CITY SHOPS, INC. Harry Osias, president and owner of City Shops, Inc. was considering whether to lengthen the credit period from 30 days to 60 days for holders of its house credit card in order to boost sales. Osias wanted to determine whether his proposed credit policy would be a profitable for City shops. If it would be profitable, he planned to finance the resulting increase in accounts receivable by taking out a short-term loan. Osias arranged a meeting with a loan officer at the companys main bank, Oriental Bank. During the meeting, he requested Salvador Yan, Oriental Banks credit officer, to provide City Shops with a short-term loan facility necessary to support his new credit policy, This company had been ran too conservatively in the past. I cant go wrong if I adjust our credit policy to increase my customers. But I need a new short-term loan to finance this new policy. I think P6 million seems like a nice round figure, Osias told Yan. Background City Shops, Inc., was one of the largest and leading department stores in the country. Danilo Osias, Harrys father, established the company in 1965 as a single store in Ermita, Manila. As consumers became more fashion-conscious, City Shops opened more outlets. The company opened new stores in quezon City, Makati and Cebu City. The rapid development of large shopping malls in the 1990s enabled City Shops to grow to its current size of eight branches. Department stores were a new phenomenon in the 1960s when City Shops started operations. The better known department stores at that time were in Rizal Avenue, Manila, and these were owned by Chinese-Filipinos and Indian-Filipinos, the current giant in the industry, SM Department Store, was only a small shoe store at that time. As the economy expanded and the political environment stabilized, the countrys middle class grew in number and purchasing power. Department stores grew in popularity, became bigger and were being located in covered parks. SM Department Store started the trend toward megamalls large shopping complexes with spaces leased to individual shops. The department store itself occupied only a portion of the megamall. Prominent shopping complexes in Manila such as SM Megamall, Shangri-la Plaza, Harrison Plaza, Centerpoint and Gotesco were the other examples of this setup. City Shops, Inc. was a department store that offered clothes, footwear, cosmetics, home appliances and electronics, kitchen equipment and travel goods. The companys eight outlets were in prominent commercial complexes in Manila and Cebu. For more than 30 years, City Shops had earned a good reputation for providing its customers with quality goods at reasonable prices. Danilo and his wife, the former Danielle Schutz of Basel, Switzerland, personally made all purchasing decisions. They slowly developed dependable suppliers dependable suppliers of quality products from Hong Kong, Singapore and local suppliers. In some products where quality was important (for example, in leather products and furniture), Danilo and Danielle relied on local suppliers with reputation for quality. A few local medium-scale enterprises worked under long-term exclusive supply contracts with City Shops. The spouses Osias regularly visited their suppliers warehouses and production facilities to ensure that they maintained and geared their production toward high quality at all times. The company did not want to compete for the few customers served by high-end boutiques and designer shops. However, City Shops tried to consistently offer products that were of higher quality than the low-end department stores located in less prestigious shopping areas. The company served a wider market segment and charged premium prices for its products. Change in Credit Policy Osias and his wife managed the company for 30 years, consistently maintaining their policy of selling only quality products. They followed industry practices in other ways. The company maintained a central warehouse in Pandacan, Manila, from where all stores except the Cebu City branch were supplied. Danilo dealt with suppliers while Danielle evaluated samples and inspected deliveries of stocks. The company was one of the first department stores to offer a private credit card service for its customers. The company called this credit facility the City Card. The company accepted credit card applications from various customers. Applicants filled up and submitted a simple application form and secured a guarantee from an existing cardholder. City Shops conducted a cursory screening of credit card applications using a rough customer profile target. The company required that the customers residence, place of work and age meet the desired profile of a customer in the upper middle income group, with the following characteristics : a) Residing in a known middle-income neighborhood b) Stable employment history c) Within the working age group The company relied heavily on the guarantee by a cardholder whose account was on current status. As a matter of policy, the company did not approve a credit card application that did not have an acceptable guarantee. In the 12 years that the credit card system had been in force, the company experienced only few cases of default. Under the terms of the card, the customer had 30 days to pay the account without financing charge. The company did not allow installment payments because it did not want to incur high administrative costs. If an account had not been paid for 30 days or longer, the company considered the account in default and imposed a financing charge of 3 percent per month. Management canceled all credit card privileges for all accounts in default. Twenty percent of sales were accounted for by City Card credit customers. In late 1995, Danilo and his spouse allowed their only son, Harry, to take over the management of City Shops as president. At the age of 70, Danilo retired and became an antique collector. He opened an antique shop in Ermita, while Danielle continued to help in the merchandising work at the department store. She took a direct hand in periodically re-layouting the stores to attract more customers. Their son Harry took over the management of City Shops. Harry had earned his undergraduate degree in business administration at De La Salle University. He worked for the company for four years after completing his degree, gaining experience in purchasing, sales, finance and accounting. Later he took his MBA at IMEDE in Lausanne, Switzerland. After a few months as president, Harry Osias thought about changing the companys credit card policies to increase sales and improve profits. He called on Salvador Yan of Oriental Bank and told him: Our margins are so thin that we need to make sales grow faster. The only way is to offer longer credit terms. The City Card is our only advantage over the big shopping malls. But your parents have set the credit terms and have successfully implemented it for many eyars. Whats wrong with it? asked Yan. Theres nothing wrong with it, I am saying that it is just too conservative. It does not take advantage of City Shops real sales potential, Harry countered. We have not been much better than SM Department Store, our major competitor. Just look at our financial statements. Exhibit 1 shows the summary comparative financial statements for City Shops. Exhibit 1 CITY SHOPS CORPORATION Financial Statements, 1996 and 1997 (In thousand pesos) BALANCE SHEET As of December 31 1996 1997 Cash 2,400 2,640 Temporary Investments 3,400 3,860 Accounts receivable 9,800 10,660 Inventory 74,000 76,400 Net fixed assets 22,000 29,200 TOTAL ASSETS 111,600 122,760 Accounts Payable 18,000 19,798 Short-term bank loan 6,018 7,500 Accrued expenses 2,400 2,640 Current portion of Long-term loan 3,000 1,700 Total Current Liabilities 29,418 31,638 Long-term loan 10,200 8,500 Capital Stock 46,800 48,800 Retained earnings 25,182 33,822 TOTAL LIABILITIES & CAPITAL 111,600 122,760 Income statement For Year Ended December 31 1996 1997 Sales 536,230 595,200 Cost of goods sold 438,330 487,960 Gross Profit 97,900 107,240 Operating Expenses 83,500 91,400 Operating Profit 14,400 15,840 Net Interest expense 3,351 2,548 Income Before Tax 11,049 13,292 Income tax expense 3,867 4,652 NET INCOME 7,182 8,640 What do you want to do and how can Oriental Bank help? Yan asked. I want to increase our City Card term from 30 days to 60 days. I think this will increase credit sales by 30 percent compared to sales on cash that will grow by 10 percent yearly. There will be no increase in bad debts because I will be extending credit to the same customers, said Harry. That sounds simple. Why dont you study your plan some more? Call me when youre ready, said Yan as the meeting ended. Financing Plan Harry thought that most of the financing he needed could be sourced internally. He believed that with higher sales, he could keep the cost of goods to sales ratio at the same level they were in during the previous year. All other expenses were to be at fixed levels. He estimated that depreciation expenses would come to P2.5 million per year. His concern was about the P4 million worth of store renovation that could no longer be postponed. The company also had to pay about P1.7 million of its long-term debts. Oriental Bank had been the main bank of City Shops for the past 10 years. The company maintained a short-term facility of P10 million with the bank. On average, City Shops used about 75 percent of this credit line. It had other credit lines with two other banks, each amounting to a maximum of P2.5 million, but it was the policy of City Shops to avoid debt financing for its operations. The company took out a term loan to finance the opening and renovation of several new branches. After pondering his companys situation, Harry believed that the increase in short-term facility should not be more than 20 percent over current levels. He called Yan and said: Remember my revised City Card plan? I will probably need P3 million more to finance that plan. Can you make that a nice round figure of P6 million just in case my customers bite? As he put down the telephone, Harry thought about his loan request. He wanted to prepare an estimate of his actual funding need in case Yan asked him later. GJUIDE QUESTIONS What do you think of Harry Osias proposal to expand sales by extending City Cards credit term?