Indiana Building Supplies
An analysis of these ratios shows that both Clemens and Willis are right. All of the profitability ratios for IBS are higher than the industry average. Thus, IBS seems to have done well. And indeed, it was done well for its shareholders in 2005. Note, however, that the current and quick ratios have generally been trending downward and are significantly lower than the industry averages as well as the stipulations in the loan covenants. Thus, liquidity is poor. Moreover, inventory is turning over very slowly and the average collection period has increased significantly. These figures are manifestations of IBS’s policy of raising prices and focusing almost exclusively on Indiana customers who are relatively price-insensitive but have a more uncertain demand. It seems like IBS is charging a sufficiently high price to overcome a sales level that is significantly lower than it was in 2004. In fact, it has probably been lucky to encounter a robust demand from its Indiana customers (it is reasonable to assume negligible demand from Ohio and Missouri), so that it did not experience a more precipitous decline in sales relative to its 2004 sales.
In addition to this, IBS has also experienced very high volatility in its liquidity and inventory turnover ratios during 2005, another development that is consistent with its pricing strategy. The lengthening of the collection period seems to indicate that Indiana customers are riskier in the sense that they don’t pay as promptly as the average customer. What does this mean for the bank? Peter Willis is correct in being concerned. What IBS seems to be doing is to adopt a strategy of increasing risk for the possibility of higher profit. Raising the prices of its outputs is equivalent to concentrating on the Indiana market and excluding the Ohio and Missouri markets. This means changing its market in such a way that IBS now faces a riskier demand schedule for its products, but one that yields it higher profits if it is “lucky”. Since the bank is simply repaid what it is owed, it does not benefit from this higher profit-higher risk strategy. If IBS is successful in selling off all that it produces (i. e. , if the Indiana customers exhibit sufficiently high demand), then all of the extra profits go to IBS.
On the other hand, if demand is poor and IBS cannot unload its finished goods inventory, the bank may not be repaid and could be left holding a mix of finished goods, work-in-progress and raw materials inventory. So, the bank absorbs much of the risk associated with IBS’s pricing strategy. This is a classic example of moral hazard related to risky debt. Note also that IBS’s debt ratio has been increasing since 2000, and now it is well above the industry average as well as what is permitted in the loan covenants. This also hurts IBS’s creditors since their risk exposure is increased. Moreover, as we saw in our discussion of capital in this chapter, a decline in equity capital relative to total assets increases the firm’s incentive to take more risk at the creditors’ expense. So, Clemens’ willingness to go along with Klinghoffer’s suggestion now is not that surprising. Note that the benefits of increased profitability are skewed more in favor of IBS’s shareholders; for 2005 the return on the net worth of IBS is 299 basis points above the industry average, whereas its return on total assets is 70 basis points above the industry average.
We would recommend not calling the old loan and extending the new loan, but asking IBS to do the following:
Reduce sales prices so as to be competitive with sellers in Ohio and Missouri.
Pursue a more aggressive marketing strategy to reduce inventories and accounts receivables.
Cut back on production to ensure inventory does not get stockpiled.
Get tough in collecting old accounts from Indiana customers even if it means sacrificing some future business.
Provide some augmentation of equity by cutting back on dividends and possibly issuing some more new equity at an appropriate time. Get the debt ratio down.
Do not take on new debt to replace the $200,000 that will be paid off with the bank loan.
Secure the bank loan with specific (inside) collateral if not already done so.
Design a realistic periodic loan repayment plan.
Consider the possibility of asking for a personal loan guarantee from Bob Clemens. We have assumed that the accounting practices of other firms in the industry are comparable to IBS’s so that a comparative ratio analysis like this is meaningful.