1. Why has Cartwright Lumber borrowed increasing amounts despite its consistent profitability?
Cartwright lumber has had to borrow substantial amounts of money due to the fact that the firm is a growing company with sales rising quickly. In order for the company to sustain this growth rate, they will have to get additional external funding. Growth in sales nearly doubled from 2001 to 2003, with a percentage growth of 18% and 34% in 2002 & 2003 respectively. While sales are growing steadily, the company’s cash is steadily decreasing year to year by 20% and 17% in 2002 and 2003. Taken together with the fact that accounts receivable has grown at a higher rate than sales, 30% & 42%, this firm can not support the growing sales relying on its assets. The DSO ratio for accounts receivable is 36.28, 39.70 & 42.36 in 2001, 2002, and 2003 respectively. With ...view middle of the document...
The firm has extended its trade credit a significant amount in an effort to remain below the 250,000 ceiling imposed by their current bank. In turn, they are giving up discounts on their purchases made. From 2001 to the first quarter of 2004, the firms total liabilities increased tremendously by 127% from $324 to $737.
We can see the effects of this financing practice by analyzing the firm’s debt management ratios. The firm’s debt ratio has increased over the passed four years from 54.55% to 58.70 to 62.70% to 67.37%. This increasing debt ratio illustrates the firm’s attempt to use its debt to highly leverage the firm. Although we do not have an industry average to compare this debt ratio to, this debt ratio is very high. Examining Cartwright Lumber Company’s current ratio and quick ratio in combination with their debt ratio, the firm’s financial strength has weakened. The Current Ratio is approximately 1.35X and the Quick Ratio is 0.55X. These ratios are very low, raising a red flag that this company may have difficulties paying off debts. Furthermore, the company is relying heavily on its inventory which is the least liquid of a firm’s current asset. This firm’s financial management is very risky and I feel it is worsening the company’s financial strength.
Furthermore, analyzing the company’s profitability ratios, Cartwright Lumber’s profitability is decreasing year to year although net income has increased. From 2001 to 2004, the profit margin decreased from 1.83X to 1.25X while the operating margin decreased from 2.18X to 1.53X. Therefore, the firm’s practicing of continually taken on more debts has not improved their profitability. In calculating the firm’s ROE, we could say that by leveraging the firm, the company has been able to increase the ROE and therefore is more profitable. The firm’s ROE is 11.48%, 12.64%, 12.64% in 2001, 2002 & 2003. However, when we calculate the firm’s ROE for the first quarter of 2004, it has decrease to 10.08%.