Gilbert Lumber Company
Background
• Owner-managed company set up in 2004
• Profitable; Sales rapidly expanding for several years; didn’t borrow upto Year 2010
• 2011: GLC took $71,000 mortgage loan; issued $105,000 note to buyback equity shares
• GLC took unsecured WC loan from Ferryn National Bank in 2012 with $250,000 limit
• WCR have outrun its capacity to generate funds internally
• The firm is forced to give up Cash discounts on payables;
• It had to borrow increasing amounts from FNB to maintain its sales growth
• Q1/2014 saw low growth The decision before Mr. Palmer Gilbert is
• Whether to continue to expand, and if so, how to raise necessary funds vs. slowdown
• The decision before Khai National Bank is:
• How much loan could be granted to GLC; Probable repayment schedule on its loan
• Nature and degree of risk in lending to GLC appropriate terms for the loan
Q1. Why this profitable business has to borrow to support asset
growth (how was the $243,000 bank loan used in these 9
quarters?)
Year 2011
Gilbert took $71,000 mort loan. Used it to clear something?
Evidence: the cash on 31-dec-11 should have been $110,000.
Year 2012:
Operations was self-sufficient in yr 2012 (CFFO= $13,000).
Might have foregone cash discount on some
Year 2013:
Not much flexibility Gave up cash discounts completely
Q1 of 2014:
Cash reserves were drawn to fund the capex.
Supplier forced converting some AP into notes payable
Summary:
1. Rapid sales growth assets up WC loan used for capex
2. Buyout added to financial pressure. No flexibility from the bank
Does OPM suffered in 2013? Explain 114K increase in 2013 WCR?
Further analysis: Operating cycle
Reasons for higher investment in OA (OC analysis):
1. OC is lengthening year-after-year
2. Both Sales and purchases rose rapidly
3. Together, they damaged the fin condition,
despite very good support from suppliers
Investment in AR is understandable. Why did ACP increase?
Liberal credit. Had AR not rose, EFR would be lesser.
Funds unlocked from AR (at 37 days) = $145,350
Cash cycle: focuses on debt & equity financing
1. Retained profits alone were not sufficient
2. Bank funding helped it a lot in
Sales growth 18% 34% 3% 2012: gave up some profitability to chase sales growth
2013: pressure from suppliers gave up some more
2014: pressure from suppliers and bk mostly cash sale
• OC analysis ignores the support from AE and other CA
16.9 Accounts payable and Accruals
Accruals
• Increases automatically or spontaneously as firm’s operations expand
• Wages paid weekly, bi-weekly, monthly basis
• Income taxes, social security payments, TDS, sales-tax
• Neither the timing nor amount controlled.
Qn.2 Why companies invest in inventory?
Any measurement issues?
• To support the level of activity during the forthcoming time period
• Q1 inventory is a seasonally low point!
• Inventory level should be high in anticipation of seasonal build-up of sales in Q2
• Inventory turn based on Q1 level would be misleading.
• Inventory turn based on year-end inventory level will also be misleading!
• If inventory turn is based on average inventory during the year, then the pattern of Gilbert
Lumber seems quite stable.
How to estimate increase in net PPE?
• 162 / 3600 = 4.5%
• Increase in net PPE is consistent with the growth in sales
Whether rapid sales growth always results in substantial financing pressure?
Qn3. Profitability and asset intensity linkage
(Impact of rapid sales increase on External financing)
Cash cow Dog Bright Star
Model 1 Model 2 Model 3
Customer pays in advance Sold on long credit period Sold on long credit period
Inventories are very low Inventories are high Inventories are high
Net PPE is very small Net PPE is high Net PPE is moderate
Profitability is moderate Profitability is low Profitability is high
Rapid sales growth results in Rapid sales growth results in The firm can self-finance the asset build-up
flood of cash to be invested huge funding requirement that supports rapid sales growth
Rapid sales growth
A large appetite for
A long cash cycle
external finance
Low profit margin and retention
Qn.4 Assess the financial strength in Q1/2014
Total-debt to Asset ratio (L/A) 0.55 0.59 0.63 0.67
• Liquidity condition weakened + Leverage rose fin condition has weakened a lot!
• In the absence of improved profitability,
• Continued rapid growth would lead to further weakening of fin position
• Estimate the rate of sales growth that does not further weaken the BS assuming:
• No change in Sales/TotalAssets
• No change in TL/OE This growth rate
• No equity issuances or repurchases is referred to as
• A return on beginning equity (ignore salary) = 20%, and
• Continuation of the policy of no dividend payments SGR
Qn.6 $465,000 is sufficient for foreseeable
future. Validate this judgement!
• DECISION point
• Whether to rely on trade credit OR pay promptly to avail 2% discount?
• Is it beneficial to borrow at 10.5% to avail cash discount?
• Does he have financial flexibility with the old bank at present?
• TC is major source for SMEs they don’t qualify for financing from other sources
• Lengthening the CP, as well as expanding sales and purchases, generate additional financing
• The trade credit, in general, is very costly! True price = gross amount ( 1 – discount percent) cost of
not taking TC can be substantial.
• Always use the free component!
• costly component used when EAC < cost of capital
• For Gilbert,
• The cost of 2/10, net 30 = 37.25% p.a. (simple APR)
• The cost of 2/10, net 44 = 21.91% p.a.
Bank finance
Options available to Mr. Gilbert
Debt finance
Long term debt
Take Very large
Trade need for finance
discounts Raise new equity capital
Rapid
Sales growth
Raise new equity capital
Forgo Large need
Trade for finance Bank finance
discounts Debt finance
Long term debt
Forgo No need for finance
Slow or No Trade Bank finance
Sales growth discounts Debt finance
Take No need for Long term debt
Trade Additional finance
discounts Raise new equity capital
16.9 Accounts payable and Accruals
(Trade credit)
• Gilbert did not have flexibility between TC and bank credit
• Old Bank capped the funding at $250,000
• Supplier forced Gilbert to convert part of AR into trade receivables!
• He may be stretching payment to some suppliers in order to avail cash
discount from other suppliers.
• Impairing general credit standing may not be a good idea!
• In the periods of excess capacity, firms may be able to get away with deliberately paying late, or
stretching the AP.
Qn. 7 Is it better to offer CD by Gilbert to
his customers?
• Offering 2/10, n/30 may reduce ACP to 25 days
• Bills are issued at beginning of next month
• Seasonal dating leads to further lengthening of ACP
• Some customers may be stretching the payment beyond 44 days
• Perform the aging analysis and offer the cash discount to delinquent
customers only
% sales approach to estimate the EFN 3,600 sales target: No purch. discount
¿ = 0.3463 * (3600-2694) – 0.1095*906 – 1.633%*3600*1
= 313.77 – 99.21 – 58.80 = 155.76
Bank loan = 233 + 155.76 + 7 = 395.76 Sufficient funding is available to achieve sales target.
% sales approach to estimate the EFN 5,500 sales target: No purch. discount
¿ = 0.3463 * (5500-2694) – 0.1095*2806 – 1.633%*5500*1
= 971.79 – 307.26 – 89.83 = 574.69
Bank loan = 233 + 574.64 + 7 = 814.64 Sales target can’t be achieved as sufficient funding not available.
% sales approach to estimate the EFN 3,600 sales target with purch. discount
COGS/Sales for year 2014 = 0.72383 * 0.98 = 0.70935 COGS for year 2014 = 2,553.67
COGS saved in year 2014 = 0.72383*2% = 1.448% of 2014 sales
Net profit margin for year 2014 = 1.633% + 1.448% * (1-0.1698) = 2.835%
Inventory on 31-Dec-2014 = 0.1552 * 3,600 = 558.57
418 + X – 2553.67 = 558.57
X = 558.57 + 2553.67 – 418
= 2,694.24 (after deducting purch disc.)
AP on 31-Dec-2014 = 2,694.24 * 10/365 = 73.81
AE on 31-Dec-2014 = 3,600.00 * 1.45% = 52.12
Spon. Liabilities on 31-Dec-2014 = 125.93
Increase in Spontaneous Liabilities during year 2014 = 125.93 – 295.00 = - 169.07
¿ = 0.3463 * (3600-2694) – X *906 – 2.835%*3600*1
= 313.77 – ( –169.07) – 102.07 = 380.77
Bank loan = 233 + 380.77 + 7 = 620.77 Sales target can’t be achieved as sufficient funding not available.
% sales approach to estimate the EFN 3,600 sales target with purch. discount
% sales approach to estimate the EFN 5,500 sales target with purch. discount
COGS/Sales for year 2014 = 0.72383 * 0.98 = 0.70935 COGS for year 2014 = 3,901.45
COGS saved for year 2014 = 0.72383*2% = 1.448% of year 2014 sales
Net profit margin = 1.633% + 1.448% * (1-0.1698) = 2.835%
Inventory on 31-Dec-2014 = 0.1552 * 5,500 = 853.38
418 + X – 3901.45 = 853.38
X = 853.38 + 3901.45 – 418
= 4,336.83 (after deducting purch disc.)
AP on 31-Dec-2014 = 4,336.83 * 10/365 = 118.82
AE on 31-Dec-2014 = 5,500.00 * 1.45% = 79.62
Spon. Liabilities on 31-Dec-2014 = 198.42
Increase in Spontaneous Liabilities during year 2014 = 198.42 – 295.00 = - 96.58
¿ = 0.3463 * (5500-2694) – X *2806 – 2.835%*5500*1
= 971.79 – ( –96.56 ) – 155.93 = 912.42
Bank loan = 233 + 912.42 + 7 = 1,152.42 Sales target can’t be achieved as sufficient funding not available.
% sales approach to estimate the EFN 5,500 sales target with purch. discount
Percentage of sales approach: SUMMARY
Don’t avail
purchase
discount
Avail the
purchase
discount
Don’t avail
purchase
discount
Avail the
purchase
discount
Further on financing
Gilbert Knows that most of this bank financing will turnout to be a long-term debt as
it has to be rolled over.
Advantages of short-term debt Disadvantages of Short-term debt
• Can be obtained much faster • If it borrows on LT basis, the interest costs
• LT credit requires thorough fin examination will be stable over time
and documentation in great detail
• If a firm borrows heavily on ST basis, a
• Ability to reverse the decisions at lower temporary recession may render it unable
cost compared to LT debt to repay (weak fin position) lender may
• Lower floatation costs not renew the loan forces the firm into
• No prepayment penalties bankruptcy.
• Less restrictive covenants doesn’t
constrain future actions
• Under normal conditions,
• STIR < LTIR (Term structure)
16.12 Key features of Short-term bank loans
Bulk of bank lending is short-term Revolving Credit Agreement
(Revolver) of Texas Petro
• written as 90-day revolving notes • Formal commitment to lend for 4 years upto
stating $10OM at P+50
• • Annual commitment fee (0.25% - 1%) payable
Amount borrowed; IR and frequency;
monthly on unused
• repayment schedule;
• Rate is pegged to 3-m prime or T-bill or other mkt-
• any collateral; determined
• and any other terms and conditions • Unrestricted draw-down schedule
• Compensating balances ranging • Clean-up clause (1 day or 1 month?)
from 10% to 20%. • Designed to help finance –ve OCF that are incurred as a
natural part of a company’s business cycle (Not a source of
• Clean-up clause may not be present! permanent capital!)
• Positive OCF during other periods shall be used to pay it off.
16.14 Uses of security in Short-term
financing
• Loans can be secured if deemed necessary or desirable
• For WC advances, banks seek security in the form of
• Hypothecation agreement
• Loan against security of movable property (say, inventory)
• Owner does not part with the possession of property
• Rights of lender depend upon the terms in the agreement
• On default, lender can file a suit to realize his dues by selling the goods hypothecated
• Pledge agreement
• Owners deposits the goods with lender as security for borrowing
• Transfer of possession of goods is a pre-condition for pledge
• Lender is expected to take reasonable care of goods pledged.
• On default, lender possess right to sell goods and recover dues
Banker’s perspective
• Khai Natl Bank shall offer a long-term loan to Gilbert!
• Little probability that bank loan can be repaid till sales growth is curbed
• Strong probability that bank will be requested to increase the loan size
• If Khai sees Gilbert as potentially a very valuable Long-term customer
• Long-run profits of the company is the basis for loan repayment
• Place severe restrictions before lending heavily to Gilbert
• In the event of collapse of earning power, the lien on AR and Inv helps the bank.
• If Khai felt that there was a significant chance that Gilbert would have
difficulty in complying with the terms of the loan, then
• It would be worth not to consider the loan at all.
Conclusions
• A Low profitability company may not be in a position to self-finance the asset
build-up.
• Super-normal growth in sales and Partner buyout would put heavy pressure on the
financial condition leads to future vulnerability
• Availing cash discount would make it further vulnerable to shocks
• Cash discount is certainly attractive than bank loan. One shall have good financial
flexibility to avail it.
• The $465,000 limit is not sufficient if cash discounts are availed
• A long-term loan is most suitable to Gilbert company.
• Collapse of earning power is a major risk to the lender. The bank needs to place
stringent conditions to extend loan.
Assignment questions
1. Why has Gilbert Lumber borrowed increasing amounts despite its consistent profitability?
2. How has Mr. Gilbert met the financing needs of the company during the period 2011
through 2013? Has the financial strength of Gilbert Lumber improved during the period?
3. Estimate the internal growth rate for years 2012 and 2013. Use the forecasted financial
statements approach to prove that these sales figures are correct.
4. How attractive is it to take the trade discounts?
5. Do you agree with Mr. Gilbert's estimate of the company's loan requirements? Use AFN
method to estimate the amount of external financing needed if it is
a.expected expansion in sales to $3.6 million in 2014 and not to take trade discounts?
b.expected expansion in sales to $3.6 million in 2014 and to take all discounts?
c.expected expansion in sales to $5.5 million in 2014 and not to take trade discounts?
d.expected expansion in sales to $5.5 million in 2014 and to take all discounts?
6. As Mr. Gilbert's adviser, would you urge him to go ahead with, or to reconsider, his
anticipated expansion and his plans for additional debt financing? As the banker, would
you approve Mr. Gilbert's loan request, and if so, what conditions would you put on the
loan?
Q1. Why has GLC borrowed increasing amounts despite its consistent
profitability?
Why has Gilbert Lumber borrowed increasing amounts
despite its consistent profitability?
Has the financial strength of Gilbert
Lumber improved during the period?
Q3. Estimate the internal growth rate for years 2012 and 2013. Use
FFS approach to prove that these sales figures are correct.
Q4. How attractive is it to take the trade discounts?
• DECISION point
• Whether to rely on trade credit OR pay promptly to avail 2% discount?
• Is it beneficial to borrow at 10.5% to avail cash discount?
• Does he have financial flexibility with the old bank at present?
• TC is major source for SMEs they don’t qualify for financing from other sources
• Lengthening the CP, as well as expanding sales and purchases, generate additional financing
• The trade credit, in general, is very costly! True price = gross amount ( 1 – discount
percent) cost of not taking TC can be substantial.
• Always use the free component!
• costly component used when EAC < cost of capital
• For Gilbert,
• The cost of 2/10, net 30 = 37.25% p.a. (simple APR)
• The cost of 2/10, net 44 = 21.91% p.a.
% sales approach to estimate the EFN
A/S = 0.3463 L/S = (256+39)/2694 = 0.1095 m = 1.633% d=0
IGR = 0.0163 (1 – 0) / (0.3463 – 0.1095 - 0.0163 (1 – 0)) = 7.3923%
AFN = 0.3463 – 0.1095) * 2694 * 0.073923 – 0.0163 * 2694 * 1.073923 = 0
3,600 sales target: No purch. discount
¿ = 0.3463 * (3600-2694) – 0.1095*906 – 1.633%*3600*1
= 313.77 – 99.21 – 58.80 = 155.76
Bank loan = 233 + 155.76 + 7 = 395.76 Sufficient funding is available to achieve sales target.
5,500 sales target: No purch. discount
¿ = 0.3463 * (5500-2694) – 0.1095*2806 – 1.633%*5500*1
= 971.79 – 307.26 – 89.83 = 574.69
Bank loan = 233 + 574.64 + 7 = 814.64 Sales target can’t be achieved as sufficient funding not available.
Q6. Whether $465,000 limit sufficient for long
period?
Assumptions under Forecasted Financial Statements approach
• Sales volume for 2014 would be $3,600,000 as anticipated
• The bank loan of $465,000 is sanctioned on January 01, 2014.
• Purchase discounts to be taken from Q1/14 to Q4/14.
• Historical relations that prevailed in 2011 – 2013 will continue in 2014
• Cost of goods sold is 72.4% of sales
• Average inventory turn is 5.2
• Operating expenses at 24.5% of sales
• 17% as marginal tax rate for year 2014
• (notes payable, trade) would be cleared immediately.
• Cash at 1.5% of sales; AR at 11.8% of sales;
• NO further investment in PPE (fixed at 162 level for rest of the year)
• AP at 10days’ purchase of yr14.
• Accrued expenses at 1.5% of sales
Sales = 3,600,000 COGS/Sales = 0.724 InvTOR = 5.2 OptgExp = 0.20*sales + dep + 95 tax rate = as per schedule
Cash / Sales = 1.5% AR / Sales = 0.118 NetInvt in PPE = 0 AE/Sales = 1.50%
Sales = 3,600,000 COGS/Sales = 0.724 InvTOR = 5.2 OptgExp = 0.20*sales + dep + 95 tax rate = as per sch.
Cash / Sales = 1.5% AR / Sales = 0.118 NetInvt in PPE = 0 AE/Sales = 1.50%
54
425
585
1064
157
2774
1221
3192
585 76
2607 54
993
1091
57
849
199 583
43 633
6 458
150 1091
40
110
Figures are in line with Gilbert’s expense in 2011 thru 2013
NOT UPDATED
Do not Do not
avail CD avail CD
• Gilbert need a much larger Line of credit to achieve 3,600 target. The peak loan would be further high:
• Inventory peak arises much before the end of year 2014
• At this time, he will have only a portion of 2014 profit
$3.24 mil sales can be targeted with $465,000 loan limit.
Which course of action is best from value perspective?
34% growth in sales ($3.60 mil) is most value-adding but not feasible due to capital constraint.
20% growth in sales ($3.24 mil) provides the highest EVA with the given $465,000 loan limit for WC.
