Problem Solution: Lawrence Sports Inc.
Lawrence Sports, a manufacturer of sports equipment, is having cash flow problems. On one hand it has obligations to pay its suppliers, but on the other hand it is expecting receivables from a customer that is unable to pay in a timely manner. On the surface, this may seem like a small problem, but in reality one has to ask, “how did this happen?” Obviously, cash outflows are exceeding cash inflows, but again, how could this happen in a structured, well-organized company?
Actually, cash flow is often a problem in big, successful companies. However, a lack of effective working capital management can cause these shortfalls to occur. In the case of Lawrence Sports, outflows exceed inflows and the shortfall is being made up by a credit line that is maxed out. Not only is the credit line maxed out, but it carries with it an interest that fluctuates depending on the amount borrowed. This is proving very costly to Lawrence.
Issue and Opportunity Identification
Lawrence Sports has a number of issues that need addressing. However, if the company is able to make positive changes toward better working capital management the company can enjoy growth and prosperity. Lawrence needs to look at working capital management as an opportunity to better serve its stakeholders and improve its current economic standing.
At the present time, Lawrence is not effectively controlling the inflow and outflow of cash. The company is being very accommodating when it comes to its sole customer Mayo. On the other hand, Lawrence is being pressed heavily by it suppliers. Suppliers are adhering to their prospective credit policies and expect prompt payment from Lawrence. The problem arises when Lawrence tries to pay for the supplies it needs to furnish the finished product from Mayo. Mayo has pushed back the payment date meaning that Lawrence will not have the cash available to pay its suppliers. Furthermore, the credit line that the company was relying on for a buffer has become maxed out and the company is subject to often high variable interest rates.
Lawrence Sports needs to step back and examine these issues and devise a better working capital management system. Working capital management is concerned with current assets and current liabilities. When dealing in the short-term, Lawrence is limited. The company does not seem to have a cash budget in place and management seems to have no clue as to the amount of capital that is needed to sustain the company for any period of time.
Looking into short-term financing, cash budgeting and a possible revamping of the credit policy are all viable solutions. However, there are a number of ways that Lawrence can accomplish these tasks. Narrowing the list of alternatives to include only those opportunities that produce the best results will be tricky.
Stakeholder Perspectives/Ethical Dilemmas
The stakeholders involved in this scenario are Lawrence Sport’s management, employees, the suppliers and Mayo. The management team has the dreaded task of keeping the company afloat from week to week. Up until this point the going has not been easy. Management has already delayed payment to Gartner, one of its key suppliers. There is a question as to whether delaying the payments to suppliers is ethical. After all, the supplier is extending credit based on a good, trusting business relationship. Taking advantage of this relationship could prove detrimental to the business relationship.
Employees are stakeholders in that jobs are on the line. In the hierarchy of Lawrence, one realizes that each department is dependent on another department. For example, the marketing department is dependent upon the product development department. Without a quality product, there would be no need to market.
Therefore, the employee pool is intertwined with individuals that work together as a team and are dependent upon one another. Is it ethical for management to conduct business in such a manner as to jeopardize the livelihood of these individuals? Is it not the responsibility of management to make sure that effective cash management systems are in place as well as working capital management systems?
The specific characteristics of the suppliers are not clear, but what is known is that credit policies and payment arrangements have been agreed upon before any problem occurred at Lawrence Sports. These suppliers are in the business to make money and are expecting timely payment. Is it fair to hold back payments from the suppliers just because Lawrence has failed to make adequate capital management plans?
Finally, Mayo is a stakeholder with the best overall position. The company no doubt realizes that it is the bread and butter for Lawrence Sports. Since, Mayo is the sole customer of Lawrence; Mayo seems to have all the pull in the business relationship. As it stands, Lawrence is a little doubtful of upsetting Mayo’s management and is standoffish when it comes to making any changes to Lawrence’s dealings with Mayo. However, if Lawrence does decide to stand strong and create a tougher credit policy, what effect would that have on Mayo? Would the company be offended and pull out? If so, would that gesture, in a business world where everyone is out to make money, be ethical?
The good news for Lawrence Sports and for all the stakeholders involved is that the issues described are fixable. The first step for the company is to identify the issues and recognize the opportunities that exist for the company. A good problem statement for Lawrence Sports is as follows: Lawrence Sports will meet short-term and long-term financial obligations through the development of effective working capital management, cash management and the revision of its present credit policy.
By implementing an effective working capital management system, Lawrence Sports is providing for its future by taking care of the present. This means that the company has control over its working capital in such a way that the company can meet its current obligations without jeopardizing its livelihood. Furthermore, by taking a closer look at its principal assets, accounts receivable inventory, cash balances and marketable securities the company can begin to notice small changes that can make a big difference in the long run. For example, a careful credit analysis of a potential customer could lessen the uncollectible accounts receivable accounts and allow Lawrence to feel more comfortable extending credit to customers.
Lawrence could also learn many ways to increase wealth and keep costs down. By learning to use cash more efficiently and investing cash whenever possible, Lawrence will also learn that the marginal value of liquidity declines as company holds more and more cash (Beasley, 2006). Investing in marketable securities and other short-term instruments could provide the company with a safety net in times when accounts receivable is low and accounts payable remains the same.
In essence, Lawrence Sports will become a more liquid, self-sufficient company that will grow and prosper into a major competitor in its industry. There is a need for Lawrence to expand its market in that at the moment Mayo is its only customer. However, with careful planning and financial management there is no reason why Lawrence cannot reach other customers domestically and globally.
The first and most obvious solution is for Lawrence to do nothing. The company can continue to try and stretch payments to its suppliers and continue to extend credit to Mayo. However, as the textbook tells us, stretching payables can be costly. A CFO study has determined that more and more companies are stretching payment dates, a practice that demands better control of accounts payable (Managing accounts payable, 2005).
The average time payables are being extend, according to the study, is 28 days. However, the study also identified key problems with stretching payables that companies need to aware. First, stretching payables may tie up accounts payable clerks with calls from disgruntled vendors which could destroy the goodwill the company has tried so hard to build. There are also the missed benefits of early payment discounts that in the long-run could mount up to a hefty sum.
After having problems with working capital in previous years, GE Corp began stretching payables in 2001 and therefore received a much needed boost in operating cash flow. Investors were happy to see this boost; however accountants were skeptical fearing that the boost was short-lived. However, one must remember that stretching payables is only a short-term way of financing and should not be considered a permanent fix. As suspected the benefits began to slow in the future period, indicating that stretching payables was merely a band-aid on a problem that would continue to exist. The company had to look to other way of boosting cash flow. Luckily no credit problems occurred as a result (Hindman, 2006).
Lawrence can renegotiate a payment plan that could strengthen the financial position of the company and allow for competitiveness. As the payment plan stands now, Mayo feels that it can manipulate the payment terms to fit its business plans. However, by narrowing the payment window, Lawrence can carefully push Mayo into paying in a timelier manner, thereby improving the collection of receivables. Furthermore, managing the accounts receivable accounts could prove very advantageous for the company. The company would need to follow-up on high-risk customers and continue “hounding” these individuals. Allowing the customers to have more and more time is detrimental to the credit policy.
Borrowing through short-term loans is another alternative available to Lawrence Sports. A term loan would allow the company to borrow the needed money, but is paid back in level amounts with a single payment at maturity (Brealey Myers, Allen, 2007). Lawrence can employ the use of commercial paper as a way to finance short term goals. Analysts say that commercial paper programs work much like credit cards and afford the user more flexibility. According to Lisa Recupero of Goldman Sachs, “IF you spend down the proceeds at the right times and the right amounts, you can invest the unspent proceeds that you’ve borrowed into taxable securities or investments, and earn an arbitrage benefit between the cost that you’re paying on the debt and the amount that you are earning on your investment” (Kaske, 2006).
The Massachusetts School Authority (MSA) is a non-profit entity that works as the transportation medium for all schools within the state of Massachusetts. Although, a non-profit organization, they are still in need of vital operating cash to pay off fuel vendors and maintenance crews. In recent years, cash flow has dwindled significantly due to high fuel costs. The MSA has made its first draw on a $500 million dollar commercial paper program. It used this program to fund new building construction it so desperately needed and renovated those buildings that could be repaired. The program will disperse denominations of $100,000 with maturity dates of no longer than 270 days.
While officials have not decided how much they intend to draw, they are determined to draw only as much as the “market would bear on a cost-effective basis” (Kaske, 2006). Officials sing the praises of the commercial paper program and recommend it as an alternative to long-term financing. This alternative to traditional borrowing has allowed the MSA the liquidity needed.
Lawrence could look into preparing a cash budget. A company does not want to keep too little cash on hand and it does not want to keep too little. Keeping too much cash on hand involves an opportunity cost; that is, the amount of interest the money could be making if it had been invested. By preparing a cash budget the company would get a sense of the inflows and outflows of the business and plan for any emergencies that may arise.
The cash management plan would include figuring the target cash balance and could also include provisions for investing the available cash reserves. Some alternatives could be investments in treasury bills or certificates of deposit. The main factor to consider when investing these cash reserves is investing in something with a positive net present value (NPV). Lawrence could also seek to increase its cash flow by using lockboxes to decrease turnaround time.
There are also a number of long-term borrowing options that Lawrence could consider. Choosing secured or unsecured loans could be more viable for Lawrence. The company could enjoy a fixed rate and have the flexibility of time, something that is not readily available with short-term financing.
Analysis of Alternative Solutions
Though it would be tempting to sit back and let the situation correct itself, the option to do nothing is really not an option. Stretching payables has been tried by the company already and ethically can not be substantiated. Investing in another form of short-term financing seems attractive, but deciding what form that financing will take is tricky. Commercial paper seems to have worked good for other firms and the time table on the loan is attractive.
Long-term financing is an alternative that Lawrence Sports may want to consider as a last result. With long-term financing, the company is tying up capital and causing the debt-to-equity ratio to rise which will be red flag for investors. Reevaluation of the credit policy is a good way to find where Lawrence has been going wrong.
Maybe the payment terms are not well defined. Perhaps, the credit department is not enforcing the collection policy, or it could be that the time line is not realistic with the amount of cash outflows of the company. The development of a cash budget would give Lawrence a firm foundation when it comes to making its money work. By targeting the amount needed in cash reserves, the company could use the remainder of the cash in other investment vehicles that could provide cash for the company down the road.
Risk Assessment and Mitigation Techniques
If Lawrence decides to change its credit policy or consider a different means of enforcement, the company may find that Mayo is unhappy. To mitigate the risk of Mayo pulling out, a positive customer service relationship is needed. Representatives from Lawrence can meet with Mayo stressing the need for the changes and insisting that Lawrence will be there to help Mayo in any way possible. If the Lawrence has established a good business relationship with Mayo, the customer should be more susceptible to a change such as the one proposed.
Cash budgeting may cause shockwaves to run through the finance department. Once management begins to realize how much money is being used inefficiently heads may roll. However, once management looks beyond the present situation and realizes the opportunities that exist, the company can begin to take positive steps toward cash efficiency. As with any decision, using cash for one alternative means that there is an opportunity cost of not using it for another alternative. However, a good cash management team will be able to put their heads together and decide on a plan to better the company.
Short term financing should be looked at with the utmost scrutiny. When deciding on short term financing, the company needs to look at the cash cycle. How quickly are payments coming in? Will the short term financing meet the needed goals? If the financing is not properly planned for the company could end up in worse shape than it began. For example, the company should consider whether it will be able to pay off the loan in three, six, or nine months.
The optimal solution for Lawrence Sports is to restructure or reevaluate its credit policy, obtain short-term financing through commercial paper and devise a cash budget. Lawrence can increase its receivables by reevaluating its credit policy, while obtaining the short term financing will give the company breathing room to operate until the cash situation gets better. The cash budget and management of the companies cash accounts will strengthen the company’s position and ensure that it meets is obligations while providing cash reserve for investment.
The credit department will need to from teams in which evaluation of the current credit policy can be done. Within a couple of weeks, the credit policy team should have a first stage plan ready for the finance manager. After final approval, the policy will be enacted. The success or failure of the policy will be measured by the accounts receivable department and the accounts receivable aging summaries. This should tell the team whether or not receivables are being collected in a timely manner or whether further evaluations should be done.
Lawrence should seek to secure short term financing with commercial paper as soon as possible, preferably within the next week or so. The length of time of the loan should not exceed 120 days. That should give the company enough time to secure enough cash to get its new credit policy up and running.
Cash management should begin from day one. A committee should be formed to determine the target cash balance and another committee should be set up to determine how the cash reserves should be invested. The goal is to make Lawrence’s cash work in a positive way and minimize the time it takes for the cash cycle to be completed.
Evaluation of Results
Lawrence Sports can evaluate the solutions implemented by applying basic ratios to its financial statements. Checking values for debt-to-equity ratios and return on investment ratios can give a terrific picture of how the company is doing. Is the company building its cash reserves and investing that cash in a positive manner. Another telltale sign of success would be the relationships with suppliers and customers. Suppliers will still regard Lawrence as a good business partner while Lawrence will have a lasting relationship with Mayo and will have built new business relationships with other customers.
In summary, the company will be able to meet its short-term obligations such as paying for raw materials from suppliers, while keeping business relationships in tact. The cash management system will help the company use its cash to the utmost. If these indicators are not present, that means that the alternatives should be reassessed.
Lawrence Sports is a company with many opportunities available to it. Not only is the company in a promising industry, but it has established goodwill with its suppliers and customers. By making a few changes to its working capital management, Lawrence Sports can propel itself into a global market and enjoy success in the sports gear industry.
Brealey, R.A., Myers, S. C. & F. Allen (2006). Principles of Corporate Finance. 8th ed. McGraw-Hill. New York.
Hindman, Paul A. (2006). GE stretching payables. Retrieved May, 2007 from website: findarticles.com.
Kaske, Michelle (2007). Massachusetts school authority kicks off its $500 million CP program. Bond Buyer. 359:325-44, p 4. Retrieved from EBSCOhost database on May, 2007.
Managing Accounts Payable (2005). CFO study reveals more companies stretch payment dates. Nov. 2005, 15:11, p 2-4. Retrieved from EBSCOhost database on May, 2007