Lawrence Sports is a manufacturer and distributor of sporting goods equipment and protective gear. They have one major customer, Mayo Stores, which supplies 95% of the company revenues for Lawrence Sports. Mayo Stores is a leading world retailer and is in the process of expanding their business internationally. The expansion process has limited Mayo Stores’ ability to make the scheduled payments to Lawrence Sports. This is having a great financial impact on Lawrence Sports business operations (University of Phoenix, 2007).
Lawrence Sports has two primary suppliers: Gartner Products and Murray Leather Works. Gartner Products is the largest supplier, providing approximately 70% of the materials for Lawrence Sports. Lawrence Sports is not a major customer for Gartner Products which could limit financial negotiation abilities. Murray Leather Works is a much smaller company. Murray Leather Works has been able to obtain Lawrence Sports as their primary customer, supplying 75% of their revenues. Negotiations with Murray Leather Works will need to be handled delicately. Delaying payments too long could have a severe impact on Murray Leather Works financial well-being. It will be important to structure agreements with both suppliers which allow for payment flexibility for Lawrence Sports (University of Phoenix, 2007).
Lawrence Sports needs to build and maintain strong relationships with both their customers and suppliers. These relationships strengthen account negotiation processes. It will also provide for proper management of accounts receivables and accounts payables which will reduce the need to rely on borrowing from the bank line of credit (University of Phoenix, 2007). Properly managing cash reserves, credit policies, negotiating supplier strategies, and available bank financing will provide Lawrence Sports with an optimal working capital strategy. This strategy shall also be monitored to ensure suitable performance is being achieved.
Working Capital Policy
Cash balance requirements including cash reserves needed for long-term opportunities that may arise. Lawrence Sports needs to determine an ideal cash reserve. An ideal cash reserve is to find a proper balance between flexible financial policies and restrictive financial policies. Flexible financial policies include maintaining large cash balances and marketable securities, holding large balances in inventory, and offering liberal credit terms. Restrictive policies are the opposite of flexible policies low cash reserves, low inventory, and no credit sales. A restrictive policy could result in shortage costs. Shortage costs occur when current assets are low which result in payment defaults or creating a need to borrow (Ross, 2004).
Lawrence Sports is required to maintain a minimum of a $50,000 cash balance in the bank at all times (University of Phoenix, 2007). This needs to be considered in determining the ideal reserve and reviewing cash budgeting. Cash budgeting includes examining the timeline of cash inflows and cash outflows and reviewing the sources and uses of cash. Currently, Lawrence Sports is faced with delayed payments from their primary customer, Mayo Stores, and a need to make payments to their suppliers. An alternative available is to borrow from a bank line of credit. This is not the preferred solution due to the high-interest costs incurred.
Lawrence Sports needs to determine a target cash reserve for their company. The target needs to incorporate the minimum $50,000 required cash balance by the bank, determine a safety reserve for unforeseen expenses, and the cash required for the company operating cycle. Lawrence Sports may want to benchmark industry websites in determining an optimal cash balance. They can also review credit policies, supplier negotiations, and financing strategies to assist with cash requirements for the operating cycle. Credit policy that balances Lawrence Sports desire to minimize accounts receivable and maximize revenue.
Lawrence Sports is currently faced with a collection issue with Mayo Stores. Mayo Stores is currently two weeks behind in their payments due to their international expansion efforts. Lawrence Sports has been informed to not expect any payments for an additional two weeks. The lack of cash inflows is creating financial burdens for Lawrence Sports. A review of the credit policy should be reviewed. Lawrence Sports has three different options in offering credit to customers: terms of sale, credit analysis, and collection policy (Ross, 2005).
The terms of sale review the period to grant credit, cash discounts, and credit instruments. Three factors affect a decision to grant credit: the probability of non-payment, size of the account, and perish-ability (Ross, 2005). Mayo Stores is Lawrence Sports’ primary customer and a good relationship has been established. Products supplied to Mayo Stores are non-perishable. Providing credit terms generally increases sales. Denying credit to Mayo Stores could be a fatal decision. Therefore, payment negotiations need to be handled delicately.
Lawrence Sports could offer a cash discount for payments received early. A cash discount such as 5/10/net 30 could be offered. This would encourage Mayo Stores to provide payments within the first 10 days by offering a 5% discount on the balance due. Payments not received within the first 10 days would not receive a discount (Ross, 2005). This would speed up cash inflows for Lawrence Sports and reduce the need to borrow bank funds.
Lawrence Sports could re-negotiate credit instruments by requiring Mayo Stores to sign a promissory note, commercial draft, banker’s acceptance, or conditional sale contract. These instruments provide for a more formal collection policy where repayment ability may be questionable (Ross, 2005). Requiring a credit instrument could damage the relationship with Mayo Stores and may not be the best option to pursue. Supplier negotiation strategy for terms of payment that balances the costs to Lawrence Sports and their cash requirements.
Lawrence Sports currently has two primary suppliers: Gartner Products and Murray Leather Works. Gartner Products is the major supplier for Lawrence Sports, but Lawrence Sports is not one of the primary customers. Therefore, losing business from Lawrence Sports would not have a large impact on Gartner Products. A delay in making payments to Gartner Products could limit the ability to receive supplies from Gartner Products. Murray Leather Works is a small supplier, but Lawrence Sports provides 75% of their revenues. Delayed payments to Murray Leather Works could have a severe impact on operations.
Lawrence Sports has a couple of options available in making payments to the accounts payables. They could stretch the payables or re-negotiate their payment terms. Stretching payables allows a company to defer payments. This can be costly due to the loss of being able to take advantage of discounts (Brealey, 2005). Lawrence Sports would need to compare the cost of losing discounts versus the cost of using bank financing. The option that provides the most benefit to Lawrence Sports should be used first.
Lawrence Sports could also re-negotiate their credit terms with their suppliers. Increasing the due date from 30 days to 45 to 60 days out would allow additional cash inflows to be received in order to satisfy the payment due dates. Increasing the credit period can reduce the price paid by the customer and can increase sales (Ross, 2005). Increasing the credit period may be beneficial for the suppliers. However, the suppliers would need to adjust their cash budgeting to accommodate the request. Short term financing strategy to ensure the availability of an adequate line of credit while minimizing the cost of that credit.
Lawrence Sports has many bank financing options available to them. Some of these options include a revolving line of credit, bridge loans, term loans, and commercial paper. Lawrence Sports currently has a revolving line of credit available to them with a maximum borrowing limit of $1.2 million. Their account is set up to automatically transfer funds if the cash balance goes below the required $50,000 balance. The downfall to using the line of credit is the interest rate associated with borrowing. When the balance reaches $550,000 or higher, the interest rate charged is 16%. Lawrence Sports prefers to keep bank borrowing and the interest rate as low as possible (University of Phoenix, 2007).
Other bank lending options include bridge loans and term loans. A bridge loan serves as short-term interim financing. Bridge loans are typically self-liquidating. Term loans for working capital purposes typically have a maturity of four to five years. These loans will normally have level payment amounts. Some situations allow these loans to have a balloon payment or a single bullet payment. Often term loans are renegotiated before maturity. Short-term loans often have a lower interest rate than lines of credit, making this an attractive feature. Term loans can require collateral. Collateral can consist of a pledge of accounts receivables, inventory, or other long-term assets (Brealey, 2005). Lawrence Sports could look to term loan financing for working capital needs. A term loan could be a viable option with a lower interest rate and set payment amounts. This payment structure could result in less demand on the working capital position.
Lawrence Sports could also consider issuing commercial paper. Commercial paper eliminates the intermediary and allows the company to issue their own short-term unsecured notes directly to investors. They are typically issued for periods ranging from 60 days to 9 months. Often bank lines of credit are used as guarantees for commercial paper, therefore, reducing the risk involved. Lawrence Sports could consider issuing commercial paper. However, they will need to ensure their credit rating is very high. Investors are often reluctant to invest in low rated companies (Brealey, 2005).
Lawrence Sports will want to examine their bank financing options in their working capital strategy. Bank financing will need to be used in situations where cash shortfalls exist between accounts receivables collections and cash outflows to accounts payables. An understanding of how the shortfalls arise and when cash inflows can be expected for repayment will be crucial in obtaining bank financing.
Metrics that will be used to monitor performance against the policy.
Lawrence Sports has a variety of methods and financial analysis tools to measure financial performance. As the Finance Manager, a regular review of the financial statements will be crucial. The information provided on the financial statements will allow for performance ratios and indicators to be created. Short-term solvency can be measured through the current ratio and quick ratio. Asset management can be monitored through the asset turnover ratio, receivables turnover ratio, and inventory turnover ratio. Leverage ratios, such as the debt-equity ratio and the long-term debt ratio, measure the company’s dependence on bank financing. Profitability is measured through the net profit margin, return on assets, and return on equity ratios (Brealey, 2005). Lawrence Sports will want to monitor these ratios on a regular basis. It is recommended that monitoring range from daily to the use of financial forecasting over a three to five year period. These various analyses will allow Lawrence Sports to monitor their financial position at all times and make adjustments as necessary for long-term company viability.
Ethical Implications
Lawrence Sports will want to ensure their financial information is documented properly. Financial information that is not properly accounted for can mislead the financial division, lending institutions, as well as investors. Misreporting information leads to faulty financial positions which can lead to obtaining more funds than the company has the ability to repay. It can also result in legal implications of falsifying documents for financial gains. Legal issues can lead to business closures and the possibility of key management personnel serving jail time. The government has put financial reporting requirements in place to help avoid financial misrepresentation. However, a proper review of financial documents needs to be completed on a regular basis by multiple persons within the financial department to serve as a check and balances system.
Conclusion
Lawrence Sports has many working capital strategies available. A mix of managing cash inflows from accounts receivables, cash outflows for accounts payables, and bank financing options will provide for a strong working capital policy. A cash reserve balance also needs to be available for unforeseen expenses. The best policy for Lawrence Sports is to work with their customers to set collection policies that will provide for cash inflows as quickly as possible while maintaining strong relationships to encourage future sales and revenues for company growth. Lawrence Sports will also need to negotiate payment terms with their suppliers that will accommodate the cash inflow trends. Relationships with suppliers also need to be carefully negotiated to maximize payment terms while at the same time providing for cash inflows for the supplying companies to operate. This is a delicate balance to achieve.
The preference is to have accounts receivables collected prior to accounts payables being due. Situations occasionally arise where accounts receivables collections need to be extended which can affect the ability to satisfy accounts payable due dates. In these short-fall situations, Lawrence Sports needs to have bank financing available. Lawrence Sports currently has a revolving line of credit available to cover shortfalls. The interest rate associated with the line of credit is extremely high. The preference is to minimize the use of the line of credit as much as possible. Lawrence Sports will want to communicate their financing policies with their employees to ensure maximum performance is achieved and employees are engaged in the company. Providing a full understanding of company policies will result in best performance on both an employee level as well as a company level.
References
Brealey, R. A., Myers, S. C. & Allen, F. (2005). Principles of corporate finance:
Managing risk. New York, NY: McGraw-Hill Companies, Inc.
Ross, S. A., Westerfield, R. W., & Jaffe, J. (2005). Executive Summary (7th ed.). New York, NY: McGraw-Hill Companies, Inc.
University of Phoenix. (2007). Working Capital Management. Retrieved September 19, 2007, from University of Phoenix, rEsource, Simulation, MBA 550 – Resource Optimization.