Summary of Facts. Butler Lumber Company is a Pacific Northwest based lumber distributor that sells plywood, moldings, and sash and door products. The sole owner of Butler Lumber is Mark Butler, accompanied by one administrative assistant and ten employees who focus on repairs and labor intensive work. Because of Butler Lumber’s competitive pricing scheme, it has seen rapid growth in the past few years. Due to the rapid growth and a shortage of cash in 1990, Butler Lumber Company is seeking to take out an additional loan in order for the business to sustain itself and grow in the coming years. Butler Lumber has the option to accept a loan of $250,000 from Suburban National Bank, or accept an unsecured revolving 90-day note of $465,000 at 10.5% interest from Northrop National Bank. If Mr. Butler decides to accept the note from Northrop National bank, it will sever the existing ties with Suburban National Bank and a new relationship must be maintained.
Problem. If Mr. Butler accepts the loan from Suburban National Bank, he must agree to a secured loan that is backed by his real property that will act as collateral for the agreed amount of $250,000. Due to Suburban National Bank’s constraints, Mr. Butler is looking to find a new banking relationship that would allow him to negotiate a much larger unsecured loan. The amount of the loan offered by Suburban National Bank has made Mr. Butler realize the company’s growth potential – increase in sales, but also realize the increase in debt. Since he is limited on his loan and has little cash on hand, he has turned to trade credit for the past few years. As consultants, we will investigate the following four key issues: * Should Butler Lumber sever ties with Suburban National bank in order to obtain a larger loan from Northrop National Bank? * Why does Butler Lumber have a cash shortage problem to begin with, and are they currently using their existing funds efficiently?
* How much additional funding does Butler Lumber need, and will they continue to need even more in the future? * What sort of implications does the firm’s growth suggest? * Are there Alternative solutions to Butler Lumber’s cash shortage problems? Analysis. The need for cash is clear; however, there could be multiple opportunities to raise the capital that is needed. It is imperative that Butler Lumber takes into consideration the costs associated with accepting external financing, and in turn be able to assess whether or not it is the best solution. If relying on external financing is not plausible, Mr. Butler will have to search for alternative methods to grow his business – whether it’s finding a different financing solution or a way to generate cash by altering management activities.
As we assess Butler Lumber’s operations from 1988 to 1990, it is clear that his reliance on trade credit and a specific focus on having a very competitive pricing schema has allowed the company to generate revenue up to this point. Although the company was able to generate revenue at an increasing rate during the given years, Butler Lumber was unable to accumulate any cash in order to fund operations moving forward. We will start by assessing one of the two immediately available options presented for Butler Lumber: Butler Lumber can remain with Suburban National Bank by accepting their loan offer of $250,000. The only apparent advantage of this option lies solely in the fact that the relationship with the bank already exists. The disadvantages are seen in the possibility that Butler Lumber will need additional financing past the initial loan amount, and the offered loan is now secured (backed by Mr. Butler’s real property), signaling that the bank has doubts that Butler Lumber will pay back the loan amount.
Though Butler may be capable of repaying the amount, it is inevitable that the company will need more financing. Due to the bank’s recent focus on the riskiness of Butler Lumber, this may alter their ability to receive more funding from Suburban National Bank. Mr. Butler could alternatively choose to take the unsecured revolving 90-day note of $465,000 at 10.5% interest from Northrop National Bank. The apparent advantages are: it is a more flexible option, it is an unsecured loan that requires no collateral from Mr. Butler, and it is of a larger amount. The big disadvantages are: the termination of the banking relationship between Butler Lumber and Suburban National Bank, and the increased interest expense on the loan. Another disadvantage of establishing a LOC with Northrop National Bank is the possibility of restrictions on the company stating that the net working capital be maintained at a level agreed upon by both parties and any increase in fixed assets with approval by Northrop.
Also there would be limitations on withdrawals of funds from the business by Mr. Butler. Another concern with the loan is that Butler Lumber would need to draw additional loans from Northrop because the company is unable to pay back the loan amount within the 90 day period due to the lack of cash and liquid assets. -Why does Butler Lumber have a cash shortage problem to begin with ,and are they currently using their existing funds efficiently? The “Sources and Uses of Funds brings forth a snapshot of the company’s cash flows and illustrates the reason behind Butler Lumber’s cash deficit. For the past two years, Butler Lumber has generated negative cash flow from operations, which is alarming for the firm. Given the typical business model of a growing firm, Butler Lumber has seen increases in both the inventory and receivable accounts.
This makes sense because the more customers Mr. Butler has, the more inventory he needs to have on hand and given his somewhat lackadaisical approach on payment collection, the amount of receivables is expected as well. This could be an issue for the firm, but if Mr. Butler has a strategy to fund operations until they are able to generate more cash, it will not break the firm. As inventory and receivables grow, an area to hone in on is whether or not these accounts are being turned over in a timely, progressive manner. As seen in the “Asset Utilization Analysis” table, the ratios for both receivable and inventory indicate that it is taking a longer period of time to collect money and a is holding on to inventory for much longer (nearly 15% and 10% longer, respectively).
It is clear that Butler Lumber is not maximizing operational efficiency and will accrue extra costs as a result. -How much additional funding does Butler Lumber need, and will the firm continue to need even more in the future? After analyzing and projecting Butler Lumber’s 1991 Pro Forma Balance Sheet, we have decided to separate the projections when considering the current payable policy and also considering discounts. We have concluded that Butler Lumber will need additional funding of $409,000 under the current payables policy, and including purchase discounts, they will need $658,000 (seen in Exhibit 1).
These figures indicate exactly how Mr. Butler has been operating, relying on specific payment terms with his suppliers and customers. Mr. Butler is using his accounts payable as a sort of leverage (funding) while he searches for external financing, which is quantitatively laid out in Exhibit 4. So the question becomes whether Mr. Butler should take advantage of the 2% purchase discount or continue to rely on the suppliers payment flexibility. The pro-forma analysis we generated is based on recent percent of sales from the years 1988-1990. -What sort of implications does the firm’s growth suggest?
NEED SOMETHING ABOUT HOW THE SALES GROWTH OVERSHOOTS THE SUSTAINABLE GROWTH
-Are there Alternative solutions to Butler Lumber’s cash shortage problems? If Mr. Butler does not or cannot obtain the loan through Northrop National bank, an alternative option is Recourse Factoring. Recourse Factoring is the selling off of Accounts receivables where the selling company is still responsible in the event of receivable default. A factor company purchases receivables from other companies and provides the necessary capital for a small fee. This can be very beneficial for companies experiencing problems with cash flows. This could be a potential option for Butler Lumber because they have slow paying clients and an extensive cash shortage problem.
Butler’s Receivable turnover has decreased from 9.92 in 1988 to 8.5 in 1991 indicating it is taking longer to recover much needed cash. If Butler was able to factor away their receivables they would have more working capital, a flexible funding program that will increase only as their sales increase and also would help Butler take advantage of purchase discounts. If Butler found a Factoring company to take on 75% of their receivables , $317,000 cash would be freed up and eliminate the need for Additional funding. Even if Butler paid a small 2% factoring fee they would still easily be able to maintain their rapid rate of growth with the current $250,000 of funding through Suburban National Bank.
Recommendation: Given the analysis of the firm, in order for the firm to continue it will need external financing. The recommendation that we give to Mr. Butler is that he accepts the LOC from Northrop National Bank, but only if the loan does not include any negative covenants such as restrictions on: the sale of assets, engaging in other businesses, and voluntary prepayment of other indebtedness. This financing is needed because the expected sales growth exceeds the firm’s sustainable growth rate and leads to a negative cash flow because of the trends Mr. Butler has displayed regarding his payables and receivables.