Horniman Horticulture Essay

Horniman Horticulture is a whole-sale nursery business that has been owned by Maggie and Bob for three years. They have seen an increase in business and number of plants grown at the nursery and are expecting demand to continue to grow. In 2005, the business’s profit margin was expected to grow to 5. 8% up from 3. 1% in 2003. This projected growth seems accurate considering Maggie’s conservative approach with the companies cash balance. Handling the finances, Maggie dislikes debt financing because of her fear of holding too much inventory and thus not being able to make interest payments. Since the business relies on good weather conditions with some mature plants taking years to grow, severe weather can destroy this inventory. The family has high hopes for the future, since changing their business strategy; they now are acquiring more mature plants in response to the demand for â€Å"instant landscape† customers and are seeing positive signs of economic strength. Because of Maggie’s accounting policies, the business has started to see a decrease in cash balance which falls below their target of comfort. Projection for 2006 Looking at Exhibit A, we have given the projection for 2006. Due to the local economy growing, demand is also going to continue to grow in their business. Most of their inventory will be ready for customers, since it has been maturing over the last 2 to 5 years resulting in their revenue growth to be estimated 30% higher in 2006 to $1,360,000. In order to have opportunities for growth, Maggie and Bob want to buy the neighboring 12 acres of farmland. Because of this plan to buy the parcel of land, their capital expenditures are estimated to be $75,000 which they do not plan to finance. Case Issue Revenue growth over the past 3 years has surpassed the industries benchmark and could indicate that Horniman can take an aggressive competitive advantage early on. Some financial ratios prove the company is performing above industry norms solely due to the fact of their decision to not pay interest on debt, causing few additional expenses. An issue that this company may see due to their determination in paying suppliers under 10 days which can be seen in the Payable Days ratio (Exhibit C). They do benefit rom a small discount of making payments early, but comparing this to the benchmark; Horniman takes an average of 50 days to collect from outside customers and vendors. This indicates that they are making payments five times faster than they are receiving them, which poses the question of whether the small discount is truly beneficial to their company. This exhibit also points out the fact that inventory are not being turned over as often and has actually continued to increase since the start of the business. In addition in 2005, they didn’t reach their target balance of 8% cash balance of total revenue; they fell to a low of . %. In summary, they are very good at driving revenue up and exceeding profits higher than the industries average, but are experiencing a cash flow problem because of the way they are running their business. If it is not dealt with now, there is potential for bankruptcy in the future, especially with their future acquisition of land for $75,000 which they do not plan to finance. Financial Statement Analysis When analyzing the financial statements, in Exhibit A we can see that Horniman has done a decent job by increasing their revenues. They increased their revenues by 33% in 2002 being at $788,500 to 2005 at $1,048,800. They have stabilized their depreciation as it only rose 20% from 2002 to 2005 ($34,200 to $40,900). Also, their tax expense did not increase dramatically by staying around 34 to 39%. After looking at the free cash flows in Exhibit D you can see that increases in net working capital is a problem with the business. In the first year their net working capital was $44,800 which is 1. 4x the net income of $32,600. In 2004, there was an improvement in net working capital but on the other hand there was a big capital expenditure of $88,100 which reduced their cash. Past 2004, net working capital in 2005 was $97,200 which is 1. 6x the net income of $60,800. If they continue to increase their net working capital like they have in the past, the projected net working capital for 2006 would be -$235,900 which would cause them a negative cash balance of -193,000. When you look at the balance sheet in Exhibit B we can see that the current assets have increased 19% and total assets increased 14. 4%. This is due primarily to the increase in inventory and accounts receivable. In the four years from 2002 to 2005 inventory has increased 8. % and accounts receivable has increased 16. 4%. Due to this, the cash balance has decreased from $120,100 all the way down to $9,400. In addition in 2005, the cash balance went below their comfort level of $10,000 down to $9,400. This is not meeting their expectation of their 8% minimum of total revenue target. Financial Ratio Analysis Even though their business was growing significantly, and they were experiencing a steady increase in revenues, they were seeing a huge decrease in their cash. The reason for this is because of their recent change to an increase in business from small nurseries. By looking at the financial ratios, even though they are increasing in sales, you can tell that they are relaxed on their accounts receivable and credit terms. Each year it takes them longer to collect their money. This is due to the fact that the carrying cost of inventory is harder for the smaller customers to endure. To add to this, Bob has to put a bigger investment in his inventory because of the more mature plants that take 2 to 5 years to grow, because of the increased demand for instant landscape. Finally, they are paying out cash significantly faster at 9 days than the benchmark of 27 days in order to receive their 2% discount. To summarize it, they are holding their inventory longer, collecting on payments slower, and paying out cash faster which in essence is destroying their cash balance. By looking at the ratios in Exhibit C, you can see the evidence of this in Receivable Days increasing from 41. 2 to 50. 9, and the Inventory Days ratio increasing from 424. 2 to 476. 3. Due to the way their business is being run, the consequences are shown in the liquidity ratios in Exhibit E for 2002 to 2005 and the projected ratios for 2006, all of their liquidity is diminishing. You can see that every ratio is steadily declining throughout the years. Analyzing them all, their cash has significantly decreased the most, diminishing an astonishing 70% from years 2002 to 2005. Compensating for Growth With larger growth coming in 2006, Maggie and Bob need to look at their cash balance and figure out what they will need for financing to avoid a negative cash balance which could put them into bankruptcy. With Revenues increasing every year, and dramatically increasing from 2005 to 2006 by 30%, they need a compensating cash balance. Since they do not pay out any cash dividends, their rate of growth is the ROC ratio. In Exhibit A, the return of capital has been an average of 4. 0% in the four years. The un-proportional increase in revenue from 15% to 30% will most likely not be supported for much longer. The need for financing, to counterbalance this significant growth is needed to avoid bankruptcy. Accounts Payable Analysis In 2002, Horniman’s cash balance was a respectable $120,100, a number which represented 11. 64% of total assets for that year. As shown in Exhibit F, a common-size cash balance of 11. 64% hardly poses any threats of short-term liquidity risk. However, the following years tell a different story where Horniman’s cash balance steadily decreases. In 2005, just 0. 80% of Horniman’s total assets were held in cash—a drop of $110,700 in just three years! Keep in mind, Horniman has displayed positive revenue growth through each of these periods negating the idea that these declining cash balances are represented by lack of growth (Exhibit C). In the case write up it was mentioned that Maggie (who controlled the financials) avoided borrowing at all costs, and would take any trade discount her suppliers would offer. To an ordinary individual this would sound like a financially responsible plan, but taking a trade discount isn’t always the best decision to make. When taking a discount, certain factors should be looked at to determine whether or not it is worth it. In Horniman’s case, Maggie accepts the discount from her supplier every time it is offered. The footnotes state that most of Horniman’s suppliers provide 30-day payment terms, with a 2% discount for payments made within ten days (2/10 net 30). This is a fairly common discount offered by suppliers to entice the buyer to make timely payments. Horniman has always had the cash on hand to make these payments within the terms of the discount, but in the long run it is hurting them. The most important factor to look at when making this decision is the current interest rate. Interest rates will help to determine whether it is practical to take the discount or to delay payment till the final day it’s due. The rule is simple: if the borrowing rate offered by a bank is greater than the annualized rate earned by taking a discount, then pass on the discount and delay your payment until it’s due in full. The rule remains true if the scenario is reversed. Maggie’s overall issue is she isn’t timing her cash inflows with outflows. Her outflows are made within 10 days of receiving the invoice, but she isn’t collecting from customers every ten days which is creating a short-term liquidity issue. Our Recommendations As you can see the business as a whole is running pretty strongly and their main problem is just the diminishing cash flow. There are quite a few ways that Bob and Maggie could attempt to raise the amount of cash that they have on hand and even stop this problem all together. In the case it says that Maggie doesn’t want to use much if any debt financing for their business because if they were to have a dramatic loss (i. e. drought, frost, etc†¦ ) they could find themselves struggling to keep up with the interest payments on the debt loans that they would have taken out, but using just equity financing can put an unnecessary strain on your business. By simply using equity financing Bob and Maggie are reducing the amount of cash that they could possibly have on hand dramatically. If Maggie were to try and find a happy medium between equity and debt financing, an amount of loans that couldn’t bankrupt them if they had a catastrophic loss of inventory but an amount that would help them with their cash inflow problem then they could see a reduction of the large negative free cash flow that they are seeing now. In reference to their huge capital expenditure they are planning on acquiring the next year, they should think about taking out a mortgage loan on it for the 6. 5%. If they took out a 30 year mortgage loan to finance the $75,000 acquisition, the payment would be $474 monthly, which would save them a huge amount of savings in 2006 instead of paying it with cash that they don’t have. Another option is for them to not always pay their suppliers in the 10 days to obtain the 2% savings. As stated earlier in the paper the 2% savings looks and sounds good to the normal person but when a business is having cash problems like Horniman Horticulture is at this time it isn’t always the smartest thing to do. Their biggest problem is that their cash outflows are being paid 5 times faster than their cash inflows are coming into their company. If they were to figure out a system to find a way to occasionally get the 2% discount offered to them by their suppliers to save some money but also hold on to their money some of the time and pay at the 30 day due date they could see a massive change in their short term liquidity problems that they are seeing and that could really help reduce their cash on hand problem. They could also adopt some form of payment reward plan like their suppliers have for customers that buy rather large quantities of inventory and take a percentage off of the amount owed for payments that are before a certain date. Another option would be to have a preferred customer policy for customers that either have large orders consistently throughout the year or for customers that always pay early on the amount that they owe. For instance they could either chop off a percentage of the price for early payments as stated before or they could offer some of their more unique plants to the preferred customers before they let anyone else have the opportunity to buy them. The final option that we discussed that could help them with their cash problem is to stray away from their new business strategy, and simply calm down on their mature plant inventory since they take so long to be able to sell and actually bring in any profit on them. From the case it sounds like this could be a profitable business but with the way that they are getting payments in and the possibility of a complete loss if the worst happened to their inventory it seems like it is somewhat of a risky move for them. This could be a much better idea once they figured out their cash problems and fixed their accounts receivable turnover so that they are closer to the 8% that Maggie feels comfortable with having as an emergency fund.