Clarkson Lumber Case Study

EXECUTIVE SUMMARY

Clarkson Lumber Company, owned by Mr. Keith Clarkson, has been in business for 15 years and currently has 15 employees. Firms who have worked with Clarkson speak very highly of him, saying that he is conservative and his operating expenses are low. The company’s revenues are projected to continue to grow. Recently, Clarkson Lumber’s accounts payable and notes payable have increased significantly.

The company has not been able to take advantage of trade discounts in recent years because of lack of funds and because of investments due to the company’s growth. While Clarkson Lumber has been increasingly profitable in recent years, the company has found the need for additional financing. Clarkson’s current bank will not provide more than $399,000 in financing without a personal guarantee. Clarkson is hoping to secure more financing in order to improve profitability by taking full advantage of trade discounts. The company is working with Northrup National Bank to possibly secure a larger loan; up to $750,000.

Northrup’s credit department is currently investigating Clarkson Lumber to see if the firm qualifies for this additional financing. Our team has identified several key issues with Clarkson Lumber’s current financial situation. The company’s over-arching financial issue is cash flow. Clarkson is borrowing too much to make up for a cash flow shortage. Clarkson’s accounts receivable is increasing and the company is still using a 2% accounts payable discount, which is contributing to the lack of available cash. The cash flow that the company does have is being used inefficiently as the sources of cash comes from financing.

Thus, Clarkson Lumber is growing at an unsustainable rate and is too reliant on short-term financing. Even if Clarkson receives the $750,000 from Northrup, the company will eventually be bankrupt if it does not curtail its growth rate. We recommend that the company utilize more long-term debt instead of short-term debt. Long-term financing will require smaller payments at lower interest rates, which will increase

CLARKSON LUMBER CASE STUDY – FINAN.

Clarkson may benefit from reducing inventory by increasing sales or reducing inventory growth.

Another option would be to lower costs by negotiating cheaper prices with suppliers. Both options will increase the company’s cash flow. Finally, we recommend increasing accounts receivable turnover. With an increase in account receivable turnover, Clarkson will experience quicker collections and will not have to pay as much in finance charges, again leading to additional cash flow.

ANALYSIS

The approval process for the loan from Northrup National Bank, required that investigators be sent to research Mr. Clarkson and his company. The investigation pointed out a few important financial aspects of the company that are worth mentioning.

In 1994, Mr. Clarkson bought out the other company partner for $200,000. This amount was to be paid off in 1995 and 1996 using semi-annual payments at an interest rate of 11%. From 1993 to 1995, net sales volume for CLC has increased from 2. 9 million to just over 4. 5 million. After yield profits for the same years also increase from $60,000 in 1993 to $77,000 in 1995 (see Exhibit 1). The investigation also paid special attention the debt position and current ratio of CLC. It was reported that sales are expected to reach $5. 5 million in 1996 and could be more if the prices of lumber rise.

Despite these profits, there was a shortage in cash which lead to an increase in borrowing. In order to stay within the borrowing limits set by Suburban Nation Bank, a lot of borrowing was being done through trade credits. In 1995 and 1996 this trade debt was rapidly increasing and was creating some concern. If the market is struggling then trade credit is normally not recommended; however, for CLC the trade credit was a short fix for long term problem. Even with the growing trade debt, CLC still was comparable to the overall percentages of other lumber outlets (see Exhibit 3).

It is also important to recognize specific ratios related to the company. The current ratio, which is helpful in understanding asset liquidity or inefficient use of cash flow, decreased from 2. 5 in 1993 to 1. 1 in 1995. High-profit companies have a current ROE for Clarkson Lumber remains relatively steady; it increased from 1993 to 1994 but decreased to 17. 1% in 1995. This ROE is only slightly lower than the ROE for high-profit companies which is at 22. 1%. After reviewing Clarkson Lumber’s financial situation, several key issues became apparent.

First, the company is clearly growing at an unsustainable rate. Exhibit 3 (various statistical ratios), shows the average internal growth rate of the company at 6. 06% and the average sustainable growth rate at 15. 78%. However, over the three full years analyzed, the company has an average growth margin of 24. 5% and an average asset growth margin of 33. 69%. This continues in the forecasted 1996 year as the company is projected to increase revenue by roughly 21. 7%. At the company’s current level, it cannot continue to support its current growth rate going forward and will require more debt to finance this growth.

Therefore, the company seems to be overly reliant on short term financing for its operations. As seen in Exhibit 5, the company projects to have $5. 5M, with most other accounts are based on the historical averages. Exhibit 5 also shows that Clarkson would need between $971K or $696K of external financing. Another issue found dealt with the company’s cash flow (see Exhibit 4). When the company generates net income, it is immediately engulfed in two areas: the increase in accounts receivable, which increased from $306K to $411K to $606K from 1993 to 1995, and inventory, which also increased from $337K to $432K to $587K during those years.

Due to these increases, and despite rising the liability accounts of notes payable from trade and accrued expenses, the company had negative cash flow from operations and needed external financing to purchase its fixed assets and pay down the debt they already had (again see Exhibit 4). Although having negative cash flows from operations is not necessarily bad in the short run, if this trend continues, it provides no long term benefit for the company. Thus, we found that the company cannot continue to allow its accounts receivable and inventory to increase at the same rate.

The final issue we noticed was the accounts payable 2% discount. Clarkson was offered a discount if it pays off its payables to its suppliers within ten days. Even though there is value here, Mr. Clarkson said the company has taken few purchase discounts in recent years. Exhibit 3 attests to this as the company pays its suppliers on an average of 38 days. If the company used this discount on its financial projections, it would receive a purchase discount of $86K to add to its operating income.

However, the trade-off is that Clarkson will have a significantly lower amount in accounts payable and will need financing to pay down these payables in order to obtain the discounts. If the company does not proceed with the discount, it will experience significantly lower net income, but will not need as much external financing.

RECOMMENDATIONS

One of our preferred recommendations for the company would be to replace some, or all, of the short term debt with a long term note. If the company used the amount of the external financing, about $975K, at 6% for 10 years, Clarkson will pay $130K a year.

At 15 years, the company will be paying $99K a year. Or the company could use half of the external financing amount, roughly $488K, at those same terms and pay $65K or $49K for ten years or fifteen years, respectively. These numbers indicate that by replacing short-term debt with long-term debt, Clarkson will be making smaller payments at a lower interest rate, freeing up additional cash flow. Another way Clarkson can increase their cash flow is by decreasing the accounts receivable period.

In Exhibit 3, we can see that on average the company takes 39 days to collect from accounts receivable and the company has a cash cycle of 55 days, meaning there is a 55 day delay between paying for inventory and collecting the sale. Thus, we recommend that the company use a stricter policy for collections for its customers. For example, if Clarkson could require payments in 30 days, their cash cycle drops to 45 days. By decreasing the accounts receivable period, the company can collect cash more quickly and will pay less in finance. The cash collected from accounts receivable can then be used to manage accounts payable. Our next recommendation is based on Clarkson’s need to increase the amount of cash available, thus capitalizing on growth opportunities. From 1993-1995, the company’s need for increased financing despite profitability comes from Mr. Clarkson’s buyout of Holtz’s share of the company, as well as the increase in inventory and accounts receivable as explained above. It is important for Clarkson Lumber to have access to larger amounts of cash to support its growth in the short and long term.

Clarkson’s current success is due to the ability to compete on price; thus a large growth opportunity exists if they can continue to use trade discounts. If the company can use trade discounts, they will receive a purchase discount of around $86K added to income. The trade-off comes from the company having significantly lower accounts payable. In the long run the company will clearly need the additional credit, shown by the internal growth rate of 6. 1% and a projected sales growth of 21. 7%.

The company will also need to alter the equity/debt ratio due to the projected growth rate of sales in 1996 which is greater than their sustainable growth rate of 15. 8%. Clarkson Lumber will potentially start producing positive free cash flows, as long as their growth rate stabilizes at a more reasonable rate. Our recommendations are aimed at producing positive free cash flows sooner, and the increase in quantity discounts will lower the cost of goods of sold and offset the financial obligations. If the $750,000 line of credit is extended by Northrup Bank, then debt and interest expenses will increase.