Case Study - Working Capital Management Introduction Bob and Maggie Brown are the owner-operators of a small, but growing horticulture business. The firm appears to be operating efficiently, generating increasing profits, but cash balances are falling at alarming rates. The firm appears to be careful with cash but is falling well below its targeting levels of 8% of revenues.

Bob Brown hummed along to a seasonal carol on the van radio as he made his way over the dark and icy roads of Amherst County, Virginia. He and his crew had just finished securing their nursery against some unexpected chilly weather. It was Christmas Eve 2005, and Bob, the father of four boys ranging in age from 5 to 10, was anxious to be home. Despite the late hour, he fully anticipated the hoopla that would greet him on his return and knew that it would be some time before even the youngest would be asleep. He regretted that the boys' holiday gifts would not be substantial; money was again tight this year. Nonetheless, Bob was delighted with what his company had accomplished. Business was booming. Revenue for 2005 was 15% ahead of 2004, and operating profits were up even more. Bob had been brought up to value a strong work ethic. His father had worked his way up through the ranks to become foreman of a lumber mill in Southwest Virginia. At a young age, Bob began working for his father at the mill. After earning a degree in agricultural economics at Virginia Tech, he married Maggie Horniman in 1993. Upon his return to the mill, Bob was made a supervisor. He excelled at his job and was highly respected by everyone at the mill. In 2000, facing the financial needs of an expanding family, he and Maggie began exploring employment alternatives. In late 2002, Maggie's father offered to sell the couple his wholesale nursery business, Horniman Horticulture, near Lynchburg, Virginia. The business and the opportunity to be near Maggie's family appealed to both Maggie and Bob. Pooling their savings, the proceeds from the sale of their house, a minority-business-development grant, and a sizable personal loan from Maggie's father, the Browns purchased the business for $999,000. It was agreed that Bob would run the nursery's operations and Maggie would oversee its finances. Bob thoroughly enjoyed running his own business and was proud of its growth over the previous three years. The nursery's operations filled 52 greenhouses and 40 acres of productive fields and employed 12 full-time and 15 seasonal employees. Sales were primarily to retail nurseries throughout the mid-Atlantic region. The company specialized in such woody shrubs as azaleas, camellias, hydrangeas, and rhododendrons, but also grew and sold a wide variety of annuals, perennials, and trees. [1] Over the previous two years, Bob had increased the number of plant species grown at the nursery by more than 40%. Bob was a "people person." His warm personality had endeared him to customers and employees alike. With Maggie's help, he had kept a tight rein on costs. The effect on the business's profits was obvious, as its profit margin had increased from 3.1% in 2003 to an expected 5.8% in 2005. Bob was confident that the nursery's overall prospects were robust. With Bob running the business full time, Maggie primarily focused on attending to the needs of her active family. With the help of two clerks, she oversaw the company's books. Bob knew that Maggie was concerned about the recent decline in the firm's cash balance to below $10,000. Such a cash level was well under her operating target of 8% of annual revenue. But Maggie had shown determination to maintain financial responsibility by avoiding bank borrowing and by paying suppliers early enough to obtain any trade discounts. [2] Her aversion to debt financing stemmed from her concern about inventory risk. She believed that interest payments might be impossible to meet if adverse weather wiped out their inventory.

Maggie was happy with the steady margin improvement the business had experienced. Some of the gains were due to Bob's response to a growing demand for more mature plants. Nurseries were willing to pay premium prices for plants that delivered "instant landscape," and Bob was increasingly shifting the product mix to that line. Maggie had recently prepared what she expected to be the end-of-year financial summary ( Exhibit 1, in the Excel workbook). [3] To benchmark the company's performance, Maggie used available data for the few publicly traded horticultural producers (Exhibit 2, in the Excel workbook). Across almost any dimension of profitability and growth, Bob and Maggie agreed that the business appeared to be strong. They also knew that expectations could change quickly. Increases in interest rates, for example, could substantially slow market demand. The company's margins relied heavily on the hourly wage rate of $8.51, currently required for H2A-certified nonimmigrant foreign agricultural workers. There was some debate within the U.S. Congress about the merits of raising this rate. Bob was optimistic about the coming year. Given the ongoing strength of the local economy, he expected to have plenty of demand to continue to grow the business. Because much of the inventory took two to five years to mature sufficiently to sell, his top-line expansion efforts had been in the works for some time. Bob was sure that 2006 would be a banner year; the firm's expected growth rate is shown on the first page of your team's Excel workbook. In addition, he looked forward to ensuring long-term-growth opportunities with the expected closing next month on a neighboring 12-acre parcel of farmland. [4] But for now, it was Christmas Eve, and Bob was looking forward to taking off work for the entire week. He would enjoy spending time with Maggie and the boys. They had much to celebrate for 2005 and much to look forward to in 2006. [1] Over the past year, Horniman Horticulture had experienced a noticeable increase in business from small nurseries. Because the cost of carrying inventory was particularly burdensome for those customers, slight improvements in the credit terms had been accompanied by substantial increases in sales. [2] Most of Horniman's suppliers provided 30-day payment terms, with a 2% discount for payments received within 10 days. [3] As compensation for the Browns' services to the business, they had drawn an annual salary of $50,000 (itemized as an SG&A expense) for each of the past three years. This amount was effectively the family's entire income. [4] With the acquisition of the additional property, Maggie expected 2006 capital expenditures to be $75,000. Although she was not planning to finance the purchase, prevailing mortgage rates were running at 6.5%. The expected depreciation expense for 2006 was $46,000.

Questions: 1. Are you concerned with the decline in cash? Discuss the trend of the cash balance in dollar value and in percent of sales? 2. Assuming strong performance in 2006, will this improve the cash position? Use the information provided in your group's Excel workbook to calculate the estimated cash position for 2006. Distinguish the variables directly varies with sales, from those subjected to financing and investing policies that do not directly vary with sales. For example, Maggie assumes 2006 Deprecation and Capital Expenditures of $46,000 and $75,000, respectively. 2006 estimates of those accounts that directly vary with sales can be based on 2005 ratios. This information is summarized in Exhibit 3, in the Excel workbook. (You can reference Chapter 12 materials for estimating financial statements. The Excel Tool kits can be helpful.) 3. Choose one of the following set of questions: a. Perform a sensitivity analysis on the cash shortfall using at least 2 different revenue growth rates above and below your teams expected growth rate, (ie. with 5% increments). Discuss your results. b. What growth rate is needed to maintain the same cash balance as 2005? Discuss your results. 4. Describe the importance of the cash conversion cycle (CCC) and its component. Determine the CCC for Horniman and the industry average. Comment on the cash cycle compared to an average firm in this industry. Discuss ways that could improve cash conversion cycle in general. (Note that the payable days formula is a bit different from the text, as the textbook is based on a simplified assumption that CoGS is equivalent to purchases, which is not the case in the real world.) 5. Choose one of the following set of questions: a. Do you agree with Maggie's accounts payable policy? Analyze the current accounts payable policy. What is the cost of trade credit if Horniman make payments to suppliers on the last day of the term? What adjustments, if any, would you suggest to improve the payable days? Why? b. Can you infer from the case and financial statement of Hornimans accounts receivables policy? Do you agree with this receivables policy? Provide ways to toughen the receivables policy and discuss its potential benefit and cost. 6. Describe Hornimans capital structure? Do you agree with Maggies capital structure decisions? Compare potential costs of various financing options, and discuss what financing alternatives you would recommend to alleviate the cash problem? (Chapter 15)