Chapter 11 - Commercial Credit

Tru-Cuts Case Study

Introduction

You are a commercial credit officer at NAITLAB Bank. You have received the attached business plan from a client who wants to borrow $100,000 for equipment upgrades. In your analysis, note that 2022 is the most recent year. A current credit check shows no derogatory information about the company or its owners.

Instructions

Begin by reading the report and identifying information that illustrates the five Cs: character, capital, capacity, collateral, and conditions. Then, calculate the ratios for each year, identify the trends, and compare them to the industry.

You will evaluate the qualitative and quantitative information provided in the business plan and make a lending decision. Your decision will be detailed in a written report that you will submit to your branch manager, I. Need Cash.

Tru-Cut Products, Inc. Business Plan

Tru-Cut Products, Inc. manufactures 1) various metal blades used in hand and power-driven saws and 2) other cutting tools for household and industrial use. Two brothers, William and Ernest Dexter, founded the business ten years ago. Each brother owns 50% of the company.

Tru-Cut employs 200 people at its plant in Tilley, Alberta, a 30,000-square-foot facility. The plant has been located there since the company's inception. The company's customer base consists of several large tool manufacturers and hardware and home center stores based primarily in Western Canada and the Pacific Northwest. Black & Decker is their largest customer, accounting for about 10% of its sales in 2022. Tru-Cut provides both contracted and private-label goods.

The company has been a customer of NAITLAB Bank for more than eight years.

Tru-Cut has a $500K line of credit and a term loan of $1,300K. They have a first charge on the accounts receivable and inventory and a second charge on all the other business assets to secure the operating loan. The term loan is secured by a first charge on the land, building, and equipment, and a second charge is secured by the accounts receivable and inventory. Liquidation values of collateral are more than adequate to cover the advances. The Dexter brothers personally guarantee both of the loans. They are financially conservative; most of their assets are a company and home investments.

Tru-Cut is one of the smaller firms in its industry. The company prides itself on its reputation; its products are recognized as high quality and highly durable. It is also known for making and stocking unique blade sizes in specialized wood and metal cutting tools. For this reason, the company's customers purchase smaller quantities that fit Tru-Cut's production capacity.

The company's competitive position has become steadily weaker over the past few years, and its market share has fallen. Sales of the more common blade products have been lost to new competitors who have entered the market with the capacity, technology, and distribution to fill larger orders at a lower cost.

Margins have steadily declined due mainly to the loss of profitable sales to several more prominent tool manufacturers, including Black & Decker and Stanley Home Products. These customers have been producing many blades they once relied on Tru-Cut to manufacture. Black & Decker is down to 10% of annual sales, down from 25% several years ago. Stanley represents less than Tru-Cut's yearly sales, down from more than 10% several years ago. In 2002, orders from both companies were related to short-run and specialty orders that continued to fall into Tru-Cut's niche.

In addition to the slipping margins discussed above, the inventory problem is related to changes in business strategy to more of a specialty supplier of cutting tools. In the past three years, inventory levels have increased, representing an oversupply of finished goods. This reflects the company's growing emphasis on specialty tools requiring slower overall inventory turns. Tru-Cut needs to carry a more extensive variety of products in its finished goods inventory to meet customers' needs within the specialty tools niche. Also, order response time is more critical to the specialty customer, and higher inventory levels are a way to improve the responsiveness required in this market.

To replace the sales lost to Black & Decker and Stanley, the company has eased its credit controls and found new replacement sales from smaller companies with slower paying habits. Bad debt expense has jumped in the past two years; at year-end 2022, a $14K invoice is 94 days past due. This customer is a home center chain that has expanded rapidly and has financial difficulties.

Management has indicated that some of the inventory slowings, in addition to the slowing of accounts receivable, are due to inattention and weak controls. The latter problems have been addressed by replacing the company's chief financial officer (CFO) and using new accounting software (purchased in 2022.) The new chief financial officer has over 20 years of experience as the assistant controller for a large auto parts distributor. In his position as assistant controller, he was a significant contributor to the reversal of that company's financial misfortunes.

Demand in the industry tends to move with the economic cycles. Vigorous construction activity in the past few years has resulted in relatively annual solid sales growth for the industryaveraging 7%-9% in the last two years. This growth has historically followed the same cyclical pattern as construction inactivity, making the company vulnerable to changing economic conditions.

Until recently, technological changes have been slow to impact the blade industry. In recent years, however, companies in the industry have begun using computerized equipment and advanced technologies in blade production. Tru-Cut has already started to address these needs by modernizing its equipment.

Tru-Cut's management is conservative. The owners have kept the earnings in the company to support growth. Management has effectively controlled operating costs as revenue and gross margins have fallen in the last three years. The key to the company's success is its ability to control costs and respond to the changing realities of its business environment.

Financial Expectations

The company's December 31, 2022, year-end has just been submitted. Following are the comments of the company's new CFO in response to your follow-up questions.

Gross Margin

We would like to see our gross margin improve up to the 32% we saw two years ago. We found out last year that we can't raise prices. The market is too competitive, and we lose customers too quickly. The only thing we can do is find ways to reduce manufacturing overhead and labour costs. We began our cost-cutting when I came on six months ago. This has begun to show some benefits because we reached a 34% gross margin for December. We will need sales to pick up if we're going to sustain this, however, because any further cost reductions will require some rather drastic steps that would be difficult to manage.

Inventory

I believe rearranging our inventory mix will help. Our finished goods inventory jumped last year. Our customers started to view us as a warehouse, ordering and expecting delivery in one day. Improved controls should help bring the stock level down by 10%-15%. I think our inventory system could use a stern look, which is one reason I have been hired. It may have worked fine while the company was carried by its large accounts. Now, we need a way to track larger quantities of inventory and be more adaptable to short-notice production changes. We may lose some customers, but it will be better for our cash flow in the long run.

Accounts Receivable

I would also like to see us do a better job on receivable collections. We've shifted to a different kind of customer in the last few years and learned some things about how and to whom we extend credit. I've hired a new, experienced credit manager from my former company to help me handle this problem. Again, we realize we may have to turn away potential customers to get receivable collections back down to around 40 days where they belong. We do have one receivable due from a bankrupt home center chain. I think we'll collect at least 80% next year, but the rest is sort of "iffy."

Capital Spending

We need newer, faster, and better equipment. If we don't upgrade our equipment, we'll lose 5%-10% of our sales volume each year because our production costs will rise, and we can't afford to have that happen. We made some sizable equipment purchases last year, which will continue with a $250K capital spending planned for the second quarter of the new year. This should get us to the point where we can reduce capital spending to a maintenance level of about $100K annually for a few years. We want a small-term loan of $100K and hope to finance the balance out of cash flow. We don't want to take on any more debt right now. This might mean we will be using our line of credit more heavily in the new year because cash flow will be tight until we can get some of our changes behind us.

Sales Growth

With the planned equipment purchases, we should be able to hold on to our current level of sales and perhaps even grow by 5%-7% over the next four years. We feel this is attainable unless construction activity hits a slowdown.

Our niche as a short-run specialty supplier is starting to sink in now, and while it's still difficult to increase prices, our customers are not forcing us into as many bidding wars as they were in the past few years. We are also getting some repeat business from a few goods, and paying customers, so it's encouragingto see our reputation getting re-established.

Tru-Cuts Commercial Credit Case:

Tru-Cuts Financials:

31/12/18 31/12/19 31/12/20 31/12/21 31/12/22 ASSETS Current Assets Cash 0 33,000 0 0 0 Accounts Receivable 511,000 649,000 836,000 978,000 1,114,000 Inventories 1,244,000 1,043,000 1, 154,000 1,405,000 1,645,000 Prepaid Expenses 22,000 2.000 2,000 17,000 15,000 Total Current Assets 1,777,000 1,727,000 1,992,000 2,400,000 2,774,000 Fixed Assets Fixed Assets (production) 2,504,000 2,284,000 2,503,000 2,535,000 3,001,000 Fixed Assets (other)(net) 131,000 142,000 372,000 416,000 349,000 Less: Depreciation -1,155,000 -1,362,000 -1,547,000 -1,813,000 -2,057,000 Total Fixed Assets 1,480,000 1,064,000 1,328,000 1, 138,000 1,293,000 TOTAL ASSETS 3,257,000 2,791,000 3,320,000 3,538,000 4,067,000 LIABILITIES Bank overdraft 573,000 0 201,000 194,000 398,000 Accounts payable 623,000 437,000 459,000 450,000 507,000 Current Portion of Debt 278,000 250,000 220,000 262,000 201,000 Other Accruals 52,000 65,000 93,000 45,000 24,000 Taxes Payable 3,000 48,000 26,000 24,000 17,000 Other Current Liabilities 79,000 50,000 8,000 8,000 7,000 Total Current liabilities 1,608,000 850,000 1,007,000 983,000 1, 154,000 Long Term Liability (Bank) 1,093,000 843,000 979,000 909,000 1, 103,000 TOTAL LIABILITIES 2,701,000 1,693,000 1,986,000 1,892,000 2,257,000 Shareholder's Equity Capital Stock 71,000 71,000 71,000 71,000 51,000 Retained Earnings 485,000 1,027,000 1,263,000 1,575,000 1,759,000 TOTAL EQUITY 556,000 1,098,000 1,334,000 1,646,000 1,810,000 TOTAL LIABILITIES & EQUITY 3,257,000 2,791,000 3,320,000 3,538,000 4,067,000TRU-CUT PRODUCTS. INC. STATEMENT OF INCOME AND RETAINED EARNINGS 31712118 31112719 31112120 31712121 31112122 Sales 8,102,000 8,306,000 8,331,000 8,532,000 8,309,000 Cost ofSaies Opening Inventory 1,244,000 1,244,000 1,043,000 1,154,000 1,405,000 Purchases 5,009,000 4,945,000 5,771,000 6,100,000 6,065,000 Less: Closing Inventory 1,244,000 1,043,000 1,154,000 1,405,000 1,845,000 Cost of Goods Sold 5,009,000 5,146,000 5,660,000 5,849,000 5,825,000 Gross Prot 3,093,000 3,160,000 2,671,000 2,683,000 2,484,000 Expenses Administrative expenses 1,979,000 1,946,000 1,838,000 1,815,000 1,767,000 Loan Interest 149,000 189,000 217,000 176,000 188,000 Depreciation 286,000 199,000 202,000 258,000 262,000 Total Expenses 2,414,000 2,334,000 2,257,000 2,249,000 2,217,000 Operating Prot 679,000 826,000 414,000 434,000 267,000 Income taxes (223,000) (244,000) (131,000) (122,000) (83,000) Net Prot 456,000 582,000 283,000 312,000 184,000 Dividends (24,000) (40,000) (47,000) 0 0 Transfer to Retained Earnings 432,000 542,000 236,000 312,000 184,000 Retained Earnings (opening) 53,000 485,000 1,027,000 1,263,000 1,575,000 Retained Earnings (closing) 485,000 1,027,000 1,263,000 1,575,000 1,759,000 TRU-CUT PRODUCTS, INC. STATEMENT OF CASH FLOW 31/12/19 31/12/20 31/12/21 31/12/22 NET SALES 8,306 8,331 8,532 Chg. In A/R 8,309 (138) (187) (142) Cash from sales (136) 8,168 8.144 8,390 Cost of sales 8.173 (5,146) (5,660) (5,849) Chg. In Inventory (5,825) 201 Chg. In A/P (111) (251) (240) (186) 22 (9) Cash paid to suppliers 57 (5.131) (5.749) (6.109) CASH FROM TRADING ACTIVITIES (6.008) 3.037 2,395 2,281 2,165 S.G& A Expenses (less non-cash expenses) (1,946) (1,838) Chg. in prepaids/deferred (1,815) (1,803) (20) (8 (7) Chg. in accruals & other pay 2 16 28 (48) Cash paid for operating costs (21) (1.950) (1.818) (1.870) CASH AFTER OPERATIONS (1.822) 1,087 577 411 343 Chg. In other assets/liabilities (29) (207) Taxes - paid in cash (111) (65) (223) (153) (124) (90) Other income (expense) & taxes paid (252) (360) (235) (155) NET CASH AFTER OPERATIONS 11 11 1 835 217 176 188 Interest Expense (189) (217) (176) Cash paid for Dividends & interest (188) (189) (217) (176) (188 ENDING CASH BALANCE 646 0 0 0