Isuru Products: Financing a Bottling Machine
Isuru runs 'Isuru Products', a sole-trader manufacturer of coconut-based foods in Puttalam. Annual sales are LKR 7,200,000, and after all payments and his drawings he retains a cash surplus of about LKR 480,000 a year. He wants a bottling machine costing LKR 2,400,000. He expects it to add LKR 3,600,000 of sales a year, with variable costs at 65% of those new sales and extra fixed costs (supervisor, power, insurance) of LKR 500,000 a year. Useful life is five years with no scrap value. Three financing routes exist:
- Bank term loan: LKR 2,400,000 at 14% a year over four years, equal monthly instalments of capital and interest (about LKR 65,600 a month), secured by a mortgage over his house.
- Supplier lease: deposit LKR 240,000 now plus 48 monthly rentals totalling LKR 3,120,000, including maintenance.
- Brother-in-law: LKR 1,000,000 for a 20% share of the business.
He also has LKR 300,000 of receivables more than 90 days overdue, and his cash balance never falls below LKR 150,000.
1. Calculate the expected annual profit and the expected annual cash inflow from the machine before financing, and explain why the two figures differ.
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Incremental contribution Extra sales LKR 3,600,000 × 35% (100% − 65% variable cost) = LKR 1,260,000 Less additional fixed costs = LKR 500,000 = LKR 760,000 before depreciation and finance.
Profit before financing Less depreciation LKR 2,400,000 ÷ 5 years = LKR 480,000 = LKR 280,000 a year.
Cash inflow before financing Profit before financing 280,000 + depreciation 480,000 = LKR 760,000 a year.
Why they differ. Depreciation is the allocation of the machine's cost over five years. It reduces profit because the asset is being consumed, but no money leaves the business each year for it - the cash went out once, at purchase. Profit is also affected by accruals and by the timing of receipts and payments, whereas cash inflow counts only money actually received or paid.
Why it matters here. Profit of LKR 280,000 looks inadequate against a LKR 2,400,000 investment (an 11.7% return on the outlay) and against the loan interest, which is roughly LKR 300,000 in year one on the declining balance. Cash of LKR 760,000, however, is the figure that must cover the monthly instalments of about LKR 787,000 a year. The project nearly, but not quite, pays for its own finance from cash - and the shortfall of about LKR 27,000 can be met from the existing LKR 480,000 annual surplus. On a profit basis alone the project would wrongly appear unaffordable.
2. Evaluate the three financing options using the figures, and recommend one with reasons.
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Bank loan. Annual cash cost LKR 65,600 × 12 ≈ LKR 787,200, total LKR 3,148,000 over four years, i.e. about LKR 748,000 of interest. It is the cheapest in total cost and he owns the machine outright, so he keeps any resale value. But he must mortgage his house, the repayments are fixed regardless of sales, and the loan must be serviced from month one, when the machine is not yet fully productive.
Lease. Deposit LKR 240,000 plus LKR 3,120,000 = LKR 3,360,000 in total; monthly cost LKR 3,120,000/48 = LKR 65,000, or LKR 780,000 a year. It costs about LKR 212,000 more than the loan, but maintenance is included, his house is not at risk, the asset does not have to be pledged, and the supplier bears the risk of breakdown. It is effectively an operating cost rather than a debt.
Equity. LKR 1,000,000 for 20% values the whole business at LKR 5,000,000, and the money is not repaid. But it covers less than half the cost so borrowing is still needed, 20% of future profits leaves the business permanently, and his brother-in-law gains a say in decisions. There is also no limited liability in a sole trader's business, which makes admitting a part-owner legally messy.
Recommendation: the lease, with the LKR 240,000 deposit taken from the LKR 480,000 surplus. Annual cash inflow of LKR 760,000 covers the LKR 780,000 rentals to within about LKR 20,000, easily absorbed by existing cash flow, and no family home is placed at risk for an unproven product line. He should first collect the LKR 300,000 overdue and negotiate a 60-month lease to cut the yearly cost to about LKR 624,000.
3. Isuru says: 'The machine earns LKR 760,000 a year, so any of these options is safe.' Identify two weaknesses in that reasoning and state the control he should put in place.
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Weakness 1 – LKR 760,000 is before financing and is not guaranteed. It is an expected figure built on LKR 3,600,000 of new sales, which may not materialise; if sales reach only 70% of forecast, contribution falls to LKR 882,000, and after fixed costs and depreciation profit is just LKR 22,000, while the lease or loan payment of about LKR 780,000 would be largely uncovered. The variable cost is 65% of sales, so each LKR 100,000 of lost sales removes LKR 35,000 of contribution - the margin of safety is thin.
Weakness 2 – The annual figure hides the monthly timing. Rentals and instalments fall every month, but the sales build up slowly and customers may take credit. He already has LKR 300,000 overdue, showing that sales do not convert to cash on time. A single late month can push him into an overdraft at a high rate, and the machine's cash inflow before financing of LKR 760,000 is less than the LKR 780,000 lease payment, so he depends on the existing surplus every year, not just in year one.
Control: a monthly cash budget for the next 12 months, plus a decision rule. The budget should show opening balance, expected collections, rentals, raw material payments and drawings, with a minimum cash floor of LKR 150,000. He should also hold back three months' rentals (about LKR 195,000), collect receivables before signing, and delay drawings if the closing balance falls below the floor. A break-even check on sales volume - LKR 500,000 fixed costs plus LKR 780,000 finance, divided by 35% contribution, requires about LKR 3,657,000 of new sales - should be reviewed quarterly against actual orders.