Relationship with Hampton Machine Tool Company

Mr. Cowins, Hampton's President, was known by the bank's management well, and is widely-respected by the business community. Hampton kept ample cash balances at the St. Louis National Bank. Mr. Cowins also sent Hampton's financial statements to the bank regularly. Hampton's market shares also improved, and it has survived the crisis in the mid-1970s. However, during the 10 years prior to December 1978, Hampton had no debt in its balance sheet. The company's debt ratio (57. 03%) increased despite the decrease in accruals (excluding taxes payable), due to the increase in accounts payable, taxes payable and customer advances.

This is not necessarily bad, since firstly, the company does not have long-term liabilities, secondly, because the company has become relatively more liquid based on the analysis above, and lastly, it has increased financial leverage. The times interest earned ratio has fallen slightly, attributable to lower earnings before interest and taxes from the decrease in sales. From the debt ratio, it could be inferred that the company's stockholders owns 42.

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97% of company assets. As seen in Hampton's Balance Sheet, most of its assets are current assets.

Given that the debt of Hampton is a short-term one, Hampton seems to have sufficient current assets which could be used as a collateral or security for its debt. The bank could choose Hampton's receivables or inventory as a security for the debt. Hampton's inventory is more than sufficient to cover the $1,350,000 debt in cases of non-payment. However, Hampton's inventory is mostly composed of specialized items, as these are usually made to order.

It isn't also marketable, as Hampton's inventory is mostly raw materials and goods-in-process.

Thus, Hampton's inventory is not desirable collateral. On the other hand, Hampton's receivables could be used as collateral, as Hampton's customer segments are the military aircraft manufacturers and automobile manufacturers. However, Hampton's receivable ($684,000) is just about half of the $1,350,000 that Hampton wants to borrow. Furthermore, given the assumption that receivables would be collected in full the following month, Hampton will never agree to pledge or factor its receivables, since it will be costly for Hampton.

Hampton's debt relative to its equity is slightly larger. Hampton stockholders own about half (42. 97%) of the company's assets, which is quite acceptable. Since significant personal financial risks in the part of stockholders are present, the bank would be assured that the management would responsibly manage the company. Thus, Hampton would pass the Capital criterion. Hampton is rather untested if it is responsible in meeting its obligations, as it had no debt prior to December 1978. However, Mr. Cowins' seems to be worthy of the loan, as his character is respectable.

He diligently complied with the requirements the bank gave him. And he has a good reputation. Meanwhile, the conditions for Hampton seem favorable. The economic conditions, if they will continue, would enable Hampton to completely recover. As for internal conditions, one root cause of Hampton's free cash flow and turnover problems is the company's inventory level, which doubled from its 1978 level. This is due to increases in raw material purchases and delays in shipping contributing to increases in goods in process.

During July and August, the company purchased excess raw materials, and it also paid off commissions payable to its 3 sales people. However, Hampton's inventory level is expected to normalize during the next months. The problems mentioned above seem temporary, as the company will reduce its purchases, expenses (except interest expense), and investments in inventory for the succeeding months. The new equipment would also maintain, if not increase, Hampton's production efficiency, and could aid Hampton in its goal of shipping more products, thus, more sales, if their forecasts would turn out to be accurate.

Furthermore, based on the pro-forma statements and ratios under alternatives D and E, it turns out that the liquidity, activity, profitability, and free cash flow would significantly improve, while the debt ratio would be lower. But then, these effects will materialize only if no negative fortuitous event occurs. The most critical criterion is Capacity to pay. Although Hampton seems to be getting more liquid, it doesn't necessarily mean that Hampton could easily pay its short-term obligations, since a bulk of its current assets are specialized, not easily marketable inventories.

Hampton became more profitable, and its operating cash flow increased, which implies that Hampton has a good chance of meeting its obligations from its operations alone. However, the operation during the months July and August was unimpressive (though these months contributed to increases in profitability ratios despite the decrease in net income), as the company earned less net income and became less inefficient with its asset management.

But taking a closer look at Hampton's cash flow management, its free cash flow, which is the amount available to creditors and stockholders, fell sharply from its 1978 level of $2,025,120 to $161,520, a reduction of $1,863,600. The company's asset turnover also worsened, and its inventory turnover ratio during July and August were terrible. Thus, Hampton's capacity to pay its debt without external financing as of the moment is doubtful. But as mentioned beforehand, the conditions seem favorable to Hampton.

Thus, if actual sales would be near the forecasted amounts, Hampton would need less external financing to settle its obligations with the bank, and thus, it would have a greater capacity to pay. But Hampton's capacity to pay would also depend on the terms of the obligation to be given to them. As mentioned above, if the bank extends the $ 1 Million debt (payable on December 31, 1979) and reject $350,000 loan, or if the bank extends the $1 Million debt (payable on December 31, 1979), and grants $350,000 loan (payable on January 31, 1980), the company would be able to meet its obligations.

This shows that Hampton has no problem in fulfilling the $1 million loan; its problem is the payment of the $350,000 loan. As shown by Exhibits A and B, the company has no capacity to pay both debts on December 31. However, the company would be able to pay the $350,000 loan on January 31, 1980, due to the increase in sales. Hampton's most feasible collateral would be its receivables, as its inventory is specialized and isn't easily marketable. However, the receivable as of August is only half of the debt requested by Hampton.

Furthermore, Hampton would probably not agree to pledge or factor its receivables (given the assumptions abovementioned), as it would lead to less cash inflows to the company. Moreover, collateral is unnecessary, since the company would be able to meet its obligations in the both of the feasible proposals discussed above. Hampton has passed the 5 C's of Credit. The problem is determining which among the feasible alternatives the bank should undertake. As shown in Exhibits D and E, the latter proposal yields larger net cash inflow. However, the $350,000 loan could be invested to have larger yield.

But since the prevailing rate of market interest was not given, and since interest rates for short-term loans are generally larger than interest rates for short-term investments and cash equivalents, it would be reasonable to assume that the returns from lending to Hampton the $350,000 would be greater than investing in short-term investments.

Furthermore, the company would be more apt to face deviations from forecasted sales (esp. lower actual sales) under alternative E than in alternative D. Under alternative E (refer to Exhibit E2), the company would be able to pay both debts unless actual sales on the average drop 13.95% from the forecasted sales. Under alternative D (refer to Exhibit D2), the company would be able to pay the $1,000,000 loan unless actual sales on the average drop 0. 66% from forecasted sales.

The actual deviations from January to August range from -48. 72% to 71. 79%, with an average of 22. 66% (27. 11% if total forecasted and actual sales are used). These figures are closer to the allowable limit under alternative E. Thus, it seems better for the bank to lend an additional $350,000 to Hampton, payable on January 1980. However, those mentioned above are not the only alternatives possible.