Case #68

Financial Analysis and Forecasting Sweet Dreams Incorporated

Summary of Case
Sweet Dreams Incorporated (SDI) is mattresses and box springs manufacturer in
southeastern part of the US. SDIs financial problems began with the recession of the early
1990s. In 1994, under pressure of low sales, inelastic demand, and increased inventories, SDI
decided to relax its credit standards and expand its fixed assets funded by taking long-term and
short-term loans from the First International Bank. These actions bogged down the company into
low sales, large inventory, and high COGS. Having a need to finance its rising inventories,
accounts receivable, and having insufficient funds to cover planned asset expansion, SDI began to
delay its payments to the First International Bank, its loan supplier.
Ingrid Diaz, vice president of First International Bank gave an opportunity for SDI to
explain current financial situation and to show the bank a tactical plan to recover stable financial
position.

Question 1
Complete the 1995 columns of Tables 3 through 6, disregarding for now the projected data in the
1996 and 1997 columns. If you are using the spreadsheet model, use it to complete the tables. Be
sure you understand all the numbers, as it would be embarrassing (and harmful to your career) if
you were asked how you got a particular number and you could not give a meaningful response.
Response:

Case #68

Andrii Korchuk & Hilary Taube

Page 1

Table 3: Common Size Balance Sheets:

1993

1994

1995

14.14%
28.43%
33.17%

7.72%
23.93%
48.44%

4.99%
29.31%
50.14%

75.74%

80.09%

84.44%

29.34%
-5.08%

26.11%
-6.20%

22.24%
-6.67%

24.26%

19.91%

15.56%

100.00%

100.00%

100.00%

5.49%
11.90%
5.74%

6.89%
13.68%
6.50%

17.69%
19.44%
7.31%

23.13%

27.08%

44.43%

10.97%
4.63%

14.43%
3.61%

10.80%
2.38%

Long-term debt

15.60%

18.04%

13.18%

Total liabilities

38.73%

45.12%

57.62%

Common stock
Retained earnings

38.12%
23.15%

29.97%
24.90%

22.43%
19.95%

Total equity

61.27%

54.88%

42.38%

Total liabilities
and equity

100.00%

100.00%

100.00%

ASSETS
Cash and marketable
securities
Accounts receivable
Inventory
Current assets
Land, buildings, plant,
and equipment
Accum. depreciation
Net fixed assets
Total assets

LIABILITIES AND EQUITY

Short-term bank loans
Accounts payable
Accruals
Current liabilities
Long-term bank loans
Mortgage

Case #68

Andrii Korchuk & Hilary Taube

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Table 4: Common Size Income Statements:

1993
Net sales
Cost of goods sold

1994

1995

100.00%
81.15%

100.00%
82.18%

100.00%
85.16%

18.85%

17.82%

14.84%

6.59%
0.92%
1.10%

8.11%
0.88%
2.00%

8.50%
1.02%
2.53%

8.61%

11.00%

12.05%

10.24%

6.82%

2.79%

0.15%
0.34%
0.13%

0.23%
0.52%
0.12%

0.75%
0.49%
0.10%

0.61%

0.87%

1.34%

Before-tax earnings
Taxes

9.63%
3.85%

5.95%
2.38%

1.46%
0.58%

Net income

5.78%

3.57%

0.87%

Dividends on stock

1.44%

0.89%

0.22%

Additions to
retained earnings

4.33%

2.68%

0.66%

Gross profit
Admin and selling exp
Depreciation
Miscellaneous expenses
Total operating exp
EBIT
Interest on ST loans
Interest on LT loans
Interest on mortgage
Total interest

Case #68

Andrii Korchuk & Hilary Taube

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Table 5: Statements of Cash Flows:

1994
CASH FLOW FROM OPERATIONS:
Sales
Increase in receivables
Cash sales
Cost of goods sold
Increase in inventories
Increase in accts payable
Increase in accruals
Cash cost of goods
Cash margin
Admin and selling exp
Miscellaneous expenses
Taxes
Net CF from operations
CF FROM FIXED ASSET INVESTMENT:
Investment in fixed assets
CF FROM FINANCING ACTIVITIES:
Increase in short-term debt
Increase in long-term debt
Repayment of mortgage
Interest expense
Common dividends
Net CF from fin activ.
Increase (decrease) in cash
and marketable securities

Case #68

1995

Pro Forma
1996

Pro Forma
1997

$281,597
(1,770)

$300,351
(17,145)

$330,386
14,722

$371,684
(3,671)

$279,827

$283,206

$345,108

$368,013

(231,424)
(25,176)
4,868
2,236

(255,775)
(20,882)
13,831
3,680

(274,220)
25,566
(5,848)
1,100

(297,347)
(4,205)
2,924
1,512

($249,496)

($259,146)

($253,403)

($297,116)

$30,331

$24,060

$91,705

$70,897

(22,844)
(5,634)
(6,704)

(25,530)
(7,599)
(1,750)

(26,431)
(5,947)
(6,338)

(27,876)
(5,204)
(12,926)

($4,851)

($10,819)

$52,990

$24,891

($3,421)

($4,057)

($9,500)

$2,903
6,536
(32)
(2,448)
(2,514)

$18,847
0
(484)
(4,011)
(656)

$9,500
0
(445)
(4,783)
0

$0
0
(472)
(4,926)
0

$4,445

$13,696

$4,272

($5,398)

($3,827)

($1,180)

$47,762

$19,494

Andrii Korchuk & Hilary Taube

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$0

Table 6: Historical and Pro Forma Ratio Analysis:

LIQUIDITY RATIOS:
Current ratio
Quick ratio

1993

1994

1995

3.27
1.84

2.96
1.17

1.90
0.77

Industry
Average
2.25
1.20

LEVERAGE RATIOS:
Debt ratio
TIE coverage

38.73%
16.69

45.12%
7.85

57.62%
2.09

50.00%
7.70

ASSET MGT RATIOS:

Inv turn, cost
Inv turn, sale
FA turnover
TA turnover
DSO (ACP)

7.17
8.83
12.07
2.93
34.95

4.24
5.16
12.56
2.50
34.45

3.39
3.98
12.83
2.00
52.85

5.50
7.00
12.00
3.00
32.00

PROFITABILITY RATIOS:
Profit margin
Gross PM
Return on TA
ROE

5.78%
18.85%
16.92%
27.62%

3.57%
17.82%
8.93%
16.27%

0.87%
14.84%
1.75%
4.12%

3.50%
18.00%
10.50%
21.00%

OTHER RATIOS:
Altman Z score
Payout ratio

25.00%

24.94%

24.66%

20.00%

Question 2
On the basis of information in the case and on the results of your calculations in Question 1, list
SDIs strengths and weaknesses. In essence, you should look at the common size statements and
each group of key ratios (for example, the liquidity ratios) and see what those ratios indicate
about the companys operations and financial condition. As a part of your answer, use the
extended DuPont equation to highlight the key relationship.
Response:
Common-Size Balance Sheet
A closer look at the common-size balance sheet shows that The cash and marketable
securities percentage of total assets decreased every year while the inventory percentage grew.
These changes shows that the company is bring in less cash from sales, but buying more
inventory. The short term loans percentage of total liabilities and equity slightly increased from
1993 to 1994, but in 1995 the percentage of total liabilities jumped to 17.69%. Accordingly,
accounts payable and accruals were steadily rising. Long-term loans decreased in 1995 except for

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Andrii Korchuk & Hilary Taube

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a jump in 1994, and the mortgage percentage was also decreasing (the same trend was observed
with mortgage percentage.) This shows that the company was relying less on long-term liabilities
and more on short-term liabilities. It may be hard the company to sustain more growth in shortterm liabilities unless the company can garner more sales.
Common Size Income Statement
In the time of crisis, a lot of companies try to downsize and cut expenses in order to
survive, expand their production capacities in order to get economies of scales, or change credit
policy in order to increase sales. After relaxing its credit policy, SDIs inventories and receivables
piled up to a level where company was compelled to take additional long-term and short-term
loans that were still not sufficient to cover mentioned above growing assets expansion, but
drastically decreased companys net income. Another trend in the common size income
statements was growing COGS. There are two reasons that could impact growing COGS in 19941995: first, relaxed credit policy; and second, increased inventory. Moreover, in parallel with
increased COGS, operating expenses negatively impacted EBIT decreasing it to 2.79, in 1995.
All of the mentioned above expenses together with increased interest on short-term loans in 1994
shrunk companys net income and earnings per share to the record-breaking 0.87% and 0.38%.
Cash Flow Statements (1994-1995)
In 1994 and 1995 there is company faced a decrease in cash and marketable securities.
This shows that the company SDI is running short on cash and could run into what can lead to
deeper financial difficulties in the future if this doesnt change. These negative cash flows are
mainly resulting from a negative cash flow from operations. This means that the company is not
bringing in enough cash to finance its cash expenditures. Also the company bought fixed assets in
this period which caused decrease in cash. Even though there was an increase in short-term debt
financing in 1995, the net cash flow was still negative showing that the problem wasnt in the
amount of financing the company received, but in the amount of money the company brought it.
Liquidity Ratios
In the period of 1993-1995, SDI has a negative trend in current ratio which lowers to 1.90
compared to industrys 2.25, in 1995. From the investors point of view, current ratio should not
be lower than industry average, because it indicates probability that company might be in
financial difficulty. One of the indicators of company having financial difficulty is an effort to
prolong payments of accounts payable while increasing its borrowing. This is the scenario SDI
faces because it changed its credit policy, decreased prices, and took additional short-term and
long-term loans in 1994-1995. The company did not receive sufficient level of sales to cover its
short-term obligations, which resulted in deterioration of SDIs short-term solvency.

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Andrii Korchuk & Hilary Taube

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The quick ratio or acid test ratio substantially decreased in period of 1993-1995, being
drastically lower than industry average, 0.77 to 1.20. A reason for such a decrease was sharply
increased inventories in 1994-1995. Increased level of production and stimulated sales by new
credit policy did not bring expected effect in sales resulting in even more increased inventories.
Being the least liquid asset, increased inventory of SDI is one of the reasons in SDIs solvency
problem.
Leverage Ratios
The debt ratio shows us that the company has a growing percentage of assets being
funded by liabilities. This means a greater amount of money being used to buy assets is coming
from liabilities. This is a weakness for the company because it shows that there isnt as a large
cushion against losses for creditors in a case the company is liquidated company liquidation..
The Times Interest Earned (TIE) ratio for SDI is large in 1993 but is rabidly descending
so that in 1995, the income for the year will only cover the interest 2.09 times (compared to 16.69
times in 1993). This shows that SDI may have difficulty paying its interest expense if the
company continues to head in its current direction.
Asset Management Ratios
The inventory turnover ratios (both COGS and sales versions) show that while the ratio is
high in 1993 it declines to below the industry average by 1995. This shows that even with the
reductions of its credit standards, SDI is turning over its inventory only 3.39 times (using COGS)
and 3.98 times (using sales) in a year. SDI is not selling and restocking its inventory as fast as it
has in previous years, which shows a possible trouble area of old inventory or lack of adequate
sales growth.
The fixed asset turnover ratio of SDI has changed little from 1993 to 1995 and is close to
the industry average. This shows SDI has about the right amount of fixed assets as compared to
other firms in the industry. SDI is using its fixed assets effectively as compared to the industry.
The total asset turnover ratio is decreasing as compared to the industry average. This
shows that the company is not generating a sufficient volume of business given its total asset
investment. This shows that either the company is not producing enough sales given it investment
in assets, or that the company has too many assets for its level of sales.
The Days Sales Outstanding (DSO) ratio shows while in 1993 and 1994 the DSO stayed
basically the same, the ratio dramatically jumped to 52.85 days in 1995. This shows that the rate
at which customers are paying back their loans is getting slower and a customer account is on
average staying unpaid for about 53 days. This is above the industry average of 32 days showing

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Andrii Korchuk & Hilary Taube

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that the company needs to reign in its credit standards and collections on accounts receivable to
improve the companys chances of survival.

Profitability Ratios
Net profit margin of SDI has a negative trend in 1993-1995 lowered to 0.87 in 1995 and
compared to industrys 3.5. In order to find out the reasons for low net profit margin, we should
break income statement into smaller parts to identify the sources of low profitability. Common
Size Income Statement indicates increased of (delete) COGS from 81.15% in 1993 to 85.16% in
1995. Accordingly, Increased COGS impacted gross profit margin that increased to 14.84
compared to industrys 18.00. As well as gross profit margin, operating profit margin has a
negative trend in the mentioned above period due to the increased administrative, selling, and
miscellaneous expenses.
The companys return on total assets, and return on common equity behaved much as its
net profit margin did over the 1993-1995 period. The SDI faced a slow increase of sales in the
period of 1993-1995, which was insufficient for SDIs planned asset expansion. This resulted in
higher interest expenses on short and long-term loans. Decreased earnings available for common
stockholders indicate that company did not perform quite well.

Question 3
Recognizing that you might want to revise your opinion later, does it appear, based on your
analysis of historical data, that the bank should lend the requested money to SDI? In other
words, if you were working for the bank, would you recommend that it meet SDIs request and
increase the line of credit? Explain.
Response:
Because of the historical data in the common-size income statements, and (delete)
balance sheets, the cash flow statements, and the ratio analysis, we would not recommend that the
(option to delete) bank to lend more money to SDI. SDIs financial data shows that they are (the
company) currently having a hard time paying off the loans they have, so financing the company
more would be risky ( so financing of the company would be more risky) and detrimental to the
bank. Most of the ratios show a downward trend as(delete) compared to the industry average
showing the high possibility that the company may never pay back the loans it already has. Thus
the bank should not increase SDIs line of credit.

Question 4

Case #68

Andrii Korchuk & Hilary Taube

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Now complete the tables to develop pro forma financial statements for the 1996 and 1997. In
making these calculations, assume that the bank is willing to maintain the present credit lines and
to grant the requested additional $9,500,000 of short-term credit effective January 1, 1996. In
the analysis, take account of the amounts of inventory and accounts receivable that would be
carried if inventory utilization (based on the cost of goods sold) and days sales outstanding were
set at industry-average levels. Also, assume in your forecast that all of SDIs plans and
predictions concerning sales and expenses materialize, and that the firm pays no cash dividends
during the forecast period. Finally, in your calculations use the cash and marketable securities
account as the residual balancing figure.
Response:

Case #68

Andrii Korchuk & Hilary Taube

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Table 1: Historical and Pro Forma Balance Sheets:

ASSETS
Cash and marketable
securities
Accounts receivable
Inventory
Current assets
Land, buildings, plant,
and equipment
Accum. depreciation
Net fixed assets

1993

1994

1995

Pro Forma
1996

Pro Forma
1997

12,523
25,175
29,366

8,696
26,945
54,542

7,514
44,090
75,424

$55,276
29,368
49,858

$74,770
33,039
54,063

$67,064

$90,183

$127,028

$134,502

$161,871

25,975
(4,494)

29,396
(6,981)

33,453
(10,041)

42,953
(13,202)

42,953
(17,218)

$21,481

$22,415

$23,412

$29,751

$25,735

$88,545

$112,598

$150,440

$164,253

$187,606

1993
4,860
10,541
5,081

1994
7,763
15,409
7,317

1995
26,610
29,240
10,997

Pro Forma
1996
$36,110
23,392
12,097

Pro Forma
1997
36,110
26,316
13,609

$20,482

$30,489

$66,847

$71,599

$76,035

9,712
4,101

16,248
4,069

16,248
3,585

16,248
3,140

16,248
2,668

Long-term debt

$13,813

$20,317

$19,833

$19,388

$18,916

Total liabilities

$34,295

$50,806

$86,680

$90,987

$94,951

33,750
20,500

33,750
28,042

33,750
30,010

33,750
39,517

33,750
58,906

Total equity

$54,250

$61,792

$63,760

$73,267

$92,656

Total liabilities
and equity

$88,545

$112,598

$150,440

$164,253

$187,606

Total assets

LIABILITIES AND EQUITY

Short-term bank loans
Accounts payable
Accruals
Current liabilities
Long-term bank loans
Mortgage

Com stk (7,000,000 sh)

Retained earnings

Case #68

Andrii Korchuk & Hilary Taube

Page 10

Table 2: Historical and Pro Forma Income Statements:

1993

1994

1995

Pro Forma
1996

Pro Forma
1997

259,325
210,431

281,597
231,424

300,351
255,775

330,386
274,220

371,684
297,347

$48,894

$50,173

$44,576

$56,166

$74,337

17,089
2,391
2,854

22,844
2,487
5,634

25,530
3,060
7,599

26,431
3,161
5,947

27,876
4,016
5,204

$22,334

$30,965

$36,189

$35,538

$37,096

$26,560

$19,208

$8,387

$20,627

$37,241

389
874
328

660
1,462
326

2,262
1,462
287

3,069
1,462
251

3,250
1,462
213

$1,591

$2,448

$4,011

$4,783

$4,926

Before-tax earnings
Taxes

$24,969
9,988

$16,760
6,704

$4,376
1,750

$15,844
6,338

$32,315
12,926

Net income

$14,981

$10,056

$2,626

$9,507

$19,389

656

Net sales
Cost of goods sold
Gross profit
Admin and selling exp
Depreciation
Miscellaneous expenses
Total operating exp
EBIT
Interest on ST loans
Interest on LT loans
Interest on mortgage
Total interest

Dividends on stock

3745

Additions to
retained earnings
EPS (7,000,000 shares)

2514

$11,236

$7,542

$1,969

$9,507

$19,389

$2.14

$1.44

$0.38

$1.36

$2.77

Question 5
Assume SDI has determined that its optimal cash balance is 5 percent of sales, and that funds in
excess of this amount will be invested in marketable securities, which on average will earn 5
percent interest. Based on your forecasted financial statements, will SDI be able to invest in
marketable securities in 1996 and 1997? If so, how much excess funds will SDI have available
for investment in marketable securities? Do your financial forecasts reveal any developing
conditions that should be corrected?
Response:
Based on our forecasts, SDI will have funds to invest in marketable securities. In 1996
SDI will be able to invest $38,757 and in 1997 it will be able to invest $56,185 in marketable
securities.

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One potential problem in the long-term is the companys inability to pay dividends on the
common stock. In the short-run, investors will probably understand the lack of payment because
of the crisis the company is facing. But if this trend no dividends continues in the long run,
especially if the company continues in upward profitability (together with companys growing
profitability), the investors may not be happy.

Question 6
On the basis of forecasts developed earlier, does it appear that SDI will be able to retire all of its
outstanding short-term loans by December 31, 1997? In answering this question, assume that the
firm will, if possible, repay the loans at a constant rate throughout the year. Therefore, on
average, the amount of the short-term loans outstanding will be half of the beginning-of-year
amount.
Response:
Even with the additional short-term loan of $9,500,000, the company will have enough
available cash (on top of the 5% required cash balance) to pay off the short-term loan balance by
December 31, 1997. If the company paid back the loan balance in equal installments so that half
of the beginning-of-year balance ($18,055) would be paid off in 1996, the other half would need
to be paid off at the same rate as the previous year so that the remaining balance would be paid by
December 31, 1997.

Question 7
If the bank decides to withdraw the entire line of credit and to demand immediate repayment of
the two existing loans (the short-term and the long-term loans) extended to SDI, what alternatives
would be available to SDI?
Response:
If the bank decides to withdraw the entire line of credit, SDI has several alternatives. The
first alternative is to file Chapter 11 bankruptcy, the second alternative is to merger or be bought
by another company of the same industry, and the third alternative is to downsize the company by
curtailing the(delete) production capacity and laying off some employees.

Question 8
Under what circumstances might the validity of comparative ratio analysis be questionable?
Answer this question in general, not just for SDI, but use SDI data to illustrate your points.
Response:

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Andrii Korchuk & Hilary Taube

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If the crisis impacts the industry in general, the industry average ratios may not be an
effective benchmark to compare against. The industry average is affected by all the companies a
given industry, thus if the whole industry is experiencing a downturn the ratios may not valid. If a
company compared itself to the industry it may lead to a false sense of stability.
For example, in the case of the profit margin ratio, the industry average was 3.5% and
SDIs ratio for 1997 was 5.22%. This means that for every dollar the industry made it only
receives three cents in profit margin. This is not a good example what profit margin ratio a
healthy company (or industry) should have.

Question 11
On the basis of your analyses, do you think Ingrid should recommend that the bank extend
existing short and long-term loans and grant the additional $9,500,000 loan, or should she
recommend that the bank demand immediate repayment of all existing loans? If she does
recommend continuing to support the company, what conditions (for example, collateral,
guarantees, or other safeguards) might the bank impose to help protect against losses should
SDIs plans go awry?
Response:

Based on our analyses, Ingrid should recommend that the bank extend existing
short and long-term loans and grant the additional $9,500,000 loan because the
profitability and cash flow of the company is on the rise. For example, there is an
increase in cash and marketable securities of $47,762 in 1996 and $19,494 in 1997 which
is substantially different from the negative cash flows in 1994 and 1995.
Whenever a financial institution is considering granting credit to a company it
pays attention to the five Cs of credit: character, capacity, capital, collateral, and
conditions. So Ingrid should also consider how trustworthy is SDIs management and
what is the history of the companys relationship with the bank.
Moreover Ingrid may require some conditions to the loan, such as assets,
as(delete) collateral, and/or guarantees on payment of the loan.

Case #68

Andrii Korchuk & Hilary Taube

Page 13