Group 3 Case Study

FI 625-200

Clarkson Lumber Company Analysis

Objective of Our Analysis
We have been asked to analyze Clarkson Lumber Companys (CLC) past,
current, and projected financial strength and compare it to those of the industry
average, comprised of high-profit and low-profit lumber companies. This analysis
was constructed using CLCs past financials. Financial ratios were derived and then
compared against the above benchmarks. This can be seen in Exhibit 1. From there,
we were asked to project CLCs financials for 1996 and provided our assumptions.
This can be seen in Exhibit 2 through Exhibit 5. When doing so, we provide the
reader with three separate scenarios for Mr. Clarkson to consider. This showcases
Mr. Clarksons flexibility with how it can alter its future forecasts.
Throughout the analysis, we seek to answer a few troubling questions for Mr.
Clarkson and his Company. These questions include, why has Clarkson Lumber
borrowed increasing amounts despite its consistent profitability? Do we agree with
Mr. Clarksons estimate of the companys loan requirements? Would we agree with
Mr. Clarksons expansion plans? And should Mr. Clarksons loan request be
approved?
Background
Clarkson Lumber Company is a partnership company founded in 1981 by Mr.
Clarkson and his brother-in-law Mr. Holtz. Mr. Holtzs shares were purchased by Mr.
Clarkson in 1994 for $200,000. The company is now owned and managed by Mr.
Clarkson only. The company remained a small employment number with efficient
management on budget and investment.

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?

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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

CLCs short-term solvency seems to be problematic. Indeed, current ratio has

been deteriorating to a worrying level of 1.15 in 1995 below the average of
low-profit companies of 1.31. The quick ratio of 0.61 vs. 0.73 for low-profit
companies does not perform well either. This is mainly due to the huge
increasing amount of current liabilities: there seems to be a maturity
mismatch in CLCs balance sheet.

Long-Term Solvency

CLCs debt to equity jumped from 82.34% in 1993 to an astounding 264.59%

in 1995, a direct result of Mr. Clarksons buyout from his partner in 1994
which he had financed. Due to the increasing amount of debt, the interest
requires additional lump sum of cash input.

Total debt ratio climbed from 45.16% in 1993 to 72.57% in 1995,

demonstrating the increase in financial leverage needed throughout the
years to finance his assets. On average, CLCs total debt ratio remained in
the industry average brackets but it conceals the weight of the current
liabilities in the balance sheet as demonstrated by the poor level of the quick
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ratio. This fact may become troublesome for CLC to pay its short term
liabilities in the near future.

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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which, when comparing this to the average growth in sales over the same period of
24.50%, we can conclude that CLC was growing faster than it could manage and
afford. Debt, and lots of it, was needed in order for CLC to sustain its growth. This
explains why CLC continued to borrow despite its consistent profitability. To make
matters worse, CLC has almost exhausted their line of credit with their current bank.
CLCs current cash position is worrisome too. Comparing the 1995 days sales
in receivables of 48.95 days to the days sales in payables of 30.37 days, we can
see how cash is being spent quicker than it is coming into the company. Mr.
Clarksons inability to enforce the 2/10 net 30 terms with his customers has a direct
correlation with Mr. Clarksons inability to take advantage of the 2% discount terms,
which can be a huge cost savings for CLC.
Given the above, we can conclude that CLC should aim to be at or near the
high-profit industry numbers in order to sustain its growth. A quick analysis using
the DuPont Identity shows that CLCs average total asset turnover of 2.86 is
comparable to the high-profit industry number of 2.92. The profit margin and equity
multiplier for CLC, however, needs improvement. Profit margin for CLC in 1995 is
1.70%, compared to 4.18% of high-profit lumber company and an average equity
multiplier of 3.65, compared to 1.82 of a high-profit lumber company.
Projected Analysis:
Mr. Clarkson is facing a major growth problem: his net working capital
increases in a way that cannot be matched by the incoming cash flows. Mr. Clarkson
seems to think that decreasing its costs will allow him to sustain his growth, thanks
to the 2% discount on purchases. Even if we dont have the exact figures, we
assume that the interests bore by the Trade notes are much more expensive than
on the Bank notes and justify Mr. Clarksons will to get a larger bank note. We
provide the following scenarii analysis based to determine if it is indeed sustainable.
All the scenarii can be seen in the Excel spreadsheet. They rely on some shared
assumptions that are:

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

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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%.

First Scenario: no change in the financial structure (EXHIBIT 2):

In order to make a reasonable comparison, we assumed Mr. Clarkson would
keep a similar financing structure, capping the banknote to $399,000 and having
Accounts Payable growing at the same rate than sales, i.e. 21.71% based on
$5,500,000 in sales for the whole year of 1996. We keep trade notes stable at a
level of $127,000 and drive accrued expenses down to 0. Under this scenario and
the previous stated assumptions, we assume that the interests paid would be equal
to $64,000 without taking into account any interest related to the Trade notes. The
shortage in cash or external financing needed would be an additional $ 307,000
without interests bore by the Trade Notes needed to finance the EFN.

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

We can draw three conclusions from the above analysis:

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1. All the scenarii present a shortage in cash, meaning that Mr. Clarkson will
have to find alternative financing sources.
2. The present financing structure is not the more accurate since scenario two is
better than scenario one.
3. The ability to attain the 2% discount in year 1 is unsustainable.
This leads us to assume that the more accurate scenario for Mr. Clarkson to pursue
lies somewhere in between scenario two and scenario three. Given our analysis of
the three scenarios, we would advise Mr. Clarkson to increase the loan requirements
so that he does not experience a shortage in funds with the projected increase in
sales. So the question becomes will the new bank agree to let CLC increase the
trade notes to finance the remaining cash shortage?

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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he would fail under bankruptcy, his creditors could seize his house, and other assets
of his.
One of CLCs strongest selling points is its price to customers. Customers are
keen to buying quality products at an affordable price and CLC provides that to
them, thanks to the control surrounding operating expenses and purchase
discounts. However, this can be viewed as an issue for CLC, especially if the sales
volume increases that way it has. It is believed that CLC has created a very strong
and devoted customer group, who has nothing but great things to say about Mr.
Clarkson and his company. Given this, CLC has the ability to carefully increase its
prices over the years, which will increase the margins and slow sales growth to a
more sustainable level. This needs to be done carefully and strategically, so not to
lose any of its loyal customers.

Action Recommendations
From a financial advisors stand point, we would recommend Mr. Clarkson to take
the following actions:

Try to manage the inventory to a reasonable level around 57 days sales in

inventory.
Restructure his debt obligations to free up cash around 10% of total assets in
long-term liabilities.
Find ways to collect money back sooner, that means decrease account
receivable collection time.
Advise Mr. Clarkson to re-finance his house and invest his own money into the
business to raise equity around 35% of the total assets.
Consider increasing the price of the goods if feasible.
Negotiate with Mr. Holtz to make him keep his money within the company as
an investment or at least some of it. This will help the companys cash
shortage by eliminate a lump sum of cash outflow temporarily.

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.