Clarkson Lumber

Business

Retail distribution of lumber products in local area Ð'- plywood moldings and sash & door products

Competes on price

Controls operating expenses

Purchases materials in large quantities at substantial discounts

Most of the products sold are for repair work (not too affected by new home sales)

Target market is growing suburb of large city in Pacific Northwest

Bulk of sales (55% to 60%) came in 6 months Ð'- April through September

Company owns land and four large storage buildings on the land

Strengths

Ð'* Energetic and passionate owner-manager and his assistant

Ð'* Personal control over every feature of the business; sound business judgment; works hard

Ð'* Controls operating expenses (almost as low as top profitable companies)

Ð'* Favorable sales prospects with ready market at all times; Sales were somewhat hedged against slow down in new home construction because most of the sales were for repairs

Weaknesses

Ð'* Negative cash flows

Ð'* Competes on price (because it gets quantity discounts and controls operating expenses) even though its cash flows are negative

Ð'* Target market segment heavily dependent on local economy (suburban pacific northwest city)

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Opportunities

Ð'* Favorable prospects for continued growth in volume of Clarkson Lumber business over foreseeable future

Ð'* Expand to other products and geographic areas

Ð'* Opportunities to improve financial performance

Threats

Ð'* Slow down in general economy might slow down rate of increase in sales

Ð'* Slow down in local economy would adversely affect the business

Ð'* Rapid increase in accounts and notes payable in the recent past

Ð'* No purchase discounts availed in the last two years because of shortage of funds (notes payable to Mr. Holtz and increase WC requirements)

1) Symptoms of existing problems (1993 Ð'- 1995)

Ð'* Increasing levels of AR (13.4%) and in 1995 it is close to AR of low profit outlets (13.7%)

Ð'* Increasing levels of inventory (13%) and in 1995 it is much higher than those of low-profit outlets (12%)

Ð'* Days AR and Inv are increasing but Days AP has remained more or less same

Ð'* These factors result in longer cash conversion cycle and this is one of the reasons for the CFO to be low and/or negative

Ð'* Because of AR and Inv, total assets are increasing pretty fast. In fact, they grew faster than sales in 1994 and 1995. As a result the ROA has decreased from 6.5% to 5.5%

Ð'* Current ratio has fallen from 2.5 to 1.15, which is well below the ratio for low-profit outlets (1.31)

Ð'* Interest bearing debt to equity ratio has increased from 0.22 to 0.52. Similarly, total liabilities as a percentage of total assets has increased from 45% to 73%

Ð'* Cash conversion cycle is taking longer: increased from 52 to 57 days in 1995

Ð'* ROA decreased from 6.5% to 4.7% because of drop in profit margin and asset turnover. Falling asset turnover indicates assets are growing faster than profit margins. That is, the efficiency in use of assets is decreasing.

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2) What is the key problem with Clarkson Lumber Company and its new proposed strategy?

Clarkson is planning to buy inventory in large quantities to avail quantity discounts. But this increases inventory levels and locks up working capital.

2% quantity discounts are available only if they are paid in 10 days.

Clarkson is extending credit to many customers (good and not so good) to continue the fast rate of growth of sales. Collections are taking longer and this is locking up working capital too.

All the above factors have reduced CFO considerably.

The company is growing at a rate much faster than it can sustain through internal financing. Therefore, it has to seek external financing to sustain the growth.

3) Sensitivity analysis

AR and Inventory are 12% of sales, gross margins = 24.2%, 2% quantity discounts

1998 Low Profit High Profit Sales growth

20% 17% 13% 10%

Profit margin 2.1% 2.1% 2.1% 2.2%

Asset turnover 2.56 2.92 3.0 3.0 3.0 3.0

ROE -14.3% 22.1% 19% 18% 17% 17%

ROIC 13.4% 13.4% 13.5% 13.5%

Max credit required 1,392 1,286 1,150 1,050

Cash cycle 84 85 86 87

Total liab / Assets 87.5% 45.2% 66% 68% 63% 61%

Debt / Capital 0.62 0.60 0.58 0.56

Interest coverage 2.7 2.7 2.7 2.8

Assets / Equity 3.0 2.9 3.0 2.6

Current ratio 1.31 2.52 1.17 1.2 1.2 1.3

Quick ratio 0.62 0.63 0.65 0.67

CFO (336), (82), (101) (336), (52), (62) (336), (12), (13) (336), 18, 22

4) AP in 10 days results in 2% savings in COGS but increase in inventory levels. What happens to debt levels and CFO if Days AP is 38 and 2% savings in COGS do not occur?