Question

Given Eric’s philosophy of just-in-time in meeting customer requirements, is he too accommodating in this inventory policies, and could this potentially lead to a cash-flow problem? Do you have any specific suggestions or recommendations, such as a loan covenant limiting inventory to a certain percentage of sales? Type your three- to four-sentence response below.

What is your assessment for receivables in terms of credit quality? In other words, how did Office Smart increase its market share—possibly by lowering credit standards? Would it be prudent to ask for detailed data on receivables for at least the top 10 customers? Type your three- to four-sentence response below.

What documentation will you require? Customary documentation includes monthly income statements, statements of cash flows, and balance sheets. In addition, you may wish to see data on forecast economic activity in the Connecticut–Massachusetts–Rhode Island area, student enrollment projections at area universities, tax returns for each year, and other information that supports the loan. Type your three- to four-sentence response below.

Which firm would be acceptable as an outside auditor? Is your bank going to be satisfied with a local accounting firm that may have Office Smart as an important client? Recall that Arthur Andersen was differential to Enron on its audit due to substantial consulting fees and the fear of losing that company as a client. Type your three- to four-sentence response below.

OFFICE SMART SELLS AND SERVICES office and telecommuni- cations equipment to businesses in the New Haven, CT, area, which includes Hartford, Wallingford, Waterbury, and Milford. The com- pany has a market reach into western Massachusetts, most of Connecticut (except for the southern part of Connecticut near Stamford), and Rhode Island. The CEO of the company is Eric Farland, who has been dealing with the local bank, Equitable Bank of New Haven (assume $250 million in assets). The bank is small in size and had a firm house limit to any one borrower of $200,000. However, Office Smart is growing and in need of short‐term work- ing capital financing in excess of $200,000; in fact, a $400,000 line of credit is being requested. You are a loan officer with the Connecticut Merchants Bank of Hartford, CT (assume $15 billion in assets). Office Smart went looking for a larger bank in its market area, and found some interest at your bank. This case presents the typical concerns as a small business transitions from a friendly, local bank to a more formal regional bank located nearby. These issues include requirements for the transfer of bank activity to the new lender, agreement on loan covenants and other restrictions, protection for the bank from the possible loss of the company’s leader, potential changes in the outside auditors, and other considerations. THE BUSINESS OF OFFICE SMART Office Smart has been enjoying increased market share on a consistent basis since the first decade of the 2000s. It aggressively doted on area businesses, offering excellent service at reasonable prices. The company was founded in 1975 and had survived a few recessions, and through its marketing efforts grew sales from a minuscule $300,000 in 1986 to an anticipated $6 million for fiscal year 2008. The fiscal year ends on December 31. See the accompanying exhibits for financial statements and significant ratios. The company began by selling office supplies and furniture, and became aware of the rapidly changing needs of businesses for communications sup- port including landlines, wireless telephones, mobile telecommuting, computer systems, fax machines, and various other services. The large communications companies are certainly willing to provide the comprehensive service packages but do not have the capacity to fully wire businesses and train employees on their various telecommunications and computer requirements. Office Smart has developed a reputation for quick responses to the inevi- table problems that can occur in businesses, including service, repair, backup systems, and even the outsourced operations of call centers. The company has also been working with area universities (Yale; the universities of Connecticut, New Haven, Hartford, and Massachusetts; and various colleges) and the State of Connecticut government. Because of the growing size of the business, manage- ment has been able to buy equipment and transportation vehicles in sufficiently large volumes to offer attractive prices to area businesses. The CEO of the company is a gregarious, friendly executive, Eric Farland, who inherited the business from his father, Ed Farland, a cautious, careful busi- nessman who passed away in 1982. Using his charm and attractive pricing, Eric convinced many of his customers that not only was the company competi- tive in its offerings but also it could deliver products on time or would provide a substantial discount for failure to do so. Eric had something of a just‐in‐time philosophy on behalf of his customers, maintaining extra inventory so that a systems problem could be diagnosed and resolved. Area businesses have become increasingly confident that Office Smart will be able to service their requirements literally overnight. In fact, it was a key to the company’s marketing strategy. Sales are invoiced on a net 30‐day basis.

In considering any new credit arrangement with a financial institution, Eric would prefer to sign a simple promissory note and not have any loan covenants, consistent with his prior arrangement with the New Haven bank. You have listened to his request but think loan covenants must be part of any lending arrangement. Your assignment includes the preparation of such covenants that should be included in the loan agreement. Additionally, you need to consider whether the working capital loan will require an annual cleanup (i.e., repayment in full for, say, 30 days), or if it will be a term loan, and if it is a term loan, for how long and with what, if any, amortization. You have already talked to a few of the company’s customers to verify the story presented by Farland. To summarize their report: “Office Smart delivers, pure and simple. We don’t get the runaround about slow deliveries, poor instal- lation or repair work, or inept service people. I don’t think Eric has ever failed to deliver on time to our locations. And he is a funny, delightful guy with whom we like to have drinks and laughs.” FINANCIAL ISSUES In your discussions with Eric, he has stressed that sales in 2008 will in all likelihood be a record year, reflecting a tremendous growth in market share and expectations of record numbers of systems installations and upgrades. Although the borrow- ings from his prior bank never quite reached $200,000, Eric is certain with these expanded sales forecasts that he will need a $400,000 working capital line of credit. In talking to Eric you were emphatic that it was critical to keep borrowings within the $400,000 limit, as your management was quite conservative and was not willing to see borrowers exceed their credit limits under any conditions. Pricing is open, but you—as the account officer—believe the prime rate plus 2 percent is appropriate. The company will provide you with unaudited quarterly financials, and year‐end financials will be audited by a local New Haven accounting firm. In assessing loan covenants that you would require, it may be quite helpful to project the revenues for fiscal 2008. You should consider what might be receiv- able and inventory levels, and the resulting borrowings. In talking to your credit department, one analyst noted concerns over the future value of inventory, not- ing that certain Office Smart technology could become obsolete and not salable at market rates due to new developments in computers and telecommunications. There are several questions that should be considered in the Office Smart case as you decide on the best approaches to doing business with Eric Farland.

	Office smart	Industry
Current ratio	1.52	2.1
Quick ratio	0.61	1.8
Debt ratio %	65.5	65.9
Inventory trunover	2.3	37.3
Receivables turnover	8.3	7.4
Asset turnover	2.5	3.2
Return on equity	92.1	78
Return on sales	12.7	8.4

Income Statemnet	2006	2007
Net sales	$4,725	5075
Costs of goods sold
Beginning Inventory	700	788
Purchases	2538	2713
Ending Invenotry	875	1050
Net Cost of Goods Sold	2,363	2450
Gross Profit	2363	2625
Operating expense	1400	1,444
Interest expense	88	105
Net income before taxes	875	1,076
income taxes	350	431
net income	525	645
Balance sheets
Cash	88	88
Accoutns recevable	525	612
Inventory	875	1,050
current assets	1488	1750
property, net	262	280
total assets	1750	2030

Answer 1

Answer 1:

The inventory turnover of Office Smart is poor 2.3 vis-a-vis 37.3 of the industry. This higher inventory is impacting its quick ratio and asset turnover ratio as well. In terms of value inventory is more than 50% of total asset value. Obsolescence risk and/or sudden reduction in prices of inventory will expose the company adversely to remain as going concern. Because of its, till successful, strategy of maintaining just in time philosophy for deliveries and meeting customer requirements, it is taking a huge risk of maintaining very high obsolescence prone inventory. Although this strategy has increased its market share and given better returns in terms of return on sales and return on equity (compared to industry), it is definitely is exposing itself to potential risk of obsolescence of inventory and potential future losses and cash flow issues. Its quick ratio is much lesser than the industry average which hints at possible cash flow issues it may face.

It will be prudent to ask for loan covenant limiting inventory to a certain percentage of sales requiring the company to look for similar arrangement (like it has for its own customers) from its suppliers as well. This will help the company to limit investment in inventory cutting down their working capital requirement without losing on sales.

Answer 2:

Receivable turnover of Office Smart is 8.3 vis-a-vis 7.4 of Industry. As such Ofiice Smart, compared to industry, is faring better in receivable management. Further, on 'return to sales' front also the company fares better than the industry. From the figures and information, it does not appear that Office Smart is using a strategy of lowering credit standards to increase sales/market shares. Rather than lowering credit standards, it is using strategy of being competitive in its offerings and delivering products on time (just‐in‐time philosophy) to increase market share.

However, the normal sales are invoiced on a net 30‐day basis. This ideally should have given a receivable turnover ratio of 12, had the company followed the credit policy strictly. I would ask for age analysis , details of receivables of top 10 customers and analysis bad debt write offs, if any to assess default risk and concentration risk.

Answer 3:

In addition to customary documentation which includes income statements, statements of cash flows, and balance sheets, I shall ask for :

Analysis of Inventory, agreements with suppliers, Expert Report on valuation, typical obsolescence period of majors stocks.

Sales Projections with necessary supporting documents,

Projected Income Statement,

Projected Balance sheet,

Projected cash flows,

Tax Returns

Answer 4:

The acceptable outside auditor has to be an Independent auditor. His/her independence should not be impaired as defined in relevant standards. The auditor should be unbiased, objective and his/her integrity unquestionable. His/her firm should be following quality control policies as required by relevant standards.