Gilbert Lumber Company is currently facing high sales growth since 2011 following the new strategy by Gilbert, where he prevails in the competitive industry by offering discounts and long credit terms to customers; and buying in bulk and on credits with suppliers. As a result, Gilbert is burning through the cash at an alarming rate, and this shortage of cash was financed by notes payable from Ferryn Bank. With the expected sales growth of 33.63% for the year 2014, additional funding is necessary to cover the working capital. Gilbert is considering replacing the debt with another by Khai National Bank with a higher credit limit at $465K.
Steven S. Rogers; Kenneth Cooper
Harvard Business Review (315137-PDF-ENG)
June 30, 2015
Case questions answered:
Case study questions answered in the first and second solutions:
- Why does Mr. Gilbert have to borrow so much money to support this profitable business?
- Do you agree with his estimate of the company’s loan requirements? How much will he need to borrow to finance his expected expansion in sales? Assume sales volume rose to $3.6 million in 2014.
- As Mr. Gilbert’s financial advisor, would you urge him to go ahead with his anticipated expansion and his plans for additional debt financing? Or would you urge him to reconsider his plans for expansion and debt financing?
Case study questions answered in the third solution:
- How well is Gilbert Lumber Company doing in terms of profitability and growth? Use performance measures derived from the financial statements to support your answer.
- How did Gilbert finance its business during the previous few years? Again, use performance measures from the financial statements to support your answer.
For question 2, prepare a statement showing the sources of funds and uses of funds for the period from 2011 through the first quarter of 2014. (Use the Excel file that accompanies this assignment. For your convenience, it also contains Exhibits 1 and 2 from the case.) This will help you determine where the money is coming from and where it is going (or, in accounting terms, what are the main sources and uses of funds).
a) Compare Gilbert’s 2011 and 2014-Q1 balance sheets.
b) Classify Assets that have increased as a use of funds and those that have decreased as a source of funds.
c) Classify Liabilities that have increased as a source of funds and those that have decreased as a use of funds.
- Why does Mr. Gilbert have to borrow money to support his business despite a record of profitable operations?
Now that you have a better understanding of Gilbert’s business, you need to look to the future and forecast his funding needs.
- Do you agree with Mr. Gilbert’s conclusion that a $465,000 line of credit will be sufficient to meet his foreseeable funding needs? How much will he need to borrow to finance his expected sales over the next few years? Would you advise Mr. Joseph to give Gilbert Lumber Company the loan?
To answer question 4, construct a pro forma income statement and balance sheet projections for 2014-2017. (The Excel file that accompanies this assignment contains all the necessary data.) Assume sales were $3.6 million in 2014. Then, prepare pro forma statements for each of the following scenarios:
a) Sales grew at 30% per year in 2015-2017, and accounts payable remained at 55 days.
b) Sales grew at 30% per year in 2015-2017, and accounts are paid by the tenth day in order to obtain the 2% discount.
c) Sales grew at 25% per year in 2015-2017, and accounts are paid by the tenth day in order to obtain the 2% discount.
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Gilbert Lumber Company Case Answers
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Executive Summary – Gilbert Lumber Company
Gilbert Lumber Company, a retail distributor of lumber products (i.e., plywood, molding, sash, and door products), is located in a small city in the Pacific Northwest.
It has experienced a shortage of cash even though the company’s sales have increased and it has also generated good profits in the past few years. For that reason, in order to acquire additional funding, Palmer Gilbert, the company’s owner, needs to consider two main solutions.
The first solution is to increase the borrowings from the Ferryn National Bank to $247,000, whereas another solution is to consider another alternative funding source, the Khai National Bank, which offers a more attractive loan amount of up to $465,000.
However, the difficulty with this decision is that if the company chooses the Khai National Bank, even though it could generate sufficient cash to enhance more flexibility in its cash flow, the company’s relationship with the Ferryn Nation Bank will become a problem. All in all, it is very important to carefully make the decision for the company’s best outcome.
This report provides an analysis of the balance sheet, income statement, cash flow statement, and financial ratios from 2011 to 2013 compared with the projection of them in 2014.
To determine which external financing source is more attractive, it is important to calculate the amount of note payable and interest expense between Ferryn National Bank and Khai National Bank to perceive which amount is lesser by setting some assumptions and considering their restrictions.
Moreover, this report suggests several ways to shorten the company’s cash conversion cycle to solve the company’s cash shortages problem, including receivables and inventory management.
Ultimately, with careful consideration, Mr.Gilbert is recommended to go ahead with his expansion plan and choose Khai Bank to be his external fund source if it does not require any negative covenants.
Gilbert Lumber Company, owned by Gilbert, has reached its full credit limit and needs additional funds. Otherwise, it cannot be expanded. It could start with an options assessment first to stay with Ferryn National Bank by accepting a loan of $250,000(ceiling).
Apparently, the only advantage of this choice is the fact that the relationship exists. The disadvantage is that Gilbert Lumber will be necessary for additional financing.
If Mr.Gilbert decides to accept Suburban National Bank’s loan, he must approve the secured loan, which is backed by his own property, acting as collateral for the agreed amount of $250,000.
However, owing to Suburban National Bank’s limitations, Mr.Gilbert is seeking new relationship opportunities with other banking organizations, which could offer him a much larger amount of unsecured loans.
The loan amount that his company receives from Suburban National Bank has reflected the company’s growth potential and has made him realize two things – not only have sales increased, but the debt has also increased at the same time.
Since his loan and cash on hand are limited, he decided to turn to trade credit over the past few years. As consultants, we shall investigate four main aspects as follows:
- Should Gilbert Lumber end its relationship with Suburban National Bank with the aim of generating a larger amount of loan from Northrop National Bank?
- What is the main cause of Gilbert Lumber’s cash shortage problem? Is his company using current funds efficiently?
- How much extra funding does Gilbert Lumber need to acquire, and will the company continuously need even more in the future?
- What type of suggestions can the firm’s growth reflect?
- Are there any other solutions to overcome Gilbert Lumber’s cash shortage crisis?
1. Why does Mr. Gilbert have to borrow so much money to support this profitable business?
By calculating a common size (in percentages of the total Assets) in the Balance Sheet, Exhibit 2, inventories and account receivables are the major portion of assets needed to support an increase in sales and an improvement in turnover ratio. Moreover, too much capital is absorbed by inventory since Gilbert Lumber company’s inventory consists of finished goods.
During the past few years, the inventory portion was around 40-45% of total assets and took around 70 days to be sold (shown in Inventory Conversion Period, Exhibit 6).
Moreover, the cost of carrying these inventories is much higher and might not be enough to cancel out (offset) by the savings from purchase discounts. Thus, capital expenditures and accrued expenses have to be increased in order to keep up with the growth.
From the cash flow statement (Exhibit 5), borrowing from Ferryn National Bank in the historical periods, the cash decreased significantly during the recent years from 2011 to 2013 and tended to be negative at the end of 2014. In addition, servicing the loan of $70,000, which is required to buy out Jones’s interest in the firm, can put a burden on cash flow.
According to a historical analysis of financial ratios related to financial statements, Exhibit 6, which highlighted a quick ratio with a downward trend in recent years, Gilbert Lumber Company has a low ability to cover its current liabilities.
Moreover, the firm needs more cash to maintain its operation since the cash ratio has been decreasing over the past few years.
Lastly, the receivable conversion period is longer than the company credit term of 30 days. This can be explained by the company’s low ability to collect the outstanding cash balance from its customers in time, causing a cash shortage problem.
To summarize, Gilbert Lumber Company has now experienced cash shortages. The major factors that contributed to this company being short of money are…
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