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Section ACASE STUDY: INDIAN GARMENT MANUFACTURING SECTOR In July 2015, Anand Khanna, owner of the AK Manufacturing Company (AK), approached the local bank for additional funding of ₹50 million1 to meet the growing requirements of his garment manufacturing company. After a sharp increase in revenue from 2 million to 8 million in three years and a phenomenal increase in profit after taxes (PAT) from ₹0.364 million to ₹0.84 million during the same period, Khanna confidently discussed the financial needs of his company. In a lengthy and healthy discussion with the bank manager, Khanna explained the development of his company and the dynamics and growth opportunities of the garment and textile market in India. Khanna proudly presented the performance of his company to the bank manager, which he believed was excellent in a highly competitive industry environment. The bank manager handed over the financial records of AK, including an income statement and balance sheet (see Exhibits 1 and 2), to his loan officer and ensured Khanna that once the documents were processed and analysed, he would get back to him in the coming week. He instructed the loan officer to process the loan application submitted by Khanna as soon as possible and inform him about the decision taken by the bank. Indian Garment Manufacturing Sector India was the second-largest producer of garments in the world. The textile sector in India contributed 24 per cent of the world’s spindle capacity and 8 per cent of the global rotor capacity. By 2021, this industry was expected to grow in size to US$223 billion2. An ample availability of raw materials and a skilled workforce had helped the country become a lucrative centre for the world garment industry. The Indian textile sector contributed 4 per cent to the gross domestic product of the country; 14 per cent of India’s industrial production came from this industry and 27 per cent of its foreign exchange inflows came from the Indian textile sector. More than 45 million people were directly or indirectly employed in the garment industry. Demand for garments in the domestic market, as well as in the international market, had strengthened the growth prospects of the textile sector. In 2014, cloth production in the Indian textile mill segment grew by 6 per cent, and the production of man-made fibre increased by 4 per cent. It was anticipated that the textile and garment manufacturing segment was set for strong, robust growth, which 1 ₹ = INR = Indian rupee; US$1 = ₹64.03 as of July 31, 2015. 2 All dollar amounts are in U.S. dollars. was also supported by data. The industry average of key ratios also illustrates that the financial performance of companies in the textile segment are reasonably constant and stable (see Exhibit 3). In the past three years, the textile market in India had registered growth of approximately 14.58 per cent. In FY2013/14, the Indian garment industry attracted foreign direct investment worth $11 billion, and a textile industry expert had anticipated that the exports of garments from India would reach $60 billion in the next three years. This would be supported by increased labour costs in China, improvements in demand from the United States, and improvement in the quality of products manufactured in India. An approximate 12 per cent higher growth over 2012-13 was achieved in 2013-14 in the export of textile products in India, which touched the encouraging figure of $35.4 billion. The United States had been the primary market for Indian garment exporters. Financial situation of AK Financial liquidity and funding problems of AK started increasing with the growth of the business. Khanna began to face funding problems due to: 1. the working capital required for regular purchases of raw materials, 2. excessive credit periods granted to customers, 3. a shortage of funds for purchasing new machines required for manufacturing, and 4. insufficient factory space. In 2012, when he started the business, Khanna incorporated the company as a private limited company where he and his wife were the only shareholders; they had shares of ₹1.2 million. He borrowed funds during that year in the form of a mortgage loan and used the borrowed funds for both the short-term and long-term requirements of the business. The total amount borrowed by the company during 2012 was ₹0.736 million (taken against the mortgage of his assets, which had a value of ₹1.9 million). As the business expanded in subsequent years and the asset requirements increased, he continued to borrow money from the bank. In the second year, the loan from the mortgage was ₹1.236 million; in the third year, it was ₹2.5 million. Khanna had little difficulty in procuring the mortgage loan, as the mortgaged value of his assets was quite high, and he also provided collateral security (his residential house) to the bank. With positive cash flows from operations, interest serving on the loans was also not much of a problem. Khanna was not particularly cognizant of the financial nuances of long-term or short-term loans, so he simply continued to withdraw money and to use the funds wherever the need was felt. A part-time accountant maintained the financial records of AK. The accountant kept daily accounting records, including vouching, cash maintenance, receipts, and payments for the company, and prepared monthly, quarterly, and annual financial statements as per statutory requirements. His financial statements were audited by a professional accountant. The business was generating profits after all the expenses and interest payments, so Khanna was happy and always felt like a successful entrepreneur. Proposal to the Bank: Current Scenario Khanna urgently needed the loan to meet the cash and investment requirements of the business. He submitted a detailed proposal and project report to the bank, along with the financial statements of previous years. As the business expanded and the number of clients increased, his financial problems had also increased. Khanna’s credibility in the market was good, so he had no problem procuring the necessary raw materials, but he faced a problem when trying to collect money from his customers because he had no structured system for keeping track of extensions of credit periods. He had also begun to observe stock piling up in his factory, as the orders were either not dispatched or the customers delayed delivery. His machines were also getting old, and he felt that the time had come to replace them with new ones that were modern and more efficient. The factory space was not sufficient, and a larger location was essential. New skilled labourers and some additional staff members were also required to support his expansion plans. All in all, Khanna faced a severe need for additional financing of ₹50 million at a minimum to continue to expand his business. Required: Case Study Questions Prepare the cash flow statement of the company for all the years possible (you can use either indirect or direct method). Do you observe any liquidity concerns from the cash flow statement trend? Prepare and analyse the common size balance sheet of the company. Comment on the trend of current and non-current assets and liabilities based on your observation.Prepare a trend income statement for the company. Comment on the trend with aspecial focus on revenue, all expenses, cost of goods sold, and PAT.Calculate the ratios outlined in Exhibit 3 for the firm. (6 marks) EXHIBIT 1: INCOME STATEMENT, APRIL 1 TO MARCH 31 (IN ₹ THOUSANDS) 2012-13 2013-14 2014-15 Sales Cash Credit 200 1,800 480 4,320 800 7,200 Total sales 2,000 4,800 8,000 Cost of goods sold 1,240 2,832 4,800 Gross profit 760 1,968 3,200 Operating expenses: General, administration, and selling expenses Depreciation Interest expenses (on borrowings) 80 100 60 450 400 158 1,000 660 340 Profit before tax (PBT) 520 960 1,200 Tax @ 30% 156 288 360 Profit after tax (PAT) (or, net income) 364 672 840 EXHIBIT 2: BALANCE SHEET (IN ₹ THOUSANDS) 2012-13 2013-14 2014-15 Assets Fixed assets (net of depreciation) Current assets Cash and cash equivalents Accounts receivable Inventories 1,900 40 300 320 2,500 100 1,500 1,500 4,700 106 2,100 2,250 Total 2,560 5,600 9,156 Equity & Liabilities Equity share capital (shares of ₹10 each) Reserve & surplus Long-term debt Current liabilities 1,200 364 736 260 1,600 1,036 1,236 1,728 2,000 1,876 2,500 2,780 Total 2,560 5,600 9,156 EXHIBIT 3: INDUSTRY AVERAGE OF KEY RATIOS Ratio Sector Average Current ratio 2.30:1 Quick Ratio 1.20:1 Accounts Receivable turnover ratio 7 times Inventory turnover ratio 4.85 times Long-term debt to total assets 24% Operating profit margin 18% Return on common equity 22% Return on assets 10% Asset turnover ratio 1.1 Non-current asset turnover ratio 2 Current asset turnover ratio 3 Interest coverage ratio (times interest earned) 10 Business Accounting