Case
Working Capital Management
Anderson Furniture Company manufactures furniture and sells its products to department stores, retail furniture stores, hotels, and motels throughout the United States and Canada. The firm has nine manufacturing plants located in Virginia, North Carolina, and Georgia. The company was founded by Edward G. Anderson in 1906 and has been managed by members of the Anderson family since that time. E. G. Anderson III is currently chairman and president of the company. The treasurer and controller of the company is Claire White, who was hired away from a competing furniture company a few years ago. Anderson owns 35 percent of the common stock of the company and (along with the shares of the firm owned by relatives and employees) has effective control over all of the firm's decisions.

Financial data relating to last year's (2003) operations, along with relevant industry comparisons, are shown in Table 16C.1. The firm's overall rates of return on equity and total assets have been around the industry average over the past several years-sometimes slightly above average and sometimes slightly below average. The company is currently operating its plants near full capacity and would like to build a new plant in Georgia at a cost of approximately $7.5 million.

White has been exploring various alternative methods of financing this expansion and has been unsuccessful thus far in developing an acceptable plan. The sale of new common stock is not feasible at this time because of depressed stock market prices. Likewise, Anderson's banker has advised the firm that the use of additional long-term debt or lease financing is not possible at this time, given the firm's large amount of long-term debt currently outstanding and its relatively low times interest earned ratio. Anderson has ruled out a cut in the firm's dividend as a means of accumulating the required financing.

The only other possible sources of financing available to the firm at this time, according to White, appear to be a reduction in working capital (current assets), an increase in short-term liabilities, or both. Upon learning of these proposed financing methods, Anderson expressed concern about the effect these plans might have on the liquidity and risk of the firm. White replied that the firm currently follows a very conservative working capital policy and that these financing methods would not increase shareholder risk significantly. As evidence, she cited the firm's relatively high current and quick ratios. Anderson was unconvinced and asked White to provide additional information on the effects of these financing plans on the firm's financial status.

1. Anderson's bank requires a compensating balance of $3 million. How much additional funds can be freed up for investment in fixed assets if the firm reduces its cash balance to the minimum required by the bank?

2. How much additional financing can be obtained from receivables if Anderson institutes more stringent credit and collection policies and is able to reduce its average collection period to the industry average? (Assume that credit sales remain constant at $75 million.)

3. How much additional financing can be obtained for fixed-asset expansion if Anderson is able to increase its inventory turnover ratio to the industry average through tighter control of its raw materials, work-in-process, and finished goods inventories? (Assume that the cost of sales remains constant at $60.75 million.)

4. Anderson's suppliers extend credit to the firm on terms of "net 30." Anderson normally pays its bills on the last day of the credit period. How much additional financing could be generated if Anderson were to stretch its payables 10 days beyond the due date?

5. Prepare a pro forma balance sheet (dollars and percentages) as of December 31, 2004, assuming that Anderson has instituted all actions described in questions 1, 2, 3, and 4, and that the funds generated have been used to build a new plant. (Assume that longterm debt and stockholders' equity at the end of 2004 remain the same as at the end of 2003. In other words, no new long-term debt is issued or old long-term debt retired, and all net income after taxes is paid out in common stock dividends.

Also assume that net fixed assets,except for the new plant, remain unchanged during 2004. Finally assume that notes payable remain unchanged during 2004.) Hint: The total amount of funds generated from the reduction of current assets and the increase in current liabilities determined in questions 1, 2, 3, and 4 is $7.5 million (rounded to the nearest $1,000). Round all figures to the nearest $1,000.

6. Prepare a pro forma income statement for 2004. Assume that sales increase to $87 million as a result of the plant expansion. Also assume that the cost of sales and selling and administrative expense ratios (as a percentage of sales) remain constant. Finally, assume that interest expense and the firm's tax rate remain the same in 2004.

7. Calculate the firm's current, quick, times interest earned, and rate of return on equity ratios based on the pro forma statements determined in questions 5 and 6. How do these ratios compare with the actual values for 2003 and the industry averages?

8. What considerations might lead Anderson and White to disagree about the desirability of using short-term sources of funds to finance the plant expansion?

9. What other sources of short-term funds might the firm consider using to finance the plant expansion?