Executive summary
Toy World Inc was a company that manufactured plastic toys for children. Some of the company’s products included toy cars, rockets, satellites, and spaceships. David Dunton was responsible for the formation of Toy World, Inc in 1973 after the navy released him from service. Together with his assistant Jack McClintock, Dunton established Toy World Inc. Dunton owned 75% of the capital stock while McClintock owned 25%. To enhance the operation of the company Dunton served as the president and McClintock was the production manager. In 1991, Dunton retired due to health issues and McClintock became the president (Harvard Business School 1).
Toy World Inc experienced rapid growth after commencing its operation in 1973. By the year 1976, the company was already enjoying profits. Come 1993, the company sales had grown to about $8 million. In early 1994, the president considered adopting a level monthly production that would run through the year. Previously the company’s production had been highly seasonal but the president wanted to improve efficiency through level production (Harvard Business School 3).
In 1993, the company’s net profit had reached $ 270,000 and the president had estimated profits for the financial year 1994 to be $351, 000. The company’s costs incurred in the production of goods averaged 0.7 of the total sales. Management expected to maintain this proportion of cost in 1994 seasonal production activities. Moreover, the company expected to incur even operating expenses throughout each month under both seasonal and level production.
The cash balance by the end of 1993 was $ 200,000 and the president wanted to expand the operation activities. However, expanding the operational activities of the company would strain the working capital of the company. The company had a loan of $752, 000 by the end of 1993. In 1994, the president was willing to increase the credit to $2 million. In 1994, the profits were declining due to overtime premium among other factors.
Moreover, the production activities of the company were highly seasonal. This left the machinery idle for long periods. Hoffman, a new employee hired by McClintock, encouraged the president to adopt the monthly level production. He believed that adopting the monthly level of production would ensure that the company reduced the overtime costs. However, a portion of the costs saved would still be used on storage costs.
Introduction
Financial models are mathematical tools used by financial analysts to calculate forecasts and analyze financial data. Financial models, therefore, range in complexity. In this light of events, financial models can be simple formulas that analyze financial data or complex computer programs that perform more than one analysis at a time. This article uses simple financial models to determine whether the challenges facing Toy world Inc have any significant economic implications to the operations of the company. The management of Toy world Inc can use the following financial ratios to analyze their situation and determine the most appropriate course of action.
Financial Model
Current Debt Ratio
This is an excellent financial diagnostic tool. The managers of Toy world Inc can use the current debt ratio to measure the ability of the company to pay its debts in a specific financial period. For a company to show that it can pay its short-term creditors, the current debt ratio ought to be greater than one. Therefore, when the financial manager in Toy world Inc calculates this ratio, he should ensure that the ratio reflects a figure that will enhance the sustainability of the company.
In the transport industry, a current debt ratio that is below 1 is an acceptable range. However, in the retail and manufacturing industry financiers accept a current debt ratio that is greater than 1. However, this figure may only rise to 1.6 to ensure that the company capital is not tied in non-profitable ventures (Ehrhardt and Brigham 131). The general assumption used by many financial analysts is that in a business where the high inventory levels are normal the current ratio will be higher. A current debit ratio will enlighten the management on concepts of stocking and debt payment.
Profit Margin
The profit margin acts as a measure of how profitable a business venture can get. Management uses the profit margin to compare the internal performance and activities. Similarly, the president of Toy World may use this ratio to analyze the internal performance of the company. Therefore, the profit margin ratios can never be used to compare competing firms. This is because the use of the ratio is limited to internal use.
Moreover, competing firms operate under different environmental and market conditions Low-profit margins indicate that an entity has a small margin of safety. This means that a reduction in the sales of the company will lead to a decrease in the net revenue of the company. Information obtained on profit margin is useful to the management of Toy World Inc when determining the pricing strategies that the company would use in the next financial year (Ehrhardt and Brigham 56).
Asset Turnover Ratio
The asset turnover ratio is useful when showing the extend which a company utilizes its assets to increase revenue. Therefore, the asset turnover ratio is an important tool when evaluating the effectiveness and the efficiency of a company’s utilization of asset. Companies that exhibit high asset turnover ratio usually have higher sales than companies with a lower asset turnover ratio (Ehrhardt and Brigham 131).
Companies would generally prefer to have a higher asset turnover ratio. However, a higher asset turnover ratio does not necessarily indicate that a company is operating at a profit. To analyze the profitability of the company, financial analysts use a different type of ratio. Managers may utilize the asset turnover ratio to forecast future sales. If the management of Toy World Inc adopt the use of asset turnover ratio, issues on sales forecasting will be easier. Moreover, the president of the company will be able to determine the ability of the company to utilize all its assets in generating revenue (Ehrhardt and Brigham 131). The following table shows some calculated ratios that may be beneficial to the president of Toy World Company.
The current debt ratio of the company is three. This, according to some analysts is unacceptable since it means the company is trying some of its assets on non-profitable activities. The profit margin ratio of the company decreased between 1991 and 1992. This shows a decrease in profitability. In 1993, the margin ratio increased considerably showing an increase in profitability. The asset turnover ratio on the other hand shows that the company utilizes its assets well in generating revenues.
Proposed Solution
Toy World Inc is faced with several challenges. The major identifiable challenges include increasing costs, the hardship of incorporating a new production system, and declining profits. To solve these problems, the company has to determine the reason for the decline in profits. Moreover, the president has to come up with a means to incorporate the new production strategy. Lastly, the company will have to cut its costs to maintain profitability.
For management to take care of the challenge in production, they must adopt a relevant financial model. This model will enable the company to calculate different financial ratios of specific financial years. The financial ratios calculated, may enable the company to forecast sales (Hordes and McMann 200). For instance, the asset turnover ratio can be used to forecast sales. These sales forecasts may be useful in determining the number of toys the company can produce in a given month. In addition to this, the financial ratios incorporated in financial models enable the managers in the company to determine pricing levels.
The ability of a company to forecast pricing may enhance its competitive advantage (Herrold 63). For example, the case study states that the company’s competition occurs on two fronts: completion of the design and competition on the pricing. With this in mind, it is easier to visualize how knowledge on pricing can improve the competitive advantage of a Toy World Inc. Prior knowledge of price ensures that the company maintains a price that the competitors may not be able to offer. Therefore, the company becomes a better competitor in the industry.
Hoffman already suggested that the way to solve the problem of high costs would be to cut the overtime wages. He had therefore advised the manager to adopt the level production strategy. However, this is not the only method that the president can use in minimizing costs. Well-designed financial models provide useful information that is useful when a manager intends to cut costs. Asset turnover ratio can be used in the process of minimizing costs incurred by Toy World Inc. The knowledge of asset turnover educates the manager on the extent to which a company utilizes its assets to generate profit (Schornstein 40).
Toy World Inc leaves its machinery idle for seven months. This shows that the company is underutilizing its capital outlay. Moreover, during the idle period, the machinery requires servicing to ensure that it is usable. Careful planning can reduce the costs involved in servicing a non-operating company. In the case of Toy World, it is safe to assume that the storage costs are fixed up to a certain level. However, the company only produces the toys on a seasonal basis. Therefore, the costs of storage are sometimes incurred while the company is not in operation. The management can minimize these costs by utilizing the storage to generate profit.
Conclusion
Toy World Inc has accompanied that manufactured plastic toys for children. The company had been profitable for a given period. However, their profits are rapidly declining and the manager is considering the alternative option to maintain the profitability of the company. In this article, we have discussed the financial ratios that the president can use to determine whether the course of action he is taking is economically viable. Moreover, the article provides possible solutions to the challenges the company is facing.
Works Cited
Ehrhardt, Michael and Brigham, Eugene. Corporate Finance: A Focused Approach. New York: Wiley & Sons, 2005. Print.
Harvard Business School. “Toy World, Inc”. Harvard University Press 295.73 (1996): 1-6. Print.
Herrold, Claudia. “How to Carve a Pie.” Foundation News and Commentary, 41.4. (2000): 56-74. Print.
Hordes, Mark and McMann, Dean. “Alternative Models for Building Wealth.” The Professional Journal 25.2 (2000): 200-215. Print.
Schornstein, Sheri. “Who Do You Trust?” Association Management 52.11 (2000): 10-67. Print.