Case study into the contrast of accounting profits to cash flow for a family nursery. Rapid expansion and sales growth of business jeopardizes firm's liquidity. Secondary Issues. misalignment of accounts receivable to accounts payable. Case calls attention to a rapidly growing firm that is utilizing cash reserves to finance expansion, while nearly exhausting cash balance. Report and spreadsheet.
Horniman Horticulture
Situation Analysis of Strengths and Weaknesses
Since acquiring Horniman Horticulture in 2002, revenues have grown 39.8% through 2005 (Pg. 140). With projected revenue growth of another 25%, over 2005, to 1.3 million, Horniman Horticulture is successfully capitalizing on their market. The recent product line expansion into mature plants offers the opportunity for greater profit margins and a diversified customer base.
However, while the overall efficiency of operations demonstrates results exceeding benchmarked competitors, the deteriorating cash situation exposes the firm to ever-greater risks from any disruption of daily operations or business cycle fluctuations. The cash balance erosion, as well as the significant increase in accounts receivable, illustrates a firm that is undergoing rapid growth without a strategy to manage and stabilize their burgeoning business.
The product line expansion offers a diversity of customer base, which can insulate the firm from loss of any particular client, and the increased profit margins are sure to mitigate any harm from increased labor costs. However, the expanded operations are sure to necessitate increased labor costs, which could exacerbate their cash needs if legislation raises wages (Pg. 138)
Co-owner, Maggie Brown, exhibits an aversion to market risks with her fear of over leveraging the business by financing operations with cash. Maggie's fear is based upon recognizing that a season of adverse weather can have devastating effects on the firm, both sales and inventory. However, Maggie's long-term focus appears to overlook the very serious short-term risks presented by her firm's lack of cash and elevated accounts receivable balance.
Horniman Horticulture appears to be growing without a cohesive plan for capital expenditures that also balances its need to maintain adequate levels of liquidity. The firm is demonstrating some solid accounting profits and performance, but is extremely vulnerable due to its poor cash flow position.
Cash Flow
Currently, the firm is experiencing a misalignment of its accounts receivables to accounts payable. The firm maximizes its returns by taking full advantage of a 2% discount on accounts payable, maintaining just a $5,000 balance, while carrying a very substantial accounts receivable balance of $146,400 (Pg. 140). Much of the firm's expanded customer base, consisting of small nurseries, is relying upon generous credit terms.
Maggie notes a comfortable cash reserve equaling 8% of revenues is desirable, yet the 2005 cash position is merely $9,400, an amount insufficient to cover the current outstanding wages of $24,400. Furthermore, it is noted that the acquisition of an additional 12 acres of land is to be purchased for $75,000, however there appears insufficient free cash for this expansion without external financing.
2006 Projections
Extending the firm's 25% revenue growth projections into 2006, and assuming the balance sheet also reflects this increase as well, demonstrates that the firm's cash position is unlikely to improve on the current course. The statement of cash flows shows that the firm has been fully utilizing their cash for operations, and depleting their cash reserves for expansion. The cash situation for 2006, showing a negative flow of $146,500 is unsustainable for the current course of business.
Accounts Payable
The current policy of paying suppliers within 10 days to take advantage of the 2% discount will have to be suspended in order to meet ongoing cash demands of operations, such as payroll.
Recommended Solutions
The revenue growth of the firm and the relative maturity of the business to its competitors, 15.5% revenue growth for 2005, compared to -1.8% benchmark, suggests room for an increase in prices (Pg.141). If the current terms must be maintained to facilitate the sale of mature plants and the small nursery clientele, then a price increase is warranted to compensate for the generous financing terms.
Financing the 12-acre expansion is necessary to preserve cash, and the case already notes that the owners are tight with their family finances; therefore it is assumed that the money for the expansion is not available from the owners. Restoring liquidity to the firm is of paramount importance. A 50% loan on the 12-acre land would improve the 2006 projections by $37,500.
A discount to accounts receivable should entice timely payment and significantly improve the cash flow situation. Going forward, offering a modest discount should help align the inflows and outflows of accounts and improve the cash situation.
A local bank credit line should be secured to ensure that the day-to-day needs of the firm are not jeopardized while realignment of accounts receivable and payable is made, and the necessary reserves are rebuild. Including the 8% cash reserve, the 2006 free cash outflow would total over $251,330. Replenishing the reserves, while also facilitating growth is unlikely to be solved within one fiscal year, therefore a credit line is necessary to ensure the firm maintains its growth.
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