Memorandum

Date: 2014/11/18
To: Professor Osmond G.
From: Yung Lam
Subject: Clarkson Lumber

Executive Summary (Issue and Significance)

Clarkson Lumber currently has a shortage of cash though it has been rapidly growing
throughout the past years. In addition, increasing working capital requirements required to the
firm to raise additional funds from external resources since the company is investing long term
debt to short term investments. Additionally, funds were used to acquire a different company.
The company has also not utilized trade discounts and increased in continued borrowing
towards sustainability. Because the company is leveraged, the company is searching for various
sources to finance itself. In addition, the company is risky due to its risk of default so major key
problems include potential default risk, terms of the bank loan and the repayment schedule of
the loan.

Increased Borrowing and Financial Strength

The financial position of the company had declined as the current ratio decreased from 2.49 to
1.15, the decrease on ROA, from 6.5 to 4.7, decreased inventory turnover from 6.53 to 5.83 and
the average collection period increased from 38 days to 48 days. All of these ratios were at the
low to mid-range compared to the industry average. (Exhibit 1) In addition, net income only
rose from $60 to $77 thousand with operating costs increasing from $622 to $940 thousand.
Lastly, though the return on sales has remained around the same, there is a decrease from the
companys return on assets of 0.07 to 0.05 as shown from the companys increased of return on
equity from 0.12 0.017 due to the companys increased leverage. (Exhibit 2)

The company had taken a loan of $399 thousand to sustain its operations. Though the average
collection period had increase and there was a decrease in inventory turnover, the company
had decreased their purchases and increase their days of payables. Lastly, the company had
decreased their net working capital to nearly 52.73% with 33.61% allocated from increase in
payments and 66.39% allocated from an increase in purchase on inventory on credit. Essentially
they had increased their trade credit to sustain their operations.

Trade Discounts

Pertaining to trade discounts, the company is offer 2/10 net 30 leading to the company saving
around $69 thousand during the year of 1996. In addition, taking the discount would decrease
net income by from $125 to $82 thousand with a 33.90% decrease and a 39.17% decrease to
EBT. The overall effective annual rate for taking this trade discount would be 73%. (Exhibit 4)
This will overall increase the balance on equity by 7.34%. (Exhibit 5)

Loan Requirements

From the project balance sheet and income statement, Clarkson would need to take out would
be $976 thousand which is well above the loan requested by the company taking trade
discounts. I disagree with the companys estimate for its expansion to $5.5 million. The
company requires additional financing for sustainability, refinance the loan to suburban bank
and to Mr. Holtz therefore he would require more than he had requested. (Exhibit 6)

Recommendation: Additional Debt Financing

I would ask the company to reconsider its thought for expansion as the company will be more
leveraged. Also, if the expansion had reached the sales target of $5.5 million, the companys
requirement is well above the estimate of $750 thousand as he needs $976 thousand for this
expansion. Lastly, the company could be cyclical; therefore, there could be larger capital
requirements at certain times before the end of the year so the company could be faced with
situations to make itself more leveraged.

Recommendation: Loan Officer

As the banker, I would not approve the companys request for debt especially since the
company could potentially be more leveraged as time increases. However, I find the
opportunity cost if I have forfeited this investment as there could be an increase in customers if
I were to approve of this project. If I were to approve this project, I would negotiate the price,
ensure certain covenants are met based of net working capital, current assets and improve on
their collection period.

Exhibit 1:
Ratio 1993 1994 1995 Industry Average
Current Ratio 2.49 1.58 1.15 1.31 2.52
Return on Sales 0.02 0.02 0.02 -0.70 4.30
Return on Assets 0.07 0.06 0.05 -1.80 12.20
Inventory Turnover 6.53 6.10 5.83
Days Sales Outstanding 38.25 43.13 48.95

Exhibit 2:
Ratio 1993 1994 1995
Return on sales 0.02 0.02 0.02
Return on assets 0.07 0.06 0.05
Return on equity 0.12 0.18 0.17

Exhibit 3:

1993 1995 Difference

Days Sales Outstanding $8,003 $12,381 $4,378

Average Collection Period 38.2 48.9 10.7

Inventory Turnover 6.5 5.8 (0.7)

Average Purchases $6,052 $9,805 $3,753

Days of Inventory 55.7 59.9 4.2

Days of Payables (Trade Notes and
Accounts) 35.2 51.3 16.1

Cash Conversion Cycle 58.7 57.5 (1.2)

Change due to Inventory $337,000 $587,000 $250,000

Change due to Inventory Turnover: $25,303
Change due to Sales: $224,697
 Change due to AR $306,000 $606,000 $300,000
Change due to Average Collection Period: $85,707
Change due to Increased Sales: $214,293

Change due to AP $213,000 $503,000 $290,000

Change due to Payments: $97,457
Change due to Purchases: $192,543

Change in Net Working Capital $430,000 $690,000 $260,000

Cash Conversion Cycle: $13,553
Operating Activity: $246,447

Exhibit 4:
Projected Income Statement for 1996
Trade
No Discount Discount
Net sales 5500 5500
Cost of goods sold:
Beginning inventory 587 587
Purchases (77.8% of sales) 4279 4279
4866 4866
Ending inventory 708 708
Cost of goods sold (75.6% of sales) 4158 4158
Gross Profit 1342 1342
Operating expenses (20.9% of sales) 1150 1150
Operating Profit 193 193
Purchase Discounts 69 0
Interest expense 85 85
Net income before income taxes 177 107 39.17%
Provision for income taxes 52 25 51.75%
Net income 125 82 33.90%

Exhibit 5:
Projected Balance Sheet Statement for 1996
Trade Discount No Discount
Assets:
Cash (1.4% of sales) 77 77
Accounts recievable, net (11.9% of sales) 655 655
Inventory 708 708
Current Assets 1440 1440
Property, net (dollar amount) 410 410
Total Assets 1850 1850

Liabilities:
Additional Financing Needed 477 477
 Notes payable, bank 399 399
Notes payable to Holtz, current portion 100 100
Accounts payable 117 117
Accrued expenses 83 83
Long-term debt, current portion 20 20
Current Liabilities 1196 1196
Long-term debt 80 80
Total Liabilities 1276 1276
Equity Balance 573 531 7.34%
Total Liabilities and Equity Balance 1850 1807

Exhibit 6:
Additional Financing Needed 477
Notes payable, bank 399
Notes payable to Holtz, current portion 100
Required Loan Amount 976