Play Time Toy Company

Maria Lorena Adum Deby Maritza Chung Xing Yanghao1

Financial Analysis
18/04/2011

Exchange student from HKUST

Introduction By switching from seasonal to level production, Jonathan King can adapt Play Time Toy Companys production to a more smooth production plan without causing significant up and down movements. At first, it seems to be a good idea because under a level production schedule there is no need to wait for clients to make orders. Idle time during slack seasons could be fully utilized to bring down the opportunity cost. Most importantly, there would be a considerable amount of savings from training temporary workers and repairing overloaded machines during peak seasons. However, risks under level production should not be ignored. As level production indicates, production occurs before real sales take place. If the company were to apply such policy, it should demonstrate enough confidence that all the products added to inventory during the low-sales season are to be fully digested when demand flourishes, that is in peak seasons. If this is not the case, there would be a serious issue of inventory hoarding, and the company could be facing liquidity crisis in no time. Also, the cost of storage needs to be taken into consideration, and if it is an influential figure, we should think twice whether to implement level production. Under seasonal production, in 1991 Play Time Toy Company would need around $6 million to support its operations (see Appendix 1). Mr. King assured that Bay Trust Company would be willing to extend a credit line of up to 1.9 million, this accounts for an approximate of one third of the credit needed. If Play Time Toy Company were to change its production plan, and if in order to do so it required a higher amount of credit, it may not be feasible to change it due to a limitation on credit. Comparison of Seasonal and Level Production Relevant financial reports have been generated under two kinds of assumptions, seasonal and level production. By comparing relatively the income statements, we find that level production would double the amount of net profit through a significant decline in COGS (cost of goods sold). Less maintenance cost of machines and overtime payment has brought down the COGS rate from 70% to an average of 65.16%. However, a storage cost of $100,000 has to be included in the operating cost of level production because of the accumulation of inventory, but this cost is not influential compared with the huge benefit of COGS savings. If we look closer into the DuPont analysis, under level production, ROS (return on sales) almost doubles, while an outstanding increase in ROA (return on assets) and ROE (return on equity) occurs. Meanwhile, turnover ratio stays the same with leverage ratio going down slightly from 1.50 to 1.40 (see Appendix 2). Level production also enlarges the asset scale brought by an expansive accumulation of inventory. The production level is supported by an increase in the amount of debt, although debt ratio relatively decreases. If the company were to follow seasonal production, an amount of $6 million would be needed; on the other hand, the pro forma balance sheet and the short term financial needs both show that if the company followed level production, the amount of credit needed would increase to an approximate of $18 million. That is, almost 3 times the credit needed under seasonal production and approximately 10 times the credit limitation set by Bay Trust Company. Such increase would not make negotiations easy for Play Time Toy

Company, and the company would have to look for other sources of financing. As the peak season arrives, so will the urgent need of credit to sustain operations in the company. Under level production, the amount of accounts receivable would increase significantly along with the need of credit during peak season. Accounts receivable would vary from a starting point of less than $1,000,000 to a sudden increase of more than $4,000,000. Play Time Toy Company would face the problem of collecting cash from its customers to pay back the debts and hold on its liquidity. Historical data indicates that customers would pay after 60 days, and the balance sheet of 1990 shows that the average collection time is even !/!!"# !,!"#!"# more, up to 127.28 days (!"# !"#$% = !,!"" = 127.28). If the company were to make no

improvement or any adjustment in its policies, it would soon face inventory hoarding plus the accumulation of accounts receivable, which would raise a liquidity issue (see Graph 1).
Graph 1: Inventory, Accounts Receivable and Cash under level production

Play Time Toy Company Financial Analysis Looking at the companys results, we can see that its profit margin varying from 4.35%, 1.19% to 3.28% respectively in 1988, 1989 and 1990 (see Appendix 2). Based on these positive figures we can conclude that the company is making profit, but not a steady one as 1989 shows a huge decline in profit margin. The condensed income statements show operating expenses growing steadily from 1988 to 1989 and 1989 to 1990, but sales vary remarkably. From 1988 to 1989 the incremental rate is 14.47%, while from 1989 to 1990 sales grows at 24.92%, a difference of more than 10% (see Appendix 2). Thus in this term we can say that sales uncertainty is causing an unpredictable movement of future profit. Through the analysis of historical data, we discovered that the average profit margin of the company is around 2.94%, while the SD (standard deviation) is 1.60%. The coefficient of variation generated from these two results by using SD divided by mean is 54.56%, which indicates that variation in sales is so large that it influences more than half of the companys profit margin. We can conclude that Play Time Toy Company faces a risk of market volatility that should not be ignored. The assumption of predictable and stable

demand under level production is contradicted by the financial situation of the company, where sales vary strongly. Whats more, according to the detailed descriptions of the plastic toys, there are a lot of negative factors that may threat the survival of companies in this industry. Low entry barriers and low technology involvement allow a big amount of competitors. Price war is likely to take place and product life is short with numerous fad products that can only be sold out within a restriction of several months. On the other side, demand for products fluctuates due to the temporal public affection towards them. Therefore, sales and profit margin are drawn to jump fiercely from year to year, and from this context, a level production plan would bring in fatal problem. Play Toy Company would get a severe strike if, say, the real seasonal demand of 1991 is much smaller than what has been projected. Then the company would face significant hoarding of inventory and low liquidity, putting its survival to the edge of bankruptcy. Bay Trust Company Mr. King should be aware that it is unlikely that Bay Trust Company will agree on a credit loan that can satisfy the needs of the change in the production plan to level production. As mentioned before, the total amount pended is too high compared with the credit limitation (18 million vs. 1.9 million). Also, judging from industrial background and the possible projection of Play Time, its operations would be confronted with severe liquidity problems due to the uncertainty of market demand and its inefficient collection of customer money. Recommendation Based on the analysis on the company, we can see that there is a tradeoff between higher return and liquidity. Seasonal production saves storage costs but implies higher production costs. However, since it is based on order-and-produce model, the production can be adjusted with more flexibility to changes in market demand, thus reducing the risk of inventory accumulation and increasing liquidity. Under seasonal production the amount of total credit needed for 1991 operations $6 million is significantly lower compared to the credit needed under level production 17 million. Therefore, it would be better for Play Time to continue with the current production plan. The specific attribution of toymanufacturing industry makes it arduous to implement the level production. Still, some modifications can be applied to increase the profitability of the company. First of all, Play Time Toy Company can classify its clients into several groups. For those with long-term solid business relationships, it is feasible to apply level production since the demand is very steady. However, for those new clients or orders of fad toys, it is better to continue implementing seasonal production. If Play Time Toy Company were to implement level production, it needs to invest in marketing to fight against market demand fluctuations, so that it can be more capable of selling out its inventories. In conclusion, it is not appropriate for Mr. King to switch the companys production plan to level production, at most, it just needs a partial adjustment to improve its ROA, but not a thorough change that can put the company at a higher risk position.