HARVARD BUSINESS SCHOOL

9-292-013

REV: JANUARY 4, 2002

Butler Lumber Company

To examine Butler’s 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 quarter’s data is provided, so in the following discussion, we us the first quarter’s 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 company’s 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, let’s 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 don’t 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 Dodge’s 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 firm’s 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:

Butler’s 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 Butler’s 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 don’t 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.