CLARKSON LUMBER COMPANY

WRITTEN ANALYSIS OF CASE (WAC)

2012

CLARKSON LUMBER COMPANY (WAC)

CASE BACKGROUND
Clarkson Lumber Company was founded in 1981 as a partnership between Mr. Clarkson and his brotherin-law Henry Holtz. The company dealt in plywood moldings and sash and door products. The business was limited to retail distribution. In 1994, Clarkson bought out Holtzs interest in the company for $200,000. Henry Holtz took a note for the $200,000 with an 11% interest repayable in the semi-annual installments of $50,000 starting from June 30, 1995 to give Mr. Clarkson some time to arrange for the necessary financing. The company showed rapid growth in its business due to increasing sales and in 1996, the Company projected a further increase in sales in the upcoming years. As a result of increasing sales, the company secured good profits but due to the credit dealings, the company faced a shortage of cash and had found it difficult to avail trade discounts or even pay the Note to Holtz, thus making it necessary for the company to increase its current borrowing capacity of $399,000 from Sub Urban National Bank. The situation became severe because of the company's inability to receive payments from customers in a timely manner that created a severe impact in the company's cash flows. Moreover, costs of goods were increasing and more inventories are left over each year causing the return on sales to decrease.

TABLE 1: RATIO ANALYSIS 1993 1994 2.49 1.58 Current Ratio 1.27 0.82 Quick Ratio 2.1% 2.0% Return on Sales 11.9% 18.3 Return on Equity 6.5% 5.9% Return on Assets 2.05% 1.96% Net Margin 3.18 3.01 Asset Turnover

1995 1.15 0.61 1.7% 17.1 4.7% 1.70% 2.76

1-Why has Clarkson Lumber borrowed increasing amounts despite its consistent profitability?
Mr. Clarkson wanted to borrow increasing amounts of loans in order to improve his profitability. As Clarkson borrows greater amount of loan, longer will be the time available for him to repay and greater the chances for him to avail trade discounts and hence higher the profitability levels. We also know that Clarkson runs his business on credits terms of 30 days which means that despite increasing revenues and profits, cash on hand is relatively quite low as A/R are higher. As there is less inflow of cash, Clarkson is unable to avail trade discounts or invest in expansion of his business. Clarkson also needs to pay back the Note Payable to Holtz for his interest, so again there is a requirement for cash on hand, and if he pays for his current cash on hand, it would further tighten his profits. We can see the evidence from the Current and Quick ratios in Table 1 which justifies the decreasing trend of Current ratio and Quick Ratio showing that the liquidity position of the firm is decreasing over the years and hence if the situation persists, Clarkson might find his business in trouble.

2-How has Mr. Clarkson met the financing needs of the company during the period 19931995? Has the financial strength of the company improved or deteriorated?
Clarkson used to borrow loans from Sub Urban National Bank during 1993-1995 in order to overcome his financial needs. This improved his financial position but as the expenses and delays in payment increased, it started becoming increasingly difficult for Clarkson to continue his business profitably hence weakening the financial position. At this point too, we can again have a look at the Current and Quick Ratios which demonstrates an increasing trend in the liabilities over time, which supports the point that the companys financial position is deteriorating as the company is increasingly becoming reliant on loans. As a result, the Return on Sales or the profits are decreasing.

3-How attractive is it to take the trade discounts?

In order to determine how attractive it is to avail the trade discounts, Clarkson should calculate his annualized interest rate which he can get in return if he avails the trade discount. If this annualized interest rate is greater than the interest rate charged when he borrows the money from a bank, then Clarkson should go for the discount. Whereas, if the interest rate to borrow the money from a bank is greater than the annualized interest rate earned by taking the discount, then Clarkson should drop the idea of taking the discount.

We will therefore calculate the annualized interest rate from the formula below:
360 100% - Discount % Credit Days - Discount Days (Number of Loan days)

Annualized Interest from i the Trade Discount

Discount % =

We can see that if Clarkson takes the discount, he gets a hefty 36.73% interest from the trade discount assuming 30 days for credits and a discount of 2% if paid on the 10th day of the purchase. This means that for every purchase of 1m, Clarkson will get an interest of 367,300. So in this scenario, the option for a trade discount is quite impressive so Clarkson should go for the discount.

4-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? In order to determine whether Clarksons estimate is fairly justified, we first take a look at Table 2 and 3
TABLE-2: PROJECTED INCOME STATEMENT FOR 1996 Net sales $5,500 Cost of goods sold: Beginning inventory $587 Purchases (77.8% of sales) $4,241 $4,828 Ending inventory $708 Total cost of goods sold (75.6% of sales) $4,180 Gross Profit $1,320 Operating expenses (20.9% of sales) $1,172 Operating Profit $149 Purchase Discounts (2% of purchases) $85 Interest expense (11% of balance) $91 Net income before income taxes $142 Provision for income taxes $46 Net income $125

TABLE 3: PROJECTED BALANCE SHEET FOR DECEMBER 31, 1996 (thousands of dollars) Assets: Cash (1.4% of sales) A/R, net (11.9% of sales) Inventory Current Assets Property, net (dollar amount) Total Assets Liabilities: A/P (10 days of purchases) Accrued expenses (1.5% of sales) Long-term debt, current portion Bank note payable (Previous + AFN) Current Liabilities Long-term debt Total Liabilities Net worth: Total Liabilities plus net worth $77 $655 $708 $1,440 $410 $1,850

$117 $83 $20 $976 $1,196 $80 $1,276 $574 $1,850

From the tables above, we can see that the net income is expected to increase in the coming years, which means, the company can safely repay the loans to the new bank. Secondly, the liabilities show an increase which is directly proportional to the sales due to increasing A/R and resulting lower cash on hand. Thirdly, we know that Clarkson has to pay back the previous loan of $399,000 borrowed from the Suburban National Bank, pay notes payable to Holtz and wants to avail trade discounts and so end up in profits, so an amount of $750,000 will at least for the time help improve the cash situation of the business to an extent. 5-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? Being Clarksons financial advisor, I would suggest him to take the initiative and go ahead with the expansion. However, I would also suggest him to reconsider his credit terms with his customers such as offer a discount and a free service to those who pay the amount within 7 days, a discount to those who pay in the first 15 days while anyone who pays in advance gets the second service free of cost. Strategies as such are likely to reduce the A/R over time and improve the cash status. Moreover, I would also suggest him to invest this money in expanding its operations, perhaps increasing the product lines or

expanding to new markets. The point of the discussion would therefore be to use the borrowed money justly. As a banker, I would act the same way as Mr. Dodge did. Mr. Clarkson is found to be an honest and fair person, who is hardworking and has good turnover in the past years and still his business is expected to increase profits in the future. However, if the credit position persists the same way as it now does and Clarkson doesnt find a way out to increase his cash inflows in a shorter period, strict covenants have to be included in the agreement for the banks safety and its current cash position.

Reference: When to Take a Trade Discount http://www.wbsonline.com/resources/when-to-take-a-trade-discount/