Wilson Lumber sells building supplies wholesale. Owned by Mr. Wilson, WL is experiencing growth and requires additional funding to meet the demands of growth. Key success factors include cost reduction of operating expenses and substantial quantity discounts which supports the ability to compete on price. Also, positioning is important. Following an economic down-turn, construction of housing has decreased. However, because WL is positioned towards selling for repairs, they are largely immunized against the down-turn. Operationally, WL has reduced costs to succeed by competing on price.
They have also positioned themselves in the repairs market, which helps their business remain steady. Their lean operations consist of reduced sales staff, taking orders by phone, and thorough oversight of costs by Mr. Wilson. Their suppliers enjoy buying on credit with discounts and WL’s creditors allow them to delay payment. WL therefore has strong relationships with buyers and sellers. WL’s financial policy has been to borrow from a competitor bank at 14% up to a limit of $173,000. They are also paying down a $50,000 mortgage over 10 years, the proceeds of which were used to pay a partial liability of $75,000 to a bought-out investor.
Profits are retained within the company. Recently, to support increased cash demands such as increased accounts receivable periods, WL has been forced to issue substantial trade debt of $110,000. Despite profitable growth, Wilson is still encumbered by debt of $75,000 to a previous owner. Payments on the mortgage prevent Wilson from taking advantage of 2% discounts because it does not have available cash to make early payments. Appendix 1 shows the sources and uses of WL’s funding. In summary, WL requires financing for purchase of inventory and property to support growing sales and to pay short term as well as long term liabilities.
WL’s alternatives to funding are also explained in the appendix. An analysis of relevant ratios is also provided in the appendix. An examination of the pro-forma statements found in the appendix suggests that under a 25% sales grown scenario (Appendices 2 to 5), WL will require more than $325,000 in financing by 1988. In that year, WL will require in excess of $415,000. Under the scenario that WL’s payable period is reduced to take advantage of a 2% discount (Appendices 6 ; 7), the cash reserves required to make early payments far exceed the cash afforded by the maximum $325,000 line of credit.
Such fast payable periods burden WL’s cash reserves too much. Under reduced sales forecasts in scenario 3 (Appendices 8 & 9), WL is even more burdened and will face negative cash flows. WL’s solvency (and profitability) rely on buying and selling on credit: Debt financing allows this flexibility. But without buying on credit, heavy debt financing will over-burden Mr. Wilson with insurmountable interest payments. By referring to the calculated ratios (Appendix 10) Mr. Wilson’s advisor might suggest further debt financing because the debt will add value to his company.
It allows him to cater to growing sales by adding the inventory and property he needs, while attracting customers with credit sales. However, Mr. Wilson should take caution not to over-leverage (e. g. , beyond a ratio of 2. 0). In this circumstance, Mr. Wilson’s interest coverage ratio slips below 2. 0, lessening his cushion for paying interest. Over leveraging on a line of credit also increases the risk that if Northrup bank calls in its line of credit, WL will be forced to liquidate its assets to service the credit. As long as scenario one holds, Mr.
Wilson is not over-leveraged, can pay his interest, and remain solvent and profitable. Under scenarios two and three, Mr. Wilson faces liquidity trouble and insurmountable interest fees. Under scenario one, Mr. Wilson’s position would be aided by increasing their inventory turnover ratio. This will lessen the burden on cash, thus reducing required funding and subsequent interest rates. Inventory turnover can be improved at the same time as accounts receivable turnover by implementing incentives for customers to pay early.
This incentive would consist of a discount that is marginally less than the value of what is saved by reducing the interest payment (because a faster AR turnover would reduce the total line of credit, hence reduced interest payments). Mr. Wilson’s bankers at Northrup would do well to agree with the advisor. Under scenario one, funding supports growing sales, as well as the lengthy payable periods. Interest payments can still be met (as seen in the appendix). However, leverage becomes a concern in that if Northrup requires sudden repayment of the line of credit, then WL’s assets would need to be liquidated quickly.
However, WL would still remain solvent under scenario one. Under scenarios two and three, WL’s interest payment ratio falls to a less than satisfactory level, suggesting over-leveraging. The bank may wish to impose constraints that further equity be raised to assure that 1) interest payment ratio is greater than 2, 2) leverage ratio is no greater than 2, and 3) current assets are always greater than current liabilities (to maintain solvency). These conditions are in addition to normal policy which would restrict withdrawals, future investments in capital be approved by the bank (to ensure solvency), restrictions on additional borrowing, etc.
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