Essay on "Financial Policy on Advance Medical Technology"

Essay 5 pages (1543 words) Sources: 0

[EXCERPT] . . . .

Finance

There are a number of reasons for the company's need for additional financing. AMD has high levels of research and development spending, has expanded its sales force significantly and has focused on entering new markets. Thus, the company has expanded spending significantly since 1983, and primarily to fuel growth. Another contributing factor was that AMD carried excessive amounts of inventory, upwards of 10-12 weeks' worth, in addition to the 8-week processing time. The inefficiency of the production process combined with the high inventory level meant that upwards for 20 weeks' worth of goods were sitting at various stages of inventory. This is a long cash conversion cycle, and a lot of the firm's capital becomes tied up in assets that are not adequate for collateral with the bank. Another problem that the company has with its cash conversion cycle is the high level of receivables. For example, 22.9% of the company's sales in October remained outstanding 90 days after sale. The average age of the company's receivables was 54 days. Combined with the high inventory levels, the cash conversion cycle for AMD is upwards of 28 weeks. Such a high level contributes significantly to the firm's need for capital, regardless of R&D levels.

This growth has fueled the need for equity capital. Between April 1985 and May 1986, the company received four equity investments from Biological Labs in the amount of $12 million total. Equity investments are appropriate for the type of long-range, business-level growth that AMD was seeking, especially since the company had the habit of spending down its cash position in order to achieve this growth.

Analyzing the company's income statement, it becomes apparent than R&D is the biggest contributor to the company's burn rate. Over the past two years, AMD has increased its revenues by 137%. Its cost of goods sold increased 105%, so it is improving its margins. The general, selling and administrative expense increased by 129%, slightly lower than the rate of increase in revenue. Research and development, however, has increased 258%, a much higher rate than the increase in revenue. AMD justifies this on the basis of the potential of its new businesses, but the bank does not lend money on the hope that a new business works out.

At this point, in April 1986, AMD now has a cash crunch. The company has been struggling to maintain its capital levels in large part due to the increase in R&D, and the fact that the past investments in research have not yet yielded sufficient profit to offset the new investments. The company owes notes to the bank, and has no money to pay that, and owes notes to Biological Labs. The company has relied on this short-term debt to finance long-term projects, which is part of the problem it has with cash flow. Clearly, AMD needs to lengthen the duration of its debt so that it matches the long-term time horizon of its costly projects.

However, AMD must also address the twin issues of its burn rate and its cash conversion cycle. The company's current ratio is a healthy 1.8, but its quick ratio is 0.5 and it has a negative cash position. Most of its current assets are inventories, not surprising given that it takes twenty weeks to process the goods and sell them, and a further eight weeks to collect on sales. The disparity between the different liquidity ratios is a clear indicator that the company does not have a liquidity problem, just a cash problem. AMD needs to manage its cash better to avoid the need for constant rounds of fundraising. That its bankers are becoming skittish about the company's cash management is not surprising, and should be taken as a sign by Haskins that he needs to smarten up.

2. Year end 1988 is still 2 1/2 years away, so it is difficult to project precisely the firm's cash needs without making some major assumptions. The first assumption is that Haskins will want to convert his short-term notes into long-term debt, something in the range of 5-10 years, and that this debt will be at around 9.4%, the rate extrapolated from the interest expense and current debt level. Thus, $6,635 will need to be converted to long-term debt. For year end 1988, the principle will be required to be financed of course, along with two years of interest (total $1,247). In addition, the company will have working capital needs.

If it is assume that the company will be generally unable to tighten its cash conversion cycle, and will be unwilling or unable to do more than hold R&D at current levels, the income statements for the next few years will look as in Appendix a. As these pro-formas illustrate, the company will turn cash flow positive if it can maintain growth rates and curtail R&D spending by FY 1987. Therefore, the company mainly needs to finance the rest of 1986 and convert the existing short-term paper into long-term debt. Thus, an additional $840 will be required in addition to the $6,635, for a total of $7,475. If there are any cash shortfalls in early 2007 before the company turns cash flow positive, they can be offset by tightening the cash conversion cycle, something that should be done anyway.

3. As Mr. Winter, I would recommend a loan to Mr. Haskins. There are, however, a number of conditions that should be attached. The first condition is that the loan needs to long-term, for somewhere between 5-10 years. One of the reasons that AMD is experiencing such a cash shortfall is that it is using short-term financing in order to pay for long-term projects. Those projects cannot generate sufficient income in the short time frame to cover the loan. AMD's cash crunch would not be nearly so bad if the company did not have over $6 million in short-term paper coming due. Thus, taking out a long-term loan is the first condition. The company has a strong long-term growth rate, so there is good reason to believe that repayment will not be a problem.

The second condition is that the company needs to freeze R&D spending at current levels for at least the next two years, until the company is cash flow positive by at least $2 million. The rapid growth in the R&D expense in the main reason that the company is experiencing its constant need for financing, and the rate of increase in the R&D expense is double the rate of revenue increase. This means that the company's burn rate is quickening, and that is something that needs to stop. For example, the same pro forma if R&D expense was held at the same percentage of sales would show that the company would lose $3.2 million in 1987 and $4.5 million in 1988. Thus, holding the line on R&D spending at its current level would be more than a recommendation, it would be a restrictive covenant.

The third condition that I would put on the loan is that the company needs to tighten its cash conversion cycle. Financing twenty weeks' worth of inventory and eight weeks' worth of accounts receivable is a significant drain on the company's cash position. As a lender, I am unwilling to take receivables or inventory as collateral, so the company will need to rely on using cash or fixed assets, two things I prefer. AMD will not reduce these figures to zero, but by tightening the cash conversion cycle, the company can save hundreds of thousands of dollars in financing costs per annum. On this covenant, I am less interested in excuses ("slow payment seemed to be a competitive reality") and more interested in results.

4. I feel that Mr. Haskins has done a terrible job of managing his banking relations. He is embarrassing… READ MORE

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