Estimating Funds Requirements Short-Term Sources of Funds Subject:O. M. Scott & Sons Company Problem:Should the O. M. Scott company keep with its Trust Receipt Plan in order to maintain 25% growth rate. Options: 1. Sell receivables to a third party at a discount rate to receive cash. 2. Issue preferred equity to help finance retailers in holding higher Inventory levels 3. Reduce growth rate to a sustainable
Recommendation: In order to maintain the 25% growth, we need to first of all, abandon the trust receipt plan which causes sales growth rate to drop ever since implementation.
we need to adopt alternative 1 (selling receivables) in order to reduce the cash cycle and free up some cash to meet our short term liabilities. Our external fund needed exceeds the maximum allowed line of credit of 12. 5 million according to the performa for March 1962, which means that we have to also incorporate alternative 2 which is to issue equity to cover for extra fund outside of the limit.
Analysis: O. M. Scott & Sons (Scott) is a lawn-care company that has its operations centered in Ohio. The company has successful established a customer base and has a positive outlook for future operations. Their goal for future years is to maintain a growth of 25% for sales and income, however, we believe that this is not plausible because receivables are not being collected at a rate that supports the growth in sales. This is the main source of the problem for the company is not getting paid for its inventory until they have been sold by the dealers.
This places significant financial strain on the company, as it is responsible for obtaining the finances necessary in order to maintain the inventory levels at each of its 10,000 dealers. Starting with an analysis of the inventory period, we see a poor trend. Logically, the inventory period has also gone from bad to worst. Also alarming are the company’s accounts receivable turnover ratios, decreasing by 72% and its accounts receivable period going up by 253% from 1957 to 1961. What is most interesting is that these numbers were fairly stable prior to 1960, the year the O. M.
Scott & Sons Co. started implementing its Trust Receipt Plan. Pushing further, the ROA reflects a poor corporate ability to extract value from its assets, as the numbers are getting worst from year to year. The operating cycle was 106. 7 days in 1957, growing by 126% to 241. 3 days by 1961, demonstrating poor management efficiency. The cash cycle was extended by 100 days during the same period, which is not the direction in which you want cash flow to go. The cash cycle needs to be shorter in order to allow cash to flow into the company sooner, easing the financial strain on the company.
Regarding profitability, the company’s net income over sales ratio was in an upward trend from ‘57 till ‘59 but dropped as soon as Scott implemented the Trust Receipt Plan. Higher operating expenses as well as interest expenses have had a non negligible impact on bottom line results. The ROE in 1961 is of 13. 53%, down from 19. 98% in 1959, demonstrating that the shareholder’s return is alarmingly going down. To dig deeper into the recent ROE results, we did a Dupont analysis and were able to relate the drop in return to the longer receivables collection and higher inventory levels.
In turn, higher inventory levels grossed up total assets and dropped the ROA. A free cash flow model was constructed to further prove our point that the Trust Receipt Plan is not successfully claiming receivables from Scott’s dealers. By looking at the numbers in 1959 and 1960, we see that free cash flow in the company decreased by 72% after the implementation of the Trust Receipt Plan. This further proves our idea that the Trust Receipt Plan is not successful in bringing cash into the company. Despite these negative outcomes from the trust receipt plan, sales have been improving ever since the implementation.
This is due to the fact that the trust receipt plan requires trustees to carry enough inventory to match seasonal peak demands as well as the full array of Scott and Son’s products. However, this growth in sales have been dropping ever since the implementation. The market for Scott and Son’s products is estimated to be $100 million yet sales in 1961 reached on $43 million. So the drop in sales growth cannot be explained by a saturated market. It can only be attributed to the trust receipt plan. Based on our analysis, we believe that in order to keep up with the projected 25% growth in sales the O.
M. Scott Co. has to abandon its Trust Receipt Plan. There few things that we noticed that can improved with some change to the current plan, below is an analysis of the alternatives we suggested. Alternative 1 An alternative for Scott is to sell its receivables to a third party such as a bank. After implementing the Trust Receipt Plan in 1960, accounts receivables nearly tripled, increasing from $5,788,400 to $15,749,700. Due to this increase, Scott will need to hire additional labour to ensure the collection of their receivables.
From, we can clearly see that the Trust Receipt Plan significantly slowed down the collection process for Scott. Scott is able to collect 75% of its receivables in the month it is due, therefore it only needs to sell the rest of the 25% to obtain cash that is equivalent to 100% of its accounts receivables. It is likely that the bank will only buy the receivables from Scott at a discounted rate, from internet research, we found that this is usually a 20% discount. This means that Scott will receive 20% instead of the full 25% of the receivables that they sell. However, when taking into consideration the time value of money, as ell as the 3% of receivables that Scott is unable to collect, obtaining 95% of the receivables by selling it to the bank seems to be the better option. Also, by selling their receivables, Scott will no longer need to implement methods such as hiring more staff to collect late receivables. By selling its receivables, Scott will immediately shorten its cash cycle, as accounts receivable period will only be 30 days. This brings the cash cycle to 23. 1 days, and the operating cycle to 89. 4 days. Alternative 2 A second alternative is to issue preferred equity in the open market.
Preferred equity would be preferable because we assume that the market is not perfectly efficient and does not follow the irrelevance of financing construct according to Modigliani and Miller. Because equity prices are going down, existing shareholder`s benefit more from issuing equity such as preferred shares. Raising equity would help finance the dealers in holding higher levels of inventory, which was the initial problem being targeted by the Trust Receipt Plan. The raised amount of equity could also be used to reduce the high debt level and also reducing the high interest payments.
This method would take pressure off the repayment timeline imposed by bank debt. Repayment to shareholders can be done on an longer schedule and dividend payments are also optional, compared to interest payments that are not. The problem with this alternative is that shareholder`s will not want to further dilute their profits while not having dividend payouts as tax deductible items. Another reason to raise equity is that our calculations of external fund needs for March 1962 is calculated to be $16. 4 million, $3. 8 million more than the maximum allowed line of credit of $12. 5 million. Alternative 3
After conducting a proforma forecast for the next four quarters, from Dec. 1961 to Sept. 1962, growing at a 25% rate for Sales and Net Income, we noticed that Scott and Sons’ short-term fund needed is not feasible, $12 million cannot cover $16. 4 million that is needed, and that Subordinated debt also exceeds that of the allowed maximum limit, 12million exceeds $11. 135 million that was calculated (Appendix: Equity Working Capital). Thus Scott and Sons’ will not be able to cover the EFN needed in March when sales peak, consequently, we must reduce the demand of EFN through reduction of the targeted growth rate of 25%.
Through analyzing Scott’s Balance Sheet, we performed a Dupont analysis, it showed us that a worse situation as the trust plan and financial target of 25% have been implemented. For example, assets turnovers have been reducing from 1. 2840 top 1. 2071 and assets turnover period lengthened from 284 to 304 day (Appendix: Ratios). As Scott and Sons’ business process have been worsening lately, we strongly suggest the firm to stop growing at a farfetched rate of 25%. However, the sales and net income were indeed growing, but at a marginal diminishing fashion.
Both sales growth and income growth showed us that the firm has been experience lower growth rate in Net Income and Sales in comparison to the prior period (Appendix: Growth in Accounts). As a result, ROA, ROE and turnover ratios also reflected that profit margin and turnover periods are getting worse in relative terms( Appendix: Dupont Analysis & Ratios). As the peak season getting closer, even though income and sales are growing, we still believe that the low profitability certainly needs to be improved by lowering operating expenses and to create a cost effective process in shipping methods – EOQ.
In summary, with the violation of bank’s covenant and the lack of external fund, Scott will have to grow at sustainable 18. 27% (Appendix: Sustainable Growth Rate) and improve internal business processes to reach a higher level of profit margin, which brings us to the conclusion that 25% growth rate needs to be adjusted in a realistic manner towards better state of business. Conclusion In order to maintain the 25% growth, we need to first of all, abandon the trust receipt plan which causes sales growth rate to drop ever since implementation. e need to adopt alternative 1 (selling receivables) in order to reduce the cash cycle and free up some cash to meet our short term liabilities. Our external fund needed exceeds the maximum allowed line of credit of 12. 5 million according to the performa for March 1962, which means that we have to also incorporate alternative 2 which is to issue equity to cover for extra fund outside of the limit. We will not go with alternative 3 and reduce growth rate because by capping growth to a sustainable rate, we are also reducing our income. Appendix | | |1957 |1958 |1959 |1960 |1961 | | |1 |Current Ratio |Current Assets/Current |2. 1273 |2. 4821 |1. 9712 |4. 2999 |3. 5864 |getting better | | | |Liabilities | | | | | | | |2 |Quick Ratio |(current assets – Inv. )/C. |1. 2245 |1. 5799 |1. 0217 |3. 5346 |2. 8840 |getting better | | | |L. | | | | | | |3 |T. A. Turnover |(operating revenue/avg. |2. 1037 |2. 0360 |1. 4058 |1. 2840 |1. 2071 |getting worse | | |& Period |total Assets) | | | | | | | | | | |173. 8 |182. 5 |260. 7 |284. 3 |304. 2 | | |4 |ROA |NI/Total Assets |0. 0508 |0. 784 |0. 0683 |0. 0597 |0. 0439 |getting worse | |5 |Net Profit Margin|NI/operating revenue |0. 0242 |0. 0385 |0. 0486 |0. 0465 |0. 0364 |getting worse | |6 |ROE |NI/Equity |0. 1927 |0. 2768 |0. 2945 |0. 2030 |0. 1679 |getting worse | |7 |Equity Multiplier|Total Assets/ Total shares|3. 7910 |3. 5308 |4. 3107 |3. 4014 |3. 8201 | | |8 |ROE |Profit margin * Assets |0. 1927 |0. 2768 |0. 945 |0. 2030 |0. 1679 |getting a lot | | | |Turnover * equity | | | | | |worse | | | |multiplier | | | | | | | Operating cycle | | |1957 |1958 |1959 |1960 |1961 | |INV Turnover |COGS/ Av INV |6. 62347 |5. 59640 |3. 44899 |7. 7069 |6. 14108 | |Inv Period |365/ INV turnover |55. 10709 |65. 22054 |105. 828 |46. 97139 |59. 4358 | |AR Turnover |Credit Sales/Av AR |7. 07420 |4. 99311 |5. 28016 |2. 43791 |2. 00647 | |AR Period |365/AR Turnover |51. 59591 |73. 10076 |69. 1266 |149. 7182 |181. 911 | |AP Turnover |COGS/AV AP |10. 06029 |8. 86100 |5. 82568 |10. 89817 |5. 0258 | |AP Period |365/AP Turnover |36. 28125 |41. 19172 |62. 6535 |33. 49185 |66. 3325 | | | | | | | | | |Operating cycle |Inventory period + A/R period |106. 703 |138. 32131 |174. 955 |196. 6896 |241. 347 | |Cash cycle |operating cycle – A/P period |70. 42175 |97. 12959 |112. 301 |163. 1977 |175. 014 | Free Cash Flow |1957 |1958 |1959 |1960 |1961 | |EBIT |1094. 6 |2165. 5 |3567. 3 |4541. 8 |4368. 1 | |1-Taxes |0. 5 |0. 5 |0. 5 |0. 5 |0. 5 | |Depreciation/Amortization |263. 2 |185. 9 |377. 6 |584. 2 |589. 6 | |Change in CA |- |3784. |5219. 7 |7474. 7 |6552. 6 | |Change in CL | |1154. 1 |3619 |-2250. 5 |2844. 7 | |Change in NWC | |2630 |1600. 7 |9725. 2 |3707. 9 | |Capex | |186 |4925. 1 |638. 8 |366. 8 | |Free Cash Flow | |-1547. 5 |-4364. 55 |-7508. 9 |-1301. 05 | Sustainable Growth Rate | |Earing per share |Dividend |NI |ROE on Beginning Equity |Sustainable Growth | | |0. 99 |0. 099 | $ 2,109. 90 | | | |Retention Rate |0. 99-0. 099 = |0. 891 | $ 10,291. 68 |20. 501% |18. 266% | 1962 March Equity Working Capital Current Assets | | | |$ 28,324 | |Current Liabilities | | |$10,138 | | |LT Debt | | |$ 12,000 | | |Total Debt | | |$22,138 | $ 22,138 | |Equity working Capital | | | |$ 6,186 | | | | | | | |Maximum allowed parent company debt |300% |x |$6,186 |$ 18,558 | | | | | | | |Subordinated Debts Allowed |0. 6 |x | $ 18,558 | $ 11,135 | Ratios & Dupont Analysis [pic] QuarterlyProforma[pic] Growth in Accounts [pic]