Professional Documents
Culture Documents
FI 625-200
Past Analysis
Profitability
Over its last three years, the Clarkson Lumber Company witnessed an
increase in net sales from its previous years total including a 19.03% increase from
1993 to 1994 and 29.97% increase from 1994 to 1995. CLC also made a net profit of
$60,000 in 1993, $68,000 in 1994, and $77,000 in 1995.
However, even if growth in both sales and profits can be a positive trend,
the profit margin decreased from 2.05% in 1993 to 1.70% in 1995 and a
poor 0.47% at the end of the first quarter of 1996, which is quite alarming.
So our first question is, what could be causing this drop in profit margin?
Our first assumption is, CLC had an increase in expenses throughout the
years which could have caused this reverse correlation. Yet, with an
average operating expense, as a percentage of sales, for 1993 to 1995 of
20.91%, CLC is slightly above the high-profit industry average of 21.30%.
The case also tells us that CLC is actually doing a great job controlling
operating expenses so we can conclude that operating expenses is not the
culprit for the reverse correlation.
Nevertheless, the average inventory of CLC, as a percent of sales,
increased to 12.99% in 1995. That proportion is definitely higher than the
low-profit average in the industry at 12.00%.
Moreover, the EBIT margin is slightly deteriorating but not as fast as the
profit margin which leads us to focus on interest expenses. Their amount
climbed from $23,000 in 1993 to $56,000 in 1995 representing 1.24% of
sales due to the increased borrowing from the bank and the note payable
to Mr. Holtz. With the accrued expenses also increasing in the balance
sheet that must be related to the cost of increasing Trade notes
interest expenses are becoming unsustainable.
While ROE of 17.15% seems to be correct versus the benchmark, it is
biased by the low weight of equity in the balance sheet. ROA of 4.70%, on
the other hand, seems to be constantly decreasing which is once again
alarming.
Short-Term Solvency
Long-Term Solvency
CLC hasnt had any issues in the past covering its interest obligations,
however CLC has experienced a decline of 45% in its times interest earned
calculation of 3.22 in 1993 to 1.77 in 1995. Taking a closer look, we see that
the total interest bearing debt to EBIT shows a disturbing increase from 1.65
in 1993 to 4.75 in 1995, which allows us to assume that if no new debt is
issued to CLC, it would take close to five years for CLC to pay off its debt
obligations. CLCs gross profit cannot support its gross in debt, so it means
supporting the firms operation by borrowing increasing amount of short-term
debt may be a bad idea for CLC and it may worsen the situation of cash
shortage since CLC is unable to pay them back in time.
Asset Management
Inventory turnover rate decreased from 6.53 in 1993 to 5.83 in 1995 which is
worse than low-profit companies meaning that CLC has difficulties managing
its inventory. We can understand that Mr. Clarkson would rather avoid the risk
of running out of stock and thereby forgoing sales since his company has
been facing huge growth but the inventory level is really too high and
decreases profitability.
Days sales in inventory for CLC also grew to 62.57 days in 1995 from a fair
level of 55.86 days in 1993 but 62.57 is far much worse than the low-profit
average (56.96 days) so a better managed inventory should be a priority for
CLC.
Receivables turnover rate also saw a decline of 2.09 from the 1993 rate of
9.55. CLC used to perform better than the high-profit companies of the
industry but now with 7.46 days it would be closer to the low-profit
companies. Similarly, days sales in receivables of 48.95 lies in the industry
average.
Total asset turnover decreased from 3.18 in 1993 (better level than high profit
companies of 2.92) to 2.76 in 1996 meaning that new fixed assets might be
not run at full capacity.
Current Analysis
CLC turned a profit and survived the past three years by issuing debt. CLC
increased its notes payable position from $0.00 in 1993 to $390,000 in 1995. In its
last two years, CLC had an average calculated sustainable growth rate of 21.54%,
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Sales at a projected level of $ 5,500,000 for the whole year 1996, meaning a
21.71% growth rate.
Inventory representing 13.5% of sales, based on its growing proportion in the
previous years.
Annual salary of $ 90,000 based on 1st quarter + additional amount of $
5,000 observed every year.
Interests paid on Mr. Holtz buyout and on the Term Loan roughly equal to
$18,000 for the whole year.
Warehouses (and property in general) not run at full capacity and able to
absorb the additional growth, meaning that the only variation in net property
is the amount of depreciation i.e. $ 4,000 per quarter based on 1996 1st
quarter.
Whole net income affected to retained earnings
If not prcised, all the other accounts are built according to pro-forma rules
relying on the growth rate in sales of 21.71%.
Second Scenario: loan with the new bank and no discount on purchases (EXHIBIT
3)
In this scenario, we consider a $750,000 loan replacing the existing $399,000
loan and all the Trade notes. Interest expenses are roughly $101,000 taking into
account $18,000 (see above) + 11%*$750,000. Under these assumptions, the cash
shortage is still $107,000 without interests bore by the Trade Notes needed to
finance the EFN. This is clearly better than $307,000 but Mr. Clarkson does not take
advantage of the discount in this scenario.
Third Scenario: loan with the new bank and discount on purchases (EXHIBIT 4)
We now consider the same assumptions presented in the second scenario but
with a 2% discount on purchases made. We need to adapt the Accounts Payable
formula to account for this assumption, making them equal to 10 days in sales. The
decrease from 30.37 days at the end of 1995 to 10 days at the end of 1996 results
in huge cash outflow for CLC, which could be burdensome. Under these
assumptions, our cash shortage is $359,000 without interests bore by the Trade
Notes needed to finance the EFN
Outcome:
In CLCs current situation, Mr. Clarkson runs a worrying cash burn situation,
particularly because of the buyout of his former partners shares and of the
increasing inventory. Against its benchmarks, however, we can observe that CLC is
less capitalized than its peers and its inventory is higher. In fact, its inventory, as a
percentage of sales, is 12.99% in 1995 which is higher than the average low-profit
companies of 12.00%. Accordingly, Mr. Clarkson could work on improving these two
issues to help strengthen his financial position and prove to his bank that he is
creditworthy.
Comparing CLCs long-term liabilities against its benchmark, we can see how
low they are compared to the industrys average. Conversely, CLCs current
liabilities are high compared to its benchmark. It is plausible then, that CLC has the
option to restructure its debt and possibly obtain part of the cash needed with a
new term loan that would be cheaper and more stable than the Trade notes. By
doing this, Mr. Clarkson should aim to bring its long-term liabilities to a sustainable
10% of total assets, which is comparable to that of a high-profit industry leader.
Mr. Clarkson needs to be more of an enforcer with his customers. He should
abide by the industry standards of net 30 terms, and offer his customers the ability
to claim a 2% discount if paid within 10 days. Enforcing a policy such as this will
allow cash to flow into the business at a much faster rate, which can be used to pay
down its liabilities at a quicker rate. As noted above, this may take several years to
develop and cannot be sustained in one short year.
Increasing his personal liability in the company is another avenue Mr.
Clarkson can take. In order to do this, Mr. Clarkson, for instance, could re-finance his
house and put the equity earned into the company he owns. This is certainly a
viable option, especially considering he is the sole owner of Clarkson Lumber
Company. Due to this ownership, Mr. Clarkson has unlimited liability meaning that if
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Action Recommendations
From a financial advisors stand point, we would recommend Mr. Clarkson to take
the following actions:
If the above actions can be worked upon by Mr. Clarkson, we feel he will become
financially stable and will be able to sustain the projected increase in growth in the
coming years.