Post on 07-Jan-2023
First Farms Corporation started as a small animal feeds manufacturing in 1950s. The company has expanded to other agribusiness products and set up nationwide facilities. Though the company has performed well, it has a dilemma – a huge deficit in the operating cash flows of Php 719 million despite increasing revenues.
BA 219
Executive Summary
This paper explained the reason behind First Farms
Corporation’s deficit in their operating cash flow and decrease
in ROE even with the significant increase in sales and company’s
net income. The aim of the study is to decide whether the company
will proceed with the construction of new plants and feed mills
using Ricardo Sarmiento’s, Vice President for Finance, point of
view.
FFC’s decision to invest their operating cash on acquiring
inventory accompanied by low inventory ratio resulted to negative
operating cash flow. Using the data of the company’s financial
statements, it could be seen that the percentage increase in
inventory is not in proportion to the percentage increase in
sales. The decrease in the ROE given the increase in sales and
net income can be traced to the IPO. The increase in equity
decreased the ratio of net income to stockholder’s equity.
The result of the financial ratio and SWOT analysis
conducted in the study suggests that FCC should not proceed with
the expansion through the construction of new dressing plants and
mills. As the VP for Finance, it is recommended that the company
venture into activities and policies that would improve its ROE
by improving their profitability, efficiency and leverage.
Implementing a rigorous collection policy will improve company’s
liquidity. Internally, the company must (1) review the current
system of operation, and (2) look for alternative sources of
inputs. These would allow them to lessen the cost of production.
Equally important is to evaluate macroeconomic factors to
determine possible price and profit increase.
Point of View
This paper used the point of view of Mr. Ricardo Sarmiento,
Vice President for Finance of First Farms Corporation (FFC), who
will present to the Board of Directors the FFC’s Financial
Statements and provide necessary recommendations.
Case Context
First Farms Corporation started as a small animal feeds
manufacturing in 1950s. The company has expanded to other
agribusiness products and set up nationwide facilities. In 1995,
FFC raised P1.1 billion from its initial public offering. P500
million of the proceeds was used as working capital (livestock
inventories and raw materials), P476 million went to expansion of
operations and acquisition of properties while P69 million was
used to pay part of the corporation’s long term debt. In the same
year, the Company acquired exclusive rights to develop and
operate California Chicken and Gulliver’s Chicken restaurants in
the Philippines.
In a stiff competition, consolidated sales for the year
still amounted to P5.7 billion which is 44% higher than the
previous year. P3.508 billion or 62% of revenue was from chicken
sales hence, taking over leadership in the business from Marigold
Foods Inc. Moreover, FFC has outpaced the industry growth on
chicken sales volume which is largely attributed to the company’s
increased contract growing base. Net income was also up 89%
amounting to P280 million despite the increasing costs of
production.1
During the year, FFC launched a new line of extruded
aquaculture feeds. It also entered the fast food business thru
California Chicken and Gulliver’s Chicken restaurants. Management
is proposing for construction of three dressing plants and four
new feed mills for the following year (1996) as they believed
that sales and profits were held back in 1995 partly by
constraints in production capacity. It is expected to be financed
by short term notes if approved.
It must be noted, that the Industry is bracing for the entry
of imported frozen chicken in 1998, when trade barriers in the
Philippines are lowered.
1 See Exhibit 6
Problem Definition
1. Why did the First Farms Corporation incur a deficit in the
operating cash flow and decline in the ROE in 1995 despite
the 44% increase in sales and 89% increase in net income?
2. Is it recommended for the FFC to proceed with the expansion
through the construction of new chicken dressing plants and
new feed mills?
Analytical Framework
Financial Ratio Analysis, Common-size and Trend Analysis (We
used 1993 as the base year) were used in order to assess the
financial position and performance of First Farms Corporation for
the period 1993-1995. Specifically, the paper looked into the
profitability ratios, operating efficiency measures and financial
leverage and Liquidity ratios and compared it across the period
1993-1995. Percentage change in Account Receivables and inventory
vis-à-vis percentage change in Sales are likewise analyzed.
To further analyze the qualitative position of FFC and to
determine the possible risks and benefits of business expansion,
SWOT Analysis was used. The company’s Strengths and Weakness and
the Opportunities and Threats in relation to the business
expansion were taken into consideration.
Analysis
Financial Ratio Analysis
Profitability
Net profit margin, which measures how much out of every peso of
sales a company actually keeps in earnings, had increased
from .03 in 1993 to .04 in 1994 then to .05 in 1995. Return on
investment, a performance measure used to evaluate the efficiency
of an investment had also improved from .13 in 1993 to .20 in
1994 then to .26 in 1995. Return on assets, that shows what earnings
were generated from invested assets, also improved. However, return
on equity, which measures the company's profitability by revealing
how much profit is generated with the money shareholders have
invested went down from .21 in 1994 to .16 in 1995. The return
on equity had gone down partly due to the issuance of 25% of
the Company's common stock in 1995. 2
Liquidity
The Company's current ratio has improved to 1.35 in 1995 from 1
in 1994. Despite the increase, it is misleading to state that the
Company is doing well in terms of liquidity without also
evaluating their cash flow. Their cash flow statement for 1995
reflected a negative operating cash flow amounting to about Php
719 million. This clearly indicates that the company might
encounter difficulty in meeting their currently maturing
obligations.3
Leverage
The financial leverage ratio reflects the company's method
of financing. Debt ratio is the company's assets financed by
2 See Exhibit 13 See Exhibit 2
creditors. First Farms Corporation's debt ratio improved
from .62 in 1993 to .54 in 1995. The same can be said to its
equity ratio, from .37 in 1993, it had improved to .46 in 1995.
Interest coverage ratio substantially improved. From 1.37 in 1993 it
jumped to 11.88 in 1995. That means that interest payments made
by First Farms Corporation were earned 11.88 times over during
the period. 4
Efficiency
Asset turnover measures a company's efficiency at using its
assets in generating sales or revenue. First Farms Corporation's
asset turnover had decreased from 2 in 1994 to 1.46 in 1995. The
decrease was caused by the Company's expansion in 1995 which was
financed by the proceeds from its issuance of 25% common stock.
Accounts receivable turnover had steadily decreased from 14.19 in 1993
to 11.35 in 1994, then to 7.65 in 1995. Accounts receivable
turnover measures a firm's effectiveness in extending credit as
well as collecting debts. Average collection period deteriorated from
25.38 in 1993 to 31.73 in 1994 then to 47.03 in 1995. 5
SWOT Analysis
The possible risks and benefits of the expanding available
production facilities through the construction of new dressing
plants and new feed mills for 1996 can be analyzed in the context
4 See Exhibit 35 See Exhibit 4
of the existing strengths and weakness of the company and the
possible opportunities and threats of this expansion.
Strengths
- The company is considered a the leading poultry integrator in
the country and have expanded to different product lines
including agribusiness products , animal feeds manufacturing,
new line of extruded aquaculture feeds and fast-food business.
- There is an available nationwide facilities and large number of
workforce that accommodate the existing demand of the products
and an additional investment of Php476 from IPO proceeds to
expand its operation capacities and to acquire additional
delivery equipment, warehouses and silos.
- Sales are up over 44% and net income by 89% on year-on-year.
- FFC significantly outpaced industry growth of about 6-7% in
chicken sales volume largely attributed to the increased in the
company’s contract growing base.
- FFC acquired exclusive rights to develop and operate California
Chicken and Gulliver’s Chicken Restaurants in the Philippines
Weakness
- The company’s ventures on the product lines with tight
competition that constrained the prices of the products.
- Most of the company’s inputs or raw materials are prone to
price increase which cause the increase in cost of production
- Production is constrained by the production capacity of the
FFC’s available facilities and expansion of such would require
large investment.
Opportunities
- Additional production facilities would increase the production
capacity of the company to accommodate demand of the products.
- New facilities may encourage potential buyers due to
accessibility of plants and greater reliability of supply.
Threats
- There is no assurance that the demand of the product and the
sales will increase given the industry’s supply glut.
- Cost of corn, soybean meal and fishmeal have been rising, thus
increasing the costs of production.
- Tight competition exists in the industry which hinders price
increase of the products.
- Threat of additional competition due to entry of imported
frozen chicken in 1998 as a result of the trade liberalization
agreement that would probably offer products at a lower price.
- Proposal for expansion is to be financed by short-term notes
but costs of borrowing are still high.
Percentage Change in Inventory vis-à-vis Percentage Change in
Sales
- Percentage change in the inventory should be proportional to
the percentage change in the cost of goods sold.
- Data shows otherwise. In 1995, inventory went up by 158% as
compared to an increase in the cost of cost sold of only 97%.6
6 See Exhibit 5
Percentage Change in Account Receivable vis-à-vis Percentage
Change in Sales
- Percentage change in the account receivables should be
proportional to the percentage change in sales.
- Data shows otherwise. Accounts receivable had skyrocketed by
1,232% increase in 1995 while sales only increased by 97%. 7
Discussion
The negative operating cash flow was a result partly of the
FFC’s investment of operating cash to acquire inventory. However,
there was a low inventory turnover8, which implies a relatively
poor sales performance and, therefore, excess inventory. Data
also showed that the percentage increase in inventory is not in
proportion to the percentage increase in the cost of goods sold.
Thus, it did not support the assumption that sales and profits in
1995 were held back due to constraints in the production capacity
since inventory turnover implies otherwise.
There is a decrease in the ROE despite the increase in sale
and net income due to IPO, as the equity increase by Php1.1
billion resulting to the increase in the stockholder’s equity.
Thus, the ratio of net income to stockholder’s equity decreased.
About Php 476 million were used in the expansion of the operation
capacities and to acquire additional equipment. Long-term effect
of these investments is expected but not yet reflected in the
short-run or in the same accounting period.
7 See Exhibit 58 See Exhibit 4
About Php500 million of the said proceeds was used as
working capital in the form of livestock inventories and raw
materials which was reflected as additional assets for the
company but was not converted into income for the said accounting
period. Thus, ratio of net income to assets (ROA) decreases
which results to the decrease of ROE-as ROA and Leverage (or
ratio of assets to equity) are factors of ROE (ROE = ROA x
Leverage).
Based on the evaluation of the company’s strengths and
weaknesses and the opportunities and threats posed by the
expansion, it is recommended NOT to proceed with the expansion
through the construction of new chicken dressing plants and new
feed mills.
Despite FFC’s strengths and limited internal weaknesses,
several macroeconomic and external factors, mostly beyond the
control of the company, hinders the possible increase in sales of
the company and outweigh the potential benefits of expansion.
Although the expansion will result to the increase in the
production capacity of the company and while it can be assumed
that market demand for the products of FFC will increase,
increase in sales and net income is still uncertain given the
tight competition and supply glut in the industry.
Cost of inputs and operating costs are increasing but prices
of products cannot be increased by same proportion due to the
competition. “Competition is keeping tight rein on prices, particularly in the chicken
business, even as the industry continues to operate in an environment of increasing
costs of production”. In addition, the industry is bracing for the
entry of imported frozen chicken in 1998 which will aggravate the
competition in the industry since if the trade barriers in the
Philippines are lowered due to liberalization agreements, this
will result to lower cost of imports, thus lower price for import
products. These would mean a decline in the FFC’s net income
which in effect will decrease the company’s ROE.
The expansion, if approved, is expected to be financed by
short-term notes. However, given the company’s liquidity ratios
(despite the slight increase) and the negative operating cash
flow, it shows that it is not in good standing in relation to its
ability to pay its short-term obligation. Similarly, it is not
advisable to finance the project by a long-term debt since the
leverages are not satisfactory9. Also, it would also be not
advisable to finance a long-term project by a short-term debt
given the company’s standing.
In addition, there is still a high cost of borrowing which
would increase interest expense for the company.
Recommendation
It is recommended for the company to improve its ROE by
improving its profitability /cost control (ratio of net income to
sale), efficiency (ratio of sales to assets) and leverage
(assets/equity). Specifically, following courses of actions are
recommended:
9 See Exhibit 3
1. Implement strict collection Policy. It is recommended to
improve the collection period and account receivable
turnover ratio to increase cash on hand and to improve
company’s liquidity. Percentage increase in the sales should
be almost of same proportion with the percentage increase in
the account receivables.
2. Review Manpower. It is recommended to further evaluate the
current system of operation of the company to determine if
the workforce of over 1,700 employees is being maximized.
Further assessment is recommended to identify if it is
optimal to hire 1,700 employees or if a certain system can
be improved that may lower the necessary workforce.
Likewise, trade-off between investing in machineries
(automation) and hiring manpower can be further studied.
3. Evaluate macroeconomic factors to determine possible price
increase. Further study of the macroeconomic variables is
suggested to determine if the company can increase price of
the products given the macroeconomic condition, and if
possible, to assess the extent in which the company can
increase price that would still result to increase in
profit. Macroeconomic analysis should be done to identify
the product’s elasticity, market demand and supply, which
will be the basis for the computation of change in profit
relative to change in price.
4. Exercise Company’s Bargaining Power. Since FFC has a large
market share in the industry, it can used its bargaining
power to enter in an exclusivity contract with its suppliers
such that suppliers will give lower prices of inputs to FFC
compared to others in the market. Similarly, they may
bargain for longer payment terms.
5. Look for alternative sources of inputs. Due to rising cost
of inputs, further study can be done to know if there are
other possible or alternative sources of inputs for the
company’s products that may lessen its cost of production.
6. Review the maintaining inventory level and its turnover
period. The average inventory turnover period has increased
in 1995. The average inventory turnover periods (day) in
1993 and 1994 are 78.97 and 70.17, respectively; it has
significantly increased to 103.40 in 1995.10 Hence, the
movement of the inventory slowed down. A possible major
implication of this is the increase in the average holding
cost of their products which directly affects the cost of
sales. Therefore, resolutions to lower down the average
inventory turnover period can improve the Company's income
and, thus, can help improve the ROE.
10 See Exhibit 4