FAO, the parent company of venerable toy retailer FAO Schwarz, soon could find itself in bankruptcy.

The company on Tuesday said it is facing a "liquidity crisis."



, which operates the Zany Brainy and Right Start retail chains, is working with

Wells Fargo

, its bank, to relax its credit restrictions, but said it can't promise that it will succeed in securing new funds.

"In the event Wells were to refuse, FAO warned that it likely would have to seek protection under the bankruptcy code in order to reorganize its operations," FAO said in a statement.

An FAO representative declined to comment on Tuesday about when the company might file for bankruptcy or if it had had any success in its talks with Wells Fargo. Wells Fargo representatives did not return calls seeking comment.

FAO, then known as The Right Start, bought FAO Schwarz in January from the Netherlands-based Royal Vendex KBB. The acquisition was the second in four months for the company; Right Start bought the assets of educational toy retailer Zany Brainy in September 2001.

Although the acquisition brought with it two high-profile brands, FAO has struggled to get its financial footing. In its third fiscal quarter, which ended Nov. 2, the company lost $23.7 million, or 66 cents per share, on $88 million in revenue. FAO lost $9.9 million, or $4.07 per share, on $57 million in revenue last year. FAO's outstanding shares ballooned from 7.2 million to 35.8 million over the last year as it issued stock for acquisitions and to fund its working capital.

The company's troubles were even more stark at its individual stores. Same-store sales for the company were down nearly 20% in the third quarter, compared with the same period last year. At the company's Zany Brainy unit, which comprises the bulk of FAO's 253 retail outlets, comparable-store sales dropped 25%. Same-store sales compare results of stores open more than one year.

The results added up to a large outflow of cash. FAO used $88 million in cash to fund its operating activities in the first three quarters, compared with $44 million in the same period last year. The company borrowed $64 million from its revolving line of credit with Wells Fargo during that time period to fund some of its operating costs, compared with $43.8 million during the same period last year.

The company ended the third quarter with just $4.5 million cash on hand, compared with $3.9 million at the end of the third quarter last year.

Over the last several months, Wells Fargo has begun to put a tighter grip on the amount that FAO could borrow, FAO said in its quarterly report filed on Tuesday with the

Securities and Exchange Commission

. Without the restrictions, FAO would have been able to borrow an additional $23.1 million from Wells Fargo; however, due to the restrictions, its available line of credit has shrunk to just $1 million, the company said in its regulatory filing.

Even if FAO does file for bankruptcy, the company's namesake brand could live on, said Margaret Whitfield, who covers the toy industry for Brean Murray, but does not specifically follow FAO.

Toys 'R' Us


and KB Toys are among those who might be interested in trying to cash in on FAO's cachet, she said.

"At a price, there's always a buyer for assets, especially with a brand like FAO," Whitfield said. (Brean Murray did investment banking business with Toys 'R' Us earlier this year as part of the company's secondary offering.)