Case 22: Timing Is Everything!

Case 22: Timing Is Everything! Case Discussion

Objectives • Evaluate a firm’s absolute and relative liquidity. • Calculate and analyze a firm’s operating and cash flow cycle. • Explore alternative policies of managing and financing working capital.

Background Information • Advanced Outboard Motors’ profit margin and EPS are down despite rising sales. • Tom Brampton, CEO, feels that shareholders will be upset and analysts might change their recommendations. • Company has been following a policy of level monthly production. • Due to seasonal sales, inventory fluctuates considerably. • Capital is tied up in idle inventory resulting in high and possibly unnecessary interest charges.

Question 1 • Comment on Advanced Outboard Motors’ absolute and relative liquidity positions.

Answer 1 • Absolute liquidity measures include cash reserves, and net working capital • Cash Reserves = $918, 280 • Net working Capital = Current Assets – Current liabilities = $5,107,880 - $1,680,000 =$3,427,880. • Relative liquidity measures include current ratio, quick ratio, cash ratio, NWC to total assets, and the interval measure. • Current ratio = CA/CL= 5,107,880/1,680,000= 3.04X • Quick ratio = (CA-Inventory)/CL • = (5,107,880-4,060,000)/1,680,000= 0.62X

Answer 1 (Continued) • Cash ratio = $Cash/CL = $918,280/1,680,000 = 55% • NWC to TA =( CA –CL)/TA = 3,427,880/18,260,000 =18.77% • Interval measure = CA/Average daily operating costs • = 5,107,880/(Cost of goods sold+Overheads) • = 5,107,880/(24,969,600/365) = 75days • Most of the firm’s current assets are tied up in inventory. • If the inventory is marketable at a fair value, the liquidity would be considered to be good. • The firm can operate for about 2.5 months (75 days) if it faced a strike. • Overall, the firm seems to have a satisfactory liquidity position.

Question 2 • Examine the company’s monthly inventory turnover ratio. What does it indicate?

Answer 2 The monthly inventory turnover ratios show how seasonal the sales are as compared to the level production rate of the firm. There is significant volatility in the turnover figures with September having the highest turnover. In contrast, November through April account for very low turnover rates.

Question 3 • How long are the firm’s operating and cash cycles? • Using a suitable diagram show the breakdown of the firm’s operating cycle into its relevant components. • What do your findings indicate?

Answer 3 • Operating Cycle = Inventory period + Accounts receivable period Inventory period = 365 days/Inventory Turnover ratio A/R period = 365 days/Accounts Receivables Turnover Inventory period = 365/(Cost of Goods Sold/ Average inventory) = 365/($20,160,000/$4,245,267) = 77 days

Answer 3 (Cont.) • A/R period = 365/(Total Credit Sales/Average Accounts Receivables) • Note: 60% of each month’s sales are on credit. A/R period = 365/((.6*28,800,000)/1,450,000) = 31 days Operating Cycle = 77 days + 31 days=108 days

Answer 3(Cont.) • Cash Cycle = Operating cycle – Accounts payable period Accounts payable period = 365 days/[Cost of goods sold/Average payables]=365/($20,160,000/1,680,0000) = 31 days • Cash Cycle = 108 days – 31 days = 77 days • On average, there is a 108 day lag between when the inventory is acquired and the payment is collected for the sale. • The firm takes on average 31 days to collect its receivables and approximately the same number of days to pay its suppliers. • Thus on average there is a 77 day delay between the time the firm pays for its inventory and the time it collects on the sale.

Question 4 How much higher would the firm’s earnings per share have been if… it had followed a policy of aligning the production output with the number of units sold each month?

Answer 4 • By aligning the production output with the number of units sold each month, the firm’s cash outflows will change resulting in a reduction in short-term borrowing and interest expenses during the years. • The calculations are shown in the spreadsheets • Spreadsheet solution (click here) Interest expenses on short-term borrowing (currently) =$287,928 Interest expenses on short-term borrowing (with alignment) =$220,000 Interest saving = $ 67,928

Answer 4 (Continued) EPS = 90.8 cents per share versus 86.4 cents per share.

Question 5 • Calculate the monthly net working capital figures for the company. Comment on your findings.

Answer 5 See spreadsheet solution (click here) The firm used 47% to 84% of short-term debt to fund its NWC during the first half of the year. It then switched to 100% long-term debt. On average, therefore it seems to be following a restrictive policy of financing its current assets.

Question 6 • Is the firm following an aggressive or a conservative financing policy for funding its working capital? • Explain.

Answer 6 • Since the firm is switching between short-term and long-term debt financing during the year, it is following an aggressive financing policy, thereby exposing itself to greater refinancing risk.

Question 7 • Is Andy correct in stating that the main culprit is the firm’s production policy? • Besides changing the production levels per month, are there any other things that the firm can realistically do to boost earnings per share?

Answer 7 • Yes, Andy is correct. • As shown above, aligning the monthly production rates to the estimated sales can help reduce the short-term borrowing of the firm and lead to a significant reduction in interest costs. • The firm could try and reduce its cost of goods sold and other costs such as overheads to boost earnings per share. • Perhaps there are plant facilities that could be leased out to generate further income.

Question 8 • Using Dupont analysis, comment on the firm’s profit situation.

Answer 8 ROE = (Net Income/Sales) * (Sales/TA) * (TA/Equity) =($864,000/$28,800,000)*($28,800,000/$18,260,000)* ($18,260,000/$5,760,000) = 3% * 1.577*3.17 = 15% The firm’s ROE is quite good at 15%, but most of it is attributable to a high debt ratio. The firm has a fairly low interest coverage ratio (1.89X) and therefore… is in a fairly risky position as far as its debt level is concerned.

Question 9 • Do you agree with the production manager’s comment that that “there’s got to be a better way?” • Please explain.

Answer 9 • An alignment of production output to expected monthly sales would lead to some layoffs and cutback in hiring during lean months. • Although this policy would not be consistent with the firm’s usual “caring” policy, the health of the firm and its perception by analysts is of dire importance. • Failure to control costs could lead to permanent closure of plants and loss of jobs which would be worse for employees. • A “better way” that would keep all sides happy would obviously be preferable, but seems unrealistic.

Case 22: Timing Is Everything!