C01-10-0008
Graeme Rankine
Smart Union Group (Holdings) Limited—
A (Short) Toy Story
Teaching Note
Case Abstract
change, which netted HK$55 million. From 2003 to 2007, the company’s sales revenues increased from HK$479
million to over HK$953 million. The company’s rapid growth was financed by issuing equity and obtaining
Teaching Objectives
company’s financial performance,
3. To analyze a company’s growth, its ability to generate cash flows, and its financial performance,
4. To evaluate a company’s financing needs, the possible financing methods it has available, and how it might
choose a preferred plan.
Specifically, students are asked to consider several issues in the case. First, students are asked to explain how
Smart Union makes money, to evaluate its business strategy for accomplishing this objective, and to evaluate
how successful execution of this strategy is likely to be observable from the company’s performance indicators.
Second, students are asked to analyze the risk faced by the company from fluctuations in commodity prices,
exchange rates, and interest rates, as well as operational risks faced in manufacturing, selling, and distributing its
products. Third, students are asked to evaluate the company’s rapid growth, its cash flow situation, and recent
financial performance, including its profitability, asset management, and leverage. Finally, students are asked to
evaluate Smart Union’s cash flows, and how it will fund the bank loan due within the next year.
The case has been used successfully in MBA programs to cover corporate financial reporting issues, and in
bank training programs focused on credit analysis and quality of earnings issues.
Suggested Case Questions
1. How does Smart Union make money? What are the key success factors in Smart Union’s business? What are
2 C01-10-0008
management, leverage, and liquidity performance?
4. Will the company be able to repay the short-term bank debt due within 12 months? What should the com-
pany do if the bank debt is not refinanced?
Case Analysis
Question 1
Smart Union manufactures toys and recreational and educational products at its facilities in China for OEMs,
such as Mattel, Hasbro, and others, whose sales are mainly generated in the U.S. and Europe. Thus, Smart
Union’s value chain of activities could be described as follows:
Toy Design and
Development
Manufacturing and
Logistics
Sales and
Marketing Distribution Servicing?
The company’s strategy was to be a low-cost and high-quality producer, maintain close relationships with
OEMs, and produce a broad array of products.
Smart Union’s success would be expected to be observable from revenue growth, as the quality of its
nated in U.S. dollars, would increase the company’s manufacturing and distribution costs. The company was
also exposed to labor cost increases, which the case mentioned occurred because of labor shortages in China, and
because of efforts by Chinese companies to attract workers with offers of better wages and working conditions.
The company was also exposed to interest rate increases, since it had financed its growth heavily with short-term
euro appreciated against the HK dollar; thus, Europe-based sales would generate more HK dollars. Finally, the
Chinese renminbi appreciated relative to the HK dollar; thus, with Chinese-based manufacturing facilities, the
company had costs that were adversely exposed to appreciation in the renminbi. On balance, this suggests that
Smart Union was squeezed in the middle, since it was exposed to both rising costs in HK dollars, and declin-
thereby incur dollar-and euro-based interest costs.
The investment in a silver mine to hedge silver costs incurred in the manufacture of its toy products was
likely to be a diversification move that decreased shareholder value. A toy manufacturer is unlikely to know much
about silver mining, and there are more effective ways to hedge silver cost exposure. It seemed a reckless move
as the company struggled to meet debt repayment obligations. One certainly wonders if the move was a related
C01-10-0008 3
Question 2
Smart Union grew rapidly, increasing sales revenue from HK$479 million in 2003 to over HK$953 million
in 2007, or a compound growth rate of 19% per year over the four-year period. Profit increased from HK$26
million in 2003 to peak at over HK$36 million in 2005, before declining to HK$5.4 million in 2007. Working
labor and commodity costs mentioned in the case, as well as the effects of price discounting to move inventory.
By 2007, the company’s operating profit percentage was less than 3%, while “bottom-line” profit was less than
1% of revenues in 2007, down from 4.2% in 2006.
The company’s return on assets at less than 1% was very weak. The company’s return on equity was a mere
1.7% in 2007, much less than the 18.3% achieved in 2006. The company’s day’s receivable increased from 52
days in 2006 to over 63 days in 2007, while the company’s day’s inventory increased from 145 days in 2006 to
165 days in 2007. And, overall, the company’s assets were less productive, with asset turnover decreasing from
1.5 times to 1.2 times. While the company’s total debt increased in amount, the company’s debt ratio remained
around 0.80, but the company’s interest coverage declined from over 4% in 2006 to around 1.45% in 2007.
The company’s liquidity measures remained steady.
The overall conclusion is that the company’s profitability fell off the edge, the company was now bloated
with inventory, and there seemed to be a receivable collection problem. Thus, the firm’s financial risk has increased
with the decline in the firm’s interest coverage.
Question 3
The instructor can ask students to prepare a cash flow statement based on the financial statements provided in
the case. A cash flow statement worksheet for 2007 is provided in Exhibit TN-2 Panel A. The resulting cash flow
statement is provided in Exhibit TN-2 Panel B. For MBA classes, this provides students with an opportunity
to practice preparing a cash flow statement. Alternatively, particularly with executive education programs, the
instructor can provide Smart Union’s actual cash flow statement, provided in Exhibit TN-3, and use that as a
basis for class discussion. The two cash flow statements are similar enough so that either one may be used for
analysis.
The cash flow statement in Exhibit TN-3 indicates that the drop off in profits reduced cash flow in 2007.
But the build up in inventories and receivables dramatically reduced cash flow from operations, and the invest-
ment in these two working capital items was only modestly offset by increases in trade payables and other accruals
and payables. Thus, Smart Union generated a negative cash flow from operations of $148 million. In addition,
capital expenditures and other such items further reduced cash from investing by $73 million. How was the hole
of $221 million plugged? The financing section shows that Smart Union increased debt by $107 million and
equity by $160 million, which resulted in a $37 million increase in cash holdings.
Question 4
The principal on the bank loan is listed under current liabilities on the company’s balance sheet as HK$239.7
million. To determine whether Smart Union can pay down the debt or would be forced to refinance or possibly
obtain additional equity financing, a forecasted cash flow statement for 2008 is needed. For the purposes of this
calculation, we’ll assume that the cash flow from operations (CFO) in 2008 was the same in 2007. Forecasted
cash flows could be determined by making additional assumptions about what assets could be liquidated, and
for how much, and what other liabilities could be increased. We’ll assume that the company spends nothing on
capital expenditures, i.e., cash flow from investing is zero.
4 C01-10-0008
2008
Cash flow from operations (assumed same as last year) -142,646
Liquidation of inventories 200,000
Collection or sale of trade receivables 100,000
Reduction in cash balances 50,000
Sale of convertible bonds 30,000
Liquidation of available-for-sale financial assets 2,342
Net cash flow 239,696
Bank debt due 239,768
Thus, Smart Union could generate enough cash to cover the principal repayment only under the very
best of conditions. The assumptions built into the forecast above are very optimistic. In order to survive, Smart
Union would likely need either an equity infusion from its principal shareholders, or would have to refinance
its debt. Would the principal shareholder be willing to kick in more equity? That depends on whether they
believed the business was a viable going concern that needed to be nursed through a transitory downturn. In all
likelihood, with a more apparent and sizeable recession in process, the owners would not be willing to invest in
new equity. Would the bank or other lenders be willing to refinance the company’s debt? Again, for the same
reasons, a bank would be unlikely to refinance the company in the deepening recession, and with an impending
credit squeeze.
Post-Case Developments
On October 18, 2008, Smart Union announced that it had appointed provisional liquidators to wind up the
toy and recreational products company and its subsidiaries.1 On October 21, 2008, it was reported that Smart
Union’s Chief Executive Officer had signed on as managing director at a rival toymaker, a company he worked
for prior to joining Smart Union.2 Selected items from Smart Union’s Interim Report for June 30, 2008, are
reported in Exhibit TN-5.
1 “Chinese Toy Firm Becomes Casualty of Global Crisis,” The Wall Street Journal, October 18, 2008.
2 “Toymaker Fails…Chief Jumps Ship,” South China Morning Post, October 21, 2008.
C01-10-0008 5
Exhibit TN-1.
Balance Sheet 2007 2006 2007 2006
HK$’000 HK$’000
ASSETS
Non-current assets
Property, plant and equipment 66,408 43,245 8.3 8.9
Land use rights 4,849 4,516 0.6 0.9
Intangible assets 2,967 632 0.4 0.1
Available-for-sale financial assets 2,342 5,120 0.3 1.1
Prepayments, deposits and other receivables 11,261 276 1.4 0.1
Deferred income tax assets 749 134 0.1 0.0
88,576 53,923 11.1 11.2
Current assets
Inventories 379,440 240,322 47.4 49.7
Trade receivables 165,438 104,029 20.7 21.5
Prepayments, deposits and other receivables 19,022 12,857 2.4 2.7
Derivative financial instruments 213 1,247 0.0 0.3
Convertible bonds 40,000 –5.0 0.0
Current income tax recoverable 1,046 737 0.1 0.2
Pledged bank deposits 5,234 5,267 0.7 1.1
Cash and cash equivalents 101,584 64,882 12.7 13.4
711,977 429,341 88.9 88.8
Total Assets 800,553 483,264 100.0 100.0
EQUITY
Share capital 34,248 24,000 4.3 5.0
Share premium 177,137 30,742 22.1 6.4
Other reserves 29,293 25,830 3.7 5.3
Retained earnings 76,112 85,832 9.5 17.8
316,790 166,404 39.6 34.4
Minority interest 1,370 607 0.2 0.1
Total equity 318,160 167,011 39.7 34.6
LIABILITIES
Non-current liabilities
Borrowings 201 2,749 0.0 0.6
Provision for long service payment 1,104 – 0.1 0.0
1,305 2,749 0.2 0.6
Current liabilities 0.0 0.0
Trade payables 195,631 158,837 24.4 32.9
Other payables and accruals 43,333 24,113 5.4 5.0
Borrowings 239,768 130,554 30.0 27.0
Derivative financial instruments 2,356 0.3 0.0
481,088 313,504 60.1 64.9
Total liabilities 482,393 316,253 60.3 65.4
Total equity and liabilities 800,553 483,264 100.0 100.0
6 C01-10-0008
Exhibit TN-2
2007 2006
Profitability
Gross profit margin 11.9% 16.8%
Operating profit margin 2.9% 6.5%
Return on sales 0.6% 4.2%
Return on assets 0.7% 6.3%
Return on equity 1.7% 18.3%
Asset Management
Day’s receivable 63.3 52.2
Day’s inventory 164.9 145.0
Asset turnover 1.2 1.5
Leverage
Debt-equity 0.75 0.80
Interest coverage 1.45 4.18
Liquidity
Quick ratio 0.56 0.54
Current ratio 1.48 1.37
Exhibit TN-1 (cont.)
Income Statement
2007 2006 2007 2006
HK$’000 HK$’000
Sales 953,623 727,225 100.0 100.0
Cost of sales -839,734 -604,952 -88.1 -83.2
Gross profit 113,889 122,273 11.9 16.8
Other income 12,320 1,906 1.3 0.3
Other (losses)/gains, net -1,893 1,804 -0.2 0.2
Administrative expenses -96,704 -78,973 -10.1 -10.9
Operating profit 27,612 47,010 2.9 6.5
Finance costs -19,035 -11,242 -2.0 -1.5
Profit before tax 8,577 35,768 0.9 4.9
Income tax expense -3,134 -5,136 -0.3 -0.7
Profit for the year 5,443 30,632 0.6 4.2
C01-10-0008 7
Exhibit TN-3. Panel A
2007 2006
HK$’000 HK$’000
ASSETS
Property, plant and equipment 66,408 43,245 23,163 Inv/Op 32,037 8,784 90
Land use rights 4,849 4,516 333 Inv/Op 402 69
Intangible assets 2,967 632 2,335 Inv/Op 3,396 144 567 350
Available-for-sale financial
assets 2,342 5,120 (2,778) Inv
Prepayments, deposits and
other receivables 11,261 276 10,985 Op
Deferred income tax assets 749 134 615 Op
88,576 53,923 34,653
Current assets
Inventories 379,440 240,322 139,118 Op
Trade receivables 165,438 104,029 61,409 Op
Prepayments, deposits and
other receivables 19,022 12,857 6,165 Op
Derivative financial
instruments 213 1,247 (1,034) Op
Convertible bonds 40,000 40,000 Inv
Current income tax
recoverable 1,046 737 309 Op
Pledged bank deposits 5,234 5,267 (33) Fin
Cash and cash equivalents 101,584 64,882 36,702 Cash
711,977 429,341 282,636
Total Assets 800,553 483,264 317,289
EQUITY
Capital and reserves
attributable to the
Company’s equity holders
Share capital 34,248 24,000 10,248 Fin
Share premium 177,137 30,742 146,395 Fin
Other reserves 29,293 25,830 3,463 Fin
Retained earnings 76,112 85,832 (9,720) Op/Fin 4,680 (14,400)
316,790 166,404 150,386
Minority interest 1,370 607 763 Op
Total equity 318,160 167,011 151,149
LIABILITIES
Non-current liabilities
Borrowings 201 2,749 (2,548) Fin
Provision for long service
payment 1,104 1,104 Op
1,305 2,749 (1,444)
Current liabilities
Trade payables 195,631 158,837 36,794 Op
Other payables and accruals 43,333 24,113 19,220 Op
Borrowings 239,768 130,554 109,214 Fin
Derivative financial
instruments 2,356 2,356 Op
481,088 313,504 167,584
Total liabilities 482,393 316,253 166,140
Total equity and liabilities 800,553 483,264 317,289
8 C01-10-0008
Exhibit TN-3. Panel B
CONSOLIDATED CASH FLOW STATEMENT
For the year ended 31st December 2007
2007
Statement of Cash Flows
Operating activities
Minority interest 763
Depreciation on property, plant and equipment 8,784
Loss on disposal of property, plant and equipment 90
Amortization of land use rights 69
Amortization of intangible assets 567
Impairment of intangible assets 350
Loss on disposal of intangible assets 144
(Increase) decrease in inventories (139,118)
(Increase) decrease in trade receivables (61,409)
(Increase) decrease in current prepayments, deposits and other receivables (6,165)
(Increase) decrease in derivative financial instruments 1,034
(Increase) decrease in income tax recoverable (309)
Increase (decrease) in trade payables 36,794
Increase (decrease) in other payables and accruals 19,220
Increase (decrease) in derivative financial instruments 2,356
Cash flow from operations (142,646)
Investing activities
Acquisition of convertible bonds (40,000)
Acquisitions of property, plant and equipment (32,037)
Acquisitions of land use rights (402)
Acquisitions of intangible assets (3,396)
Sale of available-for-sale investments 2,778
Cash flow from investing activities (73,057)
Financing activities
(Increase) decrease in pledged bank deposits 33
Increase (decrease) in short and long-term borrowings 106,666
Increase (decrease) in equity 160,106
Dividends (14,400)
Cash flow from financing activities 252,405
Net cash flow 36,702
Change in cash and cash equivalents 36,702
C01-10-0008 9
Exhibit TN-4
CONSOLIDATED CASH FLOW STATEMENT
For the year ended 31st December 2007
2007
HK$’000
2006
HK$’000
Cash flows from operating activities
Cash (used in)/generated from operations (108,626) 6,277
Interest paid (19,035) (11,242)
Profits tax paid (4,617) (8,866)
Profits tax refund 561 18
Net cash used in operating activities (131,717) (13,813)
Cash flows from investing activities
Purchase of land use rights – (4,593)
Increase in intangible sales (3,396) (886)
Purchase of available-for-sale financial assets – (2,000)
Proceeds from disposal of available-for-sale financial assets 2,999
Decrease/(increase) in pledged deposits 33 (2,430)
Investments in convertible bonds (40,000) –
Interest received 1,345 764
Net cash used in investing activities (78,879) (30,964)
Cash flows from financing activities
Proceeds from new borrowings 1,129,131 357,626
Repayment of borrowings (1,022,152) (293,683)
Decrease in amounts due to directors – (3,456)
Dividends paid (14,400) (21,000)
Issue of shares 160,055 66,000
Payment of share issuance expenses (3,438) (12,758)
Net cash generated from financing activities 249,196 92,463
Net increase in cash and cash equivalents 38,600 47,686
Cash and cash equivalents at 1st January 56,738 9,110
Exchange losses on cash and cash equivalents (1,585) (58)
Cash and cash equivalents at 31st December 93,753 56,738
From Note 18 2007 2006
HK$’000 HK$’000
Bank balances and cash 101,584 64,882
Less: bank overdrafts (Note 21) (7,831) (8,144)
Cash and cash equivalents 93,753 56,738
10 C01-10-0008
Exhibit TN-5
Six months ended 30th June
2008 2007
HK$’000 HK$’000
(Unaudited) (Unaudited)
Income Statement items
Sales 386,809 375,793
Cost of sales (525,936) (325,397)
Gross profit (139,127) 50,396
Operating (loss) profit (191,815) 4,498
Loss for the period (200,561) (2,803)
Balance Sheet items
Inventories 301,649 379,440
Trade receivables 103,215 165,438
Bank balances and cash 13,207 101,584
Trade payables 218,252 195,631
Borrowings 234,467 239,987
Cash Flow Statement items
Net cash flow from operating activities 2,298 (128,474)
Net cash flow from investing activities (21,053) (23,492)
Net cash flow from financing activities (85,214) (11,343)