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. Thefirm's annual planning processincludes 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.

  Fordreviewed the cash budget withStewart. 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 Stewartare 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.Stewartopposed 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 requireincreasing 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.  Fordthought 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.