butler lumber final first draft
TRANSCRIPT
Problems, Options and Recommendations
The problem that we have recognized in this case is that Butler Lumber Company does not have enough
funds to finance its operations in the future. The company has experienced a shortage in cash and needs
to issue debt as it moves forward. The company is also under pressure because of the payment to be
made to Mr. Stark for the buyout of his share in the company of $105,000. Although, the majority of this
payment has been made, Butler still owes Stark another $35,000 that he intends to finance through
another loan. The firm has already been using up its cash reserves to pay back its liabilities, which is not
a good sign since cash should be used for investment purposes. As we can see from Exhibit 4 (Cash flow
from operations), cash balances have been depleting year by year with a total decrease of $17000 over
the years 1988-1990.
Butler Lumber has two options to support the company’s operations. The first presents itself in the form
of a loan from the Suburban National Bank of $250000, who have asked them to secure the loan with
real property, which shows that the company’s risk profile has increased as this bank never asked for
any security while making loans in the past. But the problem with this scenario is that the company will
need a bigger loan to finance its operations, which the Suburban National Bank will not provide beyond
$250000. Therefore another option that the company can consider is to accept Northrop National Banks
offer of a loan of $465000 and abide by their terms if they undertake this loan. Hence accepting
Northrop’s offer will sever Butler’s relationship with the Suburban bank, but also allow Butler access to
more funds than Suburban would have otherwise been able to provide.
The risk profile of the company has increased over the years if we look at their current ratio, which has
fallen from 1.8 to 1.45, indicating a fall in liquidity. The debt-asset ratio has increased from 0.5455 to
0.6270 over the three years, showing that the company has been taking a lot of debt in order to finance
its assets. The interest coverage ratio has decreased from 3.84 to 2.6 over the years, showing that the
firm is facing problems paying interest on its loans. These numbers, and the various other ratios shown
in Exhibit 6, clearly indicate why the Northrop Bank has brought certain covenants on the loan that they
have offered.
Given the analysis, we recommend that the company should reject the offer from both the Northrop
Bank and the Suburban Bank, since the loan they provide do not meet the External Financing Need(EFN)
of the company as we will proceed to show. Therefore Butler has to look for a greater line of credit from
another source in order to ensure the smooth running of his company.
Proforma Analysis
To discover how much of external funds are needed in order to obtain the projected annual sales
of $3.6 million provided in this case, estimating the projected income statement and balance
sheet for 1991 is required. With the percentage of sales method, we can tabulate the projected
income statement and balance sheet for 1991 (Exhibit 5). From the historical data that is
provided, we calculate the percentage of sales for each figure in the balance sheet and income
statement (Exhibit 3). It is assumed that every figure except the fixed rate of figures such as the
current portion of a long-term debt is considered to grow with increases in sales base. Moreover,
we classify those figures into two categories – one for using the most recent percentage of sales
in 1990 and the other for using the average of all three years’ percentages of sales from 1988 to
1990, in order to estimate the projected value in 1991. These classifications assist us with more
accurate estimations since some figures are more affected by current changes and firms’
decisions while others tend to sustain at a certain average of the historical data in the industry.
For instance, since cash, accounts receivable and net payables can respond fast to recent changes
in firm’s decisions or trends, we estimate those figures with the recent percentage base of sales.
On the other hand, for other figures such as purchases, total cost of goods sold and operating
expenses, it is difficult to claim that only the values of recent years reflect the projected value,
and we utilize the average percentage of all the given data from 1988 to 1990. All of the
projected income statement and balance sheet will follow these fundamentals, with some
exceptions.
More specifically, one example of exceptions in the projected income statement can be
‘purchases’. Since the purpose of external funds is to use cash properly, which will allow the
company to get the benefit of purchase discounts, we assume that 2% discounts are applied on all
purchases that are made in 1991. In addition, provisions for income taxes can be calculated by
following the tax information that is given in the foot note. Under these assumptions and
projections, $75 (in millions) net income will be achieved in 1991, which is a substantial
increase compared to the one in 1999.
In the projected balance sheet, accounts payable can be calculated from the equation of
one of the short-term solvency ratios: (Days of purchases in Accounts payable = Accounts
Payable / Daily Purchases.) To acquire the purchase discounts, all payments should be made
within 10 days. Therefore, daily purchases multiplied by 10 give us the accounts payable value
of $75. In addition, for the calculation of Long-term debt, the previous year’s long-term debt will
be subtracted by the amount of the current portion, which is $7, and that gives us $43 (in
millions). To compute the Net worth, we add the previous year’s net worth to the projected net
income of the year. Lastly, since the total asset should be equal to the sum of total liabilities and
net worth (equity), and the only missing part of this equation is the note payable, we can
calculate the note payable by using the equation of (A=L+E). By doing the calculation, we get
$661,000 for the predicted bank note payable, which indicates the needs for External Funds.
However, this value exceeds the maximum amount ($465,000) of loan that Butler Lumber can
actually borrow from Northrop National Bank. In other words, to achieve $3.7 million of the
projected sales, Butler Lumber requires more than the maximum amount of the loan that
Northrop National Bank can offer.
Selected StatisticsIn order to compare the result and profitability between G-star (sustainable growth rate) and
actual growth sales and assets, we first calculated the margin ratios from 1988 to 1991, which we
divided by the net income over net sales. Based on the data, margin ratio is decreasing in every
period, from 1.83 to 1.63 (Exhibit 3). However, by diving the net sales over total asset, the
company’s asset turnover ratio fluctuated a bit from 1988 to 1989, but it increased by 0.02 at the
end of 1991 overall (Exhibit 3). Moreover, the leverage rate is also increasing and since there is
no dividend, our retention ratio is 1.
According to these outcomes, if Butler Lumber Company (BLC) does not accept the
offer and maintains their current position, the growth rate would be 14.47 percent in 1991
(Exhibit 3). Since the retention ratio is 1, ROE represents the sustainable growth rate, which we
multiply by all the information above. Compared to the previous year, there is not much
difference between 1989 and 1991, with a mere increase of 1.88 percent (Exhibit 3). The reason
for this is that even though the company’s margin would be decreased slightly, they use the
current and fixed assets efficiently, which indicates a higher asset turnover ratio. As a result, the
company will grow steadily without the bank loan. On the other hand, if the company agrees to
take out a loan from the Northrop National Bank, the actual growth sales rate would be changed
to 33.63 percent (Exhibit 3). Compared to the previous year of 1989, it indicates that there is a
rapid growth in sales rates, from 18.62 to 33.63 percent (Exhibit 3). In addition, actual assets
growth increased from 23.91 to 26.77 percent, which indicates that it could bring more positive
effects when the company makes an offer to borrow it (Exhibit 3).
Based on the results above, Butler Lumber Company would not negatively affect their
growth sales and assets significantly without increasing the leverage. However, if the bank
investigator’s assumption is correct, the sales will reach 3.6 million in 1991. Since our internal
rate is smaller than the external rate, the company would have to raise more funds in order to
obtain the sales of 3.6 million. Therefore, it would be greatly beneficial for the company to move
away from the current position and take out a loan, not necessarily a loan offered within the
boundaries of this case however. This could result in more progressive and rapid growth rate in
1991.
External Financing NeedIn order to achieve their goal of $3.6 Million in sales for the fiscal year of -1991, Butler Lumber Company
must use external financing. As shown in the pro forma income statement (Exhibit 5), Butler Lumber will
require external financing of $661,000 in order to achieve their projected sales for the year. The
$661,000 is the plug value computed on the assumption of $3.6 Million in sales for the year 1991, this is
also known as the EFN-External funds need plug.
The accounting identity requires that total assets equal total liabilities and equity. In the first
pass however the percentage of sales method will rarely produce this equality, as was seen in the case
of Butler Lumber. To balance the pro forma balance sheet, one must insert a plug figure so that:
Total assets = total liabilities + stockholders equity + plug
The plug figure is also known as the amount of external funds required. The cause for the
existence of this plug is because the company is predicted to grow at a rate higher than its internal
sustainable rate. Butler Lumber can internally sustain growth at the rate of approximately 14.47%,
whereas their sales (actual) growth is at the rate of 33.6% from the years 1990 onto 1991; assuming
sales of $3.6 million as given in the case. Thus, there arises a need for external funds of $661,000 to
match up to the actual growth rate of the company. This plug has been computed by simply equating
the total assets and total liabilities (including net worth) of the Butler Lumber assuming a sales goal of
$3.6 Million. The problem that arises is that this amount is higher than what Northdrop National Bank is
willing to offer Butler, and still leaves an external financing need of $661,000-$465,000=$196,000 to
achieve the projected sales of $3.6 Million. Therefore, Butler should not accept the loan as it is less than
the desired amount and will not benefit his operations the way he desires.
Butler Lumber has been heavily dipping into its cash resources over the years which projects the
desperate need for external funds. As seen in Exhibit 4, change in cash holdings have been negative for
the past 3 years and have been incremental as well- ($9000) in 1988, ($8000) in 1989, and ($17000) in
1990 projecting an urgent need for an increase in financing for Butler Lumber, from their current bank
loan of $250,000, in order to meet their required goals.
Conclusion
The future growth of Butler Lumber, a company demonstrating strong market performance, has become constrained due to its mismanagement of its cash, such as using cash holdings to retire long term debt and relying heavily on trade credit. Ultimately, to generate shareholder wealth, the company will have to change the composition of its capital structure, issue more debt, and withhold its cash for solely operating and contingent expenditures. In terms of changing the composition of its capital structure, Butler Lumber has two options on the table to consider. The first is remaining within the $250,000 borrowing limit of, what has been thus far its only banking partner, the Suburban National Bank. The main problem associated with this option is not that it requires its loan to be secured with real property, but that the Suburban National Bank’s funds are no longer enough for the Butler Lumber to achieve robust sales growth and financial stability. The second option, provided by the Northrop National Bank, allows Butler Lumber to access far more capital up until a ceiling of $465,000. However, though this would seem to be the best alternative, we conclude that neither this option is worth undertaking. Firstly, the loan offer put forth by Northrop comes heavily loaded with negative covenants. These include binding restrictions on managerial decisions, which have been a key component of the growth Butler Lumber has experienced since 1988, such as the maintenance of net working capital at an agreed limit, capital expenditures that must be agreed first by Northrop bank, and limitations on the withdrawal of funds from the business by Butler himself. Furthermore, not only does Northrop’s offer incapacitate the managerial independence and scope of Butler Lumber but the funds that it provides, though greater than those provided by the Suburban bank, are still well below the calculated $661,000 external fund need (EFN) of the company.
We conclude that neither of these options should be undertaken. A company the likes of Butler Lumber will be able to find access to all the capital it requires, and possibly even without the chokehold of negative covenants, elsewhere in the credit market. This will involve time and effort on the parts of the managers to find a suitable banking partner and till Butler Lumber finds this credit, it will always be able to continue to grow at a healthy, internally sustainable rate.
APPENDIX
BUTLER LUMBER COMPANYEXHIBIT 1
Operating Expenses for Years Ending December 31, 1988-1990, andfor First Quarter 1991 (thousands of dollars)
1st Qtr1988 1989 1990 1991
Net sales$1,69
7 $2,013 $2,694 $718Cost of goods sold: Beginning inventory $183 $239 $326 $418
Purchases$1,27
8 $1,524 $2,042 $660$1,46
1 $1,763 $2,368 $1,078 Ending inventory $239 $326 $418 $556 Total cost of goods sold
$1,222 $1,437 $1,950 $522
Gross Profit $475 $576 $744 $196Operating expenses $425 $515 $658 $175Interest expense $13 $20 $33 $10Net income before income taxes $37 $41 $53 $11Provision for income taxes $6 $7 $9 $2Net income $31 $34 $44 $9
a. In the first quarter of 1990 sales were $698,000 and net income was $7,000.
b. Operating expenses include a cash salary for Mr. Butler of $75,000 in 1988, $85,000in 1989, $95,000 in 1990, and $22,000 in the first quarter of 1991. Mr. Butler alsoreceived some of the perquisites commonly taken by owners of privately heldbusinesses.
BUTLER LUMBER COMPANYEXHIBIT 2
Balance Sheets at December 31, 1988-1990, and March 31, 1991 (thousands of dollars)
1st Qrtr1988 1989 1990 1991
Cash $58 $49 $41 $31Accounts receivable, net $171 $222 $317 $345Inventory $239 $325 $418 $556 Current assets $468 $596 $776 $932Property, net $126 $140 $157 $162Total assets $594 $736 $933 $1,094
Notes payable, bank $0 $146 $233 $247Notes payable, Mr. Stark $105 $0 $0 $0Notes payable, trade $0 $0 $0 $157Accounts payable $124 $192 $256 $243Accrued expenses $24 $30 $39 $36Long-term debt, current portion $7 $7 $7 $7 Current liabilities $260 $375 $535 $690Long-term debt $64 $57 $50 $47Total liabilities $324 $432 $585 $737Net worth $270 $304 $348 $357Total liabilities & net worth $594 $736 $933 $1,094
Memo items
Working capital $208 $221 $241 $242Nonfinancial working capital $262 $325 $440 $465
BUTLER LUMBER COMPANYEXHIBIT 3
BUTLER LUMBER COMPANYSelected statistics: 1988 through 1990
1988 1989 1990 Average
Percent of sales Purchases 75.3% 75.7% 75.8% 75.6% Cost of goods sold 72.0% 71.4% 72.4% 71.9% Operating expenses 25.0% 25.6% 24.4% 25.0% Cash 3.4% 2.4% 1.5% 2.5% Accounts receivable 10.1% 11.0% 11.8% 11.0% Inventory 14.1% 16.1% 15.5% 15.2% Fixed assets (net) 7.4% 7.0% 5.8% 6.7% Total assets 35.0% 36.6% 34.6% 35.4%
Percent of total assets Current liabilities 43.8% 51.0% 57.3% 50.7% Long-term liabilities 10.8% 7.7% 5.4% 8.0% Equity 45.5% 41.3% 37.3% 41.4%
Current ratio 1.80 1.59 1.45 1.61
Return on sales (margin) 1.8% 1.7% 1.6% 1.7%Return on assets 5.2% 4.6% 4.7% 4.9%Return on equity 11.5% 11.2% 12.6% 11.8%
Sustainable Growth:Margin 1.83% 1.69% 1.63%
Asset Turnover 2.86
2.74
2.89
Leverage (using bop equity)
2.73
3.07
Retention ratio 1.00
1.00
G-star 12.59% 14.47%Actual Growth (Sales) 18.62% 33.83%Actual Growth 23.91% 26.77%
(Assets)
BUTLER LUMBER COMPANYEXHIBIT 4
Sources and Uses of Funds, 1988 - 1990, (thousands of dollars)
1988 to 1989
1989 to 1990
1988 to 1990
Cash From Operations:Retained Earnings (=WC from Operations) $34 $44 $78Less:Change in Nonfinancial working capital $63 $115 $178Equals:Cash from Operations ($29) ($71) ($100)
Sources of Cash: From Operations ($29) ($71) ($100) From Short term Bank Loans $146 $87 $233Total Sources of Cash $117 $16 $133Uses of Cash: For Buyout of Mr. Stark $105 $0 $105 For Fixed Assets $14 $17 $31 For LTD Paydown $7 $7 $14Total Uses of Cash $126 $24 $150Change in Cash Holding: ($9) ($8) ($17)
Change in cash (check) ($9) ($8)
BUTLER LUMBER COMPANYEXHIBIT 5
Projected income statement for 1991 (thousands of dollars)1991 Value Explanation
Net sales 3,600$ 3,600$ given in caseCost of goods sold: Beginning inventory $418 from Ex 1 Purchases $2,736 76% historical % of sales
$3,154 Ending inventory $562 computed value (beg inv + purch - end inv) Total cost of goods sold $2,592 72% historical % of salesGross Profit $1,008Operating expenses $900 25% historical % of sales Operating Profit $108 Purchase Discounts* $42 2% (of purch after Q1) assumption Interest expense** $53 10.50% (of average outstanding balance) assumptionNet income before income taxes $97Provision for income taxes $21 34% schedule given in footnote 1Net income $76
*Assume purchase discounts of 2% taken on all purchases after April 1, 1991.**10.5% on the average outstanding balance.
Projected balance sheet for December 31, 1991 (thousands of dollars)1991
Assets:Cash $54 1.50% recent % of salesAccounts recievable, net (12% of sales) $432 12% recent % of salesInventory $562 computed value from above Current Assets $1,048Property, net $216 6% recent % of sales Total Assets $1,264
Liabilities:Accounts payable $75 10 days of purchasesAccrued expenses $54 1.50% historical % of salesLong-term debt, current portion 7$ 7$ constant amortizationBank note payable (plug) $661 computed plug value Current Liabilities $797Long-term debt $43 computed value Total Liabilities $840Net worth $424 computed value Total Liabilities plus net worth $1,264
Asset - (TL+NW except for Bank note) $661 computed value
Assumptions
BUTLER LUMBER COMPANY
BUTLER LUMBER COMPANYEXHIBIT 6
Ratios 1988 1989 1990
Quick ratio 0.8808 0.7200 0.6692
Current ratio 1.8000 1.5893 1.4505
Total asset turnover 2.8569 3.0271 3.2283
Receivables turnover 9.9240 10.2443 9.9963
Average collection period 36.7796 35.6297 36.5135
Inventory turnover 5.1130 5.0867 5.2419
Days in inventory 71.3871 71.7554 69.6308
Debt to Assets 0.5455 0.5870 0.6270
Debt to Equity 1.2000 1.4211 1.6810
Interest Coverage 3.8462 3.0500 2.6061
Net profit margin 0.0183 0.0169 0.0163
Return on assets 0.0522 0.0462 0.0472
A/P turnover 9.6456 9.1161
A/p days 37.8412 40.0392
Return on equity 0.1148 0.1118 0.1264