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Case Summary Star River Electronics, Ltd.

, located in Singapore, was founded as a joint venture company and quickly became a leader in producing high-end CD-ROMs, which was their main product. In the mid-1990s the market became flooded, which drove down asking price of CDROMs and Star Rivers price points. In spite of this, based solely on their reputation, Star River was able to survive the saturation of the market. However, the market was seeing a shift from CD-ROMs to DVDs, which had 14% more capacity. In a 1999 study, it was predicted that CD shipments would decline by 41% and the DVD market would rise by 59%. At the end of 2001, Star Rivers DVD sales were barely 5%. On top of all this, Star River was going through a leadership change. July 2001 saw the current CEO resigning, with Adeline Koh being named CEO. Star River was facing not only a change in new leadership, but also a shift in the market and consumer desires. Due to the above, the remaining paper will cover an analysis of historical financials and project future financial forecasts, presenting thorough information to provide a variety of alternatives and based on the history, forecasts, an alternative, and a recommendation will be made to Star River and Koh as to the financial health of the company. Case Analysis This section will analyze Star Rivers current financial base on past historical financial numbers as well as an analysis of projected future growth. Historical Financial Health Star Rivers Historical financial health is not strong and most of their weak financial strength is due from and projected from balance sheet items. From 1998 2001, their debt to equity ratio has increase from 1.13 to 2.20 or 93.6%. Their ability to cover their interest is depicted with the times interest earned ratio, which over four years is only slightly over two times. Financial Leverage Debt to Equity Times Interest Earned (2.23 average four years) Table 1 Financial Leverage Ratios 1998 1.13 2.46 1999 1.21 2.48 2000 1.99 1.82 2001 2.20 2.18

In reviewing Star Rivers asset management ratios in Table 2, one can see there is trouble. Based on a percentage of sales, year 2001s account receivables is at 33.46% while the accounts payable is low at 12.61%. This tells me they are lending too much credit to their customers and not taking advantage of the credit offered to them by vendors. Since 1998, their operating margin percentage has decrease and their inventories to COGS have increased extensively. Both are not good signs. From 1998 2001, cash saw a 5% decline, and account receivables saw a 26% increase and accounts payable only a 12% increase from 2000. Inventories have increased significantly

(174%) during the past four years in an industry that will soon be close to obsolete. Star Rivers short term debt has also increased significantly by 193% over four years. This is of concern since their cash inflow has also decreased. Star Rivers days in receivables have been increasing since 1998 and their A/R turnover ratio has not increase much over the past four years. This tells me they have a lot of cash tied up with their customers. In addition to this is their A/P turnover rate. While it has been increasing over the years, which is good for their credit and the lending institutions like to see this, but once again, they could be not utilizing the full benefits of the credit provided to them from vendors. Asset Management Analysis Days in receivables Payables to COGS Inventories to COGS AR Turnover (Credit Sales / AR) Inventory Turnover (COGS/ Inventory) AP Turnover (COGS / AP) Table 2 Asset Management Ratios 1998 112.4 36.5% 69.1% 3.25 1.45 2.74 1999 115.6 33.4% 72.1% 3.37 1.39 3.00 2000 110.7 25.6% 115.8% 3.47 0.86 3.91 2001 122.1 25.0% 119.3% 3.34 0.84 4.00

Overall, Star Rivers profitability, leverage, asset utilization, and liquidity ratios do not look much better, with most of these related to the income statement. Out of the four, the profitability ratios looked the best and saw slight increases. The liquidity ratios in Table 3 are terrible, but then again, these are balance sheet driven. According to the current and quick ratios, it Star River is not able to cover their liabilities. Liquidity Analysis Current Ratio Quick Ratio Table 3 Liquidity Ratios 1998 .76 .41 1999 .77 .41 2000 .80 .31 2001 .88 .34

The historical sustainable growth rate in Table 4 below, Star River grew at an average rate of just over 10% without having to find outside funding, however their compounded annual growth rate was 13.82% over this same period. Therefore, this tells us Star River was having to source outside funds and was dependant on debt. Their free cash flow during this historical period was very unstable. They were able to increase their Free Cash Flow (FCF) from 1999 to 2000, but then took a drastic decline in year 2001. Analyzing free cash flow is important since this represents the cash Star River is able to generate cash after sourcing funds to maintain or grow their asset base. Also, this is the cash that is available for use by Star River to seek opportunities to enhance shareholder wealth. Cash Conversion Cycle (CCC) measures the time from cash output to cash recovery, or how long each dollar is held up in sales and production before it is converted to cash. This ratio takes into account how long it takes to turn over the inventory, receivables, and payables. Generally, the lower the better. Star River has done a good job over the years in managing this cycle. However, 2001 could cause concern. They had a negative CCC, which means they were

getting paid from its customers prior to Star River providing the goods. While an inflow of cash is good, if they do not manage this early receivable of cash, they could find themselves in a future cash shortfall. Star River is not managing their Return on Invested Capital (ROIC) well, and this should be of concern to the shareholders. It has seen a steady decline and since 1998, has decreased by 40%. This tells me management is not managing the funds very well that have been invested into the company. Star Rivers WACC is 13.90%. In 1998 and 1999, Star River was barely making money on their invested capital, beginning year 2000, it was costing Star River more to borrow funds than they were getting on return. Management of Growth & Cash Sustainable Growth Rate Compounded Annual Growth Rate Free Cash Flow Cash Conversion Cycle Return on Invested Capital Table 4 Growth and Cash Ratios WACC 13.90% Wd 14.06% We 85.94% Rd 6.62% CAPM 15.36% Tax Rate 24.50% Table 5 - WACC Calculations Table 6 below depicts clearly the problems Star River is having with cash flows. From this statement, we are able to see they are not managing their cash well in operating activities or in investing activities. We are able to see a significant increase in cash from financing activities, which supports the fact Star River has been increasingly dependent on financing support for its operations. Star River Statement of Cash Flows Period ending Net income Operating activities, cash flows provided by or used in: Depreciation and amortization Decrease (increase) in accounts receivable Increase (decrease) in A/P Increase (decrease) in other accrued liabilities

1998 1999 2000 10.84% 11.74% 6.90% Over the course of the years, Star Rivers investment grew from $71,924.00 to $106,042.00 $6,680 $8,004 1.96 1.55 .25 14.09% 13.69% 9.15%

2001 10.95% 13.82% $(469) -.17 9.14%

1999 6,576 9,028 (3,216) 491 1,722

2000 4,890 10,392 (2,714) (915) (1,250)

2001 7,148 11,360 (7,408) 1,479 (3,763)

Decrease (increase) in inventories Net cash flow from operating activities Investing activities, cash flows provided by or used in: Capital expenditures Net cash flows from investing activities Financing activities, cash flows provided by or used in: Dividends paid Increase (decrease) in debt Net cash flows from financing activities Net increase (decrease) in cash and cash equivalents Table 5 Statement of Cash Flows Strengths and Weaknesses to Highlight

(4,361) 10,240 (15,542) (15,542) (2,000) 8,157 6,157 855

(26,166) (15,763) (17,746) (17,746) (2,000) 35,929 33,929 420

(9,950) (1,133) (17,254) (17,254) (2,000) 20,092 18,092 (295)

On the positive side, Star Rivers income statement has been stronger than its balance sheet. They have been able to increase its sales over the past four years, from $71,924 to 106,042, a 47% increase. While doing so, they have been to maintain steady production costs and SGAs. With the exception of year 2000, Star River has posted increases across the board. While even in year 2000, the gross profit, EBITDA, and EBIT saw increases, which tells us Star River had higher than normal interest expense, which caused the lower EBT and Net Income. They were able to regain this loss in the following year. Income Statement Condensed Sales Gross Profit EBITDA EBIT EBT Net Income Table 6 Income Statement Condensed 1998 71,924 38,222 21,489 13,412 7,949 5,728 1999 80,115 41,723 23,935 14,908 8,898 6,576 2000 92,613 46,121 24,820 14,429 6,491 4,890 2001 106,042 52,597 28,420 17,059 9,241 7,148

COGS & SGA Analysis 1998 % of Sales 1999 % of Sales Production costs and expenses 46.86% 47.92% Admin. and selling expenses 23.26% 22.20% Table 7 COGS & SG&As as a Percent of Sales

2000 % of Sales 50.20% 23.00%

2001 % of Sales 50.40% 22.80%

However, a major weakness is the companys dependency on debt in order to fund its operations and its low liquidity ratios, especially if they are considering purchasing the packaging equipment. The new CEO also needs to be concerned with increase in inventory (174%), which coupled with its debt dependency to operate, could also be a contributor to the

short-term debt increase (193%). She also should attempt to increase her receivables rate and increase her payables percentage. There is a major weakness in how the balance sheet items are managed. Future Analytical Performance This section will review the forecasted financial performance of Star River based on a sales growth of 15%, with all other line items increasing as a percentage of sales, and assuming the new equipment is purchased at SGD 1.82million. Income Statement Forecasts Assuming sales will increase 15% for the next two years, Star River will yield net income of SGD $5.4 and $3.2 million for each year, respectively. Forecasted Income Statement Condensed Sales Gross Profit EBITDA EBIT EBT Net Income Table 8 Forecasted Income Statement Condensed 2002 121,948 60,419 32,614 17,172 7,251 5,474 2003 140,241 69,491 37,516 18,173 4,239 3,200

However, Kohs expected forecast of 15% sales growth is aggressive in comparison to the linear sales trend and linear production trend in Table 9 and Charts 1 & 2. While Koh predicted 2002 and 2003 sales SGD $121,948m and SGD $140,241m respectively, the trend shows sales at SGD $116,386m and SGD 129,350m. Forecasted production costs and expenses were also overstated as compared to the trend line. These numbers could be different for a variety of reasons, but most likely due to the trend line calculating actual sales and production numbers where we may assume Koh was hoping for a 15% increase based on prior years performance. However, if this is the case, then she actually overshot her estimate. For the years 1999-2001, the average increase was only 13.83%, which what is depicted in the charts. With the increase in sales revenues, Star River has seen an increase in Earnings Before Taxes and Interest (EBIT). However, this affects their earnings before taxes, which creates a higher tax and lowers net income, resulting in lower retained earnings.

Linear Forecasts 2002 Sales 116,386 Production 59,840 Table 9 Linear Sales & Production Forecasts

2003 129,350 37,366


150,000 100,000 Sales 50,000 1998 1999 2000 2001 2002 2003 Linear (Sales)

Chart 1 Linear Sales Forecast

Production Costs & Expenses

80,000 60,000 40,000 20,000 0 1998 1999 2000 2001 2002 2003 Linear (Production) Production

Chart 2 Linear Production Costs Forecast Balance Sheet Forecasts Star Rivers balance sheet is still heavily leveraged with its inventories and its short-term debt. Coupled with that is the fact of the new packaging equipment purchase of SGD $1.82 million. If Star River did not take on any additional projects and did not purchase the equipment, they could continue to operate without seeking external funding. However, their current equipment is quickly becoming obsolete, requiring additional labor hours and additional maintenance, therefore for this scenario we are assuming they are purchasing the equipment. This will require Star River to acquire additional outside funding, as depicted by line item Short Term Debt in Table 10 below. Forecasted Balance Sheet Assets Cash Accounts receivable Inventories Total current assets Gross property, plant & equipment

2002 4,281 46,685 91,796 142,762 144,273

2003 4,678 61,418 132,123 198,219 171,573

Accumulated depreciation Net property, plant & equipment Total assets Liabilities and Stockholders' Equity Short-term borrowings (bank)1 Short Term Debt Accounts payable Other accrued liabilities Total current liabilities Long-term debt2 Shareholders' equity Total liabilities and stockholders' equity Table 10 Pro Forma Balance Sheet with equipment purchase Loan Payback

-49,135 95,138 236,253 94,304 37,306 15,327 20,638 167,575 18,200 50,478 236,253

-63,529 108,044 299,850 104,649 87,771 17,571 19,981 229,971 18,200 51,679 299,850

Star River will not be able to pay back this loan within a reasonable time frame, and even with aggressive and creative fund management, they still would be extremely challenged to pay back the loan. They have two choices to make in paying this back. They can pay it back and still pay dividends of $2000 or shorten the payback period and use the dividends in assisting with the payback. Assuming they follow prior years trends and pay dividends and assuming they have a steady growth rate it will take Star River over seventy years to pay back this loan. Ratio Forecasts Table 11 In analyzing Star Rivers profitability ratios, all have declined with the exception of Return on Sales. The increase on the Return on Sales is due to the projected 15% sales increase from the years prior, which were less than 15%. The ROE has decreased due to the increase debt Star River engaged in. Leverage Ratios are used to understand a company's ability to meet it long term financial commitments. For this industry, Star Rivers D/E ratio is high. We already know they have been using a lot of debt to finance their operations, and with the additional CAPEX, they have increased this even more. A high D/E ratio could be good if the debt is managed properly and used to generate earnings for the shareholders, however this is not the case with Star River. Also, Star Rivers Interest is not good. This low coverage ratio means they could have some problems with paying the interest on their debt. We can also look at Star Rivers liquidity ratios and see this is true. They have access to very little cash. Star Rivers Asset Utilization varies from line item to line item. Their asset growth rate increased from 2001 due to the increase in fixed assets; however, they are still having problems with inventory, which is evident by their inventory to COGS ratio and their decreasing inventory turnover rate.


Financial Ratios 2002 Profitability Operating margin (Return on Sales) (%) 14.08% Return on equity (%) 10.84% Return on assets (%) 2.32% Leverage Debt/equity ratio 2.97 Debt/total capital (%) 75% Interest Coverage (x) 1.73 Total Debt Ratio 79% Long Term Debt Ratio 27% Asset Utilization Sales/assets 51.26% Sales growth rate (%) 15.00% Assets growth rate (%) 27.79% Days in receivables 22 Payables to COGS 24.91% Inventories to COGS 149.19% AR Turnover (Credit Sales / AR) 16.55 Inventory Turnover (COGS / inventory) 0.67 Days in Inventory 544.54 AP Turnover (COGS / AP) 4.01 Total Asset Turnover 51.62% Liquidity Current ratio 0.85 Quick ratio 0.30 Table 11 Financial Ratios based on Star River Forecasted growth

2003 12.96% 6.19% 1.07% 4.08 80% 1.30 83% 26% 45.79% 15.00% 26.92% 159.9 24.83% 186.75% 2.28 0.54 681.62 4.03 46.77% 0.86 0.29

Table 12 below tells us that Star River is only able to sustain a growth rate of 7.51% and 4.09% respectively. This is way below Kohs projected sales growth rate of 15%. In addition, they are having significant problems with their cash conversion cycle. In 2002, it is too high and 2003 it is too low, which means they are having problems in their accounts receivables, accounts payables, and inventory. Growth & Cash Ratios Sustainable Growth Rate Cash Conversion Cycle (x) Free Cash Flow ROIC Table 12 Proforma Growth and Cash Ratios

2002 7.51% 13.21 9,490 12.65%

2003 4.09% -1.21 12,250 8.80%

Star Rivers ROIC in 2002 is still lower than their best years of 1998 & 1999, which averaged slightly over 14%. During these years, Star River was still generating value on their invested capital, compared to their WACC. However, year 2000 began a decline, and even thoug 2002 saw a slight increase to 12.65%, it still is not enough to cover their costs of capital. Management of Star River are not effectively doing their job and not creating value or shareholders wealth. Alternatives Continue in the current CD-ROM Market Move full forward into the DVD Market Split from New Era and become its own entity

Recommendations Splitting from New Era would not be a good idea. Due to their poor cash flow, poor financials, poor ratios, and recent change in leadership, they need a stable support base. This stability and support from New Era adds an additional level of security for lenders if Star River were to request additional sources of funds from outside financers. Based on all of the above, Star River is growing at a rate they cannot meet, which is in align with what the banker stated. Due to the declining market of CD-ROMs, Star River should begin the full transition into the DVD market or they will soon be out of business due to declining sales revenue of CD-ROMs. Firm restructuring is needed. Areas of concern are sales revenue, growth and market penetration, inventory/supply chain, SG&As, production processes. Sales revenues and growth should be a focus of Kohs, since revenue is a driver of most everything else. She needs to ensure Star River can stay at the projected 15% or greater. Should they fall below that, they will face issues since sales growth drives most financial decisions. Koh has taken on two additional capital expenditures, one for SGD $57.6m and one for SGD $1.82m. Due to the increase in debt, Koh will need to focus strongly on controllable spending, such as inventory, production costs and expenses, and SG&As. An audit of their current inventory is needed to determine what is still usable with the DVD market. At which time, whatever is not usable should either be resold or written off. A review of current supply chain processes is required and a solution needs to be developed to reduce their inventory holdings. Due to the transition into the DVD market, Koh will have to strategically plan the purchase of new DVD inventory, and not create over-abundance, as in the past. Tighter controls by management on SG&As and production will also help create greater net income for Star River. It is recommended they also adopt moving to a Just in Time or Kaizen type of production process. Restructuring in these areas will produce greater revenues, lower expenses and greater shareholder value, however they still have the issues of the large amount of debt they have undertaken. It will take many years until Star River can become fully lucrative and not as dependant on debt. In the meantime, they need additional financing to get them through the next two years. If I were a conservative lending institution, I would not lend Star River the money.

However, if I were an institution that wagered in high-risk companies, then Star River is a good investment. They had the reputation in the past to get them through when others were failing, therefore hedging on that and the restructuring of the firm, I would lend Star River the money.