Jackson Teaching Note

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5-914-506
AUGUST 1, 2013
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TEACHING NOTE
WILLIAM E. FRUHAN
WEI WANG
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Jackson Automotive Systems
Note: The “Jackson Automotive” case has two additional supplements in Excel format, both
available free of charge from HBP.
Product 913-507 is a Student Spreadsheet that Harvard Business Publishing makes widely available. It
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contains the data-based exhibits in the case.
Product 913-508 is restricted to Instructors Only. It contains data from the case and from this
Teaching Note, including the “model solution” to the basic quantitative assignment that students
are expected to complete as part of case analysis.
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Critical Issues
The “Jackson Automotive System” case focuses on cash forecasting for an automotive parts
supplier that produces advanced automotive systems for large automobile assemblers located
nearby. The company experiences a bottleneck problem in its production due to the late arrival of
some essential electronic components. As a result of this backup, the company is not able to repay its
outstanding debt that is coming due at the end of June. Furthermore, Jackson does not have the
internal finances available to fund the purchase of necessary production equipment. Given these two
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problems, the case presents a nice setting where students can apply financial forecasting techniques
to arrive at a cash budget and pro forma financial statements on a monthly basis, as well as the
interrelationship between the two basic forecasting techniques. The limited amount of raw
calculations required to complete these forecasts allow an instructor to instead devote time to
discussing the merits of the loan request and assessing the key assumptions and other peripheral
issues inherent in the case.
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________________________________________________________________________________________________________________
This note was prepared by HBS Professor William E. Fruhan and Professor Wei Wang of Queens University, Kingston, Ontario, for the sole
purpose of aiding classroom instructors in the use of “Jackson Automotive Systems” (HBS No. 913-505). It provides analysis and questions that
are intended to present alternative approaches to deepening students’ comprehension of business issues and energizing classroom discussion.
HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or
illustrations of effective or ineffective management.
Copyright © 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
This Teaching Note is authorized for use only by Melissa Paulsen, University of Notre Dame until February 2017. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860.
914-506 | Teaching Note—Jackson Automotive Systems
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Use of the Case
“Jackson Automotive Systems” was written for use in first-year, MBA-level courses in corporate
finance and financial management. It can also serve well in an undergraduate finance course that
covers short-term finances.
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Learning Objectives
1. Prepare cash budgets and pro forma financial statements to consolidate understanding of the
fundamentals of financial forecasting and the relationship between the two basic forecasting
techniques—cash budgeting and pro forma financial statement analysis.
2. Assess whether the lender should issue the loan to a profitable firm that experiences a
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bottleneck problem in its production.
3. Practice critical evaluation of assumptions underlying financial forecasts.
4. Provide a preliminary analysis on topics covered later in a corporate finance course, such as
the merits of stock repurchases and dividend payouts.
Opportunities for Student Analysis

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A starting point for the discussion could be to ask students why a profitable company like Jackson
cannot repay its existing loan. Students should be encouraged to prepare a sources and uses of funds
statement for the nine-month period from August 2012 to May 2013 (Exhibit TN-1). It’s clear that the
most prominent uses of funds were the stock repurchases as well as an accumulation of inventories.
Students should recognize that the growing inventories were caused mainly by the lack of a specific
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essential component, which resulted in the accumulation of work-in-progress and raw materials
purchases. The sizeable increase in inventory levels over this time period tied up the funds that
would have otherwise been used to repay the loan. This resulted in a strained cash position, which
was further exacerbated by the recent share repurchase from dissident shareholders.
To respond to the cash drain, the company relied on bank debt, cash on hand, a reduction in
receivables, and retained earnings as major sources of funds, which accounted for approximately 80%
of the funds sources over the period. The other major sources of funds were depreciation, customer
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advances, accounts payable, prepaid expenses, and taxes payable. From this information, students
should now realize that even though Jackson was highly profitable, its earnings retained alone were
inadequate for funding its operations over this period. The company had to rely on the cash on its
balance sheet as well as additional cash generated through the reduction in current assets and the
increase in current liabilities. Nevertheless, Jackson had been trying to rebuild its cash balance since
the stock repurchase.
The next natural question that arises is why the company needs an additional loan of $2.4 million.
As indicated in the case, the loan was necessary to purchase new equipment and consequently avoid
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possible production interruptions in the near future. Given the large backlog of unfilled orders, a
breakdown in production in the near future could be extremely costly. In fact, some students may
suggest using Jackson’s $4,994,000 in balance sheet cash to fund the equipment purchase. However,
upon preparing monthly cash budgets, students should then realize that the company has a large net
cash outlay expected in June.
2 BRIEFCASES | HARVARD BUSINESS SCHOOL
Teaching Note— Jackson Automotive Systems | 914-506
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Students should now turn their attention to the preparation of a cash budget and pro forma
income statements and balance sheets in to order to determine whether Jackson will be able to repay
a larger loan in September. The preparation of a cash budget and financial statements offers students
an opportunity to estimate the cash balance at the fiscal year end in order to understand: (1) the
interlocking nature of the financial statements, and (2) the interrelationship between the cash
budgeting and the financial statements. Sufficient information is provided in the case for preparing
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these statements. For the cash budget, students may have the tendency to ignore the effect of
customer advance payments on the collection of accounts receivable. When assigning the case, the
instructor may want to remind students of how customer advance payments could affect changes in
current assets and current liabilities.
The cash budget (Exhibit TN-2) suggests that even if the sales and operations go as Edwards
expected, Jackson cannot repay its loan at the end of September. Substantial cash drains, including
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the return of customer advances in July and August, and the proposed dividend payment in
September, utilize the funds necessary to repay the loan principal. That being said, students should
identify that repaying the loan in October seems feasible, even with an additional interest payment.
Exhibits TN-3 and TN-4 present the monthly pro forma income statements and balance sheets for
June to September. For reference, an “easier” alternative for students would be to prepare the four-
month period income statement, and balance sheet as of September month end. Under either
approach, the cash balance derived under the pro forma statements confirms the conclusion arrived
by the original cash budgeting technique. It may also be useful to test students’ understanding of the
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interrelationship between the two forecasting techniques and why they yield the same results. The
instructor should keep in mind that students without strong accounting background may find it
difficult to understand (1) the tie between changes in customer advances and change in accounts
receivable, and (2) how the accumulated materials purchase has an impact on inventory levels, and
incorporate them into the cash budget and pro forma financial statements. It is up to the instructor
whether any guidance on these points should be provided to students when the case is assigned.
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After generating forecasts of cash and other financial conditions for the company, students are
able to assess whether the bank should approve the renewal of the loan and, further, whether or not
to extend another loan for the equipment purchase. Factors in favor of approving the loan include (1)
strong demand for Jackson’s products, which are firm orders from reliable customers; (2) improved
profitability from optimistic projected sales; and (3) the value of the company’s business to the bank.
The projected sales forecast for the last four months of the fiscal year do not seem overly optimistic
given the large sales increase in automotive assemblers. The newly purchased equipment minimizes
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the chances of major breakdowns and achieves better production efficiency. Nevertheless, students
should be encouraged to perform a sensitivity analysis of the impact of a sales change on Jackson’s
ability to repay the loan. Exhibits TN-5 shows that Jackson would not be able to repay its loan if sales
drop by 5%, even if the company cuts its September dividends to zero. It is important to note that
while this large sales drop is possible, it is also unlikely given the large backlog of unfilled orders
from customers. The conservative assumptions also favor the granting of the loan. These assumptions
in preparing the cash budget and financial statements do not include any allowance for customer
advances and project prompt payment of accounts payable. Both could be important sources of funds
for Jackson in the near future.
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Arguments against the loan could begin with criticisms of the critical assumptions used for the
financial forecasts. The most important assumption is the future avoidance of the bottleneck that
affected the company in the past, assuming an orderly progression from raw materials to inventories
and through to sales. Students should recognize that bottlenecks in the production process are a key
threat to Jackson’s sales performance. Students should note that the company’s performance is
closely tied to order satisfaction and the prompt shipment of products upon completion: Customers
HARVARD BUSINESS SCHOOL | BRIEFCASES 3
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may cancel their orders if products cannot be delivered on time. Additionally, as indicated in the
case, competition in the auto parts industry is fierce. Therefore, if a 5% to 10% sales drop seems
plausible, some students may choose not to extend the loan. Other assumptions to consider include
Edwards’ ability and willingness to decrease raw material inventories and keep operating expenses
in line with forecasts.
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To decide whether to provide the loan, the bank could perform a standard credit analysis on the
company. This analysis requires an in-depth look at the Capacity, Character, Collateral, and Capital
of Jackson. This could be a nice teaching point if the standard credit analysis is an important part of
the course.
Capacity: Exhibit TN-6 presents Jackson’s key financial ratios over the 2013 fiscal year. The bank
should be confident that Jackson will be able to pay the required interest payments as reflected in its
strong EBTIDA interest coverage and EBIT interest coverage. In addition, an anticipated
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improvement to Jackson’s profitability over the course of the remaining fiscal year reinforces this
notion. That being said, the bank should still be concerned with Jackson’s ability to repay the
principal amount at the end of September.
Character: Jackson has long-term, well-established relationship with the bank. The company has
good credit history and there is no evidence of any missed interest payments. Edwards has a proven
managerial track record given his successful leadership of Jackson despite the turbulent industry
backdrop.
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Collateral: Jackson has a strong tangible asset base that can be pledged to cover the loan payment if
the company cannot generate enough cash from its operations to repay the principal. Jackson has
about $21 million of current assets at the time the loan was being considered. Even if a haircut is
imposed on the value of inventories, Jackson’s current assets are sufficiently large to be used against
the balance of the two loans. Additionally, Jackson had over $15 million net PP&E, which can be used
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as collateral as well.
Capital: Jackson has a strong tangible asset base, and it has traditionally maintained a strong
working capital position. The company was able to finance a significant portion of current assets
through trade credit such as customer advances. Given a strong recovery of the automotive parts
industry as described in the case, it is unlikely for Jackson to experience fire sale discounts if it must
liquidate its assets. Therefore, Jackson’s assets are sufficient to cover the payment of bank debt in the
near future should the bottleneck problem not be resolved. Plus, before Jackson experienced the
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operation issue it always had strong debt capacity and minimal capital needs.
Students now may propose two alternative recommendations to facilitate the loan decision: (1) to
postpone the loan maturity until October or November; or (2) to postpone the projected large
dividend payment until the loan is repaid. Both suggestions are reasonable. At times, students may
argue for the deferral of the $2.4 million capital expenditure until Jackson repays its existing loan of
$5 million. However, this comes with increased risks of a major breakdown in operations, which in
turn may jeopardize the timely payment of the existing loan. In addition, loan covenants and
collateral could be imposed during the loan renewal to reduce the risks to the bank.
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Finally, discussions can be directed to the merits of the stock repurchase and large dividend
payment in September.
Jackson paid $10 million in September 2012 to repurchase 1 million shares, which caused a 40%
drop in the number of shares outstanding (i.e., 2.5 million shares before the repurchase). As a result
of the repurchase, there was a dramatic increase in Jackson’s EPS calculation. EPS based on 2.5
million shares outstanding was $1.02 vs. $1.70 based on 1.5 million shares outstanding. Return on
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equity also increased dramatically. However, these calculations ignore the reduction in earning
power implicit in the $10 million share redemption. Nevertheless, the dramatic impact of the
repurchase was a 150% increase in the debt-to-equity ratio, which could potentially put the lenders at
risks.
The $1.6 million total dividend payment in 2013 is much larger than the $400,000 Jackson paid out
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in 2012. Given the large reduction in number of shares outstanding after the repurchase, dividends
per share are projected to rise from $0.16 in 2012 to $1.07 in 2013, a six-fold increase over one year,
which is apparently financed, at least, by bank debt. The large dividend payment may indicate the
agency problem where a company should not pay shareholders dividends at a time when its capacity
to repay a major loan is in question. This could raise a red flag to the lender about the management of
the company, leading to further discussion on other topics around the costs of debt. For example,
should the bank raise the interest rate in light of this potential agency problem?
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Discussion Questions
1. Why can’t a profitable company like Jackson repay its loan on time? What major company
developments between August 2012 and May 2013 contribute to this situation? Prepare a
sources and uses of funds statement for August 2012 through May 2013.
2. Why does the company need a new loan? How urgent is the need for the additional
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borrowing?
3. Prepare monthly cash budget and pro forma income statements and balance sheets for the last
four months of the fiscal year. Do the cash budgets and pro forma financial statements yield
the same results? Why or why not?
4. Based on your forecasts and analysis of Jackson’s credit, is the company able to repay its loan
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at the end of the fiscal year? What are the risks associated with the proposed loan?
5. Critically evaluate the assumptions on which your forecasts are based and perform sensitivity
analysis on the fiscal year-end cash balance when sales forecasts vary from expectations.
6. Should the bank extend the maturity of the current loan and approve the additional loan?
What terms and conditions should the bank impose to reduce the risks of the loan to the
bank?
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7. Why did the company repurchase a substantial fraction of its outstanding common stocks?
What’s the impact of the repurchase on Jackson’s financial condition?
8. Critically assess the company’s proposed dividend payout in September 2013. Should the
bank agree with the payout? What seems to be an appropriate amount?
Suggested Classroom Teaching Plan

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Jackson Automotive Systems is ideal for an introductory-level financial management or corporate

finance course. It provides a useful exercise for students to develop a cash budget and monthly pro
forma financial statements, and to understand the relationship between cash budgeting and analysis
of financial statements. The task is not complex, as the key assumptions on operational and financial
conditions are clearly laid out in the case. Students can concentrate on the technique of forecasting as
they learn to think critically about the core decision in the case.
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The case works well within an 80-minute session and provides ample time for examining the full
range of financial forecasting and bank lending issues. The instructor needs to decide whether to put
more emphasis on the detailed number work or the critical assessment of the lending decision and
other assumptions laid out in the case. Time can be allocated accordingly.
In an 80-minute class, the instructor may consider allocating time to the following sequence of
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discussions and questions:
(15 minutes)
Why is a profitable company like Jackson unable to repay its loan? Why does the company need an
additional loan?
(25 minutes)
Will Jackson be able to repay an even larger loan in September 2013?
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(10 minutes)
What information in the case has to be used to derive the financial forecasts? How reasonable are the
forecasts? How sensitive is the firm’s cash balance in September 2013 to projected sales?
(10 minutes)
What action should the bank take on the loan request? Should the bank approve the loan based on
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standard credit analysis?
(10 minutes)
What are the potential risks to the lender? What terms and conditions seem appropriate to impose?
(10 minutes)
Why did Jackson choose to repurchase stock in 2012? What are the merits of large dividend payment
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in 2013?
Spreadsheet Supplement
To help students prepare for the monthly pro forma balance sheets and income statements, the
instructor may consider making available the student version of the spreadsheet supplement for the
case. The spreadsheet supplement provides students with a useful tool to understand the
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interrelationship between the balance sheet and income statement, and to derive the ending cash
balances based on the indirect cash flow method. Students will find it easier to build pro forma
statements with the spreadsheet supplement in hand.
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Exhibit TN-1 Sources and Uses of Funds, August 31, 2012, to May 31, 2013 (thousands of dollars)
Sources of Funds
Increase in bank debt 5,000
Decrease in cash 3,356
Decrease in accounts receivable 2,049
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Increase in retained earnings 1,632
Decrease in net fixed assets 1,080
Increase in customer advances 1,049
Increase in accounts payable 992
Decrease in prepaid expenses 188
Increase in taxes payable 21
Total Sources of Funds 15,367
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Uses of Funds
Stock repurchase 10,000
Inventories 5,009
Decrease in accruals 358
Total Uses of Funds 15,367
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Exhibit TN-2 Pro Forma Cash Budget, June to October 2013 (thousands of dollars)
June July August September October

Beginning Cash Balance 4,994 1,627 6,536 7,034 (715)
Cash Receipts
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Collections of accounts receivable 3,744 10,881 6,474 7,201 7,394

Interest income 8 3 11 12 0
Bank loan 0 2,400 0 0 0
Total cash inflow 3,752 13,284 6,485 7,213 7,394
Cash Disbursements
Payments of accounts payable 5,969 5,200 5,200 5,200 5,200
Operating expenses 750 750 750 750 750
Capital expenditure 0 2,400 0 0 0
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Tax payments 375 0 0 375 0

Interest payments 25 25 37 37 0
Principal payments 0 0 0 7,400 0
Dividend payments 0 0 0 1,200 0
Total cash outflow 7,119 8,375 5,987 14,962 5,950
Net cash inflow (outflow) (3,367) 4,909 498 (7,749) 1,444

Ending Cash Balance 1,627 6,536 7,034 (715) 729
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Exhibit TN-3 Pro Forma Income Statements, June to October 2013 (thousands of dollars)
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June July August September
Months Total
Net sales 12,681 7,374 7,201 7,394 34,650
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COGSa 10,850 5,810 5,810 5,810 28,280
Gross profit 1,831 1,564 1,391 1,584 6,370
Operating expenses 750 750 750 750 3,000

Depreciation and amortization 120 120 130 130 500
Interest expenseb 25 25 37 37 124
Interest incomec 8 3 11 12 34
Profit (loss) before tax 944 672 485 679 2,780
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Income taxesd 321 228 165 231 945
Net income 623 443 320 448 1,835
Dividends 0 0 0 1,200 1,200
a $5,040 imminent reduction of work-in-progress in June, plus $2,440 of abnormal inventory levels spread evenly over four
months, plus monthly materials purchases.
b 6% annualized interest rate charged on outstanding debt.
c 2% annualized rate of return on the cash balance.
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d 34% tax rate.
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914-506 -9-
Exhibit TN-4 Pro Forma Balance Sheets, June to October 2013 (thousands of dollars)
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June July August September Notes
Cash 1,627 6,536 7,034 (715) Reconciliation with cash budget
Accounts receivablea 10,881 6,474 7,201 7,394 September sales
Inventory at beginning of June minus $5,040,000 work-in-progress, minus
Inventory 6,513 5,903 5,293 4,683 $2,440,000 raw materials
Current assets 19,021 18,913 19,528 11,362
Gross PP&E 45,500 47,900 47,900 47,900 Beginning PP&E plus $2.4 million capital expenditure
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Accumulated depreciationb 31,568 31,688 31,818 31,948 Beginning accumulated depreciation plus $480,000 plus $20,000.
Net PP&E 13,932 16,212 16,082 15,952
Prepaid expenses 54 54 54 54 Unchanged
Total assets 33,007 35,179 35,664 27,368
Accounts payablec 5,200 5,200 5,200 5,200 September purchases

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Notes payable, bank 5,000 7,400 7,400 0 Both loans paid off in September
Beginning tax liability plus additional tax liability in four months minus two
Accrued taxesd 219 448 612 468 payments of $375 each
Other accrued expenses 1,142 1,142 1,142 1,142 Unchanged
Customer advance payments 900 0 0 0
Current liabilities 12,461 14,190 14,354 6,810
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Shareholders' equity 20,546 20,990 21,310 20,558 Beginning shareholders’ equity plus retained earnings over four months
Total liabilities and equity 33,007 35,179 35,664 27,368
a Selling terms of net 30 days. AR in June reflects the difference between June sales and the $1.8 million shipment for which the company received customer advances. AR in July reflects the difference
between July sales and the $900,000 remaining customer advances ($2.7 million–$1.8 million).
b Depreciation for existing PP&E is $120,000 per month. Depreciation for new PP&E is $10,000 per month.
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c Purchase terms of net 30 days.
d Outstanding taxes on 2012 fiscal year income were due on January 15, 2013. On December 15, 2011, March 15, 2012, June 15, 2012, and September 15, 2012, payments of 25% of each of the estimated tax
for 2012 ($1,500,000) were due. Taxes payable for 2013 were assumed to be $1,500,000 and would be paid on December 15, 2012, March 15, 2013, June 15, 2013, and September 15, 2013, in equal increments.
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Exhibit TN-5 Sensitivity Analysis—The Impact of Sales Drop on September Cash Balance
Sales Increase/Dropa
-10% -5% 0% 5% 10%
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2400 (4,646) (3,281) (1,915) (550) 816
1800 (4,046) (2,681) (1,315) 50 1,416
1200 (3,446) (2,081) (715) 650 2,016
600 (2,846) (1,481) (115) 1,250 2,616
Dividend
0 (2,246) (881) 485 1,850 3,216
a Sales drop is assumed to be evenly distributed over four months.
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Exhibit TN-6 Capacity Analysis for 2013 Fiscal Year
2012 2013
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October November December January February March April May June July August September
Profitability ratios
Return on equity (one month) 1.79% 1.62% 1.53% 1.66% 1.45% 0.96% 0.75% 0.56% 3.08% 2.11% 1.51% 2.14%
Return on assets (one month) 1.03% 0.94% 0.91% 0.99% 0.87% 0.59% 0.44% 0.32% 1.83% 1.30% 0.90% 1.42%
Profit margin 5.16% 4.83% 4.87% 5.23% 4.76% 3.67% 3.56% 2.95% 4.91% 6.01% 4.44% 6.06%
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Short-term solvency ratios
Current ratio 1.27x 1.31x 1.35x 1.38x 1.42x 1.44x 1.37x 1.39x 1.53x 1.33x 1.36x 1.67x
Quick ratio 0.73x 0.77x 0.79x 0.84x 0.83x 0.75x 0.63x 0.58x 1.00x 0.92x 0.99x 0.98x
Leverage ratios
Total debt to capitalization 42.35% 41.44% 40.21% 40.15% 39.40% 38.29% 43.54% 43.09% 37.75% 40.33% 40.25% 24.88%
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Coverage ratios
EBITDA interest coverage 25.64x 24.01x 23.24x 25.08x 22.80x 17.00x 14.52x 12.08x 43.24x 32.56x 17.32x 22.54x
EBIT interest coverage 20.84x 19.21x 18.44x 20.28x 18.00x 12.20x 9.72x 7.28x 38.44x 27.76x 13.81x 19.03x
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3. Practice critical evaluation of assumptions underlying financial forecasts.

Opportunities for Student Analysis

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

Suggested Classroom Teaching Plan

Jackson Automotive Systems is ideal for an introductory-level financial management or corporate

HARVARD BUSINESS SCHOOL | BRIEFCASES 5

6 BRIEFCASES | HARVARD BUSINESS SCHOOL

June July August September October

Collections of accounts receivable 3,744 10,881 6,474 7,201 7,394

Tax payments 375 0 0 375 0

Net cash inflow (outflow) (3,367) 4,909 498 (7,749) 1,444

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Operating expenses 750 750 750 750 3,000

8 BRIEFCASES | HARVARD BUSINESS SCHOOL

Accounts payablec 5,200 5,200 5,200 5,200 September purchases

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