An analysis of global machinery and metals company (GMMC) and Caudilo, Houben and Noor. (Finance, Credit & lending decisions)

Part A: Global Machinery and Metals Company Case

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Part A: Global Machinery and Metals Company Case

Executive Summary

Based on information the case, this paper will outline the different mechanics of a letter of credit arrangement and determine the bank’s exposure to risk if it approved the time drafts. It will then apply the case to determine specific additional collateral that motor city bank will obtain. The financial statements of GMMC will also be examined and then a financial ratio analysis will then be conducted. This will determine whether the firm contains adequate collateral in inventory and receivables. The company, GMMC also requested an increase in its credit lines to manage its sales growth. A decision should be made whether the motor city national banks should increase its letter of credit lines with the line of credit and the special risks that might occur in this situation both to the bank and the company.

Question 1

Mechanics of a Letter Of Credit Arrangement

Letter of credit arrangements are the most secure mechanisms that are used internationally by traders. A letter of credit refers to the commitments made by a banking institution on behalf of the buyer or customer that payment shall be made to the exporter or dealer provided that the terms and conditions stated in the letter of credit are met as substantiated by the presentation of all the needed documents (Tracy, 2012). The customers or buyers pay their banks to render this service on their behalf. A letter of credit is significant when there is reliable credit information about an international buyer is hard to obtain and the exporter is satisfied with the buyer’s foreign bank creditworthiness. The buyer is protected by the letter of credit as there is no payment obligation is required until the goods have been distributed and delivered to the buyer as promised.

In the trade contract process, the buyer sends the letter of credit to his bank and requests for funding to pay for all the liabilities to the exporter in accordance to the sales contract. The opening bank the issues a letter of credit that responds to the requests of the exporter and shows the viability of the request, finally, an advising bank notifies the exporter about the state of funding that it the opening bank can offer (Stark, 2016). Finally, in the cargo shipment process, the exporter prepares the goods for shipment after receiving the letter of credit confirmation and organizes all the formalities regarding the export process.

Source: Payson, (2013)

The next process is the loading of the goods to the ship while the shipping company submits a receipt of the goods received, forwarding contract and a copy of the ownership of the goods. The shipping company delivers the goods to the importer and the shipping agent surrenders the goods to the importer (Abramov, et al. 2015). All these processes are critical and should be taken seriously by anyone seeking to sell goods internationally.

Usually a letter of credit is subject to the uniform practice and customs for documentary credits on the global chamber of commerce publication number 600.

The availability of the letter of credit

Under the uniform practices the letter of credit is made available under several conditions which include:

· Payment at sight and against acquiescent documents

· Negotiation that involves payment with or without remedy or alternative to the bona fide holder against documents which are compliant and presented under this credit.

· Drawee Bank acceptance. The bank implements payment at a future date that is determined against compliant documents. Under an acceptance credit that is drawn on the acceptance bank instead of the issuing bank, a tenor draft is usually needed under acceptance credit.

Risks Faced By the Bank in Issuing the Letter Of Credit

Risks refer to the various uncertainties involved with regard to the investments made by a firm that has the probability of having a negative impact on the financial welfare of the business. A risk refers to the likelihood or probability of gaining or losing something valuable. Valuables such as social status, physical health, and emotional wellbeing van are lost or gained when taking risks and this can result from a specific action or inaction that may be unforeseen or foreseen. Risks can also be described as the deliberate interactions with uncertainty which is the potential to have an uncontrollable and unpredictable outcome. A risk, therefore, results from the consequences of actions taken regardless of uncertainty. Risk perception defines the subjective judgment that people make concerning the probability and severity of a risk which can vary across various individuals. Any human endeavor has some risk even though some are riskier compared to others. Too much elaboration here.

Firms particularly those engaging in trade have been exposed to risks that result from unexpected movements in the current exchange rate that is characterized by volatile financial market.

When a bank is viewed to be in a weak position financially, depositors of the bank often withdraw their funds and other banks cannot lend it money (Davidson, 2011). The bank will also be unable to sell its debt securities such as commercial papers and even bonds. In the financial market and this aggravates the financial condition of the bank. Therefore, the fear of bank failure was viewed to be one of the main causes of the credit crisis of 2007 to 2009 and the cause of past financial panics. For example, in the year 2008, the Scotland Royal Bank that was the largest global bank with estimated assets worth £2.4 trillion was failed by just £8 billion pounds loss that was 0.3 percent of its assets(Kabir, 2010). This is because the bank was leveraged to the hilt. This section describes bank failure and bank runs due to having lost the trust of depositors, but the question asks for the risk the bank faces when issuing an LC to GMCC. (what could go wrong with GMCC that affects the issuing bank?)

Therefore managing these risks has become a vital aspect for the survival of these firms.

Banks have several risks that have to be carefully managed particularly because they use a significant amount of leverage. Without effectively managing risks, it can be very easy for a bank to be insolvent. Therefore, every investment that is made has a significant amount of risks and it is important to understand and accept some of the risks that the business might be exposed to. However, the firm can have a risk management plan to mitigate some of the risks that may affect the performance of the business. Elaborating the consequences of mismanaging risks, answers little to the question While banks share several similar risks as other organizations, major risks that specifically affect banks include, interest risks, liquidity risks trading risks and credit default risks.

Liquidity risks

This refers o the risk of being unable to sell the company’s investment at a fair rate and return the investment capital in a given period. Therefore, in order to sell the investment, the company will have to accept a reduced price or it may not be possible to sell the investment. Liquidity risks may arise due to mismanagement of cash flows and delays in project implementation.

Political risks

These are risks that are connected to the nationalization of some sectors of the economy, poor government policies, and actions, as well as social changes that may result in the loss of value of the company’s investment (Lackner& McEwen-Fial, 2011).

Interest rate risks

This is the likelihood that a fixed rate debt instrument will reduce in its value due to the increase in interest rates. it is the risk of losing capital due to the change in the interest rates. For instance, if the rate of interest increases the market value of bonds decreases (Beckmann et al. 2015).

Foreign exchange risks

This is the risk associated with investing in foreign countries (Brown, 2014). For instance, when purchasing foreign investments in various emerging, markets there are various risks involved such as currency restrictions, repatriation of repayments and principal amounts .

Market risks

This includes the risks associated with various investments declining in value due to economic developments or other events that can affect the whole market. Market risks include equity risk, currency risks, as well as the interest rate risks.

Commodity risks

Commodity risks include uncertainties that are related to the future market values including the size of the future revenue that can be caused by price fluctuation of products such as gas, electricity, oil and metals.

Borrower or credit risks

This is the risk that the company or government enterprise that may be offered a bond will run into financial difficulties and may not be able to pay the required interest or the principal when it matures. These risks apply to credit investments such as bonds.

Overall very good explanation of various types of risks, but better to include GMCC in the picture. For example: If an LC is issued, GMCC would first receive the materials, then the bank would pay the exporter. But If GMCC does not have enough money to pay the bank after receiving the materials, the bank would be in trouble as it would still have to pay the exporter.

Additional Collateral That Should Be Obtained By Motor Bank

These are additional assets that are set up as security by the borrower against its debt obligations. Extra collateral is used to minimize risks to the lender. Creditors often require additional collateral for a particular loan to be at the constant level of interest or even to please the credit committee and the investors. Collateral includes certificates of deposit, cash, equipment, letters of credit and stock. They are mainly employed when securing loans as a method of increasing the probability of repayment. Therefore, when the borrower defaults, the lender will have the right to get collateral in an effort to pay off the rest of the loan. When additional funds are sought, extra collateral may be required like in this case. What is valuable in GMCC for the bank? E.g Materials, Property, Plant, and Equipment can all be used as collateral. Relate more to GMCC.

Question 2

Four classes of ratios and numbers [Leverage, Liquidity, Activity(efficiency), Profitability ratios]

The shareholders of a firm are affected by the profitability of the firm which in turn affects the earnings per share. Ratio analysis is used to evaluate the ability of the firm to adequately make income from the total revenue while at the same time controlling the costs through efficient asset utilization and use equity as well as investments (Abid, 2016). Ratios have the ability to demonstrate an accurate evaluation of the corporation when it is held against its competitors in the industry as the total income as well as the net income that is most often associated with the individual operations of the company. The balance sheet demonstrates that retained earnings for the company show a decreasing trend, which is not suitable for the enterprise (Prestridge, 2013). The long-term and short-term borrowings for the group increased between 1985 and 1987, which is not appropriate for the firm (Davidson, 2011). The percentage change in various investments made by the company is not satisfactory enough.

Profitability ratio

Profitability ratios are used to evaluate a firm’s capacity to generate earnings or revenue compared to the expenses as well as costs during a particular period.

Net profit margin in percentage

This ratio is used as to work out the net profit as a percentage of the net sales.

Is calculated as profit after tax/net sales X 100

Years	1985	1986	1987
	2.37	2.57	0.53

In 1985, the ratio was excellent, but it increased in 1987, but it greatly declined from in 1987. This is alarming for the organization and GMMC had to take an appropriate action.

Year over Year sales growth

Year over year sales growth is used to measure demographic changes against the same statistics in the same period the previous year(Payson, 2013). It is a percentage calculation that evaluates the increase or decrease of the quantity measured over the past year.

Gross profit margin in percentage

The gross profit margin ratio is used to explain the gross profit as a percentage of the net sales. It is calculated as

Gross profit/ net sales X 100

Years	1985	1986	1987
	23.97	23.04	24.29

In 1985 the ratio was 23.97 that declined slightly in 1986 to 23.04 and improved to 24.29 in 1987. This rate reduction is not favorable for the GMMC because it shows an increase in the interest expenses.

DU Point analysis

This analysis is used to find out the return on equity, as well as analyzing the profit margin, financial leverage of the company and the total asset turnover (Nanavati, 2012). The analysis refers to a financial ratio that can be used in evaluating a firm’s capacity to increase its return on equity. The model breaks down restitution on capital ratio and intends to explain how the company can improve its returns for the shareholders.

Return on equity

Return on equity is calculated as

Return on equity= profit margin x total asset turnover x financial leverage

Where by the profit margin = net income/net sales, total asset turn over= net sales/ average total assets and financial leverage = total assets/ total equity.

This model evaluates the return on equity of the firm and the various impacts of performance measures of this organization (Ezzamel & Heathfield, 2013). GMMC had a low return on equity ratio, and this was not satisfactory result to the investors. Therefore, the problem was the low-profit margin realized which led to the poor financial advantage of the company.

Efficiency ratios (Activity ratio = efficiency ratio?)

These ratios are used to evaluate how efficiently a firm utilizes its assets as well as liabilities in its internal operations. They are used to calculate the turnover of their receivables, repayment of the liabilities the equity and quantity usage and comprehensive inventory and machinery use.

Days of Debtors Outstanding

Days payable outstanding refers to the average payable period of the company. It explains the amount of time that it takes a company to pay its invoices from various trade creditors, for example, the suppliers (Tracy, 2012).

Fixed Assets Turnover

The fixed asset turnover ratio is used to measure a company’s operating performance. It compares the net sales to the capital (Sheela & Karthikeyan, 2012).The fixed asset turnover ratio particularly measures the ability of a company to generate sales from fixed asset investments such as plant and equipment, property, and the explicit depreciation. Higher turnover ratio as indicated by GMMC means a more efficient investment in fixed assets and their ability to generate revenue.

Liquidity ratios

Current ratio

The current ratio is used to compare the relationship between current assets and current liabilities and demonstrate the ability of the company to pay back its current liabilities through using its existing assets. It is calculated as

Current ratio=current assets/current liabilities

Quick ratio

The quick ratio is used to indicate a firm’s short-term liquidity. It measures the ability of the firm to meet its short-term obligations using its liquid assets.

Quick ratio =

(current assets – inventories) / current liabilities

Activity or solvency ratios (Activity ratio = efficiency ratio?)

These ratios are developed to measure the level of financial risk that a business faces through considering various measures such as debt to equity, debt to asset, Gearing ratios and interest cover ratios.

Average settlement period for trade receivables

The average settlement period for trade receivables refers to the average amount of days between the day credit sales was made and the date of receiving the cash from the client. The average period of collection is also known as the period sales in accounts receivables. The average collection period was 14.45 in 1986 and 16.84 days. The average industrial period was 10 days. The average industrial accounts receivable turnover ratio was 10 days per year and thus the mean collection period was 36.5 days. An additional manner of calculating the average period of collection includes:

Average receivable accounts balance that is divided by the average daily credit sales.

Evaluating the average collection period is essential for the cash flow of a firm as well as its ability to meet its requirements when they are due.

Average inventories turnover period

Inventories form an important part of the business operations of GMMC. This is because it can account for a significant section of the assets held (Zink, et al. 2014). The ratio weighs the average period for holding the inventories. This can be done in daily, monthly and weekly basis.

AITP = (Average inventories held / Cost of sales) x 365

The average inventories can be computed as the opening and closing inventories. For highly seasonal enterprises often prefer weekly and monthly basis instead of annually. GMMC usually prefered short inventory turnover ratio.

The average inventories turnover period was 43.17 in 1985, 49.56 in 1986 and the average industrial inventory turnover period for the industry was 30 days.

Interest cover ratio

The interest cover ratio is a profitability and debt ratio that determines how easily a firm can pay outstanding debt interest. This ratio is calculated by dividing the earnings of a company before interest and taxes during a specific period by the amount paid by a firm in interest on debts during a similar period.

Interest coverage ratio= EBIT/ Interest expense

The interest coverage ratio measures the capability of a firm to handle its outstanding debt. It is a debt ratio which can be used to measure the financial conditions of a firm. GMMC had an interest coverage ratio of 14.80 in the 1985 financial year, 13.35 in 1987 and an industrial average of 10. An excellent interest coverage ratio is vital as a firm cannot grow unless it is capable of surviving, unless it effectively pays its interest on the current creditor obligations.

Can the activity ratios provide GMCC with funds from inventory and AR? Are GMCC’s Inventory and AR of sound quality? Any comments on bad debt, sales increase, etc? I.e Do any of these numbers pose a threat to GMCC?

Question 3A

The line of credit refers to an arrangement between the bank or any other financial institution as well as a customer through establishing a maximum loan balance in which the bank allows the GMMC company to access and maintain. the borrower in this case can have access to the line of credit any period as long as they do not exceed the agreed maximum amount set and meets other requirements agreed set by the other financial institution such as maximum and timely payment.

Request line of credit: $500,000 to $1M and letter of credit: $250,000 to $1M

The assistant vice president of motor city national bank, Mr. David Farmer, in the early 1988 was considering providing an extended loan request from one of the most established clients of the company that was the Global Machinery and Metals Company, Inc. David had recently joined the motor city bank after being hired from a nearby competing institution because he had an experience of two years on credit analysis and lending. The account for the customer, GMMC had been in existence for four years and it was influenced and opened by an officer that had replaced David and thus he did not have initial experience or contact with the managers of the corporation. The only understanding he has was that the account had been profitable and satisfactory for the bank since the customer started its relationship with the bank four years ago. one of the principles of GMMC corporation, Wayne Newton, approached David Farmer with a formal request for material increase in the credit facilities of the firm. Newton requested for an advanced line of credit to an amount of $1 million as well as an increase in the letter of credit to $1million. The presently approved credit for GMMC Corporation included a letter of credit worth $750,000 at prime with an additional 2 percent and a fee of 1percent annually at issue with an additional 1 percent funding. Also, the line of credit was $500,000 Tat prime with an additional 2 percent. The preceding recognized credit lines that had been improved in 1985 were safeguarded by the entire inventory and accounts receivable as well as 40 percent of the inventory in amounts that were not exceeding the approved total credit limit.

In the accounting sense, the firm can be said to have had positive earnings as the cash flow from operations was positive. Therefore, the company had to raise some money from its shareholders to support new investments. The statement of cash flow is essential in examining the short-term viability of a corporation especially its ability to pay its creditors and costs such as bills. It enables the shareholders of a company to assess how the agency’s operations are running, the source of revenues, and how the capital is being spent. It is important to accountants as they can know the liquidity position of the company. Potential creditors can also know the capability of the company to pay its debts. Employees also can learn through the financial statements of the company’s ability to pay.

Question 3B

Line of credit mainly to machine division

the bank should accept increasing both the line of credit as well as the letter of credit investment in this company because its financial performance is good and the prospective of getting a significant return on investment is high (Fritsche & Dugan, 2011). The overall performance of the organization is good as demonstrated by the various financial and non-financial performance measures. However, the team needs to develop more efficient and aggressive strategies to ensure that it achieves better performance that can steer it ahead of its competitors. Preferably use ratios to back up claims. Needs more elaboration on the business of the Machine Tools Division (Sales lowered as compared to Metals Division, but profit margin still high) Credit fully used? Yes, fully used up LC in 12/31/87

Letter of credit for additional steel inventory

All the departments of the inventory management that is the manufacturing, purchasing, marketing, and finance management are essential as they determine healthy resource chain in supply and also cause an inevitable impact on the financial strength as per the balance sheet. In every existing business, all these inventory functions are interconnected to each other and overlap at a certain instance. For example, the base of the business delivery function is made up of various aspects such as the supply chain management, inventory and the logistics. Inventory is crucial to every business, hence its management requires lots of keen and care especially during its evaluation on the basis of both internal and the external factors. These factors have to be controlled by either reviewing or planning which is done by the Department of inventory planners. Department of Inventory = Metals division The finance, purchasing, and the manufacturing departments are mostly involved by the inventory planners when monitoring, reviewing and controlling the inventory.

Bankers and other financial institutions use the current ratios as well as the profitability ratios to assess the credit worthiness of the firm. This is because the Current ratio evaluates the firm’s ability to pay its current liabilities through its current assets. The profitability statistics for GMMC are at a higher ratio when compared to the industrial average. Where are the industrial averages? While the prices of products can threaten or risk the cost-effectiveness of the firm and its peers in the industry, the Corporation has maintained a remarkable interest coverage ratio in the present years. Will interest coverage ratios determine if GMCC needs a letter of credit for additional steel inventory? If not, what are the determinants? The main risks in my view which the company can risk are solvency risks. The firm should check and adequately manage its liquidity status because of the increase in fixed asset investments. Also, the bank can face interest rate risks. Slightly redundant, why talk about the bank’s interest rate risk in this section? Does GMMC really need a letter of credit for additional steel inventory? Why?

What about Foreign Exchange risks faced by GMMC? (As GMMC imports materials from foreign countries) Any hedging required? (required for sure)

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