Case - Financial Forecasting with Pro Forma Statements
In April 1991, the owner and manager of Pop's Recycling Company, J. R. Vann, approached the Crewe National Bank (CNB) concerning a loan. This visit to the bank was the second for Vann in the last eighteen months. An unusual occurrence, he thought, for a highly profitable firm. The company (a recycler of metal, glass, and paper) was in the midst of a healthy increase in sales. Operations were begun in 1980, and the firm had shown a profit each year since 1982.
The company was founded in 1980 by J. R. Vann in response to the growing usage of recycled material in the manufacture of paper products, as well as metal and glass products. The primary raw material was scrap, which was hauled in by scrap collectors of various size. While paper and glass were recycled by the company, the business consisted mainly of the processing of scrap metal.
There had been considerable consolidation in the metal recycling business during the past decade. In fact, J. R. Vann, known as Pop to nearly everyone, started Pop's Recycling Company against the advice of certain business associates. Their primary concern was the apparent falloff in the availability of scrap metal. As a result of that trend, some of the small brokers or recycling yards had either gone out of business or had been bought by larger recycling yards such as Pop's. That meant the larger, more well-established yards were getting stronger, which in turn meant that a new entrant into the business faced an uphill climb. J. R. Vann, however, was convinced that he could make a strong showing in the business. He had become familiar with the business, over the years, through prior employment in the steel industry. As a result of that conviction, his entire savings and a sizable loan from a local insurance company launched Pop's Recycling Company.
The processing of the steel taken in from its "across the scale" purchase of scrap metal consisted of shredding or shearing the metal. Shredding was used to process such metal as junk cars, the primary source of scrap, and shearing was used to process steel bars and other structural type steel. The company took in approximately 30,000 tons of metal which required shredding and about 15,000 tons of metal which needed to be sheared.
The processed metal was shipped to foundries across the United States for use in a variety of applications. In fact, the company was such an important supplier of metal to specific foundries, it had become necessary to keep a certain level of inventory on hand in order to ensure that the demand could be met without delay. The sales forecast for Pop's for 1992 was $14,500,000.
The recycling companies which had survived the "shake-out" of the 1980s, as it had become known throughout the economy, meant to stay very loyal and dependable relative to their customer base. Accordingly, a good relationship with the foundries was a must. At the level of Pop's, this meant keeping a steady supply of scrap metal throughout the year. That goal created a need for cash. Further, machinery had to be kept in good working order and suppliers expected to be paid within the 30-day limit, which had become standard in the business. Of the approximately sixty competitors on the east coast of the United States, twenty were in the mid-Atlantic region and considered direct competitors of Pop's. Thus, a well-managed balance sheet was essential. In that regard, industry averages for certain items are shown as Table 3. Of special concern were the company's payables and inventory levels. Mr. Vann believed that a reasonable level in these areas would permit him to maintain a solid relationship with his suppliers and his customers. Vann believed that his long term debt would be constant, that is, would remain at its present level. In addition, he hoped to move the profit nearer to the industry average level, or beyond.
The loan which Mr. Vann sought from CNB was for the purpose of increasing the company's stock of scrap metal. In recent months, a large portion of railroad track and rolling stock was being dismantled at certain points in the immediate region, and an unusually large supply of steel had become available. These "bulges" in the incoming supply of scrap metal were a typical occurrence. It provided the recycling companies an opportunity to build up their backlog of steel and other metals. Such a supply would be used to feed the emerging and successful new, smaller steel companies in the United States. (The cold-roll production process used by foundries had given some hope to the once flagging steel industry).
In order to properly manage the situation, Vann considered a loan of $200,000 to be adequate for his short-term needs. The financial statements which follow illustrate certain aspects of the company's operating history.
The bank's loan officer, Cheryl Fries, wanted to make the correct and appropriate decision. Pop's Recycling had a long-standing reputation as a well-run company. In addition, her informal grapevine indicated that Vann handled his credits well. If the analysis of the company's financial statements bore out these impressions, the bank would have gained another solid commercial customer. The essential questions which Fries wanted to answer related to the necessity of the loan, the size of the loan, and if it were actually needed. She began an analysis of the company's needs based upon the audited financial statements shoWn as Tables 1 and 2.
TABLE 1
Pop's Recycling Company
Income Statement Data
|
1987 1988 1989 1990 1991
|
|
Sales
|
$8,200,000
|
$8,700,000
|
$9,500,000
|
$11,000,000
|
$12,000,000
|
|
Profit after tax
|
$410,000
|
440,000
|
332,000
|
330,000
|
336,000
|
|
TABLE 2
Pop's Recycling Company
Balance Sheet
|
|
|
1987 |
1988
|
1989 |
1990 |
1991 |
| Cash |
$290,100 |
$239,266 |
$229,500 |
$215,500 |
$205,100 |
|
Accounts receivable
|
418,200 |
488,070 |
532,950 |
425,000
|
634,742
|
|
Inventory
|
964,500 |
1,171,036 |
1,489.525 |
2,598.693
|
3,220,087
|
|
Total current assets
|
$1,672,800 |
$1,898,372 |
$2,251,975
|
$3,239,193
|
$4,059,929
|
|
Fixed assets, net
|
2,509,200 |
2,786,061 |
3,150,513 |
3,138,540
|
3,452,383
|
|
Total assets
|
$4 182 000 |
$4,684,433 |
$5,402,488 |
$6 377 733
|
$7,512,312
|
|
Accounts payable
|
$385,020 |
$408,476 |
$647,869 |
$1,140,650
|
$1,550,175
|
|
Accrued wages and taxes
|
510,480 |
541,098 |
581,400 |
610,470 |
673,130 |
|
Notes payable - bank
|
150,000 |
78,000 |
75,000 |
75,000 |
75,000 |
|
Total current liabilities
|
$1,045,500 |
$1,027,574 |
$1,304.269 |
$1,826,120 |
$2,298,305 |
|
Long-term debt
|
$585,480 |
665,839 |
775,200 |
775,200 |
1,101,600 |
|
Owners' equity
|
1,020,408 |
1,020,408 |
1,020,408 |
1,143,801 |
1,143,795 |
|
Earned surplus
|
1,530,612 |
1,970 612 |
2,302,611 |
2,632,612 |
2,968,612 |
|
Total liabilities and equity
|
$4,182,000 |
$4,684,433, |
$5.402,488 |
$6,377,733 |
$7.512,312 |
| TABLE 3 |
| Pop's Recycling Company |
| Selected Operating Data for Major Recyclers, 1991 |
|
Profit margin on sales
|
5 Percent |
|
Total debt-to-total assets
|
25 Percent |
|
Inventory-to-sales
|
28 Percent |
|
Accounts payable as a percent of sales
|
10 Percent |
|
Current ratio
|
1.80:1 |
QUESTIONS
1. Develop some additional financial data which will further illustrate the company's condition.
2. Calculate the compound growth rate in sales and earnings for the company.
3. Determine the amount of external bon-owing needed by the company, if any.
4. Discuss the company's debt ratio relative to the industry averages.
5. What is the consequence to the bank and to the company of staying within the industry average for the inventory/sales ratio and the accounts payable/sales ratio? Discuss also the relevance of the profit margin to your analysis.
6. If the bank has a philosophy of lending to businesses which have good potential as long¬term customers, does Pop's fit into this category? Why or why not?
7. From your answers to Questions I and 6, comment further upon Pop's ratios relative to the industry data from Table 3. Specifically, do the ratios calculated in Question 1 seem relevant for the bank's decision? Why or why not?
8. Are there any long-term financing implications of pro forma analysis?
9. If Pop's is a successful business, are there any reasons given in the case as to why this may be so? If there are, what are they?
10. How should the bank proceed?