As a financial consultant to Clarkson Lumber, I have analyzed four potential scenarios that are likely to occur considering their current situation. These scenarios include continued rapid growth of Clarkson Lumber with Suburban Bank as the creditor, slowed growth with Suburban Bank as the creditor, continued rapid growth with Northrup Bank as the creditor, and controlled rapid growth with Northrup bank as the creditor. Table 1, 1.2, and 1.3 represent the first scenario, which is the continued rapid growth of Clarkson Lumber with Suburban Bank as the creditor.
According to Northrup Bank’s investigator and historical income statement data, the most relevant expectation for Clarkson Lumber’s net sales in 1996 was approximately five and a half million dollars. Based on this information, it was determined that a reasonable annual growth rate of 22 percent would be applicable for the scenario. This rapid growth rate of 22 percent would be relevant for the years 1996, 1997, and 1998. Afterwards, the annual growth rate would decrease to a sustainable rate of five percent. In order to achieve the expected growth rate of 22 percent for the next three years, Clarkson Lumber needs to continue its capital expansion that began in 1995, following the initiation of rapid growth a few years prior.
Continued capital expansion is necessary as Clarkson Lumber appears to have reached its limit in terms of sales capacity. The expansion will require an investment of 14 cents for every dollar of net sales growth, with a growth rate of 22 percent. Along with the costs for expansion, variable costs, fixed costs, and capital replacement will increase in proportion to the growth rate, based on their historical ratios and levels. Furthermore, significant increases in working capital will be necessary to handle inventory and accounts payable, as well as any potential non-planned accruals or cash requirements (assuming these will not occur spontaneously).
This scenario assumes that Clarkson Lumber will maintain its future w-factor near historical levels by utilizing payable trade accounts effectively to reduce the need for working capital. However, considering the current credit limit of $400,000 from Suburban Bank, it is evident that this situation is not sustainable. Taking into consideration the costs associated with rapid growth mentioned earlier, Clarkson Lumber will need to halt any further growth by 1996. In Table one, it is depicted that gross debt rises from $610,000 to $842,000, reflecting a $232,000 increase.
Based on my calculations, Clarkson Lumber’s debt increase with Suburban Bank is limited to only $9,000, as shown on the balance sheet for the first quarter of 1996. This limited debt situation is undesirable because it would restrict Clarkson Lumber’s growth, resulting in slow progress under Suburban Bank. In the next analysis, Tables 2, 2. 2, and 2. 3 will represent a scenario of slow growth with Suburban Bank as the creditor. This scenario assumes an economic slowdown and the decline of the previously rapidly growing suburb where Clarkson Lumber operates.
According to the case book, Clarkson Lumber’s repair business is expected to have a slow growth rate of five percent instead of a flat or negative growth rate. Therefore, the inflator for Clarkson Lumber is set at four percent, which restricts the growth rates of variable costs, fixed costs, and capital replacement. Consequently, the working capital needs will remain relatively stable and there will be no anticipated costs for expansion in the foreseeable future.
In this situation, I anticipate that Clarkson Lumber will benefit from trade discounts and refrain from using payable trade accounts as cash and credit become accessible. This will help in paying off the gross debt, leading to a decrease in the v-factor to 73.5 percent and an increase in the w-factor to 16.5 percent. Although slow growth resulting from an economic decline is detrimental for a company that experienced an average growth rate of over 23 percent in the past two years and initiated capital expansion as a result, this circumstance could still be advantageous for Clarkson Lumber in multiple ways.
Firstly, after 1996, Clarkson Lumber will be able to significantly reduce its debt each year using the positive free cash flows. However, this will result in a negative common-size analysis (CATO) due to the $100,000 principal payment made to Mr. Holtz. Nonetheless, this reduction in debt will provide Clarkson Lumber with more financial flexibility for future expansions when the economy and company enter a growth cycle again.
Secondly, this situation ensures that Clarkson Lumber can effectively operate with Suburban Bank even if Northrup Bank refuses to provide credit. This is important because if the company can successfully function with Suburban Bank, it will likely be able to do the same with Northrup Bank, but with greater flexibility since it will have a higher credit limit and similar interest rates.
Next, I will consider a third scenario where Clarkson Lumber’s rapid growth persists and the company is able to discontinue its association with Suburban Bank in order to obtain credit from Northrup Bank. This particular scenario will be represented in tables 3, 3.2, and 3.3. Similar challenges as those faced in the first scenario will arise if the rapid growth rate of 22 percent is maintained throughout 1996, 1997, and 1998, followed by a decline to five percent thereafter.
Capital expansion is necessary to continue growing, but it comes with the challenge of increasing variable costs, fixed costs, capital replacement, and working capital alongside net sales and the inflator. This puts a strain on cash flow and requires financing. Luckily, Clarkson Lumber has secured an additional $350,000 in available financing from Northrup Bank, which will make growth more affordable. By taking full advantage of a two percent trade discount and avoiding payable trade accounts with extra cash, Clarkson Lumber can reduce the v-factor from 74 percent in table one to 73 percent in table three. Furthermore, the w-factor will increase from 15 percent in table one to 17.6 percent in table three. A v-factor of 73 percent indicates that Clarkson Lumber’s cost of goods sold is 73 percent, positioning it among the top five percent or higher within the industry according to the case book’s industry statistics. This impressive achievement can only be possible if Mr. Clarkson’s business associates’ claims are accurate, asserting that he is highly conservative in managing every aspect of his business.
Keeping costs low and maintaining personal control over every aspect of the company is crucial for Clarkson Lumber. When comparing the gross debt rows from table one and table three, it can be observed that the gross debt decreased by over three percent in 1996 and by over five percent in 1997. This reduction in debt was a result of the decrease in cost of goods sold, which was achieved by using cheaper materials. Despite saving costs and reducing the amount of debt needed for its growth, I consider this scenario to be undesirable for Clarkson Lumber from a financial perspective.
In 1996, Clarkson Lumber can maintain its gross debt within the limit set by Northrup Bank. This is because, after studying the liabilities on the balance sheet, the highest level of gross debt that can be reached is $969,000. Therefore, Clarkson Lumber can stay within this limit by $153,000 that year.
Moving on to 1997’s column on table three, it becomes evident that Clarkson Lumber will exceed the gross debt limit of $969,000 by $130,000. This means that the firm’s gross debt will reach almost $1.1 million.
After 1997, the gross debt goes below the ‘ceiling’ level to $951,000. However, Northrup Bank has decided to only extend credit of $750,000 to Clarkson Lumber, instead of the desired $880,000. This situation is not sustainable for the company. If Clarkson Lumber is unable to achieve a 22 percent annual growth with the higher credit ceiling from Northrup Bank, they will need to limit their growth to prevent excessive debt. Tables 4, 4.2, and 4.3 will illustrate the sustainable growth levels that Clarkson Lumber needs to adhere to in order to avoid accumulating excessive debt.
In order to maintain its current growth rate of 22 percent, Clarkson Lumber should accept credit from Northrup Bank while maintaining the same factors as in the previous scenario. This growth is expected to result in net sales of approximately five and a half million dollars for 1996. Following this, growth should be controlled at a maximum rate of 18.5 percent annually for the next two years. After this period, growth will slow down to five percent annually. It is important to limit growth in the two years following 1996 in order for Clarkson Lumber to keep its gross debt at a sustainable level. This will be achievable due to the savings from capital expansion, variable costs, fixed costs, capital replacement, and working capital.
When reviewing table four, it is evident that Clarkson Lumber’s gross debt consistently stays below the $969,000 limit, with the highest point being $951,000 in 1997. This provides a small cushion of $18,000. My recommendation for Clarkson Lumber is to accept Northrup Bank as a new creditor and cut ties with Suburban Bank. This decision will be advantageous in both the more likely scenario of continued rapid growth and the less likely scenario of slow growth. With Northrup Bank’s higher credit limit, Clarkson Lumber can save two percent on materials expenses, resulting in additional funds for expansion.
Unfortunately, due to Clarkson Lumber’s debt situation, I advise Mr. Clarkson to maintain industry-leading cost levels to facilitate maximum growth potential. Additionally, I suggest that Clarkson Lumber restrict its growth rate to a maximum of 18.5 percent beyond 1996 in order to avoid escalating debt to an unsustainable level. Looking ahead to 1999 and beyond, I recommend limiting growth to a sustainable level of around five percent or slightly above, to prevent further increases in debt levels.
