COMM 371, Lecture 6

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Lecture 6: Financing Growth – The Clarkson Lumber Case Outline for Today (Clarkson Lumber) • Case objectives

• Understand what drives the need for cash: Clarkson needs cash, but has a good record of profitability

• Evaluate Clarkson’s loan requirements and ability to repay • Link the short-term financial plan to evaluating the firm’s

long-term goals • Practice basic skills in financial analysis

• Review facts of case • Construct statement of cash flows • A closer examination of working capital • Analysis of fixed assets • What factors contribute to a need for cash? • Evaluating the “financial strength” of Clarkson • Clarkson’s sustainable growth rate • How much does Clarkson pay for AP financing? • Evaluate Clarkson’s need for bank financing and ability to repay • Long-term strategy

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Case Facts • Rapid growth in business during recent years (1993-1995). Sales

expected to reach $5.5 million in 1996 (+22% vs. previous year) • Profits in 1995 $77 thousands (+13% vs. previous year) • Clarkson is currently at the limit of its current bank borrowing

($400,000) • How quickly has Clarkson’s borrowing escalated?

• Bank debt increased from $60 in 1994 to $390 thousands in 1995

• Growth in accounts payable and in notes payable, trade • Why? Buyout:

• Clarkson is paying his purchase of Holtz’s stake. • Growth in NWC requirements

• So far: forced to forego trade discounts and rely on bank borrowing. Current bank now requires collateral, so explore other possibilities

• Clarkson’s objective: with extra financing, the firm can improve

profitability by taking advantage of trade discounts on its purchases

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• Sales

• Competes heavily on price • Gives quantity discounts • Net 30 days credit terms • Majority of sales used in repair work (less sensitive to

economy) • 55% of sales in April-September (seasonality)

• Costs: keeps costs down by purchasing in quantity at discount • Proposed borrowing is a revolving, secured, 90-day note, limit:

$750,000. • How will the bank evaluate the loan request?

• How much does he need? • Probable schedule of repayment • Debt position, current ratio, sales prospects • Borrower’s reputation with other firms dealing with

Clarkson • Risks, e.g. exposition to overall changes in the economy

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Why does a profitable firm like Clarkson need to borrow money? Statement of Cash Flows ($000) 1994 1995

Operating CF Net Income 68 77 Depreciation * (+) Change in Net Working Capital (excluding financing) Increase in receivables (105) (195) Increase in inventories (95) (155) Increase in trade payables 127 163 Increase in accrued expenses 3 30 Net cash provided (used) (70) (157) Capital Expenditures Net increase in property (29) (126) Depreciation * (-) Cash Flows from Financing Proceeds from bank loan 60 330 Buy-out of equity (200) 0 Proceeds from buy-out financing 200 0 Payment of long-term debt (term-loan) (20) (20) Payment of buy-out debt 0 (100) Net cash provided (used) 40 210 Net increase in cash 9 4 Cash at beginning of year 43 52 Cash at end of year 52 56

• There is no information on depreciation.

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• ∆Cash = ∆LTD + ∆E + [∆CL – ∆CA (excl. cash)] – ∆FA + CFO –

Dividends • Major categories affecting need for cash

• Increasing current assets

o + receivables

o + inventories)

• Increase in fixed assets

• Buyout of Holtz’s equity stake • How is it being financed?

• Operating CF

• Increase in payables

• Bank loan

• Buy-out financing Now we analyze each of these components.

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Analysis of Working Capital • The increases in receivables and inventories are major causes of

the need for financing • We want to see whether this is just due to sales growth • Receivables (assume all sales are on credit) 1993 1994 1995 1996* Receivables/Sales 10.5% 11.8% 13.4% 13.7% Collection Period (days) 38 43 49 50 *use sales in Q1x4, assume AR are constant throughout the year. Note: 38 = .104x365=(AR/sales)x365=365/(sales/AR) • So the major reason for the growth in receivables is sales growth,

but it is also due in part to a longer collection period (longer operating cycle).

• These overstate the average collection period because the

company is experiencing growth, and we are using year-end receivables rather than the average. If use avg. for 94 and 95, we get 37 and 42 days, that is, an increase of 5 days.

• Nonetheless, if receivables at year-end 1995 had remained at

10.5% of sales, thus keeping the collection period constant, the amount of receivables would have been reduced by $136,000 to $470,000 (22.4% less), but still higher than in 1993 and 1994.

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• Inventory turnover (total COGS/end or avg. inventory) Turnover 1993 1994 1995 1996* Using average inventory 6.6 6.8 6.7 5.4 Using end-of-period inventory

6.5 6.1 5.8 5.3

Inventory Period 55 54 55 68 *use COGS in Q1x4, assume inventory is constant throughout the year

• Numbers using average rather than end of period appear stable

• Seems that inventory turnover is falling, but careful. • Careful with 1996 figure (based on Q1 inventory):

inventory is high because of cyclical sales peak expected in forthcoming quarter.

By the way, note that the AP period is increasing

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Analysis of Fixed Assets • To evaluate the productivity of fixed assets, calculate net property

as a percent of sales • Net property / Sales gives you the net property required per dollar

of sales generated, so lower numbers indicate higher productivity of fixed assets.

1993 1994 1995 1996* Net property / Sales 8.0% 7.5% 8.6% • As net property/sales is stable, the growth in net property seems

consistent with the growth in sales. In summary, the factors that contribute to a need for cash: • Rapid sales growth • Long cash cycle

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Evaluating Clarkson’s “Financial Strength” • Note: Use care with the term “financial strength.” All of the

things below measure some degree of managerial flexibility or cash cushioning. There is always a cost to maintaining this flexibility, and it may be optimal in some circumstances from the shareholder point of view for management to live life on the financial edge.

1993 1994 1995 1996* Total liabilities / total assets

45% 68% 73% 72%

Days payables 35 47 54 56 Current ratio 2.5 1.6 1.1 1.2 *use COGS in Q1x4, and assumes AP constant throughout the year at the 96Q1 level. Clarkson Lumber’s financial condition has weakened since 1993 • Trade credit has been stretched from 35 days in 1993 to 56 days

in 1996(borrowing from suppliers) • Current ratio (CA/CL) has declined from 2.5 to 1.2. • Total liabilities as a % of assets increased from 45% to 72% • Plus, in the absence of improved profitability, continued sales

growth will lead to a further weakening of Clarkson’s financial condition.

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Clarkson’s sustainable growth rate Estimate the rate of sales growth that the firm can sustain without external equity financing, while maintaining a constant D/E ratio (given its ROA and retention ratio) • In 1995, Clarkson earned a return on beginning equity of 20.7%

(77/372). Assume: 1. Continued return on beginning equity of 20.7% 2. No dividend payments (beyond salary currently earned) 3. No equity issues or repurchases 4. No change in capital structure (liabilities / equity), fixed

debt capacity • In general, the sustainable growth model tells us that

RROERROEg ×−

×= 1* • In Clarkson’s case, the retention ratio is one (no dividends), so it

could grow at 26.1%. • In general, what might concern you about using the sustainable

growth formula for Clarkson?

• Continued access to debt financing at the current leverage ratios

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Clarkson’s Cost of Payables Financing • Clarkson claims that he would increase profitability by taking

advantage of suppliers’ discounts for early payment • What is the implicit financing cost? • Clarkson’s suppliers typically offer a 2% discount for payment

within 10 days, but currently, Clarkson is stretching payments to about 54 days in 1995 (to check, compute the AP payable period in 1995).

• Clarkson thus pays 2/98 = 2.04% for forty days of financing • Converting this to an effective annual rate gives

EAR = (1 + 2.04%)365/44 – 1 = 18.2% • Compared to the 11% rate that seems to be generally applicable

to bank financing, this seems quite expensive. • So Clarkson’s belief that the extra borrowing could increase

profitability by allowing him to take discounts on purchases seems about right.

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Clarkson’s financing needs and ability to repay • Major question: Would a credit line of $750,000 meet Mr.

Clarkson’s needs over the next year, as he anticipates? • Assumptions for 1996

• Sales volume will be $5.5 million

• All purchase discounts taken during the year (to simplify the analysis, examine what happens if the loan is granted and new payables policy is implemented at the beginning of the year)

• Other historical relations from 1993-1995 continue during

1996 • Construct pro forma income statement and balance sheet

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Projected Income Statement for 1996 ($000s) Assume New Bank Financing and Payables Policy

Sales 5,500 1 Cost of Goods Sold Beginning inventory (Dec. 95) 587 2 Purchases 1 4,234 5 4,821 Ending Inventory (avg. turn = 6.7 in 95) 2 657 4 COGS (75.7% of sales in 95) 4,164 3 Gross Profit 1,337 Operating expenses (20.9% of sales) 1,150 6 Operating income 187 Purchase discounts (2% of 4234-819) 3 68 7 Interest expense Bank loan 4 73 8 Existing long term debt 5 20 9 Profit before taxes 162 Provision for income taxes 6 46.43 10 Net income 116

1Purchases = Ending inv - beginning inv (calculated first) 2 Based on avg. inventory turnover of 6.7, beg. Inv. and COGS 3 Estimated purchases from above minus 819 already paid in Q1 4 Assumes that the bank loan averaged 400 during Q1, and that all the credit line was used the following month and for the rest of the year .11x((3/12)x400+(9/12)x750). 5 2 semiannual installments of $10 (footnote c, exhibit 2) 6.15x50+.25x25+.34x25+.39x(162-100). See footnote c in exhibit 1

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Projected Dec. 1996 Balance Sheet ($000s) Assume New Bank Financing and Payables Policy

Assets Cash (1.4% of sales in last 3 yrs) 77 Accounts receivable (11.9% of sales in last 3 yrs) 655 Inventory (avg. turn of 6.7, used in IS) 657 Current assets 1,389 Net property (8% of sales in last 3 yrs) 440 Total assets 1,829 Liabilities and Net Worth Notes payable, bank (plug) 965 Accounts payable (10/365 x purchases)* 116 Accrued expenses (1.5% of sales in last 3 yrs) 83 Current portion of L-T debt 20 Current liabilities 1,184 Term loan (falls by $20) 80 Total liabilities 1,264 Net worth (NW in 95 + NI in 96) 565 Total liabilities and net worth 1,829

* Assumes that by the end of December, the firm will only be left to pay purchases made in the last ten days of the month. Purchases are calculated in IS.

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• Analysis:

• It appears that Clarkson’s capital requirements have been significantly understated in the first year. In the BS, it shows that Clarkson would need around $965 thousands if he is to achieve a sales volume of $5.5 million in 1996 and if he is to take full advantage of purchase discounts.

• In addition, Clarkson may have even larger capital requirements during the yearly cyclical peak for cash needs (which occurs before the end of the year).

• At this time, Clarkson will have accumulated only a portion of its full retained earnings for the year

• So the plan proposed by Clarkson presents major problems • Alternatives

• Try to negotiate larger bank credit or other sources of funds

• Continue to rely heavily on trade credit

• Slow down projected rate of expansion

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Long-term Strategy • Rapid vs. slow growth? • Note that increasing scale has not improved operating margins

over 1993 – 1995 (EBIT/SALES stays around 3%). • Rapid sales growth

• Take trade discounts Very large need for finance • Short-term debt (bank) • Long-term debt • Raise new equity

• Forego trade discounts Large need for finance • Slow sales growth

• Take trade discounts Moderate need for finance • Forego trade discounts No need for additional finance

• Advantages of the slow-growth policy

• Improve profitability • Take all trade discounts • Reduce price competition • Tighten credit policy

• Greater financial flexibility • Less risky

• Should the bank extend the loan?