Case 368 - Directed - Financial Analysis and Forecasting 19

TABLE5
Historical Statements of Cash Flow
for Years Ended December 31
(Thousands of Dollars)

1994 1995
Cash Flow from Operations:
Sales $ 281,597 $
Increase in receivables (1,770)
Cash sales $ 279,827 $ 283,206
Cost of goods sold (231,424)
Increase in inventories 25,176) (20,882)
Increase in accts payable 4,868
Increase in accruals 2,236
Cash cost of goods ($ 249,496 ($259,146)
Cash margin $ 30,331 $ 4,060
Admin and selling exp (22,844)
Miscellaneous expenses (5,634) (7,599)
Taxes (6,704) (1,750)
Net CF from operations ($ 4,851)

Cf From Fixed Asset Investment

Investment in fixed assets ($ 3,421) ($ 4,057)

Cf From 'Financing Activities

Increase in short-term debt $ 2,903 $
Increase in long-term debt 6,536
Repayment of mortgage (32) (484)
Interest expense (2,449)
Common dividends (2,514) (656)
Net CF from fin act $ 4,444 $ 13,695
Increase (decrease) in cash and
marketable secmities ($ 3,827) $

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1m!:::
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18 Case 368 - Directed - Financial Analysis and Forecasting

TABLE 4
Common Size Income Statements
for Years Ended December 31

1993 1994 1995

Net sales 10<).00% 100.00% 100.00%
Cost of goods sold 81.15 82.18
Gross profit 18.85% 17.82%

Admin and selling exp 6.59% 8.11% 8.50%

Depreciation 0.92 0.88
Miscellaneous expenses 1.10 2.00 2.53
Total operating exp 8.61% 10.99% 12.05%
EBIT 10.24% 6.83%

Interest on ST loans 0.15% 0.23% 0.75%

Interest on LT loans 0.34 0.52 0.49
Interest on mortgage 0.13 0.12
Total interest 0.62% 0.87% 1.34%
Before-tax earnings 9.62% 5.95%
Taxes 3.85 2.38
Net income 5.77% 3.57% 0..81%

Dividends on stock 1.44% 0.89%

Additions to retained earnings 4.33% 2.68% 0.66%

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 Case 368 - Directed - Financial Analysis and Forecasting 17

TABLE 3
Common Size Balance Sheets
for Years Ended December 31

1993 1994 1995

Assets:
Cash and marketable securities 14.14% 7.72% 4.99%
Accounts receivable 28.43 23.93
Inventory 33.17 48.44
Current assets 75.74% 80.09% 84.44%

Land. buildings, plant, and equipment 29.34% 26.11 % 22.24%

Accumulated depreciation -5.08 -6.20 -6.67
Net fixed assets 24.26% 19.91% 15.56%
Total assets 100.00% 100.00% 100.00%

Liabilities And Equity

Short-term bank loans 5.49% 6.89% %
Accounts payable 11.90 13.69 19.44
Accmals 5.74 6.50 7.31
Current liabilities 23.13% 27.08% 44.43%
Long-term bank loans 10.97% 14.43% %
Mortgage 4.63 3.61 2.38
Long-term debt 15.60% 18.04% %
Total liabilities 38.73% 45.12% 57.62%
Common stock 38.12% 29.97% 22.43%
Retained earnings 23.15 24.90
Total equity 61.27% 54.88% %
Total liabilities and equity 100.00% 100.00% 100.00%

Note: Rounding differences occur in this table.

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-
16 Case 36B - Directed - Financial Analysis and Forecasting

TABLE 2
Historical and Pro Forma Income Statements
for Years Ended December 31
(Thousands of Dollars)

Pro Forma
1993 1994 1995 1996 1997
Net sales $259,325 $281,597 $300,351 $330,386 $371,684
Cost of goods sold 210,431 231,424 255,775 274,220 297,347
Gross profit $ 48,894 $ 50,173 $ 44,576 $ 56,166 $ 74,337
Admin and selling exp 17,089 22,844 25,530
Depreciation 2,391 2,487 3,060 3,161 4,016
Miscellaneous expenses 2,854 5,634 7,599
Total operating exp $ 22,334 $ 30,965 $ 36,189 $ 35,538
EBIT $ 26,560 $ 19,208 $ 8,387 $ 37,241
Interest on ST loans 389 660 2,262 3,069 3,250
Interest on LT loans 875 1,463 1,463 1,463 1,463
Interest on mortgage 328 326 287 251 213
Total interest $ 1,592 $ 2,449 $ 4,012 $ 4,784 $ 4,926
Before-tax earnings $ 24,968 $ 16,759 $ 4,375 $ $ 32,314
Taxes 9,987 6,704 1,750 $ ...Jb926
Net income $ 14,981 $ 10,055 $ 2,625 $ $
Dividends on stock 3,745 2,514
, 656 0
Additions to retained
earnings $ 11,236 $ 7,542 $ 1,969 $
EPS (7,000,000 shares) $ 2.14 $ 1.44 $ 0.38 t $
Notes:
a. Earnings per share (EPS): 1993-$2.14; 1994-$1.44; 1995-$0.38.
b. Interest rates on borrowed funds:
Short-term loan: 1993-S%; 1994-8.5%; 1995-8.5%.
Long-term loan: 9% for each year.
Mortgage: 8% for each year.
c. For purposes of this case, assnme that expenses other than depreciation and interest are totally variable with sales.

Copyright @ 1997 South-Western. All rights reserved.

 Case 368 - Directed - Financial Analysis and Forecasting 15

TABLE 1
Historical and Pro Forma Balance Sheets
for Years Ended December 31
(Thousands of Dollars)

Pro Forma
1993 1994 1995 1996 1997
Assets:
Cash and marketable
securities $12,523 $ 8,696 $ 7,514 $ $
Accounts receivable 25,175 26,945 44,090
Inventory 29,366 54,542 75,424
Current assets $67,064 $ 90,183 $127,028 $ $
Land, buildings, plant,
and equipment 25,975 29,396 33,453 42,953 42,953
Accumulated depreciation (4,494) (6,981) (10,041) (13,202) (17;218)
Net fixed assets $21,481 $ 22,415 23,412 $29,751 $25,735
Total assets $88,545 $112,598 $150,440 $ $

LUzhilitiesAnd Equity
Short-term bank loans 4,860 7,763 26,610
Accounts payable 10,541 15,409 29,240 23,316
Accruals 5,081 7,317 10,997 12,097
Cutrent liabilities $20,482 $ 30,489 $ 66,847 $71,599 $76,035
Long-term bank loans 9,712 16,248 16,248 16,248 16,248
Mortgage 4,101 4,069 3.585 3,140 2,668
Long-term debt $13,813 $ 20,317 $ 19,833 $19,388 $18,916
Total liabilities $34,295 $ 50,806 $ 86,680
Com stk (7,000,000 sh) 33,750 33,750 33,750 33,750 33,750
Retained earnings 20,500 28,042 30,010
Total equity $54,250 $ 61,792 $ 63,760 $ 1.
Total liabilities and equity $88.545 $112.598 $150, -$ $

Notes:
a. 7,000,000 shares of common stock were outstancling throughout the period 1993 through 1995.
b. Market prices of shares: 1993-$17.78; 1994-$9.70; 1995-$3.84.
c. Price/earnings (PIE) Iatios: 1993-8.31; 1994-6.74; 1995-10.11. The 1995PlEratioisbigh becauseofthedepressedeam-
ings that year.
d. Assume that all changes in interest-bearing loans and gross fixed assets occur at the start of the relevant years.
e. The mortgage loan is secured by a first mortgage bond on land and buildings.

Copyright @ 1997 South-Western. All rights reserved.

.
14 Case 36B - Directed - Financial Analysis and Forecasting

8. Under what circumstances might the validity of comparative ratio analysis be questionable?
Answer this question in general, not just for SOl, but use SOl data to illustrate your points.

9. Revise your pro forma financial statements for 1996 and 1997 on the basis of the following
assumptions:
a. Short-term loans will be repaid when sufficient cash is available to do so without reduc-
ing the liquidity of the firm below the minimum requirements set by the bank, and when
the company is able to maintain at least the target minimum cash balance (5 percent).
b. SDI will reinstate its cash dividend, set at 25 percent of earnings, in the year during
which all short-term loans and credit lines have been paid in full.

10. It is apparent that SOl's future (and that of the bank loan) is critically dependent on the com-
pany's performance in 1996 and 1997. Therefore, it would be useful if you could, as part of
your consulting report, inform management-and the bank-as to how sensitive the results
are to such things as the sales growth rate, the cost of goods sold percentage, and the admin-
istrative expense ratio. If the results would still look fairly good even if those factors were
not as favorable as initially forecasted, the bank would have greater confidence in extending
the requested crediL On the other hand, if even tiny changes in these variables would lead to
a continuation of the past downward trend, then the bank should be leery. If you are using
the spreadsheet model. do some sensitivity analyses (using data tables) to shed light on this
issue. (Hint: See the bottom part of the model labeled "SENSITIVITY ANALYSES" for
some ideas.) If you do not have access to the model, describe how one would go about a
sensitivity (or scenario) analysis, but do not quantify your answer.

11. On the basis of your analyses, do you think Ingrid should recommend that the bank extend
the existing short and long-term loans and grant the additional $9,500,000 loan, or should
she recommend that the bank demand immediate repayment of all existing loans? If she
does recommend continuing to support the company, what conditions (for example, collat-
eral, guarantees, or other safeguards) might the bank impose to help protect against losses
should SDl's plans go awry?

:>..

r
!

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 Case 36B - Directed - Financial Analysis and Forecasting 13

QUESTIONS

1. Complete the 1995 columns of Tables 3 through 6, disregarding for now the projected data
in the 1996 and 1997 columns. ITyou are using the spreadsheet model, use it to complete the ~S
tables. Be sure you understand all the numbers, as it would be most embarrassing (and harm-
ful to your career) if you were asked how you got a particular number and you could not
give a meaningful response.

2. On the basis of information in the case and on the results of your calculations in Question 1,
list SDI's strengths and weaknesses. In essence, you should look at the common size state-
mentsandeachgroupof keyratios(forexample,the liquidityratios) and see what those
ratios indicate about the company's operations and financial condition. As a part of your
answer, use the extended DuPont equation to highlight the key relationships.

3. Recognizing that you might want to revise your opinion later, does it appear, based on your
analysis of the historical data, that the bank should lend the requested money to SDI? In
other words, if you were working for the bank, would you recommend that it meet SDI's
request and increase the line of credit? Explain.

4. Now complete the tables to develop pro forma financial statements for 1996 and 1997. In
making these calculations, assume that the bank is willing to maintain the present credit
lines and to grant the requested additional $9,500,000 of short-term credit effective January
1, 1996. In the analysis, take account of the amounts of inventory and accounts receivable
that would be carried if inventory utilization (based on the cost of goods sold) and days sales
outstanding were set at industry-average levels. Also, assume in your forecast that all of
SDI's plans and predictions concerning sales and expenses materialize, and that the firm
pays no cash dividends during the forecast period. Finally, in your calculations use the cash
and marlcetablesecurities account as the residual balancing figure.

In responding to Questions 5 through 8, no spreadsheet model modifications are required.

Answers should be based solely on the data contained in the financial statements developed in
response to Question 4.

5. Assume SDI has determined that its optimal cash balance is 5 percent of sales, and that
funds in excess of this amount will be invested in marketable securities, which on average
will earn 5 percent interest. Based on your forecasted financial statements, will SDI be able
to invest in marlcetable securities in 1996 and 19977 If so, how much excess funds will SDI
have available for investment in marlcetable securities? Do your financial forecasts reveal
any developing conditions that should be corrected?

6. On the basis of forecasts developed earlier, does it appear that SDI will be able to retire all of
its outstanding short-term loans by December 31, 1996? In answering this question, assume
thatthe firmwill,if possible,repaythe loans at a constantrate throughoutthe year. There-
fore, on average, the amount of short-term loans outstanding will be half of the beginning-
of-year amount.

7. ITthe bank decides to withdraw the entire line of credit and to demand immediate repayment
of the two existing loans (the short-term and long-term loans) extended to SDI, what alterna-
tives would be available to SOl?

Copyright @ 1997 South-Western. All rights reserved.

- ---
12 Case 368 - Directed - Financial Analysis and Forecasting

Assume that Doug has hired your consulting finn to work for him, and you are on the team
assigned to the task. First, Doug wants you to verify the bank's evaluation of the company's cur-
rent financial situation and then to put together a forecast of SDI's expected performance for 1996
and 1997. Doug asks you to develop some figures that ignore the possibility of a reduction in the
credit lines, and which assume that the bank will increase the line of credit by the $9,500,000 needed
for the expansion and supporting wolking capital. Also, you and Doug expect the level of short-term
interest rates to trend up to 8.50 percent in 1996 and 9 percent in 1997. The assumed 40 percent com-
bined federal and state tax rate should also hold for the next two years. Finally, if the bank cooper-
ates, and if Doug is able to turn the company around, the PIE ratio should be 12 in 1996 and then rise
to 14 in 1997.
Next, Doug wants you to thorough1y analyze SDI's current .financial situation and to prepare
a list of strengths and weaknesses based on its historical financial statements and ratios. He hopes
that the bank will lend his firm the requested money based on its historical financial performance
alone, but he is not confident of that.
Next, he wants you to construct a set of pro forma financial statements that he can use to assess
the company's position and also to help convince Ingrid that her bank's existing loan is safe and
that SDI should be granted a larger line of credit. Assume that the bank is willing to maintain the pre-
sent credit lines and to grant an additional $9,500,000 of short-term credit effective January I,
1996. In the analysis, take account of the amounts of inventory and accounts receivable that would
be carried if inventory turnover (based on the cost of goods sold) and days sales outstanding w~ set
at industry-average levels. Doug suggests that you use the predictions stated in SDI's business plan
concerning sales, expenses, and the payment of cash dividends during the forecast period. Fmally, in
your calculations use the cash and marketable securities account as a residual balancing figure.
SDI needs to be able to make rapid payments to suppliers if it is to get the best prices, and it
has determined that its optimal cash balance is 5 percent of sales. Temporary funds in excess of this
amount will be invested in maIketable securities which, on average, will earn 5 percent interest. Doug
would like a breakdown of the cash and maIketable securities account into its two components. In
addition, SDI wants to repay its loans at a constant rate throughout the year, if that is possible.
Doug also wants you to prepare an alternative set of pro forma financial statements for 1996
and 1997 incorporating the following conditions:

(1) Short-term loans will be repaid if sufficient cash is available to fully repay the loans without
reducing cash below the optimal cash balance. If the loans are repaid, assume that they are
repaid evenly over the year. Therefore, on average, the amount of short-term loans outstand-
ing during the repayment year would be half of the beginning-of-year loan amount.
(2) SDI will not reinstate a 25 percent cash dividend during the first year until all short-term
loans and credit lines are projected to be paid in full.

It is apparent that SDrs future (and that of the bank's loan) is critically dependent on the com-
pany's financial performancein 1996 and 1997. Therefore, it would be useful if you could, as part of
your consulting report, inform management and the bank as to how sensitive the results are to
changes in such things as the sales growth rate, the cost of goods sold percentage, and the 9dminig-
trative expense ratio. If the results still look fairly good, even if those factors are not as favorable as
initially forecasted, the bank should have greater confidence in extending the requested credit. On
the other hand, if small changes in these variables lead to a continuation of past negative trends, the
bank would probably be reluctant to grant any new loans, or even to extend the current loan.
Finally, there is always the possibility that the bank may decide to revoke the entire line of
credit and demand Unmediaterepayment of the two existing loans. Doug wants you to discuss the
bank's likely reaction to the situation, anything the company could do to improve the odds on the
bank going along with the new credit, and the alternatives that might be available to SDI. To help
structure your analysis and report, answer the following questions.

Copyright @ 1997 South-Western. All rights reserved.

 Case 368 - Directed - Financial Analysis and Forecasting 11

enough to keep inventories from rising even further. Moreover, the credit policy changes caused
accounts receivable to increase dramatically by late 1995, exacerbating the company's cash flow
problems.
To finance its rising inventories and receivables, SOl had turned to the bank for a long-term ~S
loan in 1994, and higher short-term credit in both 1994 and 1995. However, this additional credit
proved insufficient to cover the asset expansion, and the company began to delay payments of its
accounts payable until a second late notice had been received.Managementrealized that this was not
a particularly wise decision for the long mn, but they did not think it would be necessary to con-
tinue paying slowly for very long. The 1995 sales seasonlooked strong, and there was optimism that
the national economy would pull out of the weak growth scenario in late 1995. Therefore, the com-
pany believed that its stable and profitable markets of the past would soon reappear.
After Ingrid's telephone call, and the subsequentreceipt of a copy of the bank's financial anal-
ysis of SDI. Doug began to realize just how precarious his company's financialposition had become.
As he started to reflect on what could be done to correct the problems, it dawned on him that the
company was in even more trouble than the bank imagined. SOl had recently signed a binding con-
tract for a plant expansion that would require an additional $9,500,000 of capital during the first
quarter of 1996, and Doug had planned to obtain this money with a short-term loan from the bank
to be repaid from cash flow expected in the last half of 1996as a result of the expansion. In his view,
once the new production facility went on line, the companywould be able to streamline production
to increase output and reduce costs. At this point, it was virtually impossible to cut back on the
expansion plans and to retrench, because of the signed construction contracts and the high cancel-
lation charges built into the contracts. Therefore, Doug regards the $9,500,000 of new capital as
being essential for SDI's very survival.
Doug quickly called his senior management teanIin for a meeting, explained the situation, and
asked for help in formulating a solution. The group concludedthat if the company's current business
plan were cauied out, SDI's sales would grow by 10percentfrom 1995to 1996, and by another 12.5
percent from 1996 to 1997. Further, they concluded that SDI should reverse its recent policy of
aggressive pricing and easy credit, returning to standard industry credit practices and to a pricing
strategy that fully covered costs plus normal profit margins. These changes should enable tlIe com~
pany to reduce the cost of goods sold from more than 85 percent of sales in 1995 to about 83 per-
cent in 1996. and then to 80 percent in 1997. Similarly, tlIemanagement group felt tlIattlIe company
could reduce administrative and selling expenses from almost 8.5 percent of sales in 1995 to 8 per-
cent in 1996, and then to 7.5 percent in 1997. Also, significantcuts should be possible in miscella-
neous expenses, decreasing from 2.50 percent of 1995 sales to approximately 1.80 percent of sales
in 1996, and to 1.40 percent in 1997.
In addition. management believes that annual depreciation expense should equal 13.5 per-
cent of net fixed assets that were in place at tlIe beginning of tlIe year. (In otlIerwords, this calcula-
tion should be made on net itxed assets existing at the end of the prior year.) In addition,
management has decided that witlI the plant expansion made in 1996, no new fixed assets would be
needed in 1997. Because management's policy to stretch its accounts payable has led to a much
higher accounts payable balance than would normally occur, management plans to reduce its 1996
accounts payable by 20 percent. Accma1s,as well as 1997accounts payable should grow at tlIe same
rate as sales. No additional long-term bank loans will be sought. SDI plans to make principal repay-
ments on its mortgage of $445,000 and $472,000 in 1996 and 1997, respectively. (Note tlIat mort-
gage interest payments are based on tlIe end-of-year balance.) Finally, SDI has no plans to issue
additional common stock. These cost reductions represent "trimming the fat," so they are not
expected to influence the quality of tlIe i1rm' s products or its effective sales efforts. Further, to
appease suppliers, future bills would be paid more promptly, and to convince tlIe bank how serious
management is about coIrecting the company's problems, cash dividends would be eliminated and
executive salaries frozen until tlIe firm regains its financialhealth.

Copyright@ 1997 South-Western. All rights reserved.

10 Case 36B - Directed - Financial Analysis and Forecasting

likelihood of bankruptcy in the next two years. A Z score much less than 3 indicates a good chance
that the firm will go into default. SOl's sub-nonnal Z score will put the bank under increased pres-
sure to reclassify SOl's loan as a "problem loan," to set up a reserve to cover potential losses, and
to take whatever steps are necessary to reduce the bank's exposure. Setting up the loss reserve would
have a negative effect on the bank's profits and reflect badly on Ingrid's performance. However, if
Ingrid takes no action and the loan later goes into default, that will look much worse on her record.
To keep SOl's loan from being reclassified as a "problem loan," the Senior Loan Committee
will require strong and convincing evidence that the company's present difficulties are only tempo-
rary. Therefore, it must be shown that appropriate actions to overcome the problems have been
taken, and that the chances of reversing the adverse trends are realistically good. Ingrid now has
the task of collecting the necessary infonnation, evaluating its implications, and preparing a rec-
ommendation for action.
Ingrid is also aware that if the bank demands immediate repayment, SDI will undoubtedly
fIle for protection under Chapter 11 of the Bankruptcy Act. The company will then be granted an
"automatic stay" under which creditors cannot attempt to collect interest or principal or take pos-
session of collateral securing their loans. The company's management will be allowed to continue
running the fino as a " debtor in possessioo," and will be given the right, if the Bankruptcy Court
agrees, to raise new money as "debtor-in-possession financing" which would be senior to all unse-
cured debt, including the bank's debt. Management may be authorized to sell off liquid assets to
cover operating expenses and legal fees, and that reduction of assets could adversely affect. the
bank's ability to recover its investment.
After a Chapter 11 filing, management would have 120 days to file a plan of reorganization
detailing how it plannedto operate in the future, a proposed new capital structure, and the like. More
likely than not, the 120days would be extended, and once management's plan is filed, creditors have
a period of time to review it, to protest it, and, if they choose, to file a reorganization plan of their
own. Generally, and in SDl's case, there are a number of classes of creditors, and each class can take
separate action such as filing a reorganization plan of its own. All of this takes time, during which
management remains in control, possibly inCUITingexpenses which have priority over the bank's
claim and selling off liquid assets. Of course, the company's employees, customers, and suppliers all
know about the filing,and that does nothing good for morale and productivity, sales, or getting favor-
able credit terms from suppliers.
Bankruptcies of companies the size of Sweet Dreams are rarely resolved in less than a year,
and two to three years is more realistic. All the while, the creditors' money is tied up, and the loan
is classified as "non-perfonning" by the bank's examiners. Ingrid is well aware of all this, so she
does not want to take actions which will lead to a Chapter 11 filing except as a last resort. How-
ever, if bankruptcy is inevitable, she would want to get on with it as soon as possible.
SDI's problems began with the recession of the early 19908, which caused a drastic decrease
in demand from its retail and hotel customers. The bulk of new bedding sales, much like other fm-
niture sales, result from individuals purchasing new homes. Furthermore, new hotels were not
being built in the Southeast due to an overabundance of rooms and high vacancy rates. SDI
responded aggressively by significantly reducing prices, but it also increased production in antici-
pation of a bounce-back in sales and to realize greater economies of scale. Sales did increase, but not
as much as the company expected. SOl's management attributed the lower than expected sales to a
slower than expected economic recovery. However, management remained confident that the econ-
omy would continue to grow stronger, so production continued unabated, and inventories increased
sharply. The demand for new beds proved to be less elastic than management thought, so the price
reduction did little to boost sales. As a result, management's response to the economic downturn
did not turn out as expected.
Under increasing pressure, SOl decided to relax its credit standards in early 1995 in hopes of
stimulating sales and reducing inventory, and it improved its already favorable credit terms. As a
result, sales growth did exceed the industry standards through the third quarter of 1995, but not by

Copyright@ 1997 South-Western. All rights reserved.

10 Case 36B - Directed - Financial Analysis and Forecasting

likelihood of bankruptcy in the next two years. A Z score much less than 3 indicates a good chance
that the firm will go into default. SOl's sub-normal Z score will put the bank under increased pres-
sure to reclassify SOl's loan as a "problem loan," to set up a reserve to cover potential losses, and
to take whatever steps are necessary to reduce the bank's exposure. Setting up the loss reserve would
have a negative effect on the bank's profits and reflect badly on Ingrid's performance. However, if
Ingrid takes no action and the loan later goes into default, that will look much worse on her record.
To keep SOl's loan from being reclassified as a "problem loan," the Senior Loan Committee
will require strong and convincing evidence that the company's present difficulties are only tempo-
rary. Therefore, it must be shown that appropriate actions to overcome the problems have been
taken, and that the chances of reversing the adverse trends are realistically good. Ingrid now has
the task of collecting the necessary information, evaluating its implications, and preparing a rec-
ommendation for action.
Ingrid is also aware that if the bank demands immediate repayment, SDI will undoubtedly
file for protection under Chapter 11 of the Bankruptcy Act. The company will then be granted an
"automatic stay" under which creditors cannot attempt to collect interest or principal or take pos-
session of collateral securing their loans. The company's management will be allowed to continue
running the firm as a " debtor in possession," and will be given the right, if the Bankruptcy Court
agrees, to raise new money as "debtor-in-possession financing" which would be senior to all unse-
cured debt, including the bank's debt. Management may be authorized to sell off liquid assets to
cover operating expenses and legal fees, and that reduction of assets could adversely affect. Ute
bank's ability to recover its investment.
After a Chapter 11 filing, management would have 120 days to file a plan of reorganization
detailing how it plannedto operate in the future, a proposed new capital structure, and the like. More
likely than not, the 120days would be extended, and once management's plan is filed, creditors have
a period of time to review it, to protest it, and, if they choose, to file a reorganization plan of their
own. Generally, and in SOl's case, there are a number of classes of creditors, and each class can take
separate action such as filing a reorganization plan of its own. All of this takes time, during which
management remains in control, possibly incuning expenses which have priority over the bank's
claim and selling off liquid assets. Of course, the company's employees, customers, and suppliers all
know about the filing,and that does nothing good for morale and productivity, sales, or getting favor-
able credit terms from suppliers.
Bankruptcies of companies the size of Sweet Dreams are rarely resolved in less than a year,
and two to three years is more realistic. All the wbile, the creditors' money is tied up, and the loan
is classified as "non-performing" by the bank's examiners. Ingrid is well aware of all this, so she
does not want to take actions which will lead to a Chapter 11 filing except as a last resort. How-
ever, if bankruptcy is inevitable, she would want to get on with it as soon as possible.
SOl's problems began with the recession of the early 19908, which caused a drastic decrease
in demand from its retail and hotel customers. The bulk of new bedding sales, much like other fur-
niture sales, result from individuals purchasing new homes. Furthermore, new hotels were not
being built in the Southeast due to an overabundance of rooms and high vacancy rates. SDI
responded aggressively by significantly reducing prices, but it also increased production in antici-
pation of a bounce-back in sales and to realize greater economies of scale. Sales did increase, but not
as much as the company expected. SOl's management attributed the lower than expected sales to a
slower than expected economic recovery. However, management remained confident that the econ-
omy would continue to grow stronger, so production continued unabated, and inventories increased
sharply. The demand for new beds proved to be less elastic than management thought, so the price
reduction did little to boost sales. As a result, management's response to the economic downturn
did not turn out as expected.
Under increasing pressure, SOl decided to relax its credit standards in early 1995 in hopes of
stimulating sales and reducing inventory, and it improved its already favorable credit terms. As a
result, sales growth did exceed the industry standards through the third quarter of 1995, but not by

Copyright@ 1997 South-Western. All rights reserved.

 20 Case 368 - Directed - Financial Analysis and Forecasting

TABLE 6
Historical and Pro Forma Ratio AnaIysis3
for Years Ended December 31

Pro Forma Industry

1993 1994 1995 1996 1997 A veraee
Liquidity RaJios:
Cwrent ratio 3.27 2.%x x x x 2.25x
Quick ratio 1.84 1.17 1.18 1.20

Leverage RaJios:
Debt ratio 38.73% 45.12% % % 50.61% 50.00%
TIE coverage 16.68x 7.84x 2.09x x 7.56x 7.7Ox

Asset Management RaJios:

Inv turn (cost)b 7.17x 4.24x x 5.5Ox 5.5Ox 5.5Ox
Inv turn (sale)C 8.83 5.16 3.98 7.00
FA turnover 12.07 12.56 12.83 11.10 14.44 12.00
TA turnover 2.93 2.50 2.00 2.01 3.00
DSO (ACP)d 34.95 34.45 32.00 32.00

Profitobility RaJios:
Profit margjn 5.78% 3.57% 0.87% % % 3.50%
Gross PM 18.85 17.82 14.84 17.00% 20.00% 18.00
Return on TA 16.92 8.93 5.79 10.50
ROE 27.61 16.27 21.00

Other RaJios:
Altman Z factorf 6.61 4.65 3.97 5.34 4.65
Payout ratio 25.00% 25.00% 25.00% 0.00% 0.00% 20.00%

Notes:
a. Year-end balance sheet values were used in. the computation of ratios embodying balance sheet items.
b. Uses cost of goods sold as the numerator.
c. Uses net sales as the numerator.
d. Assumes a 36(kIay year.
e. Industry avmages are for 1995, but they wererelative1y stable over the period 1993-1995, and they are not expected
to change significantly in 1996-1997.
f. Altman's function is calculated as fonows:
Z = O.OI2xl + 0.014~ + 0.033~ + 0.006><.. + 0.999xs
Here XI =net woddng capitalItotal assets
~=retainedeamingsltotalassets
~ =EBlT/total assets
X4 =market valne of common and preferred stockJbook value of all debt
><s = salesItotal assets
The ..Altman Z score" range of 1.81-2.99 typically represents the S<H:alled zone of ignorance. Note that the first four
variables are expressed as percentages. Refer 10 Chapter 26 of Eugene F. Brigham. and Louis C. Gapenski,
Tntem-fiatp. Financial Management (Hinsdale, Dl: The DIyden Press, 1996), and the discussion on multiple
discrimin>mt analysis for details.

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