The New South Wales whitegoods manufacturer WhiteCo employs 75 people and has annual revenue of about $6 million. A creative engineer who established it 14 years before owns it. In each of the previous 5 years, trading has been profitable but cashflow was under pressure, due in large part to over-trading, heavy research and development expenditure and poor borrowing disciplines.
The bank has been losing confidence in the group for several reasons, including the fact that it perceives the MD to have an excessive lifestyle. Recently, the bank insisted that the MD sell his top-of-the-range Mercedes and his wife’s Lexus. The MD, not wishing to relinquish these icons of success, transferred them from one company over which the bank held a registered mortgage-debenture charge to another company in the group but beyond the bank’s reach. The bank, not surprisingly, considered this action deceptive.
The bank, feeling that the company produces too many product models and that management exhibits low-level skills, has, over a six-month period, reduced the group’s loan facilities to less than half their former levels.
Statutory creditors and a group-tax bill have blown out to $600,000, of which $132,000 is due by way of late tax payment penalties.
All this on top of the fact that about two years before several of the company’s heating units had caused fires, which the authorities had traced to poor installation. Although the authorities entirely exonerated the company, the MD decided to recall all products in a bid to restore public confidence in the company. This recall has cost the company about $700,000 over two years, however the company was uninsured for product recall.
The company’s management information systems are at best ad hoc, and the group never prepares formal revenue and expenditure budgets.
The company policy is “volume” – sales at any price. Prices are pitched to beat all competition, irrespective of whether a profit is made. Accordingly, sales have been good over the past five years.
The company does not employ a cost accountant because the MD sees it as an overhead he can save on. The result is that no formal integrated costing systems exist. However, the research and development department at the time of product development prepares bills of material documentation. These are based on technical drawings prepared at the same time. In the light of product service difficulties, and inspired product design afterthoughts, products are regularly improved and updated.
However, updates and changes are not formally recorded in new technical drawings and the production department is only orally advised of changes. Consequently, advice given to one working shift is not consistently followed through by employees on other shifts, with the result that product-guarantee service calls have not diminished greatly.
Refinance or receivership
The bank has finally given an ultimatum to the directors to repay $1.3 million within 30 days. The bank holds adequate securities with a theoretical borrowing capacity of greater than $2 million, more than enough to repay the amount owed. Prospectively, an additional $700,000 could be raised to satisfy statutory and other creditors and to put the company on a regular credit footing, allowing it to re-establish regular trading terms with creditors and to take advantage of about $120,000 per year of settlement discounts.
The group’s debt-servicing capacity, after allowing for “profit add-backs” (depreciation, interest paid and excessive non-commercial payments to directors), showed a healthy debt-servicing capacity of four times the minimum required interest and debt amortisation payments.
Other relevant issues
The company is manufacturing 70 different heating and cooling models in a highly competitive, crowded market offering low gross margins.
A new series of state-of-the-art products has been researched and designed over the past 12 months. The new range requires 20% less in raw materials for production than any similar product on the market.
Tooling up and marketing for this new product range has cost about $200,000.
Management information was extracted arduously and was often found to be inaccurate because the group’s management information systems were not integrated. So much so that, in the course of preparing a credit submission to a new bank, it was noted that factory production records registered an irreconcilable overstated production volume of $500,000. There was no evidence of this in the finished inventory register. What had become of the goods? Were the records in error? Had the goods just vanished? Or was it just a case of sloppy security, as the factory doors were open to the street 24 hours a day?
A $2.8-million credit submission was made to a new banker. Under most circumstances it would have satisfied the prudential requirements of most banks, but the application was rejected. The credit submission was modified and the application reduced to $2.2 million, but it was also rejected.
In the meantime, the existing bank has become agitated and is threatening receivership if a take-out financier is not found in two weeks. Moreover, the Australian Taxation Office is pressing heavily for part-payments of arrears.
There is some good news, however. The 1998 budget pinpointed real possibilities of increasing revenue from $6 million to $9 million with projected profit of $350,000 in the first year and $1 million in the second. Also, a general manager is to be appointed (the MD has held this role in the past), as are a financial controller (previously there has been only a retired accountant still working a full week), a purchasing manager (the MD’s secretary has been doing this task), and two new service mechanics to provide better warranty service.
The new bank deliberated for five weeks before finally giving the company credit approval for $1.8 million. Although rather less than the amount asked for, it has just saved the company from receivership.
What were the main reasons that the first two credit requests were declined? What implications, if any, did the increase in budgeted turnover from $6 million to $9 million have on the financier’s attitude? What was the greatest element of risk facing a would-be lender in respect of this credit? What would you recommend to mitigate this risk?
Thanks to Dennis Goldenberg of Dennis M. Goldenberg & Associates for this case study
This case study response was prepared jointly by Michael Scales and Andrew Murphy.
Michael Scales is a partner and divisional director of the Corporate Services Division of Ernst & Young, one of the world’s largest business-advisory firms. Michael has had more than 20 years of restructuring and advisory experience in the manufacturing, retail and distribution, health, transport, and financial services sectors. He was appointed investigative accountant for two royal commissions.
Andrew Murphy is a director of Ernst & Young. Andrew has worked in the finance and banking Industry for more than 14 years. Before joining Ernst & Young, Andrew focused on high-risk and property exposures for an Australian bank.
The situation presented is much more common than most people think. To bring this into perspective, it is important to appreciate that a business that enjoys a working-capital facility with a bank will usually be subject to a review of the facility at least annually.
Rejected credit applications
Several elements contributed to the first two credit requests being rejected.
The deficiencies in the management information systems, lack of formal planning disciplines, uncommercial business decisions and poor internal communication and controls are important concerns. These deficiencies affect the credibility of management representations of past and future performance.
The company should have prepared costings, sensitivity analyses, KPIs, performance benchmarks and supporting assumptions linked to a business plan.
Transfers of assets and an excessive lifestyle indicate a possible unwillingness to repay if called upon. Most bankers consider deceptive behavior a deal-breaker.
The amounts of the first two requests were far in excess of the company’s funding needs. This showed that the management did not understand the financial and funding requirements of their business.
Significant amendments and modifications to the original submission would also be viewed unfavorably by a prospective new financier. This situation would be further compounded by distress signals such as working-capital facilities fully drawn, dishonored cheques, statutory payment arrears, the transfer of personal assets in the accounts, and pressure from the existing financier to refinance urgently.
Although security cover is an important consideration, it will be considered separately. The willingness and ability to repay is paramount; security cover offers a lender a second way out.
The business has focused on achieving increased sales volume at any price, irrespective of profit margins. As a result of past performance trends, the tabling of a further 50% increase in budgeted sales turnover to support additional overheads is unlikely to impress a new financier.
The new financier should feel some comfort that the business could be expected to achieve the budget forecasts and ultimately repay the approved advance of $1.8 million on account of the following developments:
- The new products that are expected to require 20% less in raw materials.
- The appointment of new staff with the appropriate skills.
- The use of external consultants.
However, these facts should be viewed with caution, as the profitability of the new product range has not been proved in the market and the new management team has yet to prove itself. A financier must be satisfied with the underlying assumptions supporting the budget forecasts.
Risks facing the new lender
Several unknowns face the new lender:
- The deficiencies of the existing management team are substantial. It is not known whether the new team can resolve all the identified shortfalls of the business in a timely manner and achieve budget targets with the full co-operation of the business owner.
- Whether the sales revenue from the new product line will eventuate.o Whether the inadequate management information systems and quality controls can be improved.
- Whether the poor financial forecasting, reporting and strategic planning will be resolved.
- Whether the owner is willing to reduce his lifestyle and non-commercial payments to directors, and cease transferring assets.
To minimise these risks, the lender should:
- Put in place an agreed “action plan” with appropriate allocation of accountabilities, responsibilities and benchmarks with achievable targets and time frames.
- Conduct a product-viability study to review and rationalise the large product line and confirm the profitability of the new line.
- Commission a fully integrated management information system and implement appropriate controls.
- Establish regular monitoring and reporting of R&D expenditure, financial performance, and key business drivers.
- Obtain a commitment to behavioral changes from the business owner in so far as they affect the business.
The business has survived the present crisis. However, whether it survives in the long-term will depend on its ability to notice problems and resolve them quickly. The important point is that deficiencies be resolved in an orderly manner, allowing the business to prosper. Reliable systems that produce timely information for management and the financier are an imperative.
Scott Kershaw is a partner in KPMG, providing advice on turnaround strategies to underperforming businesses and their stakeholders.
WhiteCo is affected by operational and management problems that have been festering for some time. Issues that could have been resolved – or avoided from the start – now threaten to bring it undone. These include:
- Poor profitability. The lack of a costing system and focus on quality, while pursuing an aggressive price position, means that some products may be unprofitable.
- Inadequate reporting. Without proper reporting systems and integrated financial forecasting, management will struggle to understand the capital required to fund future growth.
- Strained relationships. The managing director’s off-hand approach to the bank has soured the relationship, and the bank is making lending judgments without all the facts.
The MD’s concentration on engineering and innovation has been the strength of the business – but to the detriment of other important areas. There does not seem to be a full appreciation of WhiteCo’s value drivers or a forward-thinking approach to appropriate management disciplines.
Based on the facts as presented, the credit submission would have been short on real content. For it to have met the prudential requirements, those requirements must have been minimal and perhaps included only adequate security and demonstration of interest cover.
However, banks also expect submissions to stack up on cashflow merits. In addition, banking relationships can develop only in an environment of mutual trust. Any prospective bank would question WhiteCo’s seeking of “take-out” funding and the deterioration of the existing bank relationship. The submission may have been unsuccessful due to:
- The lack of cashflow forecasts integrated to profit-and-loss statements and balance sheets.
- Insufficient information on unit production, costs and profitability.
- The existence of unfunded and unreconciled losses.
- The lack of synthesis of financial forecasts with industry data.
- The lack of a succession plan or additional management to underwrite the forecasts.
- Insufficient information on the MD’s investment in the business and proposed equity injections designed to share the risk with the incoming banker.
- No real appreciation of the lender’s requirements based on WhiteCo’s relationship with its existing banker.
The statements WhiteCo made about potential sales growth would alarm the bank on account of several factors. These include:
- Market issues. The forecasts projecting an increase in sales of 50% do not seem to be based on a full assessment of market conditions.
- Profitability issues. WhiteCo’s focus on sales rather than profit is eroding shareholder value. As there are 70 heating and cooling models sharing only $6 million in sales (across three shifts), some may be unprofitable.
- Funding issues. It is not clear how WhiteCo will fund growth in revenue, as new sales require an investment in raw materials, work in progress and finished goods.
Without information on these issues, the bank may have formed a negative view of the competence of the MD and his understanding of the key issues.
Risks in lending
A significant proportion of the proposed lending is directed to funding past inefficiencies (group tax and product recalls) with no emphasis on the funding needed to support the (optimistic) growth expectations. As the submission has already been revised downward, WhiteCo is under-capitalised from the start. In which case, the bank is buying into the WhiteCo’s existing over-trading problem.
The funding requirement will increase in the short term unless action is taken. Two possible avenues of action exist that might enhance WhiteCo’s credibility and potential.
Avenue one: restructure
To produce value there may be no need to embark on the proposed expansion. WhiteCo could undertake a restructure incorporating:
- Sound general and financial management.
- A revised (more profitable) product range.
- New equity participants.
The MD may need to resolve the non-commercial aspects of his remuneration and focus on product design rather than financial and stakeholder relationship matters.
Avenue two: strategic alliance/takeover
The problem must be seen in the context of issues facing the industry at large. In the short term, WhiteCo may be able to continue as a niche manufacturer with the revised management structure. However, it does not seem to have the critical mass to compete in the longer term, and it may have no real business case without the MD. Given his dominance of the company, it is possible that a restructure would not be successful.
Other companies have sought access to WhiteCo’s product innovation capabilities in the past. WhiteCo may be better off looking for a merger opportunity or developing a strategic alliance to design exclusively for a larger competitor rather than continue to compete as a manufacturer. This would enable WhiteCo to focus on the MD’s real strengths and avoid the quality/price problems currently affecting profitability and relationships.