Essay About Expensive Short-Term Debt And Profit Margin

Clarkson Lumber Company
Clarkson Lumber CompanyExecutive SummaryKey problem – Weak liquidity position due to cash shortage Rely heavily on expensive short-term debt in the form of notes payables to fund growthIncrease in current liabilities have decreased the Quick and Current Ratios Increasing DSO shows ineffective credit policy offered to customersPoor financing/capital structure; too much debt and minimal equity Optimistic sales forecasts have resulted in CLC holding excessive levels of inventory thus depleting their cash reserves Increasing inventory levels and the policy to fund growth through trade credit has resulted in high levels of interest payments All these factors culminate to suggest that CLC would struggle to repay their outstanding debt if they continued to operate the way they currently are Recommendation – Issue the note as long as CLC:Reduces inventory and manages it more efficientlyImproves credit policy and enforces DSO to collect cash on sales fasterImproves capital structure by increasing equity and restructuring debt to include more long-term debtThe key problem that Clarkson Lumber Company faces is its cash flow.  The company has a weak liquidity position due to its high issuance of debt and cash shortage.  Cash Position – An increase in inventory, current liabilities, and interest charges have tied up Clarkson Lumber Company’s cash and have left the company with a cash shortage and weak liquidity position.  Profit Margin – Sales have increased from 1993-1995, but the profit margin is deteriorating.  This is not due to increased cost of goods sold as they make up 75% to 76% of the net sales, which aligns with the industry.  Poorly managed assets and reliance on debt are contributing to this decrease.Inventory – Clarkson’s inventory is too high.  In 1993 inventory was 11.5%, but in 1995 inventory made up 13% of sales, which is worse than low-profit outlets.  The high inventory weakens the cash position as money is tied up in excess inventory, storage costs increase, and inventory loses value as it sits unused.Current Liabilities – The current liabilities made up 29.92% of total assets in 1993 and largely increased to make up 66.46% of total assets in 1995. This is almost twice the low-profit outlets’ ratio of 34.8%, and shows Clarkson might have trouble paying back its short-term.  The spike in current liabilities is partially due to the buyout of Holtz’s share in the company.Current and Quick Ratios – The current ratio decreased in 1995 to 1.15, and the quick ratio decreased to .61 in 1995.  Both ratios are below the low-profit outlets and show CLC is less liquid in the short-term might have trouble paying its short-term liabilities.DSO v DPO – The DSO increased from 38.24 to 48.95 from 1993-1995 meaning CLC has become worse at collecting payment from its customers.  The DPO is smaller than the DSO, so CLC is paying its payables faster than it is collecting its receivables.  Cash is leaving faster than it is coming in, which is not good.Interest – The EBIT consistently made up ~3.5% of sales from 1993-1995.  The profit margin decreased, so this means there was a large increase in interest charges.  This spike in interest results from the increase in CLC’s issuance of debt.  As interest increased, the times interest earned ratio decreased from 4.22 in 1993 to 2.77 in 1995.  CLC made only 2.77 times their interest charges versus 4.22 times the charges in 1993.  This reduces their margin of safety.DebtCLC’s notes payable increased from $0 in 1993 to $399,000 in Q1 of 1996.In 1993 Clarkson’s debt ratio was 45.16% and increased to 72.57% in 1995.  The low-profit outlets have a debt of 52.7%, so CLC is more leveraged than others. The current liabilities are more concerning as Clarkson’s make up 66.46% of assets while low-profit outlets’ current liabilities only make up 52.7%.Debt and interest charges increase while the profit margin decreases.  This shows that CLC’s profit is fueled by debt, and the profit can’t support this debt.Clarkson has borrowed so much that it has almost exhausted its line of credit with the Suburban National Bank.Recommendations for Mr. DodgeIt is risky to issue debt for this company because of their current financial health.  CLC quickly burns through cash and could possibly default on interest payments if current operating practices are maintained.Mr. Dodge should issue the note because the company is fundamentally solid.  It has a loyal customer base, positive reviews from suppliers, and solid growth prospects.  The buyout of Holtz’s share in the company also negatively impacted ratios, and may not accurately reflect the long-term financial standing of CLC.  That being said, Mr. Clarkson needs to clean-up his policies and strengthen his company’s short-term health.Mr. Dodge should issue the note on the terms that Clarkson:Improves inventory managementReduce inventory levels to at least 12%, which will improve the DIO (62.57 days), reduce storage costs, and free up cashLower inventory levels will lower debt because CLC buys all inventory on trade credit.  This will decrease interest costs and improve net incomeEnforces credit policy CLC can leverage their strong market standing and tighten their credit policy to receive cash faster and improve their cash shortageThe 48.95 DSO in 1995 signals that customers are not taking advantage of the discounts by making payments fasterImproves Capital StructureRestructure debt to include more long-term debt instead of short-term debtDecrease debt and add more equity to decrease interest expenses and free up cash.  Clarkson could add equity by refinancing his house and investing his own money into CLC.Clarkson Lumber Company should take a more conservative approach and aim to better match the maturity of its assets to the maturity of its loansExhibit 11993199419951996 1QNet Sales2,9213,4774,519$1,062Net Income606877$5Profit Margin2.05%1.96%1.70%0.47%EBIT/Sales3.32%3.62%3.43%1.79%Ending Inv337432587607Current Ratio2.491.581.151.16Quick Ratio1.270.820.610.59DSO38.2443.1448.9550.09DIO55.8659.8662.5769.32DPO30.6240.4834.2123.62CCC58.7955.8971.4477.84Debt-Equity.822.112.652.58Debt Ratio.45.68.73.72TIE4.2232.771.46