FINANCIAL MANAGEMENT: IT MAKES OR BREAKS

Electro Korea, a Korean electronic giant, was forced into bankruptcy post-South Asian currency crisis in 1997. Mr. Gupta, the President of Electronica India Ltd., an Indian MNC, with an eye on expanding his company to global level visited Seoul to explore the possibility of taking over Electro Korea. Mr. Gupta called upon Mr. Chin-Hwa, erstwhile CFO of the Korean company, now working as a consultant, to figure out the problems that caused the firm's closure. The following conversation took place between Mr. Gupta and Mr. Chin-Hwa: Mr. Gupta: Tell me Mr. Chin what financial problems did electro Korea encounter that caused the demise of the firm? Mr. Chin: Sir! The problem was not one or two, but they were three-dimensional. The company faltered on three basic financial management tenets, i.e., investment selection, finance sourcing, and fund utilization. Mr. Gupta: Please go ahead. Mr. Chin: The problem started with a strong urge to meet the demand and capitalize on the booming market conditions. In view of the of the overwhelming demand or electronic products not only locally but in the global markets too in post 1990s, the company added a wide range of products to its existing product line. We became over-enthusiastic and to tap the growing market, expanded production capacity by 500%. Between 1990 and 1992, five new manufacturing units were set up. Mr. Gupta: Oh! that is a phenomenal growth in a short period of time. Mr. Chin: Yeah, that is there but most of this expansion was debt financed using either short-term loans from Korean banks or long-term foreign currency loans. With the ongoing phase of expansion the banks were very open-hearted in lending to the firm. By 1995, the debt -equity ratio reached a catastrophic level of 5:1. To make hay while the sun shines was the common phrase that was used by all from top, middle, and lower rungs of people. A wide array of prodcts and brands emerged by 1995, both by us and the rivals, causing a glut. Mr. Gupta: I can see some of the problems now. Mr. Chin: Recessionary conditions started in and the company witnessed idle capacity that started dragging down its ROI. Theorists say that investment decisions are irreversible. We witnessed precisely that. Due to recessionary conditions there were no buyers for the three idle manufacturing units that we wanted to sell off. There was a huge pile up of raw material, semi-finished and finished goods inventory, which could be disposed off with a great difficult at a value that was significantly below the book value. Mr. Gupta: That would cause lenders to panic. Mr. Chin: Yes it is true. The banks that were hitherto pumping in money on demand were unwilling to roll over short-term loans. To complicate matters further due to devaluation taking place, the local value of foreign currency loan of the company skyrocketed. Another major problem was that in the first half of 1990 when the company's growth rate was in double digits, the company followed a very liberal dividend policy, which unsustainable by 1995 with nose-diving revenues, profits and cash flows. a sharp cut in dividends conveyed an adverse signal and the stock price of the company crashed in 1997. Mr. Gupta: We also witnessed a similar situation in 1990s but could avert the crisis as we stuck to fundamental principles of finance. Our expansion was need based, market driven and came in a phased manner. We maintained a stable dividend payout of 40% even amidst the very high growth period of 190s and never allowed the debt-equity ratio to go beyond 2.5:1. Through better supply chain management and successful implementation of Just-in-time inventory management, we ensured that even during this high-growth phase we were carrying close to zero level of inventories. Mr. Chin: I appreciate what you did. I presume that only because of sound financial management policies you are here on a buying spree.

Time Value of Money: De-Confounding Ajay With Compounding

Vijay is a professional banker whose son Ajay just passed his seventh standard examination with excellent scores. Ajay is very keen to become an engineer and pursue an MBA thereafter. Vijay, equally keen and concerned about his son's future, informed Ajay, 'I have started saving Rs. 2000 every month in a bank deposit, and I will do so for the next 5 years when you would be ready for admission in an engineering college.' Ajay who is fond of arithmetic promptly calculated and said, at Rs. 2000 per month, the annual amount would be RS. 24,000. Over 5 years, it would become Rs. 1,20,000. Do you think this is enough to cover the admission expenses to an engineering college? 'Vijay smilingly said, 'No I would get more than this, because the bank would pay interest @ 12% every year.' Ajay again scratched his head for a while and responded, 'That would mean you would get Rs. 2,880 as interest each year. Your interest would be Rs. 14,400 for 5 years and that makes a total of Rs. 1.34,400. Even that is not enough. Vijay again smiled, 'Your maths seems alright, but you need to understand something more. Even interest earns interest. Ajay wanted to know how? 'Banks pay you interest on a quarterly basis. If you do not withdraw the interest amount, it gets added to the original amount. So, money grows faster than you think, 'explained Vijay. 'I do not understand this. What is a quarter?' Ajay asked curiously. 'A quarter means one-fourth and is equal to 3 months. Since it s one-fourth of a year, it is called a quarter. For the first payment of Rs. 2,000, I get an interest of Rs. 60 for the first quarter. This is equivalent to 12% per year. So for the next quarter, the principal becomes Rs. 2,060 on which I get an interest of Rs. 61.80 for the second quarter. This is more than what I got in the first quarter. This goes on till I do not withdraw the money.' 'You mean - even on interest, we get interest. Is it not too complicated to know the amount you will get after 5 years,' queried Ajay. Vijay quickly referred to his table and said 'Rs. 2,000 with a quarterly interest of 3% each quarter for 5 years would give me about Rs. 3,312.' 'That means without doing anything, you can get Rs. 1,312 extra. Why is this so?' asked Ajay. Vijay further elaborated, 'When I deposit this money with the bank, I cannot use it elsewhere. I forego some alternative. For example, I could have used Rs. 1,000 for buying a shirt for you. This is called the time value of money. It would also be done the same way as I did for the first Rs. 2,000. But, it would be less because the bank did not have this money for 5 years, but one month less. If I deposit Rs. 2,000 every month for 5 years, I would get, Vijay paused for a while t refer a table, about Rs. 1,63,340. Ajay got assured of his future and went to play with his friends.