Butler Lumber Company

Case A Butler Lumber Company

Q1: Why does Mr. Butler have to borrow so much money to support this profitable business?

1. Current asset of the company is mainly account receivable and this can bring high uncertainty of company development. Also, company relies heavily on the sole business which is the repair business. Besides, the growth of company after 1991 is hard to predict so that lack of cash can put high effect on its sustainable profitability.
2. For note- and account- payable, these are short term liability and company needed more cash to cover this liability.
3. Current ratio is decreasing each year and its increase of operating income is much less than the increase of current liability. Borrowing much money can solve the short-term liquidity.
4. The cash is decreasing each year and the rate is quite fast. It is high time when the company to lend more money to reduce cost of debt in the predictable future.
5. Assume company is under US GAAP, the credit line granted by Suburdan National Bank is revolving loan and this is classified as current asset- cash and this is beneficial for the company to increase current asset.
6. Management set a goal to keep account payable under 25,000 and the corporate account payable is increasing. Customer may need large amount of cash to buy inventory for further development.

Q2: Do you agree with his estimate of the company’s loan requirements? How much will he need to borrow to finance his expected expansion in sales (assume a 1991 sales volume of $3.6 million)?

I don’t agree with his estimate of the company’s loan requirements. To analyze this question, we have to estimate the exact loan requirements for this company.

First, we assume that the firm will keep the same operating efficiency in 1990. In fact, the asset turnovers from 1988 to 1990 are 2.86, 2,74 and 2.89 respectively. There isn’t significant difference between these figures. Because the prediction of sales in 1991 is 3.6 million, the total asset is expected to be 1.247 million and so is the total liabilities and net worth.

Second, from the income statement and the balance sheet, we can see that the profit retention rate is 100%. In order words, all of the net income will be invested in the company again to support the development, rather than be delivered to shareholders. For example, the net income in 1989 is 34,000, which is exactly the difference in net worth in 1988 and 1989. On the other hand, we assumed the net profit margin on sales in 1990 keeps the same as that in 1991. Actually, the net profit margin remain stable at about 1.6% in the three years. Combining the estimated sales, the net profit margin and the retention rate, we can easily calculate the net worth in 1991. So the total liabilities is 840,000.

Third, we consider the remaining accounting subjects seriously. The discussion between George and Mark indicated that the revolving secured 90-day note belongs to the subject, Notes payable, bank. To solve this problem, we have to forecast other subjects in total liabilities. From the case, Mark Butler bought out Stark’s interest for 105,000 in 1988 and borrowed money from the bank to make the payment. He also needed to pay the bank 7,000 every year until 10 years later. Thus, the notes payable, Mr. Stark is ought to be 0 in 1991. The long term debt current portion is always 7000. Meanwhile, the long term debt will decrease by 7,000 in 1991. Besides, the whole balance sheet also demonstrates that this firm deals so good with the notes payable in trade and we strongly believe that this excellent situation will still remain in 1991. As for the accounts payable and accrued expenses, they are really related to the sales of the company. That’s why we decide to assume that in 1991, these two subjects will have the same proportions. Since we have discussed all the subjects in total liabilities except notes payable, bank, we can figure out the volume of the loan requirements is 163,000 by subtracting the other projections.

From analysis above, we realize that the amount of loan requirements to finance the expansion is 163,000, rather than his estimate, 465,000.

Q3: As Mr. Butler’s financial advisor, would you urge him to go ahead with, or to 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?

Advisor:

1. Market Risk.

1. Systematic Risks. According to the major business that Butler Lumber Company(BLC) involved in, which is the retail distribution of lumber products like plywood, moldings and sash and door products, for repairing, we recognize two major systematic risks it faces. The first one is the national or regional environmental policy. Since the lumber business is not an environmental-friendly issue, it may come up with a severe regulation whenever the environment condition in the country become worse, such as the prohibition of lumbering or price limit. As the condition is not predictable, BLC maybe not well-prepared to tackle the problems like losing its stable suppliers or buyers. Next risk comes the overall condition of local economy. While lumbering business, or repairing business is a non-essential product for local residents, it may suffer more from the downside of economy cycle, in other words, it has larger price elasticity. As the truth indicated in the article, the local economy happens to be in general economic downturn. Although the prospect of BLC appears good in the foreseeable future, we should be more cautious and conservative to make predict.
2. Non-systematic Risk. According to our calculation and the information in the case, the increasing sales volume of BLC built largely on the price competition, by control of operation expenses and by the economics of scales. The operating expenses stay in stable condition, and it expected to maintain in the same way. But in terms of price privilege, it depends heavily on the suppliers’ operating strategy and state of business, which means it is not so reliable. We ought to consider the possibility that what will be the other strength of BLC if we lose the price advantage.

1. Profitability of BLC

According to our analysis, the ratio of current liability of BLC is relatively high. As indicated in the case, BLC relies heavily on the trade credit in order to hold the borrowing within 250,000. In other word, the current cash flow is not adequate to support the amount of input that transactions need. Looking at the ROIC, the profitability of invested capital is far less that the increasing of sales and net profit, which indicates a serious problem of the company’s expansion: the BLC supports its development by loaning. Noticeably, the growth rate of net income is gradually smaller in the past few years, and if we launch more debt, the interest expense will increase, thus leading to less net income.