Erongo Dry Cleaning: Replacing the Main Machine
Erongo Dry Cleaning is a family-owned business in Walvis Bay with two outlets and 11 staff. Its main cleaning machine is 12 years old and breaks down about twice a month; each breakdown costs N$2,500 to repair and loses an estimated N$6,000 of revenue. Last year the business made a profit of N$96,000 on turnover of N$1.4 million. Its current ratio is 0.9:1 and its N$80,000 bank overdraft is fully used. Trade debtors take an average of 75 days to pay.
A replacement machine costs N$240,000. The bank will lend the full amount at 13.5% a year over four years, with monthly repayments of about N$6,500, but it wants the owners' house as security. The supplier offers a rental lease at N$7,800 a month, including maintenance, cancellable after 12 months. A local investor offers N$240,000 for a 40% share of the business and a seat on the management committee.
1. Calculate the annual cost of the breakdowns and assess whether the business can afford the bank loan.
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Quantify the breakdowns first.
- Repairs: 2 x N$2,500 x 12 = N$60,000 a year
- Lost revenue: 24 x N$6,000 = N$144,000 a year
Lost revenue is not lost profit. Net margin is 96,000 / 1,400,000 = 6.9%, so if every lost sale walked away, lost profit is about N$9,900. Contribution is higher than net margin because rent and wages continue during a breakdown, so a realistic range for lost contribution is N$35,000 to N$50,000. Total avoidable loss is therefore roughly N$95,000 to N$110,000 a year.
Loan cost: 6,500 x 48 = N$312,000 repaid, of which N$72,000 is interest, and N$78,000 a year is payable.
Affordability: current profit is N$96,000 and the annual repayment is N$78,000, leaving only N$18,000 of cover, before counting the savings from fewer breakdowns. On that test the loan is affordable but tight. The real constraint is liquidity: a current ratio of 0.9 and a fully drawn overdraft mean the business has no buffer, and the owners' house would be at risk if a bad month coincided with a repayment. Recommend fixing the debtor collection problem first, then choosing the lower-risk lease.
2. Evaluate the lease, the bank loan and the equity investment, and recommend one source of finance.
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Lease: N$7,800 a month is N$93,600 a year, more than the loan repayment, and the business owns nothing at the end. In return it avoids using the house as security, includes maintenance, is cancellable after 12 months and leaves ownership intact. For a business with a current ratio of 0.9 and an unreliable cash cycle, that flexibility has real value: the maximum fixed exposure is one year, not four.
Bank loan: total cost N$312,000, the cheapest option over the asset's life if the machine lasts eight to ten years, and the business ends up owning it. But it creates a legal obligation of N$78,000 a year and puts the family home at risk, which is unacceptable when profit is N$96,000 and debtors take 75 days.
Equity: N$240,000 with no repayment and it would lift the current ratio, plus the investor may bring commercial skills. The price is high: 40% of N$96,000 is N$38,400 a year for as long as the business exists, and a family firm loses control of decisions.
Recommendation: take the lease for 12 months. It keeps the house safe, tests whether the new machine really cuts breakdowns and energy costs, and can be converted to a purchase later once debtors are under control. Approach equity only if expansion, not replacement, is the goal.
3. Explain how Erongo could improve its cash flow before taking on any new commitment, using the figures given.
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Debtors are the biggest pot of cash. At 75 days on N$1.4 million turnover, roughly 75/365 x 1,400,000 = N$287,700 is owed at any time. Cutting collection to 45 days would release about 30/365 x 1,400,000 = N$115,000, which is almost half the machine cost and enough to clear the overdraft.
Practical measures: invoice on the day of cleaning rather than weekly; offer a 2% discount for payment within 14 days (costing at most N$28,000 if every customer took it, which is cheaper than overdraft interest); do credit checks on contract customers; and stop supply politely at 60 days. A deposit for large curtain and rug jobs would help further.
Other quick wins: check stock of chemicals and hangers to release cash tied up in slow-moving items; negotiate 30- to 60-day terms with the chemical supplier; sell the old machine for scrap; and ask the bank to convert the overdraft into a small fixed-term loan so it is not repayable on demand.
The point of the exercise is that cash, not profit, is the binding constraint. Once debtors are collected faster and the overdraft is reduced, either the loan or the lease becomes genuinely affordable and the security risk falls.