1. Butler-Lumber-Case-Study-Solution - Butler Lumber Case...

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Unformatted text preview: Butler Lumber Case Study Solution Case Study Objective: As Mr. Butler¶s financial advisor, would you give urge him to go ahead with, or reconsider, his anticipated expansion and his plans for additional debt financing? As the banker, would you approve Mr. Butler¶s loan request, and, if so, what conditions would you put on the loan. The maximum loan that the Butler Lumber Company (BLC) could obtain from Suburban National was $250,000 in which his property would be used to secure the loan. Northrop National Bank offered BLC a line of credit of up to $465,000. BLC would have to sever ties with Suburban National if they were to have this LOC extended to them. As Mr. Butlers financial advisor, I would advise him to take the loan in an attempt to grow the business. One alarming fact about his business is the lack of a sales staff, yet the revenue has been able to grow at a fast pace; 18% in 1989, 34% in 1990, 19% in 1991. By adding another an experienced salesman that is working for a base salary plus commission, they can grow the revenues even more. By having this person work on commission, this will eat into the profit margin for the materials he is selling. But the net impact to the BLC will be positive. I would advise Mr. Butler to select the LOC for up to $465,000 because he can take out as little as he needs. He does not need all $465,000 this quarter, but he may need some in the first and last quarters of the year because he obtains 55% of his revenues in the second and third quarters. So it is strategically important for him to have access to this capital because of the nature of his cyclical business. As a banker, I would not grant BLC a LOC for $465,000. This is too much for a company this size, and with such little equity. The bank is too aggressive with its forecast that BLC will have revenues of $3.6 million in 1991. I believe I am aggressive in forecasting they will have $3.2 million in revenue in 1991, $400,000 less than what the bank forecasted. I came up with $3.2m by taking the 1st quarter revenue of $718,000 which is historically approximately 22.5% of the yearly revenue. Assuming this holds true again in 1991, the annual revenue in 1991 will be around $3.2m. This is a 19% year over year increase in revenue for BLC, which is inline with their year over year growth in 1989, and less than the 34% in the best year, 1990. The margins are not great for this industry, and BLC is no exception. Even with the excellent year over year growth in revenues for this company, BLC is on pace for another dismal year of net income in the high $40k. The net income for this company has been constant; $31k in 1988, $34k in 1989, $44k in 1990, and an estimated $49k in 1991. Net income of this size should not warrant extending a line of credit to this company. As the banker, I would not grant a LOC or any other type of loan this size. I would consider granting this company a smaller LOC with the similar stipulations of maintaining an appropriate working capital amount, fixed asset purchases would need bank approval and that Butler would put up personal property and his insurance policy as collateral for the loans that the business takes. HARVARD BUSINESS SCHOOL 9-292-013 REV: JANUARY 4, 2002 Butler Lumber Company To examine Butler¶s current financial situation and to answer the question of how well Butler is doing are not an easy task. There are many things to look into. Let us start with net working capital. Net working capital= current assets- current liabilities current assets current liabilities net working capital 1988 468 260 208 1989 596 375 221 1990 776 535 241 1991 932 690 242 In thousands of dollars For 1991, only first quarter¶s data is provided, so in the following discussion, we us the first quarter¶s data to represent year 1991. Using excel, I calculated the net working capital of Butler Lumber Company from year 1988 to year 1991. Net working capital can give us some ideas how much the company¶s potential reservoir money is. We see a steady increase in net working capital through these years, which is a good sign. However, merely the absolute numbers are not sufficient to make further judgment. Thus, I make this chart on common size analysis based on the total asset. net working capital total assets net working capital common size 208 221 241 242 594 736 933 1094 0.350168 0.300272 0.258307 0.221207 In thousands of dollars From the data in the above chart, we can see net working capital stands a very large weight in the total assets, thought decreasing. This also may be positive, because the decreasing of net working capital common size is not from the decrease of net working capital but from the increase of total asset. Some people may want to say larger companies are not necessarily good ones, but in some sense, the company is growing. Then, let¶s look at the funds flows and the changes of individual items. The cash in 1988, 1989, 1990 and 1991 are 58, 48, 41, and 31 (in thousands of dollars), respectively. Thus, the company financial situation is becoming worse, in terms of cash. The accounts receivable, net, in 1988, 1989, 1990 and 1991 are 171, 222, 317, and 345 (in thousands of dollars), respectively. Thus, the company relies on more and more credit sails and may make a heavy burden on daily operation. The inventory in 1988, 1989, 1990 and 1991 are 239, 326, 418, and 556 (in thousands of dollars), respectively. At this place, I see a big trouble for this company. The inventory is growing constantly and fast. It could be the products the company is producing are not satisfying the customers¶ needs or other managerial problems. As to the debt and liabilities, since the company is growing, all the current liabilities, long-term debt, and net worth are increasing logically. Before we come to the financial ratio analysis, we will discuss about the sources and usages of funds. The funds can come from three areas, operating cash flow, new issues of long-term debt, and new issues of equity. Normally, when calculate the operating cash flow, we need to add depreciation to net income, but in this case, the company is a commercial company instead of a manufacturing company, and the company owns the land, so no depreciation issues need to be considered. With on dividends, the net income is just the increase amount of the net worth, so no new equity is issued. Thus, source of funds are from operating cash flow and new issues of long-term of debt, which is 27, 37, and 6 (in thousands of dollars) in 1989, 1990 and 1991. The uses of funds also fall into three aspects, investment in net working capital, investment in fixed assets, and dividends paid to shareholders. In this case, with no dividends, so only investment in net working capital and investment in fixed assets count. Uses of funds are 27, 37, and 6 (in thousands of dollars) in 1989, 1990 and 1991. After careful calculation, we found the total sources of funds and the total uses of funds are exactly the same in numbers each year. Speaking of financial ratios, there are many kinds of ratios. When we look into all of them, we cannot find the real problem. We need to think about what we want to know most and calculate the ratio for that question, and then we can do a further analysis. In this case, Butler is facing the limit of loan from the Suburban National Bank and looking for a bigger size loan from the Northrop National Bank, so some ratios that can measure whether the company is borrowing too much and whether the company has the ability to pay back loans should be considered. Debt ratio, the ratio of long-term debt to total long-term capital, is this kind of ratio that can measure the financial leverage. Debt ratio = (long-term debt + value of leases) / (long-term debt + value of leases + equity) The following chart shows the debt ratio of the Butler Lumber Company from year 1988 to year 1991. Long-term debt Total long-term capital Debt ratio 1988 64 334 0.19 1989 57 361 0.16 1990 50 398 0.13 1991 47 404 0.12 In thousands of dollars As we can see from the chart, the debt ratios are relatively low, meaning safe to borrow. Another ratio that can measure the financial leverage is times-interest-earned. Timesinterests-earned tells how much interest is covered by earnings before interest and taxes plus depreciation. Times-interest-earned = (EBIT + depreciation) / interest The following chart shows the times-interest-earned of the Butler Lumber Company from year 1988 to year 1991. EBIT interest times-interest-earned 1988 50 13 3.85 1989 61 20 3.05 1990 86 33 2.61 1991 21 10 2.10 In thousands of dollars We always say that cash is the king. However, the cash that Butler holds is becoming less and less each year. Without further exploration, we don¶t know the exact reason that cause this situation, but we can still say that Butler did a very bad job in managing its cash flow. Butler can take three different possible courses of actions. The first choice, Butler can give up the opportunity to cooperate with the Northrop Nation Bank, strengthen internal management rather than enlarge the loan. The second choice is accept George Dodge¶s proposal. The third choice is that Butler can still deal with the Northrop National Bank, but try to get a better position with more proof that can show a health financial situation of his company. In order to tell which action Butler can take, I need to do more research on how well the Butler Lumber Company use capital. I can look into the firm¶s return on assets or return on investment. And I need to look for possible solutions that Butler can take to optimize the capital the company has been holding. I also may want to seek possibilities that the company get a better loan position with the Northrop National Bank, if Butler can persuade George Dodge his company is very financially healthy company. Problem: Butler¶s funds face a limitation with fast growth business. Options: 1 Refuse the loan agreement offered by the Northrop National Bank. Advantages: Control the interest expense and risks in the previous business model. Continue to work with the Suberban National Bank and not give up the relationship with the bank built through years. Disadvantages: Butler will lose the opportunity to get more money to increase their financial position and expand their business. 2 Accept the loan agreement offered by the Northrop National Bank. Advantages: It can solve the Butler¶s cash problem. We always say that cash is the king. However, the cash that Butler holds is becoming less and less each year. Without further exploration, we don¶t know the exact reason that cause this situation, but we can still say that Butler did a very bad job in managing its cash flow. Disadvantages: Interests will be even larger in the cost structure. From the income statement of Butler Company from 1988 to 1991, we can see that interest expense is very high as the net income is relatively low, such as 33 of interest expense to 44 of net income in the year 1990. Recommendation: Refuse the loan agreement offered by the Northrop National Bank. Reasons: First, I will do a financial projection, and then I will list some reasons. Financial projection: Assumptions: 1. The rate of total net sales to first quarter sales in 1991 equals to the rate of that in 1990. 2. New purchases of goods have a linear relationship with the net sales of the year before. 3. Cost of goods sold and nets sales of the years have a linear relationship. 4. Operating expense and nets sales of the years have a linear relationship. 5. I am very confused on how to calculate the interest expense, so I assume the interest of 1991 is the same as 1990. 6. Accounts receivable, net will be a certain proportion of the sales. The following is the project of 1991 on income statement net sales cogs begin inventory purchases end inventory cogs gross profit operating expense interest expense net income befor tax income tax 1988 1697 1989 2013 1990 2694 1991 2771 183 1278 1461 239 1222 475 425 13 37 6 239 1524 1763 326 1437 576 516 20 40 7 326 2042 2368 418 1950 744 658 33 53 9 418 2732 3150 1144 2006 765 677 33 55 9 net income 31 33 44 46 From this financial projection, we can see that the ending inventory in 1991 is extremely high. So the problem is not on financing, but the operation. With a continuous increase of inventory and a big increase in 1991, the company may want to look into its internal management instead of external financing. ...
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