Abstract
Butler Lumber Company, a lumber retailer with a rapid growth rate, is faced with the problem of cash flow shortage. In order to support this profitable business, BLC needs a great amount of cash. The loan of $250,000 from Suburban National and a line of credit of up to $465,000 from Northrop National Bank are the two choices provided. After a brief review of the operation and financial conditions of BLC, we first make analysis of the credit level of BLC from the perspective of banker.
Although the feedback from all the firms that had business dealings with Butler are quite positive , both solvency and liquidity condition and the mortgage indicates that it is not a wise decision for Northrop National Bank to offer a line of credit to BLC. Then we diagnose the business of BLC by examining the sources and uses of funds and find out that the increase in inventory and accounts payable occupies too much funds that leads to the shortage of cash flow. If BLC can make improvement in the management of these two items, definitely it can take advantage of the trade discount, which equals to an interest rate of 20. % per year. Based on the calculation of average days payable discount it can be concluded that BLC should reduce its days payable outstanding to 10 days. Since sales is expected to reach $3. 6 million in 1991, the projected income sheet and the balance sheet can be obtained through calculation so that we get the plug value (notes payable to bank) needed for the profitable business. This amount is so large that it exceeds the maximum amount the company can get from bank. In the third part of this report, we provide four suggestions for BLC to solve the problem of cash flow shortage.
The credit terms of net 30 days on open account offered to customers can be improved by Customer Credit Ranking System. Besides BLC must keep inventory at an optimal level so that if can save the opportunity cost of occupying funds. The third suggestion we offer is concerned with cash management. Accelerating cash inflow and controlling cash outflow are two major means to decrease the opportunity cost of holding cash. We also suggest BLC to finance through equity so that the liability rate can be reduced to a relatively low level. Key Words: capital budgeting,
As a full service building material dealer serving the needs of industry, contractors, builders and home owners, Butler Lumber Company is in the process of rapid growth. About 55% of total sales were made from April to September, and repair business accounts a relatively high proportion. In order to support this profitable business, BLC needs a great amount of cash. The maximum loan that the Butler Lumber Company (BLC) could obtain from Suburban National was $250,000 in which his property would be used to secure the loan. Northrop National Bank offered BLC a line of credit of up to $465,000 with many restrictions. BLC would have to sever ties with Suburban National if they were to have this LOC extended to them.
Perspective of Banker
From the perspective of banker, it is quite reasonable for Northrop National Bank to put restrictions on the line of credit offered to the Butler Lumber Company. From the investigation carried by the credit department, we can find several points to support our logic.
Customary investigation-qualification of the owner
Northrop National Bank had sent inquires concerning the credit level of Butler to a number of firms that had business dealings with him. Almost all the trade letter bore out the positive opinion about the operating condition of Butler Lumber Company. They also showed their confidence in Butler’s own credit by mentioning his good personality and the conservative operation he carried out which made the company’s operating expenses as low as possible.
Financial analysis
After the credit checking of Butler and his company, Northrop National Bank carried out the analysis of Butler Lumber Company’s realistic financial and operating condition by examining its financial reports.
Although the sale prospects were favorable, Northrop National Bank gave particular attention to the long-term solvency measures as well as liquidity ratios of the Butler Lumber Company. Debt position and current ratio of the business were especially carefully examined. Financial ratios using for analysis are shown as the following tables. Financial information used for calculation is drawn from the balance sheet and income statement of the company provided by the case. The company’s debt position shows that there was rapid increase in Butler Lumber’s accounts and notes payable in the recent past, especially in the spring of 1991.
Liquidity ratios
Two-year decrease of liquidity measures including current ratio and quick ratio reveals the problems concerning company’s short-term solvency and liquidity. Butler Lumber Company’s current ratio decreased to 145. 05% in 1990 from the level of 180. 00% in 1988.
The same decrease happened to quick ratio (decreased from 88. 08% in 1988 to 66. 92% in 1990). As the short-term lender, Northrop National Bank should have noticed that Butler Lumber Company’s ability to pay its bills over the short run without undue press needs to be carefully examined. The decrease of current ratio also implies the decreasing level of company’s net working capital, which is another sign of lower level of liquidity.
Operating management
The days sales of inventory, days sales outstanding and days payable outstanding kept similar over the past three years. Since we cannot get the industrial average level, we cannot determine whether the level of Butler Lumber Company is reasonable. However, we can notice the continuous decrease of cash and relatively high and increasing amount of receivables and debt shown by the company’s financial reports. These several phenomena still reveal the problems concerning operating management involving inventory, receivables and payables.
Assets condition used for securing
Since the Butler Lumber Company is possessed solely by Mark Butler, Northrop National Bank should evaluate not only the land and storage building owned by the company but also the assets owned by Butler himself. Butler’s assets contain the house which Butler held jointly with his wife cost $72,000 to build in 1979, which, however, was mortgaged for $38,000. Butler also held a $70,000 life insurance policy, payable to his wife. Butler’s wife owned independently a half interest in a house worth about $55,000.
Combined all the available assets mentioned above, there are assets worth of $131,500 can be used to secure the loan. However, the value of these assets accounts for a little portion of the proposed loan of $465000. Since the land and buildings possessed by the company had been used to secure the loan of $70,000, negotiated in late 1988 using for making the payment to Butler’s brother-in-law, Henry Stark, Butler himself and the company might not have enough assets to secure the new loan. If the company faces the bankruptcy and liquidation, the amount of money that can be repaid to the Northrop National Bank would probably be limited.
Summary
From the explanation above, we can tell that the Northrop National Bank would be probably not willing to provide loan to Butler Lumber Company. Although the credit condition of the company and Butler himself is good, the company’s weak solvency and liquidity condition and lack of assets using to secure the loan makes the probability for the bank to draw back the loan is quite low. Things would get worse and harm the interests of the bank if Large amount of Additional investments in fixed assets happened, so does the withdrawals of funds from the business by Butler.
So we conculde that the Northrop National Bank would not lend money to the BLC.
Perspective of Butler
BLC spent $105,000 buying out Stark’s interest in 1998, which caused the shortage of funds to some extent. However the most important reason of the lack of cash flow lies in the additional investments in working capital, increase in accounts receivable and increase in inventory. These two items accounts for 68. 4% of all the uses of funds and keeps rising. Usually credit terms of net 30 days on open account were offered to customers and the average collection period increased year by year.
As a company faces with seasonal sales, BLC haw to keep a certain amount of inventory to satisfy the large need in peak seasons, but the proportion of inventory is relatively high and occupied 37. 7% of the uses of funds. 3. 2 Cost of trade discount According to the material” The usual terms of purchase in the trade provided for a discount of 2% for payments made within 10 days of the invoice date. Accounts were due in 30 days at the invoice price, but suppliers ordinarily did not object if payments lagged somewhat behind the due date. However, because of the shortage of funds arising from his purchase of Stark’s interest in the business and the additional investment in working capital associated with the company’s increasing sales volume Butler had taken very few purchase discounts. From the Exhibit 1, we can calculate the actual average days payable outstanding of Butler Lumber Company.
Butler Lumber Company had two choices: the first one is taking the 2% discount and payoff all the payments in 10 days; the second is rejecting the discount and payoff in 46 days. In another word, the suppliers provide an interest rate of for 36 days. That is equal to an interest rate of 20. 2% per year, which is much higher than the interest rate of banks. On this account, Butler Lumber Company must accept the discount provided by supplies and reduce its days payable outstanding to 10 days.
Projected Income statements for 1991
According to the sales expectation, sales are expected to reach $3. 6 million in 1991 and may exceed this level if prices of lumber rise substantially in the near future. We use the number $3,600,000 to calculate the projected income sheet in 1991. All the accounts are shown as the following table. BUTLER LUMBER COMPANY Projected income statement for 1991 (thousands of dollars) Assumptions
1991 Value Explanation
- Net sales $3,600 $3,600 given in case
- Cost of goods sold: Beginning inventory $418
- Purchases $2,736 76% historical % of sales 3,154
Ending inventory $562 computed value (beg inv + purch – end inv)
- Total cost of goods sold $2,592
- 72% historical % of sales
- Gross Profit $1,008
- Operating expenses $900 25% historical % of sales
- Operating Profit $108
- Purchase Discounts* $42 2% (of purch after discount) assumption
- Interest expense** $53 10. 50% (of average outstanding balance) assumption
- Net income before income taxes $97
*Assume purchase discounts of 2% taken on all purchases after April 1, 1991.
**10. % on the average outstanding balance.
The numbers of 1st Quarter are not exactly corresponding with what we get by using the approach. And precisely speaking, this approach can only apply to calculating yearly numbers, for we get the original percentages of yearly data. So improvement should be made to adapt the quarterly numbers, whose characteristics are slightly different from that of yearly number. Take purchase account for example: Total cost of goods sold, operating expense are all computed in historical percentage of sales. The percent of each is 72% and 25%.
Assume purchase discounts of 2% are taken on all purchases after April 1, 1991. So the purchase discount can be computed as follow: = According to the negation between Dodge and Butler, the initial rate to be paid would be about 10. 5% under conditions in effect in 1991. So the interest expense account is $53,000.
Projected Balance sheet for 1991
With the projected income sheet for 1991, the projected balance sheet for 1991 can be calculated as follow.
Projected balance sheet for December 31, 1991 (thousands of dollars) 1991. Value Explanation Assets:
- Cash $54 1. 50% recent % of sales
- Accounts receivable, net $432 12% recent % of sales
- Inventory $562 computed value from above
- Current Assets $1,048
- Property, net $216 6% recent % of sales
- Total Assets $1,264
Liabilities:
- Accounts payable $75 10 days of purchases
- Accrued expenses $54 1. 50% historical % of sales
- Long-term debt, current portion $7 $7 constant amortization
- Bank note payable (plug) $661 computed plug value
- Current Liabilities $797 Long-term debt $43 computed value
- Total Liabilities $840 Net worth $424 computed value
- Total Liabilities plus net worth $1,264
Use the same way in computing income accounts, we adapt the quarterly numbers. Accounts receivable, property are all computed in the same way as above. After take the purchase discount 2%, days payable outstanding is reduced to 10 days. The account payable can be computed as follow: We use bank notes payable as the plug, which stands for how much fund is really needed. Under the assumption that Butler Lumber Company take the purchase discount and days payable outstanding reduced to 10, the $465,000 loan from Northrop Nation Bank is still not sufficient in 1991.
What Butler need indeed is $661,000, much bigger than the number bank could offer. Apparently, Butler Company has to find another way to solve the cash problem.
Suggestion
Accounts Receivable Management
Quantity discounts and credit terms of net 30 days on open account are usually offered to customers by Butler Lumber Company. However, this section can be improved by Customer Credit Ranking System. If there is no secure or the finance statements (such as long-term liability rate) are not good, Butler Company can shorten the credit term of this customer. In accordance with this way, bad debt can be avoided.
Downscale Inventory
With the increase in sales, inventory also flowed up. Holding inventory can produce large quant of cost, while it is impossible to run a business without any inventory. So Butler Company must find an optimal rate of the inventory to sustain the business and make the inventory cost as small as possible at the mean time.
Cash Management
In the point of ROI, the opportunity cost of holding cash is big. But is not practicable neither for a company does not have enough cash to pay the daily activities. The objective of cash management is to make the company hold the least cash for the efficient operation. Butler Company can reduce the holding of cash significantly through such ways:
Accelerate the cash inflow. Butler Lumber Company can choose a faster way to receive funds, reduce the notes check time.
- Control cash outflow.
- Accounts are due in 30 day s at the invoice price, but suppliers ordinarily did not object if payments lagged somewhat behind the due date. Butler Company should make good use of these days to control the cash outflow.
Good cash management with reducing in payment in a certain period will also reduce accounts payable.
Equity Financing
It is better for the Butler Lumber Company find a PE or VC, although a general economic downtown may slow down the rate of increase in sales, Butler Lumber’s sales are protected to some degree from fluctuations in new housing construction. As the company get invest from PE/VC, the liability rate can be reduced to a relative lower level. Butler company with less pressure can make use of the funds more efficiently.
Conclusion
According to the finance statements of Butler Lumber Company, the debt ratio is too high, the liquidity is becoming worse, the days of inventory, days sales outstanding, days payable outstanding is relative large, in consideration of small amount of secured assets, the Northrop National Bank won’t lend the loan to Butler. Butler Lumber Company should accept the discount provided by suppliers and reduce its accounts payable. In that situation, days payable outstanding is reduced to 10days. There will be a sharp incline in account payable outstanding due to the decrease.
The loan from Northrop Nation Bank will not be sufficient in 1991 even if the Butler Lumber Company reduce its account payable. According to the projected balance sheet, the funds Butler need are $661,000, more than the bank offered. It is better for Butler reducing its inventory and account receivable than looking for a larger loan. As a company in the process of rapid growth, the inventory and accounts receivable take too much amount of cash flows. If Butler could reduce these scales, it can save a lot of money from its cash flows.
