Star River Electronics Case Solution

Florida Atlantic University Star River Electronics Ltd. – Case Analysis Case Summary Star River Electronics is a joint venture company that has gained respect within the industry for producing high quality CD-ROMs to major software companies. In the mid 1990s, multimedia products created a high demand for CD-ROMs, allowing manufacturing companies of all sizes to enter the market. As a result, an oversupply ensued causing prices to decline as much as 40%. Star River survived a period of consolidation, and now faced a new threat.

DVDs are alternative storage devices that offered 14 times more storage capacity. Surveys showed that DVD disc drives would increase from 7% to 59% of all optical-disc-drive shipments by 2005. Star River Electronics began experimenting with DVD production but it only accounted for less than 5% of its sales in 2001. With an increase in capacity, Star River hoped that revenues from DVDs would increase. Newly appointed CEO Adeline Koh is faced with decisions that will have significant financial consequences. Most notably, Koh is seeking an extension on a loan from Star River’s bank.

In order to make a case for itself, Koh has appointed her assistant, Andy Chin, to evaluate the company’s historical financial statements and forecast the company’s performance over the next 2 years. In the forecast, Koh assumes that company sales will grow 15% annually, any external funding will come from debt, and also commits to the purchase of DVD manufacturing equipment. The goal of the forecast that will be presented to the bank is to prove that Star River can repay its loans and has not “grown beyond its financial capabilities”.

The following analysis will determine whether Star River has been managing its debt effectively, whether they can assume additional debt, any alternatives, and recommendations to operating and financial changes. Case Analysis The analysis will comprise of historical data and ratios incorporating the assumptions laid out by Adeline Koh in the case that: 1. Sales will grow by 15%. 2. External funding is in the form of debt. 3. Capital Expenditures = SGD54. 6 million for DVD manufacturing equipment. 4. Interest expense will include 6. 7% short-term interest rate, and 14. % long-term interest rate plus the bond interest rate. 5. WACC = 10%. [1] Historical Analytical Financial Ratios Liquidity ratios are examined below in Table 1. The current ratio increased from . 76 in 1998 to . 88 in 2001. This increase is due to the addition of assets, improving Star River’s liquidity. The quick ratio decreased from . 41 in 1998 to . 34 in 2001. This decrease was caused by an accumulation of inventory, which is excluded from the quick ratio calculation. The difference between the two ratios continues to increase from . 5 in 1998 to . 54 in 2001 proving that an inventory problem may exist. |Liquidity Ratios |1998 |1999 |2000 |2001 | |Current Ratio |0. 76 |0. 77 |0. 80 |0. 88 | |Quick Ratio |0. 41 |0. 41 |0. 31 |0. 34 | Table 1 – Liquidity Ratios

Efficiency and debt ratios are examined below in Table 2. Star River experienced a declining trend in total asset turnover from . 65 in 1998 to . 57 in 2001, a difference of . 08. A cause for the declining asset turnover can be a weak inventory turnover ratio. The inventory turnover ratio reflects a declining trend from 1998 (1. 45) to 2001 (. 84), a substantial difference of . 61. This suggests that Star River went from replacing their inventory 1. 45 times per year to only . 84 times per year. Star River’s debt to equity ratio is increasing from 1. 13 in 1998 to 2. 20 in 2001.

This proves that Star River is taking on additional debt to fund its growth. |Efficiency and Leverage Ratios |1998 |1999 |2000 |2001 | |Inventory Turnover Ratio |1. 45 |1. 39 |0. 86 |0. 84 | |Total Asset Turnover |0. 65 |0. 64 |0. 57 |0. 57 | |Debt to Equity |1. 3 |1. 21 |1. 99 |2. 20 | Table 2 – Efficiency and Leverage Ratios Profitability ratios are examined below in Table 3. For net profit margins, ROE, and ROA, Star River experienced a declining trend of 1. 22, 1. 32, and 1. 44 respectively from 1998 to 2001. This is due to an increase in cost of goods sold, particularly inventory, resulting in compressed margins. Star River’s inability to pay down its debt will cause EBIT and EBITDA to continue to show an increasing trend, until the company can control their Current Liabilities. Profitability Ratios |1998 |1999 |2000 |2001 | |Gross Profit Margin |53. 14% |52. 08% |49. 80% |49. 60% | |Net Profit Margin |7. 96% |8. 21% |5. 28% |6. 74% | |Return on Total Assets |5. 19% |5. 25% |3. 02% |3. 7% | |Return on Equity |16. 65% |16. 87% |11. 68% |15. 21% | |EBIT |13,412 |14,907 |14,428 |17,060 | |EBITDA |21,488 |23,935 |24,820 |28,420 | Table 3 – Profitability Ratios The financial ratios are indicating that a clear issue exists in Star River’s inventory levels.

The inability to turnover its inventory is contributing to the company becoming less liquid, utilizing their assets less efficiently, compressing their profitability margins, and increasing debt. Growth rate is examined below in Table 4. The sustainable growth rate of Star River fluctuates from a high of 13. 30% in 1999 to a low in 2000 of 7. 41%. The dramatic drop off was due to mismanagement of resources (i. e. accumulating inventory) resulting in the company having a lower growth rate before it had to borrow additional funds to support growth.

The compounded annual growth rate of 13. 82% represents the amount the company could have grown had it grown at a steady rate. It is clear to see that Star River’s sustainable growth rate never reached its compounded annual growth rate, causing the firm to constantly increase its financial leverage in order to sustain growth. |Growth Rate Analysis |1998 |1999 |2000 |2001 | |ROE |16. 5% |16. 87% |11. 68% |15. 21% | |b (retention ratio) |0. 65 |0. 70 |0. 59 |0. 72 | |SGR |12. 15% |13. 30% |7. 41% |12. 30% | |Asset Growth Rate |8% |13. 5% |29. 3% |14. % | |Sales Growth Rate |15% |11. 4% |15. 6% |14. 5% | |Compound Average Growth Rate |13. 82% | | | | Table 4 – Growth Rate Analysis Cash Conversion Cycle and the Free Cash Flow are examined next in Table 5. The Cash Conversion Cycle grows from 231 days in 1998 to 466 days by 2001. The increase means that Star River is not receiving cash for the sale of its inventory until over a year after the fact (in 2001).

The Free Cash Flow for Star River decreases dramatically from 707,000 in 1999 to -25 million just a year later in 2000. This means that Star River has a negative amount of money available to pursue opportunities that enhance stakeholder value. Therefore, as the Cash Conversion Cycle increases in days, Free Cash Flow continues to decrease. |Cash Conversion Cycle |1998 |1999 |2000 |2001 | |Days in Accounts Receivable |112. 0 |115. 56 |110. 66 |122. 14 | |Days in Inventory |252. 35 |262. 98 |422. 59 |435. 57 | |Days in Accounts Payable |133. 37 |121. 75 |93. 35 |91. 31 | |Cash Conversion Cycle |231. 37 |256. 79 |439. 91 |466. 0 | |Free Cash Flow | |1999 |2000 |2001 | |EBIT | |14,907 |14,428 |17,060 | |Depreciation | |9,028 |10,392 |11,360 | |Taxes | |2,322 |1,601 |2,093 | |Operating Cash Flow | |21,613 |23,219 |26,327 | |Change in Net Working Capital |5,364 |31,045 |19,641 | |Net Capital Spending | |15,542 |17,746 |17,254 | |Free Cash Flow | |707 |-25,572 |-10,568 | Table 5 – Cash Conversion Cycle (days) and Free Cash Flow ($ in 000’s) Table 6 below illustrates Star River’s sources and uses of cash. The two accounts that experienced the largest changes were Short-term Debt (73% of total sources of cash) and Inventory (54% of total uses of cash). As illustrated in Table 5, Star River’s Cash Conversion Cycle for the year 2000 was 440 days and their Short-term Debt increased by 27. 7 million. The inability to pay off any of its debt within the year translates to an increase in Interest expense, ultimately lowering Net Income. Sources of cash | |1999 |2000 |2001 | |Net Income | |6,575 |4,889 |7,149 | |Depreciation | |9,028 |10,392 |11,360 | |Change in Short-term Debt | |8,158 |35,929 |11,892 | |Change in Long-term Debt | |0 |0 |8,200 | |Change in Accounts Payable | |491 |-916 |1,480 | |Change in Other Current Liabilities | |1,722 |-1,249 |-3,763 | |Total Sources of Cash | |25,974 |49,045 |36,318 | |Uses of cash | | | | | |Dividends | -2000 |-2000 |-2000 | |Change in Accounts Receivable | |-3,216 |-2,714 |-7,408 | |Change in Inventory | |-4,361 |-26,166 |-9,950 | |Change in PP&E | |-15,542 |-17,746 |-17,254 | |Total Uses of Cash | |-25119 |-48626 |-36612 | Table 6 – Sources and Uses of Cash The Return on Invested Capital is computed below in Table 7. A declining trend is present from 1998 (14. 09%) to 2001 (9. 14%). In 1998 and 1999, when ROIC was 4 percentage points greater than WACC, the company was creating 4 cents in value for every dollar it invested in capital. The ROIC figure becomes less than the WACC (10%) in 2000, thus Star River is eroding 1 cent for every dollar invested in capital. A small difference between ROIC and WACC can translate to a large increase or decrease in Economic Profit. Return On Invested Capital |1998 |1999 |2000 |2001 | |Tax Rate |0. 28 |0. 26 |0. 25 |0. 23 | |NOPAT |9,664 |11,016 |10,869 |13,196 | |Invested Capital |68,578 |80,456 |118,855 |144,390 | |ROIC |14. 09% |13. 69% |9. 14% |9. 4% | |After-tax Cost of Capital (WACC) |10% |10% |10% |10% | |ROIC – WACC |4% |4% |-1% |-1% | |Dollar Cost of Capital |6,858 |8,046 |11,886 |14,439 | |Economic Profit |2,806 |2,971 |-1,017 |-1,243 | Table 7 – Return on Invested Capital and WACC After considering the historical financial data, it is clear that Star River is experiencing a high level of stagnant inventory that is being funded by Short-term debt.

This is also a problem due to Star River’s history of lengthy Cash Conversion Cycle (446 days), which prevents them from paying down their debts using their Free Cash Flows (which has become largely negative). Future Analytical Performance This section will evaluate Star River’s Pro Forma Financial Statements, ratios and other metrics to determine if the company can support additional debt and make timely payments on such debts. An analysis will also be performed to determine what alternatives are available to Star River, along with recommendations. The Pro Forma Income Statement found below in Table 8 includes both Koh’s assumption that sales will increase 15% for 2002 and 2003, as well as the linear trend analysis. Pro Forma Income Statement | |Koh’s Forecast |Linear Trend | |  |1998 |1999 |2000 |2001 | Table 8 – Star River Electronics Pro Forma Income Statement ($ in 000’s) The figures representing Koh’s assumptions of a 15% annual sales growth vary from the linear trend values because the trend analysis takes into account all the historical levels of sales, whereas Koh assumes that sales will continue to grow at the average rate over the past 2 years. The difference in values based on a percentage of sales based on Koh’s assumptions also holds true in Table 9, the Pro Forma Balance Sheet, because there is a direct correlation between sales and values obtained on the balance sheet. Pro Forma Balance Sheet | | | |Koh’s Forecast |Linear Trend | |Assets |1998 |1999 |2000 |2001 |2002* | |* Forecast Using 15% sales Increase |#Linear Trend Analysis | | | | Table 9 – Star River Electronics Pro Forma Balance Sheet ($ in 000’s) The external financing that would be needed by Star River would equal 18,163,000 in 2002 and 34,057,000 in 2003 (using Koh’s forecast). If the linear trend values are considered then the external financing numbers increase to 20,976,000 in 2002 and 43,540,000 in 2003.

When considering either set of numbers, it would be very difficult for Star River to be able to pay back the debt due to their long Cash Conversion Cycle and lack of Free Cash Flow. The Pro Forma Financial Ratios are found below in Table 10. |Financial Ratios |Koh’s Forecast |Linear Trend | |Liquidity Ratios |2002* |2003* |2002# |2003# | |Current Ratio |0. 84 |0. 84 |0. 83 |0. 9 | |Quick Ratio |0. 33 |0. 33 |0. 32 |0. 31 | |Efficiency Ratios | | | | | |Inventory Turnover Ratio |0. 84 |0. 84 |0. 82 |0. 79 | |A/R Turnover Ratio |2. 99 |2. 99 |2. 85 |2. 72 | |Average Collection Period |122. 14 |122. 14 |127. 98 |133. 6 | |Fixed Asset Turnover |1. 33 |1. 40 |1. 27 |1. 28 | |Total Asset Turnover |0. 57 |0. 59 |0. 55 |0. 54 | |Leverage Ratios | | | | | |Total Debt Ratio |0. 76 |0. 77 |0. 77 |0. 81 | |Long-term Debt Ratio |0. 9 |0. 08 |0. 09 |0. 08 | |Debt to Equity |2. 36 |2. 46 |2. 57 |3. 19 | |Coverage Ratios | | | | | |Times Interest Earned |1. 96 |1. 85 |1. 48 |0. 96 | |Cash Coverage Ratio |3. 67 |3. 77 |3. 16 |2. 7 | |Profitability Ratios | | | | | |Gross Profit Margin |0. 50 |0. 50 |0. 49 |0. 48 | |Operating Profit Margin |0. 14 |0. 13 |0. 12 |0. 08 | |Net Profit Margin |0. 05 |0. 05 |0. 03 |0. 00 | |Return on Total Assets |0. 03 |0. 03 |0. 2 |0. 00 | |Return on Equity |0. 13 |0. 11 |0. 07 |-0. 01 | |EBIT |17,423 |18,425 |13,483 |10,166 | |EBITDA |32,683 |37,585 |28,743 |29,326 | |* Forecast Using 15% sales Increase |#Linear Trend Analysis | | Table 10 – Star River Electronics Pro Forma Financial Ratios

Using Table 10 – Pro Forma Financial Ratios and Table 11 – Pro Forma Growth Measures, if Star River remains with their current business model they will not be able to pay back any debts, nor will any creditors agree to loan them any funds because of the growing problems the firm is facing regarding their ability to pay back debt (decreasing Free Cash Flow) along with a constant Cash Conversion Cycle that remains over 1 year before cash is collected. In both forecasts, Star River’s ROIC continues to decrease further deterring lenders from possibly granting them a loan |Pro Forma Growth Metrics |2002* |2003* |2002# |2003# | |SGR |9. 43% |8. 53% |2. 80% |-4. 2% | |Cash Conversion Cycle |466. 40 |466. 40 |466. 40 |466. 40 | |Free Cash Flow |-6,391 |-2,926 |-9,319 |-9,006 | |ROIC |7. 92% |7. 50% |6. 13% |4. 14% | |* Forecast Using 15% sales Increase |#Linear Trend Analysis | | Table 11 – Star River Electronics Pro Forma Growth Measures

A sensitivity analysis is illustrated in Table 12, between sales growth (independent variable) and the various financial ratios (dependant variable). As sales growth increases, the dependant variables (the financial ratios) are also increasing. If sales growth reaches 20% from its projected 15%, then EBIT would increase by 7. 5%, Star River’s coverage ratio would also increase by 5. 7%, however the debt to equity ratio would virtually remain the same. This may be of interest to an investor or lender. If Star River can maintain these margins forward to net income, then their request for external funding will have some supportive numbers behind it. |EBIT |D/E Ratio |Coverage Ratio |Current Ratio | |Sales growth | | | | | |15% |17,423 |2. 36 |1. 96 |0. 84 | |16% |17,707 |2. 36 |1. 98 |0. 85 | |17% |17,991 |2. 36 |2. 01 |0. 85 | |18% |18,276 |2. 36 |2. 3 |0. 85 | |19% |18,560 |2. 36 |2. 05 |0. 85 | |20% |18,844 |2. 37 |2. 08 |0. 86 | Table 12 – Star River Electronics Sensitivity Analysis After considering all the information presented in the tables, it is clear that Star River is growing too fast causing profit margins to shrink, an accumulation in inventory, which caused a sharp spike in short-term debt. Based on the analysis the banker, Mr.

Tan, was correct when he stated that Star River was “growing beyond its financial capabilities”. Therefore, Adeline Koh and Andy Chin must consider possible alternatives to presenting their forecast to the bank. Alternatives Based on the analysis of Star River Electronics, alternatives for both Adeline Koh and the bank exist. For Star River: 1. Construct a sales forecast incorporating sales from the expanding DVD segment. 2. Lower sales expectations to a sustainable growth rate. 3. Seek funding from sources other than banks (internal sources). For the bank: 1. Approve the loan based on Star River’s reputation and potential seen in the sensitivity analysis. 2. Approve the loan based on the potential in the DVD market. 3.

Approve the loan with conditions relating to default. Recommendations Adeline Koh and Star River Electronics must prepare an alternative forecast that incorporates the new DVD segment. With environmental forces showing a shift from CD-ROMs to DVDs, Star River must make a decision on how to unload its built-up inventory before these goods become obsolete. Adeline should commit the company to shifting into the DVD market, while reaching out to existing customers and offer special bulk deals on their overstocked inventory. This will create sales, make room for producing a product (DVDs) with a higher profit margin, as well as strengthening relationships with its loyal CD-ROM customer base.

Strong channel relationships and a reputable name will help Star River penetrate the new market as well as establishing a strong market presence. Also, it is imperative that Star River improves its cash conversion cycle. By increasing on-hand cash, the company will have the flexibility to use the capital towards increasing value, paying down debt (improving their relationships with their lenders), or making equipment purchases to improve operations (new packaging machine). For the bank, Mr. Tan can research further into the emerging DVD market and determine its potential. If Star River can enter the DVD market early and establish their position, large gains can be realized. ———————– [1] WACC value given in class