Jones Electrical Distribution is a wholesaler of electrical components and devices to general contractors and electricians. Although Jones Electrical Distribution has been profitable in the past few years, the company experiences a drain on its cash when it attempts to maintain a rapid growth while taking advantage of trade discounts at the rate of 2%. Problems faced by Jones Electrical Distribution are as follows: Should the company maintain a rapid sales growth or should it slow down? Which is its favorable means of financing? Equity or Debt?
For a long term borrowing, should the company turn to Southern Bank & Trust for an extended line of credit or maintain its relationship with Metropolitan Bank? Should the company take advantage of the trade discount or pay its suppliers after due date? To evaluate the case and provide possible solutions to Jones Electrical Distribution, the operating statement with and without trade discount is forecasted and financial ratios are calculated as below.
COGS in Expectation 2007=2700/Net sales in 2006* COGS in 2006 COGS in Expectation 2007 with trade discount=COGS in expectation 2007*(1-2%) Provision for income taxes in expectation 2007 with trade discount=provision for income taxes in expectation 2007/net income before tax in expectation 2007*net income before tax in expectation 2007 with trade discount
From what has been analyzed, it is obvious that Jones Electrical Distribution has experienced a slight decline in its gross profit margin, from 19.70% in year 2004 to 18.91% in year 2006. It was mainly due to the fact that a general economic downturn might cut down its profitability. Jones Electrical Distribution’s current ratio decreased from 2.14 in 2004 to 1.64 in 2006, quick ratio from 1.05 to 0.71, and working capital/sales ratio from 0.16 to 0.12. It can be safely drawn a conclusion that the company has experienced a declining trend in its ability to pay off its short term obligations with current assets or without relying on the sale of inventories. Inventory turnover days increased from 68 in year 2004 to 76 in year 2006. From the balance sheet, it shows that the company increased its inventory by 36.3% ((379-278)/278), from 278,000 in year 2005 to 379,000 in year 2006.
It is obvious that Jones Electrical Distribution is overoptimistic in its predictions but the economy encounters a downturn. Increase in inventories is a reason for its cash shortage. Cash conversion cycle looks at the length of time the company needs to sell inventory, collect receivables and pay obligations without incurring penalties. Jones Electrical Distribution’s cash conversion cycle decreased by 5 days, from about 100 days in 2004 to 95 days in 2006. In other words, the company has improved its ability to convert its products into cash through sales. On the one hand, receivable turnover days remain stable during this three-year period from 2004 to 2006, although it has a slight fluctuation about 2 days in 2005.
On the other hand, payable turnover days increased significantly by 14 days, from 10 days in 2004 to 24 days in 2006, which was mainly due to the fact that Jones Electrical Distribution took very few purchase discounts because of the shortage of funds. With regard to financial leverage, Jones Electrical Distribution has a stable debt/total asset ratio at about 0.68 and it also improved its ability to meet required interest payments on a pre-tax basis. If the company turns its banking relationship from Metropolitan Bank to Southern Bank & Trust and extends its borrowing from 250,000 to 350,000, its financial leverage might be enhanced. Return on equity (ROE) ratio measures a company’s performance in using assets to generate earnings and reflects the overall business risk involved. The ROE ratio of Jones Electrical Distribution went up from 7.61% in 2004 to 12.35% in 2006, which was mainly caused by the increase in its return of sales while asset turnover and leverage remain stable. Recommendations:
The market in which Jones Electrical Distribution competes is large, fragmented and highly competitive. The company builds up sales volume through its competitive price, aggressive direct sales force and tight operating expense control. When the economy steps into a downturn, it is advisable for the company to slow down its growth. By doing so, the company can ease up its shortage of funds. Jones Electrical Distribution is given a 2% trade discount by its suppliers for payments made within 10 days of invoice date. If the company strictly employ this policy and pay its obligations within due dates, the actual annualized interest rate it obtains would be 36% (2%* 360/ (30-10)), which is much higher than the interest rate paid for banks. In addition, from what has been calculated in the operating statement, the company will increase significantly its net income if it strictly complies with the trade discount policy.
From this perspective, Jones Electrical Distribution should take full advantage of the trade discount. Also, in order to pay off its suppliers within 10 days, Jones Electrical Distribution should build up a relationship with Southern Bank & Trust to obtain an extended line of credit instead of being stick to Metropolitan Bank. The increase in the company’s inventory seems to be unnecessary especially under a declining economic environment. Jones Electrical Distribution should improve its cash flows based on a more sophisticated demand forecast and inventory forecast. Nelson Jones is the sole owner of Jones Electrical Distribution. It is also a good option to raise money through having a partnership with other investors or issuing common shares.