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Butler Lumber Case Study Solution

Case Study Objective: As Mr. Butlers 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. Butlers 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 Butlers 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


1988 1989 1990 1991
current assets 468 596 776 932
current liabilities 260 375 535 690
net working capital 208 221 241 242

In thousands of dollars

For 1991, only first quarters data is provided, so in the following discussion, we us the first
quarters 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 companys 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 208 221 241 242
total assets 594 736 933 1094
net working capital common size 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, lets 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.


1988 1989 1990 1991
Long-term debt 64 57 50 47
Total long-term capital 334 361 398 404
Debt ratio 0.19 0.16 0.13 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. Times-
interests-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.


1988 1989 1990 1991
EBIT 50 61 86 21
interest 13 20 33 10
times-interest-earned 3.85 3.05 2.61 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 dont 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 Dodges 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 firms 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:
Butlers 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 Butlers 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 dont 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


1988 1989 1990 1991
net sales 1697 2013 2694 2771
cogs
begin inventory 183 239 326 418
purchases 1278 1524 2042 2732
1461 1763 2368 3150
end inventory 239 326 418 1144
cogs 1222 1437 1950 2006
gross profit 475 576 744 765
operating expense 425 516 658 677
interest expense 13 20 33 33
net income befor tax 37 40 53 55
income tax 6 7 9 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.