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Cape Chemical: cash and profits.(Instructor's Note)

INSTRUCTORS' NOTES

Case Overview

Cape Chemical is a relatively new regional distributor of liquid and dry chemicals, headquartered in Cape Girardeau, Missouri. The company, founded by Ann Stewart, has been serving southeast Missouri, southern Illinois, northeast Arkansas, western Kentucky and northwest Tennessee for five years and has developed a reputation as a reliable supplier of industrial chemicals. Stewart's previous business experience provided her with a solid understanding of the chemical industry and the distribution process. As a general manager for a chemical manufacturer, Stewart had profit and loss (P&L) responsibility, but until beginning Cape Chemical, she had limited exposure to company accounting and finance decisions.

The company reported small losses during its early years of operation, but performance in recent years has been very good. Sales have grown at double-digit rates, new product lines have been added and profits have more than tripled. The growth has required the acquisition of additional land, equipment, expansion of storage capacity and more than tripling the size of the work force. Stewart has proven to be an expert marketer, and Cape Chemical has developed a reputation with its customers of providing quality products and superior service at competitive prices.

At the insistence of Stewart, the company has promoted "next day delivery" since its inception. This requires Cape Chemical to carry a large number of products and large quantities of each item. As Cape Chemical has added new product lines, more and more dollars have been invested in inventory. Other chemical distributors can seldom provide "next day delivery" service because they don't stock the number of products and the quantity of each carried by Cape Chemical. Not surprisingly, "next day delivery" has proven very popular with its customers and has allowed Cape Chemical to capture a large market share. The sales force is also a strong supporter of the service, but because occasional inventory shortages cause sales to be missed, they are constantly arguing for even greater amounts of inventory to be maintained by the company. Stewart has tended to agree with the sales force and has over the years instructed the purchasing department to err on the side of carrying too much rather than too little inventory.

Stewart has also used a liberal credit policy to stimulate sales, and that also has been a contributing factor to the double-digit sales growth. Credit terms offered by its main competitors are net 30-days, which conforms to general industry practices. Cape Chemical also sells using net 30-day terms, but Stewart has encouraged the firm's credit manager to take a "soft approach" when collecting past due accounts. As a result, the credit department has been slow to press past due accounts for payment. The relaxed collection effort has proven to be popular with both customers and the sales force but has resulted in a increasing number of customers paying late. To further increase sales, Stewart suggested credit standards be lowered so that more customers can qualify for credit. The credit standards were lowered two years ago and again at the beginning of the 2007. The bad debt losses experienced by the firm have not changed significantly with the less restrictive credit standards.

Case Use

The case as written includes discussion questions to aid the student in their analysis of Cape Chemical's current financial position. It also provides two schedules for the students to complete. The case can be made more difficult by omitting the discussion questions and Schedules Three and Four.

DISCUSSION QUESTIONS

James Scott, a financial advisor, has been hired by the firm's CEO, Ann Stewart, to provide assistance developing financing options, and in solving the firm's cash problems. Students are asked to assume the role as an assistant to Scott and answer the following questions.

1. Explain why it is possible for a firm to be profitable and at the same time experience cash flow problems.

Cape Chemical, like most firm's, uses an accrual accounting system to determine profits. With an accrual accounting system, not all revenues reflect cash inflows. Sales can result in accounts receivables and receivables are converted only when collected. Not all expenses represent cash outflows (depreciation expense). A firm can report a profit but not generate a positive cash flow because revenues and expenses are not cash inflows and outflows. Reported income also does not reflect the cash outflows required to obtain the assets (current assets and fixed assets) required to generate sales. Acquiring assets to support sales growth is the major cause of Cape Chemical's ongoing cash flow problem.

2. Prepare a cash flow statement for 2006 and 2007. Interpret the information provided by the cash flow statements. How has Cape Chemical been using its cash and why is additional cash needed?

(See completed Schedule Three)

A cash flow statement provides information regarding the amount and sources of cash coming into a firm for the period and how the cash was used. Inflows and outflows are divided into three categories, cash flow from operations, cash flow from investing activities and cash flow from financing activities. As its name indicates, the focus is on cash not accounting profits.

Cape Chemical's cash has been used primarily to finance increases in accounts receivables, inventory and additional fixed assets.
Cash used to finance (000's)/$      2006    2007

Accounts receivable increase       1,700   3,042
Inventory Increase                 1,376   3,532
Increase in other current assets      20       0
Increase in fixed assets             522   1,329
Decrease in accrued liabilities       32      39
  Total cash used                  3,650   7,942


Cash has been generated primarily from income, deprecation expense, increasing accounts payable (taking longer to pay vendors) and increasing short-term and long-term borrowings.
Cash sources (000's)/$                 2006    2007

Net income                              215     554
Depreciation expense                    400     491
Decrease in other current assets          0      25
Increase in accounts payable          1,000   2,637
Increase in short-term borrowings     1,000    1,200
Increase in long-term borrowings      1,030    3,025
  Total cash generated and borrowed   3,645    7,932


Analysis of the cash flow statements reveals that the company generated $615,000 and $1,045,000 in cash from income and depreciation expense during 2006 and 2007 respectively. The company used that cash plus substantially more to finance the company's asset growth. The policy of "next day delivery" service, instituted by Stewart requires the company to carry large amounts of inventory, and the relaxed accounts receivables collection policy results in large receivable balances. To efficiently handle the larger sales volume, the firm needed to purchase additional fixed assets. To finance the asset growth, the company borrowed $2,030,000 in 2006 ($1,000,000 short-term and $1,030,000 long-term) and another $4,225,000 in 2007 ($1,200,000 short-term and $3,025,000 long-term) from its bank. The company's vendors have also contributed financing as accounts payable increased by $1,000,000 in 2006 and another $2,637,000 in 2007. The bank has indicated no additional funds will be made available until the debt ratio is lowered to 50% and the times interest earned ratio is increased to at least 4.0. Although the case does not discuss the response of the company's vendors to the aging of accounts payables, it is likely the company has experienced an increase in collection calls from its suppliers and perhaps threats of eliminating the firm's credit.

The cash flow statement clearly indicates why despite increasing profitability the company continues to experience cash flow problems and has had to borrow to the limit. Students should see the benefits of the cash flow statements, and one of their recommendations should be to require the inclusion of the cash flow statement as part of the company's regular financial statement package.

What Stewart has overlooked or doesn't understand is that assets are required to generate sales and assets require financing. Cape Chemical's rapid sales growth has required a large increase in assets and additional financing. Most business startups have limited capital thus if sales grow faster than expected a capital shortage may occur. If capital is limited, a firm needs to control sales growth to avoid a cash or capital crunch.

3. Calculate the return on equity for 2005, 2006 and 2007 using the extended DuPont equation. Interpret the results. What does the equation reveal regarding the company's profitability, use of assets and sources of financing?

The extended DuPont equation is a method of calculating a firm's return on equity (ROE) by utilizing the profit margin (PM), total asset turnover (TATO) and equity multiplier (EM). The extended DuPont equation is: ROE = PM x TATO x EM. Profit margin is calculated by dividing net income (NI) by sales revenue and is a measure of how much of each sales dollar flows to the "bottom line" as profit. Both components are found on the income statement. A firm's profit margin is an indicator of how well operating costs are controlled. The TATO is a measure of how well a firm's management has used the firm's assets to generate sales and is calculated by dividing sales revenue by total assets. The TATO relates an income statement number, sales revenue, with a balance sheet number, total assets. A company that is operating with a high the TATO generates greater sales per dollar than a firm with a lower TATO. Higher is better. A firm's equity multiplier is calculated by dividing total assets by total common equity and is a measure of a firm's financial leverage. The more debt used in a firm's capital structure, the greater the equity multiplier. The DuPont equation illustrates that a firm's ROE can be improved by increasing any one of the equation's three components.

Return on equity calculated with the DuPont equation for Cape Chemical for the three-year period 2005-2007 is as followed:
Year         ROE              PM     x   TATO   x    EM

2005   .0265 or 2.65%    =   .0067   x   2.16   x   1.83
2006   .0436 or 4.36%    =   .0075   x   2.42   x   2.40
2007   .1010 or 10.10%   =   .0113   x   2.54   x   3.51


The firm's ROE has steadily increased from 2.65% in 2005 to 10.10% in 2007. The firm's profit margin is relatively low although it has improved since 2005; total asset turnover and the equity multiplier continue to increase. The increasing TATO is surprising given the relative large increase in current assets. Additional analysis is required to gain a better understanding of the relationship between asset and sales growth. The company can improve its ROE by better controlling of operating costs and continued increased utilization of its assets. The firm's debt level is too high.

4. Evaluate the company's performance for 2005, 2006 and 2007 using ratio analysis. Calculate the following ratios and evaluate performance.

* Current ratio

* Accounts receivable turnover

* Average collection period (ACP) or Days sales outstanding (DSO)

* Inventory turnover--using cost of goods sold in the numerator

* Inventory conversion period--using cost of goods sold

* Accounts payable deferral period

* Fixed asset turnover

* Total asset turnover

* Times interest earned ratio (TIE)

* Debt ratio

* Basic earning power

* Profit margin

* Return on assets

* Return on equity

(See complete Schedule Four)

Ratios for a single year can provide insight into a company's performance but to increase the information content of ratio analysis, ratios need to be calculated for a number of years (trend analysis). In general, analysis of Cape Chemical ratios indicates declining financial performance in almost all areas except profitability. Cape Chemical's effective use of fixed assets has more than offset the increased investment in inventories and receivables and explains the high TATO. Liquidity has declined, asset utilization is poor and getting worse, and the debt ratio has increased.

The firm needs to review its policy of using a "relaxed" collection effort to attract additional sales and the policy of carrying sufficient inventory to avoid "stock outs". A balance needs to be achieved between carrying costs and lost sales due to "stock outs". The current policy of paying its vendors late will most likely adversely affect the firm's ability to obtain credit in the future.

Comparing Cape Chemical's ratios with industry averages provided by RMA would also provide additional insight regarding performance.

5. Calculate the company's cash conversion cycle for 2005, 2006 and 2007.

a. Use the cash conversion cycle to evaluate the firm's working capital policy.

b. Explain the objective of inventory management. Evaluate Cape Chemical's inventory management.

c. List the components of a firm's credit policy. Evaluate Cape Chemical's credit policy.

d. Discuss the tradeoffs associated with working capital management.

Cash Conversion Cycle

The cash conversion cycle is a tool used to evaluate a firm's working capital management. It is the length of time between when cash leaves the company (to pay for material, services and labor) and when cash returns to the company (usually collection of receivables). The cash conversion cycle is equal to the inventory conversion period (days of inventory) plus the average collection period (ACP) or (DSO) less payables deferral period. The payables deferral period is the average length of time between the purchase of materials and services and the payment of cash for them. To effectively manage working capital, a firm will attempt to balance the cost of carrying inventory and financing receivables with the impact on sales of lower inventories and tighter credit. It must also consider the impact on its credit worthiness of paying its accounts payables late.

The cash conversion cycle for Cape Chemical increased from 46 days in 2005 to 63 days in 2007 as the firm's inventory conversion period and ACP increased. The cash conversion cycle would be even greater if the firm had not delayed its payments to it vendors and service providers.
Year   Cash Conversion           Inventory           Receivables
            Cycle        =   Conversion Period   +   Collection    -
                                                       Period

2005       46 Days       =        36 Days        +     33 Days     -
2006       57 Days       =        44 Days        +     43 Days     -
2007       63 Days       =        56 Days        +     47 Days     -

Year   Payables
       Deferral
        Period

2005   23 Days
2006   30 Days
2007   40 Days


As stated as part of the answer to question 3, the firm needs to review its policy of using a "relaxed" collection effort to attract additional sales and the policy of carrying sufficient inventory to avoid "stock outs". A balance should be achieved between carrying costs and lost sales due to "stock outs". Payment of vendor invoices also should be reviewed to avoid future credit problems.

Inventory Management

The objective of inventory management is to maintain sufficient inventory to avoid material sales loses due to stock outages and at the same time, keep the costs associated with inventory low. Inventory costs can be divided into two categories, ordering costs and carrying costs. Ordering costs, as the name suggests, are those administrative costs related to placing an order. Carrying costs are the costs incurred in maintaining inventory. Carrying costs include labor cost to receive and store an order, cost of facilities (warehouse, tanks) required to store inventory, insurance, administrative costs related to storing and accounting for inventory, inventory losses due to shrinkage, damage, obsolescence or devaluation and financing cost related to the dollars invested in inventory. Of the carrying costs, the largest is usually the cost associated with financing the inventory.

An effective inventory management system recognizes the tradeoffs associated with the cost of lost sales due to inventory shortages and inventory costs. Cape Chemical should review its current inventory policy. The case does not provide inventory cost information, but it is apparent that the current policy places too much emphasis on maximizing sales without considering the costs associated with such a policy. The inventory conversion period has increased from 36 days in 2005 to 56 days in 2007.

Credit Policy

A firm's credit policy reflects its position regarding 1) credit terms, 2) sales discounts offered, 3) credit standards and 4) collection policy. Credit terms establish the length of time customers are given to pay their invoices. In most cases, industry competition will influence a firm's credit terms. If its competitors are offering customers 30-day payment terms, a company will have a difficult time offering more restrictive terms. Sales discounts (a reduction in price if the invoice is paid faster the normal terms dictate) will also be heavily influenced by industry competition. Credit standards relate to the criteria used to establish the credit worthiness of a customer. In general, the higher the standards the lower bad debt loses and collection problems. Collection policy refers to the effort a firm places on collecting its accounts receivables in a timely manner.

As with inventory management, a firm's credit policy can impact its sales and profitability. A restrictive credit policy would reflect credit terms equivalent to or less than the industry, higher than industry credit standards and an aggressive approach to collecting receivables. A restrictive credit policy would tend to reduce the costs associated with carrying receivables. Carrying costs include financing receivables, administrative costs associated with monitoring and collecting receivables and bad debt losses. The downside to a restrictive credit policy is that in addition to reducing receivables carrying costs it also tends to reduce sales (fewer customers will receive credit and those that do may have lower credit limits). Some customers may not like the aggressive collection effort (frequent inquires, and refusing future sales until past due invoice are paid). The inverse is also true; a relaxed credit policy will stimulate sales but will also result in an increase in receivables carrying costs.

The case indicates that Cape Chemical is successfully using a relaxed credit policy to stimulate sales, but little consideration has been given to the increased carrying costs associated with a relaxed policy. The company's Receivables Collection Period has increased from 33 days in 2005 to 47 days in 2007.

Working Capital Management

Effective working capital management requires a firm to balance the benefits of carrying high levels of inventory and receivables (higher sales) with the costs of carrying the higher levels inventory and receivables. A tradeoff is required. Cape Chemical should revisit its current approach to inventory and receivables management and recognize there are costs to its current policies and these need to be considered.

6. Based on answers to questions 1-5, summarize why the firm is experiencing cash problems? Provide your recommendations to improve the cash situation.

The firm's cash problems are the result of:

a. Rapid sales growth

b. A relaxed credit policy

c. An inventory policy based on never missing a sale

Student recommendations to improve performance should include:

a. A detailed review of operating costs in an effort to increase the firm's profit margin.

b. A review of the firm's credit policy and in particular the "relaxed" collection effort that has allowed accounts receivables to steadily increase.

c. A review of the firm's inventory policy.

d. It may be necessary to limit sales growth until the firm can achieve a stronger cash position.

7. What alternatives are available to the firm to acquire the $4,200,000 financing required to add the specialty chemical product line and finance the projected sales growth for 2008?

The case doesn't allow many options. Additional equity is not possible because of Stewart's desire not to reduce her ownership percentage. It may be possible to find another bank to replace the current lender. Finding a replacement bank will require time and is probably unlikely given the company's relatively high debt ratio (over 71% at the end of 2007) and TIE ratio (only 1.81x at the end of 2007). A more reasonable alternative would be to take a more aggressive approach to the management of its current assets. Reducing the inventory conversion period from 56 days to 33 days (2005 level) and the DSO from 47 days to 35 days (2005 level) will "free up" enough additional financing to more than meet the $4,200,000 needed to acquire the specialty chemical product line and projected sales growth for 2008. It would also allow the payable deferral period to be reduced.

Improving working capital management will increase the firm's ROE, reduce its cash conversion cycle as well as provide the necessary financing.

David A. Kunz, Southeast Missouri State University

Benjamin L. Dow III, Southeast Missouri State University
Schedule One
Cape Chemical
Income Statements (000's/$)

                                    2005              2006

                                $        %        $        %

Revenue                      18,675   100.00   28,675   100.00
Cost of Goods Sold           15,932    85.31   24,393    85.07
Gross Profit                  2,743    14.69    4,282    14.93
Operating Expenses
  Selling                     1,251     6.70    1,851     6.46
  General & Administrative    1,090     5.84    1,590     5.54
Total Operating Expenses      2,341    12.54    3,441    12.00
Operating Profit                402     2.15      841     2.93
Interest Expense                210     1.12      510     1.78
Earnings Before Taxes           192     1.03      331     1.15
Income Tax Expense               67     0.36      116     0.40
Earnings After Taxes            125     0.67      215     0.75

                                   2007

                                $        %

Revenue                      48,845   100.00
Cost of Goods Sold           42,007    86.00
Gross Profit                  6,838    14.00
Operating Expenses
  Selling                     2,734     5.60
  General & Administrative    2,192     4.49
Total Operating Expenses      4,926    10.09
Operating Profit              1,912     3.91
Interest Expense              1,059     2.17
Earnings Before Taxes           853     1.74
Income Tax Expense              299     0.61
Earnings After Taxes            554     1.13

Schedule Two
Cape Chemical

Balance Sheets (000's/$)

                                     2005             2006

                                      $        %        $        %
Current Assets
  Cash                                 25     0.29       20     0.17
  Receivables                       1,712    19.79    3,412    28.76
  Inventory                         1,582    18.29    2,958    24.94
  Other current assets                 44     0.51       64     0.54
    Total current asssets           3,363    38.88    6,454    54.41

Fixed Assets
  Land                                590     6.82      590     4.97
  Gross plant, property & equipmen  5,078    58.72    5,600    47.21
  (less accumulated depreciation)   (382)    (4.42)    (782)   (6.59)
  Net plant, property & equipment   4,696    54.30    4,818    40.62
  Total fixed assets                5,286    61.12    5,408    45.59

    Total Assets                    8,649   100.00   11,862   100.00

Current liabilities
  Account payables                  1,019    11.78    2,019    17.02
  Short-term notes payables           300     3.47    1,300    10.96
  Accrued liabilities                 312     3.61      280     2.36
  Total current liabilities         1,631    18.86    3,599    30.34
  Long-term liabilities             2,300    26.59    3,330    28.07
    Total liabilities               3,931    45.45    6,929    58.41

Shareholders' equity
  Common stock                      4,500    52.03    4,500    37.94
  Retained earnings                   218     2.52      433     3.65
    Total equity                    4,718    54.55    4,933    41.59

Total liabilities & equity          8,649   100.00   11,862   100.00

                                      2007

                                       $         %
Current Assets
  Cash                                   10     0.05
  Receivables                         6,454    33.55
  Inventory                           6,490    33.73
  Other current assets                   39     0.20
    Total current asssets            12,993    67.53

Fixed Assets
  Land                                  590     3.07
  Gross plant, property & equipmen    6,929    36.02
  (less accumulated depreciation)    (1,273)   (6.62)
  Net plant, property & equipment     5,656    29.40
  Total fixed assets                  6,246    32.47

    Total Assets                     19,239   100.00

Current liabilities
  Account payables                    4,656    24.20
  Short-term notes payables           2,500    13.00
  Accrued liabilities                   241     1.25
  Total current liabilities           7,397    38.45
  Long-term liabilities               6,355    33.03
    Total liabilities                13,752    71.48

Shareholders' equity
  Common stock                        4,500    23.39
  Retained earnings                     987     5.13
    Total equity                      5,487    28.52

Total liabilities & equity           19,239   100.00

Schedule Three
Cape Chemical

Cash Flow Statements (000's/$)
(for the year ended December 31)

                                                  2006      2007

Cash flow from operations
  Net Income                                       215       554
  Plus depreciation expense                        400       491
  Increase in receivables                       (1,700)   (3,042)
  Increase in inventory                         (1,376)   (3,532)
  Decrease in other current assets                 (20)       25
  Increase in account payables                   1,000     2,637
  Decrease in accrued liabilities                  (32)      (39)
    Total cash flow from operations             (1,513)   (2,906)

Cash flow from investing activities
  Increase in land                                   0         0
  Increase in fixed assets                        (522)   (1,329)
    Total cash flow from investing activities     (522)   (1,329)

Cash flow from financing activities
  Increase in short-term notes payables          1,000     1,200
  Increase in long-term liabilities              1,030     3,025
  Increase in common stock                           0         0
  Dividends paid                                     0         0
    Total cash flow from financing activities    2,030     4,225

Net cash flow                                       (5)      (10)
Plus beginning cash                                 25        20
Ending cash                                         20        10

Schedule Four
Cape Chemical

Ratios
                                       2005     2006     2007

Current Ratio                          2.06     1.79     1.76
Accounts Receivable Turnover          10.91     8.40     7.57
Days Sales Outstanding (DSO)
or Average Collection Period (days)      33    42.84    47.57
Inventory Turnover                    10.07     8.25     6.47
Inventory Conversion Period (days)    35.75    43.66    55.62
Payables Deferral Period (days)       23.03    29.80    39.90
Cash Conversion Cycle (days)          45.72    56.69    63.28
Fixed Asset Turnover                   3.68     5.12     7.05
Total Asset Turnover                   2.16     2.42     2.54
Times Interest Earned (TIE)            1.91     1.65     1.81
Debt Ratio                            45.45%   58.41%   71.48%
Basic Earning Power                    4.62%    7.09%    9.94%
Profit Margin                          0.67%    0.75%    1.13%
Total Asset Turnover                   2.16     2.42     2.54
Return on Assets (ROA)                 1.45%    1.81%    2.88%
Equity Multiplier                      1.83     2.40     3.51
Return on Equity (ROE)                2.65%    4.36%    10.10%
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Title Annotation:Instructor's Note
Author:Kunz, David A.; Dow, Benjamin L., III
Publication:Journal of the International Academy for Case Studies
Article Type:Case study
Geographic Code:1USA
Date:Nov 1, 2010
Words:4199
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