Problem Statement
The problem that the firm Guna Fibres is facing is that they lack sufficient cash flow from operations to meet their day-to-day financial obligations. Guna Fibres has become dependent on a revolving line of credit from the All-India Bank & Trust Company and due to increasing operating expenses and costs of good sold Guna Fibres is no longer able to remain solvent based on their current financial practices.
Situation Analysis
Guna Fibres is a textile manufacturing company located in India that is subject to seasonal swings in demand as well as an increasingly competitive environment. Guna Fibres has historically utilized a line of credit from All-India Bank & Trust to finance the purchases necessary to fulfill the spike in demand that occurs each summer. Historically, Guna Fibres would zero out the balance on this line of credit in October, per the banks policy. At the end of 2011, Guna Fibres found themselves running a balance on their line of credit beyond October and was subsequently denied any more credit until the firm could demonstrate solvency to pay the balance off. To examine their company’s financial position Malik and Kumar created a financial forecast for the month-to-month operations of the company in an attempt to demonstrate to the bank that they firm could indeed pay off the loan.
Analysis of the monthly forecast based on the assumptions of Guna Fibres current operating practices revealed that Guna Fibres would not be able to pay off the line of credit by the end of the year and in fact would owe a balance of 3,858,000 Rupees to the bank by December 2012. Based on the information contained in Malik’s forecast it is certain that the bank will not be willing to extend any more credit to Guna Fibres as currently there is no clear plan for the firm to pay its short term debit obligations.
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Examining Guna Fibres financial statements and business practices yields some insights into possible sources of the firm’s cash flow problems. First, by looking at Guna Fibres historical income statements one can clearly see several trends that are concerning. While gross sales have increased from 2010 to 2011, Guna Fibres has seen the firm’s cost of goods sold out pace gross sales. Additionally, due to managerial decisions to increase quality control and expand relationships with other firms, operating expenses have increased as well. The end result for Guna Fibres is that despite their sales growth the firm experienced decreasing EBIT and decreasing new profit. At the time of this analysis Kumar and Malik have also been presented with several proposals that could possibly ameliorate the company’s current financial woes by addressing policies that are currently creating financial strain on the company.
By taking closet look at Guna Fibres forecast several other concerning trends reveal themselves. Due to historically significant lag times in shipping product, Guna Fibres typically carries 60 days worth of inventory creating a storage problem in the company’s warehouse as well as a balance sheet problem as a significant portion of the firms working capital is tied up in inventory. Compounding the inventory issue is that typical collection times for accounts receivable are over 48 days, with 40% collected in a month and the remaining 60% collected in 60 days. This gap requires Guna Fibres to rely on the bank to pay for the inventory on hand.
Guna Fibres has 2 cash management policies that could be impacting their ability to pay back the bank loan. As a matter of policy Guna Fibres pays out a 500,000 Rupee dividend to shareholders each quarter, the organization’s philosophy being that the cash is safer with shareholders than with the firm. Additionally, Guna Fibres keeps 750,000 Rupees as cash on hand. Looking at the financial forecast for the beginning of 2012 one can clearly see that Guna Fibres is expected to be running at a net loss for the first quarter yet still pays a dividend and continues to maintain the same cash balance. At the same time Guna Fibres projects that it will be necessary to increase their financing needs from the bank.
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Addressing Guna Fibres current situation is of great importance as they currently have a cash flow problem that will find them shuttered and unable to fund day-to-day operations. In each of the aforementioned areas there is room for improvement by changing some of the company’s policies and procedures.
Major Strategic Alternatives
Utilizing the monthly forecast financial statement provided by Guna Fibres, Exhibit 1, it is necessary to create a statement of cash flows to begin to assess how the company’s capital is being managed through the working capital accounts of the firm. Exhibit 2 shows the breakdown of cash flows on a monthly basis based on the forecasted information provided by Guna Fibres. There are several important insights to point to instability within Guna Fibres. The first trend that is concerning is that according to Guna Fibres forecast, they will require a positive cash flow from financing activities through the month of June 2012 just maintain operations. Certainly, if this was to be presented to the bank there would be no chance that they would be willing to extend credit as Guna Fibres will not be able to zero out the debt balance in the coming months.
Examination of Exhibit 3 shows the statement of cash flows for Guna Fibres for year ending in December 2012. Note the highlighted the cell that indicates the change in short term notes payable for the year in the amount of 2,704,000 Rupees. Based on the current projections not only will Guna Fibres not pay off the balance but also they will accrue a larger balance by the end of the year. Notice that while the total cash flows from financing is only 704K Rupees the reason for the decrease is that a dividend in the amount of 2,000,000 was paid to shareholders. In addition to the concerns about Guna Fibres reliance on the line of credit is the dearth of cash flow from operations, only 330k Rupees for 2012.
Changes to Guna Fibres cash management policy could help to reduce the problems that Guna Fibres is currently facing. By examining Guna Fibres policy of paying shareholder dividends each quarter as well as their policy of keeping 750K Rupees on hand at all times one can begin to see where these policies place additional pressure on the firm to borrow. Examine Exhibit 4, which is Guna Fibres Statement of Cash Flows if they had decided not to pay a dividend. Notice the highlighted cell indicating that change in notes payable for year ending in December 2012 have decreased to 626,000. Overall, net change in cash balance remains essentially the same demonstrating that a large portion of Guna Fibres financing needs in 2012 are to fund paying a shareholder dividend.
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As stated by the firm, Guna Fibres believes that funds are more secure in the hands of the company’s shareholders. However, this assumption is likely based on the belief that dividends are paid out of net profit where the shareholders can earn a return elsewhere in the market place. In this case it is unlikely that the shareholders will find investments that return in excess of the 14.5% debit service that is being paid to finance their dividends in addition to the fact that the dividend payments are threatening to cause Guna Fibres to shut down, as they will no longer be able to finance operations.
Guna Fibres could then draw cash from their cash accounts to begin to pay down some of the balance that remains on their notes payable. Similar to the issue with Guna Fibres dividend payments, even in months when Guna Fibres posts a net loss they maintain a cash balance of 750K. By utilizing Guna Fibres cash accounts to cover operating expenses in months where Guna Fibres suffers a net loss this would reduce Guna Fibres reliance on outside funding even more as can be seen in Exhibit 5. Please note the highlighted change in change in notes payable down to 275K Rupees as a result of covering net loss with cash as opposed to financing.
Examination of Guna Fibres forecast as well as looking at some of the proposals regarding changes in operations elucidates another solution that would not require Guna Fibres to make such drastic changes to its dividend and cash balance policy. According to R. Sikh, improvements have been made to Guna Fibres shipping operations so much so that it is no longer necessary to carry 2 months of inventory. The implication for R. Sikh is that carrying 30 days less inventory will free up space in the warehouse; however, due to Guna Fibres current financial situation this change could have a great impact on the firm as a whole. Note the highlighted sections on Exhibit 6. Exhibit 6 models the impact that moving to a policy of only holding 30 days of inventory would have on Guna Fibres financials. Note the yellow highlighted row, which indicates the new inventory levels versus the levels present in Guna Fibres original forecast (exhibit 1).
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As a result of the decrease in carried inventory, the orange highlighted section indicates a decrease in total assets, as total assets are in part a product of inventory levels.
Finally, the decrease in total assets results in a greatly reduced reliance on the line of credit from the bank as less capital is tied up in inventory at any given time, this effect can be seen in the green highlighted row. Note 2 very important effects: 1. That changing to Sikh’s shipping plan for the month of January would allow Guna Fibres to zero out the balance of their notes payable for 30 days as required by the bank, and 2. That based on the forecast Guna Fibres will be able to return to their expected cycle of zeroing out the credit line by the end of 2012. Due to changes in the shipping policy Guna Fibres will need to modify their ordering policy as demonstrated by the purple row. Here the purchases in period (t) are determined by the forecasted gross sales in (t+1).
Feasibility of Sikh’s plan seems to be high as he indicates in his memo that new inventory procedures could be put in effect for January.
Guna Fibres is also considering a proposal from L. Gupta that was originated on direction from Kumar to determine the efficiency impact of switching to a level production method. According to Gupta, under level production Guna Fibres will need to purchase a consistent INR5 million per month. Gupta suggests that this will provide several benefits to the firm, it will ease labor unrest and employee dissatisfaction by creating a stable workforce, decrease the risk associated with machine downtime during the peak-manufacturing season, and finally Gupta indicates that level manufacturing will decrease manufacturing costs by 5%. While the benefits described by Gupta are significant, modeling the impact on Guna Fibres financial forecast reveals some concerns.
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Note the highlighted sections on Exhibit 7 with the yellow indicating the new level purchasing quantity and the adjusted Direct Labor and other Manufacturing costs indicated with blue. Concerns arise when looking at inventory in the months of July and August where both of these months will see Guna Fibres stocked out of product during their peak-selling season. Additionally, it is important to note the purple row indicating the balance of Guna Fibres line of credit. Not only does it not zero out the balance in 2012 under the new manufacturing system, but is also ends the year with a balance of more than 10 million Rupees.
Decision Criteria
In deciding which course of action Guna Fibres should take in response to their current crisis it is first important to determine the top priorities to maintain operations. Secondary to that Guna Fibres should make a determination as to which alternative yields the outcome that will be the most sustainable. As a result of the current crisis that Guna Fibres is facing, the first priority in determining a course of action is to implement the plan that will satisfy the bank immediately. Due to Guna Fibres reliance on their line of credit this must be restored for operations to continue.
Specifically, the plan chosen must satisfy 2 conditions: 1. It must allow Guna Fibres to zero out their balance with the bank as soon as possible so that the bank will be willing to continue to extend credit as Guna Fibres prepares for the next season, and 2. Guna Fibres must demonstrate that they will be able to consistently meet their obligations to the bank in the future, ie. be able to zero out the balance in October 2012. Tertiary concerns are related to the sustainability of the business over the long term, as such looking at how changes in policy could make Guna Fibres more susceptible/resilient to labor problems, shipping delays, etc.
Analysis of Alternatives
Analysis of strategic alternatives one involves looking to see how eliminating dividends in 2012 as well as utilizing Guna Fibre’s cash balances to cover net losses each month would allow the firm to fulfill the primary criteria identified above. Referring to exhibit 8 note that the values have been adjusted as such that Guna Fibres is no longer paying a dividend and that cash is being used to cover net losses, adjusting Guna Fibres policy of keeping their cash balance at a INR 750K. Examining the yellow highlighted row one can see that these changes improve both the monthly balanced carried on the line of credit as well as improve on the year-end balance, (see highlighted section exhibit 5).
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Unfortunately, even the implementation of both of these measures is unlikely to satisfy the bank. First, the models do not show that Guna Fibres will be able to zero out the balance on the account either in the short term or at any point next year. While the model shows a comparatively incremental increase in notes payable at years end, it shows that Guna Fibres is still unable to meet their debt obligations and the bank will be unlikely to extend any further credit.
As far as the secondary criteria, this does not seem to be a solution for the long term for Guna Fibres. While it slows some of the bleeding in the coming year, the fact remains that the firm cannot meet their financial obligations and will likely find themselves in a deeper hole next year these are the only changes implemented. One benefit of the proposed changes to cash management would be that it could be accomplished without major procedure overhaul and could provide an immediate benefit to the firm. Conversely, ceasing dividends and spending the company’s cash balance would indicate to shareholders and employees that the company in bad financial health and could create a morale problem.
Sikh’s proposal to capitalize on improvements in shipping times to improve inventory tracking had some unintended consequences that could be very beneficial for Guna Fibres. By carrying only 30 days worth of inventory at a time Guna Fibres is able to dramatically reduce the amount of capital that is invested in their inventory. In turn this reduces total assets and as a result lowers the necessary borrowing from the bank. Implementing Sikh’s plan immediately would satisfy both of the banks necessary conditions. As can be seen in Exhibit 6, the change in inventory policy would allow the balance of notes payable to be satisfied in the month of January and that Guna Fibres will be able to pay zero out the balance again in the fall as historically expected. Additionally, due to the improvements in shipping it is likely that this plan can be implemented in a manner that is sustainable and not simply a “Band-Aid” solution to deal with symptoms of the underlying problem. Finally, there are benefits and drawbacks of this plan that need to be acknowledged. As it relates to the tertiary criteria mentioned above.
The greatest benefit beyond the ability to continue operations is that doing so will not compromise the company’s dividend payments or cash balances. This should have a positive effect on company morale and continued shareholder and employee engagement. One of the possible drawbacks is that the 30 day inventory policy will reduce some of the slack in the system and the incidence of a mechanical or raw materials delay could result in stock outs for Guna Fibres. Additionally, moving to a just in time inventory system will require Guna Fibres to have very accurate projections for the next periods demand as the firm will want to avoid stock outs. While these concerns will need to be taken into account, they are subordinated to the primary need, which is to demonstrate a viable financial model that will satisfy the bank. The final proposal to shift Guna Fibres to level production fails to satisfy the immediate needs of the bank as well as the long-term requirements of being able to zero out the line of credit.
Exhibit 7 clearly shows that this policy will create an increased reliance on the bank’s line of credit to maintain operations as well as create inventory stock outs during the busy season for Guna Fibres. This proposal may yield some insights for the long term for Guna Fibres as Gupta is able to demonstrate decreases in manufacturing expense as well as benefits to morale and resilience to labor and manufacturing problems. However, at this time, this plan does not satisfy the immediate need of Guna Fibres. Comparing the three proposed plans it is clear that adopting Sikh’s new inventory management system is the ideal solution as it is the only plan that is likely to satisfy the bank. Additionally, Sikh’s plan is sustainable and does not involve the firm treating symptoms and actually addresses the underlying issue.
Recommended Solution
Based on the given analysis of the proposed solutions, Guna Fibres should implement the inventory management plan that was proposed by Sikh. Based on Sikh’s memo inventory procedures can be implemented immediately and this course of action should be chosen. Even in the presence of minor delays or transitional problems, the sustainable nature of this plan should be enough to persuade the bank that Guna Fibres will be able to pay their debit obligations going forward. The biggest area of concern will be the importance of accurately projecting demand for the next period as having 30 days less inventory will eliminate Guna Fibres ability to rely on extra stock when demand exceeds their projections. Efforts to address these concerns could include developing a more communicative relationship with the distributors that Guna Fibres sells to gain better information for making their projections.
An additional concern that needs to be addressed are how the change in inventory policy will impact Guna Fibres suppliers and if they will be able to accommodate the changes to the firms ordering policy. It is also important to keep in mind that if Guna Fibres implements this policy they still have the flexibility to cut their dividend or reduce their cash balance to cover and periodic cash flow problems. By demonstrating that new inventory plan to the bank with the additional contingency of potentially cutting cash or the quarterly dividend, Guna Fibres should be able to resume operations and a relationship with the bank.
