action standard case

7/31/2019 Action Standard Case

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Action StandardManufacturing Company

July 142012

A Case Analysis by Group 1


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ACTION STANDARD MANUFACTURING COMPANY

Table of Contents

Table of Contents ........................................................................................................ 2

Introduction ................................................................................................................. 3

Issues and Analysis ..................................................................................................... 4

Issue 1 ........................................................................................................................ 4

Issue 2 ........................................................................................................................ 7

Issue 3 ........................................................................................................................ 8

Issue 4 ...................................................................................................................... 11

Issue 5 ...................................................................................................................... 15

Issue 6 ...................................................................................................................... 19

Issue 7 ...................................................................................................................... 20

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Introduction

Action Standard is a nationally known producer of top quality lawnmowers, garden tractors, tillers

and implements established in 1920. It has grown steadily since its inception. Looking at the

opportunity presented by the growing market of tractor/lawnmowers/snow blower machines, it

decided to undertake a rapid expansion program. The financial Vice- President of the company,

Dianne Covington was pleased with the projections of rate of return and net worth. However, she

was worried by the declining profit margin, falling rate of Return on Assets, deteriorating liquidity

position and high projected debt ratio.

Some of the issues to be noted while analyzing the financial statements for the year 2005, 2006 and

estimated figures for 2007 are:

1. Increasing levels of inventory and accounts payable

2. Increasing levels of long term debt and corresponding increase in debt ratio

3. Deteriorating current ratio and quick ratio

4. Deteriorating profit margin on sales and falling return on assets

5. Increasing estimated return on equity as compared to the industry average.

Despite the increased level of efficiency from the plant modernization and expansion program,

there was declining margin on sales and rate of return because the firm had abandoned its policy of

taking cash discounts. Due to deteriorating liquidity position, the company had received a letter

from the lenders of its long term debt, the insurance company which requires current ratio to be at

least 2:1, expressing its concerns and asking the company to devise a plan to correct liquidity

situation within a reasonable period of time. However, the option of slowing down the expansionprogram might not be feasible as it could harm future operation and further hurt the profit figures.

The alternative financing options available to the company to correct its liquidity position are:

1. Trade credit financing on the terms of3/10 net 30

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2. Obtain additional bank loans from a larger bank- Security and Trust Company at a 10

percent rate, discount interest with a 10% compensation balance. The required security

for this option would be blanket pledge on all assets that are not now used as collateral for

existing loans. This option is only feasible if accounts receivable pledging and factoring is

not employed.

3. Obtain loans secured by accounts receivable from a finance company at an interest rate

of13 percent

4. Factoring of accounts receivable from the finance company on a non recourse basis,

interest rate on this is 12 percent plus a 5 percent discount from the face value of each

account receivable invoice.

5. Using commercial paper at a rate of approximately 10 percent.

6. Obtain loans secured by inventories. Interest rate is expected to be lower for this option as

inventories are to be used as collateral

Issues and Analysis

Issue 1

Does the Commercial Paper market now present a feasible alternative to Action Standard?

Explain your Reasoning.

Commercial paper is a money-market security issued by large and well established companies to

get money to meet short term financing requirements. It represents negotiable promissory notes

sold in the money market. Since it is not backed by any collateral, only recognized firms with

excellent credit ratings will be able to sell their commercial paper at a reasonable price.

Commercial paper is not a useful means of financing for small companies. It can be issued directly

to the ultimate investors or through a dealer markets. The main advantages of commercial paper is

that they are cheaper to bank loans, requires no collateral and the borrower avoids inconvenience

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and expense of financing arrangements with the number of institutions each requiring their own

terms and conditions.

Analyzing the alternative financing options available to the company by calculating the effective

rate of interest for each option we get,

Trade credit financing on terms 3/10 net 30

Effective cost of Trade credit =

=

= 56.44%

Bank Loan with 10 percent rate, discount interest with a 10% compensation balance

from Security and Trust company

Effective cost of Bank loan =

=

= 12.5%

Loans secured by accounts receivable from a finance company at an interest rate of

13 percent

Effective interest rate= 13%

Discount%

X

365

100-Discount

%

Credit period- Discount

period

3X

365

97 30- 20

Interest rate on loan

1-Discount rate %- % of Compensating

balance

10%

1-10 %-10

%

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Factoring of accounts receivable from the finance company, interest rate on this is 12

percent plus a 5percent discount

Effective interest rate =

= 12.63%

Commercial paper

Effective interest rate is expected to be 10% in line with recent commercial paper rates

Loans secured by inventories.

Effective Interest rate is not mentioned in the case. However, it is expected to be lower for

this option as inventories are to be used as collateral.

According to the above calculations, Commercial paper can be considered to be one of the

cheapest source of short term financing at present for the company. However, its feasibility needs

to be considered in broader context. Although for the past few years commercial paper dealers had

contacted the company every two or three months to ask if it was interested in obtaining funds

through commercial paper market, it had not received any solicitations during the past 6 months.

Only recognized large companies with good credit worthiness can issue commercial paper.

However, large sum of money cannot be borrowed through commercial paper and its interest rate

may fluctuate widely according to the money market rates. There is also a risk that commercial

paper may not be sold due to deteriorating liquidity situation of the company. Commercial paper is

also not suitable if the funds are to be raised immediately. Usually, commercial paper only serves

as a supplement for bank loans and the dealers of commercial paper often require borrowers to

maintain lines of credit with banks. It may harm the relationship with bankers if the company

decides to switch from commercial paper back to the bank loans.

12%

1 - 5%

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Hence, it can be said that commercial paper does not represent feasible alternative to Action

Standard Manufacturing Company at present.

Issue 2

Discuss the feasibility ofAction Standard's using its inventory as collateral for loan. If this

form of financing is undertaken, what type of security arrangements would probably be used?

Do you think that Action Standard's inventory would make very good security for loan?

Inventories are expected to rise to the level of almost $ 21 million by the end of 2007. The amount

of inventories are sufficient to be considered as collateral for the company's short term financing

requirements. There is also a possibility that a lower interest rate could be obtained due to the fact

that the loan would be secured by inventories.

Nevertheless, the factors to be considered to determine whether the inventories held by Action

Standard is eligible for collateral depends upon the quality of its inventory. The lenders decide

inventory financing based on the factors such as:

(a) Quality of inventory (marketability)

(b) Perishability(c) Market-price stability &

(d) Difficulty & expense involved in selling inventories

The inventories held by the company are not easily marketable as they produce specialized

equipments which can only be sold to specific group of customers. Hence lenders may not easily

provide loan considering the marketability of the finished inventory and the associated difficulty

and expense involved in selling it.

Although the inventories are not perishable, its price would depend upon the market demand whichmay be fluctuating. So, the lenders may only provide a smaller percentage of loans would be

provided by providing inventories as collateral for loan. Hence the company can only rely to obtain

a limited amount from this source of financing.

If this form of financing are used the possible types of security arrangements are:

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1. Chattel Mortgage: It requires inventories to be identified by serial number and the

inventories cannot be sold without lenders consent. It would also add extra cost and loss

of time for each transaction making it undesirable for Action Standard although large

items such as tractors may be suitable to be identified by a serial number.

2. Terminal warehousing and Field warehousing loan: it requires the inventories to be

stored off premises or on premises through a warehousing company. The lenders would

exercise tight control over the inventory and the warehousing company will not release

inventories unless authorized by the lender. This would also add extra time and cost of

managing the inventories and hence considered to be undesirable.

3. Floating lien: In this type of arrangement, the lender obtains floating lien over all

inventory not exercising tight control over them and it acts as additional protection to

the loan. This can be considered to be the most feasible option as there is no additional

cost of managing the inventories and no loss of time.

Issue 3

Determine the approximate rate of interest on forgone discounts. What are the advantages and

disadvantages of allowing accounts payable to build up, as the financial staff has suggested?

Discuss specifically the firm's declining liquidity position and its use of spontaneousfinancing through trade credit. Would it be a wise policy to build accounts payable?

The approximate rates of interest on forgone discounts are calculated as:

Effective cost of trade credit =

=

= 56.44%

Discount%

X

365

100-Discount

%

Credit period- Discount

period

3X

365

97 30- 20

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The advantages to the company of allowing accounts payable to build up are as follows:

1. It is readily available and convenient source of finance to the company.

2. It helps to improve temporary liquidity position as it is a continuous form of credit.

3. It is an interest free source of finance.

4. There is no need to pledge collateral for this financing.

5. There is no need to arrange financing formally with its creditors and no need to

negotiate. Hence the lead time is shorter.

6. It provides time to arrange cash to honor accounts payable.

However, there are many disadvantages to the company of allowing accounts payable to build up

such as:

1. The cash discounts would be lost, which would result in higher cost for the

company. The financial Vice-President of Action Standard has already come to realize

that declining profit margin on sales and falling rate of return on assets is a

consequence of abandoning the policy of taking cash discounts on all purchases.

2. It would hurt the company's reputation as a responsible company and it may not be

able to negotiate favorable prices in its supply contracts.

3. The availability of raw materials on quick notice from suppliers may not be

available.

4. The first preferential treatment from the suppliers may be lost

5. This may also result in deterioration in credit rating of Action Standard.

The liquidity position of the company would further deteriorate if the company chooses to use

trade credit financing as the amount of current liabilities would build up. It would not be a wise

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policy to accumulate accounts payable for the reasons as discussed above. Trade credit should only

be used for a reasonable period of time to obtain the benefit of cash discounts and good

relationship with its suppliers.

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Issue 4

The issue here is to present the pros and cons of Action Standard's using accounts receivable

financing at the present time, the impacts of accounts receivable financing on current ratio

and quick ratio and to determine the new level of these ratios. And also to identify would it be

better off factoring or pledging its accounts receivable, if the company elects to use receivable

financing. (Assume 95% loan on receivables).

Account Receivables financing stand as one of the promising source of financing for Action

Standard at the present time among various available sources of financing.

Pros and Cons of Account Receivables financing:

The pros of receivables financing can be presented as:

Easy and quick source of financing:

Since Action Standard requires cash immediately to finance its expansion, account

receivables financing is the easiest and quickest form of financing available for the

company at the moment. It can get the cash immediately without being required for the

receivables to be redeemed.

Size of receivables:

As the companys account receivables is quite huge containing more than 20% of its total

assets and it can secure 95% loan on receivables. It makes more than $ 13.5 million funds

available from the receivables financing currently which will be able to meet the firms

cash needs for growth.

Protection against bad debts losses:

The company can opt for factoring the receivables on nonrecourse basis. It would be

carefree about the non collection of the receivables since the factor will absorb the losses

from any bad debts whatsoever might arise.

Continuous and flexible:

It can be the continuous form of credit to the company in future as well. Since Account

receivables are continuous form of accounts, so the credit can be continuously extended.

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Due to flexibility in financing, any amount of credit can be secured as per the amount of

receivables which will be helpful for the company to meet its uncertain cash needs in

upcoming days.

However, there are various cons of receivables financing for the company as:

Expensive source of financing:

It is an expensive source of financing for the company. The effective cost of pledging

receivables is 13% or 12.63% for factoring which is higher than other sources of financing.

The company can get access to 12.5% on bank loan while the recent commercial paper rate

is just 10% (effective).

Limit other financing:

The company cannot opt for the bank loans if either account receivables pledging or

factoring is employed. So, it limits other cheapest sources of financing possibilities if any.

Additional costs/dual costs:

Factoring of account receivables seems illogical since the company has its own credit

department and this financing would impose additional costs to the company; one for

financing itself and the next for the in-built credit department cost which has to be borne

any ways.

Others:

o The amount received through this financing would be low if factoring is done as

loan is provided taking discount on the face value of the account receivables

invoice.

o The factor may try to put unnecessary influence and pressure to the companys

accounts and practices as they will try to impose their ways to speed up receivables

as well as new policies, timings and sales decisions.

o As the factors are involved in collecting of the receivables, which are technically

the third (alien) party to the customers, the customers may not be satisfied. They

may feel unnecessary hassles and problems as imposed by factors and they may

lose trust on the firm.

Impacts of accounts receivable financing on current ratio and quick ratio:

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Some effect can be seen in terms of liquidity ratios due to receivables financing. With such

financing, the current assets and current liabilities will subsequently decrease. The impact can be

seen as:

Decrease in Account Receivables by pledged amount i.e. $ 14.250 million

Decrease in Accounts payables by loan amount received i.e. 95% of Account receivables $

13537.5 million

Calculation of new level of Current and Quick Ratio:

Pledged Receivables = $ 14,250

Borrowed Amount= 95% of Rs. 14,250 = $ 13,537.5

Now, New Current asset = 40,032-14250

= $ 25,782

New Current liability = 22400- 13537.5

= $ 8,862.5

Current Ratio =Current Assets

Current Liabilities

= 25,782

8,862.5

= 2.909

Quick ratio = Current asset- Inventories

Current liabilities

= 25,782- 20850

8,862.5

= 0.557

Hence, the company will have the improved new Current Ratio 2.909 increased than estimated for

2007 and quick ratio as 0.557, reduced than the estimated ratio.

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Calculation of cost of receivables financing:

Given,

Account Receivables= $ 14.250 million

Loan on receivables (up to 95% of A/R) = $ 13.5375 million

Loan on pledging of A/R; Interest rate= 13%

Loan on factoring of A/R; Interest rate 12% + discount from face value 5% (each receivable0

Cost of Loan on pledging of A/R;

=13% of $ 14.250 million

= $ 1.8525 m

Cost of Loan on factoring of A/R;

(5 % discount on each receivable invoice will approximately lead to deduction of 5 % of amount of

receivables i.e. 95 % of face value in terms of loan)

=12% of $ 13.5375 million

= $ 1.6245 million

Subjective Analysis Required:

Net cost/benefit: $ 1.8525 -1.6245 = $ 0.228 million

Cost for credit department if factoring is done

Better Option: Pledging of Account Receivables financing for the company. It is seen that the net

cost while pledging is $ 0.228 million. But this cost is negligible as the company has its in-built

credit department cost.

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Issue 5

Assume that Action Standard does not go along with suggestions of building up accounts

payable to 60 days (reflected in the 2007 proforma balance sheet in Table 1) but opts instead

to start paying in 10 days and taking discounts.

(a) What is revised amount of Action Standard's projected year end 2007 accounts payable?

Given:

Estimated Accounts Payable net of discounts for 60 days for the year 2007 = $17,700,000

But if Action Standard opts to pay in 10 days and then takes the discounts;

Revised amount of Accounts Payable =60

0$17,700,00*10

= $2,950,000

Hence, the revised amount of projected year end 2007 Accounts payable is $2,950,000.

As calculated, the decrease in the amount of accounts payable will certainly lead to the

improvement in the liquidity position of the company. Hence, by taking the discount andpaying on time, the company can further enjoy intangible benefits like prompt delivery of

materials by the supplier and good reputation in the market.

(b) Determine the amount of funds Action Standard would have to borrow in order to take

discounts. What would be the effective cost? Assume at this point that bank borrowing, at

10 percent discount interest and with a 10 percent compensating balance requirement, is

used. Also assume that all asset accounts, including cash and securities now on hand,

cannot be reduced. Base your answer on Action Standard's "steady state" borrowing

requirements, which means disregarding the one-time funds requirements to account for the

fact that accounts payable are currently carried at net, yet most of them will have to be paid

off at gross.

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Given:


Because the accounts payables are stated net of discount even when not taken; let the gross

purchase for the year is y.

Therefore,

x - 3% of x = $17,700,000

or, 0.97x = $17,700,000

or, x = $ 18,247,423

Hence, the gross purchase would be $ 18,247,423

Further, the bank borrowing demands 10% discount interest and 10% compensating

balance.

So, the required amount of borrowing ; x- 0.1x -0.1x = $ 18,247,423

X = $ 22,809,279

Thus, Action Standard should borrow $ 22,809,279 in order to take the discount.

Now,

Effective cost = (0.1*$ 22,809,279)/ $ 18,247,423

= 12.5%

The quoted interest rate is only 10% but the effective interest rate is 12.5%. It is because of

the fact that the interest payment is on the discount basis and also because the bank

demands the compensating balance.

(c) What are the net savings that Action Standard will realize from borrowing to take the

discounts? Note that accounts payable are recorded net of discounts. (Hint: find the annual

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gross purchases as the initial step, followed by discount received, interest on borrowing and

so on).

Given:


Term of Credit = 3/10, net 30

Calculating Net Savings Action Standard will realize from borrowing to take discounts;

Annual Gross Purchase= 0.97

0$17,700,00

= $18,247,423

If discount is taken, Amount of discount= $18,247,423* 0.03 = $547,423

Again, if bank borrowing with 10% discount interest and 10% compensating balance is

used,

Amount to be borrowed for taking the discount = 0.1-0.1-1

3$18,247,42

= $ 22,809,279

Interest on the borrowing = $ 22,809,279*0.1

= $ 2,280,928

Thus, Net Savings from borrowing = Discount received- Interest on borrowing

= $547,423 - $ 2,280,928

= ($ 1,733,505)

Hence, it can be clearly seen that when money is borrowed from the bank so as to take

the discount on the purchase, the company suffers a loss since the discount received is

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lower than the interest to be paid on the amount borrowed. Hence, it is loss-making for

the company if it borrows from the bank so as to take the purchase discount from the

credit terms of 3/10, net 30.

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Issue 6

Effect of Covington's decision to take cash discounts has upon the current ratio, quick ratio

and profit margin:

If Covingtons rather foregone to take discount and like to take cash discount it has multiple affect

in the different types of ratio and profitability position of the company. The various effect of taking

the cash discount taking has described below:

a) Current ratio: The current ratio is the ratio of current assets and current liabilities,

computed using the formula as:

Current Ratio = Current Assets

Current Liabilities

As we take the cash discount then the account payables of the company decreases that

subsequently decreases the current liabilities of the company. On the other hand, it

decreases the cash of the company as well (i.e. the current assets) with the payment of

account payables in the discount period. But the current assets portion is more than the

current liabilities, therefore the current ratio of the company increases.

b) Quick ratio: The quick ratio is the computed using the formula:

Quick Ratio =Current Assets- Inventory

Current Liabilities

There effect of taking cash discount is same as the case of current ratio. Once the company

takes cash discount there is no any change in the level of inventory held by the company.

That means it will not have any significant effect in case of inventory. When company

takes cash discount then there is equal decrease in CA and CL but in overall there will be

increase in quick ratio position of the company as do the current ratio of the company.

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c) Profit margin: Covington's decision to take cash discountswill have significant difference

in profit margin of the company. From the calculation it is seen that the cost of not taking

discount is 54.66% p.a. There is also wider range of short term financing opportunities

available for the company such as Security Bank and trust company (12.5%), Pledging

account receivables (13%), Factoring (12.6%). Therefore in this case if company takes the

cash discount then it waves the costlier amount need for working capital. In this case the

company should borrow the short term loan available from the alternative sources

available that can raise the profitability of the company.

From the previous calculation it shows that it better to borrow the loan from the alternative

source of financing rather than taking the cash discount because the numeric value mere

does not give the holistic picture of precise profit and loss. From the calculation of the cost

and benefit analysis it has proved that, if we take the cash discount then profit margin will

have eroded by amount $ 1,733,505. ( the calculation has shown in the answer no 5)

Issue 7

Should Action Standard establish relations with and arrange a line of credit from Security

Bank & Trust Company? Give Reasons.

Action Standard has various options (sources of financing) to finance its business or working

capital from. The financing alternatives are:

Financing Source Effective Cost (%)

Trade Credit 56.44

Loan from Security Bank & Trust Company 12.5

Pledging of accounts receivable 13

Factoring 12.63

Commercial paper 10

Loan secured by inventories NA

Currently, the company is relying on extended trade credits for meeting its working capital

requirements due to which the company is deprived of taking the benefits from trade discounts.

The cost of trade credit is very high which has, in recent years led the company to a miserable

state. An extended credit period is also tarnishing the reputation of the company and its credit

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rating. Furthermore, if the company can pay the suppliers on time, it can draw a more favorable

response from suppliers and thus gain a higher bargaining power.

MidCon National Bank cannot offer more loans to Action Standard due to its single obligatory

limit, but it obtain sufficient loan from Security Bank & Trust Company for an effective annual

rate of 12.5%. Since it is a large bank, a good relationship with Security Bank & Trust Company

can be very helpful even when the company needs larger loans. Also, the loan from the bank is

cheaper than pledging of accounts receivable or factoring. Furthermore, in pledging and factorings,

the banks may be very selective in choosing the accounts receivables.

Here, commercial paper seems a cheaper option. But unlike bank loans, they are non-renewable,

and hence serve only the temporary requirement of capital. So, commercial papers are not valid in

this case. Loan secured by inventories are also subject to rigorous scrutiny by banks on the basis of

various factors like marketability, perishability etc. There are less chances that with inventories as

such Action Standard would get a large loan and at a less interest rate.

Loan from Security Bank & Trust Company seems the most feasible and profitable alternative

here. Hence, Action Standard should establish relations with and arrange a line of credit from

Security Bank & Trust Company

action standard case

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