3 pages

CAPE CHEMICAL: Managing CASH PROBLEMS

David A. Kunz

Benjamin L. Dow III

BACKGROUND

Cape Chemical is a 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 over a decade and has 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 & Loss (P&L) responsibility, but until beginning Cape Chemical she had limited exposure to company accounting and finance decisions.

To improve management of the accounting and finance area, Stewart hired Kathy Ford, an accountant who had worked with the accounting firm that conducted Cape’s first annual audit. Ford has been the company’s chief financial officer for the last seven years.

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. Bulk chemicals are stored in "tank farms", a number of tanks located in an area surrounded by dikes. Storage tanks 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 and when they need them. This requires maintaining a sizable inventory and operating efficiently. Distributors usually operate on very thin profit margins.

THE SITUATION

The company ended last year with a large cash balance, but on numerous occasions during the year it was necessary to obtain short-term bank loans in order to keep the company operating. The firm’s annual planning process includes the preparation of a projected income statement, balance sheet and cash flow statement for the coming year by the finance and accounting staff. Once the forecasted statements are approved, the annual information is broken into quarterly and monthly financial budgets. This year, Kathy Ford, the company’s chief financial officer, directed David Bush, the firm’s budget analyst, to also develop a monthly cash budget in an effort to identify potential cash flow problems.

Ford and Bush agreed on a number of budget assumptions necessary to complete the cash budget. Assumptions focused on the timing of cash inflows (collection of receivables) and timing of cash outflows (payment of vendors, operating expenses, capital expenditures, financing charges, tax payments, etc.). The cash budget indicated that the company would need additional cash (additional financing) during the third quarter (July, August and September) of approximately $2,000,000.

Ford reviewed the cash budget with Stewart. The company’s board of directors had previously established a target capital structure of 50% debt and 50% equity and the projected 2012 ending balance sheet indicates the company will be very close to the target. Cape Chemical’s primary bank also incorporated the target capital structure into its loan covenants (debt ratio could not exceed 50%). Loan covenants require a quarterly compliance report. Ford and Stewart are reluctant to increase the firm’s bank borrowing even for a short period of time. Alternatives considered were:

1) Reduce inventory levels. Ford thought this option had merit. Ford noted the firm had an ongoing program to systematically review inventory levels of all items and levels were slowly being reduced, but she thought more could be done to reduce inventory. Stewart agreed that some reduction was possible but was concerned that additional inventory reductions could negatively impact sales. Stewart stated “I don’t want to jeopardize sales by not carrying enough inventory.”

2) Collect accounts receivables faster. Cape Chemical’s selling terms are net 30. Ford thought it might be possible to increase credit standards and collection effort, but it could not be accomplished without a major confrontation with the sales staff. The sales force already feels that they are losing sales because of the company’s conservative approach to granting credit (high credit standards) and an overly aggressive collection effort. Stewart was reluctant to increase credit standards but felt the credit department could increase its collection effort on accounts that were habitually late in paying invoices.

3) Delay selected capital expenditures (equipment replacement). Capital projects of approximately $2,750,000 are planned for 2012, $400,000 for the first quarter, $1,000,000 for the second quarters, $1,000,000 for the third quarter and $350,000 for the fourth quarter. Stewart opposed delaying any capital expenditures stating, “Projected revenues are dependent upon new product lines and these lines require investment in new equipment”. Ford agreed that some projects could not be delayed, but thought some replacement projects and other expenditures such as replacing a portion of the warehouse roof, replacing selected vehicles and purchasing new office computers scheduled for the first half of the year could be delayed to the second half or longer. This would require increasing maintenance on those pieces of equipment originally scheduled for replacement and maybe a temporary roof patch for the warehouse but should not disrupt operations. Stewart was not convinced. She remained concerned about the negative impact investment delays would have on operations and sales.

4) Delay paying finance charges or tax payments. Ford thought delaying payments to the bank could be arranged, but she was reluctant to approach the bank about rescheduling payments. Approaching the bank could cause the bank to be concerned about the firm’s ability to manage its cash. Both Stewart and Ford agreed that delaying tax payments was not an option that should be pursued at this time.

5) Slow payments to vendors (accounts payable). During the early years of operation the company was not always able to pay its vendors according to terms. The delayed payments resulted in some vendors threatening to stop extending credit. This never happened but the lack of vendor credit would have caused substantial problems. Since that period, a concerted effort has been made to avoid late payments to vendors. Ford thought slowing vendor payment for a few months was possible. She thought it was unlikely vendors would notice a change in Cape Chemical’s payment pattern. Stewart was skeptical. She did not want a repeat of earlier vendor problems.

THE TASK

Income Statements and Balance Sheets for Cape Chemical (historic and projected) are provided in Appendix 1. Selected industry average ratios are provided in Appendix 2.

1) Assume you are Kathy Ford. Prepare the report evaluating the alternatives and a recommended course of action. Use ratio analysis to support your evaluations and recommendation.

2) Would your recommendation change if the projected cash shortfall was for six or nine months rather than three months? Explain.

3) Is it ethical to delay payments to vendors beyond the agreed upon terms? Support your answer.

Appendix 1
Cape Chemical
Income Statement ($000)
For the Year Ended December 31				Projected	Ind./ Avg.
	2009	2010	2011	2012	2011
	$	$	$	$	$
Sales revenue	83,200,000	89,600,000	94,300,000	108,900,000	117,400,000
Less: Cost of goods sold	74,505,600	79,878,400	83,596,950	96,703,200	104,474,260
Gross profits	8,694,400	9,721,600	10,703,050	12,196,800	12,925,740
Less: Operating expenses
Selling expense	3,078,400	3,404,800	3,489,100	3,974,850	4,343,800
General & Admin expense	1,414,400	1,702,400	1,744,550	1,960,200	1,995,800
Depreciation expense	1,264,640	1,361,920	1,716,260	1,655,280	1,784,480
Total operating expense	5,757,440	6,469,120	6,949,910	7,590,330	8,124,080
Operating profits	2,936,960	3,252,480	3,753,140	4,606,470	4,801,660
Less: Interest expense	487,720	533,600	529,300	559,111	686,195
Net profits before taxes	2,449,240	2,718,880	3,223,840	4,047,359	4,115,465
Less: Taxes (rate = 30%)	734,772	815,664	967,152	1,214,208	1,234,640
Net profits after taxes	1,714,468	1,903,216	2,256,688	2,833,151	2,880,825
Dividends	734,772	815,664	967,152	1,214,208	1,646,186
Balance Sheet ($000)
As of December 31				Projected	Ind./Avg.
	2009	2010	2011	2012	2011
	$	$	$	$	$
Assets
Current assets
Cash	499,200	448,000	471,500	544,500	704,400
Accounts receivable	11,055,342	11,512,986	11,781,041	11,934,247	15,374,575
Inventory	13,746,421	13,916,098	14,388,460	15,597,290	18,995,320
Total current assets	25,300,963	25,877,084	26,641,001	28,076,037	35,074,295
Gross fixed assets	10,100,480	12,113,920	13,503,760	16,258,770	18,161,780
Less: Accum. depreciation	4,583,000	5,944,920	7,661,180	9,316,460	10,111,982
Net fixed assets	5,517,480	6,169,000	5,842,580	6,942,310	8,049,798
Total assets	30,818,443	32,046,084	32,483,581	35,018,347	43,124,093
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable	8,863,105	8,998,904	8,822,341	9,593,487	12,468,216
Notes payable	1,300,000	1,400,000	1,000,000	1,000,000	1,774,867
Accruals	1,190,338	804,628	429,152	415,828	1,190,001
Total current liabilities	11,353,443	11,203,532	10,251,493	11,009,315	15,433,084
Long-term debts	5,510,000	5,800,000	5,900,000	6,058,000	6,901,163
Total liabilities	16,863,443	17,003,532	16,151,493	17,067,315	22,334,247
Stockholders’ equity
Common stock (at par)	5,500,000	5,500,000	5,500,000	5,500,000	7,104,176
Retained earnings	8,455,000	9,542,552	10,832,088	12,451,032	13,685,670
Total stockholders’ equity	13,955,000	15,042,552	16,332,088	17,951,032	20,789,846
Total liab. & equity	30,818,443	32,046,084	32,483,581	35,018,347	43,124,093

Appendix 2
		Industry Average
Ratio		2011
Current ratio		2.27
Quick ratio		1.04
Inventory turnover (times)		5.50
Days Invested in Inventory (365)		66.36
Average collection period (365 days)		47.15
Fixed (net) asset turnover (times)		14.58
Total asset turnover (times)		2.72
AP deferral period (days)		43.56
Debt ratio		51.79%
Times interest earned ratio		7.00
Gross profit margin		11.01%
Net profit margin		2.45%
Return on total assets (ROA)		6.68%
Return on equity (ROE)		13.86%

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