Bank Decision Making

Ted Yu Professor Hackelton Accounting 830 May 31, 2007 Term Paper: Analysis for Lending Decision

1. Circumstances Leading to Need for the Loan The case indicates that the firm needs to loan to finance working capital related to a 40 percent projected growth in sales, to repay suppliers, and to provide funds for expected nonrecurring legal and retooling costs. However, the largest working capital need appears to be related to increased investment in inventories. Currently, the firm’s Days AP Outstanding (DAO) is 128 days. Its stated desire to “repay” creditors suggests that suppliers are putting some pressure on the firm to reduce the DAO. And a part of the loan is needed to fix a cash flow problem. Part of the loan is also needed to pay legal costs on a lawsuit whose outcome is uncertain and for tooling costs that will not likely result in marketable collateral. Thus, considerable risk exists with respect to the intended use of the loan proceeds. 2. Credit The firm has an ongoing relationship with its bank, having reduced its borrowing during the preceding four years. Thus, it appears to have established credit. 3. Cash Flows The projected financial statements suggest that the Company will have sufficient cash to repay the bank loan without adversely affecting operations and capital expenditures. But the growth rate of sales 40% exceeds the growth rate in sales for Year 5 and Year 6, which were 20% and 24%, respectively. The amounts of cash on the balance sheet on December 7, Year 8 and Year 9 for different growth rates in sales are as follows: Growth Rate in Sales Year 8 Year 9 20% ..................................................$ (2,396) $ 38,556 25% ..................................................$ 2,929 $ 29,645 30% ..................................................$ 6,130 $ 12,087 35% ..................................................$ 19,229 $ 6,321 40% ..................................................$ 20,109 $ 7,403 Regardless of the growth rate in sales, it appears that the firm will have sufficient cash to repay the bank loan. The Company has reduced its days accounts receivable, inventory, and accounts payable during the last three years. Thus, maintaining the current rates of turnover for accounts receivable and inventories and reducing the days payable do not appear unreasonable. 4. Collateral

If cash flows are not adequate to service the loan, the bank has the right to sell the collateral. There does not appear to be much collateral for the increased loan. The Company's machinery and equipment already serve as collateral for the existing loan. Most of the capital expenditures will be made with the loan proceeds are for the tooling and testing of the Soapstone Stove II stove. As a special fixed asset which has a special use purpose, it’s difficult for the bank to accept it as collateral and sell to obtain funds to repay the loan when the company cannot repay the loan. The use of the loan proceeds for legal expenses may or may not result in an asset that could serve as collateral. The inventory probably serves as collateral for accounts payable to suppliers. This inventory is specific to the Company's stoves and probably not easily salable. Given that the bank already requires the pledging of investments in common stock of two of the shareholders and the personal guarantees of three of the shareholders, there is not likely much additional collateral for the increased loan. 5. Capacity for Debt All of the long-term debt relates to shareholder loans. The Company has no current plans to repay this debt. If we reclassify this long-term debt as part of the shareholders' equity, then the liabilities to assets ratio on December 31, Year 7 decreases by 4.2%. This percentage is not only very high but all of the liabilities are short-term. The interest coverage ratios are very low. Although these ratios improve by Year 8 when the loan is due, they are still not at particularly healthy levels. Thus, the Company does not appear to have much unused debt capacity. 6. Contingencies Two contingencies cloud the Company's future. First, a favorable outcome to the lawsuit is likely, but uncertain. Legal expenses might exceed the $51,000 currently forecasted. If the court finds in favor of the Company, the Company might have difficulty finding tenants for the other 40 percent of the building. If it does, it may incur costs to alter the space to suit the needs of the new tenants. On the other hand, the Company will receive cash at the time of settlement because the balance of the unpaid mortgage exceeds the option price. It could use this cash to fund needed improvements to the building or pay carrying costs until it finds new tenants. Also, the Company's aggressive pursuit of the lawsuit suggests that the market value of the building substantially exceeds the option price, possibly providing collateral for both the mortgage assumed and the increased bank loan. Finally, the Company will secure low interestrate financing upon assumption of the unpaid mortgage. The second contingency is the EPA approval status of the Soapstone Stove II stove. Actual costs may exceed those expected and the required time for approval may take longer than expected. It does not appear that this stove will be approved and generating revenue prior to the time that the Company must repay the increased bank loan. The second contingency is the EPA approval status of the Soapstone Stove IIstove. The company has already received the preliminary EPA approval. But the expected cost, $75,000 would be more than $59,000, the total amount of the loan. Therefore, repayment of the loan principle and interest most probably comes from the Company’s sales or the financing in some other way. And further, it does not appear that the Company can use the Stove II to generate revenue prior to the time that the Company must repay the increased bank loan. 7. Character of Management Character refers to both the integrity of management and to its ability to adapt successively to changing business conditions. The Company is one of the few survivors in the industry which

was strictly supervised by the EPA. It has carved itself a market niche in the retail direct marketing segment. It has gotten one stove approved by the EPA and has another stove in the approval process. The willingness to sustain significant legal expenses over a period of years suggests that the option truly has value and that the building is a part of the Company's future strategy. The willingness of the major shareholders to commit their personal wealth to the claims of creditors suggests both a commitment to the business and a need to make it successful. 8. Communication The case does not provide information on how well the Company has kept its bank informed about its activities in the past or its future plans. 9. Conditions The case is silent on constraints that the bank will place on the Company beyond the interest rate and the repayment date of the loan. The bank might specify a lid on the amount of expenditures that the Company can make to obtain approval of the Soapstone II stove. The bank would not want to impose constraints that would impede operations, such as minimum levels of net income and assets turnovers. It appears that the only way the Company will be able to repay the loan is if operations are profitable and the Company generates cash flow. Requiring additional collateral does not appear reasonable. Existing collateral does not appear to be sufficiently liquid (except the common stock investments) to make repossessing the collateral an attractive option if the Company cannot service the loan. The only potential bright spot with respect to collateral is that the building appears to have a market value in excess of the unpaid loan. If the lawsuit is successful for the Company, as expected, then additional collateral may be available to support the requested bank loan.