Case - Ohio Rubber Works Inc PDF

CaseonWorkingCapitalPolicy:OhioRubberWorks,Inc.
Ohio Rubber Works, Inc. was established in the period immediately following World
War II. Its major customer base in those years was the automobile industry. Because
the company was located in northwest Ohio, shipment of its finished products to the
automobile assemble plants located in Ohio and Michigan was accomplished with
relative ease. The company was incorporated in 1947 and had undergone the gradual
reshaping through acquisitions and mergers that has characterized so many U.S. firms
up to the present. By 2003, the companys customer base was much more varied than
it had been during the early years.
The products now being made by Ohio Rubber Works, Inc. consisted mainly of
industrial hoses and belting (pulleys and conveyer belts) for a variety of industrial uses,
from automobile manufacturing to mining. While a substantial amount of the
companys output was sold to various intermediaries (wholesalers, jobbers, and the
like), a significant amount of revenue was generated by special order materials,
especially from the airline industry and the military. As a result of that situation and the
general nature of its business, the company was very interested in maintaining control
of all aspects of its financial situation. Especially important were the monitoring and
control of the firms working capital.
Such control included the relationship between short-term and long-term financing and
the effect of each upon the return on stockholders equity. The companys financial
managers were determined to see that the company survived the downsizing,
reshaping, and general changes in the manufacturing climate so prevalent in recent
years within the United States. Careful attention to the balance sheet, as the
companys controller had put it, was considered very important.
The companys controller, Carol Henning, had recently begun a review of the firms
working capital policy. At present, the firms financial structure appears as shown in
Table 1.
The current interest rate on short-term borrowing is 6 percent. The companys longterm debt has a nine percent rate. The firm is in the thirty-five percent tax bracket
(federal, state and local taxes). Sales for 2003 were $70 million. The 2003 profit
margin was 7.65 percent. Henning knew from published industry data that firms in
similar lines of business, with similar customer bases, had a return on equity one to
three percentage points higher than Ohio Rubber Works.
Henning wondered whether the firms working capital policy was overly conservative.
Would a more aggressive policy increase the firms already strong return on common
equity? At present the firms current assets were financed with long-term debt.
Henning was very interested in the effect upon ROE of financing the fluctuating or
temporary portion of current assets with short-term debt. In addition, she wanted to
add 40 percent of the permanent current assets to those financed short-term. The
objective was to examine the effect of this change in policy upon the return to the
common stockholders and, if the change was positive, to present the plan to the
companys finance committee. The finance committee was made up of Henning, the
corporate treasurer, the vice president of finance, and the controller from the firms two
operating divisions.
In considering working capital changes relative to financing, Henning reflected upon
the actual movement of certain working capital items within the firm. In a situation such
as that of Ohio Rubber Works, inventory control was a major concern. The varied
product lines and customer types highlighted the need for attention to the effect of
inventory upon working capital management. Of particular interest to firms in this
situation is the ratio of inventory to sales, relative to the desired ratio. The major aspect
of that consideration was maintaining the desired ratio as the business cycle ebbed
and flowed in its usual pattern.
The sales for Ohio Rubber Works over the past 10 years had been steadily growing.
The reverses in sales and earnings during this upward trend had been slight, and the
desired ratio of inventory to sales had been well maintained. In addition, Henning, as
she examined historical data for the company, observed a reasonably consistent cash
conversion cycle one which was not only consistent in terms of trend, but in terms of
industry comparisons as well. Industry data were obtained from a variety of published
sources, including trade journals. Ohio Rubber Works typically had an inventory
conversion period of 42 days. As was typical in the industry, the firms average
collection period for receivables was 45 days. The firm usually operated on a 60-day
accounts payable cycle, also standard in the industry.
TABLE 1
Current assets*
Fixed assets, net
Total assets
Ohio Rubber Works, Inc.

Balance Sheet
Year-End 2003
($000s)
$16,000 Current liabilities
$24,000 Long-term debt
Common equity
$40,000 Total liabilities and capital
$3,500
$14,000
$22,500
$40,000
Note: * Twenty percent of financed current assets are considered temporary, that is, they fluctuate with
the level of sales.
QUESTIONS
1.
Calculate the return on equity (ROE) for the company under the present policy
and the proposed policy. Which one yields the higher ROE? (Assume that a
present interest of 9 percent is paid on the total amount of long-term debt. That
is, the total amount of current assets currently financed with borrowed funds is
$14.0 million. Any new financing pattern will total that same amount. Assume
also that the change from long-term debt to short-term debt, for a portion of
total debt, is frictionless, which means there are no penalties or fees attached
to retirement of a portion of the long-term debt).
2.
Comment upon your findings in question 1. Consider increased or decreased

risk related to the change in policy, and also relative to the change in ROE.
Should Henning recommended the change in policy?
3.
If the yield curve for 2004 is projected to be steeper than 20033, would this
change your answer to Question 2? If so, how would it change your answer? In
answering the question, comment upon the meaning of a steeper or less steep
yield curve.
4.
In interpreting information concerning the yield curve, what are reasonable

long-term and short-term proxies for yield curve data?
5.
How would a move toward more sales to the special category of customer be
likely to influence managements thinking concerning short-term versus longterm financing?
6.
What advantage does the company seem to have concerning the relationship
between inventory and sales? That is, what has likely caused the inventory-tosales ratio to remain at a desired level in recent time?
7.
Within a reasonable range, what is your estimate of the percent of inventory to

total assets of the typical U.S. manufacturing firm? Discuss this in relationship
to Hennings concern about inventory as a component of working capital.
8.
What are the elements of a firms cash conversion cycle? How do these
elements interrelate to provide information concerning the ability of a firm to
pay its debts? What is the cash conversion cycle for Ohio rubber Works? What
are the implications of a longer conversion cycle?
9.
If a downturn in the companys sales should occur, what adjustments would

management want to make quickly and accurately, relative to working capital?
10.
Does the companys finance committee seem to be adequately staffed? Why or

why not?

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CaseonWorkingCapitalPolicy:OhioRubberWorks,Inc.

Ohio Rubber Works, Inc.

Comment upon your findings in question 1. Consider increased or decreased

In interpreting information concerning the yield curve, what are reasonable

Within a reasonable range, what is your estimate of the percent of inventory to

If a downturn in the companys sales should occur, what adjustments would

Does the companys finance committee seem to be adequately staffed? Why or

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