Financial Analysis and Forecast of Sweet Dreams Inc Essay

Sweet Dream Incorporated (SDI) is a manufacturing company focused on mattress and box spring production for large retailers and hotel chains. With two facilities at their disposal, SDI manufactures over 20 different styles of bedding for their consumers. SDI’s founder and president, Douglas May, has contacted our consulting firm with regards to current financial problems between himself and SDI’s bank, First International Bank. Due to the spike in bank failures in the early 1990’s First National has become extremely sensitive to problem loans (loans which show ratio performances below the industry standard). Unfortunately, SDI has had poor liquidity and debt ratios for the past three years which has caught the banks attention. After a phone call from the bank Doug has realized that SDI is in even worse trouble than the bank thinks. He has just signed a 9.5 million dollar contract to expand the business which was allegedly being loaned from the bank. Seeing as how the bank is debating closing Doug down it doesn’t look likely that they would want to front him another 9.5 million. Following a brief meeting with his senior managers, Doug and his team decided that this 9.5 million dollar loan from the bank is the only way to keep their business alive. They have decided to reverse their current policy of aggressive price drops and easy credit, reduce their administrative, selling and miscellaneous expenses, not acquire any new fixed assets or sell common stock, decrease accounts payable, stop paying dividends, and freeze executive salaries. All this is an attempt to prove to the bank that Sweet Dreams Inc. is taking their financial situation very seriously and that the bank should strongly consider giving SDI the 9.5 million dollar loan. Doug has asked us to verify the bank’s evaluation of his company, predict the expected performance of Sweet Dreams Inc. for 1996 and 1997, and prepare a list of SDI’s strengths an d weaknesses. All of these requests will be used to influence the bank to grant a 9.5 million dollar short-term loan to SDI as well as not forcing the bank to demand immediate re-payment of their loans. Sweet Dreams Incorporated (SDI) is struggling currently. With a current ratio of 1.9, SDI looks good up front. However the company’s inventory occupies close to 60 percent of its current assets. The quick ratio better shows SDI’s performance. With a ratio of .77, SDI cannot pay their short-term liabilities as they come due. This shows the first problem of Sweet Dreams Inc; Inventory Management. Also in Doug’s efforts to spin his recent losses he has decided to change his traditional dividend payout from 25% to 0. This symptom cuts to the core problem that SDI’s bottom line has suffered in the past years, partly because of economic downturns and partly because of management’s response to the economic downturn. Finally SDI’s Z score poses a problem with the banks’ standards. An Altman’s Z score is calculated by combining five different ratios of a company. First National claims that a Z score below the industry standard shows weakness in a firm and increases the likelihood of default. SDI’s Altman score is 3.07 which is not enough to worry the bank, but enough to put increased pressure on Sweet Dreams Inc. Therefore the problem here lies at minimizing costs and increasing revenues. To solve these problems SDI would need to focus their efforts on inventory management, company decisions, and effectiveness and efficiency. Regarding inventory SDI can lower the current level of mattress production to let inventory deplete to an acceptable percentage of current assets. As for company decisions when the economy is hurting companies should focus on cutting wages or hours to minimize costs, not reducing prices to increase sales. Finally the company needs to work on improving their ratios. Strong ratios come from more selling and less spending which in turn will lead to a better Altman’s Z score. 2) After finding the results of Question one, it is evident that SDI has more weaknesses than strengths as of 1995. If you look at the common size statements, Table 3, it shows that inventory increased as a percentage of sales, which indicates that a smaller percentage is being sold. All current liabilities increased as a percentage of total liabilities, which indicates that SDI is facing more debt. Figure one also clearly shows many of the weaknesses of SDI. Both liquidity ratios are below the industry average. Although the debt ratio appears to be above the industry average, it is actually a weakness because it indicates that SDI has more debt than equity. The only asset management ratio that is above industry average is the fixed asset turnover ratio, the rest are either equal to, or beneath their industry average. However, it’s not all bad; Figure one also shows that SDI has managed to hold a payout ratio on dividends that is 5 percent above the industry average. 3) Based on our analysis of historical data, I do not believe that the bank should lend the requested money to SDI. We believe SDI is unfit for the loan because they are below the industry average in a majority of financial ratios used to measure overall success in the company. These include liquidity ratios, leverage ratios, asset management ratios and profitability ratios, all shown in Table six. The fact that SDI Is facing decreased demand resulting from the recent depression also adds to their adversity they are facing to be a successful retailer. The current financial situation they are in makes them very sensitive to any unexpected economic event, making the risk of lending to them even greater. We firmly believe that it would not be beneficial to the bank to grant SDI this loan. 5) SDI has determined that its optimal cash balance will be 5 percent of total sales. In addition, all excess funds of this amount will be invested in marketable securities, which in turn will earn a 5 percent interest rate. Based on the forecasted financial statements, we have determined that SDI will be able to invest in marketable securities in 1996 and 1997. As shown in Table two, net sales for 1996 and 1997 are $330,386,000 and $371,684,000 respectively. Table one shows that in 1996, SKI had $55,276,000 in cash and marketable securities. With the optimal cash balance at 5 percent, only $16,519,300 of this amount will be in cash. The remaining $38,756,700 will go towards marketable securities. Likewise the figures in 1997, which exceeds $18,584,200, the 5 percent optimal cash balance. Therefore, SDI was able to invest $56,183,800 in marketable securities. A potential problem that our financial forecasts reveal is that we are investing a considerably larger amount of money into the marketable securities than we are holding in cash. While this money is earning interest, it may cause a future problem seeing as how there are so many loans that require cash to be paid off. With cash being the most liquid of all assets, it may be essential to keep more on hand in order to successfully pay off short and long term loans that will accumulate as a result of the $9,500,000 increase in capital from the plant expansion. 6) On the basis of previously developed forecasts, it does not appear that SDI will be able to retire all of its outstanding short-term loans by December 31, 1996. At this date, SDI’s short term SDI has on hand at this time is only $16,519,300, as the rest of their cash will be invested in marketable securities as a result of the 5 percent optimal cash balance. 7) Should the bank decide to withdraw the entire line of credit and demand payment immediately, a few alternative options would be available to Sweet Dreams Inc. The first option is that Sweet Dreams Inc. would immediately file for bankruptcy. Along with this they will file for protection under Chapter 11 of the Bankruptcy Act. This will allow Sweet Dreams Inc. to run as a firm and raise new money under restricted circumstances. Sweet Dreams Inc. will also be able to sell off any liquid assets in order to cover operation expenses and legal fees involved in this process. However, filing for Chapter 11 Bankruptcy is not a n easy way out because more often than not the bank is unable to recover its initial investment. Along with this, employee productivity and morale descends, and the company will begin to have difficulty obtaining credit in the future because of their soiled credit history today. Another option is that Sweet Dreams Inc. would sell current assets at market value to pay off the requested amount from the bank. Their short-term bank loan is equal to $26,610,000 and their long-term bank loan is equal to $16,248,000 in 1995. Combined, this will equal a total of $42,858,000. This amount will need to be paid off as soon as possible. Due to the fact that they cannot sell total assets, Sweet Dreams Inc. needs to sell their current assets first at market value. For this example, we will use 28% as a fair market value. At 28% of face value, the $127,028,000 worth of current assets would be worth $91,460,160 to the creditors. First, Sweet Dreams Inc. would pay back the bank because they are requesting those funds immediately. After the loans are fully paid off, Sweet Dreams Inc. would be left with $48,602,160. The next action would be to pay off the stockholders who are still entitled to money. This amount would total to $2,660,000, with 7million shares valued at $.38. This would leave Since Sweet Dreams Inc. with $45,942,160. Although they still have money, Sweet Dreams Inc. took a major financial hit and will most likely need to default regardless. 8. There are several circumstances that would affect the validity of the comparative ratio analysis. For example the text quotes, â€Å"SDI’s problems began with the recession of the early 1990’s, which caused a drastic decrease in demand from its retail and hotel customers,† When outside sources such as a recession or an inflation occurs one can expect that the forecast would be altered. Unforeseeable events such as natural disasters can also affect the normality of the forecast, as these can affect potential sales. Also, if one makes a mistake in a forecast, and adds incorrectly or uses the wrong formula then the comparative ratio will be thrown off. When forecasting, one can only trust the facts of the past. For example, in this case study, SDI managers saw a decrease in demand from this recession. This caused many retail and hotel customers to steer away from purchasing new bedding. Although the sales from new homeowners were still there, hotels were not being built in the Southeast. Even though SDI responded by lowering prices and increasing production, people were still not buying and sales never increased. Hence, the management forecast was not accurate, and sales hardly improved. In most cases, forecasting is a very effective tool in predicting what will occur in the future, but there must be some room for managers to be flexible in order to account for discrepancies in the data or unknown events. 10) Based on the Altman’s Z-Score table we are confident that if a company is within 25% of expected sales they will still be close to the minimum Altman score of 3.2. Therefore the company would have strong enough ratios to not be flagged by the bank for, â€Å"Problem Loans.† Also Cost of Goods Sold as a percent of sales and the Altman Z score are inversely related. This shows that the end results are sensitive to Cost of Goods Sold. 11) While looking at the pro-forma financial statements, we believe Ingrid should give Sweet Dreams Inc. the 9.5 million dollar loan. All of the ratios are above the industry averages which hold strong signs for the future of the company. That being said SDI’s pro forma statements are of course, speculative. Ingrid should implement certain prevention systems to monitor SDI’s statements. For instance the bank should state in part of their indenture that SDI must keep 20% of their revenue in a savings account that the bank has access too. This serves the bank by holding 20% of their assets, but more importantly it lets the bank see how much money the company is making proportionately. The bank also has the right to use said assets as collateral until SDI is able to pay the bank back. With this contingency plan installed we believe that Ingrid would be justified in giving the loan to Sweet Dreams Incorporated.