FM Butler Grup 2

Butler Lumber CompanyFinance Management

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Nanda Pujiputranto 10K16008

Yuliyanti 10K16016

INTRODUCTION

MAGISTER OF BUSINESS ADMINISTRATION GADJAH MADA UNIVERSITY

2010

Butler Lumber CompanyCase Study of Financial Management WE-16 Group II

Butler Lumber Company was a growth company in the late 1980. This Company faced tremendous sales growth since it had been founded in 1981 by Mr. Butler and his brother-in-law, Henry Stark.In 1988, Mr. Butler bought Mr. Stark’s share for $105,000 that would be paid off in 1989. For this payment, Mr. Butler has been loan of $70,000 in late 1988. This loan was secure by Butler’s land and buildings, carried an interest rate of 11% and was repayable in quarterly installments at the rate of $7,000 a year over the next 10 years. Mr. Butler was also mortgaged his house for $38,000. Besides that, Mr. Butler held a $70,000 life insurance policy, payable to Mrs. Butler.

Mr. Butler as the owner waslooking for new source of funding by extends his current unsecure bank loan because the company had shown a significant decrease in cash and increase in liabilities over the last three years.The maximum loan that the Butler Lumber Company could obtain from Suburban National was $250,000 in which his property would be used to secure the loan.

George Dodge, an officer of a much larger bank, the Northrup National Bank. He offered Butler Lumber Company a line of credit of up to $465,000. The interest on the new loan would be prime 2%. Butler Lumber Company would have to sever ties with Suburban National if they were to have this LOC extended to them.

MAIN ISSUES

Was Butler Lumner Company a profitable business? Why Mr. Butler has to borrow so much many to support his company?

Butler Lumber Company had a problem with a shortage of cash that was not allowing them to expand the business. For this reason, thecompany needed a larger unsecured loan that would allow them to expand the bussiness. The company expected larger sales figures in the near future. Therefore ButerLumber Company needed to determine if it wanted to grow the business or not.

Northrup National Bank offered Butler Lumber Company a line of credit of up to $465,000. Was the bank’s offer of $465,000 revolving credit enough (assume a 1991 sales volume of 3.5 million)?Could the cash flows of Butler Lumber support additional debt or stay with Suburban National’s loan?

A quick glance at Butler Lumber’s Operating Statements and Balance Sheets might seem positive because the company was seeing a steady increase in Net Sales.After closer examination, Butler Lumber Company was not as might expect with such robust growth in sales.One main question begs to be asked, why was sales growth so robust, but net income growth anemic at best?

ANALYSIS

PROFORMA

Pro forma Income Statement and Balance Sheet for period ending December 31, 1991 is prepared to determine how much Butler Lumber Company will need to borrow if it expands as planned.

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INCOME STATEMENT

Table 1 Projected Income Statement for 1991 of Butler Lumber Company

BUTLER LUMBER COMPANYProjected Income Statement for December 31, 1991

(thousands of dollars)

Assumptions 1991 Value Explanation

Net sales $ 3,500 $ 3,500 Given in case Cost of good sales

Beginning Inventory $ 418 $ 418 From Exhibit 2 1990 Purchases $ 2,646 75.61% Historical % of sales based on prior 3 years

$ 3,064

Ending Inventory $ (546) Computed value (total COGS - beg inv - purchases)

Total cost of goods sold $ 2,517 71.93% Historical % of sales based on prior 3 years

Gross Profit $ 983Operating expense $ (876) 25.02% Historical % of sales based on prior 3 years

Operating Profit $ 107

Purchases Discount $ 40 2% Assume purchase discounts of 2% taken on all purchases after April 1, 1991.

Interest expense $ (45) 10.50% Given in case Net income before income tax $ 101

Provision for income tax $ (22) 34%

Net income $ 78

Beginning inventory was pulled from the previous year’s ending inventory. Purchases were projected from a trend of 75.61% of sales for the previous 3 years. The total cost of goods sold assumed the previous 3-year average of 71.93% of sales would continue. Provision for income taxes was calculated as 15% for the first $50 income, 25% for the second $25 income, and 34% for above $75 income.

BALANCE SHEET

Table 2 Projected Balance Sheet for 1991 of Butler Lumber Company

BUTLER LUMBER COMPANYProjected Balance Sheet for December 31, 1991

(thousands of dollars)

Assumptions1991 Value Explanation

AssetsCash $ 53.27 1.52% Recent % of salesAccounts receivable, net $ 411.84 11.77% Recent % of salesInventory $ 546 Computed value from above

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Current assets $ 1,011.29Property, net $ 203.97 5.83% Recent % of sales

Total assets $ 1,215.26

LiabilitiesNotes payable, bank $ 616.28Accounts payable $ 72.50 10 Days of purchases

Accrued expenses $ 50.781.45% Historical % of sales based on prior 3

years Long-term debt, current position $ 7 $ 7 Constant amortization

Current liabilities $ 746.56Long-term debt $ 43

Total liabilities $ 789.56 Computed valueNet worth $ 426

Total liabilities and net worth $ 1,215.26

* Bank note $ 616.28

The balance sheet was created with the assumption that Butler wouldn’t take the additional loan. The trend that cash followed from the previous years was used to project the cash asset. Account receivable was based on % of sales previous year. Property was expected to increase by 5.83% based on the previous year’s trends.

Accounts payable stayed at 10 days of purchases. Accrued expenses were based on historical 3 years i.e. 1.45% of sales. The long-term debt for the purchase of the company would be paid down to $43,000. Net worth of Butler Lumber Company was net worth from the previous year and net income from the projected income statement for the last 1991.

Based on the pro forma income statement and balance sheet, it was determined that Butler Lumber would need to increase their current debt to approximately $616.28 to continue their expansion as planned.

FINANCIAL CONDITION

LIQUIDITY

Table 3 Liquidity Ratio of Butler Lumber Company

Liquidity Ratio

Formula 1988

1989

1990

1991 Q1

Comments

Current Ratio Current AssetsCurrent Liabilities

1.80x

1.59x

1.45x

1.35xtrend is getting worse

Quick RatioCurrent Assets -

InventoryCurrent Liabilities

0.88x

0.72x

0.67x


Cash Ratio CashCurrent Liabilities

0.22x

0.13x

0.08x


The current and quick ratios were designed to indicate the organization’s ability to meet its short-term obligations such as payments and other short-term debts, which typically were paid for current assets. A current ratio aproaching one was desirable. A lower value could indicate that a company might be having

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difficulties meeting its short-term obligations, while a current ratio value higher than one could be indicative of poor or inefficient use of funds.

Butler Lumber Company’s current ratio was quite high at 1.45, yet its quick ratio was only o.67 (in 1990). This indicate that Butler Lumber Company was not best use of the funds available to it. Mr. Butler choosed to purchase inventory in quantities large enough to quality for discount for promt payment, but he rarely was able to take advantage of that discount. All of the difference in the current and quick ratios was inventory.

Liquidity ratios of Butler Lumber Company were decreased yearly.For its current ratios, the company still can pay off its current liabilities through its current assets even has decreased. The decreasing trend was worrisome especially given the low quick ratios. But Butler Lumber Company covers its interest expenses 2.61 times in 1990 although the trend for TIE was also worsening (shows in table of Financial Leverage).

The notable trend in this section was toward reduced liquidity. Butler was experiencing a shortage of working capital that needs to be addressed to sustain growth in this profitable business.

FINANCIAL LEVERAGE

Table 4 Liquidity Ratio of Butler Lumber Company

Financial Leverage Ratio

Formula 1988 1989 1990 Comments

Total Debt Ratio Total Assets - Total EquityTotal Assets 55% 59% 63% Trend towards

increased leverage

Debt-Equity Ratio Total DebtTotal Equity 1.20x 1.42x 1.68x

Equity Multiplier Total AssetsTotal Equity 2.20x 2.42x 2.68x

Times Interest Earned EBITInterest 3.85x 3.05x 2.61x Interest expense is

increasing

Cash Coverage EBIT + DepreciationInterest 3.85x 3.05x 2.61x

Number of Days Payable

Accounts PayableAnnual Purchases/365 35 days 46 days 46 days Good position -

helping cash flow

In 1990, Total Debt Ratio of Butler Lumber Company was about 63%. This was high given the slow move in inventories and low liquidity ratio. The trend showed increase in the use of debt.

The data showed that Butler was becoming more leveraged, primarily in terms of short term debt. It further showed that the interest expense was outpacing the earnings growth, which could be helped by securing the new loan at a more favorable interest rate.

ASSET UTILIZATION

Table 5 Asset Utilization of Butler Lumber Company

Asset Utilization Ratio


Inventory Turnover

Cost of Goods SoldInventory 5.11x 4.42x 4.67x

Anticipated sales is increasing inventory on hand

Days Sales Inventory

365 DaysInventory Turnover 71 days 83 days 78 days Taking longer to turn

inventory

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Asset Utilization Ratio


Receivables Turnover

SalesAccounts Receivable 9.92x 9.07x 8.50x

Days Sales in A/R 365 DaysReceivables Turnover 37 days 40 days 43 days Taking longer to receive

paymentAverage Collection Period

Accounts ReceivableSales/365 Days 37 days 40 days 43 days

Total Asset Turnover

SalesTotal Assets 2.86x 2.74x 2.89x Stable

Capital Intensity Total AssetsSales 0.35x 0.37x 0.35x Stable

Total asset turnover is slightly less than 3 for the three years under consideration. Butcomparison of the three years indicate deteriorating trend with respect to average collection period and inventory turnover ratios.

Average collection period increased from 37 days in 1988 to 43 days in 1990 indicated the company takes longer days for taking payment. With increasing sales figures, as displayed in the previous years by the Butler Lumber Company, these long collection days have a greater effect on the business as the amount of outstanding – proportional to the sales figures – increase also.

Inventory Turnover needs to be improved through better management of the inventory mix, and that increased effort is required to encourage customers to pay in a timelier manner. Done correctly these two actions should actually help reverse the downward trend in profit margin.

PROFITABILITY

Table 6 Profitability of Butler Lumber Company

Profitability Ratio Formula 1988 1989 1990 Comments

Profit Margin NISales 1.83% 1.69% 1.63% Decreasing trend is a concern

ROE NITotal Equity

11.48% 11.18% 12.64%

ROA NITotal Assets 5.22% 4.62% 4.72%

The Butler Lumber Company has positive Profit Margins and ROE, therefore it was a profitable business.However, the profit margin of company only had 1.83% in 1988 and always decline every year. Beside that, all of these ratios are trending in a negative direction, as a result of the analysis presented above.

SUGGESTION

Butler Lumber Company was on a growing path. It was evident from the case that the volume has been built due to successful price competition, careful control of operating expenses and purchases at substantial discounts. The data was tabulated below:

Table 7 % Increase in sales of Butler Lumber Company

% increase in sales of Butler Lumber Company1988 1989 1990 Expected 1991

Net Sales $ 1,697 $ 2,013 $ 2,694 $ 3,500

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% Increase NA 18.62% 33.83% 29.92%

As Mr. Butler’s financial advisor, we wouldn’t advise him take the loan in an attempt to grow the business even though the business was profitable and growing. The revenue has been able to grow at a fast pace; 18.62% in 1989, 33.83% in 1990, 29.92% in 1991 but it was not recommended that Butler continue with their expansion plans. Although sales are high, the company was still relying heavily on borrowed funds to finance its daily activities. Increasing the loan amount would drive the company closer to bankruptcy, if the funds were used for expansion. Butler could however use the money to pay his account payable

As a banker, we would not grant Butler Lumber Company a LOC for $465,000. This was too much for a company like this size, and with such little equity. The Days Sales A/R ratio was trending in the wrong direction, and more effort needs to be spent on collecting receivables in a timely manner. Additionally, the Inventory Turnover was decreasing, tying up too much cash, and exacerbating the shortage of working capital. More effort needed to be spent on inventory management, making sure there was not a growing amount of stagnant inventory, and that the mix was correct for the intended market.In addition to the conditions stipulated in the text, the bank should put require that these two ratios (Days Sales A/R and Inventory Turnover) return to their 1988 levels, and that Mark Butler’s compensation be tied to these objectives.

CONCLUSION

Based on its profitability ratios, Butler Lumber Company was a profitable business. Butler Lumber Company has borrowed increasing amounts despite its profitability because the net income was growing at a slower rate than operating expenses. Between the years of 1988-1990 the net income only rose from 31, 34, 44 thousand repectively. The operating costs for the 3 years rose from 425, 515, 658 thousand repectively. Mr. Butler needed to take out loan so he could increase the purchasing power of goods. This would be accomplished by Mr. Butler has liquid cash to use for prompt payment, which would lead to acquiring trade discounts and then Mr. Butler would have a competitive advantage in terms of buying power.

Table 8 Spread of Butler Lumber Company for 1988-1990

1988 1989 1990ROIC 12,29% 13,52

%17,63%

ROE 11,48% 11,18%

12,64%

D/R 54,55% 58,70%

62,70%

Spread

-1,47% -3,98% -7,95%

The table above shows the spread of butler lumber company from 1988 to 1990. From the table it can be seen that the spread continues to show negative results. This is due to its ROIC value greater than the value of its ROE. ROE was the result of the advantage if using internal and external funds, while ROIC only use internal funds only. Value of negative spreads continued to show that the company could not grow anymore. Thus Butler Lumber Company wasn’t recomend to continue their expansion plan. Increasing their loan made the company become bankruptcy.

Table 9 Spread of Butler Lumber Company for projected 1991

projected 1991ROIC 17,43%

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ROE 18,30%D/R 64,90%Spread 1,33%

On the prediction of financial statements for the year 1991, the company would increaseits spread. This only happened if the company has 3,5 million for volume sales in 1991.

If sales volume of Butler Lumber Company assumed in 1991 was 3,5 million so the company has to increase its debt until 616.28 thousands. The Northrup National Bank’s offer of 465 thousand revolving credit was not enough.

Table 10 % Inventory to total assets of Butler Lumber Company

1988 1989 1990% Inventory to total assets 40.24% 44.16% 44.80%

Based on the table, Butler was short on funds due to their inventory. In 1990, inventory was almost 45% (i.e 44.80%) of their total assets. Better inventory management might increase the cash fund as well as free up space in the warehouses.

ATTACHMENT

Table 11 Exhibit 1 of Butler Lumber Company

BUTLER LUMBER COMPANYEXHIBIT 1

Operating Expenses for Years Ending December 31, 1988-1990, and for First Quarter 1991(thousands of dollars)

1st Qtr. 1988 1989 1990 1991

Net sales $ 1,697

$ 2,013

$ 2,694 $ 718 (1)

Cost of good salesBeginning Inventory

$ 183

$ 239

$ 326 $ 418

Purchases$

1,278$

1,524$

2,042$ 660

$ 1,461

$ 1,763

$ 2,368

$ 1,078

Ending Inventory $ (239)

$ (325)

$ (418) $ (556)

Total cost of goods sold

$ 1,222

$ 1,438

$ 1,950 $ 522

Gross Profit$

475$

576$

744 $ 196

Operating expense(2)$

(425)$

(515)$

(658)$ (175)

Interest expense$

(13)$

(20)$

(33) $ (10)

Net income before income tax

$ 37

$ 41

$ 53

$ 11

Provision for income tax $ $ $ $ (2)

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(6) (7) (9)

Net income$

31$

34$

44 $ 9

PS:

(1) In the first quarter of 1990 sales were $698,000 and net income was $7,000 (2) Operating expenses include a cash salary for Mr. Butler of $75,000 in 1988, $85,000 in 1989, $95,000 in

1990, and $22,000 in the first quarter of 1991. Mr. Butler also received some of the perquisites commonly taken by owners of privately held business

Table 12Memo Items for Exhibit 1 of Butler Lumber Company

Memo Items 1988 1989 1990 Average1 Purchase to sales 75.31% 75.71% 75.80% 75.61%2 Cost of good sales to sales 72.01% 71.44% 72.38% 71.94%3 Operating expense to sales 25.04% 25.58% 24.42% 25.02%4 Growth (sales) - 18.62% 33.83%5 Growth (assets) - 19.29% 21.11%

Table 13 Exhibit 2 of Butler Lumber Company

BUTLER LUMBER COMPANYEXHIBIT 2

Balance Sheets at December 31, 1988--1990, and March 31,1991 (thousands of dollars)

1st Qtr 1988 1989 1990 1991Assets

Cash $ 58 $ 49 $ 41 $ 31Accounts receivable, net $ 171 $ 222 $ 317 $ 345Inventory $ 239 $ 325 $ 418 $ 556

Current assets $ 468 $ 596 $ 776 $ 932Property, net $ 126 $ 140 $ 157 $ 162

Total assets $ 594 $ 736 $ 933 $ 1,094

LiabilitiesNote payable, bank $ - $ 146 $ 233 $ 247Notes payable, Mr. Stark $ 105 $ - $ - $ -Notes payable, trade $ - $ - $ - $ 157Accounts payable $ 124 $ 192 $ 256 $ 243Accrued expenses $ 24 $ 30 $ 39 $ 36

Long-term debt, current position $ 7 $ 7 $ 7 $ 7

Current liabilities $ 260 $ 375 $ 535 $ 690Long-term debt $ 64 $ 57 $ 50 $ 47

Total liabilities $ 324 $ 432 $ 585 $ 737Net worth $ 270 $ 304 $ 348 $ 357

Total liabilities and net worth $ 594 $ 736 $ 933 $ 1,094

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Table 14 Memo Items for Exhibit 2 of Butler Lumber Company

Memo Items 1988 1989 1990 1st Qtr.1991

Average

1 Networking capital $ 208 $ 221 $ 241 $ 242 $ 2282 Networking operating capital $ 320 $ 374 $ 481 $ 653 $ 4573 Cash to sales 3.42% 2.43% 1.52% 2.46%4 Account receivable to sales 10.08% 11.03% 11.77% 10.96%5 Net property to sales 7.42% 6.95% 5.83% 6.74%6 Accrued expenses to sales 1.41% 1.49% 1.45% 1.45%7 Account payable to sales 7.31% 9.54% 9.50%

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FM Butler Grup 2

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