BA280.1: Financial Management Hampton Machine Tool Company
Group 3 Del Rosario, Martin Ocampo, Ojie Quejado, Nikki Raborar, Rowena Yambao, Liezl
Executive Summary
Hampton Machine Tool Company (HMTC), established in 1915, caters to the military aircraft manufacture manufactureres res and automobile manufactureres manufactureres in the St. Louis area. The company’s current success can be attributed to their conservative financial policies, making them survive the different economic turmoils a couple of years ago. In December 1978, Mr. Cowins, President of HMTC, took down a loan of $1 million from St. Louis National Bank to purchase stocks of dissident stockholders. Now, wanting to improve the company’s performance, Mr. Cowins sent a letter to Mr. Eckwood in September 1979, Vice President of the St. Louis Bank, asking him to extend the loan to the end of the year and also for an additional $350,000. After conducting a financial analysis, focusing primarily on their cash budget, it was found out that HMTC would not be able to fully repay their $1.35 million loan by the end of the year. Even if they repay portions of the loan early on to reduce their interest burden and also stop paying divide dividends nds,, they they would would still still have have proble problems ms in paying paying back back their their loan. loan. Howeve However, r, it was also discovered that the company could pay back their loan on January. As such, Mr. Eckwood should reject HMTC’s proposal and instead propose to extend the loan for another month but with an interest rate increase. With a re-negotiation of the loan’s terms, which are extending the deadline of the payment to January January and increasing increasing the interest rate to 1.75%, 1.75%, both HMTC and the bank will have a better outcome. For HMTC, they would have a new equipment to help in their operations. They would also push on with their dividends and finally get rid of their outstanding loan balance. For the bank, they would earn more interest income from the increase in interest rate.
Case Context
Hampton Machine Tool Company (HMTC) is a machine tool manufacturing business which starte started d in 1915 1915 and has been been a stable stable compan company y since since its establis establishme hment. nt. The compan company’s y’s revenues rely heavily on military aircraft and automobile manufacturers within the St. Louis vicinity. During 1960’s until end of 1970’s, HMTC experienced highs and lows which were mainly due to increa increases ses and decrea decreases ses in produc productio tion. n. This This is influe influence nced d by the Vietna Vietnam m war, war, econom economic ic cond condit itio ions ns,, expa expans nsio ion n of expo export rt mark market et and and demi demise se of comp compet etit itor ors. s. Thou Though gh adve advers rse e circum circumsta stance nces s happen happened, ed, HMTC HMTC has succes successfu sfully lly surviv survived ed these these proble problems. ms. This This can be attributed to the company’s conservative financial policies. In December 1978, Benjamin Cowins, President of HMTC, requested a 1M USD loan to St. Louis National Bank to purchase stocks of several dissident shareholders. The interest rate for the loan was 1.5% to be paid monthly monthly and the principal of the loan is to be paid on September September 1979. Mr. Jerry Eckwood, Vice President of St. Louis National Bank allowed the loan request because of three reasons: 1) HMTC’s submission of projected sales and forecasted financial statements; 2) HMTC’s credibility as depositor in St. Louis Bank and 3) Mr. Cowins’ credibility in the business community. However, in September 1979, Mr. Eckwood received a letter from HMTC requesting to extend repayment of the loan to December 1979 and a further loan request of 350,000USD for equipment purchases. Point of View and Problem Definition
The point of view to be taken in this case will be as Jerry Eckwood, a creditor. As a creditor, aside from the financial ratios, one of the most important things to be looked at for a possible borrower is whether they could repay their loan upon the date of the loan’s maturity. As such, the main problem for this case is: Should Mr. Eckwood accept Mr. Cowin’s proposal regarding the extension of the original loan and an additional $350,000 loan? Framework
A. B. C.
The group will take a creditor’s point of view for this case. As such, the important things to be looked at are the financial ratios and, more importantly, their cash budget. By looking at their cash budget, the group would be able to find out if they could pay their debt in their proposed target date. Profitability Ratios Liquidity and Leverage Ratios Cash Budget
Analysis Financial Ratios
To analyze the financial viability of the company, we used financial ratio analysis to evaluate HMTC’s profitability, operating efficiency, liquidity and leverage. (See Exhibit A for the financial ratios of HMTC). Profitability
HMTC’s HMTC’s profitabili profitability ty ratios, generally, generally, has an unstable unstable trend. Though, most of these ratios ratios are seen to be improving over time especially the projected ones. There is a significant increase in HMTC’s operating profit margin and gross profit margin from historical trend to its projected using the projected financial statements. As seen in the ratios, its gross profit margin is high except for September. The main reason for this is because of the WIP inventory reduction of $1320 $1320 in Septem September ber.. Becaus Because e of this this huge huge reducti reduction on in WIP, WIP, operat operating ing profit profit margin margin for September is -13%, signifying that HMTC would be operating at a loss. However, it would be good to note that after this reduction in WIP, profitability ratios for the company would be seen to be increasing. With COGS and Operating Expenses would be forecasted to be relatively stable from October to December and Sales to be increasing over the period, the profitability ratios would naturally show that HMTC would be profitable for the three months after September. With this, it can be seen that the company is profitable, making them worthy of extending credit to. Liquidity and Leverage
The result of the company’s liquidity and leverage ratios based on the projected financial statements shows an improving set of ratios. HMTC’s quick ratio is less than 1 and has been consistent consistently ly below 1. Its current current ratio trend plays around 1 to 2, which which is not acceptable acceptable for an industrial machinery company since this only applies to companies which have inventories that can immediately be converted into cash. Furthermore, an average of quick ratio less than 1 connotes that the liabilities end up being greater than the company’s assets and thus there is a great reliance on inventories to cover for immediate payment obligations. HMTC’s total assets are financed by debt with an average of 56% during June to August but, declined declined to 46% using its projected projected ratios. On the other hand, the company’s debt-equity debt-equity ratio has an average of 0.97. For a company with a capital-intensive nature, it is acceptable to have a debt-equity ratio and total liabilities-total assets ratio of above 1 but this implies that most of HMTC’s company's assets are financed through debt and thus, the company has a great tendency to aggressively finance its operations and growth with more debt.
Current Cash Budget
Seeing, however, that the company’s cash budget could be computed, it would be better to focus on this instead of on their ratios. Looking at Exhibit B, it can be noticed that the problem does not have any liquidity problems stemming from their usual operations. Their cash could definitely cover their cash disbursements for operations even though there would be times when their cash receipts are low. The following assumptions were used in coming up with the cash budget: a) 100% of the previous previous month’s month’s Accounts Accounts Receiv Receivable able will be collecte collected d given the 30 days credit terms. b) Purchases are paid a month after. c) Tax paymen payments ts will will be done on on September September and Decemb December. er. d) Other Operating Expenses will remain stable for the period and are paid the month itself. As seen in Exhibit B, HMTC would perform quite well once they get their equipment to improve their operations. Their ending cash balances reflect that they don’t need additional borrowings to fund their operating activities. However, the only problem HMTC would experience is their repayment of the loan. If they go through with with their current cash budget, they will actually need extra funds to cover a negative cash balance of $331,500 due to the loan payment. Actually, even if HMTC restructures their loan by paying ahead of time to decrease the interest burden and also postpone paying dividends (see Exhibit C), HMTC would still have a negative cash balance of $163,500 by December. This shows that HMTC still can’t pay their outstanding debt on December even if they tinker with their figures. However, still looking at their current cash budget in Exhibit B, one would notice that HMTC would have a cash balance of $933, 500 on January. This is due to the collection of their accounts receivable coming from December sales. As such, the company, instead of asking for an extension of up to December, should have asked for an extension up to January. HMTC seemingly forgot that, even with their good forecast figures, they have to also check when they expect to collect their sales. In this case, it seems as if they neglected to factor in that they could only collect their sales fully the next month. As such, by extending the payment of the loan to January instead of to December, HMTC would be in a much better position to fulfill their proposal to pay their outstanding loan of $1.35 million. Decision and Justification
The decision, after analyzing the company’s performance, especially their current cash budget, woul would d be to reje reject ct thei theirr prop propos osal al.. As a cred credit itor or,, whos whose e main main conc concer ern n is the the borr borrow ower er’s ’s repayment of the loan along with the required monthly interest payments to it, it would be easy to see that HMTC would not be able to repay in full their outstanding loan on December. Even
by postponing postponing its payment payment of dividends dividends and repaying part of their their loan early on to reduce their interest burden, HMTC would still not be able to pay in full their $1.35 million loan by the end of the year. From the analysis done, however, it was seen that HMTC could repay their outstanding loan on January the next year. It would be better, then, for the bank and also for HMTC if the repayment coul could d be exte extend nded ed for for one one more more mont month. h. As such such,, term terms s rega regardi rding ng the the loan loan shou should ld be renegotiated. Operationalize the Decision
Of course, renegotiating renegotiating the loan repayment repayment should have a penalty penalty attached to it. The penalty will come in the form an increase on the interest rate on the loan HMTC would be facing. By raising the interest rate from 1.5% (18% per annum) to 1.75% (21% per annum), the bank would be gaining more interest income from HMTC’s loan (see Exhibit D). As such, the extension of the loan would be good for both parties. For HMTC, they could still distribute dividends on December since they would have cash on hand. Also, though they would be faced with more interest expense, they could still incur this increase as the increase in interest expense would not dent their financials too much. They could also finally settle their outstanding loan and have it finally removed from their liabilities. For the bank, apart from the increase in interest income of $26,625 coming from the renewed terms on HMTC’s loan, their working relation with HMTC would improve. HMTC would most likely acknowledge the bank’s continued assistance to them by accomodating them through the company’s tough times. However, as seen with the decision, penalties would arise if HMTC would fail to meet their obligations with the bank. Operating Efficiency - Could we remove this since we will be assuming naman their operations
to be fixed to arrive at our forecasts? Comparing Compar ing the his histor torica icall dat data a to its pro projec jected ted rat ratios ios,, HMT HMTC C is exp expect ecting ing to hav have e hig higher her turnovers of its accounts receivables and inventories. From June to August, the company’s accoun acc ounts ts rec receiv eivabl able e wer were e dec decreas reasing ing in dol dollar lar;; thi this s dec declin line e goe goes s han hand-i d-in-ha n-hand nd wit with h the compan com pany’s y’s dro droppi pping ng net sal sales. es. In Sep Septem tember ber,, HMT HMTC’s C’s projected projected a gran grand d $21 $2163 63 fro from m its previous year’s sales of $507 that is equivalent to a 327% increase. This led to an increasing accounts receivable turnover ratio from August to September. On the other hand, the velocity of conversion of HMTC’s HMTC’s inventories into sales is relatively slow if we will compare the company’s net sales and inventories. Over the years, the company’s inventories have been increasing its share to its total assets. With such high inventory, it is
unlikely to sell everything in less than a year to pay off its current obligations on time and can result to even greater losses. – losses. – How can you say this if we will assume that we will collect all AR in 30 days?
Exhibit A: Financial Ratios FINANCIAL RATIOS
Aug.
Pro Forma Sept.
Oct.
Nov.
Dec.
1% 2% 8% 17% n/a
1% 2% 15% 33% n/a
-2% -5% -7% -13% 6%
4% 7% 15% 26% 53%
4% 6% 15% 30% 56%
10% 14% 26% 51% 69%
0.856 427 0.495
0.570 641 0.200
0.741 492 0.106
1.635 223 0.648
1.932 189 0.465
1.000 365 0.513
1.000 365 0.749
1.581 0.762
1.572 0.705
1.542 0.494
1.765 0.666
1.788 0.636
1.814 0.782
2.430 0.948
1.216 0.549
1.249 0.555
1.327 0.570
0.928 0.481
0.801 0.445
0.809 0.447
0.488 0.328
Historical June
July
2% 4% 9% 18% n/a
Profitability
Return on Assets Return on Equity Net Profit Margin Operating Profit Margin Gross Profit Margin Operating Efficiency
Accounts Receivable Turnover Average age of Receivables Inventory Turnover Liquidity/Solvency
Current Ratio Quick Ratio Leverage
Total Debt/Equity Total Liabilities/Total Assets
Exhibit B: Current Cash Budget September
Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts
October
November
December
January
684,000 0 684,000
1,323,000 350,000 1,673,000
779,000 0 779,000
1,604,000 0 1,604,000
2,265,000 0 2,265,000
Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Principal Repayments to Bank: Dividends Total Cash Disbursements
948,000 400,000 0 181,000 15,000 0 0 1,544,000
600,000 400,000 350,000 0 15,000 0 0 1,365,000
600,000 400,000 0 0 20,250 0 0 1,020,250
600,000 400,000 0 181,000 20,250 1,350,000 150,000 2,701,250
600,000 400,000 0 0 0 0 0 1,000,000
Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance
1,559,000 -860,000 699,000
699,000 308,000 1,007,000
1,007,000 -241,250 765,750
765,750 -1,097,250 -331,500
-331,500 1,265,000 933,500
Total Interest Payments:
70,500
Exhibit C: Early Payment of Principal Loan and No Dividends September
Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts
October
November
December
January
684,000 0 684,000
1,323,000 350,000 1,673,000
779,000 0 779,000
1,604,000 0 1,604,000
2,265,000 0 2,265,000
948,000 400,000 0 181,000 15,000 300,000 0 0 1,844,000
600,000 400,000 350,000 0 10,500 100,000 0 0 1,460,500
600,000 400,000 0 0 14,250 100,000 0 0 1,114,250
600,000 400,000 0 181,000 12,750 500,000 350,000 0 2,043,750
600,000 400,000 0 0 0 0 0 0 1,000,000
Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance
1,559,000 -1,160,000 399,000
399,000 212,500 611,500
611,500 -335,250 276,250
276,250 -439,750 -163,500
-163,500 1,265,000 1,101,500
Total Interest Payments:
52,500
Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Payment of 1st Loan Payment of 2nd Loan Dividends: Total cash outflows:
Assumptions: -
No Di Dividends Loan Loan Paymen Payments ts wil willl be start started ed earl early y to redu reduce ce inte interes restt expens expense e
Exhibit D: Loan Extension to January and Interest Rate Increase September
Cash Receipts: Collection of Accounts Receivable Bank Loan: Total Cash Receipts
October
November
December
January
684,000 0 684,000
1,323,000 350,000 1,673,000
779,000 0 779,000
1,604,000 0 1,604,000
2,265,000 0 2,265,000
Cash Disbursements: Payment of Accounts Payable Other Operating Expenses Purchase Equipment Tax Payments Interest Expense Payments Payment of 1st Loan Payment of 2nd Loan Dividends: Total cash outflows:
948,000 400,000 0 181,000 17,500 0 0 0 1,546,500
600,000 400,000 350,000 0 17,500 0 0 0 1,367,500
600,000 400,000 0 0 23,625 0 0 0 1,023,625
600,000 400,000 0 181,000 23,625 500,000 0 0 1,704,625
600,000 400,000 0 0 14,875 500,000 350,000 0 1,864,875
Reconciliation: Beginning Cash Balance Net Cash Flow Ending Cash Balance
1,559,000 -862,500 696,500
696,500 305,500 1,002,000
1,002,000 -244,625 757,375
757,375 -100,625 656,750
656,750 400,125 1,056,875
Total Interest Payments:
97,125
Assumptions: -
Inte Intere rest st rate rate will will be incr increa eased sed to 1.75 1.75% %
Exhibit E: Hampton’s Income Statement Income Statement September October
Net sales Purchases Work-in-Progress Raw materials reduction Cost of goods sold Gross Profit
November
December
2,163,000 600,000 1,320,000 105,000 2,025,000 138,000
1,505,000 600,000 0 105,000 705,000 800,000
1,604,000 600,000 0 105,000 705,000 899,000
2,265,000 600,000 0 105,000 705,000 1,560,000
Depreciation Other expenses Total Other Expenses EBIT
10,000 400,000 410,000 -272,000
10,000 400,000 410,000 390,000
13,646 400,000 413,646 485,354
13,646 400,000 413,646 1,146,354
Interest expense Net income before taxes
15,000 -287,000
15,000 375,000
20,000 465,354
20,000 1,126,354
Income taxes Net income
-137,760 -149,240
145,000 230,000
223,370 241,984
540,650 585,704
Dividends Retained Earnings
0 -149,240
0 230,000
0 241,984
150,000 435,704
Exhibit F: Hampton’s Balance Sheet Balance Sheet
Cash Accounts receivable, net Inventory
699,000 1,323,000 3,339,000 5,361,000
1,007,000 779,000 3,234,000 5,020,000
766,000 1,604,000 3,129,000 5,499,000
-331,000 2,265,000 3,024,000 4,958,000
4,010,000 3,100,000 910,000 42,000 6,313,000
4,360,000 3,110,000 1,250,000 42,000 6,312,000
4,360,000 3,123,646 1,236,354 42,000 6,777,354
4,360,000 3,137,292 1,222,708 42,000 6,222,708
1,000,000 600,000 552,000 160,240 726,000 3,038,240
1,350,000 600,000 552,000 305,240 0 2,807,240
1,350,000 600,000 552,000 528,610 0 3,030,610
0 600,000 552,000 888,260 0 2,040,260
Total Equity
428,000 2,846,760 3,274,760
428,000 3,076,760 3,504,760
428,000 3,318,744 3,746,744
428,000 3,754,448 4,182,448
Total Liabilities and Equity
6,313,000
6,312,000
6,777,354
6,222,708
Current assets
Gross fixed assets Accumulated depreciation Net fixed assets Prepaid expenses Total assets
Notes payable, bank Accounts payable Accruals Taxes payable* Customer advances Total Liabilities
Common stock ($10 par value) Additional Pa Paid-in Ca Capital
