I. Statement of Financial Problem
Butler Lumber Company is facing the internal risk of not having enough borrowing power to continue operations as desired. The owner of the company has established a relationship with a new bank to increase their borrowing power, however, based on Butler Lumber Company’s past Operating Statement and Balance Sheet, the company is expecting to continue substantial growth without considering external risks that may affect their business. Currently the company requires debt to maintain daily operations and growth.
II. General Framework for Financial Analysis
A company should maintain higher liquidity ratios that will sustain operating activities and desired growth, as well as allow the company to pay any short-term debt obligations. One way to maintain higher liquidity ratios is to collect on receivables timely, and use cash obtained to take advantage of discounts offered on inventory purchases.
Additionally, a company’s inventory should turn several times per year. As sales are forecasted a company should increase their inventory to accommodate forecasted sales on a monthly basis, but keep as little as possible on hand. Ideally, inventory would turn 10-12 times per year.
III. Application of the Financial Framework
Butler Lumber Company has experienced significant growth over the last few years. Their pricing has remained competitive compared to similarly available product. The company expects to continue growing at this level and to do so, requires the availability of credit from their bank to maintain current and increased inventory levels and to cover operating expenses.
Butler Lumber Company maintains a high level of inventory. Essentially, the company is leveraging their credit and using that to maintain their high inventory levels. As the company grows, their inventory purchases should be based on their forecasted monthly sales. In 1990 their inventory was turning 4.67 times per year, or every 2.5 months. While continued growth may make this feel necessary, the company has failed to consider external risk factors that could affect their business drastically. While they’re sales are driven by not only new home construction, but home repairs as well, in the event of an economic crisis home repairs would likely decrease. As a result, Butler Lumber Company would have a substantial amount of wasted inventory on hand.
Butler Lumber Company’s sales have increased, however so have their receivables. With receivables sitting uncollected for 42 days, the company is unable to use that cash to pay their outstanding payables with discounts or cover their operating costs without incurring debt.
Finally, the company’s liquidity ratios support their need for better cash management. Their current ratio suggest the company is solvent and would be able to cover their short-term liabilities if needed. However, the quick ratio for the company is very low year after year. Their cash on hand would not cover their short-term liabilities.
IV. Assumptions and Special/Mitigating Circumstances
No assumptions were made in this analysis. The company’s financial statements clearly state their condition. Recommendations are based on that information.
V. Conclusions and Recommendations
Butler Lumber Company should monitor their inventory levels closely and maintain only the inventory required to get them through 1 to 1.5 months of sales. They should also employ an aggressive collections team to assist with collecting within the terms of payment outlined in customer agreements.
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