Problem Statement: Chem-Med Company is positioned strongly in its industry to achieve high growth and earn large profits in the future, but it is in need of financing. To secure this financing, Chem-Med must address concerns of potential financers and investors regarding liquidity, efficiency, cash flow, and the need for funding despite apparent growth. In addition, Chem-Med’s primary competitor, Pharmacia, is out-competing the company and stealing valuable market share and sales volume with lower prices.
Analysis: To understand Chem-Med’s problems, we must first look at the company’s liquidity and efficiency through the calculation of various ratios. Common measures of liquidity, activity, and profitability for ChemMed and its competitor Pharmacia can be found in the following table: Chem-Med Pharmacia 2.9 2.8 1.08 5.8 30.15% 7.00% 13.67% 55.00% 29.66% 29.56% 0.8493 1.9
Current Ratio Inventory Turnover Net Profit Margin Debt-to-Assets Return on Equity Total Asset Turnover
Chem-Med is competitive with Pharmacia in terms of Current Ratio and Return on Equity. But Chem-Med turns over inventory much slower than Pharmacia, at 1.08 times per year versus Pharmacia’s 5.8 times. Chem-Med also utilizes assets more poorly, generating sales equal to only .8493 times total assets compared to Pharmacia’s 1.9 times.
It is interesting to note that Chem-Med has a much higher profit margin than Pharmacia while maintaining virtually the same Return on Equity. To understand this phenomenon, we must deconstruct each firm’s Return on Equity (ROE) using the DuPont Method. ROE Chem-Med Pharmacia We can see that Pharmacia makes up for its lower profit margin with a much higher total asset turnover as well as a better use of debt to achieve a return on equity similar to that of Chem-Med. While ChemMed operates with a much higher profit margin than Pharmacia, its utilization of assets and debt falls far below the standards of its competitor, causing the firm problems. Chem-Med has a three-year plan for the future. This business plan comes complete with financial projections that the bank has used to determine whether or not Chem-Med 2008 2009 2010 is a safe loan risk. The bank has agreed to make a loan to the firm on the condition that it upholds several loan covenants, Current Ratio (> 2.25) 2.72 2.39 1.98 Debt/Assets (< 30%) 13.51% 14.03% 13.87% expressed in the table at left.
The problem statistic (a current ratio of 1.98 in 2010) is highlighted. This figure is below the mandated current ratio of 2.25. Chem-Med must address this projected liquidity problem to secure the necessary financing to implement its business plan. In addition to liquidity and efficiency problems, Chem-Med must address cash flow concerns. A pro-forma cash flow statement for the years 2008-2010 follows: Chem-Med’s cash flow statement provides encouraging data for potential investors. The firm expects to have positive operating cash flows over the $ 167 next three years and therefore requires little outside financing to finance the investing outflows which will sustain the firm’s growth.
Chem-Med is very $ (66) profitable Projected Net Income (2008-2010) $ 101 and is 2008 2009 2010 Total effectively converting those profits into operating cash flows. In fact, $ 1,150 $ 1,274 $ 1,943 $ 4,367 the firm’s operating cash inflows exceed the projected profits for the Chem-Med Company Statement of Cash Flows Opening Cash Balance (1/1/08) Operating Cash Flows $ 6,050 Investing Cash Flows $ (6,205) Financing Cash Flows $ 89 Closing Cash Balance (12/31/10) firm over the three year period. Chem-Med is effectively converting its profits into operating cash inflows and by doing so the firm has almost enough operating cash to finance its investing outflows.
There is only a very slight cash flow problem as investing outflows still outstrip operating inflows, but only by a slim margin. The firm also faces a problem in terms of efficiency in collection of debts. The collection periods for the firm for the years 2007 – 2010 are presented here. 2007 2008 2009 2010 As is evident, the firm’s ability to collect on Collection Period (Days) 53.24 61.15 72 80.87 its debts is actually decreasing in the future. Instead of increasing efficiency, the firm is decreasing in efficiency. Projected Growth In Net Income (2008-2010) 2008 2009 2010 10.8% 52.5% 49.4%
Despite liquidity and efficiency problems, Chem-Med has a healthy cash flow and anticipates high growth. The projected year-to-year growth rates in net income for 2008-2010 are displayed in the adjacent table. As can be seen, the firm expects robust growth over the next three years and is therefore an attractive opportunity for investors.
It appears, then, that the problems of liquidity and efficiency do exist and should be addressed. Chem-Med has a healthy cash flow and is only slightly deficient in operating cash flow, but because the firm is experiencing such robust growth, it is not entirely surprising that the firm has a high need for investing cash. Recommendations: Chem-Med’s most pressing problems involve its competitor, Pharmacia. Pharmacia is engaging in price wars with Chem-Med, taking a 59% market share to Chem-Med’s 25% share. Chem-Med should lower its prices in response to Pharmacia’s tactics to gain market share. Pharmacia is already operating at a much lower profit margin, so it is unlikely that the firm can cut prices as steeply as Chem-Med. Chem-Med can still maintain a healthy profit margin while gaining valuable market share and sales volume. Increasing sales volume through price cuts will increase the firm’s gross sales while having no affect on total assets. This, in turn, will improve the company’s total asset turnover and bring it more in-line with Pharmacia’s. Increasing sales volume, however, will not necessarily improve the firm’s inventory turnover rate as both sales and inventory will increase to accommodate the increased volume.
To improve upon this, Chem-Med should consider investing in an inventory control system or consider new methods of ordering (such as just-in-time ordering) to improve its control of inventory. In addition, Chem-Med should take note that its Debt-to-Assets ratio is well below Pharmacia’s. Engaging in more debt financing will increase the firm’s financial leverage and magnify the healthy returns it expects to see in the next three years. This increased debt usage will also magnify the firm’s return-on-equity, making it an even more attractive firm for potential investors. Chem-Med should consider offering discount terms to its customers for prompt payment. Such terms will encourage customers of Chem-Med to pay sooner and therefore reduce Chem-Med’s collection period. This, in term, frees up cash flow for the firm and will increase its overall operating efficiency and can help to alleviate some liquidity problems.
Collecting in a timely manner will also decrease the likelihood of default on accounts receivable as the accounts remain outstanding for shorter periods of time. To further alleviate liquidity problems, specifically that posed by the firm’s current ratio in 2010, Chem-Med should consider using more long-term debt. The firm could take out a long-term loan to settle its accounts payable. This would decrease Chem-Med’s current liabilities, which in turn would increase the firm’s current ratio. This would make the firm appear as a lower risk to bankers and investors as its ability to meet its current obligations will have improved. By lowering its prices to increase sales volume and market share, offering discounts to decrease collection periods, and refinancing its short-term debt with long-term debt, Chem-Med Company can improve its marketability to investors, gain a competitive advantage in its industry, and look forward to improved long-term performance as a more efficient and robust firm.