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Case Study: Emerson Engineering Ltd
(a) What evidence is there in the case to suggest that Emerson is overtrading?
- increase in costs because of more statt, new machinery and more overtime
- agreement of too long credit terms (90 days credit)
- delayed payments of two regular customers
(b) (i) Calculate the value of working capital for Emerson in 2002 and 2003.
(ii) Do the answers in (i) confirm that Emerson has a cash flow problem?
In 2002 Emerson Engineering recorded a working capital of 342. In 2003 Emerson's current liabilities increased sharply and rose above current assets - resulting in a negative working capital of 2,108 and a current ratio of 0,77. This current ratio of under 1 suggest that Emerson would be unable to pay off its obligations if they came due.
As a result, Emerson Engineering has a cash flow problem which needs to be solved.
(c) Explain the disadvantages to Emerson of using (i) sale and lease back (ii) debt factoring to resolve the cash crisis.
(i) The leaseback is a business strategy that involves selling an asset to a buyer, then leasing that asset back from the lender for a specific period of time. The arrangement may continue for a number of years, and may eventually result in the repurchase of the leased asset. Along the way, there are several benefits the lessee enjoys, such as continued use of the asset without the need to pay property or other taxes associated with ownership. At the same time, the terms of the leaseback may mean that the seller loses certain rights and privileges associated with ownership, such as tax breaks or deductions.
(ii) Do the answers in (i) confirm that Emerson has a cash flow problem?
- current assets (excluding cash) increase: 6.863 - (1.001+1.765+1.778) = 2.319
- working capital = current assets - current liabilities
- change in working capital = Year 1 (CA-CL) - Year 2 (CA-CL)
- 2002: 5.783 -5.441 = + 342
- 2003: 6.863 - 8.971 = - 2.108
- change in working capital: 342 - (- 2.108) = 2.450
- current ratio:
- 2002: 5.783 / 5.441 = 1,06
- 2003: 6.863 / 8.971 = 0,77 ( a ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point )
In 2002 Emerson Engineering recorded a working capital of 342. In 2003 Emerson's current liabilities increased sharply and rose above current assets - resulting in a negative working capital of 2,108 and a current ratio of 0,77. This current ratio of under 1 suggest that Emerson would be unable to pay off its obligations if they came due.
As a result, Emerson Engineering has a cash flow problem which needs to be solved.
(c) Explain the disadvantages to Emerson of using (i) sale and lease back (ii) debt factoring to resolve the cash crisis.
(i) The leaseback is a business strategy that involves selling an asset to a buyer, then leasing that asset back from the lender for a specific period of time. The arrangement may continue for a number of years, and may eventually result in the repurchase of the leased asset. Along the way, there are several benefits the lessee enjoys, such as continued use of the asset without the need to pay property or other taxes associated with ownership. At the same time, the terms of the leaseback may mean that the seller loses certain rights and privileges associated with ownership, such as tax breaks or deductions.
- The company loses the control of an asset ( create dependence ) and certain rights and privileges associated with ownership, such as tax breaks or deductions.
- The new owner may be unwilling to renew the lease after the initial contract expires, or even entertain the possibility of selling the asset back to the original owner.
- Even if the lessor is open to the idea of renewing the lease, he or she may choose to increase the amount of the installment payments in the renewed agreement. If the asset used as part of the leaseback is essential to the operation of the lessee’s business, then there may be no choice but to agree to the higher payments, a move that reduces the net profits for the operation.
- does not solve longterm issues
- high running costs
(ii) Debt factoring is the process of selling customer accounts receivable to a specialized finance company known as a factor. The invoices are purchased at a discount and then the factor collects directly from the customers.
Factoring can have several disadvantages for businesses that should be considered.
Factoring can have several disadvantages for businesses that should be considered.
- Cost - Factoring may be an expensive way to obtain financing. Accounts receivable are sold at a discount. This may imply a cost of capital greater than other sources of financing ( loss of earnings ).
- Outside Influence - Depending on your specific arrangement, a factor may begin to have influence over your business. They may not allow you to deal with certain customers or attempt to change your sales practices.
- Customer Relations - Since your customers will deal directly with a factor to pay invoices, an unprofessional factor can negatively impact your customer's perception of your business ( lose trust and communication from customers ).
(d) Discuss whether you think Emerson is in danger of going out of business