Clarkson Lumber Case Study_Sol

Business Finance I - Written Assessment of Case

Clarkson Lumber Company Prepared By: Wali ul Islam Hashmi MBA Evening - City Campus Seat # 5035

Question 1: Why has Clarkson Lumber borrowed increased amounts despite its consistent profitability? Answer: The main reasons behind increasing borrowings are: (i) To pay off Mr. Holtz to become the primary owner of the company. (ii) Net income is growing at a slower rate as compared to the operating expenses; therefore additional funds are required to increase purchasing power for goods by having liquid cash. Question 2: How has Mr. Clarkson met the financing needs of the company during the period 1993-1995? Has the financial strength of the company improved or deteriorated? Answer: Between 1993 and 1995, the financing needs were met using a term loan of $399,000 that was fixed by the assets that the company had. The financial strength of the company could be analyzed using financial ratios of this period: Ratio Current Ratio Return on Sales Return on Assets Inventory Turnover Days Sales Outstanding

1993 2.49 2.10% 6.50% 6.53 38.25

1994 1.58 2.00% 5.90% 6.1 43.13

1995 1.15 1.70% 4.70% 5.83 48.95

Industry Average 1.31 2.52 -0.7 4.3 -1.8 12.2

Above data shows that financial condition of Clarkson Lumber has weakened, as shown by: (i) Current Ratio declining from 2.49 to 1.15 (ii) Return on assets decreasing from 6.5 to 4.7 due to a high total assets figure inflated by liabilities taken in the form of trade credits (ii) Falling inventory turnover (iii) The Average Collection Period has jumped from 38 days to 48 days since 1993. Thus, the limited amount of cash inflow is largely tied in inventory, and payments on loans Question 3: How attractive is to take the trade discounts? Answer: Trade discounts are definitely a very lucrative option. Clarkson Lumber can get a discount of 2% on a payment made within 10 days, which means that they will have to pay $98 instead of paying $100 in 30 days. Also from our projections for 1996 we can see that if Clarkson Lumber avails all the available purchase discounts that they could save a total of $69,000 which is a substantial amount considering that without these trade discounts their net income would be just $82,000 and will have an overall impact of $42,000 on their balance sheet

Question 4: Do you agree with Mr. Clarkson's estimate of the company's loan requirements? How much will he need to finance the expected expansion in sales to 5.5 Million in 1996 and to take all trade discounts?

Answer: We can find out the loan amount required by Clarkson Lumber to reach the $5.5 Million sales target and to take full advantage of purchase discounts by creating a pro forma income statement and balance sheet (next spread sheet) and then plugging in the value of bank notes to balance the total assets and liabilities. We find out that Mr. Clarkson's estimate is rather under stated as total loan requirement stands at $976,000 which is significantly higher than his estimate of $750,000. Furthermore Clarkson Lumber may have even larger capital requirements during the yearly cyclical peak for cash needs which occurs before the end of the year at which time only a portion of company's retained earning's would have been accumulated

Question 5: As Mr. Clarkson's advisor, would you urge him to go ahead with, or to re-consider, his anticipated expansion and his plans for additional debt financing? As the banker, would you approve Mr. Clarkson's loan, and if so, what conditions would you put on the loan? Answer: As an advisor: I will suggest to Mr. Clarkson that he may slow down his anticipated expansion and go for slow and steady growth, rather than debt financing he may float equity. Increasing sales does not necessarily means improvement of financial conditions as it is evident from his past three year's performance. He can improve his profits at the same sales level by simply taking more purchase discounts or by increasing his price. As a banker: After looking at Clarkson Lumber's past financial performance and its decreasing financial health and also at the financial situation created due to Clarkson's planned expansion in sales I would realize that there is little hope of the loan amount being repaid at this expansion rate and a greater problem of a future request to increase the loan amount. I will have to decide how valuable is Clarkson as a customer to me, considering the positive feedback from their clients and market players, I could bet on Mr. Clarkson's abilities as a manager and on long term profits to repay the loan. I will negotiate with Clarkson to reduce their target of net sales and settle for a loan between $750K and $976K. I will also put some restrictions on the accounts receivables, net working capital and inventories and also to improve their average collection period and fixed asset utilization.

Projected income statement for December 31, 1996 (thousands of dollars) % of sales Net sales Cost of goods sold: Beginning inventory Purchases Ending inventory Total cost of goods sold Gross Profit Operating expenses Earning before interest and taxes Purchase Discounts Interest expense Net income before income taxes Provision for income taxes Net income

Remarks

1996

$5,500 Forecast

77.80%

75.60% 20.90%

$587 $4,279 $4,866 $708 $4,158 $1,342 $1,150 $193 $69 $85 $177 $52 $125

From 1st quarter data

Cost of goods sold-purchases

2% of (Purchases in 1996-Purchases in first quarter of 1996 without discounts) 11% of Average Outstanding Balance

Projected balance sheet for December 31, 1996 (thousands of dollars) % of sales Assets: Cash (1.4% of sales) Accounts receivable, net (11.9% of sales) Inventory Current Assets Property, net (dollar amount) Total Assets Liabilities: Additional Financing Required from Northup Notes payable, Suburban Notes payable to Holtz, current portion Accounts payable Accrued expenses Long-term debt, current portion Current Liabilities Long-term debt Total Liabilities Net worth Total Liabilities plus net worth

1.40% 11.90%

1.50%

Balance Total loan amount required from Northup National will be:

Remarks

1996

$77 $655 $708 From income statement $1,440 $410 $1,850

$477 $399 $100 $117 10 days of total purchases, since taking trade discounts $83 $20 $1,196 $80 Remaining portion of long term debt after payment of $20,000 $1,276 $574 1995 Net worth + Net income of 1996 $1,849 $0 Assets - Liabilities plus net worth

$976

To pay-off total bank notes