Butler Lumber Company - Possible Reasons for Butler Lumber Company to Make a Loan

Case Study:

 Butler Lumber Company

Conducted by:

Huajun

Jiaqi

Yanqi

Xuan

Possible reasons for Butler Lumber Company to make a loan

Mr. Butler, the owner of Butler Lumber Company (BLC), planned to borrow a large amount of money to support his business. Because BLC adopts a strategy of quantity purchases of materials at a substantial discount to gain competitive advantages, the large amount of inventory holds the cash and relies on additional funds conventionally. With an expected sales expansion to 3.6 million dollars in 1991 and about 55% of sales generated during April to September, BLC needs to invest more in working capital during peak seasons. Lastly, Mr. Butler may want to take advantage of 2% discount for early payment. Above reasons mainly triggered Mr. Butler to borrow a considerably amount of money.

Loan Requirement Forecast

Using common-size analysis method, we note that for every $100 increase in sales, the company needs to invest $28.66 more in current asset and will gain $10.23 from variable liabilities (account receivables and accrued expenses). Besides, the company must sever the relationship with the Suburban National Bank; the company needs to cover the balance of notes payable to bank $233,000. Therefore, expecting an increase of $906,000 in 1991 sales (by assuming the 1991 sales of $3.6 million), the company has a loan requirement of $400,000, lower than the proposed maximum loan offered by the Northrop National Bank.

If BLC wants to utilize the 2% for early payment, the accounts payable days should be shortened from 41 days on average to 10 days. Holding the cost of goods sold, the yearly average accounts payable should be lessened to $70,000. This will increase an additional demand for liability for approximate $170,000 and could not be satisfied by the estimated amount of loan.

Financial advisor’s point of view

From the perspective of financial advisor, we would recommend Mr. Butler to turn to Northrop National Bank for liability financing and to modify the business model in long run.

During 1988 – 1990, the business of the company expanded in a very fast speed with revenue increasing by 19% and 34% respectively, and kept the profit margin around 28%. It’s reasonable to estimate a high growth rate in business in 1991. If the company can remain the same operating efficiency in 1990, the estimated net income in 1991 is $59,000. Even if the sales don’t grow as much as what Mr. Butler expects, the sufficient credit line will grant more flexibility to BLC. Therefore, the debt financing plan can facilitate the business expansion plan.

In the economic downturn, turning the fixed interest rate into floating rate (Cost of financing = prime rate + 2%) can protect the company from fluctuating sales and operating expenses. Because usually when the economy slows down, the interest rates will decrease in the mean while. However, the fixed interest rate wouldn’t decrease even during the economic downturn, resulting in unnecessary expenditures. As a result, net profits are even more risky than operating profits.

However, when we focus on the solvency ratios of the company, they’re worsening year by year. The main reason is that the company heavily relied on debts to finance the purchase. To gain a quantity discount in the transaction, the company had to invest most of its cash into inventory. The daily sales of inventory are greatly larger than the average collection period, indicating that the company had insufficient cash to pay out the purchase before collecting bills from customers. As a result, the company went to the bank for short term funds to make payments to suppliers. But if the economy keeps going down, the banks may tighten their monetary policy, and the company may not obtain the expected amount from the banks. Moreover, the bad debt ratio might increase in a downturn because downstream customers will encounter financial distress as well. These two changes will bring serious financial risk to the company.

Therefore, to lower the risks, the company needs to follow up the customer payment and make sales plan so as to shorten the average collection periods, instead of just waiting for the call orders.

Banker’s point of view

First, we noticed the company’s worsening solvency ratio. The current ratio has been decreasing in recent years from 1.80, 1.59 to 1.45, and the quick ratios in 1988, 1989, and 1999 are 88%, 72%, and 67%. The falling quick ratio indicates that the company has an increasing number of current liabilities compared to current assets. Besides, quick ratios are always less than one, which suggests that the inventory occupies large part of current assets. Decreasing cash ratios also means that the company do not have enough money to pay for  its current liabilities, which will lead to higher risks.

Secondly, the issue of loans would face a huge risk according to Mr. Butler’s personal assets. BLC is a solely-owned enterprise and its owner Mr. Butler must shoulder joint liability for the company’s debt. Mr. Butler and his wife owned a house which had cost them $72,000 and mortgaged for $38,000. In addition, they had no sizeable personal investments. However, Mr. Butler wanted an unsecured loan up to a maximum amount of $465,000, and this is far more than what he had already owned. That means that once the company came to bankruptcy, the bank would not get liquidation from Mr. Butler.

 Due to the reasons above, we would not approve Mr. Butler’s loan request.

Value created for shareholders

Economic value added (EVA) estimates the value created in excess of the required return of the company’s shareholders. We use the following formula to calculate the EVA of BLC.

EVA = NOPAT - WACC * (total assets - current liability)

NOPAT = operating profit * (1 - tax rate)

WACC = interest expense / (notes payables + long-term debt, current position + long-term debt)

Profits exceed the capital cost of the company only when the EVA is positive. Based on the financial data, we calculated that the EVAs from 1988 to 1990 are 16.83, 16.25 and 26.09 (thousands of dollars). Therefore, we could say that BLC did create value for its shareholders in the past three years.

Other signs are shown by Return on Assets (ROA) and Return on Equity (ROE). These two indicators did not change much in the previous three years (ROAs are 5.22%, 4.62%, 4.72%, and ROEs are 11.48%. 11.18%, 12.64% respectively). This also means that from the perspective of the ability to create profits, BLC maintained a stable level from 1988 to 1990.

Appendices

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