Case analysis: Kota Fibers, Ltd. Group 1: Bhavananda Jha (14317) Chanda Kiran Adhikari (14301) Niraj Ghimire (14314) Pragya Joshi (14318) Prajwal Sagar Shrestha (14331)
Introduction Kota fiber is nylon fiber producing company situated in Kota, India. The business has been running smoothly with steady market share. But the company is facing serious liquidity crunch and even in the heavy selling season, the business has to take more loans. The situation has become worse as the company had overdrawn the bank account and could not pay the excise tax. The company had taken loan from the bank with a contract to clean up on December 2001 but the financial projection for 2001 shows inability of Kota Fiber to repay all its line of credit to bank on the specified period. On the other hand, there are four different proposals from managers of different departments, which may be beneficial for the company. The reassessment of the financial forecast including the new proposals is needed to find out the actual debt position of the company. Issues Some of the issues taken into consideration are: 1. 2. 3. 4. 5.
The current situation of business. The reasons for company to run out of cash and its consequences. Analysis of clean up requirement of the bank Analysis of Mehta’s financial forecast and cash cycle analysis. Analysis of impact of proposals given by employees and managers of Kota Fibres on the
debt position of the company. 6. The actions that can be taken by Pundir. Analysis of the Issues Current Situation: The firm does not have enough cash in their bank accounts to pay off the tax inspector that demand the excise tax to be paid. This situation backlogs the trucks ready to depart the night before, but is unable to until the tax inspectors paid. The company has also overdrawn on its bank account three weeks in a row and that situation needs to be addressed. The bank has already been disappointed by the company’s inability to clean up its debt balance for 30 days during this past off-season and would be expected to advance no more cash unless the situation changes.
The reasons for company to run out of cash and consequences: Kota fiber has run out of cash for because of the following main reasons: o Sales growth (20% anticipated in 2001): In the year 2000, the actual growth in sales is 18% but in 2001 the company is expected a growth rate of 20% for which the company need more cash. o Declining profitability: An analysis of case reveals that net profit as a percentage of sales has fallen over the past year 2000, from 5.6% to 3.4% of gross sales and is projected to fall to 1.5% in 2001 o Aggressive dividend payments: The Company is paying a dividend of INR 2 million per year which is higher than the expected net profit of INR 1.33 million. o Increase in Cost of goods sold: The ratio of cost of goods sold to gross sales has risen by 2% from 69% to 71% and is expected to mount to 73.7% in 2001. o Decrease in ROE: Kota return on equity is 21.5% in 2000 and falls to 11.9% in 2001 which is below than interest rate of 14.5%. The consequence for the company is going to be o If Kota does not clear line of credit, the bank will stop providing credit facilities to the company. o Insufficient cash flow will hamper the day to day operations of the business. Analysis of Clean- up requirement of Bank Clean-up requirement is a traditional way through which banks can secure its loan from being default. Normally clean up requirement are from 30 to 60 days. The cleanup period is usually arranged right after the peak sales time in the year for a particular business. After peak sales period when receivables have mostly been collected and cash need for purchasing new inventory is comparatively low, the portion from gross profit is to be paid to bank to remain debt free for the specified period. This is a banking practice that requires a borrower to pay off all balances of any renewable lines of credit and keep them at zero for 30 to 60 days or so. Banks require cleanup of loan in order to manage the unsecured loans provided to businesses. In case of Kota Fibers, the bank may have added clean up requirement in the loan contract in order to prevent Kota fibers to use line of credit as ongoing permanent financing.
The bank must not continue to waive compliance with clean-up of the loan for Kota Fibers. As the business is facing scarcity of cash, for certain years, the waiver may be continued so that Kota Fiber would not have extra burden of mandatory clean up. But in long run, the waiver must be ceased. On the other hand, after few years, if Kota fibers can turn the business as highly profitable and if the loan given by the bank can be declared as secured loan, then the waiver of clean up may be given continuity for long run.
Analysis of Mehta’s Financial forecast and cash cycle analysis. The financial forecast was constructed based on the past financial report and to generate the ability to clean up the loan by the end of 2001. The monthly forecast of the financial statements was developed using the operating assumptions in exhibit 11 of the case. The forecast was developed as the bank asked for a proper financial forecast of Kota fibers for the coming year. The bank was refusing to extend further line of credit to Kota fibers unless the financial forecast of the company demonstrated the ability of the firm to clear the loan by the end of 2001. Mehta’s financial forecast shows that the expected Gross sales will be increased by 20% in 2001 which was increased by 18% in 2000. The expected gross net profit margin will be only 1.5% of gross sales in 2001 which was 3.4% in 2000. The cost of goods sold which is increasing year by year will expected to reach to 73.7% of sales in 2001 which was 71% in 2000. According to the financial forecast, the current ratio as well as quick ratio are expected to decline in 2001 indicating poor liquidity to be expected in the coming year. The gross profit margin is also expected to decline to only 13.29 %. Return on assets is also expected to decline. And the debt to assets ratio is expected to increase from 10.85% to 28.41 %, because of increase in short term financing needs.
Financial Ratios Current ratio Quick ratio Gross profit margin Total asset turnover ratio Return on assets Debt to asset ratio
Actual(2000)
Forecast(2001)
4684237/1,443,637
6,690,525/ 4,440,345
3.24 (4,684,237-1,249,185)/1,443,637 2 64,487,358/10,621,447 16.47% 64,487,358/13,295,604 4.85 2,550,837/ 13,295,604 19.18% 1,443,637/13,295,604 10.85%
1.5 (6,690,525-2,225,373)/ 4,440,345 1 77,265,092/10,271,712 13.29% 77,265,092/15,628,161 4.94 1,335,848 /15,628,161 8.57% 4,440,345/15,628,161 28.41%
The calculation of Cash Cycle based on the financial forecast done by Mehta. S
Forecasted
N 1
Particulars Average inventory
Actual 2000 1249185.00 53865911.0
2001 2225372.57
2
COGS Inventory
0
66993379.60
turnover
3 4 5
ratio(2/1) Inventory period(365/3) Receivable
43.12 8.46 2672729.00 64487358.0
30.10 12.12 3715152.20
6
Sales Receivables
0
77265092.00
7 8 9
turnover(6/5) Receivable period(365/7) Payables
24.13 15.13 759535.00 53865911.0
20.80 17.55 1157298.44
10 11 12 13 14 15
COGS Payables turnover(10/9) Payable period(365/11) Operating cycle Payable days Cash cycle
0 70.92 5.15 23.59 5.15 18.45
66993379.60 57.89 6.31 29.67 6.31 23.37
The Cash Cycle prepared with the financial forecast shows that both operating cycle and cash cycle will increase in 2001 from 23.59 days to 29.67 days and 5.15 days to 6.31 days respectively because of which the company have to face crisis of cash flow in upcoming year with this financial forecast.
Exhibits Analysis: The sales forecast in Exhibit 1 shows that the overall operations of the company is expected to increase by 19.8 % and reach to INR 90.9 million in the fiscal year that ended Dec 31,2001. From Exhibit 2 we can observe that the gross profit margin was 16% in 1999, which declined to 14% in 2000 and is expected to decline to 11% in 2001. The gross profit margin might have declined because of production inefficiencies, as the plant is operated at peak capacity for only two months and at modest levels for the rest of the year. The journey were slow and dangerous which made the truck to take 10 to 15 days to negotiate the trip between Calcutta and Kota. Hence because of slow production and distribution system the gross profit margin of the firm has been in declining trend and is expected to decline in the coming years unless certain actions are taken in order to increase the production efficiency and distribution system. Interest expense has also been in increasing trend because of the fact that the company is heavily dependent on bank line of credit for day to day cash needs. As the level of outstanding debt increases the interest expense has also increased. Interest expense is expected to increase by 48% from 2000 to 2001. As a result of increased interest expenses and decrease in gross profit margin, the net profit of the firm is expected to decrease by 47.6% from 2.5 million in 2000 to around 1.3 million in 2001. So despite expectation of increase in the sales of the company by 19.8%, the net profit is expected to decrease by 47.8%. The main reason behind this is in efficiency in production, poor management of working capital and higher outstanding debt for financing short term financing needs. By analyzing the actual and forecasted balance sheet of the Kota fiber, we can say that the ending cash balance has not changed that much and firm is expected to maintain a minimum cash balance of 750,000 in all the months of the coming year. But for maintaining the cash balance the firm is expected to take more line of credit from the bank. So the notes payable to bank is expected to increase by 406% from 648102 in 2000 to 3463701 in 2001. The main reason behind his huge increase in notes payable might be attributed to poor cash management of the firm. The firm is not expected to generate enough cash collections to cover the cash disbursement in each month of the coming fiscal year, as a result of which the outstanding debt is expected to increase in order to maintain the minimum cash balance at the end of each month.
Analysis of proposals and their impact on the debt position of the company. Exhibit 4: Memo from field Sales Manager One of firm’s goals is to keep the credit terms to 45 days. Pondicherry textiles propose that Kota fibers, ltd extend the credit terms to 80 days and they will make the Kota as its prime yarn suppliers. From the calculation of debt outstanding after incorporating the proposal given by Pondicherry Textile, we can see the debt position in December raised to 3897616 which is IRs. 433915 higher than the forecast done by Mr. Mehta.
Sales Purchases (1) Debt Outstanding
1,696,07 4 684,102
July Sales Purchases (1) Debt Outstandin g
January 2,788,80 1 2,607,52 9 1,344,09 3
February 3,083,77 0 5,161,96 3 3,439,51 7
August
March 4,740,96 2 8,141,15 4 9,639,28 8
September
April 9,385,388 10,312,12 8 18,913,73 6
October
17,392,465
9,138,686
5,363,079
4,740,962
2,949,693
2,607,529
2,070,685
1,622,331
29,863,049
17,800,191
9,583,567
May 14,802,09 8
June 18,749,32 4
9,565,856 29,278,46 8
5,026,277 35,809,12 2
November 3,764,881
December 2,949,693
1,965,500
2,093,837
3,827,762
3,897,616
5,754,282
Although net profit will rise after accepting this proposal, it is still not acceptable. The company is facing liquidity crisis at present. To decrease the cash cycle, company has to focus on decreasing the account receivable turnover. Instead of this, if this proposal is accepted, more time will lag between the sales and receipt of cash. This will require more debt financing which is not favorable in present situation. So, this proposal should be rejected now.
Exhibit 5: Memo from Transportation Manager Comparing the initial case and after applying the according to memo by transportation manager, there has been the decrease in interest expense by 21.41%. The decrease in interest expense points that there has been decrease in debt outstanding. Also the average inventory per month has
decreased by 34.8%. This model has hence helped in increasing the quick ratio of the company from 0.8622 in average to 1.01. There has also been increase in average account payable from 3403855 to 3522896 i.e. by 3.5%. This too plays role in improvising cash conversion cycle. It can be seen that the proposal don’t have significant effect in improvising the working capital condition, however, something is better than nothing and company should adopt this policy along with other policies to improvise its working capital condition.
Total
Total Note
Current Assets
Inventories
Current
Payable-
Current
Quick
Liabilities
Bank (6)
Ratio
Ratio
1146269.05
2.17219673
1.31242873
5831484.03 Jan
5 9891667.05
2308135.035
2684602.15
7 2962622.64
9 1.44906286
3 0.59205878
Feb
8 17617985.0
5850125.058
6826251.167 9 8767030.69
3 1.14458819
9 0.37434939
Mar
6 28689052.7
11855841.06
15392422.43 4 17419379.4
8 1.09626326
3 0.42230790
Apr
3 38413382.0
17637315.33
26169856.88 2 26997556.9
4
4 0.53144639
May
7 39968408.8
19666227.07
35275721.32 9 32950665.3
1.08894675 1.08508964
7 0.69225766
Jun
3
14469651.83
36834199.82 7 27167192.8
6 1.13202496
1 0.90008295
July
33262875.7 21825158.8
6815272.098
29383517.74 1 15795793.1
7
9 1.01130965
Aug
1 12703996.0
3883970.01
17740549.36 9 8352899.26
1.23024143 1.34237087
2 1.03063127
Sept
6 8899885.90
2950256.658
9463849.618 8 5002010.51
1 1.57388727
5 1.24587136
Oct
4
1854836.904
5654716.21
5 3278055.00
8 1.75812638
5 1.36951834
Nov Dec
7419141.86 6690524.77
1639892.46 2225372.569
4219913.831 1 4440346.362 3463701.86
7 1.50675740
3 1.00558646
231213562. Total
9
153303176. 91156896.09
194085946.9 8
7 1.19129471
5 0.72162188
5
5
Forecasted Particulars
Actual (2000)
Exhibit
model 5 option 2225372.56
Inventory Accounts
1249185
9 1157298.43
1827609
Payable Accounts
759535
8
1191195
2672729 684102
3715152.2 3463701.86
3715152 2957147 9090010
Sales
75867480
90900108
8 6699338
COGS Inventory days Receivable days Payable days Cash cycle
53865911 66993379.6 8.46 12.12 12.86 14.92 5.15 6.31 16.18 20.74
0 9.96 14.92 6.49 18.39
receivable Debt outstanding
From the above table we can see that the inventory is expected to decline if the proposal from the transportation manager is accepted. The inventory is expected to decrease because the purchase will be required to be made for only one month now, compared to two months previously. As a result of this the accounts payable is also expected to decrease. All of these will decrease the level of outstanding debt at the end of 2001. The proposal will have a good impact on Kota’s short-term debt position as reduced amount of inventory will reduce the net working capital requirement for the company and eventually the debt outstanding in all the months from January to December is expected to decrease. Also the cash cycle is expected to be shortened to 18 days after this proposal is accepted. So this proposal will have a good impact on short term debt position of Kota fibers. The decrease in borrowing requirement and debt outstanding makes sense as the proposal reduces inventory requirements to half, which means that the amount of financing required for current assets is lesser.
Exhibit 6: Memo from Purchasing Agent The use of JIT method as proposed by Hibachi Chemicals includes purchase of 35% of one of the raw materials. The proposal included the reduction of pellets inventory from 60 days outstanding to 2 to 3 days. The proposal was calculated in excel sheet and was found to have following positive impact on the debt outstanding and borrowing of the company. January
February
March
Debt Outstanding
1,353,298
2,017,987
5,754,537
Debt Outstanding initially
1,146,269
2,962,623
8,767,031
July
Debt Outstandin g Debt Outstandin g initially
August
September
April
May
June
12,043,36 1 17,419,37 9
19,390,52 8 26,997,55 7
24,728,08 9 32,950,66 5
October
November
December
21,067,369
12,403,927
5,990,806
2,980,827
1,646,578
1,844,640
27,167,193
15,795,793
8,352,899
5,002,011
3,278,055
3,463,702
Total Current Inventories Assets
(3)
Total Current Note Payable- Current Liabilities
Bank (6)
Ratio
Quick Ratio
2.44473 Jan Feb
4975358.765 7219122.884
1452009.765 2035130.44 3177580.884 4357241.09
1353297.856 2017987.213
7 1.731264 1.656811 0.927546 1.19121
Mar
12700823.76
6938679.761 10662059.87
5754536.944
7 1.12325
Apr May
21578653.44 30312426.48
10526916.04 19210779.92 11565271.48 27271180.58
12043361.35 19390527.64
8 0.575288 1.111519 0.687435 1.10260
Jun Jul
33365082.66 29283772.99
7866325.664 30260342.47 2836169.388 25373312.02
24728088.95 21067368.77
1 0.842646 1.154117 1.042339 1.27438
Aug
19302136.33
1360947.533 15146281.94
12403926.55
1 1.45224
1.184528
Sep
10711655.03
957915.6323 7375929.187
5990805.687
5
1.322374
0.540434
1.85071 Oct
7308058.487
263009.4868 3948771.776
2980826.654
7 2.26718
1.784111
Nov
5955715.801
176466.4009 2626923.044
1646577.928
3 1.89093
2.200007
Dec
5079974.454
614822.2544 2686484.25
1844640.455
8
1.66208
This gives that the average current ratio of the company is upgraded to 1.54 per month. On January, November and December, the working capital is relatively higher than other months as well as the overall current ratio is better than the base model. Similar goes with the quick ratio. The quick ratio is 1.2 and is better than the scenario of improvised transportation model. Also the interest expense on debt is dropped down drastically by 99.4%. The decrease in debt outstanding on average is reduced by 28.44% monthly ranging from 21% to 49.8%. Particulars Inventory Accounts Payable Accounts receivable Debt outstanding Sales COGS Inventory days Receivable days Payable days Cash cycle
Actual (2000) Base model Hibachi 1249185 2225372.569 614822.3 759535 1157298.438 1002041 2672729 684102 75867480 53865911 8.46 12.86 5.15 16.18
3715152.2 3715152 3463701.86 1844640 90900108 90900108 66993379.6 66993380 12.12 3.35 14.92 14.92 6.31 5.46 20.74 12.81
By accepting Hibachi proposal the inventory level is expected to decline drastically to only IRS 614822.3 from original expectation of IRS 2225372.569. The debt outstanding is also expected to decline drastically to only IRS 1.8 million from original forecast of IRS 3.46 million. The decrease in debt outstanding is as a result of decrease in net working capital requirement of the firm after the implementation of JIT proposal. The decrease in net working capital requirement is also indicated by decrease in current and quick ratio after implementing JIT proposal. If this proposal is accepted, cash cycle is expected to decrease to 12.81 days from 20.74 days.
Therefore, it is better to include Hibachi proposal. It is better to go both with the proposal by the transportation manager and Hibachi proposal simultaneously.
Exhibit 7: Memo from Operation Manager From the application of this proposal, it is expected that gross profit margin will increase by 2% to 3% which may be because of reduction in seasonal training and set up cost and increase in production efficiency. The work force will be more motivated to work and machine break down will be less frequent. But, if we see the following calculation, the proposal seems vague and inapplicable. If we convert the monthly sales as percentage of total sales in a year we will get the following percentage of sales as shown in figure below. To make level production means to have same percentage of total production every month which will eventually add up to 100% annually. Now of when we add total sales requirement the product up to July i.e. till the end of peak sales season, we find 73.21% of sales is made up to July. But when we add up the total production only 58.33% is produced till the end of July. The strategy of the company is to produce goods only according to demand and it is mentioned in the case description that company does not follow overproduce the product as the profit margin is small and carrying cost will be high. This also means the sales and production amount must be approximately equal. But if level production strategy is followed, the company will not be able to fulfill the market demand in time of peak sales due to under production. While on the other hand, company will be over producing in the time of slack sale from the month of August till December. This will create imbalance in the demand supply mechanism of the business.
Hence, this proposal of level production must be rejected.
Summary of all the Proposals. Initial Forecast
Pondicherry
Debt Balance Summary Jan 01 1,146,269 June 01 32,950,665 Dec 01 3,463,702
Debt Balance Summary Jan 01 1,344,093 June 01 35,809,122 Dec 01 3,897,616
Inventory Debt Balance Summary Jan 01 1,200,185 June 01 25,435,575 Dec 01 2,957,147
Hibachi JIT Debt Balance Summary Jan 01 1,353,298 June 01 24,728,089 Dec 01 1,844,640
The action that can be taken by Pundir Pundir can take the following steps: o Reject the proposal from Field sales manager. o Accept the proposal of Transportation manager o Reducing raw material inventory by 30 days will reduce peak debt to INR 25 million and ending debt to INR 3 million, respectively, and will also increase the profitability of the firm by INR 275,202. But the company should be aware of the dangers of reducing inventory, a reduction from 60 to 30 days, although significant, still leaves a good margin of safety. o Accept the proposal of JIT from Hibachi Chemicals. o Reject the proposal from Operations manager. o Instead of providing quarterly dividend of INR 500000, the money can be used in the business to manage the liquidity need. The Pundir family’s belief is not appreciable regarding the funds of firm. The excess money would play significant role in enhancing debt position of the company if used wisely rather than just giving out dividends. Dividends can be taken when the debt position gets stronger after time being. Only after implementing the strategies mentioned above, the level of debt outstanding can be reduced to zero by the end of 2001. Which would mean that the company would be able to clear the line of credit by December 2001.
Recommendations o The firm should move towards cutting down the cash cycle and increase its liquidity. One of the way the firm can do this is moving towards receiving their supplies on a JIT basis. This will tie up less cash in inventory that is sitting in the warehouse. They could also lower credit terms to receive funds quicker from their buyers. This strategy will lower their cash cycle and free up cash and have more liquidity on hand. From these plans, company does not have to purchase more inventory in the first two months since it will use raw material on hand and order accordingly. o The company should also request that the note payable be repaid in December of the fiscal year, not October. This allows Kota fibers time to collect its outstanding receivables from its peak selling season. o The company should not provide dividend to its shareholder till all outstanding debt are settled. o The company can ask shareholder to invest in the company. Learnings from the case o The firm with poor cash management generally has trouble in carrying out day to day operating activities such as making payments to the tax inspector for the excise tax due to lack of liquidity in their cash balance. As a result of which, the level of debt increases to meet the liquidity needs. o If the firm is unable to manage its working capital, especially cash, then the short term debt of the firm is going to increase which will have negative impact on the profitability of the company through increased interest expenses. o In order to manage the cash effectively and efficiently, the firm should try either to decrease its inventory days or accounts receivable days or increase its accounts payable o
days so that the cash cycle of the firm can be shortened. One of the ways a firm can reduce its inventory level is to implement Just in time system. JIT production strategy strives to improve business return on investment by reducing in process inventory and associated carrying cost. JIT focuses on continuous improvement and can improve a manufacturing organization’s return on investment, quality and efficiency.
