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Cape chemical: cash and profits.

BACKGROUND

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.

CHEMICAL DISTRIBUTION

A chemical distributor is a wholesaler. Operations may vary but a typical distributor purchases chemicals in large quantities (bulk--barge, rail or truckloads) from a number of manufacturers. They store bulk chemicals in "tank farms", a number of tanks located in an area surrounded by dikes. The tanks can receive and ship materials from all modes of transportation. Packaged chemicals are stored in a warehouse. Other distributor activities include blending, repackaging, and shipping in smaller quantities (less than truckload, tote tanks, 55-gallon drums, and other smaller package sizes) to meet the needs of a variety of industrial users. In addition to the tank farm and warehouse, a distributor needs access to specialized delivery equipment (specialized truck transports, and tank rail cars) to meet the handling requirements of different chemicals. A distributor adds value by supplying its customers with the chemicals they need, in the quantities they desire, when they need them. This requires maintaining a sizable inventory and operating efficiently. Distributors usually operate on very thin profit margins. RMA Annual Statement Studies indicates "profit before taxes as a percentage of sales" for Wholesalers--Chemicals and Allied Products (Standard Industrial Code number 5169) is usually in the 3.0% range. In addition to operating efficiently, a successful distributor will possess 1) a solid customer base and 2) supplier contacts and contracts that ensure a complete product line at competitive prices.

THE SITUATION

While profits have increased over the last three years (2005-2007), cash flow has been a problem. Stewart has struggled to maintain sufficient cash to pay obligations in a timely manner. The company reached its bank-borrowing limit at the end of 2006, but Stewart used fixed assets as collateral to successfully negotiate an additional $3,000,000 in long-term borrowings. The additional capacity was used during 2007 as well as an extra $1,000,000 provided by a working capital loan extended by the bank. At the end of 2007 the debt ratio was 71% and the TIE ratio was 1.81. The bank has refused to grant additional loans until the debt ratio can be lowered to below 50% and the times interest earned ratio increased to above four.

Stewart has been attempting to acquire an attractive specialty chemical product line since starting the company. Adding this product line will require an investment of $200,000 to acquire the necessary special handling and packing equipment. Inventory investment will require another $800,000.

Stewart has hired James Scott, a financial advisor, to provide assistance developing financing options and solving the firm's cash problems. To finance the expected sales growth for 2008, Stewart has estimated the firm will need at least $2,000,000 for additional current assets and another $1,200,000 for capital expenditures. In total, the company needs approximately $4,200,000 in new financing to add the specialty chemical line and provide the necessary resources to achieve the planned sales growth for 2008. Issuing more common stock is not an option since Stewart does not want to further dilute her ownership position. The stock is not publicly traded.

At their first meeting, Stewart provided Scott with income statements and year-ending balance sheets for the most recent three years (See Schedules One and Two). A complete analysis at the meeting was not possible, but Scott noted the increase in accounts payable and inventory. Stewart explained that a large inventory investment was necessary to support the company's "next day delivery" service and how the use of a liberal credit policy has caused accounts receivables to increase. She also stressed the importance of each to the company's continued sales growth. When asked about the firm's daily sales outstanding (DSO) and days invested in inventory, Stewart stated that ratios are not calculated. Stewart said she really doesn't understand all those ratios and besides she doesn't need them to run the business. Since the company's inception, an outside accounting firm has prepared the financial reports based on data supplied by the firm's bookkeepers. To keep overhead expenses low Stewart has been reluctant to hire a full-time accountant. The company's accounting firm prepares a quarterly financial statements consisting of an income statement and balance sheet. No cash flow statements are prepared.

THE TASK

Assume you are an assistant to Scott. Evaluate the firm's current situation. In your analysis answer the following:

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

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

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?

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

a. Current ratio

b. Accounts receivable turnover

c. Average collection period (ACP) or Days sales outstanding (DSO)

d. Inventory turnover--using cost of goods sold in the numerator

e. Inventory conversion period- using cost of goods sold

f. Accounts payable deferral period

g. Fixed asset turnover

h. Total asset turnover

i. Times interest earned ratio (TIE)

j. Debt ratio

k. Basic earning power

l. Profit margin

m. Return on assets

n. Return on equity

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 goals 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.

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

Provide your recommendations to improve the cash situation.

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?

SUGGESTED REFERENCES

Brigham, Eugene F. and Joel F. Houston (2007), Fundamentals of Financial Management, Concise 5th ed., Thomson South- Western.

RMA Annual Statement Studies, Robert Morris Associates.

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

Income Statements (000's/$)

                                          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 assets             3,363    38.88     6,454    54.41

Fixed Assets
  Land                                 590     6.82       590     4.97
  Gross plant, property &            5,078    58.72     5,600    47.21
    equipment
  (less accumulated                  (382)   (4.42)     (782)   (6.59)
    depreciation)
  Net plant, property &              4,696    54.30     4,818    40.62
    equipment
    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 assets            12,993    67.53

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

Statements of Cash Flow (000's/$)

                                      2006     2007

Cash flow from operations
  Net Income                           215      554
  Plus depreciation expense                     491
  Change in accounts receivables
  Change in inventory
  Change in other current assets
  Change in account payables
  Change in accrued liabilities    (1,513)
    Total cash flow from
      operations

Cash flow from investing
  activities
  Change in land
  Change in fixed assets             (522)
    Total cash flow from
      investing activities

Cash flow from financing
  activities
  Change in short-term notes
    payables
  Change in long-term
    liabilities
  Change in common stock
  Dividends paid
    Total cash flow from
      financing activities

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

Schedule Four
Cape Chemical

Ratios
                                     2005     2006      2007
Current Ratio
Accounts Receivable Turnover                   8.4
Days Sales Outstanding (DSO)
  or Average Collection Period
 (days)                               33
Inventory Turnover
Inventory Conversion Period
  (days)
Payables Deferral Period                                39.9
  (days)
Fixed Asset Turnover
Total Asset Turnover
Times Interest Earned (TIE)                   1.65
Debt Ratio                          45.45%
Basic Earning Power
Profit Margin
Total Asset Turnover                          2.42
Return on Assets (ROA)              1.45%
Equity Multiplier
Return on Equity (ROE)
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Article Details
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Title Annotation:CASES
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:Oct 1, 2010
Words:2312
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