FINAN 4300 Problem Set 12

Clarkson Lumber’s strong profitability in 1995 means it should be able to finance its growth internally without needing additional borrowing

False

Clarkson Lumber is profitable, but profits are not sufficient to finance rapid growth. Every extra dollar of sales generates receivables and requires inventory, which tie up cash. Net income is positive, but liquidity is deteriorating, so Clarkson must borrow

Rapid sales growth can weaken a company s financial condition even if gross margins remain stable

True

Rapid sales growth can weaken financial health because receivables and inventory rise faster than payables, creating a larger financing gap. This means more external funding is required even though the income statement shows improvement.

Clarkson’s need for external financing is driven by three factors:

• rapid sales growth

• long cash cycle

• low profit retention

True

The need for external financing comes from rapid sales growth (more customers and sales to fund), a long cash cycle (slow conversion of inventory/receivables into cash), and low profit retention (profits are not retained at a high enough level to cover growth). Together, these create persistent financing requirements.

A company’s net income is always a reliable indicator of its ability to generate cash for operations

False

Net income is not a reliable indicator of cash availability. Timing mismatches between receivables, inventory, and payables can cause liquidity shortages despite profitability. Cash flow statements tell a different story than accounting income.

By not taking advantage of the 2% discount offered by suppliers for payment within 10 days Clarkson is effectively borrowing at an annualized interest rate of more than 18%

True

Forgoing the 2% discount on 40 -day trade credit is effectively borrowing at around 21% annualized cost. This is far more expensive than typical bank financing, and bankers view it as a sign of severe liquidity stress.

From a banker’s perspective Clarkson s increasing days payable is a sign of strong bargaining power with suppliers rather than a red flag

False

Stretching payables is not a sign of strength; it is a sign of distress. Suppliers may cut credit or demand faster payment if they notice a company consistently delaying. Bankers treat this as a warning signal, not leverage.

Growth that requires expanding receivables and inventory faster than payables can lead to a situation where a profitable company becomes cash-poor

True

Growth that requires larger receivables and inventory commitments while payables lag inevitably consumes cash. Profits on paper don t prevent a cash crunch, which is why Clarkson s condition worsens as sales expand.

Extending a larger line of credit to Clarkson is risk-free as long as projected profitability remains positive

False

Lending is never risk-free. Even with profitability, Clarkson could default if receivables are uncollected or if working capital pressure becomes too severe. Banks focus on repayment capacity, not just accounting earnings.

If the bank were to approve a larger line of credit, requiring a lien on accounts receivable would give the bank direct claim to cash inflows from Clarkson’s customers in the event of default

True

A lien on receivables gives the bank first claim on cash inflows from Clarkson s customers if the company defaults. This lowers credit risk by tying repayment directly to collections.

Requiring inventory as collateral is less desirable to the bank than receivables because inventory may be harder to liquidate in the event of default

True

Receivables are easier to convert into cash than lumber inventory, which is subject to price fluctuations and may be harder to liquidate quickly. This makes receivables preferable collateral.

A covenant requiring Clarkson to maintain a minimum current ratio would directly limit how much short -term debt the company can accumulate relative to its liquid assets

True

A covenant requiring a minimum current ratio forces Clarkson to maintain liquidity discipline. It ensures current assets remain large enough relative to current liabilities, limiting overreliance on short-term debt.

A covenant restricting additional borrowing from other lenders protects the bank from being diluted or subordinated in priority of claims

True

Restricting further borrowing from other lenders prevents Clarkson from diluting or subordinating the bank s position. It helps the bank remain the senior creditor and reduces default risk from overleveraging

An equity infusion from Clarkson or a new partner would reduce the company s reliance on debt and improve its attractiveness to the bank

True

An equity infusion reduces debt dependence, strengthens the balance sheet, and improves leverage and liquidity ratios. This makes Clarkson more creditworthy and lowers the bank s exposure to default.

Why does Mr. Clarkson need to borrow money to support a profitable business?

Because rapid growth ties up cash in receivables and inventory faster than it is collected

Which combination of factors explains Clarkson’s appetite for external finance?

• Rapid sales growth

• long cash cycle

• low profit retention

Why does rapid sales growth potentially weaken Clarkson’s financial condition?

Growth forces larger investments in receivables and inventory creating liquidity strain

The 2% discount offered by suppliers 2/10 net 50 is equivalent to what annualized cost of not paying early?

20% per year

Which of the following best reflects a banker’s concern in the Clarkson case?

The financing gap grows with sales growth requiring more debt despite profitability

Which of the following loan structures would be most appropriate for a banker concerned about Clarkson’s liquidity risk?

Approve partial increase secured by receivables and inventory with financial covenants

Which covenant would not be typical for a short-term working capital loan like Clarkson’s line of credit?

Covenant requiring the company to expand into new geographic markets

If the bank imposes a borrowing base covenant what does this mean?

The borrowing limit is tied to the value of current assets such as receivables and inventory

Which of the following covenants would most directly protect the bank from excessive short-term liquidity risk?

Minimum current ratio requirement