As a financial consultant to Clarkson Lumber, I analyzed four potential scenarios with relatively high probabilities of occurring given Clarkson Lumber’s current situation. The four scenarios analyzed are 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. Clarkson Lumber’s first scenario is one of continued rapid growth with Suburban Bank as the creditor and is represented by tables 1, 1.
2, and 1. 3.
Using the most relevant expectation of about five and a half million dollars in 1996 net sales for Clarkson Lumber, as given by Northrup Bank’s investigator along with historical income statement data, I found that an annual growth rate of 22 percent was reasonable this scenario. Rapid growth of 22 percent applies during 1996, 1997, and 1998, before dropping to a sustainable annual growth rate of five percent thereafter. To achieve the expected growth rate of 22 percent for the next three years, Clarkson Lumber must continue capital expansion through 1997 that began in 1995 after rapid growth has begun a few years earlier.
Continued capital expansion is mandatory because Clarkson Lumber seems to be at sales capacity. Expansion will require 14 cents of investment for every dollar of net sales growth at a growth rate of 22 percent. In addition to costs for expansion, variable costs, fixed costs, and capital replacement will increase at their historical ratios and levels relative to the growth rate in a rapid growth situation. Finally, substantial increases in working capital will be required to manage inventory and accounts payable along with any possibility spontaneous accruals or needs for cash (which I assumed would not be spontaneous).
This scenario assumes that Clarkson Lumber will keep its future w-factor close to the historical levels by continuing to take full advantage of payable trade accounts to lower the need for working capital. My conclusion for this scenario is that the situation is unsustainable given the current credit ceiling of $400,000 from Suburban Bank. Taking into account the costs of rapid growth explained in the previous paragraph, Clarkson Lumber would need to stop any growth sometime during 1996. Table one shows gross debt increasing from $610,000 to $842,000, an increase of $232,000.
From my calculation of Clarkson Lumber’s debt situation, it is limited to only nine thousand dollars of debt increase with Suburban Bank, which the company reaches in the first quarter of 1996 according to the balance sheet. This situation is undesirable because Clarkson Lumber would be limited to very slow growth by Suburban Bank. A scenario of slow growth with Suburban Bank as the creditor is the next situation analyzed and will be represented by Tables 2, 2. 2, and 2. 3. This scenario assumes an economic slow down and the slow down of the once rapidly growing suburb Clarkson Lumber operates within.
Because of the nature of Clarkson Lumber’s repair business the case book mentions; slow growth of five percent would be expected for the company, instead of a flat or negative growth rate. Because of the slow growth rate, the inflator for Clarkson Lumber is set to the inflation rate of four percent, limiting growth rates of variable costs, fixed costs, and capital replacement. Because of the low growth rate, working capital needs will become almost flat and there will be no expansion costs within the foreseeable future.
Further, in this scenario I would expect Clarkson Lumber to take advantage of some trade discounts and avoid using payable trade accounts as cash and credit become available while gross debt is paid off, moving the v-factor down to 73. 5 percent and the w-factor up to 16. 5 percent. While slow growth due to an economic downturn is always bad news for a company that just had a geometric average growth of over 23 percent for the previous two years and started capital expansion as a result, this situation could benefit Clarkson Lumber in a few ways.
First, Clarkson Lumber would payoff a substantial amount of debt each year from positive free cash flows after 1996 (which has a negative CATO because of the last $100,000 principal payment to Mr. Holtz). A much lower debt position would put Clarkson Lumber in a much more flexible position to finance expansion once the economy and company begins a growth cycle again. Second, this situation allows Clarkson Lumber to operate effectively with Suburban Bank if Northrup Bank declines credit to the company. This is important to note because if the company can urvive and operate effectively with Suburban Bank, it undoubtedly will be able to do the same with Northrup Bank with more flexibility due to a higher credit ceiling with a similar interest rate. Now I will examine a third scenario where Clarkson Lumber’s rapid growth continues and the company is able to sever its ties with Suburban Bank in order to receive credit from Northrup Bank. This scenario will be represented in tables 3, 3. 2, and 3. 3. Many of the same issues will be faced by Clarkson Lumber from the first scenario if rapid growth of 22 percent applies during 1996, 1997, and 1998, before dropping to five percent thereafter.
Capital expansion must continue while variable costs, fixed costs, capital replacement, and working capital all grow with net sales and the inflator, forcing a drain on cash and demanding financing. Fortunately for Clarkson Lumber, an additional $350,000 in additional available financing from Northrup Bank will make growing less expensive. If Clarkson is able to take full advantage of the two percent trade discount with extra cash while avoiding payable trade accounts, it can drop the v-factor from 74. percent in table one to 73 percent in table three while the w-factor will rise from 15 percent in table one to 17. 6 percent in table three. A v-factor of 73 percent means that Clarkson Lumber’s cost of goods sold is 73 percent, which based on the industry statistics in the case book would land around the top five percent or higher of the industry. This amazing accomplishment is only feasible if what is said by Mr. Clarkson’s business associates holds true, that he is extremely conservative with all aspects of his business.
This involves keeping costs as low as possible with personal control over every feature of the company. Comparing the gross debt rows from table one versus table three shows how gross debt fell over three percent in 1996 and over five percent in 1997, contributed to the decrease in cost of goods sold due to cheaper materials. In making a financially analytical conclusion from this scenario, I found this scenario to again be undesirable for Clarkson Lumber despite the fact it has saved some costs and reduced the amount of debt its growth will require.
Looking at the gross debt in 1996 on table three, Clarkson Lumber will be able to keep that years gross debt level within the window allowed by Northrup Bank by $153,000, considering the highest level of gross debt that can be reached in $969,000 after analyzing the liabilities in the balance sheet. Meandering into 1997’s column on table three reveals that Clarkson Lumber will break the gross debt ‘ceiling’ of $969,000 by $130,000, reaching almost one and one-tenths million dollars in gross debt.
After 1997, gross debt falls back below the ‘ceiling’ level to $951,000 in gross debt, but unfortunately Northrup Bank has decided only to extend credit of $750,000 to Clarkson Lumber, not $880,000, making this scenario unsustainable. If Clarkson cannot grow at 22 percent annually with Northrup Bank’s higher credit ceiling, then the company must mitigate some of its growth to prevent unsustainable debt levels. This last scenario will evaluate the sustainable growth levels Clarkson Lumber must stay within to prevent a build up of excessive debt and will be represented through tables 4, 4. 2, and 4. 3.
Keeping all of the factors the same as the previous scenario while accepting credit from Northrup Bank, Clarkson Lumber should allow rapid growth to continue at 22 percent for 1996 to the expected net sales level of about five and a half million dollars, followed by two years of growth controlled to a maximum of 18. 5 percent annually before growth slows to five percent annually. Limiting growth in the two years following 1996 is important because the savings from capital expansion, variable costs, fixed costs, capital replacement, and working capital will allow Clarkson Lumber to keep its gross debt at a sustainable level.
Viewing gross debt levels in table four reveals that Clarkson Lumber’s gross debt never passes the $969,000 ‘ceiling’ level, only reaching $951,000 in 1997 which allows for small but potentially important buffer of $18,000. My recommendation to Clarkson Lumber is to accept Northrup Bank as a new creditor while severing ties from Suburban Bank, which will be beneficial in the more probable case of continued rapid growth along with the less probable case of slow growth. Northrup Bank’s extended credit ceiling will allow Clarkson Lumber to save the potential two percent on materials, creating additional funds for growth.
Unfortunately the reality of Clarkson Lumber’s debt situation means that I must recommend Mr. Clarkson keep costs at an industry leading level to allow for maximum growth potential. Further, I recommend that Clarkson Lumber limit its growth potential beyond 1996 to a maximum of 18. 5 percent in order to prevent the costs of growth from increasing debt to an unsustainable level. My recommendation for 1999 and beyond is to limit growth to a sustainable level around five percent or not much higher to prevent debt levels from increasing further.
Cite this Clarkson Lumber Case
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