AMD Cash Flow Analysis: Financing Needs and Lending Conditions

Reasons for Additional Financing

There are a number of reasons for AMD's need for additional financing. AMD has high levels of research and development spending, has expanded its sales force significantly, and has focused on entering new markets. The company has expanded spending significantly since 1983, primarily to fuel growth. Another contributing factor is that AMD carried excessive amounts of inventory — upwards of 10–12 weeks' worth — in addition to an 8-week processing time. The inefficiency of the production process combined with the high inventory level meant that upwards of 20 weeks' worth of goods were sitting at various stages of inventory.

This is a long cash conversion cycle, and a significant portion of the firm's capital becomes tied up in assets that are not adequate collateral for the bank. Another problem AMD faces with its cash conversion cycle is a high level of receivables. For example, 22.9% of the company's sales in October remained outstanding 90 days after the sale. The average age of the company's receivables was 54 days. Combined with the high inventory levels, the cash conversion cycle for AMD is upwards of 28 weeks. Such an extended cycle contributes significantly to the firm's need for capital, regardless of R&D levels.

Equity Capital and Income Statement Analysis

This growth has fueled the need for equity capital. Between April 1985 and May 1986, the company received four equity investments from Biological Labs totaling $12 million. Equity investments are appropriate for the type of long-range, business-level growth that AMD was seeking, especially since the company had a habit of spending down its cash position in order to achieve that growth.

Analyzing the company's income statement, it becomes apparent that R&D is the biggest contributor to the company's burn rate. Over the past two years, AMD increased its revenues by 137%. Its cost of goods sold increased by 105%, so it is improving its margins. General, selling, and administrative expenses increased by 129%, slightly below the rate of revenue growth. Research and development, however, increased by 258% — a rate more than double the increase in revenue. AMD justifies this on the basis of the potential of its new businesses, but a bank does not lend money on the hope that a new venture works out.

By April 1986, AMD faces a serious cash crunch. The company has been struggling to maintain its capital levels largely due to the increase in R&D spending and the fact that past investments in research have not yet yielded sufficient profit to offset new investments. The company owes notes to the bank with no money to pay them, and also owes notes to Biological Labs. AMD has relied on short-term debt to finance long-term projects, which is a core source of its cash flow problem. Clearly, AMD needs to lengthen the duration of its debt so that it matches the long-term time horizon of its costly projects.

AMD must also address the twin issues of its burn rate and its cash conversion cycle. The company's current ratio is a healthy 1.8, but its quick ratio is only 0.5 and it holds a negative cash position. Most of its current assets are inventories — not surprising given that it takes twenty weeks to process and sell goods and a further eight weeks to collect on sales. The disparity between these liquidity ratios is a clear indicator that the company does not have a liquidity problem per se, but rather a cash management problem. AMD needs to manage its cash more effectively to avoid the need for constant rounds of fundraising. That its bankers are becoming uneasy about the company's cash management is not surprising, and should be taken as a signal that management needs to act decisively.

Projected Cash Needs Through Year-End 1988

Year-end 1988 is still approximately two and a half years away, making it difficult to project the firm's cash needs precisely without making some major assumptions. The first assumption is that management will want to convert short-term notes into long-term debt — somewhere in the range of 5–10 years — at approximately 9.4%, the rate extrapolated from the interest expense and current debt level. On that basis, $6,635 will need to be converted to long-term debt. By year-end 1988, the principal will require financing, along with two years of interest (totaling $1,247). In addition, the company will have ongoing working capital needs.

Assuming that the company will be generally unable to tighten its cash conversion cycle and will hold R&D at current levels, the pro forma income statements (see Appendix A) suggest that AMD will turn cash flow positive if it can maintain its growth rate and curtail R&D spending by fiscal year 1987. Therefore, the company mainly needs to finance the remainder of 1986 and convert existing short-term paper into long-term debt. An additional $840 will be required beyond the $6,635, for a total of $7,475. Any cash shortfalls in early 1987 before the company turns cash flow positive can be offset by tightening the cash conversion cycle — something that should be pursued regardless.