Summary of Facts Tire City Inc, a retail distributor of automotive tires, has had a significant increase in sales for the past three years. Sales had grown at a compound annual rate in excess of 20% as a reflection of excellent service and customer satisfaction. In order to keep up with this growth in sales, Tire City has decided to expand its warehouse facilities to accommodate future growth, maintain great service, keep competitive pricing, and to continue yielding high levels of customer satisfaction.
Through previous business with MidBank, TCI has established a good line of credit with them. In 1991, TCI took out a loan from MidBank to build a warehouse. This loan was being repaid in equal annual payments of $125,000, leaving a remaining balance of $875,000 at the end of 1995. In order to expand its warehouse facilities and utilize this line of credit, TCI plans to invest $2,400,000 on this expansion; $2,000,000 to be spent during 1996, the remaining to be used in 1997 as needed, fulfilling the company’s anticipated needs for the next several years.
Issues Due to the fact that Tire City already has an outstanding loan that is still in the process of being paid off, the main issue arises. Already bearing financial obligations towards MidBank, as well as other everyday business obligations, can Tire City afford to expand? If so, how much can be internally financed? How much external financing will Tire City need in the form of a bank loan from MidBank? Lastly, can Tire City reduce their inventory and still function properly? Analysis TCI’s future financials look fairly stable for the most part.
Using management’s projections, a growing TCI is revealed with great sales growth and stable ratios. 1 The management case reveals slight decreases in Current and Quick ratios as well as slight increases in Total Liability to Total Assets and Total Liability to Equity do to the increase in Bank Loans Payable from the forecasted loan for the warehouse. 2 Accounts Payable DOH and Accounts Receivables DOH remain fairly constant while Inventory Turnover spikes and Inventory DOH dips due to decreased inventory during 1996.
Construction of the warehouse then returns to normal levels once the warehouse is completed in 1997. 3 Using the mangers projections, a bank loan of $332,000 in 1996 and $1,106,000 in 1997 is found to externally finance the building of the $2. 4 million warehouse. 2 The remainder of the warehouse will be internally funded by decreasing inventory. If management’s projections are correct, TCI will be able to expand while reaming profitable, and also keeping reputable customer, vendor, and lender relations.
If sales did not increase as management predicts and only increases by 5% annually, TCI would still be fairly sound financially. This level of sales only slightly decreases Net Income over 1996 and 1997 from the managerial case and most ratios react the same as seen in the managerial case proformas. 4 However, because sales does not grow as much and inventory does not need to be increased as much from 1996 to 1997, less external financing is needed to build the warehouse. A Bank Loan of $313,000 is required in 1996 and $483,000 in 1997. This amount of financing increases the Current and Quick Ratios as well as decreasing Total Liability to Total Assets and Total Liability to Equity from the managerial case because less financing is required. 4 This decrease in sales growth prediction shows us the stability in TCI financials. When evaluating the loan amount for TCI, one cannot always be optimistic like management. It is a concern of MidBank that Tire City may not be able to minimize their inventory during warehouse construction as planned.
This could cause serious issues physically for construction, but lets take a look at the financial effects. If inventory was to continue the historical pattern from previous years, inventory in 1996 would be increased by 10% from 1995, and inventory for year ended 1997 would be a 10% increase from 1996 as seen in Exhibit 8. Taking a look at exhibit one, you can see the two inventory numbers highlighted in yellow. While pushing forward through the financials and comparing the total assets to total liabilities and shareholder’s equity, Tire City’s need for a bank loan increases drastically.
In order to make ends meet Tire City is looking at needing a loan worth $2,864,000 for 1996 and 1997 combined as seen in Exhibit 8. This loan amount is a big difference from our two previous scenarios. At this point in time, Tire city does have the inventory itself to pledge as collateral and plenty of accounts receivable as well, but at MidBank we would classify these outcomes as a highly risky loan situation. We have to assume that the worst possible outcome could possibly happen, and if inventory could not be minimized, Tire City would need way more money than MidBank would be comfortable with loaning at this point in time.
The amount of external financing needed could also be affected by an increased depreciation expense on the new warehouse. In the managerial case, for every 1% increase in depreciation on the warehouse in 1997, a $10. 6 average increase in Bank Loan is required. 6 Average Collection Period changes could also greatly affect the need for external financing. If Accounts Receivable DOH is reduced to 45 days in 1997, an Accounts Receivable of $4,173 is required. This change in Accounts Receivables greatly reduces the need for external financing in 1997 from $1,106,000 to $201,000. Conclusion In conclusion, we feel comfortable that Tire City’s growth will continue and the loan will be able to be repaid. Even with a decrease forecast on annual sales, TCI will need less external financing, still having the proper finances to repay their bank loan. As part of our analysis we considered inventory not being able to be reduced, causing the loan to be around $3 million. As a group, we concluded that this would be a very risky loan, and that the bank would not agree to such a large amount.
From the aspect of the 5% sales proforma (as exhibited in our base case), this drop in sales drops the external financing amount, concluding that even if TCI’s sales are not as good as they predict, they still do not need as much external financing. Through our managerial aspect, we feel that a loan of $1. 6 million is what is needed. From a banks perspective, even though TCI already has $500,000 left on senior debt, they have enough cash, accounts receivable, and inventory that if they default on the loan, they still have enough assets that can be liquidized to pay back the $1. 6 million loan.
