Eastern Electronics

Eastern Electronics headquartered out of Berlin Germany was a cottage industry that prospered after the unification of Germany and the growth of the electronics era. Hans Schmidt, owner of the company, has enjoyed good growth over the last several years. With sales concentrated primarily in Germany, Austria, Poland, and the Czeck Republic.

Hans saw that he had a limited market in the eastern European countries and that his company was facing stiff competition from other electronic firms in Europe as well as from companies in the United States, Korea and Japan. In order to grow in size and statue and remain competitive in this industry, Hans knew he had to expand his market into other countries.

In 20x3, Hans had a vision to aggressively market and sell electronic components in the recently liberated Russian republics. He hired Alex Demeshkin, a computer and marketing expert, to introduce sales to the Ukraine, Georgia, and the western area of Russia. Hans felt that he could compete effectively in these new countries, even though they were relatively unfamiliar with a capitalist system. Eastern Electronics had the advantage of location, with relatively easy distribution to the former Soviet countries. He also produced high quality products indicative of precise German engineering standards. Hans believed that the customers in the former Soviet countries would appreciate and pay for quality, especially as they were transitioning to a capitalistic form of economics. Businesses could not afford to have less than satisfactory electronic systems that might not perform appropriately as new business practices and procedures were being implemented.

Alex had numerous connections in the former Soviet countries and also had instant credibility because of his technical expertise. He was able to represent the Eastern Electronics products very well and illustrate how the potential customers would greatly benefit from the services of Eastern. While financial results started slowly in 20x4, it was evident by 20x6 that the majority of the growth in sales for Eastern Electronics was coming from the work that Alex was doing in the former Soviet countries. Also, the budget projections for 20x7 and 20x8 also showed continued good growth in the former Soviet countries with only limited growth in the European market. Indeed the expansion into the former Soviet countries was critical to the immediate success of Eastern Electronics.

Alex was being paid a flat salary of Euro $40,000 plus a commission of 9.0% of the annual sales increase in the former Soviet countries. In 20x6, his salary would be Euro $149,800 or Euro $40,000 plus (3,780,000 2,560,000)0.09 = Euro $149,800. He had implemented some very creative processes to stimulate sales to the former Soviet countries during this time of economic conversion and opportunity. Since it was very difficult for new start up companies in the former Soviet countries to obtain necessary capital for asset acquisition, Alex provided short-term capital in the form of inventory and accounts receivable policy.

The general terms for payment on account with customers in the European countries was 2/10 net 40. Those customers often paid within the ten-day discount period to take advantage of the favorable discount terms. However, customers in the former Soviet countries did not have a favorable cash flow situation and rarely were able to pay in the short ten-day discount period. In fact, customers had great difficulty paying in the 40 day time period. Therefore Alex offered credit terms of 2/10 net 80 and often unofficially extended the terms to 90 days.

These new start up companies really appreciated the generosity of Alex which allowed them to purchase the electronic components from Alex and then sell them to other customers within the country and collect on the sales before having to pay Eastern Electronics. That way these companies did not have to seek short-term financing from the banking institutions and be forced to pay unfavorable interest rates. Also, it allowed the customers in the former Soviet countries more favorable opportunities in the currency exchange process. Since they had more time before payment was due, and they could essentially use customers money versus their own. These companies could minimize the number of currency exchange transactions they needed to make in their payments to Eastern. Given that companies generally lose at the minimum an exchange rate fee, every time a currency exchange is made, the customers in the former Soviet countries were very supportive of Alexs arrangements.

Alex felt that Eastern Electronics had a strong enough cash flow situation, and certainly stronger than these companies, to provide these sales terms. Furthermore, this was only a one time hit to Eastern Electronics of extending the payment terms by about 50 days. Once a sales pattern and resulting payments was established, the differentiation offset itself. Besides, this collection policy gave Eastern a competitive advantage in securing sales in these former Soviet countries. The obvious increase in sales volume easily offset any concerns regarding repayment.

Alex also helped the new companies in carrying inventory. He arranged to ship a majority of the inventory to the companies generally after these companies had made their sales to other customers. Sometimes Alex could even have Eastern Electronics ship directly to the customers of the new companies if the orders were of a sufficient quantity. This often eliminated one shipment, and saved Alexs customers time and money.

With the big problem of theft in the former Soviet countries, the customers of Alex were very concerned about carrying a large inventory of highly desirable Eastern Electronic products at a storefront location. The capital cost for these new companies to provide secure inventory storage for a large amount of product was often prohibitive for the new companies. Since Alex was able to cut down the requirements of inventory, he is in a sense providing no cost start up inventory capital to the companies in the former Soviet countries.

The inventory policy offered by Alex also gave Eastern Electronics a competitive advantage especially over companies from countries like Japan, Korea and the United States. The new companies in the former Soviet countries especially liked the way Alex was watching out for their best interest. They felt Alex was a comrade who was really looking out for them as they started their companies. They rewarded Alex with increasing levels of sales orders, and the sales projections for the next two years look particularly promising.

With the continual increase in sales levels, Eastern electronics is looking to make some capital expansion of their own. Eastern is nearing capacity limitations on production and storage facilities. Given the anticipated growth in the former Soviet market, it is possible that Eastern will consider building a major storage facility in the Ukraine. Such an action will also help to show their commitment to their expansion program with the former Soviet countries and could allow them further expansion into countries like Kazakhstan and Uzbekistan even beyond to the east. Hans sees these areas as untapped markets and with the modernization of some of the more Arab nations, he wants to get a foothold in these markets as soon as the opportunities are available.

Hans is very pleased with the work Alex has done to open the markets in the former Soviet countries and is considering a significant raise in both the base salary and commission rate for him beginning in 20x7. He is also excited about the growth opportunities and wants to pursue a capital expansion program so Eastern electronics can meet the anticipated demand increases for the next five years. He feels he can get some very favorable financing rates with the German National Bank of 11.5% for secured capital loans, and there is always the use of internally generated funds and maybe new external funds to support a growth opportunity.

Financial statements for the years of operation from 20x3 to 20x6 along with the projected budgets for 20x7 and 20x8 are presented as follows.

Eastern Electronics

Income Statement

For the years Ending December 31, 20x3 20x8

Years 20x7 and 20x8 are Budget Projections

All amounts in Euro $100,000

Account	20x3	20x4	20x5	20x6	20x7	20x8
Sales Europe	156.4	158.0	162.0	167.0	172.0	177.2
Sales Russia	-	6.2	25.6	37.8	54.8	71.2
Net Sales	156.4	164.2	187.6	204.8	226.8	248.4
Operating Expenses
Production	81.4	86.8	100.4	112.6	130.8	142.6
Admin & Selling	31.4	32.0	37.4	40.4	42.0	48.0
Depreciation	9.2	10.8	14.8	15.4	15.4	17.0
Excise Duties	23.0	22.4	23.4	23.8	24.4	25.2
Total Operating Exp	145.0	152.0	176.0	192.2	212.6	232.8
Operating Margin	11.4	12.2	11.6	12.6	14.2	15.6
Other Expenses
Interest Expense	1.6	1.6	4.6	4.2	4.8	5.4
Earnings before Tax	9.8	10.6	7.0	8.4	9.4	10.2
Income Tax	3.4	3.6	2.8	3.2	3.2	3.6
Net Earnings	6.4	7.0	4.2	5.2	6.2	6.6
Dividends	4.8	5.2	3.0	4.2	4.8	4.8
Retention of Earnings	1.6	1.8	1.2	1.0	1.4	1.8

Eastern Electronics

Balance Sheet

As of December 31, 20x3 20x8

Years 20x7 and 20x8 are Budget Projections

All amounts in Euro $100,000

Account	20x3	20x4	20x5	20x6	20x7	20x8
Assets
Cash	13.6	20.0	22.4	24.6	27.0	29.8
Accounts Receivable
Europe	17.4	18.0	18.2	19.0	19.4	19.8
Russia	0	0.6	6.0	9.0	13.4	17.6
Allowance	-0.2	-0.2	-0.2	-0.2	-0.6	-0.8
Inventory	15.4	15.8	18.0	28.6	31.8	34.8
Total Current Assets	46.2	54.2	64.4	81.0	91.0	101.2
Property, Plant & Equi	147.4	147.4	153.0	153.0	170.8	188.0
Accum Depreciation	-59.0	-69.8	-84.6	-100.0	-115.4	-132.4
PP & E Net	88.4	77.6	68.4	53.0	55.4	55.6
Long-Term Invest	7.8	7.8	7.8	7.8	6.0	6.0
Total Long-Term	96.2	85.4	76.2	60.8	61.4	61.6
Total Assets	142.4	139.6	140.6	141.8	152.4	162.8
Liabilities & Equity
Accounts Payable	9.0	9.2	9.4	10.6	11.4	12.4
Short-Term Notes	7.6	14.4	15.2	15.8	25.6	34.6
Other Current Liab	18.6	18.0	20.6	22.6	25.0	27.2
Total Current Liab	35.2	41.6	45.2	49.0	62.0	74.2
Long-Term Notes	40.6	29.6	25.8	22.2	18.4	14.8
Total Liabilities	75.8	71.2	71.0	71.2	80.4	89.0
Stockholders Equity	60.0	60.0	60.0	60.0	60.0	60.0
Retained Earnings	6.6	8.4	9.6	10.6	12.0	13.8
Total Liab & Equity	142.4	139.6	140.6	141.8	152.4	162.8

There are 60,000 shares of closely held stock outstanding in the company.

Required

Comment on the accounts receivable policy being implemented by Alex for the companies in the former Soviet countries. Do these policies appear sound? What are some of the advantages and disadvantages of such a policy?