Financial Management

Toy World, Inc. Case Analysis

Final Report

Submitted By: Group 8, Division C

Monika Anand C005

Gagandeep Singh Bhatia C013

Arshiya Gupta C019

Prasoon Gupta C021

Sarang Modi C040

Raakesh Thakkar C061

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 Table of Contents
Sr. No. Title Page No.

1. Executive Summary 3

2. Company Background 3

3. Industry Background 3

4. Problem Statement 4

5. Questions & Solutions 5

Questions 1 5

Question 2 6

Question 3 6

Questions 4 7

6. Conclusion 9

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 Executive Summary

Toy World, Inc. is a toy manufacturing company since 1973. At the end of 1993, revenue and
profit came close to $8 million and $270 thousand respectively. Sales in the toy market are
seasonal, reaching peaks in the months of August through December, while remaining
relatively flat during the remaining months of the year. This seasonality has affected the
company’s production schedule. During this off season, inventory is low, skilled workers are
underutilized, and machinery is left idle and when the busy season finally arrives, Toy World
is forced to hire more workers, pay additional overtime wages, and operate at full capacity.
Dan Hoffman sees inefficiencies in this schedule and proposes a level production plan that
would eliminate overtime wages and fully utilize skilled workers. Under level inventory, toys
would be manufactured evenly every month i.e. uniform distribution through January to
December. Also, the company must also take on additional loans to compensate for the high
inventory levels for working capital financing. In an industry that has relatively low capital
requirements, Hoffman’s strategy may increase overall profitability, but may affect the
company’s liquidity. Hence, we through this project need to find the Inventory schedule and
Pro Forma Cash Flow Statement for 1994.

Company Background

Toy World, Inc. was founded in 1973 by David Dunton who was a naval officer. His assistant
Jack McClintock established Toy World Inc. Each having a capital Stock in the ratio of 3:1. Jack
served as a production manager and Mr. Dunton was the President. After Mr. Dunton’s health
deteriorated he retired from the company and handed over charge to Jack. To find a new
Production Manager- he hired Dan Hoffman who was an MBA graduate and had prior
experience in the field.

Industry Background

The manufacture of plastic toys was a highly competitive business. The industry was
populated by a large number of companies, many of which were short on capital and

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management talent. Since capital requirements were not large and the technology was
relatively simple, it was easy for new competitors to enter the industry. On the other hand,
design and price competition was fierce, resulting in short product lives and a relatively high
rate of company failures. A company was sometimes able to steal a march on the competition
by designing a popular new toy. Such items generally commanded very high margins until
competitors were able to offer a similar product.

Problem Statement

Toy World Inc.’s used to produce in response to customer orders. This meant only a small
fraction of capacity was needed to meet demand for the first seven months of the year
ordinarily, not more than 25%- 30% of manufacturing capacity was used at any one time
during this period. The first sizable orders for the Christmas business arrived around the
middle of August. From August to December the work force was greatly expanded and put on
overtime, and all equipment was used 16 hours a day. This resulted in huge overtime
premiums and increase in direct wages. For example- In 1993 overtime premiums were as
high as $185,000. Because of seasonal expansion and contraction, the company had problem
in recruiting and decreased profit margins. Therefore, the administration was planning to shift
to level production method – in which inventory is produced uniformly throughout the year.
This would significantly reduce overtime premiums and would result in direct wage saving.
However, the holding cost of inventory would spike. The Aim of project is to find out the
potential risks associated with the new method of Inventory Production and its benefits also.

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 Questions and Solutions

Q1. What factors could Mr. McClintock consider in deciding whether or not to adopt the
level production plan?

Mr. McClintock will need to look at the following factors while deciding whether to adopt the
level production plan –

 Finance: How much finance the transition will require and whether the company can
bear the brunt of the cost associated with the transition. This will depend upon how
Mr. McClintock perceives the safe limit he wants his company to see on the balance
sheet. If the cost of movement is so high which Mr. McClintock does not feel is safe,
he might decline the shift. However, if his assessment of the cost to return feels
favourable to him, he might be inclined toward the shift of production process.

 Credit Limit: The company has a credit limit of $2 Million. He will need to check
whether the current credit limit which they receive from banks is enough to cover this
shift or will they need an extension on their credit limit. Again, he will need to consider
whether it would be good to increase his credit limit. Also, will the bank be willing to
extend his credit limit. If he approves the shift but the bank refuses to extend the
credit limit, he will need to keep alternative sources of funds ready so that the project
is not delayed as delay will also eventually add to the cost.

 Risks: He will need to analyse the risks involved with level production plan. These are
not only financial risks but also operational risks like unused inventory or market risks
like fall of demand industry wide. He will need to see how these factors will fit in the
big picture.

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Q2. Estimate the net savings from level production?

Amount ($ ‘000)
Overtime Premiums 225
Other Direct Labor Savings 265
Net Savings before charges, losses and taxes 490
Increase in Interest Expense (99)
Reduction in Income from Marketable Securities (20)
Increase in Storage Costs (115)
Pre – Tax Savings 256
Taxes @ 34% (87)
Net Savings 169

 Hence, net savings will increase under level production.

 Detailed derivation in attached excel file.

Q3. Estimate the monthly pattern of funds required if the company adopts level production
instead of seasonal production?

Month Amount ($ ‘000)

January 0
February 0
March 118
April 769
May 1369
June 2055
July 2685
August 3320
September 3975
October 3139
November 2078
December 768

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 Q4. If you were the banker, how would you evaluate whether to extend the line of credit
required for shifting to level production plan?

The firm needs $4 Million in order to finance level production.

From the bank’s perspective, the firm is performance is healthy until now. Any disturbance
that could occur because of the change could be accommodated by the company. The bank
could waive of the inventory loses for one year and ask the company to repay it next year.

However, the change is going to increase the risk for the company. Inaccuracy in sales forecast
is directly going to affect the net income of the company and could end up wiping the savings
of the company.

As bankers, we would just have to trade off between profitability and liquidity. Although level
production would increase profitability, but it will affect the firm’s liquidity as well. Personally,
we feel that the bank should extend the line of credit. The company’s performance has been
good over the years telling that both the management and the company’s product are
reliable. There would be some short-term pain but in the long run, the company would be
able to turn around.

We would also look at the 5 C’s of Credit – Character, Capacity, Capital, Collateral and
Conditions.

 Character - Given the case is silent about the credit history of Toy World Inc., we are
taking cues from the company’s policy which states that “retire trade debt as it came
due”, which signifies good character of the management towards repaying its debt.
 Capacity - We need to measure our borrower’s ability to service the loans, for this we
calculate Interest Coverage Ratio.

Interest
Coverage Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total
Ratio

EBIT -168 -161 -154 -161 -161 -161 -154 356 433 537 588 180 975

Interest
9 4 4 4 9 14 19 24 28 33 27 19 194
Expenses

Interest
Coverage - - - -
-42.6 -17.2 -8.2 15.1 15.3 16.2 21.8 9.5 5.0
Ratio 18.1 44.5 36.0 11.6
(times)

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  Capital - Is the firm willing to raise additional capital from its shareholders to finance
its working capital requirement? This will help the banker to ascertain that there is
low default risk.
 Collateral - The firm’s willingness to attach its assets to its loan will further reduce the
risk to the lender. The line of credit provided to Toy World Inc. is a secured loan which
are attached to its inventory and accounts receivables. Given the firms projection, the
note payable balance of the firm is greater than the inventory and account
receivables. The credit requirement of Toy World, Inc. is around $4 million which is
lower than its collateral (accounts receivables and inventory), which is around $6
million.

Notes
Payable as a
percentage
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
of Inventory
&
Receivables

Notes
0 0 114 765 1366 2051 2681 3316 3971 3136 2074 764
payable, end

Inventory +
2110 1762 2240 2691 3123 3574 4033 5000 6025 5694 5194 3986
Receivables

Notes
Payable as a
% of 0% 0% 5% 28% 44% 57% 66% 66% 66% 55% 40% 19%
Inventory &
Receivables

 Conditions - The borrowers’ willingness to accept the terms and conditions of the
bank. The condition of the bank is to secure its loan by the firm’s inventory and
accounts receivables.

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 Conclusion
Though Toy World, Inc. was a profitable business, our analysis shows that it could benefit
greatly from level production schedule. Adjusting their business model to implement a level
production plan in 1994 as opposed to past seasonal production will result in a positive impact
on the company’s profitability but there will also be a negative impact on its liquidity. Also, in
order to implement these changes, Toy World, Inc. will need an extension on their credit limit
from the bank. If the company’s projections are accurate enough to avoid significant
inventory write offs and can obtain approval for an extension in the line of credit, transitioning
to a level production plan will greatly improve profitability and operational efficiency.