MASSACHUSETTS STOVE COMPANY—BANK LENDING DECISION

Massachusetts Stove Company manufactures wood-burning stoves for the heating of homes and businesses. The company has approached you, as chief lending officer for the Massachusetts Regional Bank, seeking to increase its loan from the current level of $93,091 as of January 15, Year 12, to $143,091. Jane O’Neil, chief executive officer and majority stockholder of the company, indicates that the company needs the loan to finance the work- ing capital required for an expected 25 percent annual increase in sales during the next two years, to repay suppliers, and to provide funds for expected nonrecurring legal and retool- ing costs.

The company’s woodstoves have two distinguishing characteristics: (1) the metal frame of the stoves includes inlaid soapstone, which increases the intensity and duration of the heat provided by the stoves and enhances their appearance as an attractive piece of furni- ture, and (2) a catalytic combuster, which adds heating potential to the stoves and reduces air pollution.

The company manufactures wood-burning stoves in a single plant in Greenfield, Massachusetts. It purchases metal castings for the stoves from foundries in Germany and Belgium. The soapstone comes from a supplier in Canada. These purchases are denominated in U.S. dollars. The catalytic combuster is purchased from a supplier in the United States. The manufacturing process is essentially an assembly operation. The plant employs an average of eight workers. The two keys to quality control are structural airtightness and effective operation of the catalytic combuster.

The company rents approximately 60 percent of the 25,000-square-foot building it uses for manufacturing and administrative activities. This building also houses the company’s factory showroom. The remaining 40 percent of the building is not currently rented.

The company’s marketing of woodstoves follows three channels:

1.    Wholesaling of  stoves to retail hardware stores. This channel represents approxi- mately 20 percent of the company’s sales in units.

2.    Retail direct marketing to individuals in all 50 states. This channel utilizes (a) national advertising in construction and design magazines and (b) the sending of brochures to potential customers identified from personal inquiries. This channel represents approximately 70 percent of the company’s sales in units. The company is the only firm in the industry with a strategic emphasis on retail direct marketing.

3.    Retailing from the company’s showroom. This channel represents approximately 10 percent of the company’s sales in units.

 

 

The company offers three payment options to retail purchasers of its stoves:

1.    Full payment: Check, money order, or charge to a third-party credit card is used to pay in full.

2.    Layaway plan: Monthly payments are made over a period not exceeding one year. The company ships the stove after receiving the final payment.

3.    Installment financing plan: The company has a financing arrangement with a local bank to finance the purchase of stoves by credit-approved customers. The company is liable if customers fail to repay their installment bank loans.

The imposition of strict air emission standards by the Environmental Protection Agency (EPA) has resulted in a major change in the woodstove industry. By December 31, Year 9, firms were required by EPA regulations to demonstrate that their woodstoves met or sur- passed specified air emission standards. Besides these standards being stricter than indus- try practices at the time, firms had to engage in numerous company-sponsored and independent testing of their stoves to satisfy EPA regulators. As a consequence, the number of firms in the woodstove industry decreased from more than 200 in the years prior to Year 10 to approximately 35 by December 31, Year 11.

The company received approval for its Soapstone Stove I in Year 11, after incurring retooling and testing costs of $63,001. It capitalized these costs in the Property, Plant, and Equipment account. It depreciates these costs over the five-year EPA approval period. A sec- ond stove, Soapstone Stove II, is currently undergoing retooling and testing. For this stove, the company incurred costs of $19,311 in Year 10 and $8,548 in Year and has received pre- liminary EPA approval. It anticipates additional design, tooling, and testing costs of approximately $55,000 in Year 12 and $33,000 in Year 13 to obtain final EPA approval.

The company holds an option to purchase the building in which it is located for

$608,400. The option also permits the company to assume the unpaid balance on a low- interest-rate loan on the building from the New England Regional Industrial Development Authority. The interest rate on this loan is adjusted annually and equals 80 percent of the bank prime interest rate. The unpaid balance on the loan exceeds the option price and will result in a cash transfer to the company from the owner of the building at the time of trans- fer. The company exercised its option in Year 9, but the owner of the building refused to comply  with  the  option  provisions.  The  company  sued  the  owner.  The  case  has  gone through the lower court system in Massachusetts and is currently under review by the Massachusetts Supreme Court. The company incurred legal costs totaling $68,465 through Year 11 and anticipates additional costs of approximately $45,000 in Year 12. The lower courts have ruled in favor of the company’s position on all of the major issues in the case. The company expects the Massachusetts Supreme Court to concur with the decisions of the lower courts when it renders its final decision in the spring of Year 12. The company has held discussions with two prospective tenants for the building’s 10,000 square feet that Massachusetts Stove Company does not use in its operations.

Jane O’Neil owns 51 percent of the company’s common stock. The remaining stockhold- ers include John O’Neil (chief financial officer and father of Jane O’Neil), Mark Forest (vice president of manufacturing), and four independent local investors.

To assist in the loan decision, the company provides you with financial statements (see the first three columns of Exhibits 5.27–5.29 on pages 414–416) and notes for the three years ending December 31, Year 9, Year 10, and Year 11. These financial statements were prepared by John O’Neil, chief financial officer, and are not audited. The company also provides you with projected financial statements for Year 12 and Year 13 (see the last two columns of Exhibits 5.27–5.29) to demonstrate its need for the loan and its ability to repay. The loan requested involves an increase in the current loan amount from

 

 

 

 

Â	Â	Actual	Â	Â	Projected
	Year 9	Year 10	Year 11	Â	Year 12            Year 13
Sales	$ 665,771	$ 783,754	$ 955,629	Â	$1,194,535       $1,493,170
Cost of goods sold	(460,797)	(474,156)	(514,907)	Â	(609,213)	(731,653)
Selling and	Â	Â	Â	Â	Â	Â
administrative	(177,631)	(290,719)	(390,503)	Â	(489,760)	(612,200)
Legal (Note 1)	(28,577)	(30,092)	(9,796)	Â	(45,000)	—
Interest	(25,948)	(24,122)	(23,974)	Â	(26,510)	(26,510)
Income tax (Note 2)	—	—	—	Â	—	—
Net Income (Loss)	$ (27,182)	$ (35,335)	$   16,449	Â	$     24,052	$   122,807

                                                                     

 

 

$93,091 to $143,091. The company will pay monthly interest and repay the $50,000 addi- tional amount borrowed by December 31, Year 13. Exhibit 5.30 (see page 417) presents financial statement ratios for the   company.

The assumptions underlying the projected financial statements are as follows:

Sales: Sales are projected to increase 25 percent annually during the next two years, after increasing 17.7 percent in Year 10 and 21.9 percent in Year 11. The increase reflects continuing  market  opportunities  related  to  the  company’s  strategic  emphasis  on retail direct marketing and to the expected continuing contraction in the number of competitors in the industry.

Cost of Goods Sold: Most manufacturing costs vary with sales. The company projects cost of goods sold to equal 51 percent of sales in Year 12 and 49 percent of sales in Year 13, having declined from 69.2 percent of sales in Year 9 to 53.9 percent of sales in Year 11. The reductions resulted from a higher proportion of retail sales in the sales mix (which have a higher gross margin than wholesale sales), a more favorable pricing environment in the industry (fewer competitors), a switch to lower-cost sup- pliers, and more efficient production.

Selling and Administrative Expenses: The company projects these costs to equal 41 per- cent of sales, having increased from 26.7 percent of sales in Year 9 to 40.9 percent of sales in Year 11. The increases resulted from a heavier emphasis on retail sales, which require more aggressive marketing than wholesale    sales.

Legal Expenses: The additional $45,000 of legal costs represents the best estimate by the company’s attorneys.

Interest Expense: Interest expense has averaged approximately 6 percent of short- and long-term borrowing during the last three years. The projected income statement assumes a continuation of the 6 percent average rate.

Income Tax Expense: The company has elected to be taxed as a Subchapter S corporation, which means that the net income of the firm is taxed at the level of the individual share- holders, not at the corporate level. Thus, the pro forma financial statements include no income tax expense. The firm has operated at a net loss for tax purposes for several years

 

 

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Actual                                                                                          Projected

 

                                                                                                                                                                                                                                                                                                                         

December 31:                                                                        Year 8                     Year 9                  Year 10                  Year 11                 Year 12                                                                                                Year 13

 

ASSETS

Cash                                                             $    3,925          $   11,707       $    8,344        $   37,726       $   11,289                                                                      $    6,512

Accounts receivable                                         94,606              54,772             44,397            31,964            40,035                                                                          49,964

Inventories                                                      239,458            208,260           209,004          225,490          291,924                                                                        329,480

Total  Current Assets                                                    $ 337,989                $ 274,739              $ 261,745               $ 295,180             $ 343,248             $ 385,956

                                                                                                                                                                                                                                                       

Property, plant, and equipment, at  cost     $ 258,870         $ 316,854        $ 362,399        $ 377,784       $ 440,284                                                                      $ 487,784

Accumulated depreciation                            (205,338)          (228,985)         (250,189)        (274,347)        (302,502)                                                                       (333,694)

Property, plant, and equipment,  net           $  53,532         $  87,869        $ 112,210        $ 103,437       $ 137,782                                                                      $ 154,090

Other  assets                                                $   17,888        $   17,888       $   17,594       $   17,006      $   17,006                                                                      $  17,006

Total Assets                                                                   $ 409,409        $ 380,496       $ 391,549       $ 415,623      $ 498,036      $ 557,052

                                                                                                                                                                                                                                                       

 

LIABILITIES AND SHAREHOLDERS’ EQUITY Accounts payable	  $ 148,579	  $ 139,879	  $ 189,889	Â	  $ 160,905	  $ 198,206	  $ 176,915
Notes payable—Banks (Note 3)	152,985	140,854	125,256	Â	93,091	143,091	93,091
Other current liabilities (Note 4)	13,340	11,440	23,466	Â	62,440	33,500	41,000
Total Current Liabilities	$ 314,904	$ 292,173	$ 338,611	Â	$ 316,436	$ 374,797	$ 311,006
Long-term debt (Note 3)	248,000	269,000	268,950	Â	298,750	298,750	298,750
Total Liabilities	$ 562,904	$ 561,173	$ 607,561	Â	$ 615,186	$ 673,547	$ 609,756
Common stock	$      2,000	$      2,000	$      2,000	Â	$      2,000	$      2,000	$     2,000
Additional paid-in capital	435,630	435,630	435,630	Â	435,630	435,630	435,630
Accumulated deficit	(591,125)	(618,307)	(653,642)	Â	(637,193)	(613,141)	(490,334)
Total  Shareholders’ Equity	$(153,495)	$(180,677)	$(216,012)	Â	$(199,563)	$(175,511)	$ (52,704)
Total Liabilities and Shareholders’ Equity	$ 409,409	$ 380,496	$ 391,549	Â	$ 415,623	$ 498,036	$ 557,052

                                                                                                                                                                                                                                                       

 

 

 

 

 

 

 

 

 

OPERATIONS

 

Actual                                                             Projected

 

                                         

Year 9                 Year 10                Year 11                 Year 12               Year 13

 

Net income (loss)                   $(27,182)        $(35,335)       $ 16,449          $ 24,052        $122,807

Depreciation and

amortization                          23,647            21,204           24,158             28,155           31,192

 

 

 

 

 

 

 

           

 

 

 

 

 

 

 

 

(Increase) Decrease in accounts receivable 39,834   10,375 12,433 (8,071) (9,929) (Increase) Decrease in inventories   31,198     (744)   (16,486)   (66,434)   (37,556) Increase (Decrease) in accounts payable   (8,700)     50,010   (28,984)   37,301   (21,291) Increase (Decrease) in other current liabilities   (1,900)     12,026   38,974   (28,940)   7,500 Cash Flow from Operations $ 56,897   $ 57,536 $ 46,544 $(13,937) $ 92,723 INVESTING Fixed assets acquired   $(57,984)     $(45,545)   $(15,385)   $(62,500)   $(47,500) Other investing —   294 588 — — Cash Flow from Investing $(57,984)   $(45,251) $(14,797) $(62,500) $(47,500) FINANCING Increase (Decrease) in short-term borrowing     $(12,131)       $(15,598)     $(32,165)     $ 50,000     $(50,000) long-term borrowing 21,000   (50) 29,800 — — Cash Flow from Financing $   8,869   $(15,648) $  (2,365) $ 50,000 $(50,000) Change in Cash $   7,782   $  (3,363) $ 29,382 $(26,437) $  (4,777) Cash—Beginning of year 3,925   11,707 8,344 37,726 11,289 Cash—End of Year $ 11,707   $   8,344 $ 37,726 $ 11,289 $   6,512   Â

Increase (Decrease) in

 

 

 

 

 

                                                                                                                                                                  

 

 

 

prior to Year 11, primarily because of losses of a lawn products business that it acquired ten years ago. The company discontinued the lawn products business in Year 10.

Cash: The projected amounts for cash represent a plug to equate projected assets with projected  liabilities  and  shareholders’  equity.  Projected  liabilities  include  the requested loan during Year 12 and its repayment at the end of Year 13.

Accounts Receivable: Days accounts receivable outstanding, calculated on the average accounts receivable balances, will be 11 days in Year 12 and Year 13.

Inventories: Days inventory held, calculated on the average inventory balances, will be 155 days in Year 12 and Year 13.

 

 

 

 

Actual                                     Projected

 

               

Year 9        Year 10       Year 11     Year 12    Year 13

 

Profit Margin for ROA	(0.2%)	(1.4%)	4.2%	4.2%	10.0%
Assets Turnover	1.7	2.0	2.4	2.6	2.8
Return on Assets	(0.3%)	(2.9%)	10.0%	11.1%	28.3%
Cost of Goods Sold/Sales	69.2%	60.5%	53.9%	51.0%	49.0%
Selling and Administrative/Sales	26.7%	37.1%	40.9%	41.0%	41.0%
Legal Expense/Sales	4.3%	3.8%	1.0%	3.8%	—
Interest Expense/Sales	3.9%	3.1%	2.5%	2.2%	1.8%
Days Accounts Receivable	41	23	15	11	11
Days Inventory	177	161	154	155	155
Days Accounts Payable	122	127	122	96	89
Fixed Assets Turnover	9.4	7.8	8.9	9.9	10.2
Current Ratio	0.9	0.8	0.9	0.9	1.2
Quick Ratio	0.2	0.2	0.2	0.1	0.2
Operating Cash Flow to Current	Â	Â	Â	Â	Â
Liabilities Ratio	0.187	0.182	0.142	(0.040)	0.270

Liabilities to Assets Ratio           1.475       1.552       1.480      1.352    1.095

Long-Term Debt to

Total Assets Ratio                   0.707       0.687       0.719      0.600    0.536

 

Operating Cash Flow to	Â
Total Liabilities Ratio	0.101	0.098	0.076	(0.022)	0.145
Interest Coverage Ratio	0.0	(0.5)	1.7	1.9	5.6

 

Property, Plant, and Equipment: Capital expenditures for Year 12 include a $55,000 cost for retooling the Soapstone Stove II and $7,500 for other equipment; for Year 13, they include $33,000 for retooling the Soapstone Stove II and $14,500 for other equipment. The projected balance excludes the cost of acquiring the building, its related debt, the cash received at the time of transfer, and rental revenues from leas- ing the unused 40 percent of the building to other businesses.

Accumulated Depreciation: This is continuation of the historical relation between depreciation expense and the cost of property, plant, and equipment.

Other Assets: A new financial reporting standard no longer requires amortization of intangibles after Year 11.

Accounts Payable: Days accounts payable outstanding, based on the average accounts payable balances, will be 97 days in Year 12 and 89 days in Year 13. The decrease in days payable reflects the ability to pay suppliers more quickly with the proceeds of the increased bank loan.

Notes Payable: Notes payable is projected to increase by the amount of the bank loan in Year 12 and to decrease by the loan repayment at the end of Year 13.

Other Current Liabilities: The large increase at the end of Year 11 resulted from a major promotional offer in the fall of Year 11, which increased the amount of deposits by

 

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customers. The projected amounts for Year 12 and Year 13 represent more normal expected levels of deposits.

Long-Term Debt: Long-term borrowing represents loans from shareholders to the com- pany. The company does not plan to repay any of these loans in the near future.

Retained Earnings: The change each year represents net income or net loss from opera- tions. The company does not pay dividends.

Statement of Cash Flows: Amounts are taken from the changes in various accounts on the actual and projected balance sheets.

Notes to Financial Statements

Note 1: The company has incurred legal costs to enforce its option to purchase the build- ing used in its manufacturing and administrative activities. The case is under review by the Massachusetts Supreme Court, with a decision expected in the spring of Year 12.

Note 2: The company is not subject to income tax because it has elected Subchapter S tax status.

Note 3: The notes payable to banks are secured by machinery and equipment, shares of common stock of companies traded on the New York Stock Exchange owned by two share- holders, and personal guarantees of three shareholders. The long-term debt consists of unsecured loans from three shareholders.

Note 4: Other current liabilities include the following:

 

Â	Year 8	Â	Year 9	Â	Year 10	Â	Year 11	Â
Customer Deposits	$11,278	Â	$ 9,132	Â	$20,236	Â	$59,072	Â
Employee Taxes Withheld	2,062	Â	2,308	Â	3,230	Â	3,368	Â
Â	$13,340	Â	$11,440	Â	$23,466	Â	$62,440	Â

 

Required

Would you make the loan to the company in accordance with the stated terms? Explain. In responding, consider the reasonableness of the company’s projections, positive and negative factors affecting the industry and the company, and the likely ability of the company to repay the loan. (Excel spreadsheet for this case is available at www.cengage.com/accounting/wahlen.)