improve significantly (sub-total CAD 27,420) as Q2 is the strongest sales quarter. With these funds, it can pay cash for the capital purchase and make a modest payment on its line of credit.

In Q3, cash flows will improve again (sub-total CAD 67,039) due to Q3 being the second strongest sales quarter and the large accounts receivable collections from Q2. Inventory purchases also fall as the company reduces its inventory purchases for Q4 which is the slowest sales quarter. With its greatly improved cash flows, it can pay off its line of credit and invest in a temporary investment (CAD 19,961). The line of credit has to be paid off once a year (usually just before the seasonal low) to meet its loan requirements and the temporary investment will serve as a cash buffer for Q4 and Q1, so the difficulties experienced in Q1 do not re-occur. The temporary investment should not be allowed to become excessive though and the long-term debt to total capitalization ratio should be maintained at the optimal level of 40.0% on average. Surplus cash should be used to finance profitable growth opportunities or paid out to the owners.