Butler Lumber Company - Case Report

Background

Butler Lumber Company is a profitable company in the retail business of lumber products. From 1988 to 1990, it has experienced a rapid business growth and at the same time a shortage of cash. In anticipation of a further substantial increase in sales, the company in the spring of 1991plans to increase its borrowing from the Suburban National Bank who, however, would only grant maximum loan of $250,000 secured with the company’s real property. Therefore, the company is seeking for a new banking relationship for a larger and unsecured loan, to satisfy its liquidity and capital needs.

Analysis

1. Although the company has seen rapid sales growth for the past years, it has not generate enough real cash flows and the net profit margin has been low as shown in Table 2, which result in the needs for more borrowing. A closer examination of the financial statements reveals the following reasons. Firstly, cash needs arise from an inefficient operation. As shown in Table 8, the increasing days of receivable means that the company takes longer time to collect payment. It is also worth noting that the days of receivables has always been longer than the days of payable. What’s more, a large amount of cash has been tied up in increasing inventories in order to enjoy the quantity purchase discount, which leaves less cash in hands. Secondly, the company has low working capital and high liquidity risk. As shown in Table 5, current ratio, quick ratio, and cash ratio have all worsened dramatically from 1988 to 1990. This means higher risk for Mr. Butler to go bankrupt if he couldn't pay the interest and payables in case of any unexpected events. A comparison of interest and net income as a percentage of net sales shows that the interest has eaten up much of the profit and resulted in low net profit margin. As a given fact, the company has relied heavily on trade credit and been unable to enjoy the 2% cash discount offered by some of its suppliers. If more cash available, it could take the 2% discount and well improve its profitability. Based on the above analysis, Butler Lumber Company needs more cash in order to run the business more efficiently, safely and profitably.
2. Based on the projected income statement in Table 1 and balance sheet in Table 3 for year 1991, we do not agree with Mr. Butler’s estimate of the loan requirement. Assume the same operating efficiency as in 1990, the estimated cash needs in 1991 is projected to be $372,000. Lower loan amount than this may not be sufficient for Mr. Butler to support its growing sales, while an excessive debt amount will further increase the leverage which is already at alarm, thus increasing the company’s risk. Therefore, from our perspective, a loan amount of $372,000 is sufficient enough for the company to expand its sales in the coming year and control interest expenses while being capable to handle unexpected events in the business running.
3. As Mr. Butler’s financial advisor, we would encourage him to go ahead with his anticipated expansion while being prudent with the degree of expansion. To begin with, this company is quite conservative given its personnel structure of only five employees in the office and in sales. Hiring a professional sales or marketing team might bring in even more sales and make it more competitive among the industry. Second, we support Mr. Butler’s plans for additional debt financing. Additional capital allows the company to better manage its accounts payable and take the 2% cash discount by early payment, which helps to reduce sales costs and improve operating efficiency.

As the banker, we will not approve such a large loan to Butler Lumber Company at its current size. However, we will consider granting a smaller loan amount such as $372,000 to it. First of all, the low liquidity ratios in Table 5 indicate higher short-term risk of the company. If these ratios still get worsened in 1991, the company will face liquidity difficulty and may have to cut its sales and business, and in the worst scenario to go bankrupt. Besides, the profit margin has been low and decreasing during the past three years as shown in Table 7. Based on the industry and company characteristic, we predict that the company’s profitability may remain stable over 1991. If the company could maintain its good growth prospects and improve its operating efficiency, we are more favorable to grant it a loan with the following conditions in addition to those mentioned in the case: 1) keep accounts receivable at an agreed level; 2) take Mr. Butler’s personal property as collateral.

1. Positive profit margin, ROA and ROE shown in Table 7 do not necessarily mean that the company has created value for shareholders. The correct measure of true value created for shareholder is the Economic Value Added (EVA), which attempts to capture the true economic profit left for shareholders after deducting the financing cost of debt and opportunity cost of equity. The calculation steps for EVA is provided in Table 10. Based on the calculation, we work out that the EVAs for year 1988 to 1991 are -$11,760, -$11,450, -$7,330 and -$9,210, respectively. The negative values indicate that the profits generated by the company did not exceed the costs of total invested capital. Therefore, Butler Lumber Company has not created value for its shareholders in the recent years.

References

Berk, J. & DeMarzo, P. (2007). Corporate Finance. Boston: Pearson Addison Wesley.

Appendices

Table 1. Income Statements for Butler Lumber Company (thousands of dollars)