Why has Clarkson Lumber borrowed increasing amounts despite its consistent profitability? How has Mr.

Clarkson met the financing needs of the company during the period 1993-1995? Has the financial strength of the company improved or deteriorated? How attractive is it to take the trade discounts? Do you agree with Mr. Clarksons estimate of the companys loan requirements? How much will he need to finance the expected expansion in sales to $ 5.5 Million in 1996 and to take all trade discounts? As Mr. Clarksons financial advisor, would you urge him to go ahead with, or to reconsider, his anticipated expansion and his plans for additional debt financing? As the banker, would you approve Mr. Clarksons loan, and if so, what conditions would you put on the loan?

Clarkson Lumber Company Solutions

Questions: 1.What problems does Clarkson Lumber face? 2.Why does Mr. Clarkson have to borrow money to support this profitable business? 3.Is a line of credit of $ 750,000 sufficient to meet the firms future financial needs? 4.As a banker, would you approve Mr. Clarksons loan request, and if so, what conditions would you put on the loan? 1. The Problem Defined: The Clarkson Lumber Company has been expanding rapidly for several years. Increases in working capital requirements have outgrown the capacity of the firm to generate funds from internal sources. Also, part of the funds were used to buy out a partner, further increasing financial pressure. The firm has foregone taking discounts on accounts payable and is borrowing

increasing amounts from the bank so as to maintain its expansion. Mr. Clarksons decision today is whether to expand and , if so, how to raise new funds. He is seeking a new bank connection from which he can borrow larger amounts. In turn, the bank must estimate the amount of funds actually needed by Mr. Clarkson, the probable repayment schedule, the nature and degree of the risks incurred and the appropriate terms of such a bank loan.

2. Why Borrow? See statement of changes in cashflows from1993 through 1995 in Table TN-A Points to Note: The RAPID INCREASE in Accounts Receivables, Inventory, and Plant & Equipment have mainly been responsible for Clarksons urgent need for funds. The Buyout of Clarksons partner has added fuel to the fire. A major reason for the increase in accounts receivables and inventories since 1993 has been the RISING SALES VOLUME. Also, the Collection period has increased from 38 days at year-end 1993 to 49 days at year-end 1995. See Table TN-B. What combination creates a voracious appetite for external financing? 1.Rapid Sales growth, PLUS 2.A Long Cash Cycle PLUS 3.A Low Profit Retention. Refer to Table TN-D. Clarkson Lumbers financial condition has weakened since 1993. The trade credit has been stretched from 35 days to 54 days; the current ratio has declined from 2.5 to 1.2, and total liabilities as a % of total assets has soared from 45 % to 72 %. Were profitability to decline due to adverse circumstances, this situation will worsen.

3. Is $ 750,000 sufficient? The answer depends on the degree to which Clarkson relies on using trade credit as a source of funds. As exhibit 2 shows, Clarkson has waited for about 35 to 54 days to pay his suppliers. If Mr. Clarkson is offered a discount of 2 % for a payment made in 10 days and he does not pay until 50 days, what interest rate is he forgoing ? On a purchase of $ 1000, he either pays $ 980 in 10 days or $ 1,000 in 50 days. He thus pays $ 20 for the use of $ 980 for 40 days which is 2.04 % for 40 days, or about 18.6 % annual. This cost may be overstated. Clarkson may be taking part of his discounts and extending other payables beyond 50 days out; such a policy would reduce costs shown. Also, if Mr. Clarkson could delay payment on his purchases for more than 50 days without incurring punitive action, the cost is over stated. In a similar vein, Mr. Clarkson may offer his customers a 2 % discount for payment in 10 days, net 30 days. Collection periods on a/c receivables has been 38 to 49 days. This cost comes to 31 % annual ( HW: calculate this #) Assumptions: 1. Mr. Clarkson will reduce his payables period to 10 days and take the 2 % purchase discount, and 2. Mr. Clarkson will pay his suppliers in 48 days, as per his practice in 1994 and 1995. 3. Sales Volume will be $ 5.5 million in 1996. 4. The historical relations between 1993-1995 will continue in 1996. Table TN-E shows a projected income statement for 1996 and Table TN-F shows a projected balance sheet. Observe that Clarkson needs to borrow $ 971, 000 at the end of 1996 and his PEAK loan requirements may be higher due to :

1) he may need to finance a larger volume of current assets during his seasonal peak, which occurs well before the end of the year, and 2) at this time, he will have accumulated only a portion of his total retained earnings for the year. The plan of action proposed by Mr. Clarkson poses MAJOR DIFFICULTIES. Several alternatives are available: 1.Get MORE bank credit 2.Slow Down his projected rate of expansion, or 3.Continue to rely heavily on trade credit and pay off bills slowly. In the third case, if Mr. Clarkson waits 50 days to pay off his bills, he will have a/c payable of $ 580,000 outstanding reducing his bank borrowings well below 4 750,000 but will the bank lend now ??? DECISIONS, DECISIONS: See Figure TN-A for a mapping of major alternatives. Mr. Clarkson can expand his operations rapidly but can he increase profits as rapidly ? To do so, he will need more financing unless he relies on high cost trade credit. Continued expansion at a rate that cannot be financed proportionately from retained earnings can leave hin in a vulnerable high risk position. Clarkson NEEDS bank financing in larger amounts for longer terms than he realizes. Float equity? It is NOT clear that slowing down the rate of expansion will lower profits. Increasing scale has not improved operating margins or the return on invested capital during 1993-95 ( See Table TN-G). Clarkson can earn high returns on the same volume of operations simply by taking more of his purchase discounts. With less aggression, he may be able to charge higher prices or avoid giving quantity discounts on sales, thus increasing profits. Such a policy may leave him in a more flexible

financial positionand probably subject him to less overall risk. 4. What does the BANKER do? Does the bank wish to make a long-term loan to Mr. Clarkson? Until the expansion rate is curbed, there is little hope of the bank loan being repaid, and a greater prob. of a future request to increase the loan amount. Is Mr. Clarkson a very valuable Long-term customer ?? if so, the bank will lend but with severe restrictions. Now, the bank is betting heavily on Mr. Clarkson as a manager and as a person, and it will look to long-term profits to repay the loan. In case earnings collapse, a lien on accounts receivables and inventories will be imposed. What is the prob. that Mr. Clarkson will comply with the loan?? Undoubtedly, a sizable increase in a projected bank loan will be accompanied by a number of restrictive covenants.