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BUTLER LUMBER FINAL FIRST DRAFT
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Transcript Problems, Options and Recommendations The problem that we have recognized in this case is that Butler Lumber Company does not have enough funds to finance its operations in the future. The company has experienced a shortage in cash and needs to issue debt as it moves forward. The company is also under pressure because of the payment to be made to Mr. Stark for the buyout of his share in the company of $105,000. Although, the majority of this payment has been made, Butler still owes Stark another $35,000 that he intends to finance through another loan. The firm has already been using up its cash reserves to pay back its liabilities, which is not a good sign since cash should be used for investment purposes. As we can see from Exhibit 4 (Cash flow from operations), cash balances have been depleting year by year with a total decrease of $17000 over the years 1988-1990. Butler Lumber has two options to support the company’s operations. The first presents itself in the form of a loan from the Suburban National Bank of $250000, who have asked them to secure the loan with real property, which shows that the company’s risk profile has increased as this bank never asked for any security while making loans in the past. But the problem with this scenario is that the company will need a bigger loan to finance its operations, which the Suburban National Bank will not provide beyond $250000. Therefore another option that the company can consider is to accept Northrop National Banks offer of a loan of $465000 and abide by their terms if they undertake this loan. Hence accepting Northrop’s offer will sever Butler’s relationship with the Suburban bank, but also allow Butler access to more funds than Suburban would have otherwise been able to provide. The risk profile of the company has increased over the years if we look at their current ratio, which has fallen from 1.8 to 1.45, indicating a fall in liquidity. The debt-asset ratio has increased from 0.5455 to 0.6270 over the three years, showing that the company has been taking a lot of debt in order to finance its assets. The interest coverage ratio has decreased from 3.84 to 2.6 over the years, showing that the firm is facing problems paying interest on its loans. These numbers, and the various other ratios shown in Exhibit 6, clearly indicate why the Northrop Bank has brought certain covenants on the loan that they have offered. Given the analysis, we recommend that the company should reject the offer from both the Northrop Bank and the Suburban Bank, since the loan they provide do not meet the External Financing Need(EFN) of the company as we will proceed to show. Therefore Butler has to look for a greater line of credit from another source in order to ensure the smooth running of his company. Proforma Analysis To discover how much of external funds are needed in order to obtain the projected annual sales of $3.6 million provided in this case, estimating the projected income statement and balance sheet for 1991 is required. With the percentage of sales method, we can tabulate the projected income statement and balance sheet for 1991 (Exhibit 5). From the historical data that is provided, we calculate the percentage of sales for each figure in the balance sheet and income statement (Exhibit 3). It is assumed that every figure except the fixed rate of figures such as the current portion of a long-term debt is considered to grow with increases in sales base. Moreover, we classify those figures into two categories – one for using the most recent percentage of sales in 1990 and the other for using the average of all three years’ percentages of sales from 1988 to 1990, in order to estimate the projected value in 1991. These classifications assist us with more accurate estimations since some figures are more affected by current changes and firms’ decisions while others tend to sustain at a certain average of the historical data in the industry. For instance, since cash, accounts receivable and net payables can respond fast to recent changes in firm’s decisions or trends, we estimate those figures with the recent percentage base of sales. On the other hand, for other figures such as purchases, total cost of goods sold and operating expenses, it is difficult to claim that only the values of recent years reflect the projected value, and we utilize the average percentage of all the given data from 1988 to 1990. All of the projected income statement and balance sheet will follow these fundamentals, with some exceptions. More specifically, one example of exceptions in the projected income statement can be ‘purchases’. Since the purpose of external funds is to use cash properly, which will allow the company to get the benefit of purchase discounts, we assume that 2% discounts are applied on all purchases that are made in 1991. In addition, provisions for income taxes can be calculated by following the tax information that is given in the foot note. Under these assumptions and projections, $75 (in millions) net income will be achieved in 1991, which is a substantial increase compared to the one in 1999. In the projected balance sheet, accounts payable can be calculated from the equation of one of the short-term solvency ratios: (Days of purchases in Accounts payable = Accounts Payable / Daily Purchases.) To acquire the purchase discounts, all payments should be made within 10 days. Therefore, daily purchases multiplied by 10 give us the accounts payable value of $75. In addition, for the calculation of Long-term debt, the previous year’s long-term debt will be subtracted by the amount of the current portion, which is $7, and that gives us $43 (in millions). To compute the Net worth, we add the previous year’s net worth to the projected net income of the year. Lastly, since the total asset should be equal to the sum of total liabilities and net worth (equity), and the only missing part of this equation is the note payable, we can calculate the note payable by using the equation of (A=L+E). By doing the calculation, we get $661,000 for the predicted bank note payable, which indicates the needs for External Funds. However, this value exceeds the maximum amount ($465,000) of loan that Butler Lumber can actually borrow from Northrop National Bank. In other words, to achieve $3.7 million of the projected sales, Butler Lumber requires more than the maximum amount of the loan that Northrop National Bank can offer. Selected Statistics In order to compare the result and profitability between G-star (sustainable growth rate) and actual growth sales and assets, we first calculated the margin ratios from 1988 to 1991, which we divided by the net income over net sales. Based on the data, margin ratio is decreasing in every period, from 1.83 to 1.63 (Exhibit 3). However, by diving the net sales over total asset, the company’s asset turnover ratio fluctuated a bit from 1988 to 1989, but it increased by 0.02 at the end of 1991 overall (Exhibit 3). Moreover, the leverage rate is also increasing and since there is no dividend, our retention ratio is 1. According to these outcomes, if Butler Lumber Company (BLC) does not accept the offer and maintains their current position, the growth rate would be 14.47 percent in 1991 (Exhibit 3). Since the retention ratio is 1, ROE represents the sustainable growth rate, which we multiply by all the information above. Compared to the previous year, there is not much difference between 1989 and 1991, with a mere increase of 1.88 percent (Exhibit 3). The reason for this is that even though the company’s margin would be decreased slightly, they use the current and fixed assets efficiently, which indicates a higher asset turnover ratio. As a result, the company will grow steadily without the bank loan. On the other hand, if the company agrees to take out a loan from the Northrop National Bank, the actual growth sales rate would be changed to 33.63 percent (Exhibit 3). Compared to the previous year of 1989, it indicates that there is a rapid growth in sales rates, from 18.62 to 33.63 percent (Exhibit 3). In addition, actual assets growth increased from 23.91 to 26.77 percent, which indicates that it could bring more positive effects when the company makes an offer to borrow it (Exhibit 3). Based on the results above, Butler Lumber Company would not negatively affect their growth sales and assets significantly without increasing the leverage. However, if the bank investigator’s assumption is correct, the sales will reach 3.6 million in 1991. Since our internal rate is smaller than the external rate, the company would have to raise more funds in order to obtain the sales of 3.6 million. Therefore, it would be greatly beneficial for the company to move away from the current position and take out a loan, not necessarily a loan offered within the boundaries of this case however. This could result in more progressive and rapid growth rate in 1991. External Financing Need In order to achieve their goal of $3.6 Million in sales for the fiscal year of -1991, Butler Lumber Company must use external financing. As shown in the pro forma income statement (Exhibit 5), Butler Lumber will require external financing of $661,000 in order to achieve their projected sales for the year. The $661,000 is the plug value computed on the assumption of $3.6 Million in sales for the year 1991, this is also known as the EFN-External funds need plug. The accounting identity requires that total assets equal total liabilities and equity. In the first pass however the percentage of sales method will rarely produce this equality, as was seen in the case of Butler Lumber. To balance the pro forma balance sheet, one must insert a plug figure so that: Total assets = total liabilities + stockholders equity + plug The plug figure is also known as the amount of external funds required. The cause for the existence of this plug is because the company is predicted to grow at a rate higher than its internal sustainable rate. Butler Lumber can internally sustain growth at the rate of approximately 14.47%,
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