Question

Problem: Magma Minerals, Inc

Managerial Finance Concept: Cash budgeting as a support to credit planning

Financial Analysis Technique: Preparation of a cash budget

Decision Context: The company needs to program its cash flows to meet a maturing bank loan

William Chua was reviewing the figures he had gathered from his accountant at Magma Minerals, Inc, a processor of raw kaolin mineral. Kaolin was a nonmetallic mineral used in ceramics and rubber. The company had to pay the current portion of its long-term loan from First Development Bank due at the end of May. The company planned to generate cash from its sole source of revenue, namely, one processing or “tolling” contract with Mega Industries. Chua wanted to prepare a plan intended to raise the required cash to repay the loan out of that single contract.

Company Background

Magma Minerals, Inc, was founded by partners William Chua and Rufino Ledesma, both of whom were engineers with a knack for research and development and entrepreneurship. They saw an opportunity to build a plant that could process the raw mineral kaolin. Manufacturers were importing processed kaolin which was not locally available. The partners pooled their savings to build an experimental plant using machinery and equipment that they designed and fabricated. Chua became the general manager of the company while Ledesma continued in his research and development activities.

The production of processed kaolin actually involved several steps. The difficult part was manufacturing products that meet the narrow tolerance levels for the degree of fineness of the particles and in purity (from metallic content). The process involved grinding, mixing and drying. To simplify their operations, the partners decided to serve the needs of distributors of kaolin as a processor under a tolling contract. Under this arrangement, the distributor provided the raw kaolin and Magma Minerals only processed the materials, charging a straight per unit (kilogram) fee. Towards the end of the experimental phase of the project, the partners took a five year term loan from First Development Bank to build the machinery and refurbish the plant for full commercial operation. The loan had a grace period during which time the company paid only the interest. The first loan amortization was due on May 30.

In November of the previous year, the company approached Mega Industries, an importer specializing in kaolin and other mineral products for the ceramics industry, to offer their processed kaolin. Mega Industries agreed to try Magma Minerals’ product with an initial order of 60 tons or about three truckloads. Mega Industries provided raw kaolin to ensure quality of the raw material. The company tested the finished products before delivering to them. After a processing period of two months inclusive of quality testing and use by the ceramics manufacturers, the two parties agreed that the processed kaolin was of acceptable quality.   Mega Industries gave Magma Minerals a contract to process kaolin for one year, renewable at the end of each year. The contract was to begin in February.

Forecast Sales and Future Cash Flows

Before the end of January, Chua prepared an estimate of tolling fees (in pesos) for the next eight months, as follows:

February	900,000
March	975,000
April	1,125,000
May	2,200,000
June	1,050,000
August	900,000
August	600,000
September	1,850,000

Deliveries under the tolling contract matched the highly seasonal sales pattern of ceramic tiles which thrived during the construction peak season from April to August. Mega Industries shipped processed kaolin to these companies following the same pattern.

Under the tolling contract, Mega Industries paid the company 50 percent in the month of sale, 30 percent in the month following the sales, and 20 percent two months after the sale. The staggered payment schedule was designed to allow Mega Industries time to receive feedback from ceramics manufacturers, their customers, regarding the quality of the processed kaolin. If adverse responses were received, Mega Industries will ship back the identified lots and Magma Minerals would re-process them through a “beneficiating” process (further refining and mixing). In this way, the payments of accounts in the tolling contract were independent of the manufacturing of the product.

The company planned to hire factory labor and to run the plant according to the level of orders from Mega Industries. Fuel was the main expense at 10 percent of tolling fees per month. Labor was about 8 percent of tolling contract revenues per month. Maintenance expense was about 5 percent of tolling contract revenues. Other expenses were salaries to administrative staff and sundry expenses amounting to P195,000 per month. Depreciating expense came to P129,750 per month. The company had to pay some remaining balances to equipment contractors worth P278,400 in March. Taxes amounting to 35 percent of income were also payable at the end of each quarter.

The First Loan Amortization

Chua worried about the payment of the first loan amortization on the long-term loan from First Development Bank. The test processing for the initial 60 MT of kaolin nearly depleted the company’s cash balance which currently stood at only P50,467. Chua would have wanted to keep at least P150,000 in the bank at any given time. Chua remembered that one of the conditions involved an “acceleration clause” that meant that if the company reneged on its amortization schedule, the balance of the loan would become due and demandable. In case the internal cash was not sufficient, Chua thought that members of the family could put up the balance if he could give them at least a few months’ notice.

After examining the loan documents, Chua found out that the first loan amortization due on May 30 amounted to P620,450. He wondered whether he would have sufficient cash by then. He realized that he faced risks because such amortization had to be met to remain in good standing with First Development Bank.

Guide Questions

c.) What variables determine the monthly cash position of the company?

Answer 1

Monthly cash position is basically the difference between the value of cash inflows and outflows. The monthly cash position of the company is determined by following key variables:

1) Cash available with the company at the start of the month. Any amount of cash balance at the beginning of the month is added to the amount of cash realized by the company during the month from its business and related activities in order to determine the total amount of cash available for making payments.

2) Company's cash sales and cash collected from customers for items sold on credit basis during previous/current month(s). Cash receipts from sales account for major source of cash for any company.

3) Company's operating expenses (such as rent, salaries, sales commissions, advertising expenses, etc.) paid in cash during the month. This would include both prepaid (such as prepaid insurance) and outstanding expenses (such as payment to creditors for purchases) which have been paid during the month.

4) Company's capital expenses (such as purchase of machinery or any other equipment) paid in cash during the relevant month. While the benefit of such an expenditure may be realized by the company over a certain period of time, its cash position will get affected in the month of making the payment.

5) One important variable that would affect the cash position would be the need to maintain a certain minimum level of cash balance at the end of each month. So, if there is a deficit, the company might have to borrow cash from its bank (or other sources). Further, the company may be required to pay interest on the amount borrowed in previous months. This would also affect the monthly cash position. However, in case of surplus, there may not be any need to take a loan to maintain the desired cash balance.