IN1046

Great Eastern Toys (A)

08/2015-4876

This case was written by Gabriel Hawawini, The Henry Grunfeld Chaired Professor of Investment Banking and Lee
Remmers, Emeritus Professor of Finance at INSEAD. It is intended to be used as a basis for class discussion rather
than to illustrate either effective or ineffective handling of an administrative situation.
Additional material about INSEAD case studies (e.g., videos, spreadsheets, links) can be accessed at
cases.insead.edu.
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 It was late July 1998. Paul Cheng, sole owner of Great Eastern Toys, was getting ready to
leave his office. An hour earlier, John Li, the company’s general manager, had dropped on
Cheng’s desk the company’s financial statements for the year ending June 30, 1998, as well as
several other reports (see Exhibits 1 to 5). Paul Cheng decided to take these documents home
with him. He wanted to examine them in detail before meeting with Li tomorrow morning.
Two issues were on Paul Cheng’s mind. First, he wanted to determine the effectiveness of the
policies and efforts of John Li, whom he had hired as general manager nearly two years
earlier. Second, he wanted to review the evolution of his company’s financial condition and
prepare for a meeting with his banker in the next few days.

Great Eastern Toys was established in Hong Kong almost 30 years ago by Paul’s father, to
create and design children’s toys and books. It had few production facilities itself, but relied
mainly on a number of local suppliers who manufactured to its specifications. Less than 5%
of the firm’s business was local, the largest part of its sales being to export markets. Its
customers included toy companies as well as department stores and other large retail chains.
Dollar markets [mainly the United States and Canada] accounted for slightly more than 50%
of total sales, with Western Europe accounting for the rest.

Paul Cheng took over the business after his father’s death in the summer of 1994. The two
fiscal years ending June 1995 and June 1996 of his tenure were considered good years for the
industry, but the performance of Great Eastern Toys was disappointing in comparison to the
year ending June 1994, when Paul’s father was still running the company. In late autumn of
1996, Paul decided to hire a general manager to help him turn things around. He attracted
John Li to the company by offering him a share of the profits in addition to a salary. Li had
been the general marketing and sales manager of another Hong Kong firm that exported
sporting goods and various other consumer products to markets in Asia and North America.
Both men agreed that, as general manager, Li would have full authority to execute any
changes he desired.

Since his father’s death, Paul Cheng had been troubled by the question of whether his family
should retain their interest in the company or sell out. He had heard his father speak of the
steadily declining margins in the toys-and-books business in recent year and, while he and his
family enjoyed considerable wealth, he had been wondering whether they shouldn’t sell out
and invest the proceeds in an enterprise of greater promise, or in the stock market and real
estate. In fact, he had told Li at their first meeting that he might be interested in finding a
buyer for the company because operating margins had been so drastically reduced in recent
years. “My father worked on an average pre-tax operating margin of about 10% not many
years ago,” he said. “Now we are lucky to average about 5%. My feeling is that, if the trend of
the last few years keeps up, this business will soon be dead.”

Li replied that he was certainly familiar with the declining margins problem and that he had
given it a great deal of thought. He was convinced, he said, that the answer lay in doing a
high-volume business. “I don’t think we’ll ever see average pre-tax operating margins of 10%
in the business again, but I do think we can maintain an adequate return on investment by
building volume and controlling costs. It’s not easy, but I think it can be done.” Li’s
confidence had been an important factor in Paul Cheng’s decision to leave the family money
in the company, at least for the present.

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 During his first few weeks in the company, Li reviewed in detail the records of the operating
and sales departments with the help of his staff: Peter Gray (the company’s accountant), Mr.
Ignacius Tang (the operations manager) and Robert Ho (the sales manager). He was
particularly concerned with their lack lustre exports to European markets achieved by the
company in 1995-1996 in relation to the estimated potential. And with some more effort, he
believed that sales could be substantially increased in the United States and Canada. Li was
also interested in the trends in operating margin and in the net profit shown by product lines.
Finally, he noted the financing of the company: a mixture of short–and–medium, term loans
in both Hong Kong dollars and Japanese Yen. Concerned with the potential risk from
borrowing in Yen, the accountant explained that this funding had been used since it provided
by far the cheapest funds available.

As a result of his review, and with the aid of the operations manager and the general sales
manager, Li submitted to Paul Cheng the following short memo:

To: Paul Cheng

From: John Li
Re: Outline of our action plan for fiscal year 1998 (July 1997 to June
1998)
Date: March, 1997

1. We intend to control costs in order to improve margin and profitability. Higher profits
should allow us to sustain faster growth rates during the coming years.
2. We will build up volume by:
(a) reviving older (but potentially profitable) products
(b) introducing new products, particularly in the video game sector
(c) make a major campaign to increase sales to the European markets.
3. We will review our portfolio of products with the objective of discontinuing products that
do not contribute adequately to the overall profitability of the company.
4. We will make every effort to speed up the collection of our accounts receivable and to
obtain overall inventory turns of ten times in order to get the most use of the company’s
supply of capital.

Shortly afterwards, in the spring of 1997, Li began to put his plan into action. Additional
personnel were recruited and, as the monthly sales reports were received, Paul Cheng
observed a substantial overall increase in sales in comparison to the previous year. With the
increased activities, however, the company was experiencing serious difficulties in controlling
the growth of its working capital. Since most of this was financed with short-term debt, the
firm’s bankers were becoming more and more concerned. As the economic situation in Hong
Kong and other Asian countries deteriorated during the second half of 1997, and with the
crisis getting worse in 1998, banks were facing up to the prospect of widespread default from
their lending.

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 During his telephone conversation with his banker, Cheng learned that since all banks were
caught in a severe credit squeeze, the current size of the short-term borrowing could not be
maintained and that in any event it was highly unlikely that the bank would be willing to lend
Great Eastern Toys more than HK$ 25 million beyond the end of the current quarter. Interest
rates had skyrocketed during the past months and lending by the banks was being sharply cut
back as the Hong Kong monetary authorities had taken drastic steps to defend the currency.

Late in July 1998, John Li gave Paul Cheng copies of the company’s Profit and Loss Account
and Balance Sheet for the 12 months ending June 30, 1998, together with a memo from the
sales and operations managers (see Exhibits 1, 2 and 3). For comparative purposes Peter Gray,
the company’s accountant, gave Paul Cheng selected financial and operating statistics for
three companies in the recreational products industry (see Exhibit 4) whose operations, he
stressed, were only partially comparable. On receipt of these reports, Paul Cheng began to
analyze the effectiveness of Li’s plans and operations during the fiscal year 1998.

In the meeting with his banker, when Cheng explained that he did not expect sales to grow as
fast as in the past year, he was told that even with slower growth, the bank’s lending to Great
Eastern would have to be reduced. Much more of its funding needs would have to be
generated internally through the retention of profits and a better management of the firm’s
assets.

Finally, he wondered whether - on the basis of Li’s performance to date and the long-term
prospects of the business - the Cheng family might be justified in investing additional funds of
their own in the company by reducing the dividend and, if necessary, through an injection of
new equity. This probably would not be well received since he knew that his family would be
unhappy by any substantial cut in the cash dividend. Over the past several months, the
company was forced to borrow Hong Kong dollars at rates as high as 19% at times, although
recently they had hovered around 12%. Most people believed bank loans would return to
more normal rates of 8% to 10% or less once the economic situation improved and the
currency crisis calmed down.

But selling the company was still on his mind. In the past, Cheng had considered a return of
16% to 18% on the family’s investment to be acceptable. But given the economic crisis and
other uncertainties since the summer of 1997, Cheng felt that this was not high enough to
justify the risk of having all of their wealth invested in the company; they now needed, he
believed, an average return on capital of at least 20 percent. This they had not achieved since
his father’s death. He was ready, if someone made him a tempting offer, to seriously consider
selling the business.

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 Exhibit 1
Income Statements - Millions of Hong Kong Dollars

Year Ending Year Ending Year Ending

June 1996 June 1997 June 1998

Sales revenues [net] 171.275 100.00% 187.500 100.00% 244.900 100.00%

Cost of sales [COS] 131.295 76.66 143.810 76.70 187.225 76.45

Selling and administrative expenses [S&A] 27.800 16.23 29.700 15.84 36.765 15.01

Depreciation expense 4.650 2.71 4.800 2.56 5.700 2.33

Earnings before interest and taxes [EBIT] 7.530 4.40 9.190 4.90 15.210 6.21

Interest expense 1.960 1.14 2.970 1.58 6.125 2.50

Earnings before taxes [EBT] 5.570 3.26 6.220 3.32 9.085 3.71

Taxes 0.919 0.54 0.995 0.53 1.454 0.59

Earnings after taxes [EAT] 4.650 2.72 5.225 2.78 7.631 3.12

Dividends paid 3.100 4.810 4.810

Retained earnings 1.550 0.415 2.821

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 Exhibit 2
Balance Sheets - Millions of Hong Kong Dollars

30 June 1996 30 June 1997 30 June 1998

Cash & marketable securities 6.588 8.17% 7.750 9.43% 2.400 2.45%

Accounts receivable 22.475 27.88 24.800 30.19 33.325 33.99

Inventories 27.125 33.65 29.450 35.85 42.550 43.40

Prepaid expenses 0.387 0.48 0.925 1.13 1.163 1.19

Net fixed assets 24.025 29.81 19.225 23.40 18.600 18.97

TOTAL ASSETS 80.600 100.00% 82.150 100.00% 98.038 100.00%

Short-term debt 1 17.900 22.21% 18.580 22.62% 27.774 28.32%

Accounts payable 14.610 18.13 15.500 18.87 19.850 20.25

Accrued expenses [operations] 3.100 3.85 3.705 4.50 5.108 5.21

Long-term debt 1 6.240 7.74 5.200 6.34 3.320 3.39

Owner’s equity 38.750 48.08 39.165 47.67 41.986 42.83

TOTAL LIABILITIES & NET WORTH 80.600 100.00% 82.150 100.00% 98.038 100.00%
1 Short-term debt consists of bank loans in Hong Kong dollars, a Japanese Yen revolving credit facility, plus the current repayment portion of long-term debt. The long-
term debt was a seven-year note denominated in Yen, repayable ¥ 10 million each six months.

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 Exhibit 3

To: Paul Cheng

Cc: John Li
From: Robert Ho (Sales Manager)
Ignacius Tang (Operations Manager)
Re: Report on sales, receivables and inventories
Date: July, 1998

1. Accounts Receivable

Our receivables are in good condition with 92% current in June. Doubtful accounts have increased
marginally and hence our bad debt reserve should be maintained at the same level as last year.

June 1998 May 1998

Current 92% 94%
Past due:
1 to 60 days 5% 4%
61 to 90 days 2% 3½%
91 days and over 1% ½%

2. Inventories

Our inventories as of June 1998 amounted to HK$ 42.55 million. They are up considerably from a
year ago, primarily as a result of the addition of the video games, our newest product. Our inventory
position and corresponding operating margins are as follows:

Sales Sales Cost of Sales Inventory

Item Budgeted Actual Actual Actual
Books 55.800 61.225 46.092 (75%) 9.250
Toys 69.750 73.470 52.932 (72%) 10.710
Board games 37.975 36.735 31.233 (85%) 8.965
Video games 38.750 39.138 27.435 (70%) 3.875
Other products 34.100 34.333 29.533 (86%) 9.750
TOTAL 236.375 244.900 187.225 (76%) 42.550

3. Accounts Payable

Our payables are settled promptly, usually no later than six to seven weeks, in order to maintain a
good relationship with our suppliers and ensure rapid delivery of goods in the future.

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 Exhibit 4
BENCHMARKING: June 1998 - RECREATIONAL INDUSTRY SAMPLE

Company A Company B Company C

ª ST Assets º 1
Current ratio « » 1.7 2.0 1.6
¬ ST Liabilities ¼

Short term / Total debt 60% 75% 65%

Average collection period 32 days 29 days 30 days

[days of sales]

Average payment period 30 days 32 days 37 days

[days of purchases]

Inventory turnover 8 times 10 times 9 times

[based on cost of sales]

Pre-tax operating margin 6.0% 6.8% 6.5%

[ EBIT/Sales]2

Return on invested capital

[EBIT/Invested capital]3 20.5% 28.1% 24.2%

Pre-tax return on equity

[EBT/Equity]4 18.4% 24.6% 21.9%

Effective tax rate 15% 16% 16%

1 ST = Short term [or current] assets / liabilities

2 EBIT = Earnings before interest and taxes
3 Invested capital = Cash + working capital requirement + net fixed assets
4 EBT = Earnings before taxes

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 Exhibit 5
Quarterly Sales Forecast Fiscal Year 1998/1999
Millions of Hong Kong Dollars

Second Quarter 1998 58.125 (Actual)

Third Quarter 1998 100.700

Fourth Quarter 1998 80.100

First Quarter 1999 48.250

Second Quarter 1999 59.700

Total for July 98-June 99 288.750

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