Ted Yu

Professor Hackelton
Accounting 830
May 31, 2007
Term Paper: Analysis for Lending Decision

1. Circumstances Leading to Need for the Loan

The case indicates that the firm needs to loan to finance working capital related to a 40 percent
projected growth in sales, to repay suppliers, and to provide funds for expected nonrecurring
legal and retooling costs. However, the largest working capital need appears to be related to
increased investment in inventories. Currently, the firm’s Days AP Outstanding (DAO) is 128
days. Its stated desire to “repay” creditors suggests that suppliers are putting some pressure on
the firm to reduce the DAO. And a part of the loan is needed to fix a cash flow problem.
Part of the loan is also needed to pay legal costs on a lawsuit whose outcome is uncertain and for
tooling costs that will not likely result in marketable collateral. Thus, considerable risk exists
with respect to the intended use of the loan proceeds.
2. Credit
The firm has an ongoing relationship with its bank, having reduced its borrowing during the
preceding four years. Thus, it appears to have established credit.
3. Cash Flows
The projected financial statements suggest that the Company will have sufficient cash to repay
the bank loan without adversely affecting operations and capital expenditures. But the growth
rate of sales 40% exceeds the growth rate in sales for Year 5 and Year 6, which were 20% and
24%, respectively. The amounts of cash on the balance sheet on December 7, Year 8 and Year 9
for different growth rates in sales are as follows:
Growth Rate in Sales Year 8 Year 9
20% ..................................................$ (2,396) $ 38,556
25% ..................................................$ 2,929 $ 29,645
30% ..................................................$ 6,130 $ 12,087
35% ..................................................$ 19,229 $ 6,321
40% ..................................................$ 20,109 $ 7,403

Regardless of the growth rate in sales, it appears that the firm will have sufficient cash to repay
the bank loan. The Company has reduced its days accounts receivable, inventory, and accounts
payable during the last three years. Thus, maintaining the current rates of turnover for accounts
receivable and inventories and reducing the days payable do not appear unreasonable.

4. Collateral
If cash flows are not adequate to service the loan, the bank has the right to sell the collateral.
There does not appear to be much collateral for the increased loan. The Company's machinery
and equipment already serve as collateral for the existing loan. Most of the capital expenditures
will be made with the loan proceeds are for the tooling and testing of the Soapstone Stove II
stove. As a special fixed asset which has a special use purpose, it’s difficult for the bank to
accept it as collateral and sell to obtain funds to repay the loan when the company cannot repay
the loan. The use of the loan proceeds for legal expenses may or may not result in an asset that
could serve as collateral. The inventory probably serves as collateral for accounts payable to
suppliers. This inventory is specific to the Company's stoves and probably not easily salable.
Given that the bank already requires the pledging of investments in common stock of two of the
shareholders and the personal guarantees of three of the shareholders, there is not likely much
additional collateral for the increased loan.

5. Capacity for Debt

All of the long-term debt relates to shareholder loans. The Company has no current plans to
repay this debt. If we reclassify this long-term debt as part of the shareholders' equity, then the
liabilities to assets ratio on December 31, Year 7 decreases by 4.2%. This percentage is not only
very high but all of the liabilities are short-term. The interest coverage ratios are very low.
Although these ratios improve by Year 8 when the loan is due, they are still not at particularly
healthy levels. Thus, the Company does not appear to have much unused debt capacity.
6. Contingencies
Two contingencies cloud the Company's future. First, a favorable outcome to the lawsuit is
likely, but uncertain. Legal expenses might exceed the $51,000 currently forecasted. If the court
finds in favor of the Company, the Company might have difficulty finding tenants for the other
40 percent of the building. If it does, it may incur costs to alter the space to suit the needs of the
new tenants. On the other hand, the Company will receive cash at the time of settlement because
the balance of the unpaid mortgage exceeds the option price. It could use this cash to fund
needed improvements to the building or pay carrying costs until it finds new tenants.
Also, the Company's aggressive pursuit of the lawsuit suggests that the market value of the
building substantially exceeds the option price, possibly providing collateral for both the
mortgage assumed and the increased bank loan. Finally, the Company will secure low interest-
rate financing upon assumption of the unpaid mortgage. The second contingency is the EPA
approval status of the Soapstone Stove II stove. Actual costs may exceed those expected and the
required time for approval may take longer than expected. It does not appear that this stove will
be approved and generating revenue prior to the time that the Company must repay the increased
bank loan. The second contingency is the EPA approval status of the Soapstone Stove IIstove.
The company has already received the preliminary EPA approval. But the expected cost,
$75,000 would be more than $59,000, the total amount of the loan. Therefore, repayment of the
loan principle and interest most probably comes from the Company’s sales or the financing in
some other way. And further, it does not appear that the Company can use the Stove II to
generate revenue prior to the time that the Company must repay the increased bank loan.
7. Character of Management
Character refers to both the integrity of management and to its ability to adapt successively to
changing business conditions. The Company is one of the few survivors in the industry which
was strictly supervised by the EPA. It has carved itself a market niche in the retail direct
marketing segment. It has gotten one stove approved by the EPA and has another stove in the
approval process. The willingness to sustain significant legal expenses over a period of years
suggests that the option truly has value and that the building is a part of the Company's future
strategy. The willingness of the major shareholders to commit their personal wealth to the claims
of creditors suggests both a commitment to the business and a need to make it successful.
8. Communication
The case does not provide information on how well the Company has kept its bank informed
about its activities in the past or its future plans.
9. Conditions
The case is silent on constraints that the bank will place on the Company beyond the interest rate
and the repayment date of the loan. The bank might specify a lid on the amount of expenditures
that the Company can make to obtain approval of the Soapstone II stove. The bank would not
want to impose constraints that would impede operations, such as minimum levels of net income
and assets turnovers. It appears that the only way the Company will be able to repay the loan is if
operations are profitable and the Company generates cash flow. Requiring additional collateral
does not appear reasonable. Existing collateral does not appear to be sufficiently liquid (except
the common stock investments) to make repossessing the collateral an attractive option if the
Company cannot service the loan. The only potential bright spot with respect to collateral is that
the building appears to have a market value in excess of the unpaid loan. If the lawsuit is
successful for the Company, as expected, then additional collateral may be available to support
the requested bank loan.