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Stength Of Steel Case Analysis Case Solution

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Based in West Chester - Ohio, AK Steel is the manufacturer of flat-rolled carbon and stainless tubular products for automotive, infrastructure and other sectors. The company is currently managing operational activities of 8 steel plants, 2 coke plants and 2 tube manufacturing plants across different states in the U.S. One of the tube manufacturing plants is located in Mexico (AK Steel, 2016).

Following questions are answered in this case study solution

  1. Introduction - Company Overview

  2. Problem

  3. Analysis - General Industry Trend

  4. Analysis – AK Steel

  5. Solution

  6. Justification

  7. Summary

  8. Response to Case Questions:

  • What is the working capital at the end of 2010?

  • What is the balance in the LIFO reserve account at the end of 2010? Describe this account.

  • If the LIFO reserve account was added to the inventory at LIFO, what would be the resulting inventory number at the end of 2010? Which inventory amount do you consider to be more realistic?

  • Does the use of LIFO or FIFO produce higher, lower, or same income during (1) price increases; (2) price decreases; and (3) constant price? (Assume no decrease or increase in inventory quantity).

  • Does the use of LIFO or FIFO produce higher, lower, or the same amount of cash flow during (1) price increases: (2) price decreases; and (3) constant costs? Answer the question for both pretax cash flows and after-tax cash flows.(Assume no decrease or increase in inventory quantity).

  • Assume that the company purchased inventory on the last day of the year, beginning inventory equaled ending inventory, and inventory records for the item purchases were maintained periodically on the LIFO basis. Would that purchase be included on the income statement or the balanced sheet at year-end?

  • Explain how liquidation of LIFO layers generated income.

Case Analysis for Stength Of Steel Case Analysis

2. Problem

The central issue that AK Steel Holding Corp. is facing to date is inventory management in the face of a lumbering paced economy growth and the high leverage financing being used despite lofty debt costs. The global recession of 2008 had its impact on all including AKS. The economic slowdown not only stimulated a plunge in revenues but consumer demand plummeted as well. Its direct impact was felt by AKS because it kept inventory levels high enough to meet orders during an unexpected increase in demand for steel. 

3. Analysis - General Industry Trend

Before moving forward with the analysis of AK Steel, let’s have a look at the general trend prevailing in the steel industry. Steel is an essential product in an economy due to its various uses in different consumer products. For instance, the infrastructure that an economy is physically built upon has dominant steel contribution - railway lines, flyovers, network towers are just a few examples (Energy.Gov, 2016). 

Steel has also received adoration for being the most recycled material, which has further exacerbated its usage as a green (environment friendly) raw material. The economic importance of steel can be evaluated by looking at its contribution in terms of the value of goods produced by the steel industry. In 2011 alone, steel and iron produced goods generated $103 billion in sales revenues for the U.S. economy. Steel Industry‘s overall contribution to the global crude steel production stood at 6 percent during 2011. However, the huge influx of low cost steel imports has weakened the local steel industry in the U.S. and is putting a further barrier for the incumbents that are trying to penetrate the market (Energy.Gov, 2016).

Another significant point to ponder over is the fact the steel industry created job opportunities for over 135,000 people through its 100 setups across the country in 2010. Post-recession and due to industry synergies and consolidation, this number has fallen due to inevitable downsizing (Energy.Gov, 2016). 

Governments have begun to realize the importance that steel industry holds for any economy both economically and geographically, and thus government support has abetted countries around the world in achieving higher production capacity for steel. This capacity has, however not matched the demand for steel which has led to the excessive dumping of steel products. With cheap steel imports coming into the United States routed from India, China and Korea, domestic steel production has suffered a great deal. Excess steel is dumped at below market rates which make it attractive and low cost for steel users in the U.S. to prefer imports over home products (Economic Policy Institute, 2014). 

4. Analysis – AK Steel

The problems facing the U.S. Steel market have been identified above, and these seem to be threatening AK Steel just as much. There has been unemployment following the stagnation in demand for steel products across the country. Capacity increases have required financing that AKS has acquired through debt, and continuous leverage has created a debt trap for AKS. This debt trap seems to have been burgeoning with every passing year. The total debt has increased by 2.5 times since 2012, and this seems to be following an upward trend as shown in the graph (Appendix: Exhibit - 1) (Market Realist, 2014). In 2015, with $ 2.3 billion in total debt, the issue remains as it was before, and the leverage multiplier has gone up to 5.9 times this time around (White & Case, 2016).  This has resulted in AKS underfunding its pension plan for the year 2011, and has, therefore, been tagged as the worst performer for the year in regards to its pension plan contribution (Market Realist, 2014). 

The problems being faced by AKS can be attributed to a couple of reasons that seem too conspicuous. Firstly, the high leverage problem that AKS faces is primarily due to the fact that it is involved in a couple of investment projects and a joint venture that are being financed through a hybrid - equity and debt. The situation is alarming for AKS because its rivals such as ArcelorMittal (MT) and U.S. Steel Corp. (X) are making every possible effort to keep their debt levels in control contrary to AKS. The balance sheet extract in (Appendix: Exhibit-2) shows that the long term debt of AKS has gone up since 2007 and is highest during 2010, an obvious indication of AKS not taking precautionary actions to keep leverage low (Market Realist, 2014). 

As far as the high inventory levels are concerned, the piece of information extracted out of AKS’s Annual Report 2010 (Appendix: Exhibit-3) has been used to calculate some ratios to judge performance:

Current Ratio (2010) = Current Assets / Current Liabilities = 1404.1 / 844.5 = 1.66

Quick Ratio (2010) = (C. Assets-Inventory) / Liabilities = (1404.1 - 448.7) / 844.5 = 1.13

5. Solution

An ideal current ratio is 1.5 or above, and AKS seems to be having good liquidity position as indicated from the current ratio calculation. It has ample current assets to pay off its short term liabilities. However, the quick ratio is one that raises concerns regarding the liquidity situation of AKS. An ideal ratio is 1.1 and above; 1.13 is just slightly above the ideal which means the company has capital tied up in inventory that could be released and invested elsewhere. Investment through this capital might even help keep debt levels low. Therefore, an improvement here might as well solve two of the major problems being faced by AKS as this analysis seems like a win-win. 

Another way it might be able to reduce leverage is through an increased reliance on equity financing. Managing a good balance between equity and debt financing is crucial to every company’s success. This hybrid debt financing is also commonly known as Mezzanine. AKS’s debt trap can easily be avoided if it considered shedding part of its inventory which is blocking capital as mentioned before.

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