Gilbert Lumber Company

Specimen

Gilbert Lumber Company

Memo From:                 Samira Khajehi, Chiren Shah, Ryan Shields and Oumar Sy

Subject:                 Gilbert Lumber Company Financing Decision

Problem:        GLC wants to grow 33% in 2014. Achieving this growth without making additional financing decisions is not possible, as GLC is already experiencing cash flow problems. Meanwhile, its account payables are rapidly increasing. In order to increase liquidity and achieve 33% growth, GLC is considering its options.

Options:        

1. Modify credit policy to decrease A/R collection period
2. Take out inventory loan (50-75%)
3. A/R Financing (50-75%)
4. Line of Credit

1. Ferryn National Bank
2. Khai National Bank

1. Take advantage of A/P discount benefit to decrease cost of capital

Recommendation:        

Through our analysis below, we have determined that there are several issues with Gilbert Lumber’s current operations; however GLC also has a number of options available to help combat their cash issues. Based on our analysis we recommend that GLC combine several of the options in front of them to help mitigate the cash flow issues. Firstly, it will be necessary to accept the external funding from Khai National Bank, as there is not sufficient room to maneuver given how close Gilbert Lumber Co. is to the Ferryn limit. Next, we suggest that Mr. Gilbert reduces his salary by 30% to temporarily reduce operating expenses to free up cash flow. Lastly, we recommend the operational improvements of imposing a late penalty on Accounts Receivables which will help improve Days in A/R, combined with inventory management, and price increases to somewhat alleviate unsustainable growth while improving profitability.

Analysis:        

Ferryn National Bank – Current ST Debt

GLC’s Cost of Capital from Ferryn National Bank is approximately 11.33% on the $233K loan taken out in 2013 (Exibit 10). Of the $33K interest expense that year, $6,641 was attributable to the long term debt and the remaining to notes payable. In the spring of 2014, the company’s borrowing increased to $247,000 with a total interest expense of $10,000.

Khai National Bank- Current ST Debt

Khai National Bank proposed an initial APR of 10.5%. However, if we take into account additional fees that may apply, the effective interest rate may be higher. A partnership with this bank will reduce Gilbert’s reliance on trade credit as well as give him more flexibility on principal repayment.  

Based on the current interest rates alone, we can see that there would be some degree of interest savings with Khai national bank as compared to Ferryn National; however, there is no mention of whether or not Ferryn’s LoC is fixed or floating.

Supplier discount for early payment

The cost of forgoing the discount 2% discount from suppliers is 37.5%. If GLC had made use of the cash discount, it would have saved $66K in 2013. However, to do so it would be a very large upfront cost which does not seem viable given the cash shortage facing Gilbert Lumber.

Ratio Analysis vs. Industry Ratios

1. Quick Ratio (Short term solvency)

In 2013, Gilbert Lumber had a Quick Ratio of 0.67 which is substantially lower than the industry average of 1.104^[1] which suggests that its liquidity is much lower than the industry average. The company's downward trending quick ratio of less than 1 is troublesome as it indicates that the value of the near cash assets, namely Cash and Accounts Receivable, does not cover its current liabilities.

1. Debt-to-Equity Ratio (Financial leverage)

GLC is somewhat over-leveraged with a Debt/Equity Ratio trending upwards, compared to industry average (1.68 vs. 1.0^[2] in 2013). One option to improve upon this ratio would be Palmer Gilbert infusing capital into the company as equity.

1. Interest coverage ratio (Financial leverage)

This ratio indicates how easily a company can pay interest on outstanding debt. A rule of thumb is to keep this ratio above 1.4^[3]. While Gilbert is well above that benchmark (at 2.61), the ratio is decreasing at an alarming average annual rate of 17.8%. Keeping everything else constant, the company’s interest coverage ratio is projected to hit 1.4 by the end of 2017.  

1. Profit margin (profitability)

Gross Profit of ~28% exceeds industry average of 25.78%, while the Net Margin of ~2% falls below the industry average of 6.44%^[4]. These metrics are likely due to the smaller size of GLC’s operation; GLC pays a higher interest rate on debt and has higher operating expenses relative to sales, as it lacks economies of scale. Given the strong gross profit, it is promising that there may be potential for strong net margins in the future as growth naturally begins to level off.

1. Turnover

Days of purchase has been increasing over the past three reporting periods from 35.4 days in 2011 to 45.76 days. Despite this increase, suppliers are still satisfied with their relationship with the company. Even though increasing days of purchase is a form of internal financing, it has a drawback. Taking too long to its invoices from suppliers might upset them, eventually leading to less or no credit extensions in the future as well as less favorable terms.  

The average collection period has been slightly decreasing over the past three reporting periods but it is still slightly over the credit term of 30 days. Some accounts are being overdue, due to some customers paying late. Offering a discount on early payment will give an incentive for certain customers to pay earlier or putting in place a late payment fee may free up cash.

Why Gilbert lumber company is having Cash problems:

Servicing the loan of $70,000 required to buy out Jones’s interest in the company put a heavy burden on the company’s cash flow. In addition, the company's downward trending quick ratio and its inability to cover its current liabilities using its near cash asset is troublesome.

Inventory absorbs too much financing, for too long. GLC is a wholesale business, meaning inventory is made up of finished goods. In December 2013, inventory represented 45% of total assets and it took almost 70 days for acquired goods to be sold. From 2011 to 2013, the industry average for days in inventory was 52 days. Furthermore, the savings obtained by quantity purchases of materials at substantial discounts might not offset the cost of caring materials in stock for almost 70 days.