MSc Finance 2022/23

Corporate Finance

Submitted By:
GILBERT
Group C7
LUMBERT Sagarika Jindal
Marlene Heiland
CASE Nuno Bras
Florian Kausch
Henri de Sloovere
13/11/2022
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Corporate Finance

1. INDUSTRY DESCRIPTION
The Gilbert Lumber Company (GLC) operates in the lumber industry as a retail distributor of lumber
products, such as plywood, moldings, and sash and door products. In general, the lumber industry
follows the same trend as housing and construction markets and has grown significantly due to the
increased demand for residential construction and house remodeling.
In the USA, the lumber demand growth in the second half of 2020 and early 2021 was driven by a
mix of government stimulus money and people having more time and disposable income to spend on
their homes during the pandemic. People’s spending pivoted from the service side of the economy to
home improvements. New housing construction also took off as home purchases soared amid the
pandemic. Meanwhile, the supply side of the wood products market was under pressure. Mills
curtailed aggressively early in the pandemic for fear that the housing market was going to see a
significant downturn. However, demand picked up quickly and mills struggled to ramp up production 1.
GLC generates its sales by selling products to housing-construction clients and selling most of its
products for repair work. While the former accounts for 55% of sales from April to September and is
subjected to economic downturns and rising lumber prices, the latter is relatively less subjected to
fluctuations posed by economic downturns. The company can strengthen its position in the following
ways:
i. Since the business is located in a growing suburb of a small city in the Pacific Northwest, there
is a potential to expand in other local areas post due diligence.
ii. Enhance sales in both wood products and repairing business by contracting sales
representatives and implementing marketing strategies in the nearby areas.
iii. Diversifying business into other-related services which can effectively utilize existing
resources of the company and vertical expansion of the value chain.
From an operational standpoint, GLC has managed to maintain a positive impact on the business. As
sales grew from 18.6% (in 2012) to 38.3% (in 2013), EBIT grew from 22% to 41% in the same period.
This resulted in an increase in operating margin from 2.9% (in 2011) to 3.2% (in 2013). Moreover,
given the financial and operational conditions, the sales are expected to reach USD3,6 million in 2014.
Hence, this indicates that the company’s conservative approach (as highlighted by the supplier
Theodore Company) with respect to strict control over operating expenses and price competition
strategy has benefitted the company with growth and improvement in business operations over the
period.

2. REASONS FOR INCREASED BORROWING ACTIVITIES

Although GLC demonstrates increasing revenue and operational growth, the company seems to
suffer from liquidity constraints. For instance, while evaluating company’s liquidity from 2011 to 2013,
we observed the following regarding the company:
i. Current ratio decreased from 1.80 to 1.45.
ii. Quick ratio decreased from 0.88 to 0.67.
iii. Cash conversion cycle (CCC) increased from 72.75 to 75.43.
This indicates that the company is facing a cash crunch, the main drivers of which are:
i. Need to finance its growth: net properties increased by 24.60% from 2011 to 2013, which
comes with costly investments that need to be funded. Its sales have increased by 19% and
23% in 2012 and 2013, respectively, however, its operating margin is not high enough to fund
the working capital and additional investments needed for the accrued growth of sales.
ii. Increasing accounts receivable and high-level of inventory: GLC offers credit terms of 30 days
to customers, whereas most are not paying on time, and quantity discounts to guarantee a
high sales volume.
iii. Trade discount from suppliers: the company has the possibility to purchase materials at
quantity discounts of 2% for paying within 10 days instead of 30 days, however, it is not making
use of this discount.

1 Sutton, A. (2022, March 21): Lumber industry trends. Gordon Brothers. Retrieved November 13, 2022, from

https://www.gordonbrothers.com/insight/commercial-and-industrial-lumber/
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iv. Increase in net properties: It increased by 24.60% from 2011 to 2013, which comes with costly
investments that need to be funded.
v. High debt and interest expense: Lumber took a long-term loan of USD70,000 in 2011 to buy
out his partner Jone’s interest in the Company. This 10-year loan includes quarterly payments
of USD7,000 with a high interest rate of 11% (given the CPI rate of 1.5% in that period 2),
secured by land and buildings.
Hence, to finance the growth in its operations and forecasted sales, it is imperative for the company
to borrow more from the bank.

3. FINANCIAL SITUATION OF GLC

i. Leverage: From 2011 to 2013, GLC has been taking increasingly more debt since debt to
equity and debt to assets ratios are becoming larger over time, what reflects the worsening
financial situation of the company. Furthermore, the Interest Coverage Ratio has been
decreasing, meaning that a greater amount of the yearly company income has been used to
pay interests, instead of being allocated in the strategies that we discussed in question 1.
Table 1: Leverage Ratios
Leverage Ratios 2011A 2012A 2013A
Debt / Equity 1.20 1.42 1.68
Interest Coverage Ratio 3.85 3.05 2.61
Debt / Assets 0.55 0.59 0.63
Source: Elaboration based on Gilbert Lumber Company Case

ii. Liquidity: As mentioned in the previous question, the company is suffering a downward trend
in both the current and the quick ratio. While the current ratio averaged at 1.6, the quick ratio
remained below 1. Moreover, the cash ratio declined from 0.22 to 0.08. This highlights that
the company is struggling to meet its current liabilities and current assets overtime and might
heavily depend on inventory to meet its short-term obligation.
Table 2: Liquidity Ratios
Liquidity Ratios 2011A 2012A 2013A
Current 1.80 1.59 1.45
Quick 0.88 0.72 0.67
Cash 0.22 0.13 0.08
Source: Elaboration based on Gilbert Lumber Company Case

iii. Working Capital Management: To evaluate the working capital management, we calculated
the following ratios:
Table 3: Working Capital Ratios

Working Capital Ratios 2011A 2012A 2013A

Inventory Turnover 5.11 4.41 4.67
Receivables Turnover 9.92 9.07 8.50
Payables Turnover 10.31 7.94 7.98
Inventory Conversion ratio 71.39 82.80 78.24
Receivables Conversion Ratio 36.78 40.25 42.95
Payables Conversion Ratio 35.41 45.98 45.76
Cash Conversion Cycle 72.75 77.07 75.43
Source: Elaboration based on Gilbert Lumber Company Case

2Worldbank: Inflation, consumer prices (annual %), International Monetary Fund, International Financial Statistics and
data files. https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG?end=2013&name_desc=true&start=2010&view=map
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Corporate Finance

Vis-à-vis the working capital management, we notice that:

a. Inventory conversion ratio increased from 71 days to 78 days, highlighting the fact that
money is increasingly blocked-in inventory. This might result from less demand of lumber
products or inefficient inventory management.
b. Receivables conversion ratio ranged between 36 to 42 days even though GLC provided
net credit terms of 30 days.
c. Payables conversion ratio rose from 35 days to 45 days, which indicates that it now takes
GLC longer time to pay back its suppliers. Although, it might help GLC to hold some cash
in shorter-term but can affect the long-term relation with suppliers.
d. Cash Conversion Cycle (CCC) is increasing overtime which reflects that it takes GLC
longer time to generate cash as its sales grow.
Hence, GLC needs to effectively collect outstanding payments quickly, extend its suppliers payables
and improve its inventory management to shorten its CCC and foster a healthier growing environment
for the company.

iv. Profitability:
Table 4: Profitability Ratios
Profitability Ratios 2011A 2012A 2013A
Gross Margin 27.99% 28.61% 27.62%
Operating Margin 2.95% 3.03% 3.19%
Net Profit Margin 1.83% 1.69% 1.63%
ROA 5.22% 4.62% 4.72%
ROE 11.48% 11.18% 12.64%
Source: Elaboration based on Gilbert Lumber Company Case

Since all the ratios have shown growth rates (except gross margin that has been stable) over the
2011–2013 timeframe, the company's profitability has sensibly increased overall. For the ROE, this
is especially true. However, we must consider the amount of debt that has been raised by the
company in this period, which increases the chances of default risk. Hence, ROE may be biased.

4. SOURCES AND USES OF FUNDS

Table 5: Sources and Uses of Funds Statement (in USD thousand)

Uses of funds 2011-12A 2012-13A

Accounts receivable, net (51) (95)
Inventory (87) (92)
Net property (14) (17)
Notes payable (Stark) (105) -
Long-term debt repayment (7) (7)
Total (264) (211)

Sources of funds 2011-12A 2012-13A

Decrease in Cash 10 7
Notes payable (Bank) 146 87
Accounts payable 68 64
Accrued expenses 6 9
Long-term debt (current portion) - -
Net worth 34 44
Total 264 211
Source: Elaboration based on Gilbert Lumber Company Case
The sources and uses of funds for the 2011-2012 and 2012-2013 period show that Gilbert Lumber
relies largely on short-term liabilities and credit from suppliers to fund its operational activities (81.1%
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Corporate Finance

in 2011-12 and 71.6% in 2012-13 of total sources of funds). In order to decrease the amount of debt,
the company could be more efficient on the other side of the scale, by decreasing accounts receivable
and inventory in the uses of funds. Investing in the management of its inventory and customers would
improve both the accounts receivable and inventory conversion.

5. T RADE DISCOUNT ATTRACTIVENESS

Taking the trade discount implies a cost reduction of 2% for paying 20 days earlier (after 10 days
instead of after 30 days). In other words, GLC would give a 20 day “loan” to the supplier. To validate
the discount, we calculated an annualized interest rate of 37.24% Lumber would earn with this loan,
based on the formula below.
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 365 𝐷𝑎𝑦𝑠
𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = ( )× ( )
100% − 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐿𝑜𝑎𝑛 𝐷𝑎𝑦𝑠
As the interest rate of 37.24% Mr. Lumber would receive is higher than any interest rate he would
have to pay for a short-term loan from the bank, we should accept the trade discount. Moreover, trade
discounts of more than 1% (considering credit days of 30 days) are almost always advantageous,
even if the company needs to access short-term debt to finance it. This is because the annual effective
interest rate is almost always going to be higher than the cost of short-term debt, which is 10.5% in
the case of GLC´s banks annual interest rate.
Furthermore, it is stated that suppliers ordinarily did not object if payments lagged somewhat behind
the due date. If this timeframe can be stretched from 30 days to e.g., 60 days, the implied annual
interest rate declines to 14.9%. Moreover, 90 days would result in a 9.3% implied interest rate. In this
scenario, not taking the trade discount is appropriate.

6. LOAN REQUIREMENT ESTIMATION

We computed the free cash flow forecast for the year 2014 based the following assumption:
i. COGS at 72% and Op. Expenses at 25% of sales as historical data suggests.
ii. Interest expenses would be maintained at historical levels as a percentage of debt outstanding
(banks payables + long term debt).
iii. Tax rate at historical levels of c. 17%.
iv. D&A to 10% each year.
v. CAPEX is net PP&E from the current period minus net PP&E from last period. PP&E growth
rate for 2014 was assumed to be congruent to that of sales as it needs to be supported by
growth in the company’s asset base.
vi. For NWC, we assumed that inventory, accounts receivable and accounts payable would be
maintained at historical levels (% sales).

Table 6: Financing Needs Forecast

Source: Elaboration based on Gilbert Lumber Company Case and group assumptions

Following the financial analysis and forecasting of GLC, we conclude that the firm will need an
additional loan of USD 413k to finance its operational activities. We found this value by estimating the
unlevered free cash flow of the firm for the year 2014 (-USD 94k) based on our assumptions, which
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Corporate Finance

we then added to our current debt (USD 247k). The negative UFCFF is mainly driven by a significant
increase in Expansion CapEx and NWC growth to satisfy top-line expectations. Furthermore, we
assumed a minimum operational liquidity requirement at 2% of net sales (USD 72k).
We conclude that Mr. Lumber's loan estimations are accurate after considering his estimate of USD
3.6m in revenue. A USD 465k revolving 90-day note will give the business enough leverage if the
same financial setup as in prior years is kept, allowing it to sustain the necessary level of growth.
Gilbert Lumber will gain flexibility to maintain efficient operations by growing working capital and
keeping a solid cash reserve for any instant payment or short-term requirement. Gilbert Lumber would
be able to pursue the desired growth, invest in sales representatives and marketing or launch any
initiative involving product diversification as described in Q1 with additional funds.

7. FINANCIAL ADVISER PERSPECTIVE ON ADDITIONAL DEBT FINANCING AND ALTERNATIVES

We believe Mr. Lumber should go ahead with his anticipated expansion. We also agree with his plans
for additional debt financing, however, we believe that he doesn´t require the full amount of the loan
of USD 465,000, as depicted in Q6.
In general, Mr. Lumber needs to consider the increase in risk and financial distress the company faces
with the higher amount of debt.
i. Another option would be to finance the liabilities via equity. However, as Mr. Gilbert bought
his partner Jone’s stake of the company, we believe that he would like to avoid losing any type
of control over the company.
ii. Another financing option would be to work on the working capital structure. First, we advise
Mr. Lumber to work on his payments schedule to take advantage of the 2% discount for paying
after 10 days instead of 30 days. Additionally, he could shorten his receivables days by placing
penalties for payments after 30 days (currently receivables conversion ratio ranged between
36 to 42 days) or offering discounts for early payments.
iii. Furthermore, the use of both factoring and supply chain-finance (inverse factoring) would
optimize the working capital structure. As a result, working capital would be leaner, and cash
flows more predictable. With more liquidity, the cost of capital would be reduced, increasing
overall firm value.
iv. As the cash from the loan will gradually convert into an increase in working capital, cash from
the bank will decrease gradually. In the beginning of the year, cash will be available to make
trade discounts. By the end of the year, we expect only to have USD 52k left in the bank (USD
465k - USD 413k), which might not be enough to make the appealing trade discounts, as
calculated in question 5.
v. One way to optimize the debt financing would be to use a higher revolving credit facility, which
means that GCL could withdraw only the amount needed for the loan and could ask for a
higher amount. The undrawn part of the loan would have a lower reservation commission, and
this is therefore a more flexible way of financing the company’s cash requirements.

8. BANK PERSPECTIVE ON ADDITIONAL DEBT FINANCING AND APPROVAL CONDITIONS

As the banker, we would approve the loan request because of Mr. Lumber’s constant growth in sales,
net income, stable financials, and solid asset base. Nevertheless, the following conditions must be
respected to guarantee the loan:

i. Strictly maintaining liquidity and leverage at agreed upon level. This implies a minimum current
ratio of 1.5x and maximum net leverage of 3.0x. These numbers are to be reported on a regular
basis.
ii. Use of funds is strictly limited to agree upon nature. New investments in fixed assets will only
be possible with the approval of the bank.
iii. Withdrawal of funds from the business, as well as further issuances of debt must be approved
by the bank.
iv. Current accounts receivable conversion of 43 days must be improved. By reducing this value
to 30 days, GLC would have USD96k more in cash at the end of 2013.
v. The loan is subject to the collateralization of GLC’s assets.