Butler Lumber Finance Case
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Butler Lumber Company is looking for more cash due to a fast-paced lumber market and a shortage of funding. Their regular bank, Suburban National Bank, is not willing to expand their exiting loan to an amount greater than $250,000 without securing the loan with real property. Another loan is being offered by a second bank, Northrup National Bank, for $465,000, with the understanding that the previous loan would be rolled into the second. The interest on the new loan would be prime + 2%.
The co-founder, Mark Butler, owes a major note to the other original partner, who Mark bought out. He has a mortgage on his 12-year-old house and no other significant investments. Mark’s personal references indicate that he is hard-working and watches his business very closely.
Mark’s current outstanding debts are as follows:
Bank note for $247,000
Outstanding debt from trade partners $157,000
Accounts payable $343,000
Accrued expenses $51,000
Current portion of long-term debt $7,000
Long-term debt $43,000
Total liabilities $848,000
Net income is projected at $56,000 based on projected sales of $3.6m. Butler’s business relies more heavily on the repair industry than on new construction, so it is somewhat protected against market fluctuations on new construction.
Northrup National Bank should extend the loan to Butler. The company will roll much of its existing debt into the new loan, without extending itself significantly further than it currently is, and at a more favorable rate. Butler has been successful in keeping current on its debts, and based on projections should have the means to start paying these debts down. From the bank’s perspective, there’s little risk involved. With the industry expected to grow so much in the next year, Butler will be in a strong position, and potentially interested in borrowing more at the end of 1991.
Butler Lumber Co. should take the short term loan and if necessary roll the $157,000 trade credit into it.
Nature of the problem
Butler’s short-term loan options are completely maxed out, so the company has no cash flexibility. Inventory levels indicate Mark is ramping up in expectation of the massive influx of sales in the warmer months. More of Butler’s sales are in the warm months, when repairs are easier to make in the Inland Northwest. The loan will give Butler the ability to finance more inventory to meet the expected growth in sales.
Why does Mr. Butler have to borrow money to support his profitable business? Theoretically, according to the balance sheet, no additional funding is necessary to meet the growth in sales in 1991. In fact, the balance sheet shows that Mark can pay down his debt by $33,000. However, there are advantages to borrowing additional funds to improve his cash flexibility and to consolidate his debt at a lower interest rate.
Do you agree with his estimate of the company’s loan requirements? Butler can meet their expected sales without additional funding. If the goal is to eliminate the trade debt, while maintaining the current bank note at $247,000, Mr. Butler would need an additional $124,000, the remaining balance after subtracting $33,000 from the trade credit of $157,000. But the current bank will not offer this additional funding, which would then come to $371,000, resulting in the discussions with Northrup.
As Mr. Butler’s financial advisor, would you urge him to go ahead with or reconsider his anticipated expansion and his plans for additional financing? We feel that Butler should go ahead with the anticipated expansion because the business is profitable and growing. However, as shown above, this will require additional working capital to meet his current obligations to his lender and suppliers. Current liabilities total $404,000, so the credit line under consideration will provide additional financial flexibility, which is needed considering the downward trend of the current ratio. Furthermore, the debt would be carried at a more favorable rate. Finally, based on financial projections, Butler would have an additional $33,000 available to begin paying down this debt by the end of 1991.
As the Banker, would you approve his loan, and under what conditions? Yes, we feel that the cash shortage is a short term problem and that the underlying business is sound and his references and credit history are favorable. However, there are several areas of concern that should be monitored as a condition of the loan. First, the Days Sales A/R ratio is trending in the wrong direction, and more effort needs to be spent on collecting receivables in a timely manner. Additionally, the Inventory Turnover is decreasing, tying up too much cash, and exacerbating the shortage of working capital. More effort needs to be spent on inventory management, making sure there is not a growing amount of stagnant inventory, and that the mix is correct for the intended market. In addition to the conditions stipulated in the text, the bank should put require that these two ratios (Days Sales A/R and Inventory Turnover) return to their 1988 levels, and that Mark Butler’s compensation be tied to these objectives.
Exhibit 1 is the Projected Income Statement for Butler Lumber Co. Beginning inventory was pulled from the previous year’s ending inventory. Purchases were projected from a trend of 75.5% of sales for the previous 3 years. The total cost of goods sold assumed the previous 3-year average of 72% of sales would continue. Interest expense was extrapolated from the $10,000 1st quarter amount, multiplied by 4 quarters. Provision for income taxes was calculated as 15% for the first $50,000 income, and 25% of the remaining income.
Exhibit 2 is the Projected Balance Sheet for Butler Lumber Co. for the year ending December 31,1991. The balance sheet was created with the assumption that Butler wouldn’t take the additional loan. The trend that cash followed from the previous years was used to project the cash asset. Accounts receivable was based on an increasing average trend of .7%. The average inventory turnover was 4.73 for the previous 3 years. Property was expected to increase by $20,000 based on the previous year’s trends. The note payable was expected to be maxed out immediately. The note payable from the trade partner would continue at $157,000. Accounts payable stayed at 46 days, as in the prior 2 years. Accrued expenses were based on an increasing trend of $3,000 annually on top of the previous year’s numbers. The long-term debt for the purchase of the company would be paid down to $43,000. According to the balance sheet, Butler has an additional $33,000 left over after meeting his short term requirements.
No more trade credit is available
The loan from Suburban is the only note to be rolled into the Northrup loan.
Exhibit 3 is a table of all the relevant financial ratios for Butler Lumber dating back three years.
Liquidity Ratios. The notable trend in this section is that trend is toward reduced liquidity, which has precipitated the discussion. Butler is experiencing a shortage of working capital that needs to be addressed to sustain growth in this profitable business.
Leverage Ratios. The data shows that Butler is becoming more leveraged, primarily in terms of short term debt. It further shows that the interest expense is outpacing the earnings growth, which could be helped by securing the new loan at a more favorable interest rate.
Utilization Ratios. The numbers in this section are also trending in the wrong direction, but this is an area that can be more directly managed. In particular, we feel that Inventory Turnover needs to be improved through better management of the inventory mix, and that increased effort is required to encourage customers to pay in a more timely manner. Done correctly these two actions should actually help reverse the downward trend in profit margin.
Profitability Ratios. Again, all of these ratios are trending in a negative direction, as a result of the analysis presented above. Going forward with the proposed financing strategy would have two fundamental advantages. First, the debt would be carried at a lower interest rate which would reduce interest expense and improve earnings. Second, based on financial projections it is believed that 1991 will result in $33,000 available to reduce this short term debt.