ClarksonLumberCompanyCaseSolution.doc

clarkson lumber company financial analysis1. backgroundclarkson lumber company is owned and operated by the hardworking, 49-year-old mr. clarkson. it has low operating expenses, a small staff, and strong management. the overall impression is one of a conservative, efficient operation. clarkson himself leads a frugal lifestyle with little personal debt.the company has been in growth during recent years and anticipated a further increase in sales. despite of consistent profits, the company has suffered shortage of cash and borrowed fund needed for its business growth.2. financial analysissee appendix i, ii & iii. we find that increasing amount of borrowing despite of its consistent profitability came from following reasons. first is the firms financial position. as sales have increased by 55% from 1993-1995, the assets that support increase of sales increased by 78%. the increase amount of assets is over the amount of net income (addition to net worth). to meet financial needs, the company received short-term loans from bank, $60 in 1994 and $390 in 1995. the net profit margin and operating expenses ratio have been stable over three years, however, interest expenses has increased almost 1.5 times. the firms current ratio deteriorated again and as a result, the firm has experienced the shortage of fund regardless of its consistent profitability. second is the amount of note payable against holtz. mr. clarkson bought out mr. holtz interest for $200,000 paid off in 1995 and 1996. because of this cash outflow, the company needed cash inflow from bank. thirdly, the companys collection period (48.95 in 1995 and 38.24 in 1993) and avg days in inventory (62.57 in 1995 and 55.86 in 1993) are deteriorated as well.according to the cash flow statement in appendix ii, we know that the company has some main financing channel to meet the needs of fund. one is using the fund of suppliers, which increased the amount of a/p from $213,000 to $376,000 and the amount of n/p trade to $127,000. the other one is bank loan from suburban national. but the ceiling of $399,000 in borrowing ability placed on the company by the suburban national bank is consistently insufficient to meet their growing needs.we take leverage, liquidity, cash cycle and profitability measurement into consideration to analyze the financial performance of the clarkson lumber. looking at the individual ratios seen in appendix iii and comparing it to the industry average gives a sense of where this company stands. we learn that the times-interest-earned decreased dramatically; on the contrary, the total debt ratio has been deteriorated and get closer to those low-profit outlets level. meanwhile, the liquidity of the company decreased significantly. but the profitability seems to be steady and the roe has risen to 0.17. all these ratios serve to point out the lack of cash in this company. the cash flow has been decreasing because, it takes longer to get the money from customers, but the company still needs to pay for its purchases.clarkson lumber currently purchases inventory from its vendors in large quantities, requiring large amounts of capital to fund these purchases. suppose the company takes advantage of an additional 2% trade discount offered by its vendors for quick payment, will its profitability be increased and rectify its current cash flow situation? without prejudice to the companys reputation, the annual rate of a/r is 2% / (30-10)* 365 = 36.5% and the payment may be a slight delay, the annual rate could be 24.33% if this period extend to 40 days. so this capital cost is much higher than the cost of bank loan, the trade discount offered is attractive to the company, but it still depends on the line of credit offered by northrup national bank.3. financing planningwe project 5.5 million dollars, or more, in sales for clarkson lumber in 1996. as seen in the pro forma statement in the appendix iv.we build pro forma mostly based on the assumptions as below:1. with the 2% trade discount, the cogs also reduced by 2% while the selling price remain the same.2. pay off the note payable to holtz on schedule. only the bank loan to suburban national bank and northrup national bank are the interest-bearing liabilities for 19963. a/r only exists in 10 days and n/p trade return to zero.4. the new line of credit of bank loan has no ceiling.5. mr. clarkson issued no new equities and paid no dividends during the forecasted years. only source of the change in the net worth is the net income for the same period.then the bank loan would exceed to the credit line to $1,169,000. without the approval of the bank, mr. clarkson would not be able to expand his business at the current growth rate. actually, since the new credit line is fixed at $750,000, mr. clarkson would have to find other ways of financing the operation such as issuing new equity.if the company dont take advantage of the trade discount, then, as shown in appendix iv marked by yellow. if the clarkson lumber sells $5.5 million and their percentage of sales were to stay the same for the balance sheet items, they would have a more than $298,000 increase in uses of cash, not including the $399,000 that they have outstanding on their previous line of credit. if you subtract the almost $300,00 that they would generate in new sources of cash you can see that the will already use $697,000 of their $750,000. consequently, if they grew at the same rate, the company would blow through their new $750,000 line of credit quickly according to our pro forma statement.clarkson lumber is an illustration of a firm that is growing at a rate greater than it can sustain with existing asset requirements and internal financing capacity. it is relatively well managed, but the huge absorption of funds into financing growing inventory and accounts receivable, due to the increase in sales, is putting it into a difficult situation. its reliance on bank financing is growing and the requested line of credit is insufficient to permit taking the available trade discounts. the greater risk is that the firm will be dramatically impacted should the trade lose patience and decide to put them on a cod basis.4. recommendationas the financial advisor, my recommendations to the clarkson lumber are:1. the company must reduce liabilities and debt before accruing more and being consumed with payments and interest payments.2. set a reasonable stock level to reduce inventory.3. the business cannot support the current rate of growth much longer. mr. clarkson has no choice but to infuse the business with outside cash right away, however he needs to seriously consider other forms of financing after that.4. he should explore the possibilities of equity financing, in order to bring cash into the business. such possibilities could include recommending to his brother in law to keep his money in the business and receive dividends. another equity financing option would be to re-mortgage his home and invest his personal cash in the business.5. clarkson lumber would be to slow down growth and seek equity financing. clarkson lumber company needs to have stricter policies on the customers they allow to purchase from them on credit.6. the company needs to seriously think about increasing its internal funding through greater profits at the same time it reduces its growth rate to a more sustainable level.from banks perspective, the kpi we need to take care is the leverage ratio and liquidity, by contrast, profitability is not much important, and leverage ratio and liquidity of clarkson lumber have already been poor. if we provide the company with a $750,000 loan, though the profitability could be improved, other kpis will further deteriorate. taking the features of bank into account, in the present circumstances, the short-term bank loan may not be suitable. if we want to develop the market and the capital structure of clarkson lumber can be improved, the bank loan is reasonable but at the same time there must be stricter restrictions, such as:1. re-mortgage his home and invest his personal cash in the business or seek other equity capitals to increase the proportion of equity investment while reducing clarksons wage income to reduce the risk of creditors.2. asking clarkson to make detail plans to reduce a/r and inventory and the implementation should be supervised by the bank.3. strict control of the additional investment in fixed assets in the near future to avoid new cash outflow.as an outside equity investor, we will compare the advantage and disadvantage of the company and point out the opportunities and threats we my met to see whether we are willing to buy the stocks of the firm. regarding clarkson lumber we find that:strengthshave energetic and passionate owner-manager.well control of the business; sound business judgment; works hard.favorable sales prospects with ready market at all times; sales were somewhat hedged against slowdown in new home construction because most of the sales were for repairs.weaknessesnegative operating cash flows and competes on price.target market segment is heavily dependent on local economy.opportunitiesfavorable prospects for continued growth in foreseeable future.expand to other products and geographic areas.have space to improve financial performance.threatsslowdown in general economy might decrease the growth rate of sales.increase rapidly in account receivables and notes payable in recent years with the fueled expansion.no purchase discounts availed in the last two years because of shortage of funds.take all these facts into account, and since the company is sole owned by mr. clarkson and has no dividends in past years, also the free cash flow is hard to predict for the following years. we may simply consider the net worth as the same of firm value. we are willing to pay no more than $120,000 for 30% stock of the company, and this contributed capital may be helpful to solve clarksons dilemma.appendix ibalance sheet at 31st dec, 1993 1995, and 31st mar, 1996 (thousands of dollars)93949596(1st quarter)net sales$2,921 $3,477 $4,519 $1,062 cogsbeginning inventory330 337 432 587 purchases2,209 2,729 3,579 819 $2,539 $3,066 $4,011 $1,406 ending inventory337 432 587 607 total cogs$2,202 $2,634 $3,424 $799 gross profit719 843 1,095 263 operating expenses622 717 940 244 earnings before interest and taxes$97 $126 $155 $19 interest exp.23 42 56 13 net income before income taxes$74 $84 $99 $6 provision for income tax14 16 22 1 net income$60 $68 $77 $5 operating expenses for years ending 31st dec, 1993 1995, and for q1 1996 (thousands of dollars)93949596(1st quarter)net sales$2,921 $3,477 $4,519 $1,062 cogsbeginning inventory330 337 432 587 purchases2,209 2,729 3,579 819 $2,539 $3,066 $4,011 $1,406 ending inventory337 432 587 607 total cogs$2,202 $2,634 $3,424 $799 gross profit719 843 1,095 263 operating expenses622 717 940 244 earnings before interest and taxes$97 $126 $155 $19 interest exp.23 42 56 13 net income before income taxes$74 $84 $99 $6 provision for income tax14 16 22 1 net income$60 $68 $77 $5 appendix iicash flow for years ending 31st dec, 1994 & 1995 (thousands of dollars)19941995inflowoutflowinflowoutflowcashflow from oa(2)(80)net income68 77 increase in receivables(105)(195)increase in inventory(95)(155)increase in account payable127 36 increase in note payable127 increase in accrued expense3 30 cashflow from ia(29)(126)increase in ppe(29)(126)cashflow from fa40 210 proceeds from bank loan60 330 buy-out of holtz equity interest(200)proceeds from buy-out financing200 (100)payment of long term debt(20)(20)payment of buy-out debtnet increase in cash9 4 appendix iiiassessing clarkson lumbers financial health for years ending 31st dec, 1993 1995 and comparing to selected samples (thousands of dollars)199319941995low-profithigh-profitmeasuring leveragetotal debt ratio0.45 0.68 0.73 0.88 0.45 debt-equity ratio0.28 0.59 0.22 2.78 0.29 times-interest-earned4.22 3.00 2.77 liquidity ratiocurrent ratio2.49 1.58 1.15 1.31 2.52 quick ratio1.27 0.82 0.61 0.73 1.35 cash ratio0.16 0.09 0.05 0.06 0.00 cash cycleavg days in inventory55.86 59.86 62.57 56.96 56.38 avg collection period38.24 43.14 48.95 50.01 45.26 avg payment period35.31 47.11 40.08 measuring profitabilitynet profit magin0.02 0.02 0.02 (0.01)0.04 return on assets (roa)0.09 0.09 0.07 (0.02)0.12 return on equity (roe)0.12 0.18 0.17 (0.14)0.22 cogs ratio0.75 0.76 0.76 0.77 0.75 op exp ratio0.21 0.21 0.21 0.22 0.21 appendix ivpro forma for year 1996 operating expenses (thousands of dollars)93949596 (q1)9696net sales$2