Evaluate Clarkson Lumber Financial Performance. Why Did They Borrow So Much During 93 to 95 Despite Positive Profitability?

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1: Evaluate Clarkson Lumber Financial Performance. Why did they borrow so much during 93 to 95 despite positive profitability?

A: With regards to a horizontal-analysis, we may see that between 1993 and 1995, total assets have increased by 78%. Meanwhile, total liabilities have increased by 186% which was mainly led by the loan and the pay-out of Mr. Holtz.

Not taking these loans into consideration would show a total liability increase of 68% and would show strong growth of the company over the period, and increased Equity. However, in Clarkson Lumber case, the financial statement is influenced by the repayment of Mr. Holtz, creating a lack of available cash, thus causing liquidity and solvency issues.

Looking at the Income Statement, Net Sales and COGS have both increased by 55% between 1993 and 1995, representing no change in the company’s gross profit, showing no kind of economies of scale have been made. Finally, net income has only increased by 28%. Looking at the data and the history of the company we can extract that this is due to increased interest expenses. In both financial tables, we may see that loans are pulling down the results of Clarkson Lumber, strongly, which raises some concerns with regards to its relationship with debt.

With regards to Financial Performance ratios, we split these in 4 categories: Profitability, Solvency, Liquidity and Efficiency. As previously noticed, the company is doing well, with a growing profitability. However, it is borrowing more and more every year. This would raise the question of its relationship to debt. However, looking at the solvency ratios, even if the Debt-to-Equity ratio doubled from 1993 to 1994 (from 0.92 to 1.9), it shrinks back to 1.11 in 1995. This indicates that the company should have no issues paying back any loan, expecting by the end of the year 8 cent in debt for every $1 in equity. With regards to efficiency and liquidity ratios, we may see that it has issues collecting money, with Accounts receivables turnover decreasing from 9.5 in 1993 to 7.5 in 1995. Accounts Payables stands at 10.38 in 1993 to 9.1 in 1995. This shows that the company takes much time receiving its payments and takes even more time paying its suppliers. This could be explained by the lack of available cash in the company and is indeed supported by extremely low liquidity ratios. As a matter of fact, the current ratio stands at 2.5 in 1993 and decreased to 1.15 in 1995. At the same time cash ratio, followed a same trend from 0.16 to 0.05.

Cross-analyzing the horizontal and vertical analysis, we may assume that the company has rapidly developed and might have expanded, incurring development and R&D expenses. This cost come on top of the buy-out of one of the partners, creating additional costs for the company. Thus, we may say that the company is doing very well from a financial perspective. As the company is developing itself, it is also investing to pursue this development in addition to previous incurred costs. This means the company also need to fund its investments with additional borrowing from the bank. Finally, we could add that, additional borrowings whilst in prosperous period may seem reasonable as it would offer more funds at lower interest rates than if the company was borrowing in a tight period.

2) Prepare full set of financial statements (BS, IS, CFS) for 1996 if it will grow with 25% annual rate without purchase discount (none discount is taken).

A: There are several assumptions we made to forecast the financial documents of 1996. The criteria given in the question was 25% annual growth rate without any purchase discount.

The first projection was the Income Statement. Revenues grew by 25% to 5,65 Million.

Now, beginning inventory for 1996 shall be the ending inventory for 1995. We calculated Purchases based on the average percentage of sales over the last 3 years. Final COGS too has been estimated based on the 3-year average percentage of average percentage of sales of low-profit and high- profit outlets.  So, Final COGS is 4.29 million and Ending Inventory estimated to be 687,000.

Operating expenses is again calculated as average percentage of sales from the low profit and high profit outlets. We forecast an EBIT of 152,500. Interest expense is calculated based on interest payments of a loan of 399,000 for the first quarter and the rest financing amount for the rest of the year. Interest rate assumed is 11%. Subtracting interest expense, our net income before tax is 89,900. Putting the figure into the corresponding tax brackets, we keep a provision of 18,800 for tax and forecast a Net Income of 71,100.

For the Balance Sheet, on the Assets side, we assume Inventory and Property, Net to grow by 25%.

In the Liabilities side, Accounts Payable and accrued expenses increased by 25%. Notes payable to Mr. Holtz, current portion is assumed 50,000 to be payable at the end of 1996. So, we forecast a total liability of 1.46 Million.

Net worth is last year’s net worth plus the Net income for the year and it’s forecasted to be 520,000.

Net Working Capital is Operating Current assets minus operating current liabilities. Here, NWC is assumed to be [Current Assets – (Notes Payable, Trade + Accounts Payable + Accrued Expenses + Term Loan, current portion)]. Changes in Net working capital for 1996 is estimated to be 139,750.

The debt is based on Notes Payable, Bank and Term Loan. Change in debt for 1996 is projected to be 166,000.

For the Operating Cash Flow, we used EBIT(1-T) + Depreciation.

Firm free cash flow, Operating Cash flow- Change in NWC – Capex

Equity Free Cash Flow is Firm free Cash Flow- Interests+ Change in debt.

Although operating cash flow is positive for 1996, we see that firm free cash flow is negative and equity free cash flow is marginally positive.

3. How much does Clarkson need to borrow in 1996 to cover his financial needs?

A: Except Notes Payable, Bank, we could forecast everything else based on the 25% growth and average percentage of sales for different parameters.  So, Notes Payable, Bank is the account to record for the new credit, so that Clarkson Lumber’s financial need can be covered with the loan amount. The old credit (399,000) and the remaining amount payable to Mr. Holtz also needs to be considered.

Our total assets show a balance of 1.98 Million in 1996. The total liabilities and net worth, without the bank loan shows a net balance of 1.35 Million. So, we can suggest an additional bank credit of 626,000 for Clarkson Lumber Company to cover the financial operations given a 25% sales growth.