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Gilbert Lumber Case - A11
Corporate Finance (Universitat Ramon Llull)
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GILBERT LUMBER CASE - Group A11
(Anna Fagotto, Juan Antonio Fernández Chaves, Namrata Chandrasekhar, Nicolas Beni, Tamara Kinga Kruczek)
Question 1
For a structured analysis of the industry and the positioning of the company, the research was
centered on the SWOT analysis and Porter's Five Forces model.
The main strengths start from the powerful and trustworthy image of the owner and the brand in the
suburb where they operate, that lead to a constructive relationship with the suppliers and the
customers. The experience and working style of Palmer Gilbert helped the company to build an
effective supply chain and operation system, that allows them to reach great results in terms of price
competition, linked with the strategic position close to the railway station and in an economically
growing suburb. Lumber’s competitive pricing allows it to build up high barriers against new entrants.
The diversification of the business into construction and repairs plays a great role combined with the
stable demand of the repairs business.
As for the weaknesses, the Accounts Payable is increasing constantly, in combination with an increase
in Accounts Receivable, therefore increasing the need for cash while expanding the business.
Moreover, the Inventory Turnover is low and the finances are absorbed by a costly Inventory. Also, the
conservative nature of the business leaves little room for innovation. Further, since the market is
growing for the suppliers as well, the company might have high bargaining power with the suppliers,
but cash shortage and low Inventory Turnover might affect the relationship and power.
The company has many opportunities, starting from growing demand in increasing suburbs, which
may suggest the opportunity to expand the business in other areas using different marketing and
channels of sales, fostered by the proximity to the railway station, making the logistic process more
efficient.
Concerning the threats, the weaknesses that were previously explained will most probably lead to a
shortage of cash, and the probability of not being able to meet their liabilities. Moreover, it is crucial
to consider new materials and metals that can represent a substitute product.
Question 2
The key factor to understanding the underlying reasons for additional borrowing, is a combination of
growing demand and cash shortage caused by the following factors.
Firstly, a decrease in profitability, visible in the decline in Gross Profit Percentage and Operating
Margin Percentage.
Secondly, an increase in the Days Sales Outstanding - the company needs more days to collect the
money from the sales, which is increasing the shortage of cash. Moreover, an increase in Accounts
Payable further impacts the shortage of cash.
Thirdly, a low Inventory Turnover and a high Inventory indicates that the company has tied up financial
resources, further contributing to increase of cash shortage.
Finally, Operating Cash Flow Ratio is also decreasing, thereby indicating that the company’s ability to
finance itself from operating income is reducing. Hence, bringing about a need for more borrowing.
An additional factor, which should be highlighted, that caused the increasing need for money, is the
recent buyout that the company made and the consequent rising of debt obligations.
Question 3
3.1. Analysis of short term liquidity ratios
The Current Ratio of Lumber is over 1.0, indicating that the company’s current assets are sufficient to
cover its Current Liabilities. However, it is to mention that the ratio is decreasing. Since the Current
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Ratio includes Inventory and given the fact that Inventory Turnover of Lumber isn’t good, the Current
Ratio is not adequate to estimate Lumber’s ability to meet its short term debt obligation.
Therefore, a more adequate ratio to assess the company's short term liquidity is the Quick Ratio.
Calculating this ratio, it can be seen that it is below 1.0, which means that the company is not able to
meet its Current Liabilities with its Cash and Accounts Receivable.
Further it can be seen, that the company is not able to meet its short term debt from his Operating
Cash Flow, which means that the money generated out of their operations is not sufficient to serve
the short term debt of the company, which will most likely require them to acquire more debt.
All three ratios show a decreasing trend, which signals that the short term liquidity will worsen in the
future.
Ratio 2011 2012 2013 Trend Average
Current Ratio 1,80 1,59 1,45 -11,41%
Quick Ratio 0,88 0,72 0,67 -14,96%
Cash Ratio 0,22 0,13 0,08 -70,65%
Operating Cash Flow Ratio 0,19 0,16 0,16 -9,71%
3.2. Analysis of Debt Management ratios
By looking at the Times Interest Earned Ratio, it can be seen that by now the company is still able to
pay its interest obligation of the current year with their Net Income. However, this ratio is decreasing,
which could signal that in the future the company will not be able to meet its interest obligations.
Further it can be seen that the short term debt obligation is increasing, since the Debt-to-Equity ratio
is increasing on average by 15% while the Long-Term-Debt-to-Equity ratio is decreasing by 28%. This
is especially critical, since the company is already not able to meet its Current Liabilities (see 3.1),
which will subsequently put the company financially under more pressure.
A major part of the increasing Current Liabilities in 2013YE is due to the Accounts Receivable which
accumulate to 47,9% of Total Current Liabilities. In 2014, the Accounts Receivable and Trade Notes
Payable accumulate combined for 58% of Current Liabilities. This could be an indicator that the
company could soon not be able to pay its suppliers.
Ratio 2011 2012 2013 Trend
Times interest Earned 3,85 3,05 2,61 -21,57%
Long Term Debt to Equity 0,24 0,19 0,14 -28,46%
Debt to Equity 1,20 1,42 1,68 15,51%
Long Term Debt to Total Assets 0,11 0,08 0,05 -41,82%
Debt to Total Assets 0,55 0,59 0,63 6,73%
3.3. Analysis of Asset Efficiency ratios
Looking at the Days Inventory Outstanding (DIO), shows that it took the company about 78 days to
turnover its Inventory fully back in 2013. This is especially critical as about 53% of the Current Assets
is made up of Inventory. As it takes them so long to sell its Inventory, it is tying up lots of his assets and
financial resources, that can not be used for other means (i.e. paying of short term debt). It is even
more critical, due to the fact, that the Inventory Turnover is an increasing number, as well as the
Inventory in 2014Q1 made up almost 60% of total Current Assets, tying up even more capital of the
company.
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The Days Sales Outstanding (DSO) ratio signals, that it takes the company over 40 days to collect
money for its sales and trending towards an increase of this number, which could further lead to a
cash shortage, if the company does not receive their money in time.
The increasing Days Payable Outstanding Ratio (DPO), shows that Lumber is facing increasingly
difficulties to pay back its Accounts Receivable in due time (less than 30 days), which as seen before is
due to the increasing DSO and DIO, signalling the before mentioned cash shortage to pay off Current
Liabilities.
Ratio 2011 2012 2013 Trend
Days Inventory
Outstanding 71,39 82,80 78,24 3,98%
Days Sales Outstanding 36,78 40,25 42,95 7,45%
Days Payable Outstanding 37,04 48,77 47,92 11,14%
Operating Cycle 71,13 74,29 73,27 1,43%
3.4. Analysis of Profitability ratios
All of the company's profit margin percentages are decreasing, especially the Operating and Net Profit
Margin is decreasing on an average of 5,29% and 5,78% respectively.
Ratio 2011 2012 2013 Trend
Gross Profit Percentage 27,99% 28,61% 27,62% -0,72%
Operating Margin Percentage 2,18% 2,04% 1,97% -5,29%
Net Profit Margin Percentage 1,83% 1,69% 1,63% -5,78%
Return on Assets 6,07% 5,41% 5,52% -5,09%
Return on Equity 11,48% 11,18% 12,64% 4,44%
To put it all together, the financial situation of Lumber is increasingly showing signs to be unhealthy.
Starting off, that most of the company’s assets are tied up in Inventory, while an increasing Inventory
Turnover, points out, that the company is not able to meet its short term debt obligation (Quick Ratio
< 1). This cash shortage is even increased by the fact that the Lumber takes longer to collect the money
from its sales, which is actually expressed in the high amount of Trades and Accounts Payable (58% of
current assets) and by the increasing difficult to pay back its Accounts Payable (increasing DPO). All
this combined with a decreasing profitability leads to a severe cash shortage, which needs to be
financed.
The company being not able to pay off its short term debt with its operating activities further signals,
that the money generated from operations is used to finance Inventory. Hence assuming trends
continue, in order to pay off its Accounts Payable the company needs to take on new debt, which
could subsequently further harm their financial stability.
Question 4
Applying the 2% discount on purchases of 2011, 2012 and 2013, the company would be reducing the
cost of goods sold by $25k, $30k and $49k respectively, thereby boosting the net income up to $52k,
$59k and $77k respectively (after adjusting for taxes). However, the Days Payable Outstanding
average at 44.57 days for the 2011-2013 period, arising as a result of tied up capital and Inventory and
Days Sales Outstanding (DSO) averaging at 40 days. Therefore under the current scenario, paying
suppliers within 10 days to benefit from the 2% discount would not be possible given the shortage of
cash.
The reason for the cash shortage is the high Inventory cost and high DSO which brings about a need
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for additional borrowing to meet operating expenses. However, given the downward trend in the
Current and Quick Ratios which indicates that the company is finding it increasingly difficult to meet
its short-term debt obligations, the additional borrowing may further deteriorate these ratios. So,
while the 2% discount is attractive, it is unattainable until the company has increased inventory
turnover and reduced days sales outstanding.
Question 5
To validate the reliability and accuracy of Mr. Lumber’s estimation, the reasoning proceeded assuming
a 2014 sales volume of $3.2 million, the forecasts are as follows (all figures in thousands of dollars):
2011 2012 2013 2014 Forecast
Net sales $1.697 $2.013 $2.694 $3.200
Cost of goods sold
Beginning inventory $183 $239 $326 $418
Purchases $1.278 $1.524 $2.042 $2.433
$1.461 $1.763 $2.368 $2.851
Ending inventory $239 $326 $418 $518
Total cost of goods sold $1.222 $1.437 $1.950 $2.333
Gross profit $475 $576 $744 $867
Operating expenses $425 $515 $658 $771
Interest expense $13 $20 $33 $47
Net income before taxes $37 $41 $53 $49
Provision for income taxes $6 $7 $9 $8
Net income $31 $34 $44 $41
The forecasts were carried out with two different methods.
With respect to the Income Statement, Purchases, Ending Inventory, Operating Expenses and Interest
Expenses were forecasted by calculating the multiplicative trend with the past three years values. In
order to generate the forecast of the Balance Sheet, financial ratios, calculated for the 3 previous years
were used, summing the multiplicative trend effect. In particular, the COGS/Current Liabilities Ratio
was used for Current Liabilities and the Sales/Current Assets Ratio was used for Current Assets. With
these two values, the Working Capital need was obtained (Current Assets - Current Liabilities) and
subtracted from the forecasted Net Income to obtain the financial need. Finally, the last value was
summed with the $247k of the already existing bank loan, that needs to be repaid in order to end the
first banking relationship.
Calculation of Financing Need
Forecasted 2014 Current Assets (CA) $940 = Net Sales (2014) X estimated CA/ Net Sales ratio (2014) [29,39%]
Forecasted 2014 Current Liabilities
(CL) $715 = Net Sales (2014) X estimated CL/COGS ratio (2014) [30,64%]
Estimated working capital needs $225 = Forecast CA 2014 - Forecast CL 2014
Estimated external financing need $184 = Estimated Net Income (2014) - Estimated working capital needs
Estimated Net Borrowing: $431 = - Estimated external financing need + existing bank loans
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Trend Calculation (Balance Sheet)
Current Liabilities (CL) / Cost of Goods Sold (COGS)
Years 2011 2012 2013 Trend Estimated 2014
Ratio 21,28% 26,10% 27,44% 11,68% 30,64%
Current Assets (CA) / Net Sales
Years 2011 2012 2013 Trend Estimated 2014
Ratio 27,58% 29,61% 28,80% 2,03% 29,39%
Question 6
Acquiring more debt to finance the sales expansion will not solve the trend of having too much
Inventory and cash shortage. The main focus must be on sorting the Inventory, before buying new
quantities from suppliers, as it was mentioned before. Lowering the Inventory will free capital and give
them more liquidity to pay back their suppliers faster, which will improve their short term liquidity
ratio.
Further, it would be advisable to drastically decrease the Days Sales Outstanding (DSO) Ratio, in order
to collect money from sales faster. The company should give incentives (e.g. 1% discount) to their
customers if they pay their bill within the first 10 days. Additionally, he should charge a surplus if it
takes the customers longer than 30 days to pay back their obligation. By giving out the 1% discount,
Lumber can further improve one of its already existing competitive advantages, the good price
competition. If the customers pay within the 10 days period, the company will be able to profit from
the 2% discount granted by the suppliers, if Lumber is able to pay within 10 days of time. This would
subsequently increase their profitability again and generate more money to repay debt obligations.
Before thinking about financing option, it should become clear for Lumber that they can only escape
the debt cycle if they are able to improve their Days Sales Outstanding, Days Inventory Outstanding
and Days Payable Outstanding ratios, which will subsequently help him to free up capital, pay back
debt and become more profitable.
Question 7
To determine whether the loan should be approved, it’s essential to look at the financial ratios to
determine the company’s ability to meet short term debt obligations, given the reduced profitability
and cash shortage. (Short term liquidity ratios in answer 3.1)
If the analysis is focused on the Debt to Asset Ratio, it can be seen how it has been increasing and it
has been over 0.5 since 2011 although it is still adequate. They have enough assets to meet their short-
term obligations in case of default. The reduction of Inventory would be requested by the bank before
granting the loan since the company would be in a good financial position if it wasn’t for the high
Inventory, hard to liquify, as seen in the Current Ratio, Quick Ratio and the Cash Ratio. They could
apply an incentive for clients if they engage in early payment as explained in Q6.
Consider the following figures retrieved from 2014-Q1 which is when they would take the loan: $465k
adding to the existing debt would amount a total sum of $751k ($465k loan, $243k Accounts Payable,
$36k Accrued, $7k Interest (long term portion), $47k long term debt). Against this stands the Retained
Earnings of $357k, $31k Cash and $345k Accounts Receivable, all that can be liquefied easily to repay
$733k. The company is able to sell at least $18k of its $556k Inventory, being able to repay. Besides,
in a case of default the short term debt is to be paid off first, meaning that the $47k in long term debt
are only paid after all short term debt is paid back. Additionally, if Lumber manages to sell the
Inventory, before purchasing new quantity, they should be able to sell the $18k Inventory in the
following 90 days (the two strongest quarters), which would cover all debt obligations in case of
default.
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Keeping this in mind, the loan would be approved if the Inventory was reduced and controlled, which
would imply having less purchases for less quarter. This way, the solvency of the company would
improve and the risk of default would be lower.
