Clarkson Lumber Company is a classic example of a privately held company that has experienced a rapid growth in sales and has reached a point where it is facing a shortage of cash to sustain the expected growth in sales in the following years. The owner, Keith Clarkson, bought out his partner’s interest in the company in 1994 for $200,000. His partner, Henry Holtz, took a note for the $200,000 with an interest rate of 11% and was repayable in the semi-annual installments of $50,000 beginning June 30, 1995.
The note was taken to give Mr. Clarkson time to arrange for the necessary financing. Mr. Clarkson seems to be running the company well, evident by the constant growth in sales year after year. However, the company is running low on cash on hand, and needs some form of financing to reach the expected sales of 5. 5 Million in 1996. Moreover, the borrowing limit set by the Suburban Bank has been reached, prompting the bank to ask Mr. Clarkson to guarantee the loan personally.
Mr. Clarkson has been in communication with another bank, Northrup Bank, which might be willing to extend a line of credit of up to $750,000.
Analysis There are several reasons for Mr. Clarkson’s need to rely on borrowing despite good profits. Although the profits are good, they are not good enough in our view. The Net Profit Margin has been close to 2% since 1993 (Exhibit D). The cost of goods relative to the sales is high and is keeping the profit margin low. In other words, the costs have increased at a faster rate than sales. The Cost of Goods Sold is consistently around 75% of sales. Secondly, the Return on Assets is roughly 5% in 1995 (Exhibit D). This ratio is kept low due to a high total assets figure.
Total assets are also inflated due to the liabilities taken in the form of trade credits by Mr. Clarkson The company is keeping a high volume of inventory in stock as shown by its Inventory Turnover ratio average of 6%. The Average Collection Period has jumped from 38 days to 48 days since 1993 (Exhibit B). Thus, the limited amount of cash inflow is largely tied in inventory, and payments on loans. Mr. Clarkson has been unable to take full advantage of the trade discounts (2% if paid with in 10 days) during the last two years ‘due to a shortage of funds arising from his purchase of Mr.
Holtz’s (his partner) interest in the business and the additional investments in working capital associated with the company’s increasing sales volume’ (Case, Pg 2). And even though Mr. Clarkson has been able to use the credit from Suburban Bank of up to $400,000 to finance the increase in sales, the ceiling has also forced the company to use cash to fund itself and pay off loans. The current and quick ratios both support this fact (see Exhibit D). Based on the pro forma sheets there is an additional $251,000 needed to attain the goal of $5. 5 million in sales.
Also, since part of the agreement is to break off from Suburban National Bank, the line of credit has to cover the 399,000 covered by the loan. With about $650,000 line of credit used, the remaining $100,000 of the new loan could be used to pay off Mr. Holtz and enable Mr. Clarkson to take advantage of the trade discounts by paying his suppliers back in 10 days; thus achieving the sales target with lower cost. Recommendations We recommend Mr. Clarkson to seriously consider taking the new line of credit. The line of credit will enable the company to take advantage of the trade discounts and pay off previous debt.
Lowering the costs should be a high priority and it might be worth while to consider holding less inventory (if it does not affect the service and quality clients expect). Mr. Clarkson should identify and prioritize the high profit margin products/services the company offers and focus on those. The company would also do well to try to reduce the Average Collection Period to with in 30 days. As far as Northrup Bank is concerned, we recommend that the bank extend the line of credit but makes sure that the company does not reach the ceiling again.
A high proportion of the credit line would be used in the beginning but that is due to the line of credit covering the previous loan, Mr. Holtz interest and some immediate financing for inventory purchases. In the foreseeable future though, once the company sheds the loans it carried and get more streamlined, it will start increasing its cash gradually. Mr. Clarkson’s business references are excellent and the company has always paid its bills on time. Therefore, the company is not a risk and the line of credit should be approved.