Jones_Electrical_DistributionDr_C_Bulent_AybarProfessor_of

Jones Electrical Distribution

Dr. C. Bulent Aybar Professor of International Finance

Context

• Jones Electrical Distribution has been expanding rapidly for the past several years.

• Increases in working capital requirements have significantly outrun the capacity of the company to generate funds from internal sources.

• The company has been forced to forgo taking discounts on accounts payable and to borrow in increasing amounts from its bank to maintain its expansion.

• Jones must decide whether to continue to expand and, if so, how to finance the growth.

Jones Income Statement

2004 2005 2006 Net sales 1,624.00 1,916.32 2,242.09 Cost of goods sold 1,304.07 1,534.97 1,818.34 Gross profit on sales 319.93 381.35 423.76 Operating expenses 272.00 307.38 346.54 Interest expense 26.80 29.83 31.24 Net income before taxes 21.13 44.14 45.98 Provision for income taxes 7.40 15.45 16.00 Net income 13.74 28.69 29.98

Impact of Growth on Jones: Investment Requirements

– Inventories + Accounts Receivables

– Investment in inventory and A/R has been growing at a rate of ~22% . (current assets has grown at 18.4%) > Sales growth of 17.49% for the same period

– Fixed Assets

– Growth in fixed assets is moderate!

2004 2005 2006

$430 $509 $643

2004 2005 2006 Net Fixed Assets $113 $103 $118

Acquisitions $15 $50

Working Capital and Sales Growth

2004 2005 2006

WC/Sales 26.47% 26.54% 28.67%

FA/Sales 6.96% 5.37% 5.26%

Sales $1,624 $1,916 $2,242

COGS $1,304 $1,535 $1,818

A/R $187 $231 $264

Inventory $243 $278 $379

A/P $36 $42 $120

ACP 42 44 43

Inventory Turnover 5.37 5.53 4.80

DSI 68 66 76

APP 10 10 24

CCC 100 100 95

WCR $381 $453 $509

WCR/Sales 23.47% 23.63% 22.70%

What is the impact of slowing inventory turnover and collection period on Jones’s investment requirements?

Working Capital is Growing Faster than Sales: Some Details

• In 2004 Sales and A/R were 1.624m and $187,000 respectively. As a percentage of sales A/R was 11.51% of the sales.

• If the collection did not deteriorate, when the sales increased to $2.242m in 2006, A/R would be roughly around 258,000 (2.242m x 0.1151=$258,054).

• In other words, sales increase would require a 71K increase in A/R provided that there is no deterioration in collections.

• However, JED’s A/Rs in 2006 is 264K. This suggests a slight deterioration in collections; JED had to invest in WC 6K more just because of inefficiency in collection.

Inventories

• We can check inventories with the same approach. In 2004 inventories were 243K, or 14.96% of sales.

• In 2006 when sales increased to 2.242m, we would expect inventories to increase to 2.242 x 0.1496=335.4K, but JED’s inventories in 2006 were 379K.

• If inventory management remained as efficient as in 2004, we would expect 335.4-243=$92.4m change in inventor; but inventories increased by 375-243=136K,

• This means that JED had to invest 136-92.4=43.6 m more in inventories just because of poorer inventory management.

WC Investment is Growing Faster than Sales! 2004 2006 Change

Accounts receivable $187 $264 $77.3 Sales $1,624 $2,242 Change in accounts receivable as pct of sales 11.51% 11.78% 0.27%

12/31/06 Accounts Receivable at 12/31/04 pct of Sales $258.0 Actual 12/31/06 Accounts Receivable $264.1 Accounts Receivable due to increased receivables as % of sales $6.1

2004 2006 Change Inventory $243 $379 $135.7 Sales $1,624 $2,242 Change in Inventory as % of sales 14.96% 16.89% 1.93%

12/31/06 Inventory at 12/31/04 pct of Sales $335.4 Actual 12/31/06 Inventory $378.6 Inventory due to increased Inventory as % of sales $43.2

Combined $ $429.8 $642.8 $212.9 Combined % of sales 26.47% 28.67% 2.20%

$ of A/R and Inventory at 12/31/06 due to slower turnover $49.3 Combined $ due to sales growth $163.6

Sales growth is driving the funding need!!

• While there is some deterioration in WC management, 164K of the 213K increase in WC is attributable to sales increase.

• 49.3K increase is due to poorer collections and inventory management.

• Therefore it is fair to argue that sales growth accounts for a substantial part of the additional funds invested in receivables and inventories.

Does Jones Generate Sufficient Cash Flows?

2005 2006 2005‐06

Net Income $29 $30 $59 Depreciation $25 $35 $60 Inventory ($35) ($101) ($136) Accounts receivable ($44) ($33) ($77) Trade credit (Accounts payable) $6 $77 $84 Accrued expenses $1 $1 $1 Cash flows from operations ($18) $9 ($9)

Capital expenditures ($15) ($50) ($65) Cash flows from investing activities ($15) ($50) ($65)

Bank borrowing (Line of credit) $65 $35 $100 Reduce long‐term debt ($24) ($24) ($48) Cash flow from financing activities $41 $11 $52

Increase / (decrease) in cash $8 ($30) ($22)

JED is not generating sufficient cash, hence its cash position is deteriorating

JED’s SGR

• SGR in 2005: – PM=28.69/1,916.32=1.49%

– AT=1,916.32/664.52=2.88

– LM=664.52/184=3.61

– RR=1

– SGR=1.49% x 2.88 x 3.61=15.5%

• SGR in 2006: – PM=29.98/2,242.09=1.33%

– AT=2,242.09/664.52=2.86

– LM=783.75/212/69=3.68

– RR=1

– SGR=1.33% x 2.86 x 3.68=14.02%

Is Jones’ Assessment of Funding Need Accurate?

• Maybe, if Jones continues to rely heavily on trade credit as a source of funds, as he has been during recent years

• Probably no, if he decides to pay his accounts payable promptly in order to take advantage of the 2% discount offered on payments made within 10 days of the date of invoice.

• It is time for pro forma statements!

Assumptions for Forecasting Funding Need

Sales 2,700,000

Operating Expenses 15%

Interest Expense 31,000

ACP 43

DSI 76

Principal Paid 24,000

Cash 32,000

Net PPE 110,000

COGS/Sales with discount 79%

COGS/Sales without discount 81%

Tax Rate 35%