Cartwright Lumber Financials

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Cartwright Lumber Company

Case Report

1. Lumber industry

Cartwright Lumber Company is located in a growing suburb, which positively impacts the growth of the lumber industry and increases the demand for the company’s products which include plywood, moldings, and sash. What also helps the firm is that it owns a warehouse and has access to nearby railroads. Although the Cartwright Lumber Company didn’t have any sale representatives, the telephone sales based model has been effective over the years 2002 and 2003. In fact, sales grew by 18.6% in 2002 and 33.8% in 2003. Additionally, sales in Q1 2004 increased by 2.87% from the previous year. Indeed, the company’s sales figures improved over the past years; however, we believe that this was mainly driven by a rising product demand. Accordingly, we could assume that the business has forgone incremental revenues due to its price competitive model. Furthermore, our profitability analysis showed that the company has serious problems in managing its costs and inventory: Inventory/ Days Inventory Outstanding (DIO) has increased strongly from 2001 to 2003, suggesting a mismatch between observed growth in demand and inventory. This development leads to higher costs and indicates bad management. Hence, both, gross and net margin, have decreased over the past three years. First, gross margin fell to 27.6% in 2003 from 28% in 2001. Second, net margin decreased from 1.8% in 2001 to 1.6% in 2003. The net profitability of the firm was impacted by the interest payments due on the $70,000 loan. To improve its position the company could focus on different operational aspects. First, the firm produces a higher percentage of its revenues during the second and third quarter. Thus, assuming weak seasonality, marketing efforts could enhance the firm’s revenues. Additionally, a change to a more pro-active business model could foster sales in historically weak quarters. This could take the form of direct marketing to (potential) clients who would otherwise postpone purchases or buy from competitors. Second, management could engage in additional optimization of its production costs and efficiency, which would ease some pressure on the gross margin. Finally, a hike in prices could be adopted while, in return, offering the customers some discounts, bundle prices, and loyalty programs.

1. Need for additional borrowings despite profits

Although the firm has been profitable, it hasn’t been sufficiently liquid for two main reasons. First, Mark Cartwright‘s purchase of Stark’s share could not be financed with the available liquidity in 2001. Thus, a loan of $70,000 was needed to execute this transaction. This has created an obligation to repay the interest and principle on a yearly basis. Since the company already had a shortage of funds prior to the deal; more loans were needed for the repayment of the loan and the continuation of operations. The cash balance in year ended 2001 was equal to $58,000; therefore, the company was short on funds to close the deal. Second, Lumber has continuously been tying cash in its Working Capital. This is mainly the result of an inventory build-up and increase in Days of Sales Outstanding (DSO); in contrast, the cash balance was low and has even been decreasing. The company was selling its products on credit, therefore its account receivables were largely increasing. In fact, the account receivables grew by 85.5% in the period 2001-2003, whereas the cash account decreased by 29.3% in the same period. This observation can be explained by either bad management or a strategic action. In latter case, Lumber might aim to attract more customers or offer larger bulks to (potential) customers at favourable payment conditions, creating a competitive advantage for the company. However, since the company was not publicly listed at that time, it was unable to raise funds through equity and, thus, additional loans were needed to fund the operating business. In Q1 of 2004, however, Lumber opted for an alternative form of financing, the trade notes payable. In general, this form of financing is likely to enhance uncertainty among third parties, such as suppliers.

1. Financial situation of Lumber

After calculating the current, quick, and cash ratio, we were able to depict a clear decreasing trend in the liquidity measures. At first, one can assume that the firm is financially healthy by analysing the current ratio. Even though the current ratio was decreasing in the last three years it was still above 1.  However, when moving to the quick ratio, we noticed that in all three years the ratio was below 1. By excluding the large amount of inventory, we concluded that the firm is unable to cover its future obligation with its current assets. Furthermore, the firm’s cash ratio indicated that it is not able to pay off its current liabilities with only cash and cash equivalents. The cash ratio decreased in 2003 to a very low level of 7.66%, which explains its continuous demand for loans. This observation is highlighted when analysing the needs for funds for operations (Accounts Receivables + Inventory – Accounts Payable) and the Working Capital (Current Assets – Current Liabilities): While the needs for funds for operations increase, Working Capital increases as well, indicating that an increasing portion of financing for operations stems from long-term financing. The analysis of the company’s cash flow statements allows us to understand that the increase in receivables and inventories were balanced by an increase in accounts payable and the acquisition of new loan. Without further financing activities, the firm closes each year with a negative change in its cash balance, indicating a strong use of cash funds. Furthermore, the firm was investing in PPE although it had not enough cash to cover the expenditures.

1. Attractiveness of trade discounts

To assess whether trade discounts are beneficial it is necessary to analyse the trade-off between the cost of raising short-term funds and the cost of trade credit when not taking the discount. If Cartwright Lumber can borrow money at a lower rate than the cost trade credit (the cost of not taking the discount), then it should be attractive to pay suppliers within the discount period. According to the data provided (discount rate of 2%, normal payment deadline of 30 days and 10 days payment deadline to get the discount) and using the following formula: ^[1]; we conclude that the cost of trade credit is 44,59%. Taking the 11% interest rate paid on the $70.000 loan as a benchmark, it becomes very clear that the cost of taking the discount is worth taking in a normal scenario. However, if we consider the poor liquidity situation of the company (especially if the new loan agreement is not received, leaving the company using almost the full line credit amount of $250.000), trade credit, even if costly, might be crucial in order to avoid bankruptcy.[pic 1]