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Copyright 2010, Ivey Management S ervices Version: (A) 2010-02-19 When Fredrik Blix got Darlarna Furnitures 2008 financial statements back from the accountant in mid- January 2009, he became quite concerned about the dramatic drop in profits, as he knew the venture capitalists were looking to sell their investment soon. He was also alarmed by reports in the media that a number of investment firms in the United States had failed and required government bailouts to continue operating. Could a severe recession be soon to follow? How would this influence demand for his products? Would the Bank of Montreal still be prepared to provide needed financing? In response to these concerns, Blix retai ned Sally Delaney, chartered accountant, to conduct an analysis of Darlarna Furnitures operations and to make recommendations for future action within the week. COMIN G TO CANADA Fredrik Blix immigrated to Canada in 2003 after meeting his wife, Cathy, a Canadian, on a Mediterranean holiday. Blix was born in Darlarna province in Sweden, but moved to Stockholm after completing the Canadian equivalent of high school, called gymnasium. While in Stockholm, Blix earned a diploma in commercial design and apprenticed with Arlanda, a furniture manufacturer that supplied the IKEA chain with innovative new products. After workin g for Arlanda for eight years and acquiring a reputation as a very inventive young designer, Blix moved to Winnipeg, Manitoba, his new wifes hometown, and secured a design job with Palisar, Canadas largest furniture manufacturer. Initially, Blix enjoyed his job at Palisar, became involved as a hockey coach in the local community and was an avid curler, but after a few years, he became frustrated at work. Although he had a very friendly relationship with his colleagues and received a number of raises and promotions, he longed to return to designing furniture with more of a Swedish influence as he had at Arlanda back in Sweden. A NEW VENTURE In early 2005, Blix approached th e Crocus Fund, a labour-sponsored venture capital firm located in Winnipeg, about financing a new boutique furniture manufacturer. His new company, Darlarna, would design and manufacture high-end Swedish-style furniture for distribution in Canada initially, but he hoped eventually to crack the U.S. market. Instead of distributing his product through the large chains, such as The Brick, Dufresne, Leons or department stores, such as Sears or The Bay, Blix hoped to sell his products through high-end, independently-owned furniture retailers who provided interior design services along with an extensive selection of home furnishings. After preparing a detailed business plan and raising $180,000 in financing from friends and family in the Mennonite community in Winnipeg and Steinbach, the Crocus Fund agreed to make a matching investment for a 40 per cent share in Darlarna Furniture. By October 2005, Blix had purchased a small factory and the necessary manufacturing equipment and had recruited skilled furniture makers he knew from working at Palisar. Darlarna began shipping products in January 2006, and quickly built up sales in its target market with its unique designs. EXPANSION After a very successful 2006, Blix found that his current factory could not keep up with demand so he began purchasing additional manufacturing equipment. Instead of buying used equipment for which there was an active market in Winnipeg with Palisars large manufacturing operations, Blix felt new equipment might help impress customers when they came for factory visits. By late 2008, the factory was becoming too small, due to growing sales and large inventories of raw materials and work in process, so a search began for new facilities in Winnipeg. In 2008, the Winnipeg economy was booming and it was very difficult to find skilled furniture makers, given opportunities in the building trades and the Tar Sands oil developments in northern Alberta. As a result, Darlarna was forced to give its workers a significant increase in wages and benefits to retain them. Also, key production inputs, such as fine leathers and foam cushioning materials, rose dramatically in price due to a rapid expansion of the Chinese furniture industry. By 2008, Blix felt that Darlarna was ready to expand into the U.S. market, so he began taking out ads in a number of American design magazines to test the market, and prepared an expensive new catalogue displaying its many products. With the prospect of increased orders from the United States, the company expanded its order processing, shipping/receiving and accounting functions despite industry reports of a possible deep recession in the United States in the coming year due to excesses in the mortgage, consumer and corporate lending markets. FINANCIAL STATEMENTS The financial statement s for Darlarnas first three years of operation are shown in Exhibit 1. Blix was also able to attain average ratios from the Bank of Montreal (see Exhibit 2), which the ban k considered typical of operations in the high-end furniture manufacturing industry. NANCING Darlarna wa s able to secure both line of credit and term loan financing with the Bank of Montreal. The line of credit had a limit of $300,000 and was secured by both inventory and accounts receivable. Since Darlarnas customers were small retailers with more limited access to financing compared to the large chains or department stores, the Bank of Montreal was only prepared to lend 40 per cent of the value of the accounts receivables that were not yet past due. Also, because the inventory was composed mostly of raw materials and partially completed furniture and was consequently difficult to sell, the bank agreed to lend only 20 per cent of its value. The line of credit was non-committed, which meant the bank was not obligated to lend to the company under the loan agreement if it felt the company was in financial difficulties or if the bank had a shortage of loanable funds. All loans required that the company maintained a current ratio of 2.0, a cash flow coverage ratio of 4.0, and a long-term debt to total capitalization ratio of 55 per cent. The loan agreements also specified that Blix could withdraw no more than $70,000 a year for living expenses, and that he had to receive the banks permission to make capital purchases. Financial statements were to be provided when Blix met with his loans officer in July and January each year. Darlarna sold all products Net 60 and purchased most of its inputs 2/15, Net 60. These terms were typical of the high-end furniture manufacturing industry. Whal fancial problems is Dartarna cury Ping in the areas of liquidity, muragement, longterm deli-paying ability and profitability! What are their causes? What actions should Durlarne to prevent bankrupicy