Kota Fibres

Case 1: Kota Fibres, Ltd.BackgroundKota Fibres, Ltd. was established in 1962 with an objective of producing nylon fibre. Ms. Pundir was running the business along with the support from her family. With the use of new technology and domestic raw materials, the firm supplied synthetic fibre yarns to local textile to make saris. Due to growing population and national income of India, synthetic textile market enjoyed huge potentiality to grow i.e. the market keeps a steady 15% annual growth. Though Kota Fibres enjoyed growing sales, but one of the constraint that limit its capacity to expand and increase its operation cost was seasonal demand for nylon textiles. Thus, the seasonal demand for nylon yarn would peak in mid-summer.

Their existed high competition among suppliers to retain merchants as consumers directly purchased the cloth from the cloth merchant. To remain in and increase the market share Kota had to adopt low cost strategy and grant a credit to support sales. With the different strategies, they were doing perfectly fine in business and had been consistently profitable. In the year 2000, sales had grown at an annual rate of 18% and their projected sales also were projected to reach to INR 90.9 million. Though they were regarded as very profitable organization but at later phase of business they were pulled into the situation which was characterized by declining profit, increasing interest expenses, high dependence on loan to meet seasonal demand, and declining cash flow. Thin profit margin had prompted Pundir to adopt policies against overproduction and overstocking. The yarn plant operates at peak capacity for two months of the year and modest levels the rest of the year imposing the ritual of hiring and layoffs. But still the company had to depend on more loans just as their heavy selling begins. To ensure prompt service, it established two distribution warehouses, but due to narrow roads which were in poor condition, trips were accident prone and very slow. Due to short term cash crunch they were unable to pay short term debt, excise tax, maintain timely delivery system, and maintain seasonal line of credit with bank. Kota fibre had a line of credit at All-India bank and trust company which had compliance of maintaining 30-day clean up of the loan but this time Kota was unable to repay the required amount.

This situation acted as an alarm and forced All-India Bank & Trust Company to deny any kind of seasonal credit and demand reasonable financial plan for the company. Ms. Pundir was shocked by the existing situation and she along with Mr. Mehta, the bookkeeper went through financial condition and prepared a forecast of financial statements for 2001, using different assumption they had made. It was very important issue because Kota required additional loan to fulfill short term obligations and for time being they also to needed to extend their line of credit. If they were not able to convince the bank then they will be in big problem and there was high chance of going bankrupt. Their projected financial statement showed that they can’t repay loan any sooner and need additional debt. So, to convince the bank their ability to clean up loan by the end of

2001, Ms. Pundir decided to reconsider their assumptions and also the different proposals that she had received to increase sales and decrease inventory level from her employees.

Question 2: What does Mehta’s financial forecast show? How was the forecast constructed? Using the financial forecast, prepare to show the cash cycle of the firm?Interpretation of the financial forecastMehta’s financial forecast does not show a satisfactory performance of the company. From the case, it is obvious that, although Kota Fibres Ltd. at times is suffering from cash shortage, it is a profitable company that has been enjoying profit as well as sales growth in the past. But, the financial forecast has shown that the forecasted profit of INR 1335848 in the year 2001(which accounts to be only 1% of the forecasted gross sales) is far below than the profit of INR 2550837 in the year 2000 (which accounts to be 3% of the gross sales for that year). Therefore, based on the Mehta’s forecasts, even though the company continues to remain profitable, its profitability will even decline in the year 2001.

Also, the monthly forecast of the income statement of the company shows that the company will experience a net profit in the business only in the 5 months, which is during the months of the seasonal peak in the demand for the nylon yarn. The inability of the company to maintain even a minimum level of profit in the rest 7 months might indicate a poor performance of the company.

By comparing the forecasted balance sheet of the company for 2001 with the actual balance sheet for 2000, it has been seen that there has been a considerable increase in the accounts receivable as well as inventory according to the forecast. This has increased the size of investments in current assets from 35% (4,684,237/13,295,604) of the total assets in the year 2000 to 43% (6,690,525/15,628,161) as forecasted in the year 2001. This increase in the size of current assets is not desirable for the company as its larger amount is one of the reasons for the need for external funding without a corresponding increase in profits for the company. Also, the forecasted schedule of the cash receipts and disbursements shows that in order to fulfill all the disbursements and to maintain the cash balance of INR 75,000 the company needs to borrow considerable amount of money for 7 months, that is, from January to June and again on December. So, on the basis of this forecast, the company’s total borrowing would be INR 32,452,209 whereas the repayment would be only INR 29,672,610 which may be a sign of the company’s inability to fully pay its short term liability on timely basis.

Financial Ratio AnalysisFinancial Ratios Actual(2000) Forecast(2001)Current ratio =4684237/1,443,637

= 3.244747733=6,690,525/ 4,440,345 =1.5067577

Quick ratio =(4,684,237-1,249,185)/1,443,637 =(6,690,525-2,225,373)/

=2 4,440,345 =1

Average collection period

=2,672,729/(64,487,358/365)=15.12770922

=3,715,152/(77,265,092/365) =17.550364

Average payment period =759,535/(53,865,911/365) =5.146671469

=1,157,298/(66,993,380/365)=6.3053066

Total asset turnover ratio =64,487,358/13,295,604 =4.850276504

=77,265,092/15,628,161 =4.9439657

Debt to asset ratio =1,443,637/13,295,604 =0.108579994 or 10.85%

=4,440,345/15,628,161 =0.2841246 or 28.41%

Gross profit margin =64,487,358/10,621,447 =0.164705882 or 16.47%

77,265,092/10,271,712 =0.1329412 or 13.29%

Return on assets =2,550,837/ 13,295,604 =0.19185563 or 19.18%

=1,335,848 /15,628,161 =0.085477 or 8.57%

From the above calculation, in 2001 both current ratio and quick ratio has declined from past, which suggest that ability of firm to pay its short-term debt/bills has declined. We’ve also calculated inventory turnover ratio, Average collection period, Average payment period, Total asset turnover ratio to determine how fast firm convert their credit sales into cash. There is low turnover rate in 2001 compared to past and this is because firm is carrying large number of inventory. Average collection period is not very large, which is good and their average payment period is very low which means that they are fast in paying their bills. Due to this they might be given high rating by their suppliers but there exist high gap between receivables and payables and this situation might lead to shortage of cash flow. If we look upon the debt ratios, we can infer that Kota is using high debt compared to past i.e. in 2000. Profit margin shows that it has declined from past which suggest that they will have to increase the sales or reduce expenses.

Basis for the construction of the forecastHere, the forecast was created using the current accounting assumptions. Some of these assumptions were created through the observations of the past practices. For example, in the past, it was observed that the sales collection in any given month had been running at the rate of 40% of the last month’s sales and 60% of the sales from the month before last. So, forecast for the accounts receivable for 2001 was created with an assumption of the continuation of similar trend in future. Also, similar assumptions based on the past operating practices were made for issues such as purchase of raw materials, wages, etc were made. Also, certain other assumptions such as assumption to pay the dividend of INR500,000 per quarter, keep the minimum cash balance of INR750,000 and so on were based on the discussion, agreement and judgment between Pundir and Mehta.

The set of assumptions have been presented in the table below:- Ratio of: Income Tax/Profit Before Tax 30% Excise Tax/Sales 15%

This Month Collections of Last Month's Sales

40%

This Month Collections of Month-before-Last Sales

60%

Purchases/ Sales two months later 55% Wages/Purchases 34%Annual Operating Expenses/Annual Sales 6.00%Capital Expenditures (every third month) 350,000 Interest Rate on Borrowings (and deposits) 14.5%Minimum Cash Balance 750,000 Depreciation/Gross PP&E (per year) 10% (per month) 0.83%Dividends Paid (every third month) 500,000

Table: Forecast Assumptions

Calculation of the cash cycle of the firm:2000 (Actual) 2001 (Forecasted)

InventoryAccounts ReceivablesAccounts PayableNet SalesCost of Goods Sold

1,249,185 2,672,729 759,535 64,487,358 53,865,911

2,225,3733,715,152 1,157,298 77,265,092 66,993,380

Inventory PeriodInventory TurnoverInventory Period

53,865,911/ 1,249,185 = 43.12365/43.12 = 8.46

66,993,380 / 3,715,152 = 30.10365 / 30.10 = 12.12

Receivables PeriodReceivables TurnoverReceivable Period

64,487,358/2,672,729 = 24.13365/24.13 = 15.13

77,265,092 / 3,715,152 = 20.80365/20.80 = 17.55

Operating Cycle 8.46+15.13 = 23.59 12.12 + 17.55 = 29.67Payables PeriodPayables TurnoverPayable period

53,865,911/759,535 = 70.92365/ 70.92 = 5.15

66,993,380/ 1,157,298 = 57.89365/57.89 = 6.31

Cash Cycle 23.59 - 5.15 = 18.44 days 29.67 - 6.31= 23.36 days

Figure: Forecasted Cash Cycle for 2001Here the forecasted cash cycle of 23.36 days for the means that, on average for 23.36 days, cash is tied up to the current assets of the company. From the calculation, it was found out that for the year 2000, the actual cash cycle of the company was only 18.44 days. Increment in the inventory and receivables in the forecasted period as compared to the year 2000 has led to this increase in cash cycle. For Kota Fibres Ltd., it is much desirable to shorten this cash cycle. Because, longer the cash cycle, greater will be the need for external financing. And with the problem of the cash shortage that the company is facing, shortening this cash cycle one of the good solutions for the company. This cash cycle can be shortened by reducing the inventory period, reducing the receivable period or increasing the payable period. Since this is the case of short term financing, viewing the cash cycle on the monthly basis is also important. Presented below is the monthly cash cycle of Kota Fibres Ltd. based on the monthly forecasted data of 2001:-

Month Cash Cycle (Days)January 40.431February 49.268March 59.535April 58.097May 60.353June 62.041July 65.672August 92.016September 94.722October 65.345November 58.270December 59.679

As shown in the table, the company has a higher cash cycle in the months of August and September and lower cash cycles in the months of January and February.

Question 3: Examine the exhibits in the case. On the basis of Mehta’s forecast, how much debt will Kota need to arrange for the coming year? Will Kota be able to repay the line of credit this year?In the given Exhibit 8, Notes payable represent the debt financing done by the bank to Kota. Analyzing the Exhibit 8, we find that the calculations of these values as per the excel sheets show that these values are calculated by deducing the balancing amount, that is, finding the value of Total Assets less Accounts Payable, Accrued Taxes and Shareholders' Equity.

According to the figures of Notes Payable in monthly forecast displayed in Exhibit 8, we find that the debt outstanding balance on January is INR 1,146,268, the maximum loan amount required by Kota is during the month of June, that is, INR 32,950,665/- and the debt outstanding for the end of the year 2001 is INR 3,463,701/-.

As mentioned in the case, Kota needs to supply to their main customers (cloth merchants) at a competitive credit policy (lower than preferred) and they also receive little or no trade credit from their own suppliers. This causes a period of cash deficit for Kota in peak sales seasons, that is, the summer season. Thus, as their sales increase their debt needs also increase. Therefore, even though the company is profitable, they suffer from cash crunches during their peak seasons as can be seen from the sharp increase of debt outstanding during the summer months, May, June and July.

Studying Exhibit 9 given in the case, we observe that months April, May and June have the highest amount of borrowings, INR 8,652,349/-, INR 9,578,178/- and INR 5,953,108/-. Though the months through July to November shows repayments, the month of December stills shows a borrowing of INR 185,647/- and the net borrowing amount for the year 2001 is INR 2,779,599/-. Therefore is conforms to the statement made by Pundir as per mentioned in the case, that the forecasts prepared by Mehta show that Kota Fibres Ltd. will not be able to repay the line of credit this year and rather they further require credit form the bank.

Question 4: What are Pundir’s alternatives for action? What impact might the four operating proposals have on the financial needs of the firm?

Alternative 1: Pondicherry textiles – increase sales with lax credit termsThe first alternative involves a proposal from Pondicherry Textiles that is willing to offer Kota Fibres an increase in sales revenue of Rs. 6 million provided that Kota gives them a credit period of 80 days, which is a significant increase from Kota’s standard credit period of 45 days.

Impact of the proposal on financials of KotaThe proposal from Pondicherry will have a positive impact on profitability of Kota as it involves an increment in sales revenue. More specifically, the forecasted profit for the forecasted period (2001) will increase by Rs. 126,325, which is a 8.64% increase in net profit.However, we recommend that Kota should not go ahead with this proposal because Kota’s problem is not that of profitability but cash management and this proposal from Pondicherry will have a detrimental impact on the firm’s short-term debt and cash position.For instance, accepting this proposal will require Kota to consistently borrow more in all months so that its highest debt outstanding (in the month of July) will increase from Rs. 32 million to Rs. 35 million.

Jan Feb March April May June

Debt Outstanding Adjusted 1,344,092 3,370,024 9,503,690 18,729,070 28,941,414 35,240,240

Debt Outstanding 1,146,268 2,962,622 8,767,030 17,419,379 26,997,556 32,950,665

Increase in debt outstanding 197,824 407,402 736,660 1,309,692 1,943,858 2,289,575

Jul Aug Sep Oct Nov Dec

Debt Outstanding Adjusted 29,076,414 16,955,838 8,970,898 5,399,639 3,562,712 3,704,996


Increase in debt outstanding 1,909,222 1,160,045 618,000 397,630 284,657 241,295

Jan Feb March April May June

New Borrowings (Repayments) 659,990 2,025,932 6,133,666 9,225,381 10,212,344 6,298,826

Borrowings adjusted 462,166 1,816,354 5,804,408 8,652,349 9,578,178 5,953,108

Increase in borrowings 197,824 209,578 329,258 573,032 634,166 345,717


New Borrowings (Repayments) (6,163,826) (12,120,576) (7,984,940) (3,571,259) (1,836,928) 142,284

Borrowings adjusted (5,783,473) (11,371,400) (7,442,894) (3,350,889) (1,723,956) 185,647

Increase in borrowings (380,354) (749,176) (542,046) (220,370) (112,972) (43,363)

Alternative 2: Reduce inventory through better transportation managementThe first alternative involves a proposal from the transportation manager who suggests that since shipments in the last 6 months have been on time due to the new road between Kota and New Dehli, Kota can reduce its raw material inventory requirement from 60 to 30 days, which would reduce the company’s inventory by one month.

Impact of the proposal on financials of KotaThe proposal will have a good impact on Kota’s short-term debt position as reduced amount of inventory will reduce the debt outstanding in all the months from January to December as can be seen from the table below.

Jan Feb Mar Apr May Jun


Debt Outstanding Adjusted 20347.3241

158861.2909 3107487.081 8974693.117 17496956.08 25889398.04

Decrease in Debt Outstanding 1,125,921 2,803,761 5,659,543 8,444,686 9,500,600 7,061,267




13579044.42 6585028.064 3727314.587 2088851.368 1984962.101

Decrease in Debt Outstanding 3,550,811 2,216,748 1,767,871 1,274,695 1,189,203 1,478,739

The proposal will also reduce the monthly borrowing requirement in most months from January to December as can be seen from the table below.


Borrowings462166.0532

1816353.585 5804408.038 8652348.714 9578177.569 5953108.394

Adjusted 455363.6131792611.757 5753275.578 8567135.665 9469758.133 5965658.262

Decrease in Borrowings

6802.440217

23741.82813 51132.46023 85213.04833 108419.4361 -12549.86798


Borrowings -5783472.57 -11371399.6 -7442893.923 -3350888.76 -1723955.522 185646.8519

Adjusted -5847587.21 -11406245.3 -7430057.448 -3369270.929 -1738841.574 169528.035

Decrease in Borrowings

64114.63621

34845.66977 -12836.47511 18382.16882 14886.05215 16118.81688

The decrease in borrowing requirement and debt outstanding makes sense as the proposal reduces inventory requirements to half, which means that the amount of financing required for current assets is lesser.

Alternative 3: Purchase the raw materials on “just-in-time” basis from Hibachi ChemicalsThis alternative involves purchasing 35% of the raw materials (polyster pellets) from Hibachi Chemicals on a “just-in-time” basis. This action is expected to reduce the inventory of pellets from 60 days outstanding to only 2 to 3 days.

Impact of the proposal on financials of KotaThe proposal will have a good impact on Kota’s short-term debt position as reduced amount of inventory with the use of “just-in-time” purchase will reduce the debt outstanding in all the months from January to December as can be seen from the table below.


Debt Outstanding1146268.5 2962622

8767030.1 17419379 26997556 32950665


978996.59

4732628.5 11384942 20205093 27910000

Decrease in Debt Outstanding

778892.76

1983625.5

4034401.6 6034437

6792463.7 5040665


Debt Outstanding 27167192 157957938352898.6

5002009.9

3278054.4

3463701.2

Debt Outstanding Adjusted 24648261 14235423

7114973.5

4118690.9

2456531.3

2434617.6

Decrease in Debt Outstanding 2518931

1560369.2

1237925.2

883318.97 821523.1

1029083.6

The proposal will also reduce the monthly borrowing requirement in most months from January to December as can be seen from the table below:-


Borrowings462166.05

1816353.6 5804408

8652348.7

9578177.6

5953108.4

Adjusted457460.24

1799663.4

5768049.1

8591516.1

9500681.7

5961889.1

Decrease in Borrowing

4705.8104

16690.214

36358.914

60832.567

77495.858

-8780.7356


Borrowings5783472.6

11371400

7442893.9

3350888.8

1723955.5

185646.85

Adjusted5829145.1

11396045

7433632.9

3363704.6

1734255.6 174466.1

Decrease in Borrowing

45672.559

24645.772

9261.0462 12815.85

10300.088

11180.749

The decrease in borrowing requirement and debt outstanding makes sense as the proposal reduces the inventory holdings by a considerable amount, which means that the amount of financing required for current assets is lesser.

Alternative 4: Adopt the Scheme of Annual Level ProductionThe fourth proposal is a memo from the Operations Manager, L. Gupta, to whom Pundir had requested to estimate the production efficiencies arising from a scheme of level annual production.

Impact of the proposal on the performance of KotaAccording to Exhibit 7, the significant advantages to be gained are:

The first advantage is that due to absence of certain seasonal training and setup costs, labor savings and production efficiencies is gained from a stable work force, therefore increasing the gross profit margin by 2% or 3%.

The seasonal hiring and layoffs would stop. This will allow Kota to create a stronger work force and, perhaps, to suppress labor unrest. As their unions have indicated that reducing seasonal layoffs will be one of their major negotiating objectives this year, this will help them negotiate on more favorable terms with the union.

With annual level production, the machineries would be in function all year round, thus, they would suffer less from equipment breakdowns and could better match the routine maintenance with the demand on the plant and equipment.

Kota Fibres

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