Essay, Pages 8 (1998 words)
Jones Electrical Distribution (hereinafter Jones Electric) is currently facing an issue with cash flows, which will ultimately affect the overall profitability and growth potential for the company. The owner, Nelson Jones, is diligent in paying his suppliers within ten days in order to capitalize on a two percent early pay discount, but in doing so, has over-extended cash flows. Though the company has been profitable and growing over the past three years, its current lender, Metropolitan Bank, will not increase a line of credit (LOC) beyond $250,000, a LOC upon which Jones has recently fully drawn.
In order to ease the tensions of depleting cash reserves, Jones is seeking a higher LOC from another lender, Southern Bank & Trust (SB&T). A higher LOC will not only cover overhead expenses and take advantage of early pay discounts, but could also be invested in the continued growth of sales, as well as, potentially opening new locations. After weighing his options, Jones is convinced that he has to take on more debt in order to keep the business moving forward.
Thus far, Jones is only contemplating one financing option, a higher LOC from SB&T.
The terms of LOC are not favorable when weighed against Jones’s objective to grow the business. SB&T will limit the drawable amount, control investments in fixed assets, and control Jones’s withdrawal of funds from the business. As such, Jones needs to reconsider SB&T’s offer and consider other financing options or reduce the need to borrow by changing operating procedures.
Jones is seeking a $350,000 LOC from SB&T, which is $100,000 more than the current LOC. Therefore, we assume that the difference of $100,000 is the target dollar amount needed for Jones Electrical.
Coupled with alternative financing options, business operations will have to be adjusted if Jones Electrical is going to stay in business. Nature of the Issue The issue facing Jones Electrical is cash flow. More specifically, a slipping margin due to an inability to capitalize on early pay discounts. The shortage of cash has been the result of continually paying suppliers early to receive a discount but not collecting accounts receivable as quickly. Over the past three full operating years, the days payable outstanding averaged 11. 88 days whereas days sales outstanding averaged 43 ays. Clearly, the practice of continually paying vendors approximately 30 days before customers has created the current stress on cash flows. As a result of slow cash flows, Jones Electrical has not only experienced an inability to fully take advantage of the early pay discounts, but is now struggling to pay vendors within standard net terms. The first quarter of 2007 indicates days payable outstanding jumped to 33 days while days sales outstanding stayed relatively the same; however, we forecast this to decrease overall in 2007 as cyclical orders even out.
This is indicative of poor cash flow management, and should be assessed to find a middle ground to sustain operations. In 2006, the gross margin slipped one percent, which slipped another one percent in the first quarter of 2007. Again, this is the result of cash flow struggles to capitalize on early payment discounts. Given the volume of business Jones Electrical does, taking advantage of the early pay discounts saves approximately $31,000 a year. This is a considerable amount of money that can ultimately be reinvested in the firm, but given the business strategy Jones implemented, does not align with operations.
Jones Electrical has traditionally competed on price, which implicitly means lower margins. The early payment discounts offset the lower prices for customers, but the lower prices have not offset the cash flow required to sustain this strategy. Furthermore, inventory management has started to slip and looks to be inefficient. The past three years show days in inventory to be averaging 70. 07 days, which we forecast to jump to 77. 13. This could be due to the cyclical nature of the industry, meaning, Jones has forecasted increased demand for the upcoming construction season.
Either way, the cost of storing inventory could most likely be cut in half, but without knowing lead times of suppliers, this is just a conjecture. Moreover, not only does the inventory sit in-house not earning revenue for 65 days, but will take another 41 days to actually see the cash from customers. This brings the operating cycle for the past four years to average 108. 4 days and cash conversion cycle to 91 days. This is obviously the reason for slow cash flows, which has ultimately led to the current cash woes Jones Electrical is facing.
Thus, Jones now seeks more credit from SB&T. SB&T will only allow Jones Electrical to borrow up to 75% of accounts receivable and 50% of inventory. As of the 1Q07 balance sheet snapshot, this would only give Jones access to approximately $207,000, which does not even cover repayment of the current LOC to Metropolitan Bank. Even with the cash on hand, Jones would be $11,000 short of covering the $250,000 due to Metropolitan Bank, which is an agreement SB&T requires him to severe.
If the LOC is based on our forecasted numbers, AR of $318,000 and inventory of $456,000, Jones would have access to much more cash from SB&T (approximately $466,000). This, of course, assumes our assumptions are correct. Moreover, the solvency ratios for Jones Electrical indicate a risky firm, hence the floating rate offered by SB&T (prime plus 150 basis points). While the debt to asset ratio has improved considerably over the past three years, the interest coverage and cash flow coverage ratios are shaky.
The quick ratio trends also indicate a firm struggling to fulfill financial obligations. As a bank, this investment seems quite risky regardless of profitability and potential growth. Furthermore, as a business owner, taking on more debt in this situation would be unwise as cash obligations go to secured creditors first, which takes away from early payment discounts and the ability to cover supplier invoices. If more debt is incurred, the cash conversion cycle will need to be drastically reduced in order to sustain operations.
This would entail: slowing accounts payable, decreasing inventory levels, collecting accounts receivable quicker, and/or making selective early pay discounts. To retain the 20% gross margin from 2004, prices to customers will have to increase as less supplier discounts will be taken, which could be offset by reduced costs of inventory. Lastly, as of the end of the first quarter in 2007, almost 48% of sales are tied up in accounts receivable. This is a dramatic jump from the previous three years that averaged 11. 8% of sales in accounts receivable.
Again, this could be due to the influx of orders in preparation for the impending construction season, but given the increased levels of inventory, a mismatch is present. However, we calculate that 2007 AR as a percentage of sales can be brought back down to historical levels (based on our assumptions below). Collecting on cash owed from customers would appear to be a better solution than taking on more debt. It could be that Jones needs cash immediately to sustain operations until accounts receivable are collected, at which point other means of financing might be more beneficial.
The housing market appreciates around three percent a year, which coupled with the principal of approximately $19,500 applied to Jones’s home loan, he has access to over $100,000 in home equity from which he can draw. Alternatively, if he wanted to maintain the equity in his house, he could use his $250,000 life insurance policy as collateral for a temporary loan. Drawing on personal assets poses some risky decisions as Jones would not be sheltered from financial implications if the business were to fail.
As such, this measure should only be considered if the funds are only needed to float until cash comes into the business and then repaid back immediately. All other things considered the company is operating as lean as possible. Operation costs have grown in relation to overall sales which has boosted the bottom line as a percentage of net sales. The issue of slow cash flows stems from a sluggish cash conversation cycle, which will have to be changed to be more efficient to sustain operations. ? Analysis Exhibit A: Income Statement Forecast
Exhibit B: Balance Sheet Forecast Our forecasts are based on various assumptions. Our overall assumption is that Jones Electric will return to 20% margins, 2004 level. Thus, accounts payable (AP) will be lowered. We assume that property, plant, and equipment (PPE) will remain the same, carried over from 2006 PPE is $252,000. Thus, accumulated depreciation will be $166,000, leaving us with total PPE of $86,000. Next, we recommend that Jones not take out the additional LOC from SB&T. However, there is excess cash at the end of 2006 and the LOC should be paid down by $50,000.
Because of the difference between pro-rata total assets and pro-rata liabilities & net worth, we assume that Jones Electric has external finance needed (EFN). We discuss temporary bridge lending from Jones to the company to float the business in our recommendations listed below. Exhibit C: Turnover Ratios and Cash Conversation Cycle As discussed above, the current cash conversation cycle is hindering Jones Electrical to capitalize on the early pay discounts offered from its suppliers, which has lowered its gross margin. Moreover, the slow cash ycle has put stress on cash reserves and indicates an inability to not only meet supplier invoice obligations, but also cover interest and debt expenses. Exhibit D: Solvency and Liquidity Ratios From a banks perspective, the interest and cash flow coverage ratios are pretty alarming. While the current cash position shows an ability to cover interest expenses, the historical average from the three previous years suggests quite the opposite. This is further explained in the current and quick ratios, which has been steadily decreasing over the past four years, indicating Jones Electrical is less and less liquid.
The return on assets calculation also supports this downward trend, showing a dwindling return from 9. 3% to 1. 5%. Regardless of the recommendations Jones has received, the downward spiral his company is demonstrating despite a 17. 5% compounded annual growth rate over the past three years should be very alarming to lenders. This should also clue Jones that his current approach to operating the business is flawed and needs to be reengineered to manage cash flow and inventory better. Recommendation and Conclusion
Jones’s decision to open a higher credit line should be his last resort. He should focus his attention on collecting the large outstanding balance of accounts receivable first and foremost. This has the potential to bring in a considerable amount of money without having to be micromanaged by another bank. Furthermore, Jones needs to analyze the business cash conversion cycle to identify all the inefficiencies. Reducing the cash conversion cycle should be the ultimate goal for Jones regardless of gaining outside financing.
Managing cash flow better has to be done in order for Jones Electrical to sustain business, let alone grow. While the savings potential of paying early for discounts is substantial and permits the lower prices to customers, Jones needs to weigh each orders’ value and be selective of when to capitalize on early pay discounts. Meaning, the larger the order, the larger the discount, and therefore should be taken advantage of, whereas small orders may often be paid within net terms. As discussed above, other solutions to reduce the cash conversion cycle include: ollecting accounts receivable quicker, decreasing inventory levels, raising prices, and/or slowing payments to vendors. It would appear that there is a considerable amount of sales being held in accounts receivable. The current cash crunch could be a result of this, which could just mean that cash is needed to float for the short term. If so, Jones could look to take out a personal loan, either a home equity line of credit or a loan against his life insurance, to get by until customers have paid their invoices.