Gilbert Lumber Company Case Study

Problem: Gilbert Lumber Company, located in the Pacific Northwest, is currently facing a shortage in cash, caused by rapid growth, a limited borrowing ability and a massive increase in working capital. Thus, Gilbert must find the proper solution to be able to run his company sustainably. He has to decide as to whether he should maintain an aggressive growth rate, and if so, how to finance it adequately?

Options:

1) Slow down growth rate to reach a much lower and sustainable growth rate

2) Increase the sustainable growth rate by increasing asset turnover or profit margins

3) Issue equity or long-term debt to finance the expected strong growth of the company

4) Choose the revolving secured 90-day note capped at $465,000 of Khai National Bank and reduce sales growth rate as of 2015 to achieve sustainability on the long-run

Recommendation:

We recommend that Gilbert Lumber should take Khai Bank’s note to finance its growth. This will allow the company to resolve its issues with cash shortages, be able to benefit from suppliers’ discounts and maximize return for shareholders. In addition, the company should restrain its sales growth to the SGR (sustainable growth rate) of 29.1% as of 2015, thus allowing the company to operate sustainably and profitably in the long run.

Analysis:

Financial Statement Analysis:

Income statement

Gilbert Lumber company had encountered substantial growth since FY2011. Its sales grew by 18.62% and 33.83% in 2012 and 2013 respectively. Gross margin has stayed relatively stable in the past three years, averaging 28.07%. Profit margin has been gradually eroded by the increasing interest expenses, decreasing by 10.6% between 2011 and 2013. (Exhibit 1) According to the bank’s investigator, sales are expected to reach “$3.6 million in 2014” which represent a 33.6% growth compared to the previous year.

Balance sheet

Total assets have increased by 57% between FY13 and FY11. This is explained to a large extent by a growth in Account Receivables and Inventories by 85% and 75% respectively. However, cash has decreased by 29%. (Exhibit 2) Hence, the combination of cash shortage and high account receivables is detrimental to the financial health and profitability of the company. This increase in assets was primarily financed by short-term liabilities, notes and accounts payable.

Short-Term Solvency Ratios

The company's current ratio has decreased since 2011 from 1.8 to 1.45. This can be explained by a large increase in notes and accounts payable. However, this ratio remains above 1, thus current assets are still able to finance current liabilities. In contrast, the quick ratio is below 1. (Exhibit 2) This is due to a high level of inventory, which accounts for more than 50% of current assets. (Exhibit 3)

Turnover Ratios

Throughout the years, the company has been more efficient in managing its assets and in selling its inventory. Assets and inventory turnovers have indeed improved between 2011 and 2013. Account receivables period is relatively stable, averaging 36 days. However, this can signal an issue in collectability since the firm usually offers “credit terms of net 30 days on open account”. Account payable period has also increased, reaching 42 days in 2013 and exceeding the suppliers’ due date by 12 days. (Exhibit 2) This does not seem an issue for suppliers, since they do “not object if payments lagged somewhat behind the due date”. However, Gilbert Company is forgiving the 2% discount for payments made “within 10 days of the invoice date”. Hence, the firm could improve its profitability by reducing its Account Payable and Receivable period.

Financial Leverage Ratios

Over time, the debt ratio has been increasing. In 2011, 55% of assets were financed with debt compared to 67% in Q1-2014. This is due to a higher leverage of the company and is reflected by the interest coverage that decreased from 3.85 in 2011 to 2.1 in Q1-2014. (Exhibit 2) This situation is particularly harmful to the company, as profit margin is being eroded. Hence, the company should remediate this increasing issue.  

 Profitability Ratios

As mentioned earlier, net profit margin has decreased through years. This is due mainly to an increase in interest expenses. Return on assets has been slightly decreasing from 5.22% to 4.72% in 2011 and 2013 respectively. This can be explained by the substantial increase in inventories and account receivables. In addition, the return on equity has improved between 2011 and 2013, increasing from 11.48% to 12.64%. (Exhibit 2) This is due to a larger percentage increase in net income compared to shareholders equity, which means a higher profitability for shareholders.

Pro Forma Statements:

                To properly create a pro forma financial statement analysis, it is assumed that the bank’s sales projection of $3.6M in 2014 is correct. This projection implies a growth rate of 33.63% as seen in Exhibit 1. Looking at the income statement for 2013, total cost of goods sold, and total operating expenses were 72.38% and 24.4%, respectively. Assuming interest expense remains the same, net income after taxes is projected to be $68k. With a net income growth of 54.57%, at first glance, it seems as though Gilbert Lumber is doing well.   

                However, the pro-forma balance sheet brings to light a major problem: the high estimated external funds needed (Exhibit 2). The 2013 values as a percentage of sales of cash (1.52%), accounts receivable (11.77%) and inventory (15.52%) result in projected total assets of $1.229M. Given the accounts payable (9.5%), accrued expenses (1.45%) and assuming notes payable remain the same, total liabilities are projected to be $694k in 2014. Coupled with the projected total liabilities, total assets and the net income after taxes of $68k, it is projected that the estimated funds needed are of $119k. When looking at Gilbert Lumber’s line of credit of $250k, there is not enough credit while sales growth is at 33.63%. Given that Gilbert Lumber has already used $233k by 2013, there is a very large amount of estimated funds needed. Therefore, there is a choice of either finding external financing for the remaining $119k or to scale down the growth rate to a much more sustainable one.