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Butler Lumber Company, Case Study Example

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Case Study

Butler Lumber Company has been enjoying impressive sales growth over the years and its net income has also continuously increased in absolute terms. The company’s owner Mark Butler is an ambitious individual who is well liked for his work ethics and people skills by those who know him. However, in his major focus on sales expansion, Butler has failed to notice the deteriorating liquidity and operating performance of the company. The recommended course of action to Butler is to scale back expansion plans, improve operating performance and leverage position of the company, and possibly seek a different capital structure.

This profitable company has been forced to borrow so much from the bank because it’s sales are expanding at a higher rate than what could be supported through internal funds. At first glance, it seems the company is quite profitable but a closer look at the profitability ratios reveal that the profit margins have actually been decreasing over the years. This is because the company’s expenses to support the rising sales have been growing at a faster pace and one example is Butler’s own salary which increased from $75,000 in 1988 to $95,000 in 1990.

1988 1989 1990
Profit Margin = Net Income = 31 = 1.83% 34 = 1.69% 44 = 1.63%
Sales 1697 2013 2694

The profit margin was 1.83%, 1.69%, and 1.63% in 1988, 1989, and 1990 respectively which means the company’s operating performance is on a downward spiral. This makes the sales growth less appealing because marginal expenses to support the growing sales keep rising each year. The picture is mixed though when it comes to asset utilization rate such as inventory turnover rate which decreased to 6.17 in 1989 from 7.1 in 1988 but increased to 6.44 in 1990 though still below the 1988 level.

1988 1989 1990
Inventory Turnover (Times) = Sales = 1697 = 7.10 2013 = 6.17 2694 = 6.44
Inventory 239 326 418

 

One of the reasons why the company might have been able to improve the inventory turnover rate in 1990 is by offering more generous credit facilities to the customers in order to grow sales and this assumption is indeed supported by the balance sheet that shows a huge jump in accounts receivables in 1990 at $317,000 from $222,000 in 1989. Thus, the company has been sacrificing operating liquidity in exchange for higher sales and the actual expenses may turn out to be higher due to higher risk of bad debts.

The company estimates that it needs a revolving loan facility of $465,000 which is quite an overestimation. Assuming that the company’s sales will be $3.6 million in 1991 and the company retained $9 million out of $44 million of net income in 1990, the company’s external financing in 1991 need should be approximately $215,000 as shown below.

 

External Financing Needs =
A/S*(S1-So) – L/S(S1-So) – M*(St)*(1-D)
=

 

933/2694(3600-2694) – 256/2694(3600-2694) – (44/2694)*(3600)(1-(35/44) = 215.650

 

By this estimation, the company is asking for more than twice its external financing need and going for unnecessary debt when its current debt position is already a cause of concern.

1988 1989 1990
Debt to Total Assets = Total Debt = 324 = 0.55 432 = 0.59 585 = 0.63
Total Assets 594 736 933

 

Debt has continued to become a greater portion of the company’s overall capital structure during the period from 1988 to 1990. This means the company’s interest expense has also continued to increase, negatively affecting its net profit margin. This is also one reason why the company’s profit margins continue to decline. In addition to direct costs, this is also costing the company indirectly because one of the reasons the company has not been able to take advantage of trade discounts by promptly paying for its purchases is because it has always been low on funds. And the opportunity cost has been quite huge.

The company made inventory purchases of $2,042,000 in 1990. If the company had paid the invoice within ten days, it would have been eligible for 2% discount which translates to $40, 840. This figure is almost the same as the company’s net income in 1990 which was $44,000. The company could have earned almost twice the net income had it taken advantage of trade discounts. Yet, instead of realizing the seriousness of the problem, the company is keen on taking more loan that is needed to fund its planned expansion in 1991.

As we looked over the figures during the period 1988-1989, the annual purchases have been about 75-76% of the net sales figure. If the expected sales in 1991 is $3.6 million, this translates to $2.7 million of purchases at 75% of the net sales figure. By taking advantage of the trade discounts, the company can save about $54,000 which is a significant number and higher than the net income in all of the previous three years. The company should take advantage of this opportunity but it seems unlikely if the past is any indication unless the company takes drastic steps to manage its deteriorating short term liquidity.

As Mr. Butler’s financial advisor, I would advise him to reconsider his anticipated expansion and plans for additional debt financing. I would advise Mr. Butler to focus on improving operating efficiency, lowering short term liabilities, and adopt controlled growth policy instead of aggressive growth policy. If we look at the short term, liquidity ratios, it is apparent that the company’s growth is coming on the shoulders of short term liabilities.

1988 1989 1990
Current Ratio = Current Assets = 468 = 1.80 596 = 1.59 776 = 1.45
Current Liabilities 260 375 535

 

The current ratio decreased from 1.80 in 1988 to 1.45 in 1990. Part of the reason may be higher accounts payable levels every year. So far the company is managing its relationship with the suppliers well but if the trend continues, the suppliers may demand prompt payment and become less generous with credit. Similarly, quick ratio also shows the same trend and is a better indicator of short term liquidity than current ratio because it excludes inventory.

Quick Ratio = Current Assets – Inventory = 229 = 0.88 270 = 0.72 358 = 0.67
Current Liabilities 260 375 535

 

The company’s quick ratio declined by approximately 24 percent from 1988 to 1990. Another sign of deteriorating short term liquidity is declining days payables outstanding ratio. While it took the company about 37 days to pay its suppliers in 1998, the figure has jumped to nearly 48 days. This may also be happening because of the company’s generous credit facility to customers and, thus, a significant portion of sales is now non-cash.

1988 1989 1990
Days Payables Outstanding = Accounts Payable * 365 = 124 * 365 = 37.038 192 * 365 = 48.768 256 * 365 = 47.918
COGS 1222 1437 1950

 

As a banker, I would not approve Mr. Butler’s request of $465,000. This is because I have looked at different financial ratios and they show quite a disturbing trend. I would be concerned that Mr. Butler has already difficulties meeting his current obligations and new loan would only further worsen his ability to meet his debt obligations. First of all, the company’s ability to meet its short term interest payments is deteriorating.

 

1988 1989 1990
Times Interest Earned = Income before Interest & Taxes = 50 = 3.85 61 = 3.05 86 = 2.61
Interest 13 20 33

 

While the 2.61 ratio in 1990 is still not a bad figure but the three-year trend indicates signs of troubles ahead. The ratio was 3.85 just two years ago in 1988 and now stands at about 68% of the 1988 level in just two years. This is because the company has been accumulating debt too quickly and its income has not been keeping up pace. Similarly, as mentioned before, the company has been taking longer and longer to pay back its suppliers and has difficulty taking advantage of trade discounts that could make a huge difference in its financial performance. The company’s external financing need is about $215,000 and I would be willing to consider this figure but only if the company agrees to certain covenants.

One requirement is that the company will not open credit facility of any kind with any other institution except when permitted by the bank. Second covenant is that the whole amount of the remaining principle as well as applicable interest will be immediately due if the company misses any payment unless the bank agrees to change the term. In addition, the company will not pay any dividend during the term of the loan. The company will also be required to inform the bank of any capital investment plans and the bank will have the right to inspect company’s financial documents anytime. Moreover, the company will maintain a profit margin of at least 1.5% during the term of the loan.

If Mr. Dodge turns down his request for increased credit line, Mr. Butler could raise funds by offering common stock to the investors. The company could also sell its account receivables to a third party at a discounted value. Mr. Butler could also sell some of the company’s assets to raise funds. Mr. Butler could also consider obtaining loans that are secured against the assets of the company. Mr. Butler doesn’t want to follow this course of action but doing so will allow him to obtain more attractive terms from the lenders.

If I am Mr. Butler, I would follow a more controlled growth rather than aggressive growth. I will obtain only $215,000 but not to support sales expansion but to attempt to improve liquidity and operating performance. Even then, I will attempt to obtain loans against the company’s assets to get better terms and reduce interest expense. Since my focus is on improving operating efficiency and liquidity, I will also agree to covenants to further reduce my debt costs. I will sell some of the company’s assets such as warehouses and improve relationships with the suppliers by more prompt payments and working with them to implement more efficient supply chain to reduce storage costs and improve inventory turnover.

I will also implement more conservative credit facility to the customers and take steps to increase cash-based sales. Customers will be offered discounts for prompt payments. I will also try to quickly pay down debt and change the company’s capital structure to equity-intensive one. This will help improve both profit margins and liquidity and will especially be helpful in difficult economic conditions. Most of the company’s future capital investments will be funded internally instead of through debt financing.

I will replace many assets with operating leases. Operating leases would prevent the need for high capital investments as well as providing flexibility. Moreover, lower asset base would also mean lower depreciation expense and higher profits.

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