Сборник кейсов по менеджменту. Сборник-бизнес-кейсов по менеджменту (2). Сборник бизнескейсов алматы, 2015 Выпуск 1 Алматы Менеджмент Университет Высшая Школа Бизнеса
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What financial decisions should Darithana take to cover these two urgent liabilities: to the Bank and to its employees? 71 DARITHANA This note serves as a facilitator’s guide to the Darithana case study. After a brief case synopsis, the note describes the learning objectives and key lessons. Assignment questions are listed and a teaching plan to guide the discussion and answer the questions is presented. Case Synopsis Darithana, a listed company of generic and branded drugs in Kazakhstan, faced the two urgent liabilities: (1) the Bank’s requirement to repay its loan ahead of time because of its inability to meet the requirement to the Current Ratio and (2) debts on employee wages. But the Company currently did not have sufficient funds to carry out these obligations. Its liquidity problems had been linked to construction of the new factory within the Company’s long-term investment project that needed cash outflows. What financial decisions should the CFO Serik Junn take to cover these two urgent liabilities: repay the debt to the Bank and pay the employees? Learning Objectives This case is best used as the introduction to the Ratio Analysis or Financial Reports & Analysis, especially on Liquidity Ratios. The case can also be used to assess the financial policy of a company and its creditworthiness. It can also raise another issue of international and national scales of financial rating for companies and their financial instruments (e.g. bonds). The purpose of this case is to stimulate students’ discussion on the following issues: 1. Current Ratio (CR) concept 2. The structural analysis of short-term assets and liabilities 3. The approaches to standard values of Current Ratio 4. The two types of financial policy Suggested Lesson Plan Activity Instructional Strategy Duration (min) Class discussion Class discussion 50 Break 10 Lecture on Liquidity Ratios and a company’s financial policy Lecture 50 110 Students Discussion Questions: 1. What should the CFO do to meet urgent liabilities? 2. Why does the Bank require the Current Ratio to be greater than 1.5? 3. How would you describe the Bank’s financial policy: conservative or aggressive? What happens if you attract long-term sources and which kinds of them (e.g. loans, bonds, etc.)? 4. How is the Current Ratio linked to a company’s long-term solvency? 72 Case Analysis and Teaching Plan 1. What should the CFO do to meet urgent liabilities? Students should contribute to the discussion here. If students have not read the case, listing issues allows them to catch up and hence be participative in the discussion. The students will typically advocate the two quite obvious solutions: 1. Request the Bank to give additional time to increase liquidity. 2. Communicate with the staff and ask them to be patient by promising to promptly pay all salary debts. The instructor should support these possible solutions. However, you should tell the students that such approaches do not always work and do not provide long-term effect. For example, if the Bank has any financial difficulties itself, it may simply reject the Company’s request. Then you could ask the students to name a few other options when the above two offers do not work. 2. Why does the Bank require the Current Ratio to be greater than 1.5? The instructor could focus the students' attention to the Current Ratio’s formula and ask students: "What do you think, why does the Bank require the Current Ratio to be greater than 1.5?" This question allows you to elaborate on the problem of the ratio’s optimal value and its essence. In explaining of the Current Ratio’s role, it would be useful to write on the blackboard the formula as shown in Figure 1 in order to help the students visualize it: Figure 1: Current Ratio Theoretically, this short-term coefficient reflects how company's current liabilities are covered by current assets. Using Figure 1, you could draw students' attention to the fact that the ratio shows how much of a company's current debt can be repaid through available cash, future payments from debtors as well as on condition of selling of existing inventories, including finished products and other tangible current assets. In other words, short-term liquidity measures are typically based on “how quickly assets can be converted into cash to settle obligations that are due soon” Excess of current assets over short-term financial liabilities provides a reserve stock to compensate for losses that may be incurred by companies when placing current assets, except cash. The higher the margin, the greater the confidence of creditors that the debts will be paid. Typically, the recommended value, especially by banks, is ≥ 2. To visualize, it would be useful to calculate the company’s assets percentage and changes over the period. CR = Current Assets Current Liabilities = (1.1) Cash and cash equivalents (1.2) Trade and other accounts receivables (1.3) Inventories (1.4) Other current assets (2.1) Short-term financial liabilities (2.2) Trade and other payables (2.3) Liabilities under other mandatory and voluntary payments (2.4) Employee benefit liabilities (2.5) Tax liabilities (2.6) Other current liabilities 73 $000 01/07/12 % 01/07/13 % Changes (4-2) А 1 2 3 4 5 Cash and cash equivalents 9 298 18,37 4 630 7,75 -10,62 Trade and other accounts receivables 16 081 31,77 24 649 41,28 +9,51 Inventories 21 968 43,39 27 283 45,71 +2.32 Other current assets 3 275 6,47 3 141 5,26 -1,21 Total current assets (1) 50 622 100,00 59 703 100,00 - At this point you could ask, “What is the liquidity of each item of current assets?” starting with cash. Guide the students with the following examples: 1. The more cash, the more guarantee of debt repayment. However, there exist no common standards and recommendations for the ideal level to cash a company should hold because a company with even a small sum of cash could always be financially solvent if it is able to balance and synchronize cash inflow and outflow efficiently and on time. 2. If most assets consist of accounts receivable, which is difficult to collect, then it would likely require a higher ratio of assets to liabilities, and vice versa. Students could extend this list. You could conclude the discussion that the single correct value or guideline of Liquidity Ratios (including Current Ratio, Cash Ratio and Quick Ratio) does not exist. In each case, it may be different depending on the company’s financial position and specific external situations. In analysing the company’s financial ratios, it would be useful to establish benchmarks that you could use to compare its relative performance, for example, against its industry or its previous years’ ratios. Here it is relevant to point out that the usual recommended value of CR is greater than 1. Depending on the industry and other business specification, this recommendation may vary. Discuss the other side of a Current Ratio - what kinds of liabilities does a company have to pay? For clarity, students need to compile the similar table on the structure of current liabilities and its changes over the period, by posting information on a separate board, but next to current assets. $000 01/07/12 % 01/07/13 % Changes (4-2) А 1 2 3 4 5 Current portion of long term loans - - 22 172 47,71 +47,71 Short-term loans 14 403 48,25 8 0,02 -48,23 Trade and other payables 13 448 45,06 19 550 42,07 -2,99 Liabilities under other mandatory and voluntary payments 23 0,08 - - Employee benefit liabilities - - 50 0,11 +0,11 Tax liabilities 43 0,14 - - -0,14 Other current liabilities 1 930 6,47 4 693 10,10 +3,63 Total current liabilities (2) 29 847 100,00 46 473 100,00 - Analyzing the table, you could ask the question "What are the two essential changes that took place in 74 the structure of the company’s liabilities over the period?" Students undoubtedly note the following: 1. The appearance of the balance sheet item "current portion of long term loans" which amounted to 47.71%. 2. The emergence of employees’ wage debts. The first element would enable you to ask the following question: "Could the CFO bring long-term sources to meet current liabilities?" and move on to discuss legitimacy of company’s financial policy when it attracts short-term loans for long-term financing of the construction of a new plant. This will begin to acquaint the students with the differences between conservative and aggressive financial policy of a company. 3. How would you describe the Bank’s financial policy: conservative or aggressive? What happens if you attract long-term loans and which ones? Within the third question, it may be useful to use Figure 2 for explanation of the differences between company’s conservative and aggressive financial policies. Figure 2: Sources of funding Assets &Funding sources Variable part of current assets Short-term funding Permanent part of current assets Long-term Fixed funding assets time Explanation for the Figure 2 could be the following: The permanent part of current assets is the minimum needed to carry out enterprise’s operating activity and its value does not depend on seasonal fluctuations in output and sales. As a rule, this part is fully financed by equity capital and long-term borrowings. The variable part of current assets is subject to fluctuations due to seasonal change in the company’s activity. Usually it is financed by short-term borrowed capital as well as in a conservative approach - partially by equity. You could show in the Figure 2, how to distinguish between two basic types of financial policy. A conservative financial policy is the behavior when a company uses long-term financing to cover a part of current assets. The higher the line of long-term financing on the graph, the more conservative will be the financial policy of the company, and costs will be higher. An aggressive financial policy is the opposite of a conservative one. In this case, a company’s 75 permanent current assets are financed by short-term loans. As a result there could be a negative effect of collateral for loans and a constant need to refinance its loans by the end of the period, which could lead to additional risks. Here it would be appropriate to engage students into a discussion with the question: "To what type of financial policy could you attribute Darithana’s policy? What are the additional risks of short-term financing? How is it possible to reduce these risks?" Most likely, the students would say that the company’s policy was aggressive as Darithana currently had to look for other sources of short-term financing to repay the two urgent liabilities. Among the possible additional risks of short-term financing students may include the following: (1) The shorter period of payments on a schedule, the greater the risk that a company would not be able to loan repayments and interests on them. (2) Cash flows from fixed assets erected due to short-term financing are likely to be insufficient for the return of loans and there would be a risk that a creditor refuses to prolong maturity of a loan. (3) In the short-term lending there could be a high risk associated with increasing interest rates on subsequent loans. (4) When you refinance short-term loans during the period of rising interest rates, the amount of interest paid might be greater than service payments of long-term loans. If you are extending the case, this is an ideal point to bring up the next question: “How could we maintain the necessary level of collateral for a loan?” Possible student responses could be the following: (1) by increasing the proportion of liquid assets, which could reduce risks of insolvency; (2) by requesting the Bank to change or extend the maturity schedule. 4. How is the Current Ratio linked to a company’s long-term solvency? The instructor should guide the students in following direction: the requirement to maintain the Current Ratio at a certain level has a deep theoretical. The interpretation of this ratio connected with an important hypothesis about the correct arranging financing: companies do not use short-term sources of financing for the acquisition of long-term assets. To clarify this hypothesis, it would be useful to go back to the board with the formula of a Current Ratio (Figure 1) and transform it. Figure 1: Current Ratio Or after transformation: Figure 1: Current Ratio CR = Current Assets Current Liabilities = Total Assets minus Non-Current Assets OR (Current Liabilities plus Non-Current Liabilities plus Equity) minus Non-current Assets Current Liabilities 76 From this, the students will see that the reasons for liquidity deterioration might to be found in the components of fixed capital, such as an amount of equity (mostly earned profit over the period) and long-term loans, as well as in the size of non-current assets (including capital costs). Investments (con- struction of new capacities, acquisition of equipment and other companies, etc.) in excess of a compa- ny’s financial possibilities (mainly of earned profit) would require new debts. The growth of non- current assets greater than that of borrowed funds could lead to lower liquidity. The other cause for the decrease of liquidity is associated with the funding costs for the acquisition of long term assets. Financial management rules are simple and logical: long-term loans should be in- volved in the financing of capital expenditures, and short-term - for working capital. In another words, to maintain an acceptable liquidity, value of capital expenditures should not exceed the sum of earned profit and involved long-term loans over the period. Epilogue The loan agreement for Darithana included a more stringent requirement, according to which the Company had to have bank accounts in the Bank-creditor to get all payments due to the Company from customers, and to ensure that the fees in a predetermined amount will be deposited in the Bank. The Company had not complied with this requirement, and the Bank could get the right to claim immediate repayment of all amounts under the loan agreement. But the Company's management was able to not only prolong the loan term for one more year, but increase the sum of the credit line. This, apparently, could explain the appearance of the sum in the line "current portion of long term loans" in the balance sheet on 01/07/2013. Obviously, under the requirement to maintain the necessary level of liquidity, as described in the case, the Bank immediately could not require repayment of the debt, and take additional measures to get other sources of collateral for the loan. The company realized that it needed long-term loans for the investment project for the period of five years. Therefore, in January 2013, it released 10 million bonds with nominal value of $6.60. The total amount of the bond issue at nominal value – $66 million, the coupon rate - 8% per annum, maturity – five years. But by the 01/09/2013 the Company was able to accommodate only 8900 bonds, which can be seen in the balance sheet at 01/07/2013 within non-current liabilities. Regarding the Company’s financial policy, the credit ratings service Standard & Poor’s had assigned Kazakhstan producer of medicines on national scale rating as kzBB. The agency had estimated the financial risk profile of the company as aggressive. Such an assessment showed inadequate (less than enough) liquidity, reflecting some uncertainty about how successful bonds placement will be held. Standard & Poor’s had assigned the credit rating kzBB to the debt obligation of the upcoming issue of unsecured bonds for $66 million. This rating was substantiated by the credit rating of the Company and the absence of factors that increase or reduce the risks of the securities. Before the bond issue the Standard & Poor’s forecast was as follows: “We appreciate the liquidity as less than adequate, taking into account the expected bond issuance and some doubts about its success CR = 1 + Equity plus (Non-Current Liabilities minus Non-Current Assets) Current Liabilities 77 and placement because of the current state of the debt capital markets. Furthermore, if the bond issue has not been successfully placed, the company would have to use alternative sources of resources, among which are likely to be dominated by short-term and possibly unsubstantiated credit lines of banks. Therefore, the assessment of liquidity in accordance with our criteria may deteriorate. Due to this uncertainty, we estimate the company's liquidity as less than adequate” Interestingly, their forecast came true? Wrap-Up This is a case that could happen routinely in a company’s financial activity as it often faces cash shortages and problems with liquidity. But the stability of a company’s financial position should not be judged only on the basis of Liquidity Ratios. Usually it is recommended to analyze them together with a range of other coefficients, such as turnover and profitability ratios, the ratio of debt to equity, etc., which could give correct company's financial health diagnosis. |