CASE 7 UNHAM COSMETICS For the last 26 years, Dunham Cosmetics has obiained virtually all of its busi- ness loans from the Graham County Bank (GCB). For the most part, Dunham hasbeen a valued customer, though in 1980 Dunham fell behind in its debt pay- ments when a new line of toiletries was a complete disaster, After this the bank monitored Dunham’ financial situation extremely closely, requiring monthly financial statements. As the company’s financial situation improved, the bank went fo quarterly and—eight years ago, in 1987—yearly evaluations. This was a sign that GCB felt the company was a good credit risk, and in recent years Dunham has had little difficulty obtaining bank financing. In fact, Dunham will seek a $675,000 loan in the near future. Its in the second year of its Equipment Improvement Program and will use the funds to modemize the factory and much of the equipment. The completion of this program is considered vital to the current and future health of the company. Jean Reardon was promoted to corporate banker with GCB four months ago and is the officer in charge of Dunham’s account, replacing an officer who apparently was considered too lenient in corporate loan decisions. Reardon has known of Dunham's intended loan request for three weeks, and her initial, reaction was that approval of the loan would be highly probable. Fortunately she never expressed this opinion to Lionel Jensen, Dunham's general manager. She realizes circumstances do change, and it would be very embarrassing to tumdowna loan request om a longtine dientafter hinting uch loan would be “likely.” There are a number of factors indicating Dunham will have borrow- ing difficulties, and she calls a meeting with Jensen to discuss the company’s debt situation,a PART Il FINANCIAL ANALYSIS JENSEN AND REARDON MEET Reardon reminds Jensen that the Federal Reserve is tightening credit in order to eliminate inflationary pressures in the economy. This means that loans will become hanter to obfain and the bank will be lookingat each loan request much more carefully. Even more serious, the bank has just finished its yearly financial evaluation, and Reardon emphasizes to Jensen that, in her opinion, Dunham's financial position is “poor and seems to be getting worse,” She also points out as tactfully as possible that Dunham is violating its loan agreements, For exam- ple, one provision stipulates the current ratio car’ fall below 1.85. ‘A final issue concems the terms of the company’s loans. Jensen tells Reardon that “I am considering whether to restructure the company’s debt” and “might request” that the bank take all of Dunham's debt and amortize it over five years. “Of course, this may be unnecessary,” he is quick to add, Rearcion explains to Jensen that in light of Dunham’ difficulties the loan com- mittee would much prefer that any debt be repaid as quickly as possible. This ‘means that (1) the loan committee would prefer not to restructure the debt; and 2) the new loan request, assuming it is even granted, would likely be in the form of a note payable. However, Reardon does tell Jensen that the bank is willing to “work with you to develop a financial plan satisfactory to all par- es.” Reardon then suggests they meet again in the near future to discuss the situation further. ‘A few minutes after Jensen leaves, Reartion wonders if she wasn’t a bit too “hardline,” especially regarding Jensen’s request to restructure Dunham's exist- ing debt, She knowss that the officer previously in charge of the firm’s account hhad raised no red flags with Jensen at last year’s annual meeting. This is surprising given the company’s “off” year in 1994. Prudent banking dictates that an officer express concern over @ deterioration in a firmr’s position and seriously investigate the reasons for any poor performance. ‘And there are possible legal considerations, Suppose that the bank either calls the loan or refuses to allow Dunham to restructure. If, asa result, Dunham ends up in serious financial difficulties, then it is possible that GCB could be held legally liable for these problems because of the failure to adequately warn Dunhama year ago. Everything consiclered, Reardon thinks it may well be in the banks interest to allow Dunham to restructure its existing debt. The new loan request is another matter, however. Although approval of the loan i not out of the question, Dunham will need a very solid andl convincing business plan to stand any chance. Back at his office, Jensen reflects on the meeting with Reardon and the firm's situation, He is annoyed that he had not anticipated the bank’s evalua- tion but feels there is a positive side to the situation. “Perhaps this will give our board the kick in the pants it needs,” he thinks, Jensen knows Dunham is in difficulty and has a number of measures he wants implemented. Unfortunately, the board feels the company’s problems are largely the result of a poor cosmetics market; the members believe there is little to do but waitCASE7 DUNHAM COSMETICS 43 for the “inevitable recovery.” Jensen agrees that part of Dunham's problem hhas been the soft market that has existed for the past two years, However, industry experts agree this decline is over, and there are indications that demand is on the rise. Jensen himself believes a safe prediction is for sales to increase by 10 percent in 1996. JENSEN’S RECOMMENDATIONS He also feels there are a number of changes Dunham can make. When the company realized that demand would be down, it hoped to increase sales with more liberal credit and through a larger inventory that would increase cus- tomer selection. Jensen opposed those measures at the time on the grounds that “they have never worked in the past, and we have a competitive, even gener- cus credit policy.” At present Dunham has an especially large level of inventory and a very high amount of receivables. Jensen believes receivables should be reduced to 60 days of sales in 1996 and the inventory turnover (sales/inven- tory) ratio could be raised to 54, the industry average. In addition he has a number of suggestions for reducing Dunham’s costs. He believes the com- any can increase its gross profit margin to 31 percent and reduce selling and administrative expenses to 21.5 percent of sales. “One reason for our lousy current ratio is we've gradually taken longer and Jonger to pay our bills! I've gotten more than one nasty letter in the last year! I’m going to suggest we get payables to 9 percent of sales, which would be com- petitive with other firms,” Jensen has also been critical of how the company has obtained external fund- ing for the last few years. Virtually all such money has been supplied by GCB, and Jensen has secretly felt that the bank has been “extremely generous” in honoring Dunham's Joan requests. Personally he believes the firm should have used more equity by eliminating dividend payments and selling more stock. In fact, in 1993 he had recommended that the firm lower its payout ratio from. 50 to 20 percent of net income. The proposal received little support then and con- sequently Jensen hesitates now to propose a reduction in dividends. He decides to make any financial forecast assuming the payout ratio remains at 50 percent. Though Jensen doesw’t really think GCB will grant the $675,000 loan request, he believes that Dunham should not accept the money even if it is offered. “But maybe Iam wrong,” he admits. “I will work up a financial forecast based on these changes and see what the numbers look like.” Jensen will present his suggestions at the meeting he has called in 72 hours, and believes “they'll be implemented considering the situation with the bank.” Jensen knows that the board wants the $675,000 loan, and if Dunham doesn’t show the bank a solid plan, it will not only have no chance to obtain the $675,000, but the bank could foreclose on the existing loans. “And maybe, just maybe,” he sighs, “if the bank likes our plan we won't be required to submit a monthly review. I really hate those!”“4 PART Il FINANCIAL ANALYSIS QUESTIONS 1. Calculate Dunham's 1995 financial ratios. (See Exhibits 1, 2, and 3). 2, Does a trend analysis indicate Dunham’s position has been deteriorating? (Gee Exhibit 3.) 3, Is the bank justifiably concemed? Justify your answer. 4. Nineteen ninety-four wasa “own” year for Dunham. Do you think that GCB hada responsibility to express concern in 1994, especially since the current ratio was close to 1.85, the number that could trigger a call of the loan? Explain, 5, Suppose Dunham had followed Jensen’s 1993 recommendation to lower its payout ratio. Recalculate the firm’s debt and current ratios for 1995 assum- ing that the payout ratio was 20 percent from 1993 to 1995. (Assume that the extra money was used to reduce the firms notes payable.) 6.(@) Jensen discussed Dunham's situation with Paula Robinson, an account- ing friend. Robinson said that, in her opinion, Dunham has “too little long-term capital, especially considering your receivables and inventory needs.” Why is it frequently appropriate to use a long-term capital sourte like bonds or equity to finance items like inventory and receiv ables that appear on a balance sheet as short-term assets? (©) What advantages are there to using short-term debt to finance long-term assets? What are the disadvantages? 7. (@) Project Dunham’s income and balance sheet for 1996 (see Exhibit 4) assuming the bank grants Dunham a $675K note payable at 12 percent and no existing interest-bearing debt is retired. (Dividends will be 50 percent of net income.) Cash will be the residual or balancing item in the forecast. (©) Estimate the firm's 1996 minimum cash balance assuming that on aver- age during 1993 to 195 its cash situation was normal. (© Use any excess cash at the end of 1996 to retire notes payable. 8.(@) Will the bank be impressed by Jersen’s changes? Explain, (©) What other options does Dunham have, assuming the bank denies the loan request? Critically evaluate each of these options. SOFTWARE QUESTION 9, Dunham Cosmetics presently has $4,466,000 of interest-bearing debt. Nearly all of the debt is due in the next three years. Jean Reardon thinks that it is a good idea to allow Dunham to restruc- ture its debt and spread the payments over at least five years. She reasons that Dunham is unlikely to generate sufficient cash to pay the annual debt due the way the loans are presently structured. This could create problems for Dunham and the bank, and she wants to avoid, if possible, any “collection hassle.”CASE7 DUNHAM COSMETICS 45 She also is considering a new loan of up to $325,000 which is about half of the $675,000 that Lionel Jensen requested. Reardon is convinced that (1) any loan would be adequately secured and (@ Jensen has a solid business plan, though she believes it may take him longer than he expects to fully implement it. Before she approves any loan, however, she would require Dunham to reduce its payout ratio, pethaps even have Dunham eliminate dividends entirely. NOTE 1: Dunham’s payout ratio is presently 50, that is, half of net income is paid out as dividends. NOTE 2: Dunham needs $675,000 of financing. If the new loan is granted, this provides Dunham with $325,000 of the needed financing, and it would raise the remainder by selling new stock. If only the existing debt were restructured, that is, no new loan is granted, then all of the $675,000 would be financed with equity. Thus, any new loan amount reduces dollar-for-dollar the amount of new equity that Dunham must raise. Reardon decides to evaluate Dunham's ability to pay off a new five-year $325,000 Joan in the following scenarios, and assuming equal amounts of prin- Gipal are due each year. The interest rate would be 12 percent. She also decides to evaluate payout ratios of .50, .25, and 0 for each scenario. NOTE 3: This loan would total $4,791,000, which equals the $4,466,000 of existing interest-bearing debt plus the additional $325,000. Principal due each year is $958,200. S-1 is Reardon's best-guess (mostikely) scenario, Rearion labels S-2 “conservative” and S-3 “pessimistic.” 1995 Estates SI & SB Sales growth, a0 10 8 Gus margin » a a AP a0 6500 0 Sales/Inv. 540) 540 510 1997-2000 Estates Sales growth, 6 6 B Gus margin a. 20 x» AP so 000 600 Sales/Inv. 5m 540 54046 PARTI FINANCIAL ANAL} For all scenarios she will assume in every year that administrative expenses and payables are 21.5 percent and 9 percent of sales, respectively, Reardon will also assume that capital spending will be $900(000) in 1996, $200(000) in 1997, increasing by the sales growth rate after that. Finally, the min- imum cash balance each year is $1,127(000), Perform the appropriate analysis, (@) Does it appear that allowing Dunham to restructure its $4466,000 of existing (old) debt is a good idea? Explain. (b) Would you grant Dunham an additional $325,000? Explain. NOTE: Make sure when you address part (b) that (1) the “new equity” input is set at $350 for 1996 and 0'in 1997-2000, and @) “net new debt” is set at $325, EXHIBIT 1 Income Statements (000s) Presenter 1993 199 1985 Sales so5264 $2567 Cost of goods 17.180 18293 Grss profit S054 788 Administrative expenses 554 6,068 Depreciation m2 m EBIT 228 TBI Interest 296 oq Eamings before tases 2222 73 Taxes G0'%) 116 a Net ineome Ll 5 (Cemmen stock dvicrels aS 188 Retained earingsCASE7 DUNHAM OOSMETICS 47 EXHIBIT 2 Balance Sheets (000s) Presenc Yer 1B 194 1995 Asets (Cash & marketable securities s1264 i237 37 Receivables 370 5204 590 Inventory 402 Sua 618 Cument acts WS 156 Re Gross fixed assets 3024 4123 537 ‘Accumulated depreciation aay) sz) ony Net fined assets 185 2601 38% Total asets 1090 as 16268 Liabilities and Equity Notes payable silt sist 240 ‘Accounts payable 2021 3,126 3866 ‘Accruals 655 p10 1234 (Cuument iailities 378 5940 70 “Tem loans 1254 11 2066 (Cemmen stock 45 4050 4950 ‘Retained earings 188 2373 25 ‘otal lnblities and equi 7090 us 16268 EXHIBIT 3 Financial Ratios for Dunham Cosmetics Indisry Aura 193 1994 195 BIB Liguiity Curent 20) 194 195 Quick 1B 108 100 Leverage Debt (9) 4600 5500 5300 ‘Times interest eamed 854 520 500 Activity Tnventory tumover (ses) 65 510 540 Fhod asset tumover BR 991 1000 ‘Total aset tumever 20) 182 210 Averagecalletion period (days) SLD 7270 51.00 Profitability Gress profit margin (%) 20 3200 3050 Net prot) 40 370 300 ‘Retum on total assets (4) 1040 670 60 Retum onexq 18 1480 133048 PART Il FINANCIAL ANALYS sales Cost of goods Goss profit Administrative expenses Depreciation EBIT Interest Earnings before tones: Toes Netincome Cument assets Gross fixed assets Accumulated lepreciation Net fixed assets Total assets Libiltes and Buty Notes payable Accounts payable “Aconials (Cument liabilities Bonds (Common stock Retained eamings ‘Total liabilities and equity EXHIBIT 4 1996 Inacme Statement of Dna Casas (0008) 1995 Balance Sheet (Ow eu (250)