Corporate finance

Liquidity

Lamar Swimwear has a serious liquidity problem, which could soon result in bankruptcy if preventative measures are not taken. The current, quick and cash ratios have all been below industry average since the company’s inception and are getting progressively worse. The main cause of this problem is rapid growth, which is being financed by the stretching of the accounts payable, the drawing down of cash balances to dangerously low levels, and an increase in long-term borrowing resulting in higher interest and principal payments. The liquidity crisis is being made even worse as creditors raise interest rates and limit borrowing in reaction to the higher risk.

A high growth rate is normally a good thing, but if it’s not managed properly, it can cause serious liquidity problems. If the company wishes to grow in excess of a prudent sustainable growth rate (reasonable financial leverage), more equity must be issued.

Further contributing to Lamar’s liquidity crisis is its poor accounts receivable management, which slows cash collections. The A/R turnover in days is well above the industry average and is getting worse. Slow collections and high bad debts are a major problem in the swimsuit industry because of the large number of small, poorly capitalized retailers. Even the industry average A/R turnover in days is above the standard credit terms of net 30, although this could simply be due to companies requiring the cheque in the mail by the due date and not in hand.

Inventory turnover in days is also above the industry average, but not by a substantial amount, and there has been definite improvement since 1998.

Asset Utilization

Lamar’s poor Accounts Receivable management could be improved by:

· Locked boxes or EFTS payment;

· More thorough credit investigations (references and credit bureau checks);

· Swift follow up on overdue accounts (letter, phone, collection agency);

· Interest on overdue balances; and

· Faster billing (if the bill gets out faster, the net 30 period starts sooner).

There is a possibility that Lamar’s high growth rate was due not just to a superior product line, but because they were extending trade credit to many retailers that other swimsuit manufacturers had refused. Being more selective in granting credit may not only help to solve Lamar’s liquidity and asset management problems but may also help to reduce the growth rate. Company’s should not maximize sales at any cost but should instead focus on quality growth were the profits from additional sales exceed increased costs.

As mentioned, Lamar’s inventory turnover has been improving, but it is still slightly higher than the industry average. This could be due to Lamar charging a premium price compared to its competitors. Perhaps it is finding that it can generate more revenue by charging a slightly higher price despite lower turnover. Still, Lamar should investigate measures to increase inventory turnover such as JIT production, expanding the breadth and depth of the product line, and improving customer service. Alternatively, the problem could simply be that Lamar is still “sitting on” unsold stock from the previous summer season at year-end in December. The company might consider “moving” unwanted items by selling them to off-price stores.

Lamar’s fixed asset utilization was well above industry average in 1998 but fell to slightly below industry average in 1999. This was due to the major capital purchases in 1999. It appears that the company has just not had enough time to fully utilize these new facilities. As demand grows in future years, fixed asset utilization should return to its superior level. Ed Lamar has also been very conscious of keeping overhead to a minimum since beginning operations.

Long-term Debt Paying Ability

Lamar Swimwear’s use of financial leverage has become excessive. Although its leverage ratios in 1997 approximated the industry average, they have since grown to dangerously high levels. The company’s vendors have already warned them to pay their accounts payable more promptly and their bankers have interest rates to reflect the added risk. Cash and carry status and being cut off at the banks are very real possibilities.

As mentioned, Lamar’s problem with financial leverage is due to an actual growth rate that exceeds a prudent sustainable growth rate. To compensate for this, the company has stretched its payables and borrowed long-term instead of issuing more equity. This problem has been made worse by below average profitability, which has resulted in even weaker coverage ratios.

Definitely, Lamar Swimwear must issue more equity. If the loss of control is a concern to Ed Lamar, then consideration must be given to cutting back on expansion to improve the company’s liquidity and long-term debt paying positions. Some equity was issued in 1999, but it was not enough. Possibly, this is why Ed Lamar has approached Bob Atkins as a potential investor.

Profitability

Lamar’s gross profit margin is below the industry average and is getting worse. Excessive scrap contributed to a higher cost of goods sold in 1999, but this was countered partially by the premium prices it was able to charge. Due to the popularity of its product line, Lamar might experiment with raising its prices even further in hopes of increasing the gross profit margin. It might also consider:

· Overseas sourcing of materials or manufacturing to reduce costs;

· Greater use of quantity discounts and competitive bidding when buying materials;

· Self-directed work teams and improved quality control procedures;

· JIT inventory and production management; and

· Automation of the production process.

The operating margin is still slightly below the industry average, but there was a dramatic reduction in selling and administration as a percentage of sales in the last year. Economies of scale and Mr. Lamar’s frugal nature were likely the main contributing factors. Others may have included:

· Downsizing of the staff;

· Freezing or cutting wages or benefits;

· Reducing commission rates and expense allowances;

· Computerizing office operations;

· Cutting the advertising and promotional budget; and

· Moving the office or factory to a lower rent area.

Depreciation expense was up as a per cent of sales, but this should decrease as the new facilities are better utilized in the future.

Interest expense was also up to over twice the industry average due to the company’s overuse of financial leverage and the higher interest rates being charged. Income taxes as a per cent of sales have also fallen primarily due to tax credits earned on asset purchases. Improved tax planning or tax rate reductions could also be factors.

Overall, Lamar’s ROA is below industry average as is its ROE despite a much heavier reliance on financial leverage than the industry. A significant drop in asset turnover contributed to its below average ROA and the higher interest rates charged reduced the benefits of financial leverage—the spread between ROA and cost of capital was smaller.

Recommendations

Lamar Swimwear is a fast-growing company with a popular product line. It has the potential to become quite profitable if management executes effective pricing and cost management strategies. This rapid growth is causing serious liquidity problems though. With a prudent sustainable growth rate that falls well short of its actual growth rate, Lamar has chosen to meet its growth potential by raising financial leverage to an intolerable level. Clearly, the company must issue more equity than it has or slow growth to a safer level.

Any potential investors must decide whether Ed Lamar is able to make these needed changes. He has a reputation of being quite stubborn and autocratic and thus unlikely to accept input from other investors on how to deal with this growth versus liquidity dilemma. He is also unlikely to tolerate losing control in the company he founded.

It is recommended that Bob Adkins only invest if Ed Lamar agrees, in writing, to make the necessary changes. If he is not willing, it is suggested that Mr. Adkins wait and possibly invest later. If Mr. Lamar does not make the needed changes, he will be even more desperate for help later on. He should also be offering better financial terms and be much more open to advice at that time.

Exhibit 1: Ratio Table

Exhibit 2: Vertical Analysis (Income Statement)

Exhibit 3: Vertical Analysis (Balance Sheet)

Exhibit 4: Horizontal Analysis (Income Statement)

Exhibit 5: Horizontal Analysis (Balance Sheet)

Exhibit 6: Cash Flow Statements

Exhibit 7: 5-Way Analysis of ROE

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