Liquidity must become a primary focus for any business hoping to create sustainable growth. Lawrence Sports, a fictional company, is presently in need of capital management analysis and methodology overhaul. Included in this paper is a discussion of the issues, opportunities, values and solutions that the firm should be considering. The 9 step problem solution model is the format used to take the reader through critical identification, evaluation and implementation of elements that will transform a problem into new growth opportunity.
Lawrence Sports is a $20 million dollar revenue company that assembles and distributes sporting goods. The focus of the scenario is to provide the opportunity for the student to develop solutions to trade off issues, thus establishing stability for the firm. Mayo, who is a retailer responsible for 95% of sales, is hindering Lawrence from paying raw materials suppliers. Unfortunately, this cash positioning problem is direct result of the Lawrence credit policy and the Mayo request to delay payment until the week of April 14-20. Borrowing money to deal with supplier payables is not an option, due to the $1.2 million dollar maximized bank limit. Therefore, this paper will strategize from the perspective of a financial manager who will turn a working capital problem into the chance to design a new credit policy, implement cash management models and introduce risk mitigation techniques.
A credit policy that is too liberal will continue to cause damage to Lawrence Sports. Presently both receivables and payables are unsynchronized, which is putting undue financial distress on the firm, as well threatening supplier relationships that have helped build the company. Considering the dominant sales role that Mayo plays in the supply chain, Lawrence will have to be very careful in pressuring the payment of receivables. The terms of a new credit policy will be further discussed later in the paper. Usually a firm will extend credit if the choice to do so is at lower cost; however, Lawrence is not in a bargaining position. “In general, a firm will extend trade credit if it has a comparative advantage in doing so” (Ross et al., 2005).
Issues and Opportunities
Lawrence does not have leverage to build the business due to unpredictable cash flows. Though this situation is limiting growth, redefining the cash management strategy will open new opportunities within the current supply chain system. Focusing on realistic inventory turnover that creates a positive cash balance will shift the failing policies towards a fresh perspective. This will only happen as a result of new financial planning linked to targeted goal. “Most financial managers regard a planned cash balance of zero as driving too close to the edge of a cliff. They establish a minimum operating cash balance to absorb unexpected cash inflows and outflows” (Brealey et al., 2005) Instead of the present unpredictable receivables turnover, the new credit policy will allow the basis to calculate a minimum cash balance to increase liquidity. Additionally, previous survival trade off decisions will fade as carrying costs and shortage costs become the opportunity costs of foregone investments and having enough cash to invest in securities holdings.
Another issue that Lawrence Sports is dealing with is the over reliance on Mayo to complete 95% of sales. Allowing Mayo to stretch payments creates a problem for the vendors, thus de-stabilizing the supply chain. Therefore, this paper will discuss the possibility of outsourcing raw materials. If this becomes an alternative, International currency fluctuations will have an effect on earnings and will have to be prepared for. The Lawrence outsourcing team will have to monitor the exposure co-efficient and decompose the dollar variability to optimize cost advantages.
Stakeholders Perspectives
Stakeholders are essential to the life of any organization. Without a clear understanding of the key entities/people affected by processes, the strategic goal will not be aligned. Suppliers, retailer and the employees are the primary stakeholders for the Lawrence scenario. Murray and Gartner supplied the materials for manufacturing and sales to take place, which surfaces ethical dilemmas. These vendors need to become a priority in order for sporting goods to continue to reach the consumer. A supply chain will function only when active parties are sufficiently compensated for work completed. If Lawrence Sports does not establish a new credit policy with Mayo, the outsourcing option may be necessary to meet future payables restrictions. Selling the receivables to a collection firm is also a way to liquidate current receivables.
The employees at all points of the supply chain are also affected by the lack of cash flow control. The new strategic plan should be designed by Lawrence, and respectfully communicated to encourage commitment orientation and boost morale. This will potentially affect both the vendors and Mayo by establishing a leadership role in the supply chain.
Problem Statement
The Lawrence Sports cash positioning problem exists because of an out of control credit policy. Liquidity problems will continue to challenge the firm unless strategy/efficiency becomes the goal. Though Mayo is a global retailer, Lawrence Sports must professionally communicate credit guidelines. Additionally, as Ann Wu (director, vendor relationships) believes, one or more of the vendors will experience financial distress if Lawrence delays payments.
Currently, Lawrence lacks the needed systemic capital management structuring to deal with the uncertain cash flows. The postponement of the $1,360 million dollar invoice payment may ensure a substantial order for the week of April 21-27; however, Lawrence may be without a vendor for finished leather products. The trade off decisions that the company must make does not create the opportunity for growth. Accordingly, the firm will have to take control of any future supplier payment uncertainty, while also addressing potential raw materials variability.
Using the course simulation as a means for trial and error examples produced an interesting predicament. Attempting immediately to improve the working capital position, by pressuring Mayo to pay, upset the retailer. Unfortunately, the choice to collect the outstanding receivables affected the sales for the week of April 21-27. This was the expected reaction considering the lack of preparation and agreement. Not having a predetermined contract had an adverse affect on sales, and jeopardized the vendor relationship that Lawrence relies on.
End State Vision
“Value creation depends on cash flows” (Ross et al., 2005) A new cash positioning will exist for Lawrence Sports when receipts and disbursements create positive net working capital, supported by a sustainable infrastructure of processes. Following the new cash yielding trade off decisions, the company should start experiencing growth opportunities. Additionally, awareness of necessary balance between choices regarding profit margin vs. turnover, and tax subsidies vs. financial distress will define the firm’s direction. Once these concepts are of frequent discussion within management, positive net working capital may be turn to a reality.
Lawrence has developed into a $20 million dollar revenues company, however, must over-come the unsynchronized cash flow problem. Unfortunately, the Mayo sales have not happened in time to pay the vendors for raw materials. Therefore, the excessive pressure to close the cash flow gap will breathe new life into the firm. Taking advantage of this opportunity will allow Lawrence to become the internally financed entity that the owners hope it to be.
“Profitable firms generate cash internally, implying less need for outside financing…the greater the cash flow of more profitable firms creates greater debt capacity” (Ross et al., 2005). Though it may seem that Lawrence is in a difficult situation that could potentially threaten future sales, the implementation plan will establish the correct direction. The external financing limitation is a blessing in disguise by forcing better policies. Following the transition into more synchronized cash flows, the firm will find bills paid and net working capital. Successful companies eventually learn that organizations must have survival strategies built into the system. This is the focus of the next section of this paper. To link policies, and processes with value creation.
Alternative Solutions
Primary alternatives for Lawrence Sports are based on significant company benchmarking that provide approaches to develop a programmed solution. Dell Computers, Honeywell and Coca-Cola are three firms that sustain relative competitive advantage in their respective industries. Decisions for Lawrence alternatives included analysis of the annual reports, which yielded valuable lessons on how to transform a financially challenged organization.
Dell Computers has found a way to balance cash flow and create net working capital. In 2008 the company reported $9.2 billion dollars in cash and cash equivalents. Dell has consistently held a cash balance by communicating directly with the customer, reducing inventory risk and maintaining a conservative credit policy. “We use cash generated by operations as our primary source of liquidity and believe that internally generated cash flows are sufficient to support business operations” (Dell Annual Report, Financing Receivables).
Lower level trades off decisions are challenging Lawrence Sports. For Dell, higher level decisions for carrying costs and shortage costs include net working capital decisions such as optimizing investment alternatives. This was accomplished by ensuring that receivables are collected before issuing disbursements. If Lawrence adopts this policy, the firm will be able to use the cash from operations as the source of liquidity. Improving the perception of how to accomplish this type of financial growth is necessary. The company will either choose to struggle with receipts/disbursements or take control of the trade credit policy.
Another choice of alternatives for Lawrence is to calculate a targeted cash balance, using the Miller-Or model, while seeking potential suppliers that will accommodate the firm’s policy needs. Though Mayo is responsible for the majority of sales for the firm, without a more conservative policy, payables will surely continue to be restrained. Honeywell, “continues to manage its businesses to maximize operating cash flows as the primary source of liquidity” as Dell does (Honeywell 2007 Annual Report, Liquidity and Capital Resources). Additionally, the firm is not solely dependent on one or two suppliers. Honeywell chooses to use long-term price agreements for raw materials, and claims minimal concern for the supply of raw materials.
With the possibility that Lawrence may lose a vendor, (as a reaction to granting Mayo the right to delay receivables payments) lower cost may be achieved by outsourcing. If dependence on Mayo is the choice, then the firm should investigate how International suppliers will be able to help the firm maintain the liberal credit policy. In this case, Lawrence will need to consult foreign currency experts.
Coca-Cola has to deal foreign currency fluctuations, and uses derivatives to reduce economic exposure. The firm “enters into forward exchange contracts and purchases currency options (principally Euro, Japanese Yen, and dollars to hedge certain portions of forecasted cash flows denominated in foreign currencies” (Coca-Cola 2007 Annual Report, Quantitative and Qualitative Disclosures About Market Risk). Discussion on forward contracts is included in the risk mitigation section of this paper. If outsourcing is management’s decision, then a plan must be designed to deal with foreign currency fluctuations.
Analysis of Alternative Solutions
Lawrence Sports will be able to correct the cash flow problem with a conservative credit policy. This alternative receives the highest rating because, without balanced receipts and disbursements, optimal trade off choices will not exist. When the CEO realizes that the liberal credit policy is a hindrance, the path to liquidity will surface. The second alternative to expand the supplier base is also important, however, not as critical as the credit policy implementation. As relations improve within the supply chain, Lawrence will find more time to consider new supplier options. The final alternative is a contingency plan for the loss of a vendor. When Murray and Gartner begin to receive reliable payments, outsourcing options can be considered as a cost advantage strategy.
Risk Assessment and Mitigation
Deciding to implement a new credit policy is the best way to ensure sustainability. Mayo’s response will hopefully be accepting. If not, a reliable mitigation plan must be in place. Factoring receivables will help ensure that Murray and Gartner are paid for raw materials. “Factoring refers to the sale of a firm’s accounts receivable to a financial institution known as a factor” (Ross et al., 2005). Instead of endangering the relationship with vendors, factoring will relieve the payables problem by relinquishing approximately 4% of the invoice amount to the factor. Considering the global reach of Mayo, factoring may be the viable solution for the short term.
As mentioned in the benchmarking section of this paper, Coca-cola has found a way to use derivatives to hedge foreign currency fluctuations. If Murray and Gartner end the relationship with Lawrence Sports, and outsourcing becomes a cost saving alternative, the firm will turn to international suppliers for raw materials. Lawrence will have the choice of either entering into a bilateral forward contract with a commodity resource or using an exchange to establish forward prices. Depending on how well the Lawrence staff plans for the outsourcing agreement, the project could become very advantageous.
Optimal Solution
Three common elements for success in any company are strategy, financial and corporate governance. Lawrence Sports has a responsibility to initiate cash control to increase profitability in the supply chain system. This means that future competitive advantage will exist as the response to contracted policies and formalized cash management techniques. The following section is a justification of the optimal solution to help save Lawrence Sports.
When the firm manufactures the raw materials and relies on a retailer, a tremendous obligation is created. The vendor offered credit to Lawrence, which then extended credit to Mayo. An inability to pay for accounts receivables in the supply chain has endangered every link in the process. Therefore, the goal is to make sure that a fresh policy is implemented to improve the average collection period. Sustainability will rely upon this.
The example from Dell Computers earlier is a good example of how to deal with receivables. Collecting before disbursements will ensure that bills will be paid. Ongoing cycles of successful net working capital outcomes will begin to change the inertia of the firm. Ultimately this process will increase value within the supply chain system, while allowing Lawrence to focus more on strategic goals. The ability to change an organization is relative to which activities require the most attention. If Lawrence is inundated with cash management issues, the time is always limited by functional dilemmas. For example, if a human does not have enough food, they cannot think about progress. This is similar to the premise of Maslow’s hierarchy of needs. When cash flows are created and established properly, net worth can increase.
A decision to grant credit to Mayo is not as much of an issue due to the 3,000 stores and international reach. The economies of scale should not be the deciding factor. Mayo will stay in business, even if it means liquidity problems for manufacturers. Therefore, with the new guidelines to deal with receipts/disbursements, Lawrence will survive the next time Mayo (or any other retailer) decides to stretch payments. Focusing on an optimal credit relationship is essential. “At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable” (Ross et al., 2005).
Unless a major disagreement happens with the vendors, an outsoucing of raw materials does not to be considered. Educating the company’s change agents to act according to the strategic plan might avoid this situation. Using financial data to calculate the targeted cash balance will happen as a result of efficient cash flow balancing. Essentials of proper management include the marriage of efficiency and strategy.
When short term financial decision making becomes the emphasis for value creation, Lawrence will have less difficulty dealing with liquidity. The fundamentals of converting raw materials into cash are the primary puzzle, because unsynchronized cash cycles have damaged the firm.
A realistic credit policy leads to gap minimization of cash flows and the potential to expand or invest. Proper management of operations will help Lawrence turn a time of despair into one of profitability. “The need for short term decision making is suggested by the gap between cash inflows and outflows” (Ross et al., 2005). Borrowing money from the bank is not an option for Lawrence. Zero liquidity reserve is available, and cash flows are uncertain. The only solution is the overhaul the credit policy. As fore mentioned, a factoring company will have to be used to survive the short term cash dilemma.
Implementation Plan
Implementing the new trade credit policy and cash management process will happen according to the following guidelines. After deciding on agreeable terms of sale with Mayo, management will outline the next profitable horizon. Future retailers will be bound by a policy contract that includes the terms of sale, credit analysis and a collection policy. The credit team should have the new policy terms established within one week. This will be negotiated with Mayo, considering the need of immediate action.
When the trade credit guidelines are set, the finance team will be able to calculate the targeted cash balance, which should be assessed every two weeks. From this, the capital management outlay will be created. After the policy and cash flow plan is established, management can then begin investigating alternative retailers and suppliers.
Evaluation of Results
Part of project implementation is guaranteeing a way to measure results. Unfortunately, Lawrence must design a new policy immediately. “Change occurs, as it must, but it does so in an atmosphere of crisis and confusion. Substantial loss may result before the needed design is complete” (Pyzdek, 2003). Lawrence Sports does not have the flexibility of Dell, Honeywell and Coca-cola. Therefore, management will be advised to enroll in online Six Sigma courses, as well instructed to immediately update techniques for financial/operational analysis.
The evaluation schedule is as follows. Credit policy reviews will happen once a month, supplier payables correspondence on a weekly basis, operations will be assessed daily, financial investments analysis reports will occur and retailer analysis memos will be delivered bi-weekly.
Conclusion
“Focus comes from two perspectives: down from the top-level goals and up from problems and opportunities” (Pyzdek, 2003). Lawrence Sports will be able to leverage professional policy terms into positive net worth. The past uncertainties can be used as an historical example on the importance of cash flow responsibility. Future reports will include successful cash balances and new growth opportunities.
Table 1
Issue and Opportunity Identification
Issue Opportunity Reference to Specific
Course Concept
(Include citation) Concept
Lawrence needs to establish a better control over the credit policy to enable the possibility of closing the gap between cash inflows and outflows. This is the only way to create working capital. With all due respect to Mayo, this is the time for Lawrence Sports to prepare for a bright future in sporting goods manufacturing. “At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable” (Ross et al., 2005). Optimal Credit Policy
Balancing cash flows between receivables and payables is causing financial and professional distress to Lawrence. After the new credit policy is created, Lawrence will have to seek new retailers and calculate the expected profit formula to make credit decisions. Mayo is still the main retailer, because the firm is a large volume customer. “In other words, you have fixed your terms of sale; you have decided on the contract that customers must sign; and you have established a procedure for estimating the probability that they will pay up” (Brealey et al., 2005) Expected Profit Formula and Credit Decisions
Once the struggle between receivables and disbursements are solved for Lawrence Sports, a minimum cash balance will have to be established in order to accommodate uncertainties. Now is the time for Lawrence Sports to get control of asset liquidity, and re-assess the capital management infrastructure. For fluctuating cash flows, the Miller-Or model is preferred to calculating a target/minimum cash balance. “Most financial managers regard a planned cash balance of zero as driving too close to the edge of the cliff. They establish a minimum operating cash balance to absorb unexpected cash inflows and outflows” (Brealey et al., 2005). Target/Minimum Cash balance
A short term financing predicament has occurred as a result of the Lawrence Sports liberal credit policy with Mayo. When the firm gets control of working capital (through new policies), excess cash management will need to be dealt with. A positive cash balance will begin to open doors of opportunity for Lawrence Sports. Eventually, earlier critical trade off decisions regarding credit will evolve into investment maximization. “…study focuses only on liquid assets (i.e., cash, and market securities), so that carrying costs are the opportunity costs of holding liquid assets and shortage costs are the risks of not having cash when investment opportunities are good”(Ross et al., 2005).
Improved Cash Management Trade Off Decisions
The current capital conflict is keeping Lawrence Sports from establishing a sustainable cash balance. With the bank limit at $1.2 million already, the firm should assess the possibility of new retailers or vendors. If this is the case, International companies will be considered options as well. An improved credit policy and cash positioning team will potentially find a new retailer or vendors (depending on the relationship with Mayo). If a change occurs that involves International companies, hedging techniques will be used. “For many firm’s the wide fluctuations in interest rates and exchange rates have become at least as important as a source of risk as changes in commodity prices. Financial futures are similar to commodity futures, but instead…you place an order to buy or sell a financial asset at a future date” (Brealey et al., 2005). Futures Hedging
Table 2
Stakeholder Perspectives
Stakeholder Perspectives
Stakeholder Groups
The Interests, Rights, and
Values of Each Group
Suppliers Murray and Gartner have the right to be paid for the raw materials supplied to Lawrence Sports. The present credit policy is pressuring the business relationship.
Retailer Mayo has to delay payment to Lawrence sports until the week of 4/14 to 4/20. A new credit policy will have to be put into effect, which must be respectfully communicated.
Employees Implementing new policies and cash management techniques will affect the career paths of all employees. When Lawrence re-designs the organizational credit/finance infrastructure, the employees will be able to function more comfortably.
Table 3
Risk Assessment and Mitigation Techniques
Risk Assessment and Mitigation Techniques
Alternative Solution Risks and Probability Consequence and Severity Mitigation Techniques
New Credit Policy (Dell) • High
• • •
• Medium• • Communicate the necessity of the credit policy (respectfully).
New Suppliers/
Target Cash Balance
(Honeywell) •
•
• Low •
•
• Low • The minimum cash balance is a part of the new Lawrence plan to increase liquidity. Credit policy is the risk mitigation technique.
Outsourcing
(Coca-cola) • High
• • • High • Hedging techniques can be used to avoid currency fluctuations.
Table 4
Optimal Solution Implementation Plan
Deliverable Timeline Who is Responsible
Decide on Credit Terms 1 week Credit Team
Implement Credit Policy 2 weeks Management
Determine Target Cash Balance Bi-weekly Finance Team
Outline Capital Management 1 week Finance Team
Delegation of Duties 1 week Management
Re-assess policies 2 months Financial Analyst Team
Investigate Retailer Alternatives 2 weeks Domestic/International
Table 5
Evaluation of Results
End-State Goals Metrics Target
Balanced Cash Flows Credit policy reviews One per month
Collected Receivables Before Payables Supplier payables correspondence Weekly conference calls
Perfect orders Management assessments Daily (operations)
Investments Finance reviews Weekly
Retailer flexibility Management research and analysis Bi-weekly analysis
References
Brealey, Richard A., Myers, Stewart C., Allen, Franklin., (2005) Principals of Corporate
Finance, The Mc Graw-Hill Companies, New York.
Coca-Cola Company Annual Report 2007, Foreign Currency Hedging to Protect the Competitive
Position. Retrieved November 24, 2008 from the World Wide Web:
http://www.thecoca-colacompany.com/investors/annual_other_reports.html
Honeywell 2007 annual report, Retrieved from the World Wide Web December 29, 2008
http://library.corporateir.net/library/94/947/94774/items/282921/HON07AR1.pdf
Keeir, Dan. Peetz, Karen. (Nov. 2002) Cash Management Takes Center Stage. New York.
Vol. 16, Iss. 11; pg. 48, 5 pgs.
Pyzdek, Thomas. (2003) The Six Sigma Handbook. McGraw-Hill Companies. New York.
References
Ross, S.A., Westerfield, R.W., Jaffe, J. (2005). Corporate Finance, 7e. Ch. 2: Accounting Statements and Cash Flow. [University of Phoenix Custom Edition e-text]. The McGraw Hill Companies. Retrieved November 8, 2008, from the University of Phoenix, rEsource Web site: https://ecampus.phoenix.edu/content/eBookLibrary, MBA/540 – Maximizing Shareholder Wealth.
Whole Foods-Credit Risk Management Retrieved from the World Wide Web on December 29,
2008 http://www.wholefoodsmarket.com/company/pdfs/ar07.pdf