LP Laboratories Ltd: Financing Working Capital

BJ22111 - Advik Jain

BJ22116 - Anuja Davda
BJ22118 - Atharva Kanitkar
BJ22112 - Akash Gupta

Introduction
LP Laboratories is a pharmaceutical company that is engaged in the production and export of a
wide range of drugs, including bulk drugs, pharmaceutical formulations, injectables, and fine
chemicals. The company is controlled by the Gupta family, who own a majority stake of 60%
and are actively involved in its management. LP Laboratories' primary source of revenue is
derived from the manufacture of anti-TB drugs and bulk drugs, which account for a significant
proportion of its total turnover.

In order to drive growth and expand its product range, LP Laboratories has adopted a strategic
approach focused on developing high-margin products, particularly in the United States,
Europe, and Japan. Furthermore, the company is targeting the anti-infective and cardio-vascular
markets, which are characterized by a strong demand for pharmaceutical products. To achieve
its goals, LP Laboratories has embarked on a series of major projects, including joint ventures
and strategic alliances, aimed at expanding its network and diversifying its product offering.

To finance its operations, LP Laboratories employs various forms of working capital finance,
such as credit cash, bill discounting, and credit for exports, which are sourced primarily from
Kendriya Bank of India Ltd (KBIL). The company has requested an increase in its letter of credit
(LC) limits in order to raise resources through the global depositary receipt (GDR) route. In light
of these developments, KBIL has ordered a special audit and stock inspection of LP
Laboratories and has advised the company to obtain an insurance policy to mitigate risks
associated with its operations.

Analysis of the company's financials

Working capital
Working capital is an essential financial indicator that represents the disparity between a
company's current assets and liabilities, indicating its short-term financial liquidity and its
capacity to meet its obligations within a year. The formula for working capital is derived by
deducting the current liabilities from the current assets, making it an integral metric for financial
analysis, cash flow management, and financial modeling. In the case of LP Laboratories, it
appears that their working capital, when subtracting the cash used, is only 11%, implying that
the company has yet to fully leverage their credit facilities.
Cash Credit
Cash credit is a type of financial instrument similar to an overdraft, where banks extend loans to
their clients without capping the amount that can be withdrawn, provided that certain conditions
are met. LP Laboratories availed this facility from various branches of KBIL, including Mumbai
Main Office and Santa Cruz Branch, resulting in an outstanding balance debit of 46.73 and a
remaining balance of 100% for credit. As per exhibit 8, the credit facility for cash credit/packing
credit was frequently overutilized, with KBIL being the only entity with a positive remaining credit
percentage of 7.67%, while other banks such as Bank1 reported negative percentages, with
-2.97%. The total percentage of credit facility utilized stood at 155.33%, indicating that LPL had
exceeded the cash credit limit and would require an extended period to repay the loan.
However, upon examining the total credit utilized, only a mere 10.88% had been consumed.

Investing in long term assets

LP Laboratories had made a Rs. 17 million investment in equity shares of Poly Industries,
despite the latter's recent financial struggles. Being an unlisted company, Poly Industries had
limited financial and corporate disclosures available to the public. LP Laboratories' group of
associate companies numbered 20, with five of them having negative tangible net worth.
Furthermore, 18 out of these 20 companies had taken credit facilities from KBIL.

Working capital loan

LP Laboratories made a request to increase their LC limit to Rs. 900 million, which would be
accompanied by a provision allowing for the entire LC limit to be utilized as a Document
Payment or Document Acceptance facility. Additionally, during the year, LP Laboratories paid off
a long-term debt of Rs. 6,109 million.

Cashflows
Based on the cash flow statement of LPL for the year 2010-2011, the overall cash flow appears
to be satisfactory, but there are instances of cash outflows without proper documentation of the
recipients. LPL extends credit to its customers, resulting in delayed payments. Additionally, LPL
has been delaying payments to suppliers and holding onto cash, which poses a risk to the
suppliers and may lead to quality issues with inventory, further delaying payments.

Profitability
The analysis based on LPL suggests that it experienced an 8.15% decline in return on capital
employed (ROCE) during the first two years (2010-2011), indicating decreased efficiency or
lower premium compared to other companies. Although the ROCE improved in the third year to
38.03%, it dropped again by 19.45% from the previous year. However, the ROCE in the fourth
year was still higher than that of the second year. This trend can be attributed to the fact that
LPL primarily financed its assets through banks and trade creditors, rather than relying on
shareholders' capital. Therefore, a company with a smaller amount of assets but higher profits
may yield a higher return than a company with twice the assets but the same profits.
Recommendations
Our recommendation for the company is to use a combination of factoring and inventory
financing to meet its working capital requirements. This strategy enables the company
to access the funding it needs while minimizing the risks and costs associated with each
financing option.

Factor Financing
Factoring financing, also known as accounts receivable financing, is a type of financing
where a business sells its accounts receivable (unpaid invoices) to a third-party financial
institution, called a factor, in exchange for immediate cash. The factor will typically
advance the business a percentage of the invoice amount, usually around 80-90%, and
then collect the full amount from the customer.

This type of financing can be beneficial for businesses that have slow-paying customers
or seasonal fluctuations in cash flow. By selling their accounts receivable, businesses
can receive immediate cash to fund their operations and growth, rather than waiting for
the payment from the customer.

Factors typically charge a fee for their services, which can vary depending on the
creditworthiness of the business, the amount of the invoices, and the length of time it
takes for the invoices to be paid. Factoring financing can be a useful tool for businesses
to manage their cash flow and maintain a steady stream of working capital.

Covenants for Factor Financing

1. Notification: The business must notify the factor of any changes in its financial
status or any significant changes in its operations.
2. Accounts Receivable Aging: The business must provide the factor with a report
on the aging of its accounts receivable on a regular basis.
3. Payment Terms: The business must maintain the payment terms agreed upon
with its customers.
4. Eligible Accounts: The factor will only purchase certain types of accounts
receivable, such as those that are not disputed or past due.
5. Concentration Limits: The factor may limit the percentage of accounts
receivable that can be outstanding with any one customer.
6. Financial Ratios: The business may be required to maintain certain financial
ratios, such as a minimum level of working capital or a maximum level of
debt-to-equity.
7. Audits: The factor may have the right to conduct audits of the business's books
and records to ensure compliance with the agreement.
Inventory Financing
Inventory financing is a type of financing where a business uses its inventory as
collateral to obtain a loan or line of credit from a lender. This type of financing is
common among businesses that need to purchase inventory to sell to customers but
have limited cash flow.

In inventory financing, the lender will typically advance a percentage of the value of the
inventory, usually around 50-80%, and then hold the inventory as collateral until the loan
is repaid. As the business sells the inventory, it can use the proceeds to repay the loan
and replenish its inventory.

Inventory financing can be a flexible financing option for businesses that have seasonal
fluctuations in sales or need to purchase large amounts of inventory to meet demand.
However, it can also be a more expensive form of financing compared to other options,
such as traditional bank loans or lines of credit, as lenders may charge higher interest
rates and fees to mitigate their risk.

Covenants for Inventory Financing

1. Inventory audits: The lender may require periodic inventory audits to ensure
that the inventory being held as collateral is accurately valued and is not
obsolete.
2. Advance rates: The lender may specify the percentage of the inventory value
that can be advanced as a loan, and may adjust the rate based on the type,
quality, and age of the inventory.
3. Inventory turnover: The lender may require the borrower to maintain a certain
inventory turnover ratio to ensure that the inventory is being sold quickly and
efficiently.
4. Collateral value: The lender may require the borrower to maintain a certain
collateral value for the inventory, which could limit the amount of inventory that
can be financed.
5. Financial ratios: The lender may require the borrower to maintain certain
financial ratios, such as a minimum level of working capital or a maximum level of
debt-to-equity.
6. Insurance: The lender may require the borrower to maintain insurance on the
inventory to protect against damage or loss.
7. Sales reporting: The lender may require the borrower to provide regular sales
reports to track the performance of the inventory and ensure that it is being sold
at the expected pace.