Merit Marine Corporation was one of the Omni Bank's customers. In the beginning of the 1985 Omni Bank's relationship manager Ginny Shields and a member of bank's corporate finance department Jeff Finch were considering how to expand bank's reputation for providing financial advisory services to the existing customer.

Merit Marine Corporation is exclusive Florida distributor of Olympus brand commercial and recreational marine products since January 1976. In addition to distribution function, Merit Marine Corporation runs one of the state’s largest marinas at its headquarters in Tampa.

Stated problem

Decline in sales during 1982-83 (due severe recession and high interest rates and oil prices) and difficulty in finding fixed-rate long term financing created problems in realizing of substantial investment plans of Merit Marine. The main stated problem is evaluation of three alternative programs and find out which one is most profitable for the bank and meets the requirements of Merit Marine.

In order to become the lead bank for the Merit Marine Corporation and maintain profitability of the relationship with Merit Marine, Omni Bank's officials were considering the following issues:

• How to find the loan alternative for Merit Marine Corporation that would create sustainable and safe profits for the bank and make the customer satisfied.
• How to change Merit Marine's existing floating rate loans to long term fixed-rate loan in order to maintain stability for the company
• If too much of Merit's debts was fixed for too long a period, the company would incur a prepayment penalty if cash flow was sufficient to reduce outstanding long term debt
• How permanent would be commercial paper based, floating rate debt, which Merit was going to have from its supplier- Olympus. If those funds became unavailable during the life of the swap, Merit Marine would have to find the swap with prime-based debt and would incur additional interest expense between prime rate and the commercial paper rate plus 50 basis points.

There were some other types of recreational facilities in the recreational market that can be substitutes of marine products. However, for commercial companies that were in marine industry and use waterways in providing their services, for the individuals who love water sports and for cruisers, there were not particular substitutes of commercial and recreational marine products.

There are some options for consumers to consider in making purchasing decisions. Switching cost is relatively high because of specifications in features of products that different producers offer and partly because of the brand loyalty. Consumer confidence is very important issue in this industry. Economic recession might hurt this industry harshly because marine products were partly recreational products.

Since market (outboard engine market) was characterized as oligopoly, entry to this industry was almost impossible. There were only a few companies that operated there. Entry for new possible competitors was very hard because that would require huge capital resources. On the other hand, the recreational boat industry was characterized as market with monopolistic competition. There were 20 national and regional manufactures, which were competing in this market. Entry was not easy too, because of capital consuming character of industry and a brand loyalty to the products.

The supplier was the Franchisee Company - Olympus, so Merit Marine was almost totally bounded with this supplier. Merit also sold gas and some accessories for boats, which the company purchased from different suppliers. Suppliers’ power (mainly Olympus's influential power) on Merit was high enough.

Industry competition was relatively high. Almost all of competitors were big established companies, so was Olympus. As it is characteristic for oligopoly markets companies had established market share. Competition among the market participants was not based on the sales price, but non-price competition was high (additional services, the brand name). As an exclusive distributor in Florida, Merit Marine was faced competition from the distributors of the other market participants, and partly from the regional recreational boat manufacturers.

The Marine Merit was the exclusive distributor of one of the biggest participants of the marine products industry. This was main strength of the firm. Another strength was the firms' location, Florida, which was one of biggest recreation centers in the country. The firm has also enough experience in this business.

There are some weaknesses of the firm. First, the activity of the company is capital consuming; it requires a lot of capital (keeping big warehouses, maintenance cost and etc.). Second, sales in this industry was mainly seasonal and cyclical, which hinders stabile flow of activities of the company. Third, Merit Marine Corporation was only Olympus's distributor, so Merit depended on Olympus. If a something-unfavorable situation happened in Olympus's business it would probably affect Merit Marine, too.

The firm was investing in fixed assets, which would give it opportunity to increase sales in the near future. Merit Marine had quite established image in the market, so it has chance to expand its own business (besides as Olympus's distributor), or even if its relationships with Olympus allow to become distributor for other companies, too.

There were some threats to the Merit's business. First of all, the maturing portion of long term debt and notes payable in the next two years was going to be very high- 31,223,000 and 25,595,000 respectively (Exhibit 2 in the case). The firm has to manage to pay these debts on time. In this situation the firm is very vulnerable if any economic downturn happens. Even slight changes in demand to the industry's products may put Merit on an undesirable position. Merit Marine had been unsuccessful in arranging a reasonably priced mortgage. Since then because of the firm's questionable creditworthiness and the prevailing interest rate environment the firm could not receive fixed rate financing.

Five years historical data was given in this case. Thus, some trends could be established. A full set of ratios was calculated for 1980-1984.

The firm is highly leveraged. The debt to the equity ratio ranges from 2.8 to 1.9 (1980-1884). Times interest earned ration is not high enough. This ratio historically ranges on average around 0.7. If we take into consideration that Merit Marine had sales drop in 1982 and 1983, and therefore times interest earned ratios these years were too little, then we would have serious concerns about creditworthiness of the firm. In these years (1981-1983) Merit marine could just barely cover the interest expenses.

The firm has strong liquidity ratios. Merit Marine had on average 1.6 Current ratio and 1.0 quick ratio (1980-1984). This shows that a certain part of current assets is in inventory. For this type of business big inventories is not unusual. Merit's inventories should have high value (boats, engines), therefore they have taken a big part in the structure of current assets. Even with 1.0 quick ratio the firm seems a quite liquid.

Merit Marine had strong enough accounts payable days ratio (average for 5 years was 19). Because of sales-drop, the firm's average payable days increased in 1982-1983, but in the other historical years this ratio on average is 15 days.

Profitability ratios of the firm are positive, but at the same time are not strong. According to the case information Olympus's products have premium nature. Therefore, it would be reasonable to expect higher profitability ratios from Merit Marine's activities than they were during the historical period. ROE and ROA for historical five year averages 0.08 and 0.014, respectively. For historical period Gross margin ratio averages to 0.23 and Operating margin averages 0.05. Average Net profit margin for five years is very small- 0.015. Thus, Merit Marine was almost in break even point. Moreover, in the last years the cost sales has increased relative to sales level, but at the same time Merit Marine decreased its operating expenses relative to sales in order to keep positive income. The situation requires checking Merit's financial statements more carefully to see what caused these changes in operating expenses.

Company had huge fixed assets turnover ratio (average for historical five years 10.3, in 1984 this ratio was 5.2). In the future, beginning from 1985 company intends to invest annually $3 million in fixed assets. Therefore it might be expected, fixed assets ratio would decline in future years if sales don’t increase in receptively. There is no information about Merit's credit policy (sales policy). We assume that Merit Marine makes all its sales on credit bases (no cash sales). According to that assumption and premium nature of products (high prices) that Merit Marine sells, historical average collection days ratio was not too poor (80 days). Historical average inventory days ratio was high. It might be explained (assumption) with seasonal sales versus level purchases policy. Data from 1982-83 approve this assumption, since when sales level sharply decreased in 1982 and 1983 inventory days ratio increased up to 121 and 142, respectively.

The prognoses that are given in the case were used as assumptions for optimistic proforma (5% sales increase). Keeping the ratios that are given in the case, we will get these results (see Attachment 4). Except items that changed according to the assumptions given in the case, most balance sheet and income statement items are changed spontaneously according to sales level change. As a plugging item long term debts was used. (In all 3 alternatives short-term debt was used as a plugging item) I assumed that even if Merit could not receive long term loans from Omni Bank, Merit can receive it form another bank. According to the Exhibit 2 in the case, maturing part of debts in 1986 is 25,595,000. This number was used as a total of short-term debt and current portion of long term debt. Average for five historical years tax rate was used as a tax rate for proforma analysis.

With these assumptions Merit Marine can keep 2.4% net income/sales ratio and approximately 0.31 net working capital/sales ratio. Based on the assumptions Merit Marine's profitability ratios would not change a much. According to the same assumptions, as a result of sales increases Merit's both liquidity and leverage ratios would strength slightly. Historically, Merit was highly leveraged company. In optimistic case Merit's times interest earned ratio would increase from 5 years historical average 0.7 to 1.2, and debt-equity ratio would decrease from 5 years historical average 2.0 to 1.7.

In the pessimistic proforma 5% decline in sales level were used as an assumption. This is somewhat consistent with 1982-83 declines. Some balance sheet and income statement items have changed spontaneously according to change in sales level. Depreciation and investments are kept as they were in optimistic profroma. Depreciation does not change according sales level change, and there is information in the case that Merit Marine was going to have 3,000,000 investments for next several years. According to the pessimistic assumptions profitability ratios would have further declines. I assumed that the company would not drop operating expenses artificially in order to boost net income. ROA and ROE ratios would decrease because equity and non-spontaneous assets would not change together with sales. Times interest earned ratio would drop to 0.92 which is very dangerous for the company. Debt -equity ratio would decrease together with decrease in sales because company would need less capital resources to fund sales. (from 1.9 to 1.6). Without the consideration of Omni banks alternatives Merit Marine would have hard time to cover its expenses and to fund the sales.

Assumptions according to each of 3 alternatives were also calculated in both optimistic and pessimistic scenarios. According to the calculations (see attachments 4, 13, 14), Merit Marine would probably take the first alternative. In both optimistic and pessimistic scenarios this alternative seems better deal for the firm.

1. Merit should pay to Olympus A1-P1+ 0.5% (8.01+0.5%=8.51%)

2. Bank pays to Merit LIBOR

3. Merit pays bank- 3 year Treasury note rate +1.08% +0.25%

4. Merit's fixed rate = 3 year Treasury note rate +1.08% +0.25% +(A1-P1- LIBOR)

Merit's fixed rate for LTD = 10.1%+1.08+0.25%-1.02= 10.41%

1.Olympus's commercial paper would be in short term debt

2. Merit's fixed LTD effective annual rate = 12.55% (12% is nominal, but paid quarterly)

Total amount of the debt would be $15 million. I assume that this would be enough for Merit and the company would not take additional long-term debt. Merit marine would have three-year option to fix the same for a term of three years. I assume that Merit would exercise that option.

1. Olympus's commercial paper would be in short term debt.
2. Merit's fixed LTD effective rate = 12.55% (12% is nominal, but paid quarterly)
3. Merit would pay bank as a bank's compensation $125,000 (1% of $10 million+5% of the rest $5 million)

• Sales are seasonal- 70% in spring-summer and early autumn (10% of annual sales per month*7 month) and 30% in autumn and winter (6% of annual sales per month*5 month).
• Purchases are level (annual sales/12 month).
• All sales and purchases are made on credit bases.
• Operating expenses and income taxes distributed among months of year according to sales distribution pattern
• Minimum required cash per month is defined according to purchase policy (level).
• Cash surplus per each month would be used to pay bank loans
• Cash outflow for investment to fixed assets ($3 million) would be distributed among months in which cash receipts maximum.

Because sales are seasonal and due to credit policy (historical- ACD-80 days and proforma ACD- 80 days for optimistic scenario and 82 days for pessimistic scenario) in both optimistic and pessimistic cases Merit Marine would have cash shortages up to June 1985. This might justify Merit Marine's needs for additional short-term debt. Beginning from June 1985 Merit Marine would have cash surplus and partially pay its bank debts. Towards to the end of the year Merit's cash inflows tend to decrease (seasonal sales).

According to the sensitivity analysis with 3 alternatives the following conclusions were made:

• Using first alternative Merit's interest expenses per month would decrease because Merit would substitute its floating rate short debt with fixed long term-debt. Moreover, because of the same reason Merit's maturing portion of long-term debt and notes payable would decrease for the year 1985 in both optimistic and pessimistic cases.
• Using second alternative Merit's interest expenses would be distributed among months with little bit different pattern than in alternative one. Because interest payments for $10 million bank loans should be paid quarterly rather than monthly, Merit would be able to move payments for April and May to June and might have positive cash flows as early as in May.
• Third alternative gives fewer advantages to Merit than the other two. Pattern of distribution of interest expenses among months would be similar to the second alternative (short-term debt interest paid monthly, long-term debt interest paid quarterly) but actual interest expenses higher than in the second alternative. It seems that Merit does not need so much long-term debt.

Summarizing all above mentioned we might make a conclusion that any of these alternatives can improve Merit's position from the point in which the company was. In other words it would be better to have one of them rather the to have the current situation. According to analysis the first alternative seems the best way for Merit Marine in both optimistic and pessimistic cases. Overall these alternatives are maintained to support Merit's long-term goals. Therefore, it wold be right to analyze the impact of these alternative variants to the company's activities during the next several years than just for one proforma year.

The following assumptions are made for the breakeven analysis:

• Since Merit Marine is mainly Distributor Company, almost all of its cost of sales would be variable costs. It is assumed that 95% of Cost of sales are variable costs and 5% are fixed (The firm also operates a marine, so it might have some portion of cost of goods sold as fixed)
• Because of the character of its business, Merit Marine has to have big warehouses to keep the company's business going. In addition to that, salaries of officers are also paid from operating expenses. Therefore, it is assumed that most of company's operating expenses are fixed. 70% of operating expenses was allocating as fixed costs and the rest as variable costs.
• All interest expenses are considered as fixed costs because generally they don’t depend on sales level.
• "Other expenses" are considered as variable expenses. (There is no additional information about these expenses).
• Amount for "interest income and earned discount", which is given in Income Statement has not been added to Net income before taxes for breakeven analysis. Since we don’t know for sure whether this amount relates to sales, I did not take into consideration this amount for the breakeven analysis.

For the historical year 1984 Merit Marine operated almost in break even sales level. The safety margin of sales was just 0.04%. Therefore, it is clear that any decline from this level would cause operating loss. Indeed, in the pessimistic scenario (without consideration of alternatives) Merit Marine would have $566,000 (-2.36% safety margin) net operating loss. In optimistic case company would have Net operating income $982,000 or 3.75% safety margin. Again, in both optimistic (13.3% safety margin) and pessimistic (11.7% safety margin) cases the first alternative gives Merit Marine higher net operating income and safety margin than in the other variants. Overall with Omni banks alternatives Merit Marine could have positive NOI for at least the next year (see Attachment 13).

The main goal of the concept of sustainable growth is to show which growth rate for the firm is better in the given conditions. If the actual growth rate (sales growth) is higher than sustainable growth, the firm has to do some changes in the way it operates. For instance, new investments (debt or equity) would be required to fund the sales increase, leverage ratios would increase and etc.

In Merit Marine's case the Omni Bank 's would not be happy if Merit's actual growth rate overcomes sustainable growth. Merit Marine is highly leveraged firm, and if the actual growth rate overcomes sustainable growth rates the situation would be worse than it is. First of all Merit has questionable creditworthiness and therefore, currently have difficulties in obtaining new loans. Second, Merit Marine currently has high debt-equity ratio. Therefore, it would not be secure for any lender to give the firm new debts. Finally, Merit Marine should follow the certain covenants (e.g. working capital =$28 million, current ration =1.5, total liabilities/equity=3.0) to use the current debts.

Accumulating all above mentioned and taking into consideration Merit Marine's current problems with finding new loans, Merit Marine's actual growth rate should be equal or less than sustainable growth rates.

According to the historical data Merit's actual growth rate in 1984 was much higher than all its sustainable growth rates (See Attachment 14). This might be the explanation why Merit Marine needs new debts and the debt restructuring. Generally, Merit Marine's actual growth rate and its sustainable growth rates were much different during the 5 historical years.

From Omni Banks point of view, 3^rd sustainable growth rate (spontaneous liabilities growth at the same rate as sales) is most relevant. This growth rate does not require new debts and spontaneous liabilities increase just as the same rate as sales do. This growth rate should appropriate from Merit Marine's point of view, too.

As the calculations show Merit Marine's proforma sales’ growth rate would be higher than its sustainable growth rate even in optimistic case (5% vs. 3.97%) (See Attachment 14). This shows that a current condition of the firm does not allow it to fund even 5% sales growth internally.

Analysis of Merit Marine's financial situation gives little incentive to the Omni Bank for restructuring Merit's debts. The bank had better to do some actions before giving a loan to Merit:

There should be explanation of Merit's suspicious activities with operating expenses. The bank had better be sure that everything is the same in reality as they are shown in the financial statements.

If the Omni Bank decides to give a loan it needs to put covenant that Merit can not obtain any new debt unless the bank will agree with that.

Although the first alternative gives the Merit better opportunity to solve its problems and enhance its position, this alternative would be risky for the bank because of poor credit risk of the firm. Therefore, the second or the third alternative is more acceptable for the bank in terms of being safer than the first alternative (private placement with an insurance company would shift the risk from the bank or at least distribute the risk for the loan).