"they have never worked in the past, and we have a competitive, even generouscreditpolicy." At present Dunham has an especially large level of inventory and a very high amount of rexivables. Jensen believes recivables should be reducet to 60 days of sales in 1996 and the inventory turnover (sales/inventory) ratio could be raised to 5.4 , the industry average. In addition he has a number of suggestions for reducing Dunham's costs. He believes the company can increase its gross profit margin to 31 percent and reduce selling and administrative expenses to 21.5 percent of sales. "One reason for our lousy current ratio is we'vegradually taken longer and langer to pay our tillst I've gotten more than cne nasty letter in the last year! I'm going to suggest we get payables to 9 peroent of sales, which would becompetitive with other firms." Jensen has also been critical of how the company has obtained external funding for the last few years. Virtually all such money has been supplied by GCB, and Jensen has secretly felt that the tank has been "extremely genercus" in honoring Dunham's loan requests. Personally he believes the firm should have used more equity by eliminating dividend payments and selling more stock. In fact, in 1993 he had recommended that the firm lower its payout ratio from 50 to 20 percent of net income. The proposal received little support then and consequently Jensen hesitates now to propose a reduction in dividends. He decides to make any financial forecast assuming the payout ratio remains at 50 percent. Though Jensen doesn't really think GCB willgrant the $675,000 loan request, he believes that Dunham should not accept the money even if it is offered. "But maybe I am wrong," he admits. "I will work up a financial forecast based on these changes and see what the numbers look like." Jensen will present his suggestions at the mecting he has called in 72 hours, and believes "they'll be implemented considering the situation with the bank." Jensen knows that the board wants the $675,000 loan, and if Dunham doesn't show the bank a solid flan, it will not cnly have no chance to obtain the $675,00, but the bank could foreclose on the existing loans. "And maybe, just maybe," he sighs, "if the bank likes our plan we won't be required to submit a monthly review. I really hate those!" matter, however. Although approval of the loan is not out of the question, Dunham will need a very solid and convincing business plan to stand any chance. Back at his cffice, Jensen reflects on the meating with Reardon and the firm's situation. He is annoyed that he had not anticipateil the bank's evaluation but feels there is a positive side to the situation. "Terhaps this will give our board the kick in the pants it needs," he thinks. Jensen knows Dunham is in difficulty and has a number of measures he wants implemented. Unfortunately, the board feels the company's problems are largely the result of a poor cosmetics market; the members believe there is little to do but wait CASE 7 DNHAMOOAMETCS 43 for the "inevitable recovery." Jensen agres that part of Dunham's problem has been the soft market that has existeal for the past two years. However, industry experts agree this decline is over, and there are indications that demand is on the rise. Jensen himself believes a safe prediction is for syes to increase by 10 percent in 1996. JENSEN'S RECOMMENDATIONS He also feels there are a number of changes Dunham can make. When the company realized that demand would be clown, it hoped to increase sales with more libcral credit and through a larger inventory that would increase customer selection. Jensen opposed those measures at the time on the grounds that 1. Calculate Dunham's 1995 financial ratios. (See Lxhibits 1, 2, and 3). 2. Does a trend analysis indicate Durham's position has been deteriorating? (See Exhibit 3.) 3. Is the bank justifiably concerned? Justify your answer. 4. Nineteen ninety-four was a "down" year for Dunham. Do you think that GCB had a responsibility to expressconcern in 1994, especially since thecurrent ratio was close to 1.85 , the number that could trigger a call of the loan? Explain. 5. Suppose Dunham had followed Jensen's 1998 recommendation to lower its payout ratio. Recalculate the firm's debt and current ratios for 1995 assuming that the paycutratio was 20 percent from 1993 to 1995. (Assume that the extra money was used to reduce the firm's notes fayable.) 6* (a) Jensen discussed Dunham's situation with Paula Robinson, an accounting friend. Rocinson said that, in her opinion, Dunham has "too little long-term capital, especially considering your receivables and inventory needs." Why is it frequently appropriate to use a long-term capital source like bonds or equity to finance items like inventory and recieivables that appear on a talance sheet as short-term assets? (b) What advantages are there to using short-term debt to finance lang-term assets? What are the clisadvantages? JENSEN AND REARDON MEE 1 Reardon reminds Jensen that the Federal Reserve is tightening credit in order to climinate inflationary pressures in the cconomy. This means that loans will become harder to obtain and the bank will belocking at cach loan request much more carefully. Even more serious, the tank has just finished its yearly financial evaluation, and Reardon emphasizes to Jensen that, in her opinion, Dunham's financial pocition is "poor and seems to be getting worse." She also points out as tactfully as possible that Dunham is violating its loan agrecments. For cxample, cne provision stipulates the current ratio can't fall below 1.85 . A final issue conorns the terms of the company's loans. Jensen tells Reardon that "I am considering whether to restructure the company's debt" and "might request" that the bank take all of Dunham's debt and amortize it over five years. "Of course, this may be unnecessary," he is quick to add. Reardon explains to Jensen that in light of Dunham's difficulties the lcan committee would much prefer that any debt be repaid as quickly as possible. This means that (1) the loan committee would prefer not to restructure the debt, and (2) the new loan request, assuming it is even granted, would likely be in the form of a note payable. However, Reardon does tell Jensen that the bank is. willing to "work with you to develop p financial plan satisfactory to all parties," Reardon then suggests they meetsgain in the near future to discuss the situation further. A few minutes after Jensen leaves, Reardon wonders if she wasn't a bit too "hardline," especially regarding Jenser's request to restructure Dunham's existing debt. She knows that the officer previcusly in charge of the firm's account had raised no red flags with Jensen at last year's annual meeting. This is surprising given the company's "off' year in 1994. Prudent banking dictates that an officer express concern over a deterioration in a firm's position and scriously investigate the reasons for any poor performance. And there are possible legal considerations. Suppose that the bank either calls the lcan or refuses to allow Dunham to restructure. If, as a result, Durham ends up in sericus financial difficulties, then it is possible that GCB could be held legally liable for these problems because of the failure to adequately warn Dunham a year ago. Everything considered, Reardon thinks it may well be in the bank's interest to allow Dunham to restructure its existing debt. The new loan request is anothe "they have never worked in the past, and we have a competitive, even generouscreditpolicy." At present Dunham has an especially large level of inventory and a very high amount of rexivables. Jensen believes recivables should be reducet to 60 days of sales in 1996 and the inventory turnover (sales/inventory) ratio could be raised to 5.4 , the industry average. In addition he has a number of suggestions for reducing Dunham's costs. He believes the company can increase its gross profit margin to 31 percent and reduce selling and administrative expenses to 21.5 percent of sales. "One reason for our lousy current ratio is we'vegradually taken longer and langer to pay our tillst I've gotten more than cne nasty letter in the last year! I'm going to suggest we get payables to 9 peroent of sales, which would becompetitive with other firms." Jensen has also been critical of how the company has obtained external funding for the last few years. Virtually all such money has been supplied by GCB, and Jensen has secretly felt that the tank has been "extremely genercus" in honoring Dunham's loan requests. Personally he believes the firm should have used more equity by eliminating dividend payments and selling more stock. In fact, in 1993 he had recommended that the firm lower its payout ratio from 50 to 20 percent of net income. The proposal received little support then and consequently Jensen hesitates now to propose a reduction in dividends. He decides to make any financial forecast assuming the payout ratio remains at 50 percent. Though Jensen doesn't really think GCB willgrant the $675,000 loan request, he believes that Dunham should not accept the money even if it is offered. "But maybe I am wrong," he admits. "I will work up a financial forecast based on these changes and see what the numbers look like." Jensen will present his suggestions at the mecting he has called in 72 hours, and believes "they'll be implemented considering the situation with the bank." Jensen knows that the board wants the $675,000 loan, and if Dunham doesn't show the bank a solid flan, it will not cnly have no chance to obtain the $675,00, but the bank could foreclose on the existing loans. "And maybe, just maybe," he sighs, "if the bank likes our plan we won't be required to submit a monthly review. I really hate those!" matter, however. Although approval of the loan is not out of the question, Dunham will need a very solid and convincing business plan to stand any chance. Back at his cffice, Jensen reflects on the meating with Reardon and the firm's situation. He is annoyed that he had not anticipateil the bank's evaluation but feels there is a positive side to the situation. "Terhaps this will give our board the kick in the pants it needs," he thinks. Jensen knows Dunham is in difficulty and has a number of measures he wants implemented. Unfortunately, the board feels the company's problems are largely the result of a poor cosmetics market; the members believe there is little to do but wait CASE 7 DNHAMOOAMETCS 43 for the "inevitable recovery." Jensen agres that part of Dunham's problem has been the soft market that has existeal for the past two years. However, industry experts agree this decline is over, and there are indications that demand is on the rise. Jensen himself believes a safe prediction is for syes to increase by 10 percent in 1996. JENSEN'S RECOMMENDATIONS He also feels there are a number of changes Dunham can make. When the company realized that demand would be clown, it hoped to increase sales with more libcral credit and through a larger inventory that would increase customer selection. Jensen opposed those measures at the time on the grounds that 1. Calculate Dunham's 1995 financial ratios. (See Lxhibits 1, 2, and 3). 2. Does a trend analysis indicate Durham's position has been deteriorating? (See Exhibit 3.) 3. Is the bank justifiably concerned? Justify your answer. 4. Nineteen ninety-four was a "down" year for Dunham. Do you think that GCB had a responsibility to expressconcern in 1994, especially since thecurrent ratio was close to 1.85 , the number that could trigger a call of the loan? Explain. 5. Suppose Dunham had followed Jensen's 1998 recommendation to lower its payout ratio. Recalculate the firm's debt and current ratios for 1995 assuming that the paycutratio was 20 percent from 1993 to 1995. (Assume that the extra money was used to reduce the firm's notes fayable.) 6* (a) Jensen discussed Dunham's situation with Paula Robinson, an accounting friend. Rocinson said that, in her opinion, Dunham has "too little long-term capital, especially considering your receivables and inventory needs." Why is it frequently appropriate to use a long-term capital source like bonds or equity to finance items like inventory and recieivables that appear on a talance sheet as short-term assets? (b) What advantages are there to using short-term debt to finance lang-term assets? What are the clisadvantages? JENSEN AND REARDON MEE 1 Reardon reminds Jensen that the Federal Reserve is tightening credit in order to climinate inflationary pressures in the cconomy. This means that loans will become harder to obtain and the bank will belocking at cach loan request much more carefully. Even more serious, the tank has just finished its yearly financial evaluation, and Reardon emphasizes to Jensen that, in her opinion, Dunham's financial pocition is "poor and seems to be getting worse." She also points out as tactfully as possible that Dunham is violating its loan agrecments. For cxample, cne provision stipulates the current ratio can't fall below 1.85 . A final issue conorns the terms of the company's loans. Jensen tells Reardon that "I am considering whether to restructure the company's debt" and "might request" that the bank take all of Dunham's debt and amortize it over five years. "Of course, this may be unnecessary," he is quick to add. Reardon explains to Jensen that in light of Dunham's difficulties the lcan committee would much prefer that any debt be repaid as quickly as possible. This means that (1) the loan committee would prefer not to restructure the debt, and (2) the new loan request, assuming it is even granted, would likely be in the form of a note payable. However, Reardon does tell Jensen that the bank is. willing to "work with you to develop p financial plan satisfactory to all parties," Reardon then suggests they meetsgain in the near future to discuss the situation further. A few minutes after Jensen leaves, Reardon wonders if she wasn't a bit too "hardline," especially regarding Jenser's request to restructure Dunham's existing debt. She knows that the officer previcusly in charge of the firm's account had raised no red flags with Jensen at last year's annual meeting. This is surprising given the company's "off' year in 1994. Prudent banking dictates that an officer express concern over a deterioration in a firm's position and scriously investigate the reasons for any poor performance. And there are possible legal considerations. Suppose that the bank either calls the lcan or refuses to allow Dunham to restructure. If, as a result, Durham ends up in sericus financial difficulties, then it is possible that GCB could be held legally liable for these problems because of the failure to adequately warn Dunham a year ago. Everything considered, Reardon thinks it may well be in the bank's interest to allow Dunham to restructure its existing debt. The new loan request is anothe