Butler
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Butler Lumber Company
Introduction
Butler Lumber Company is an owner operated corporation. In the late 1980’s it faced tremendous sales growth. The growth in sales resulted in increase in funding needs. The shortage of funds forced the company to forgo cash discounts on trade credit. Mr. Butler, the owner-manager, is looking for a new source of funding.
The main issues under consideration are:
Is the need for funding a short-term one or long-term in nature?
Is the bank’s offer of $465,000 revolving credit enough?
Should Butler Lumber Company take the cash discounts on trade credit even if it has to borrow from a bank?
Should BLC borrow and pursue the expansion?
Financial Condition of Butler Lumber Company
Liquidity: Current ratios of BLC varied from 1.80 in 1988 to 1.45 in 1990. Quick ratios were 0.88 in 1988 and decreased yearly to 0.67 in 1990. BLC has not defaulted. But it was unable to take cash discounts on trade credit. While the current ratios of above 1 indicate adequate liquidity, the decreasing trend is worrisome especially given the low quick ratios. But BLC covers its interest expenses 2.6 times in 1990 although the trend for TIE is also worsening. Please see the attached schedules Selected Ratios.
Asset Utilization: Total asset turnover is slightly less than 3 for the three years under consideration. But comparison 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. Trade credits used to be paid in 35 days in 1988, but in 46 days in 1990. These indicate inefficiency compared to the net 30 days terms and the condition is worsening.
Financial Leverage: Debt ratio is about 63% in 1990. This is high given the slow move in inventories and low liquidity ratio. The trend shows increase in the use of debt. This increases financial risk and future lenders may demand high interest rate.
Profitability: Net profit margin is very low (less than 2%). Gross profit margin is about 28%. These indicate that BLC has substantial amount of administrative and general expenses. Return on equity varied between 11% and 12.6%. Return on assets is about 5%. Basic earning power for BLC were 8.42%, 8.29% and 9.22% respectively for the three years (1988, 1989 and 1990). BLC pays interest rate of 11% on its debt and is seeking to get a 10.5% revolving loan from Northrop National Bank. So it earns 9.22% on its investment, but pays 10.5% and 11% on its debt. This is not profitable although the interest bearing debts are only a fraction of its financing.
Sources and Uses of Funds
The main sources of funds for Butler over the three years are short-term bank loans, trade credit and profit from sales. Bank loan is the largest. Butler used funds mainly for inventory build up, credit for customers and repayment of former partner’s interest in the business. (See attached Sources and Uses of Funds Statement).
Nature of Financing Needs
Butler’s need for funds in the Spring of 1991 are the result of both seasonal factors and permanent need due to growth. It is indicated in the case that 55% of sales occurred during the six month period of April to September. Anticipation of increase in sales during this season requires inventory build up in advanced. Secondly, sales increased overtime from $1,697,000 in 1988 to $2,694,000 in 1990. This is about 26% average annual growth rate. The forecast for 1991 is that sales will be $3.6 million. This requires permanent increase in assets and hence permanent need for funds.
If the financial statement proportions are assumed to be stable, additional funds needed (AFN) to support the forecasted sales would be:
AFN = в?†S*(A/S) – в?†S*(Ls/S) — S1*p*b
Where: в?†S = change in sales based on forecast
A/S = total assets to sales ratio
Ls/S = spontaneous liabilities to sales ratio
S1 = forecasted sales for the new planning year
p = net profit margin on sales
b = retention ratio
= 313.77 — 99.21 — 58.68
= 155.88.
So Butler needs about $155,880 in new financing assuming the current levels of debt continue and before considering the financing feed back effects.
If we consider the financing feed back effect, the total need for external financing would be about $187,000 if Butler does not take purchase discounts on trade credit (see attached projected balance sheet at end of 1991 assuming purchase discounts are not taken).
If purchase discounts are taken, Butler would need more external funding because it has to pay trade credit within 10 days. The total external funds needed would be $444,000 in that case. (see attached projected balance sheet assuming purchase discounts are taken).
In either case, the $465,000 credit Northrop National Bank offered is sufficient for Butler’s current financing needs.
Should Butler take the purchase discounts and pay trade credit within 10 days? Remember since it doesn’t have enough funds, it would borrow from bank to pay trade credit in 10 days.
Cost of trade credit if discounts are not taken:
(2/98)*365/(46-10) = 20.69%.
Assuming trade credits can be paid within 46 days without any penalty as Butler’s past experiences show. This means not taking the purchase discounts is tantamount to borrowing at an annual rate of 20.69%. Since this is by far greater than the interest rate on bank loan (10.5%), it is better to take the purchase