Reference no: EM13489211

Kasbian Ltd ('Kasbian') operates steel foundries in the Gauteng Province of South Africa. The manufacturing processes involve melting scrap steel and other alloys in furnaces and then pouring the melted product into casting moulds. Thereafter the resultant castings are cleaned and heat-treated. Castings produced by Kasbian include pumps, valves and pipes, which are supplied to mining customers who use these products in platinum and gold mining operations.

Scrap steel is purchased from various scrap metal dealers in Gauteng. Scrap steel prices vary according to the quality of the material and the prevailing steel commodity prices. Scrap metal dealers supply the South African market and also export to foreign customers. They determine the selling price of scrap steel in US dollars and then convert this into rand, based on the exchange rate on the date of sale to South African customers. Scrap steel prices increased in 2007 and 2008 due to the high demand for steel globally.

Listing on the Johannesburg Securities Exchange

Kasbian listed on the Alternative Exchange (AltX) of the Johannesburg Securities Exchange in October 2006. The company raised R50 million prior to listing through a private placement of two million shares with a par value of 1c each, issued at a premium of R24,99 per share. Upon listing, Kasbian had ten million shares in issue. At the end of October 2006 the share price had increased from the listing price of R25 per share to R27 per share.

Acquisition of Solar Foundries (Pty) Ltd

Kasbian acquired the business of Solar Foundries (Pty) Ltd ('Solar Foundries') as a going concern with effect from 1 October 2007 for a purchase consideration of R49 900 000. Kasbian settled the purchase price through a cash payment of R40 million and the issue of 360 000 shares at the prevailing market price of R27,50. Goodwill arising on the purchase of Solar Foundries amounted to R17 500 000. On 1 October 2007 Kasbian obtained a R40 million loan from RBZ Bank to fund the cash portion of the purchase consideration. The loan from RBZ Bank is repayable annually in arrears in four equal instalments. The first instalment of R13 587 727,60 was paid on 30 September 2008. The loan bears interest at a fixed rate of 13,5% per annum.

Global economic crisis

The global economic crisis in late 2008 precipitated a slowdown in consumer demand. Mining output dropped in the fourth quarter of 2008 and this trend has continued in 2009. Steel commodity prices declined as demand for this base metal product decreased among most industrialised nations.

While gold mining production declined during the period October 2008 to September 2009, the gold price has risen during this period mainly as a result of the perception of gold as a 'safe haven' investment. Unfortunately the platinum mining sector did not escape as lightly as the gold mining industry. Platinum is used mainly in the automotive and jewellery industries and there was a significant decline in demand for this precious metal during the past year, which has led to a decline in platinum mining activities.

Kasbian's revenue for the year ended 30 September 2009 dropped by 36% from the prior year as the lower mining production translated into lower demand for castings.

Trial balances

The trial balances of Kasbian for the financial years ended 30 September 2008 and 2009, together with explanatory notes, are set out on the next page.

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KASBIAN LTD
TRIAL BALANCES AT 30 SEPTEMBER
2009 200 Notes 8
Dr Cr Dr Cr
R'000 R'000 R'000 R'000
Revenue - South African customers 2 144 000 240 000
Revenue - exports 2 67 200 90 000
Cost of sales 188 304 223 916
Opening inventories of finished goods and
raw materials
5
69 630
49 936
Scrap steel purchases 3, 7 98 880 152 475
Other raw material purchases 7 15 960 21 535
Direct labour expenses 8 37 500 41 250
Electricity 9 15 444 14 850
Depreciation: Manufacturing plant and
equipment
6 100
6 000
Other overheads 6 500 7 500
Closing inventories of finished goods and
raw materials
6
61 710
69 630
Other income 11 650 3 250
Selling and administrative expenses 34 900 38 600
Retrenchment costs 8 1 800 -
Depreciation: Non-manufacturing equipment 2 180 2 200
Interest paid: RBZ Bank 4 295 5 400
Interest on bank overdraft 3 616 2 450
Normal income tax 0 16 992
Secondary tax on companies 0 1 500
Net loss/profit for the year 23 245 42 192
Share capital 104 104
Share premium 59 876 59 876
Retained earnings - beginning of the year 78 801 51 609
Dividends declared 12 15 000
Loan from RBZ Bank 22 520 31 812
Trade payables 13 25 729 16 686
Tax owing to SARS 0 5 748
Shareholders for dividends 0 15 000
Bank overdraft 14 40 614 17 500
Plant and equipment 15
Furnaces, moulding lines and other
manufacturing equipment
72 600
75 500
Non-manufacturing equipment 15 520 16 500
Goodwill 17 500 17 500
Inventory
Finished goods 42 570 52 080
Raw materials 19 140 17 550
Trade receivables 34 719 43 397
Other receivables 2 350 2 250
Cash and cash equivalents 0 750
227 644 227 644 240 527 240 527
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Notes

1 The above trial balances do not include any adjustments and entries to appropriately account for the impairment of assets (IAS 36) and financial instruments (IAS 39). No provisions have been raised against inventories either. Any such entries are processed after year end for the purposes of Kasbian's annual reports.

2 Tonnages of castings sold and related sales prices are summarised in the table below:
2009 2008
Tonnes of castings sold
South African customers 30 000 40 000
Export customers 12 500 15 000
Average price per tonne sold
South African customers R4 800 R6 000
Export customers US $640 US $750
Exchange rates US $1 = ZAR
Average rate during the financial year R8,40 R8,00
Exchange rate at year end R7,70 R8,05
Kasbian experienced increased competition from certain Chinese foundries in the latter part of the 2009 financial year. These Chinese foundries targeted Kasbian's international customer base and offered them discounted prices to secure their business.

3 Kasbian entered into a two-year supply agreement with EDC Scrap Metal (Pty) Ltd ('EDC Scrap Metal') with effect from 1 October 2007. The company undertook to purchase a minimum of 15 000 tonnes of scrap steel annually from EDC Scrap Metal at a fixed price of US $350 per tonne (to be invoiced in rand, based on the prevailing exchange rate at the date of supply). EDC Scrap Metal is a South African based company. Kasbian entered into the agreement in 2007, as it was concerned about escalating scrap steel prices.

4 Manufacturing volumes and utilisation of raw materials during the 2008 and 2009 financial years are summarised below:
2009 2008
Tonnes Tonnes
Finished goods (castings) manufactured 40 000 60 000
Raw materials used in manufacturing processes 40 000 60 000
Scrap steel purchased from EDC Scrap Metal 12 500 13 500
Scrap steel purchased from other local suppliers 23 500 40 500
Other raw materials 4 000 6 000
Manufacturing volumes were evenly spread throughout the 2008 financial year. In the 2009 financial year, Kasbian manufactured 13 000 tonnes of castings in the first quarter and 9 000 tonnes in each of the next three quarters.

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5 Opening inventories comprised the following:
2009 2008
Tonnes Tonnes
Finished goods 12 400 7 400
Scrap steel: EDC Scrap Metal 1 500 0
Scrap steel: Other local scrap steel suppliers 3 700 6 700
Other raw materials 600 700
Cost of opening inventories per tonne R R
Finished goods 4 200 3 900
Scrap steel: EDC Scrap Metal 2 800 0
Scrap steel: Other local scrap steel suppliers 3 000 2 780
Other raw materials 3 750 3 500
Cost of inventories reflected in trial balances R'000 R'000
Finished goods 52 080 28 860
Scrap steel: EDC Scrap Metal 4 200 0
Scrap steel: Other local scrap steel suppliers 11 100 18 626
Other raw materials 2 250 2 450
69 630 49 936
6 Closing inventories comprised the following:
2009 2008
Tonnes Tonnes
Finished goods 9 900 12 400
Scrap steel: EDC Scrap Metal 4 000 1 500
Scrap steel: Other local scrap steel suppliers 2 200 3 700
Other raw materials 800 600
Average cost of inventories per tonne R R
Finished goods 4 300 4 200
Scrap steel: EDC Scrap Metal 2 750 2 800
Scrap steel: Other local scrap steel suppliers 2 300 3 000
Other raw materials 3 850 3 750
Cost of inventories reflected in trial balances R'000 R'000
Finished goods 42 570 52 080
Scrap steel: EDC Scrap Metal 11 000 4 200
Scrap steel: Other local scrap steel suppliers 5 060 11 100
Other raw materials 3 080 2 250
61 710 69 630
Kasbian uses a first-in, first-out system with regard to all categories of inventories.
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7 Raw material purchases during the 2008 and 2009 financial years are summarised in the table below:
2009 2008
Raw materials purchased during the year Tonnes Tonnes
Scrap steel purchased from EDC Scrap Metal 15 000 15 000
Scrap steel purchased from other local suppliers 22 000 37 500
Other raw materials 4 200 5 900
Average purchase cost per tonne of raw materials R R
Scrap steel purchased from EDC Scrap Metal 2 940 2 765
Scrap steel purchased from other local suppliers 2 490 2 960
Other raw materials 3 800 3 650
Purchases reflected in trial balances R'000 R'000
Scrap steel purchased from EDC Scrap Metal 44 100 41 475
Scrap steel purchased from other local suppliers 54 780 111 000
98 880 152 475
Other raw materials 15 960 21 535
8 Kasbian retrenched 10% of its direct labour force at the end of December 2008 in response to the declining production and sales volumes. The once-off cost of retrenching these employees amounted to R1 800 000.

9 The company used 20% less electricity for the purposes of manufacturing in the 2009 financial year. Despite this reduction in electricity consumption, the electricity expense for the year was higher than in 2008 because of Eskom's 30% tariff increase.

10 The costs per tonne of finished product manufactured in the 2008 and 2009 financial years are set out in the table below:
2009 2008
R R
Scrap steel 2 453,00 2 596,68
Other raw materials 378,25 362,25
Direct labour 937,50 687,50
Electricity 386,10 247,50
Depreciation 152,50 100,00
Other overheads 162,50 125,00
4 469,85 4 118,93
11 Other income represents settlement discounts received from suppliers. Kasbian is entitled to a 2,5% settlement discount from all raw material suppliers if it pays amounts owing within 30 days of the date of the statement.

12 Kasbian declared a R15 million dividend to all registered shareholders on

15 September 2008. The dividend was paid to shareholders on 30 November 2008.

13 Kasbian experienced significant cash flow difficulties during the 2009 financial year. The company has been stretching the trade creditor repayment period by delaying payments to them. A number of Kasbian's raw material suppliers have expressed concern about overdue amounts as they are also experiencing cash flow pressures.

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14 Africa Commerce Bank has been Kasbian's commercial bankers for ten years. Africa Commerce Bank increased the company's overdraft facility limit to R45 million on a temporary basis during 2009. However, they are concerned about Kasbian's operating losses and poor cash flow generation and, in a letter dated 27 September 2009 addressed to the Chief Executive Officer of Kasbian, gave the company an ultimatum to reduce the amount owing on overdraft to R20 million by 15 December 2009. It further stated that the bank would withdraw the entire overdraft facility if Kasbian Ltd did not meet this target. Interest on the overdraft is charged at the prevailing prime overdraft interest rate, whichwas 10,5% on 30 September 2009 (30 September 2008: 13,5%).

15 There were no disposals of plant and equipment during the 2009 financial year. Banking facilities and potential recapitalisation

The board of directors of Kasbian is concerned about the ability of the company to trade out of its current predicament. The directors believe that sales volumes will increase significantly in the 2010 financial year, based on feedback from their major customers. It is difficult to predict commodity prices but Kasbian's directors have noticed that steel prices have stabilised recently, which is indicative of the end of the current trend of declining prices.

In view of the threat by Africa Commerce Bank and the potential threat that certain creditors may demand immediate repayment of outstanding amounts, the major concern of the directors of Kasbian is whether the company will be able to continue trading until volumes increase.

Kasbian is presently negotiating with Dinkum Partners, a hedge fund based in London. Dinkum Partners has expressed interest in investing in Kasbian on the following terms and conditions:

· Dinkum Partners will advance a loan of US $6 million to Kasbian bearing interest at a fixed rate of 8% per annum. The loan is repayable annually in arrears in equal instalments over a three-year period;

· Dinkum Partners will be entitled to appoint a director to the board of Kasbian for the duration of the loan agreement;

· Kasbian will be required to pay Dinkum Partners an annual fee of US $200 000 for the next three years;

· Kasbian is to grant Dinkum Partners an American call option to subscribe for two million Kasbian ordinary shares at a strike price of R4,50 per share. The call option is exercisable at any time during the next three years; and

· No dividends may be declared or paid to shareholders until Kasbian has repaid the loan in full.

The weighted average share price of Kasbian over the 30-day period ended 31 October 2009 was R4 per share.

The board of directors has approached various banks for funding facilities to replace those of Africa Commerce Bank. All of the banks approached expressed reluctance to extend an overdraft and/or medium-term facilities to Kasbian in view of the company's exposure to the mining industry.

The major shareholders of Kasbian are its executive directors, who do not at present have the financial ability to subscribe for new shares in the company and/or to advance monies to the company.

7 The board of directors believes that it may not have any other option in the short term but to enter into the arrangement with Dinkum Partners outlined above.

REQUIRED

(a) Calculate the annual change in revenue derived from sales to South African customers and export revenue for the year ended 30 September 2009 in volume terms, price per tonne and overall change.

(b) Calculate and estimate the impact of entering into the supply arrangement with EDC Scrap Metals (Pty) Ltd on the profits and cash flows of Kasbian Ltd for the year ended 30 September 2009.

(c) Identify, with the necessary calculations, and explain the key reasons for the lower profitability of Kasbian Ltd for the year ended 30 September 2009.

(d) Calculate the relevant working capital ratios of Kasbian Ltd at 30 September 2008 and 2009. You should base your calculations of the relevant ratios for finished goods and categories of raw materials on

• volumes and not rand amounts; and
• year-end inventories as opposed to average inventories during the period.

(e) Critically comment on the management of inventories by Kasbian Ltd during the 2009 financial year.

(f) Identify and discuss the potential adverse consequences that delaying payments to trade creditors could have for Kasbian Ltd.

(g) Critically analyse and discuss the terms of investment proposed by Dinkum Partners from the perspective of the shareholders of Kasbian Ltd.

(h) Identify and discuss the critical factors which may influence the future cash flow generation of Kasbian Ltd.

(i) Critically discuss the actions of the directors of Kasbian Ltd in declaring and paying a dividend in 2008.