Liquidity|Legit essays

Posted: February 11th, 2023

Memorandum

 

To: Bob Adkins

From: Jan Kindrat CPA, CFA

Subject: Purchase of 15% Interest in Lamar Swimwear

Date: February 23, 2000

 

 

Liquidity

 

Lamar Swimwear has a serious liquidity problem, which could soon result in bankruptcy if preventative measures are not taken. The current, quick and cash ratios have all been below industry average since the company’s inception and are getting progressively worse. The main cause of this problem is rapid growth, which is being financed by the stretching of the accounts payable, the drawing down of cash balances to dangerously low levels, and an increase in long-term borrowing resulting in higher interest and principal payments. The liquidity crisis is being made even worse as creditors raise interest rates and limit borrowing in reaction to the higher risk.

 

A high growth rate is normally a good thing, but if it’s not managed properly, it can cause serious liquidity problems. If the company wishes to grow in excess of a prudent sustainable growth rate (reasonable financial leverage), more equity must be issued.

 

Further contributing to Lamar’s liquidity crisis is its poor accounts receivable management, which slows cash collections. The A/R turnover in days is well above the industry average and is getting worse. Slow collections and high bad debts are a major problem in the swimsuit industry because of the large number of small, poorly capitalized retailers. Even the industry average A/R turnover in days is above the standard credit terms of net 30, although this could simply be due to companies requiring the cheque in the mail by the due date and not in hand.

 

Inventory turnover in days is also above the industry average, but not by a substantial amount, and there has been definite improvement since 1998.

 

Asset Utilization

 

Lamar’s poor Accounts Receivable management could be improved by:

 

· Locked boxes or EFTS payment;

· More thorough credit investigations (references and credit bureau checks);

· Swift follow up on overdue accounts (letter, phone, collection agency);

· Interest on overdue balances; and

· Faster billing (if the bill gets out faster, the net 30 period starts sooner).

 

There is a possibility that Lamar’s high growth rate was due not just to a superior product line, but because they were extending trade credit to many retailers that other swimsuit manufacturers had refused. Being more selective in granting credit may not only help to solve Lamar’s liquidity and asset management problems but may also help to reduce the growth rate. Company’s should not maximize sales at any cost but should instead focus on quality growth were the profits from additional sales exceed increased costs.

 

As mentioned, Lamar’s inventory turnover has been improving, but it is still slightly higher than the industry average. This could be due to Lamar charging a premium price compared to its competitors. Perhaps it is finding that it can generate more revenue by charging a slightly higher price despite lower turnover. Still, Lamar should investigate measures to increase inventory turnover such as JIT production, expanding the breadth and depth of the product line, and improving customer service. Alternatively, the problem could simply be that Lamar is still “sitting on” unsold stock from the previous summer season at year-end in December. The company might consider “moving” unwanted items by selling them to off-price stores.

 

Lamar’s fixed asset utilization was well above industry average in 1998 but fell to slightly below industry average in 1999. This was due to the major capital purchases in 1999. It appears that the company has just not had enough time to fully utilize these new facilities. As demand grows in future years, fixed asset utilization should return to its superior level. Ed Lamar has also been very conscious of keeping overhead to a minimum since beginning operations.

 

Long-term Debt Paying Ability

 

Lamar Swimwear’s use of financial leverage has become excessive. Although its leverage ratios in 1997 approximated the industry average, they have since grown to dangerously high levels. The company’s vendors have already warned them to pay their accounts payable more promptly and their bankers have interest rates to reflect the added risk. Cash and carry status and being cut off at the banks are very real possibilities.

 

As mentioned, Lamar’s problem with financial leverage is due to an actual growth rate that exceeds a prudent sustainable growth rate. To compensate for this, the company has stretched its payables and borrowed long-term instead of issuing more equity. This problem has been made worse by below average profitability, which has resulted in even weaker coverage ratios.

 

Definitely, Lamar Swimwear must issue more equity. If the loss of control is a concern to Ed Lamar, then consideration must be given to cutting back on expansion to improve the company’s liquidity and long-term debt paying positions. Some equity was issued in 1999, but it was not enough. Possibly, this is why Ed Lamar has approached Bob Atkins as a potential investor.

 

Profitability

 

Lamar’s gross profit margin is below the industry average and is getting worse. Excessive scrap contributed to a higher cost of goods sold in 1999, but this was countered partially by the premium prices it was able to charge. Due to the popularity of its product line, Lamar might experiment with raising its prices even further in hopes of increasing the gross profit margin. It might also consider:

 

· Overseas sourcing of materials or manufacturing to reduce costs;

· Greater use of quantity discounts and competitive bidding when buying materials;

· Self-directed work teams and improved quality control procedures;

· JIT inventory and production management; and

· Automation of the production process.

 

The operating margin is still slightly below the industry average, but there was a dramatic reduction in selling and administration as a percentage of sales in the last year. Economies of scale and Mr. Lamar’s frugal nature were likely the main contributing factors. Others may have included:

 

· Downsizing of the staff;

· Freezing or cutting wages or benefits;

· Reducing commission rates and expense allowances;

· Computerizing office operations;

· Cutting the advertising and promotional budget; and

· Moving the office or factory to a lower rent area.

 

Depreciation expense was up as a per cent of sales, but this should decrease as the new facilities are better utilized in the future.

 

Interest expense was also up to over twice the industry average due to the company’s overuse of financial leverage and the higher interest rates being charged. Income taxes as a per cent of sales have also fallen primarily due to tax credits earned on asset purchases. Improved tax planning or tax rate reductions could also be factors.

 

Overall, Lamar’s ROA is below industry average as is its ROE despite a much heavier reliance on financial leverage than the industry. A significant drop in asset turnover contributed to its below average ROA and the higher interest rates charged reduced the benefits of financial leverage—the spread between ROA and cost of capital was smaller.

 

Recommendations

 

Lamar Swimwear is a fast-growing company with a popular product line. It has the potential to become quite profitable if management executes effective pricing and cost management strategies. This rapid growth is causing serious liquidity problems though. With a prudent sustainable growth rate that falls well short of its actual growth rate, Lamar has chosen to meet its growth potential by raising financial leverage to an intolerable level. Clearly, the company must issue more equity than it has or slow growth to a safer level.

 

Any potential investors must decide whether Ed Lamar is able to make these needed changes. He has a reputation of being quite stubborn and autocratic and thus unlikely to accept input from other investors on how to deal with this growth versus liquidity dilemma. He is also unlikely to tolerate losing control in the company he founded.

 

It is recommended that Bob Adkins only invest if Ed Lamar agrees, in writing, to make the necessary changes. If he is not willing, it is suggested that Mr. Adkins wait and possibly invest later. If Mr. Lamar does not make the needed changes, he will be even more desperate for help later on. He should also be offering better financial terms and be much more open to advice at that time.

 

Exhibit 1: Ratio Table

 

	Lamar Swimwear	Industry Averages
	1997	1998	1999	1999
Liquidity
Current Ratio	1.78	1.54	1.15	2.02
Quick Ratio	.87	.85	.68	1.26
Cash Ratio	.20	.17	.10	.60
Asset Management
A/R Turnover in Days	—	52.20	60.25	39.00
Inventory Turnover in Days	—	86.16	76.76	71.00
A/P Turnover in Days	—	89.50	113.54	60.00
Cash Conversion Cycle	—	48.86	23.47	50.00
Fixed Assets Turnover	—	2.12	1.74	1.75
Total Assets Turnover	—	1.22	1.09	1.12
Long-term Debt Paying Ability
Debt Ratio	49.58%	52.12%	59.23%	44.00%
Long-term Debt to Total Capitalization	36.95%	36.00%	45.12%	35.65%
Times Interest Earned	4.57	4.13	3.06	6.61
Cash Flow Coverage Ratio	2.75	2.64	2.27	4.73
Profitability
Gross Profit Margin	33.33%	30.67%	30.13%	32.00%
Operating Profit Margin	13.34%	12.40%	13.88%	14.59%
Net Profit Margin	7.35%	6.12%	6.38%	7.96%
Return on Assets	—	9.88%	10.29%	11.94%
Return on Equity	—	15.28%	15.93%	16.01%

 

 

 

Exhibit 2: Vertical Analysis (Income Statement)

 

	1997	1998	1999	1999 Industry Average
Sales	100.00	100.00	100.00	100.00
Cost of Sales	66.67	69.33	69.87	68.00
Gross Profit	33.33	30.67	30.13	32.00
Selling and Administration	14.99	13.27	9.32	10.51
Depreciation Expense	5.00	5.00	6.93	6.90
Operating Profit	13.34	12.40	13.88	14.59
Interest Expense	2.92	3.00	4.53	2.20
Income Before Taxes	10.42	9.40	9.35	12.39
Income Taxes	3.07	3.28	2.97	4.43
Net Income	7.35	6.12	6.38	7.96

 

 

 

Exhibit 3: Vertical Analysis (Balance Sheet)

Delisle Industries

 

Assume the role of Jolly Jeffers, CMC, and prepare a 3-page memorandum that analyzes the financial condition of Delisle Industries and makes recommendations relating to the company’s operational and financial problems and the proposed expansion.

 

The memo should be divided into sections entitled Liquidity, Asset Management, Long-term Debt Paying Ability, Profitability, and Recommendations. The memo should be single-spaced and use the 12-point Calibri font with 0.7-inch margins. All headings should use a 12-point Calibri font and be bolded.

 

The following financial exhibits for 2006 through 2010 should also be included:

 

· Ratio table

· Vertical analysis of income statements and balance sheets

· Horizontal analysis (index numbers) of income statements and balance sheets

· Cash flow statements (2007 through 2010)

· 5-part analysis of ROE

 

All ratios should be calculated based on year-end totals only – no averages should be used. The specific ratios to be used include:

 

	2006	2007	2008	2009	2010	Industry Average
Liquidity
Current Ratio
Cash Ratio
Asset Management
Parts Inventory Turnover in Days
Work-In-Progress Turnover in Days
Finished Goods Turnover in Days
A/R Turnover in Days
A/P Turnover in Days
Cash Conversion Cycle
Fixed Assets Turnover
Total Asset Turnover
Long-term Debt-Paying Ability
LT Debt to Total Capitalization
Fixed Charge Coverage
Profitability
Gross Margin
Operating Profit Margin
Net Profit Margin
ROA
ROE

 

 

 

Analysis of ROE
	EBIT/Sales	EBT/EBIT	NI/EBT	Total Asset Turnover	Debt Ratio	ROE
2006
2007
2008
2009
2010

 

 

 

 

 

Case 1: Delisle Industries

 

Evaluation Form

Total: _________ / 100

 

Letter Grade: _________

 

Accuracy of Financial Data – 25%

 

Ratio table	/10
Vertical/horizontal analysis	/5
Cash flow statements	/5
5-part analysis of ROE	/5

 

 

Thoroughness of Analysis – 50%

 

Liquidity	/8
Asset management	/14
Long-term debt-paying ability	/6
Profitability	/12
Recommendations	/10

 

 

Layout and Writing Quality – 25%

 

Memo layout	/5
Grammatical and spelling errors	/10
Writing style	/10

 

 

Comments

 

2

Delisle Industries

 

Micheline Rousseau, CEO and owner of Delisle Industries received the 2010 financial statements from the company’s auditors and compared these results with previous years. She was very happy with the company’s rapid growth but had some serious concerns about its future. What should be done about the operating problems resulting from such rapid expansion? Was the company overly dependent on Costco to distribute its product? Is the establishment of a new production facility in Winnipeg advisable? What can be done about its poor cash management and over-reliance on debt financing? How can future growth be financed?

 

After discussing these issues with her vice-presidents it was agreed that a management consultant Jolly Jeffers, CMC should be retained to conduct a financial review of Delisle. Based on his report, Rousseau would implement operational improvements and decide whether to open a factory in Winnipeg and add plastic fencing to its product line.

 

Company Formation

 

Delisle is a manufacturer of plastic products. It was formed in 2005 in Saskatoon, Saskatchewan by Micheline Rousseau, P.Eng. who had worked for over twenty years at Rubbermaid, a U.S.-based plastics manufacturer. At Rubbermaid, Rousseau held positions in operations and was very familiar with the specialized injection molding equipment used in production. Later in her career, she worked as a designer and earned an excellent reputation for her innovative products. After failing to be selected for the VP-Research and Design position at Rubbermaid, Rousseau decided to return to her hometown of Saskatoon and start her own company.

 

Rousseau’s father had been a successful Saskatoon businessman and owned a manufacturing company that produced laminated oak staircase components such as railings, steps, and risers. Her father decided to close the business in 2003 after suffering a heart attack but kept the building and equipment and continued to hope his daughter would someday return home and take over the operation. When she eventually returned, her father was overjoyed, but she explained her expertise was in plastics and that industry held more potential than wood products. With her savings, severance pay from Rubbermaid, and a gift of the facility by her father, Rousseau began operations.

 

Rousseau’s first hire was Frank Dempsey as VP-Marketing and Sales. Together, the two thoroughly researched what products should be produced and decided on storage sheds which most households in North America had in their backyards. These sheds contain various items such as gardening supplies, tools, tires, and bicycles. Historically, they were built on cement blocks and made of wood. They were expensive to buy or have built because construction was so labour intensive and the materials so expensive. There was also considerable maintenance as the buildings had to be painted regularly and were subject to rot in more humid climates. If the sheds were made of plastic panels they could be produced more cost-effectively and would last longer with little maintenance. The sheds could also be easily produced in different colours to match existing home designs.

 

Rousseau and Dempsey agreed to distribute sheds using two channels. A website was developed showcasing the company’s products. Customers can order the sheds on-line and they are shipped in “knock-down” form to reduce shipping costs using a third-party carrier. The sheds are easy to assemble, so customers only have to ensure a proper cement pad is in place – basic paving stones are all that is needed. Costco Wholesale also agreed to carry the sheds. Several standard designs and colours are available in-store for customers wanting to take immediate possession, but Costco also accepts orders for all the variations and delivers them to their stores for pick-up. Costco offers the sheds through its website as well.

 

Company Expansion

 

Delisle’s products proved to be very popular and sales expanded quickly. Merchandisers at Costco immediately asked the company to develop additions to their product line. By 2008, Delisle began producing rain barrels, patio furniture, and plant holders in varying designs and colours. Rain barrels were a success as competitor’s products were made from metal and prone to rust and were not visually appealing. Patio furniture was also very popular as Delisle reproduced many of the traditional wood designs that other plastic furniture makers did not. They could be produced at a fraction of the cost of wooden furniture and were much more durable and did not need painting or refinishing. The plant holders were less of a success as there were already a large number of competing products on the market with many coming from low-wage countries.

 

By late 2010, Delisle’s production facility in Saskatoon was reaching its limit. The building had been expanded several times, but there was simply no more room on the lot and the company was not able to buy any adjoining property. Making this problem worse was a request by Costco to begin producing plastic fencing. Research indicated consumers were frustrated with building expensive fences from wood only to have them deteriorate rapidly due to weather. Even after using more expensive cedar or treated lumber, fences quickly began to lose their visual appeal. Frequent painting or staining was also needed, which was becoming a problem for Canada’s aging “baby boomer” population. By creating an array of fencing designs in various colours, Costco felt an important need for “do-it-yourselfers” and contractors would be met.

 

Expanding the product line to include fencing would require the construction of a new factory. Output from the existing facility might also be transferred to this new plant to address space restrictions. Skilled labour was in short supply in Saskatoon due to rapid growth in the resource sector in Alberta and Saskatchewan. Winnipeg was viewed as a good location for the new facility. The city was very affordable with low land and labour costs and had a ready supply of skilled production workers.

 

SOLUTION