RJET Task 5

Key points of the companys financial picture To analyze the key points of this companys financial picture, it is necessary to focus on the three areas of profitability, liquidity, and solvency. These are the areas that will be of most interest to the banker when considering the loan for the European expansion. Profitability focuses on how much money the company makes. Profitability is driven by sales and expenses. Sales declined by 6.44% in year 13, but have made a slight increase in year 14 by 1.28% over year 13. This is important to the banker because it shows that, while there was a decline in sales in year 12, the sales are rebounding slightly. Gross profit and selling expenses also declined in year 13 by 6.44% and increased slightly in year 14 by 1.28%, which is directly proportional to the sales figures. This is important to the banker because it shows that this company did a good job of maintaining its cost of goods sold and its selling expenses in those years. General and administrative expenses increased by 7.24% in year 13 and by 6.5% in year 14. This is important to the banker because it shows that the company did not do a good job of managing those expenses during that time. All of these factors played a role in the decline in net earnings of 67.66% in year 13 and 72.11% in year 13. This is important to the banker because, although sales rebounded slightly in year 14, overall net earnings declined drastically in both year 13 and year 14. Liquidity focuses on how much money a company has to spend. Liquidity is driven by assets. Current assets increased in year 13 by 12.3% due to an increase in cash of 64.1% and in short-term investments of 20%, but decreased in year 14 by 16.6%, due in great part to a decrease in short term investments in this year of $150,000. Furniture, fixtures, and equipment increased by 66.7% in year 14, meaning that the company most likely cashed out most of its short term investments to purchase additional assets of some type. This is important to the banker because it shows that the company is using its capital to reinvest in the company. Accounts receivable decreased by 6.4% in year 13 and in year 14 it increased by 1.3%, which was proportional to the sales figures. This is important to the banker because it shows that the companys receivables are remaining steady. Total assets declined in year 13 by .5% and in year 14 by 2.3%. This is important to the banker because it shows that while the companys sales decreased by over 6%, it was able to maintain a decrease in assets of only $47,585, which is just 2.7% in the 3-year period. Solvency focuses on the amount of the companys outstanding debt. Current liabilities decreased by 3.7% in year 13 and increased by .7% in year 14. Accounts and notes payable

declined by 6.4% in year 13 and increased by 1.3% in year 14, which was in proportion with the decrease in sales. This is important to the banker because it shows that the company is not paying all of its accounts and notes payable in a timely manner. The current portion of long-term debt also remains the same for the 3-year period at $55,000. This is important to the banker because it shows that the company is not using its capial to pay its debts. Long-term liabilities such as mortgage payable and other long-term liabilities decreased by 6.4% in year 13 and by 6.8% in year 14. This is important to the banker because it shows that the company is keeping up with its regular mortgage and other long-term liability payments. Total liabilities decreased by 6% in year 13 and by 5.8% in year 14. This is important to the banker because it shows that the companys liabilities are decreasing pretty much along the same lines as sales, meaning that overall, the company is adequately maintaining its debt. Retained earnings increased over the 3-year period by $66,375. This is important to the banker because it shows that the company has been able to hold on to a substantial portion of its earnings, even though sales have been in a slump. Financial risks and how they will be mitigated by the company There are several financial risks involved with this loan. From a profitability standpoint, the biggest financial risk is that the companys sales will not continue to increase. To mitigate this risk, the company should ensure that its sales staff is properly trained and motivated to make these sales happen. Part of this motivation could include raising sales commission percentages or giving other such perks for reaching the sales goals. It must also be sure to maintain product costs to keep its gross profit margin steady. It must also maintain its selling expenses as it has done for the past 3 years. Another risk is that the companys general and administrative expenses will continue to rise. To mitigate this risk, the company must thoroughly investigate the source of these excess expenses and determine ways to lower them. From a liquidity standpoint, one of the biggest financial risks is that the company cannot collect its outstanding accounts. To mitigate this risk, the company must stay on course with its accounts receivable management to ensure that accounts are not allowed to become delinquent. Another risk is that the company will retain many dollars worth of raw materials and finished goods inventory. To mitigate this risk, the company should implement and properly maintain a just-in-time inventory management system. It should also calibrate its production and billing cycles so that all finished goods are billed out before the end of each period. This will ensure that the company maintains an optimal amount of quick assets to be used for working capital. From a solvency standpoint, one of the biggest financial risks is that the companys accounts and notes payable continue to increase and that the current portion of long-term debt does not decrease. To mitigate these risks, the company must ensure that its accounts and notes payable are all paid in a timely manner and that some of the companys cash is used to pay down the current portion of long-term debt.

Ratios that will indicate the ability to repay the principal and interest on the 5-year loan The current ratio is computed by dividing a companys current liabilities into its current assets. In other words, it measures how a company can cover its current liabilities with its current assets. The current ratio for Custom Snowboards has fallen from 6.68 in year 13 to 5.53 in year 14. This ratio means that Custom Snowboards can cover its current liabilities 5.53 times with its current assets. Their competition, Winter Sports, has a current ratio of 4.20, so Custom Snowboards is ahead of its competition in this area. This is important to the banker because it shows that the company should be able to cover its short-term obligations. The average collection period is a measure of how many days it takes a company to collect payment for its charge accounts. The average collection period for Custom Snowboards has remained steady for years 13 and 14 at 11 days, which is nearly three times better than that of their competitors 32.5 days. This is important to the banker because it shows that this company does an excellent job of managing its account receivables, which creates cash to be used for things such as making loan payments. The debt ratio measures how many company assets are financed. Custom Snowboards debt ratio is high at 51.6% in year 14, but this has decreased slightly from 53.5% in year 13. This means that over half of the companys assets are financed. This ratio is also much higher than it competitors ratio of 38%. This is important to the banker because it shows that there might be issues with the companys debt management. Net profit margin is a measure of how well a company turns sales revenues into actual profits. The net profit margin for Custom Snowboards is low and has declined from .8% in year 13 to .2% in year 14. This is well below the 5.1% net profit margin of its competition. This is important to the banker because it shows what kind of job the company does at converting sales dollars into profit dollars that can be used for things such as making loan payments. Return on total assets is a measure of how well a company uses all of its assets to create income. This figure was 3% in year 13 and has dropped to .9% in year 14. The competition is way ahead in this area with a ratio of 4.8%. This is important to the banker because it shows that the company is not optimizing its assets to produce income which could lead to future cash flow problems. Times interest earned is a measure of the companys ability to pay the interest owed on its debts. This figure was 1.83 in year 13 and dropped to 1.23 in year 14. This means that the company can only pay the interest owed on its debts 1.23 times with its earnings before income taxes. This is well below the competitors ratio of 5.10. This is important to the banker because it shows that this company could have a problem keeping up with its interest payments.

Historical analysis of past performance This historical analysis of the companys past performance will help to provide a clear picture of how the company got to where it is today. Sales declined by 6.44% in year 13, but have made a slight increase in year 14 by 1.28% over year 13. Gross profit and selling expenses also declined in year 13 by 6.44% and increased slightly in year 14 by 1.28%, which is directly proportional to the sales figures. General and administrative expenses increased by 7.24% in year 13 and by 6.5% in year 14. The biggest contributors to the overall $136,500 increase in these general and administrative expenses for the 3-year period were administrative and executive salaries, utilities and services, and other general and administrative expenses. Interest income decreased by $2,200 over the 3 years and interest expense decreased steadily at $5,000 per year each year. All of these factors played a role in the decline in net earnings of 67.66% in year 13 and 72.11% in year 13, making for an overall decrease in net earnings for the 3 years of $146,025. Current assets increased in year 13 by 12.3% due to an increase in cash of 64.1% and in short-term investments of 20%, but decreased in year 14 by 16.6%, due in great part to a decrease in short term investments in this year of $150,000. Furniture, fixtures, and equipment increased by 66.7% in year 14, meaning that the company most likely cashed out most of its short term investments to purchase additional assets of some type. Accounts receivable decreased by 6.4% in year 13 and in year 14 it increased by 1.3%, which was proportional to the sales figures. Raw materials inventory decreased by 6.4% in year 13 and increased by 1.3% in year 14, which is proportional to the decrease in sales. Other current assets increased by 9.5% in year 13 and by 5.8% in year 14. Total assets declined in year 13 by .5% and in year 14 by 2.3%. Current liabilities decreased by 3.7% in year 13 and increased by .7% in year 14. Accounts and notes payable declined by 6.4% in year 13 and increased by 1.3% in year 14, which was in proportion with the decrease in sales. The current portion of long-term debt also remains the same for the 3-year period at $55,000. Mortgage payable decreased steadily at $50,000 per year and other long-term liabilities also decreased steadily by $5,000 per year. Total liabilities decreased by 6% in year 13 and by 5.8% in year 14. Common stock and paid-in capital have remained unchanged over all three years. Retained earnings increased over the 3-year period by $66,375. Total liabilities and equity have decreased by $47,585 or 2.7% in the three year period. The current ratio for Custom Snowboards has fallen from 6.68 in year 13 to 5.53 in year 14. This ratio means that Custom Snowboards can cover its current liabilities 5.53 times with its current assets. Their competition, Winter Sports, has a current ratio of 4.20, so Custom Snowboards is ahead of its competition in this area.

The earnings per share ratio for Custom Snowboards has dropped from .06 in year 13 to .02 in year 14. This is an extremely low earnings per share number and is below the competitions EPS of .08. The price/earnings ratio has risen from 169.56 in year 13 to 197.03 in year 14. However, this number is skewed because of the low earnings per share number of .02 which is so far below the market price. What the historical analysis indicates about future performance The historical trend analysis shows that sales peaked in year 12 at $6,745,900 then declined by 6.4% in year 13. The sales then rebounded slightly in year 14 by 1.28% over year 13. Overall sales decline in the three year historical analysis was $354,200 or 5.25%. The forecasted trend analysis for years the next three years shows sales increasing by $191,751 or 3% in year 15, declining slightly by $63,917 or 1% in year 16, and then rebounding again slightly by $111,216 or 1.7% in year 17. Overall, sales are forecasted to increase in the three year period by $239,050 or 3.7%. This forecasted trend is patterned after the historical analysis trend which indicates that the sales increase in the first year, decrease in the second year, and then increase again in the third year. This historical analysis for years 12-14 shows a modest increase in sales which also equated to modest profits for the company because profit factors such as cost of goods sold, gross profit, and operating expenses were kept in proportion with these modest sales increases. This is echoed in the forecast of future performance therefore the profitability in years 15-17 should remain steady so long as these same profit factors also remain constant. The peak sales of this six year period actually occurred in the first year of the analysis, year 12, with sales of $6,745,900. The forecast for year 17 will come in as the second biggest sales year of the six year period with anticipated sales of $6,630,750. If this forecasted trend continues, a 2% sales increase in year 18 would set a new high sales peak. How current operations can be improved through better cost controls Traditional costing methods use a predetermined overhead rate to assign indirect costs to products. This predetermined overhead rate is calculated by estimating overhead costs and dividing these costs by a cost driver, such as man hours, machine hours, etc. This method assigns all overheads costs to the products, regardless of their involvement with that product. This method is much simpler to use but it does not represent a true picture of the actual product costs as it includes costs that are not directly related to the product. Activity-based costing methods assign indirect costs to products based on the actual use in that product by breaking down activities into pools and assigning the actual indirect costs that were used for each activity to each activity pool. This method is much more complicated to

implement and to use, but it provides a much truer picture of actual product costs since it involves only those costs that are directly involved with the product. Current operations can be improved through better cost controls by changing the costing method from the traditional costing method to the activity-based costing method. Since the company is manufacturing two different types of products, regular and personalized snowboards, it is important that the activity-based costing method be used in order to better track costs and expenses that are relative to each individual product. In the overhead analysis, the regular snowboards cost $119 and the personalized snowboards cost $162 using the traditional costing method. Using the activity-based costing method, the regular snowboards cost $105 each and the personalized snowboards cost $218 each. This illustrates the big difference there can be in using the two costing methods. The traditional method overvalues the cost of the regular snowboards and undervalues the cost of the personalized snowboards, which is now evident when looking at the activity-based costing figures. Because the activity-based method breaks the activities down into categories and allocates only the costs that are incurred in these categories, it provides a much more accurate cost figure than does the traditional method. Now that the costs have been broken down into the different activity pools for each type of snowboard, the company can analyze these costs and look for ways to improve operational results. The costs for the personalized snowboards are much higher in the activity costs per unit in all of the categories except packaging and shipping, so it is possible that the company can research these costs and find ways to lower them to get these costs more in line with the costs of the regular snowboards. The use of the activity-based costing method also allows the company to easily pinpoint any fluctuations in product costs and trace them right to the source. This helps to the company keep a handle on costs and expenses which in turn keeps profits steady. Current operations can be improved through better cost controls by implementing a justin-time inventory management system. A just-in-time inventory management system is one in which the company only buys the materials that it needs to produce the units that are actually sold. This method cuts down on dollars that are tied up in inventory held in raw materials inventory and finished goods inventory. The company had over $35,000 tied up in raw materials inventory and over $130,000 tied up in finished goods inventory for each of the three years in the analysis. Using a just-in-time inventory management system benefits the company by lowering these amounts considerably, because there are few materials kept in raw materials inventory and the most of the finished goods are billed in the period in which they are produced. The dollars previously tied up in inventory are more quickly converted to cash to be used as working capital. Internal risks that Custom Snowboards, Inc. will face with any expansion alternative into the European market Internal risks are business risks that management has control over because they originate inside of the company. Among the internal risks facing Custom Snowboards with any expansion

alternative into the European market are different accounting standards, different pricing structures, and an inexperienced management team. There is an internal risk of misstated financial statements because the United States and Europe have different accounting standards. This can cause serious financial problems for this company both overseas and at home if the financial statements are incorrectly calculated. To mitigate this risk, the company should hire a CPA firm that is well-versed in both accounting systems to ensure that the company is in compliance with all accounting regulations and produces accurate financial reports. Another internal risk is different pricing structures between the United States and Europe. Just because a product sells for a specific price in the United States does not mean that product will bring the same price in Europe. If the pricing structure is too high, the company will not sell many products. If the pricing structure is too low, the company will miss out on sales dollars and it could give the product a reputation for being of poor quality. To mitigate this risk, the company must conduct thorough market research in order to develop the proper pricing structure for its products in Europe. This will include researching the countrys gross domestic product as well as the overall demand for the product in that market in order to determine the price that this market can bear. An inexperienced management team is yet another internal risk that this company could face when expanding into this market. Doing business overseas is very different than conducting business in the United States. This could cost the company many dollars in unnecessary mistakes caused by inexperienced and untrained leadership and decision making. To mitigate this risk, the company must take the time to thoroughly train its management in all aspects of overseas business before moving into this market. The company should also consider hiring a consultant that is familiar with overseas business structures to help with this transition. External risks that Custom Snowboards, Inc. will face with any expansion alternative into the European market External risks are business risks that management has not control over because they originate outside of the company. Among the external risks facing Custom Snowboards with any expansion alternative into the European market are a difference in language and culture, different laws and regulations, and the logistical challenges that come with being overseas. The difference in language and culture poses a large external risk for this company. Most of the employees and other business associates involved with the new plant will likely not speak English, which could pose great difficulties in all aspects of this new business. This could be costly to the company in terms of extra time of translation, mistakes caused by misunderstanding, and various other mishaps originating from poor communication. To mitigate this risk, it is vital that all management personnel learn to speak German in order to be able to properly communicate with the employees. The cultural differences must also be researched so

that management learns about the lifestyle of its employees and does not inadvertently hurt feelings or otherwise step on any important aspects of this countrys culture. It would also be most helpful in mitigating these risks to hire a few employees that are also fluent in English to help bridge these cultural and language barriers. Another external risk faced by this company is the differences in laws and regulations in Europe. The company can be subject to costly fines if it is found to be in violation of any of these laws and regulations. Environmental regulations, in particular, will likely be different and perhaps more stringent in Europe which could lead to in the production procedures for the snowboards at the new plant. To mitigate these risks, a consultant should be hired to educate management on the actions that need to be taken to comply with these new laws and regulations. This consultant should also assist in the filing of local permits and other required documents with the appropriate agencies. Logistical challenges pose another external risk that this company will face. It will likely be too costly to have parts shipped from the companys current suppliers to the new overseas plant. Also, it is possible that the addition of this plant can lead to increased product shipping costs by not paying close attention to the exact geographic location of the orders. To mitigate these risks, the company should immediately begin working to form a new network of suppliers and other business-related partners that are located in Europe. It is possible that the same consultant firm that is hired to address the other risks can be helpful in this area as well. Additionally, the company will need to determine the exact location of each order that is placed, to ensure that shipping and other related expenses are minimized by shipping from the plant that is nearest to the products destination. Potential returns of procuring a new plant in Europe This is the primary financial analysis of the build (or direct expansion) alternative where Custom Snowboards expands into Europe on their own. Net present value and the internal rate of return methods will be used in this analysis to determine if this alternative is a viable option. The net present value of a project is essentially a measure of a projects profitability in dollars. This is an important measure because the net present value represents how much money, at the present rate, a project will make for the company. If a project has a positive net present value, then it should be accepted it will be a profitable venture. If a project has a negative net present value, then it should be rejected as it will be unprofitable venture. For this build option, there is a positive net present value of $80,899, meaning that this option should be accepted as it would be a profitable venture for the company. The internal rate of return is the point at which the projects cash flows equal the projects costs, meaning the NPV is zero. This is also known as the expected rate of return for the project. This internal rate of return is the compared to the required rate of return, also known as the

hurdle rate, which is the rate that management has determined as the minimum rate of return required for the project to be accepted. This is the cost of capital required for the project to be profitable. This is an important measure because it determines whether or not the project will make money. If the internal rate of return falls below this hurdle rate, the project should not be accepted because it will not make enough money to cover the cost of capital required for the project. If the internal rate of return is above this hurdle rate, the project will make money. The more the internal rate of return is above the hurdle rate, the more money the project will make. In analyzing this option, the project goal is to exceed the hurdle rate of 10%, which management has set for capital budgeting and expansion decisions. Meeting this goal is important because anything above this goal of 10% will make money for the company. For this project, the internal rate of return has been calculated at 12.1%, making this option come in 2.1% above the hurdle rate. This means that this project has met its goal and should be accepted because it will make money for the company. Recommendation of the best option for expanding operations in Europe There are three options to be considered for expanding operations in Europe. These three options are building a new facility which also has a lease option, merging with European Snowfun which is an already established snowboard company, or acquiring European Snowfun by purchasing the company outright. The build option is a profitable venture for the company as the analysis shows that this project has a net present value of over $80,000 and its internal rate of return is 2.1% above the cost of capital, meaning that this option will return a profit for the company. This is a viable option because it will make money for the company and will also increase the companys assets. However, this option cannot happen without the incurring long-term debt or selling shares of common stock, both of which affect the owners financial leverage. It also likely involves the added expense of property taxes on the new facility but also comes with an income tax advantage in the form of depreciation. The build option does contain an additional financing option of a sales-leaseback. The lease option is the best alternative for preserving working capital because it only requires cash outflows over the 5-year period of $653,355 which is $156,054 less than the buy option. This means that less cash is spent and more working capital is retained or preserved. The buy option requires cash outflows over the 5-year period of $809,409, which spends more cash than the lease option, thus retaining or preserving less working capital. The excess capital preserved by choosing the lease option will can be used for other expenses concerning the expansion such as the $200,000 of extra working capital needed for start-up operations, such as the purchase of equipment and other expenses that will be incurred in stocking and staffing the new plant. This lease option will likely not involve the added expense of property taxes and should have some income tax advantages in the form of lease payment percentage deductions.

Another option for expansion into the European market is to merge with European Snowfun, an already-established snowboard manufacturing company in Europe. This merger involves a stock swap, with the shareholders of European Snowfun receiving one share of Custom Snowboard stock for each three shares they hold at the time of the merger. This is not a good option for the Custom Snowboards current stockholders because it drops their earnings by .06 per share from .98 per share to .92 per share. The addition of shareholders with the stock swap also dilutes the shares owned by Custom Snowboards stockholders, which means that their proportional interest in the company will be less than before the merger. This would be a great deal for the stockholders of European Snowfun as their shares increase from .27 per share to .98 per share. The positive points to this merger are that European Snowfun already has an established facility, an established customer base, and an established workforce that is experienced in production similar to that of Custom Snowboards. However, European Snowfuns product is less durable which may lead to customer service issues. The last option is to acquire, or buy outright, European Snowfun. When considering the acquisition, the net present value of European Snowfuns projected cash flows over the next five years of $732,522 is compared to European Snowfuns offer price for the company of $720,000. This sales price is $12,522 below the net present value of the companys projected 5-year cash flows, meaning that this is a good deal for Custom Snowboards as it would cost less than the money could be making elsewhere and it would increase the overall value of the company. The positive points to this acquisition are the same as with the merger in that European Snowfun already has an established facility, an established customer base, and an established workforce that is experienced in production similar to that of Custom Snowboards. However, as with the merger, European Snowfuns product is less durable which may lead to customer service issues. My recommendation for the best option for expanding operations in Europe is the build option with the sales-leaseback. This option preserves the most working capital for the company to use to cover expenses connected with starting up operations. It also does not have the added property tax expenses that come with the straight purchase option and could have additional income tax advantages. This option was chosen over the acquisition of European Snowfun because, although there is already an established facility, workforce, and customer base with this company, they also have quality issues with their products which could inflict long-term, irreversible damage on the reputation of Custom Snowboards. I think it would be better for Custom Snowboards to enter the market as a new company and let its products speak for themselves. Eventually, Custom Snowboards will be able to dominate the market as their products will be far superior to those of European Snowfun. Financing recommendation for chosen expansion option An analysis was performed to choose the optimal capital structure to fund the European build option with the sales-leaseback. Below is an analysis of the capital structure options using

the EBIT (earnings before income tax) numbers from the European forecast for years 15 through 19, along with a recommendation for the approach that will best maximize shareholder return. Securing the capital using 100% common stock gave the highest average income return for the 5-year period of $121,332 but the lowest average earnings per share return of .17. This form of equity financing is not desirable because it does not provide the greatest return to the shareholders. Securing the capital using the 30% long-term debt/70% common stock option gives the second to highest average income return for the 5-year period of $106,144 but gives the second to lowest average earnings per share return of .19 per share. This combination of long-term debt financing and equity financing is not desirable because it does not provide the greatest return to the shareholders. Securing the capital using the 80% long-term debt/20% common stock option gives the second lowest average income return for the 5-year period of $80,832, but gives the second to highest average earnings per share return of .27 per share. This combination of long-term debt financing and equity financing is not desirable because it does not provide the greatest return to the shareholders. This analysis shows that the most favorable option is the long-term debt option because it nets the highest average earnings per share at .31 per share for the 5-year analysis period. While this option gives the lowest average income return at $61,279, it is the option that I recommend because it provides the greatest return to the shareholders.