Clarkson Lumber Company

1) The Reasons Driving The Need For Borrowing Funds

There are many reasons that are causing the need of borrowing funds at the Clarkson Lumber, however, they can be summarized as having a negative cash flow. This can be further illustrated through a cash flow statement and a statement of sources and uses of cash as given below.

It is evident from the above given statement of cash flows and the statement of soures and uses of funds, that although the company is generating positive income each of the years in question, however, it is unable to generate enough cash and so there is a shortage of cash in both the years.

Further investigations of the statement reveals that the main issue is with the inventory and accounts receivables which is eating up most of the income and so the company does not generate as much cash from operations as much it should. So these both are causing the main need of borrowed funds.

The current ratio is decreasing with every passing year as in 1993, the current ratio was 2.49, which deteriorated in 1994 to just 1.58, and fell further in 1995 to just 1.15. So, if the company has managed its operational efficiency appropriately, or maintained at the 1993 level,  around 2.52, which is also the high profit average of the industry, the company would have not faced these cash flow problems and thus would not have needed any borrowed funds.

As a matter of fact, this declined efficiency of the operations would also be a big concern for the lenders.

Another reason for the cash flow shortage in 1995 is the payout of $100K to Mr. Holtz which is traded for the equity. Although a loan of $330K was arranged from the bank, however, it was not sufficient to cover the huge cash shortage and the increase in the current assets. As, another payment of $100K due in 1996 to Mr. Holtz, thus it is advised that the company should manage its operations more efficiently. It not only needs to manage its inventory better, ideally to just in time inventory if possible, and also tightening its accounts receivable policy which seems very lenient at the moment causing increased in accounts receivables.

2) Trends In Inventory Turnover, Days In Inventory, Accounts Receivables Turnover, And Days In Receivables Ratios For 1993-1995

Note: It is assumed that all sales are credit sales.

It can be said that the major driver behind both inventory and receivables are sales as cost of good sold and receivables only occur when the sales are made. However, management inefficiency can be attributed the biggest role in the controllable factors. However, it can also be representative of the trend in the industry overall.

However, apparently, it seems that these numbers make sense as inventory at hand and the accounts receivables are growing along with the sales. However, a deep look towards the figure in shape of the ratio reveals a different picture. It is evident that both inventory and accounts receivable are growing at a much rapid pace as compared to the sales.

While both sales and cost of goods sold increased at a rate of around 19% in 1994 and 30% in 1995, the inventory grew at a much higher rate of 28% in 1994 and further increased to 36% in 1995. In the same way, accounts receivable increased at a rate of 34% in 1994 while they grew at a rate of 47% in 1995. So it shows the problem that started in 1994 is worsening with the passage of time which is causing the cash shortage which is already discussed in the part 1 above.

On looking at the inventory turnover figure for the industry, the Inventory Turnover is 8.30 times (100/12) for the Low-ProfitOutlets while it further increases to 8.62 times (100/11.60) for the high profit outlets, which translates to 43.8 days of inventory for the low-profit while 42.44 for the high-profit segment. On comparison with the industry average, it is evident that the inventory turnover and inventory days figure for the company are much worse as compared to the industry and thus the problem is the company specific. It shows that the management is managing the inventory inefficiently and the management practices regarding the inventory needs to be look at. Moreover, it may also be due to the reason that the company may have a lot of obsolete items sitting in the inventory for which further investigations need to be carried out. This also causes increased holding costs. These practices must be improved or else the cash shortage will continue to be further grave.

There is a problem with the accounts receivables as well. Using the data in exhibit 3, accounts receivable turnover for the industry can be calculated. It is 7.3 (100/13.7) for Low-Profit Outlets and High-Profit Outlets has an accounts receivable turnover of 8.00 (100/12.4). In this regard, there does not seems to be much of a problem with regard to the Clarkson Lumber Company’s accounts receivable turnover as well as accounts receivable days which are pretty much similar to that of the industry.

However the 1996Q1 shows a further detonation of the inventory and receivable management efficiency as both inventory and receivable days gone up exponentially in this quarter. From the case description, it is evident that around 55% of total sales are madein the period from April through September. Assuming Q1 and Q4has about the same sales, 22.5% of total annual sales,  and so the Quarter 1 does not seems to showing any trend causing the company’s sales to be reaching the 5500K sale figure in 1996. On the other hand, the inventory turnover ratio and days increased over 100% in Q1 of 1996 which shows that the company has piled up the inventory in the anticipation of higher level of sales in the coming months. However, the inventory level should only correspond to the anticipated increase in sales. Again, better inventory management practices can help company greatly in managing its optimum level of sales within its means, which is mainly through maintaining the appropriate level of inventory and better operations management.

3) Has the company’s financial condition strengthened or weakened since 1993?

A better way to look at it is the analysis of the company’s financial statements and its ratios. The vertical analysis of major line items and important ratios are given below:

As evident from the above table, the COGS and operating expenses grew almost at the same rate as that of the sales and they are also pretty much in line with the industry averages. However, net incomes is not growing according to sales and the trend is uneven with decline in 1994 and then growth in 1995. Moreover, as already discussed, both current assets and current liabilities are also growing faster than that of the growth rate in sales. The main problem with the companies is disproportionate increase in account receivables, inventory and current liabilities as the company is unable to found an appropriate solution to finance its increased inventory and receivables while the apparent permanent growth in sales and pay out of equity to Mr. Holtz is being financed through the high interest bearing short-term debt which is also negatively impacting the net income. In this case. Securing a long-term debt may help the company streamlining its cash flows better while also reducing the interest cost.

4) Estimation of The Sustainable Growth Rate For 1996

The Sustainable growth rate is the growth rate the maximum growth rate that can be achieved with no additional equity financing.

SGR = ROE x retention rate / (1- ROE* retention rate)

Since no dividends are payed, retention ratio = 1

Therefore, SGR = ROE / (1-ROE)

ROE = ROS * S/E

If the ratios are assumed to remain same as in the first quarter, then ROS = 0.47%, and Sales

to Net Worth =1062/452 = 2.34

ROE = 2.34 *0.47% =1.099% ~1.1%

SGR = 1.1/98.9 = 1.11%

If the ratios are assumed to remain same on average (of the last three years), then ROE =

15.77% (Average of the ROEs calculated in question 3)

SGR = 18.72%

SGR = ROE x retention rate / (1- ROE* retention rate)

Since no dividends are payed, retention ratio = 1

Therefore, SGR = ROE / (1-ROE)

ROE = ROS * S/E

If the ratios are assumed to remain same as in the first quarter, then ROS = 0.47%, and Sales

to Net Worth =1062/452 = 2.34

ROE = 2.34 *0.47% =1.099% ~1.1%

SGR = 1.1/98.9 = 1.11%

If the ratios are assumed to remain same on average (of the last three years), then ROE =

15.77% (Average of the ROEs calculated in question 3)

SGR = 18.72%

Sustainable Growth Rate= ROE x retention rate /(1- ROExretention rate)

As the company is not paying any dividends, so,

retention ratio = 1

Thus, Sustainable Growth Rate = ROE / (1-ROE)

ROE = ROS * S/E

Lets assume that these ratios will remain the same in the Q1 of 1996 as well, then,

then ROS = 0.47%, and Sales to Net Worth =1062/452 = 2.34

ROE = 2.34×0.47% =1.099% ~1.1%

Sustainable growth rate= 1.1/98.9 = 1.11 times

On the other hand, if it is assumed that the ratios will remain same on average of the preceding three years, then,

ROE = 15.77%

Average ratios are calculated in part 3 above.

Sustainable growth rate= 18.72%

5) Effective Annual Rate

Clarkson Lumber Company can get a 2% of prompt payment discount if it pays suppliers within Ten days whereas, the normal due period for an invoice is 30 days.

In case when the company takes advantage of the 2% discount, it will be paying 98% of the invoice amount effectively. The effective discount rate in this case is thus:

1/.98×2% = 2.04%.

Effective rate in this case is

2.6% = (1+2.04%/18.25)^18.25-1

As there are 18.25 of 20 days in an year comprising 365days

The Effective Annual rateis

2.6% x18.25=37.6%

The bank is currently offering loan at an annual rate of 11%, that converts to effective annual rate of 11.57%, lot lower than the 37.6% effective annual rate in this case, and thus the company should take advantage of the discount offered by the suppliers.

6) Projected Income Statement and Balance Sheet

Following assumption are taken into account for this purpose:

1. 1996 sales will be $5.5M (as Mr. Clarkson anticipates)
2. All purchase discounts are taken for the period April 1 to December 31, 1996
3. The other historical relationships and ratios remain about the same as in prior years
4. Use additional debt (Notes Payable, Bank) as the plug to make the balance sheet balance

The accounts for the 1996 are projected on the basis of 1995 accounts with all profit and loss accounts corresponds to the ratio to sales for 1995. Purchase discount in only applicable to the second quarter and after purchase ((4,356-819)*0.02). The interest expense is calculated on the basis of the new bank loan $817k at 11% interest rate and 10% of $100k of term loan. Finally, the income tax is calculated on the basis of the provided tax table in the Exhibit 1.

The projected balance sheet as at on the Dec 31,1996 balance sheet, is projected by using the ratio of these accounts to sales of 1995, adjusting for the 1996 projected sales figure.

The AR and the accrued expenses are also maintained at the same ratio as per the year 1995. The resultant net income increased the net worth as there are no projected dividend. The resultant difference is then plugged into the new loan amount.

7) How Large Of A Line Of Bank Credit Would Mr. Clarkson Need

As evident from the table above, cash would decline by $12 as compared from the previous year. Accounts receivable seems to the main source of cash. Apart from the loan, and the projected at sales of 5,500, the accounts receivable balance would end at 5,368.

While, in uses of cash, the accounts payable is calculated on the bases of the balance of 1995 and adding 1996 additional balance into it after taking into account the projected discount at the rate of 2% while paying back the old bank loan as well as the pay out of Mr. Holtz and adjusting for the projected payable payment. It is estimated that the company will need an additional loan of $719K in this case

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