Operating cash flow improved from 1978 to the first 8 months of 1979.
Thus, the company is generating positive cash flows, and its generated cash flows from operations increased. However, its net current asset investment increased tremendously, partly because the company purchased more raw materials than needed during the first 8 months of 1979, which could have been used for more profitable investments or non-current assets. The company, meanwhile, did not invest in its fixed assets, which made it less risky (since the company became more liquid) but less profitable (as current assets are less profitable than fixed assets).And because of the large increase in net current asset investments, the company has smaller free cash flow compared to its 1978 level, which means that the company has less cash flow to cover all of its operating costs and investments than before. This is also a cause for concern, since the free cash flow has fallen tremendously and the company would have a harder time paying its creditors and stockholders. The company is still in need of more cash (and this is further proven by the fact that the company’s cash is less than the customers’ advances).The regional capital goods industry, including Hampton, suffered from the Arab oil embargo which led to higher oil prices. There was also the 1974-1975 recession, which slowed down the US economy.
However, Hampton recovered prior to 1979, because of the increase in military aircraft sales, a stable automobile market, and increase in market share of Hampton, as its conservative financial policies aided in its survival amidst economic and financial difficulties. Furthermore, Hampton’s sales forecast shows a significant increase in sales during the succeeding months, showing that Hampton is confident in its future.The company has problems on paying its initial $1 million loan due to the fact that their actual sales were less than the forecast sales. This can be attributed to three major factors. First, a major component supplier failed to deliver their part on time. This caused Hampton to have seven machines worth $1. 32 million completed except for the inclusion of these parts. Second, the company bought $420,000 worth of components over its normal levels of inventory.
This, together with the goods in process worth $1. 32 million mentioned above, has caused an excessive investment in inventories.Third, the company’s machines have given Hampton problems with maintaining capacity production. Their machines are getting older and less efficient, since the company has tried not to investment in capital expenditures as it wants to conserve cash. It also wants to pay a dividend of $150,000 in December 1979, as goodwill for their stockholders who did not desert the company, and as a means to maintain their loyalty. Thus, the company will have less cash available on December.
However, these reasons are mostly temporary, as the company will undertake measures to solve some of these problems.Hampton plans to use the additional $350,000 to purchase new equipment to maintain production efficiency. This would mean an additional $5,250 interest payment from November to December, and an additional after-tax depreciation expense of $1,895. 83 per month. The equipment would also give rise to a deferred tax asset of $35,000, which means that Hampton would have tax savings of $35,000 on March 15, 1980. Hampton would pay taxes of $181,000 on September 15 and on December 15.
It also plans a larger dividend payment, $150,000, on December.However, the electronic components which caused delays in shipment arrived last week, and together with the new equipment, this could lead to increased sales. If Hampton’s forecast turns out accurate, Hampton would earn $7,537,000 from September to December 31, 1979. And on October, the advances of General Aircraft Corporation would become zero since Hampton’s shipments would exceed $1,566,000.
This would reduce Hampton’s current liability. Furthermore, selling and administrative expenses is expected to fall to $400,000.Regarding Hampton’s inventories, the excess in raw materials of $420,000 is expected to be used up by the end of the year. Raw material purchases would fall to about $600,000 per month, and work-in-process goods worth $1,320,000 is expected to be completely constructed and sold in the weeks to come.
The effects could be seen in the pro-forma Income Statements ( exhibit L and N), pro-forma Balance Sheets (exhibit M and O), and the ratios (exhibit P) under both alternatives. The net income for September to December is almost equal to the net income from January to August for both alternatives.Profit margins have also increased, though EPS, ROA and ROE fell slightly due to the slight decrease in asset turnover (but it’s not sign of inefficiency, as net sales are slightly lower during the 4 months than those of previous 8 months). Average Age of Inventory and Average Collection period is significantly better under the 4 months for both alternatives, and debt ratio has fallen (due to payment of $1,000,000 loan). And although operating cash flow is slightly lower, the free cash flow under both alternatives is significantly greater.