Jones Electrical Distribution Dr. C. Bulent Aybar Professor of International Finance

Context Jones Electrical Distribution has been expanding rapidly for the past several years. Increases in working capital requirements have significantly outrun the capacity of the company to generate funds from internal sources. The company has been forced to forgo taking discounts on accounts payable and to borrow in increasing amounts from its bank to maintain its expansion. Jones must decide whether to continue to expand and, if so, how to finance the growth.

Impact of Growth on Jones: Investment Requirements Inventories + Accounts Receivables Investment in inventory and A/R has been growing at a rate of ~22% . (current assets has grown at 18.4%) > Sales growth of 17.49% for the same period Fixed Assets Growth in fixed assets is moderate! 2004 2005 2006 $430 $509 $643 2004 2005 2006 Net Fixed Assets $113 $103 $118 Acquisitions $15 $50

Working Capital and Sales Growth 2004 2005 2006 WC/Sales 26.47% 26.54% 28.67% FA/Sales 6.96% 5.37% 5.26% Sales $1,624 $1,916 $2,242 COGS $1,304 $1,535 $1,818 A/R $187 $231 $264 Inventory $243 $278 $379 A/P $36 $42 $120 ACP 42 44 43 Inv.Turnover 5.37 5.53 4.80 DSI 68 66 76 APP 10 24 CCC 100 95 WCR $381 $453 $509 WCR/Sales 23.47% 23.63% 22.70% What is the impact of slowing inventory turnover and collection period on Jones’s investment requirements? ?

WC Investment is Growing Faster than Sales!   2004 2006 Change Accounts receivable $187 $264 $77.3 Sales $1,624 $2,242 Change in accounts receivable as pct of sales 11.51% 11.78% 0.27% 12/31/06 Accounts Receivable at 12/31/04 pct of Sales $258.0 Actual 12/31/06 Accounts Receivable $264.1 Accounts Receivable due to increased receivables as % of sales $6.1 Inventory $243 $379 $135.7 Change in Inventory as % of sales 14.96% 16.89% 1.93% 12/31/06 Inventory at 12/31/04 pct of Sales $335.4 Actual 12/31/06 Inventory $378.6 Inventory due to increased Inventory as % of sales $43.2 Combined $ $429.8 $642.8 $212.9 Combined % of sales 26.47% 28.67% 2.20% $ of A/R and Inventory at 12/31/06 due to slower turnover $49.3 Combined $ due to sales growth $163.6

Contribution of Declining Efficiency: 23.2% Change in company’s working capital is $212.9 (~213K) The company’s financing needs were increased by 2.20% of sales, or $49.3 thousand by the longer collection period and slower inventory turn in 2005 and 2006. The figure of $49.3 thousand amounts to only 23.2% of the total increase in accounts receivable and inventories of $213 thousand between December 31, 2004 and December 31, 2006; Therefore sales growth accounts for the a substantial majority of the additional funds invested in receivables and inventories.

Does Jones Generate Sufficient Cash Flows?   2005 2006 2005-06 Net Income $29 $30 $59 Depreciation $25 $35 $60 Inventory ($35) ($101) ($136) Accounts receivable ($44) ($33) ($77) Trade credit (Accounts payable) $6 $77 $84 Accrued expenses $1 Cash flows from operations ($18) $9 ($9) Capital expenditures ($15) ($50) ($65) Cash flows from investing activities Bank borrowing (Line of credit) $65 $100 Reduce long-term debt ($24) ($48) Cash flow from financing activities $41 $11 $52 Increase / (decrease) in cash $8 ($30) ($22)

Is Jones’ Assessment of Funding Need Accurate? Maybe if Jones continues to rely heavily on trade credit as a source of funds, as he has been during recent years Probably no if he decides to pay his accounts payable promptly in order to take advantage of the 2% discount offered on payments made within 10 days of the date of invoice. How can we tell?

Before we move on to assessment of funding need.. What is the cost of not taking the discount for Jones? Assume $1000 purchase Take discount pay $980 on day 10 Do not take discount pay $1,000 on day 30 Not taking the discount costs $20 for 20 days of $1,000 purchase, or 2% per 20 days Annualized cost 2% x (365/20)=36.5% If APP is stretched to 40 days cost s ~24%

Assumptions for Forecasting Funding Need Sales 2,700,000 Operating Expenses 15.46% Interest Expense 31,000 ACP 43 DSI 76 Principal Paid 24,000 Cash 32,000 Net PPE 110,000 COGS/Sales with discount 81.11% COGS/Sales without discount 83.11% Tax Rate 35%

Income Statement 2007 Net sales 2,700,000 Cost of goods sold 2,189,970 2,243,970 Gross profit on sales 510,030 456,030 Operating expense b 417,310 Interest expense 31,000 Net income before taxes 61,720 7,720 Provision for income taxes 21,602 2,702 Net income 40,118 5,018

Pro Forma Balance Sheet Take Discount No Discount Cash 23,000 Accounts receivable 318,082 Inventory 455,994 467,238 Total current assets 797,076 808,320 Property & equipment Accumulated depreciation Total PP&E, net 118,000 Total assets 915,076 926,320 Accounts payable 59,999 184,436 Line of credit payable 249,183 Accrued expenses 14,000 Long term debt, current portion 24,000 Current liabiliities 347,183 471,619 Long-term debt 110,000 Total liabilities 457,183 581,619 Net worth 282,790 247,690 Total liabilities and net worth 739,973 829,310 Funding Need (Excess) 175,103 97,010 Line of Credit after Adjustment 424,286 346,193