Butler Lumber Company Case Solution

An Analysis on estimating Funds Requirements Presented By : Saurabh Kumar Sinha 2009PGP049 Saurabh Patawari 2009PGP050 Siddharth Shankar Prasad 2009PGP051 Sourjyo Das 2009PGP052 Sreethala Ganapathy 2009PGP053 Shubhangi Shree 2009PGP054

 Butler Lumber in Spring 1991  Originally founded but Butler and Stark  Butler buys out Stark for $105,000 by taking a $70,000 loan

payable over 10 years at 11% p.a.  Needs $247000 - approaches Suburban National Bank  Relies heavily on trade credit  Why does Butler Lumber want to shift banks?

 Now, Suburban National bank wants ‘real’ collateral for its

loans  He, however, wants a larger unsecured loan (Suburban bank has cap of $250,000 on it’s loans)  He also wants a larger loan that would give him flexibility  He considers Northrop National Bank as an alternative

 Reasons for choosing Northrop over Suburban  Higher cap on loans $465,000  This credit line would provide to him larger flexibility

Company History • Began in 1981 as a partnership by Butler ad Stark • Business incorporated in 1988 by Butler by buying out Stark’s share for $105,000 • Paid $35,000 ,$70,000 as bank loan at interest rate of 11% repayable at $7000 over a period of 10 years

Business operating conditions Located in a suburb in Pacific Northwest Company owned land and buildings near a railroad Credit term of 30 days offered to customers  Company had a good reputation as researched by Northnorp National Bank  Personal assets of Butler-joint equity on a house of $72,000 mortgaged at $38,000  Company pays suppliers after 30 days not availing the discount of 2% offered by the suppliers for payment within 10 days

Terms of Northrop National Bank    

Secured 90-day note with a limit of $465,000 Maintaining the net working capital to an agreed level Constraints on capital expenditure and withdrawing Interest rates on floating basis at 10.5%

Assumptions  Projected sales in 1991 at $3.6 million with scope for improvement  About 55% of the sales during April-September period  Permanent severance of relationship with Suburban Bank

 Low Credit Limit :

-Credit limit of Suburban National bank was $ 250,000 but the cash requirement of Butler lumber company was more  Heavy reliance on Trade Credit: -To stay within credit limit Butler had to rely heavily on Trade Credit. A larger loan amount would ease this reliance  Security for loan : -Suburban was now seeking Collateral whereas Butler wanted unsecured loan

 Limitations would be placed on withdrawal of funds  

 

which may negatively impact his salary Loss of autonomy for making investments in fixed assets as approval of Bank would be required Loan would be issued on variable interest rate which depends on market fluctuations- a high Interest rate will decrease net income Rigid control on Working Capital level will have to be maintained Loss of flexibility in regard to additional borrowing as restrictions imposed by National Bank

Concept :  It describes lender’s contribution for each dollar of owner’s contribution  It estimates stability  Standard Value is 2:1  If it is less than this, it is favourable because: 1) High safety margin for lenders 2) Less interest payments 3) Scope for more loans 4) No trading on Equity

LEVERAGE RATIOS

 Debt equity ratio

It has been increasing over the years which suggests increased dependency on external funds and high financial risk . Moreover , it indicates rapid growth in company as well which arises greater need of external funds  Debt Ratio It has been increasing over the years which increased extent of debt financing in business Hence, majority of the company’s assets are being financed by external funds

 Concept :  Indicates availability of Current Assets for each unit of

Current Liability  It estimates short term Liquidity of the Company  It also estimates margin of safety for creditors – a high ratio means less risk for creditors  A ratio of less than 1 is a cause of concern Quick Ratio  Considers only cash as quick assets for meeting short term liability

CURRENT RATIO  It has been decreasing over the years, which suggests that it has more current claims than current assets.  In fact a satisfactory ratio of 2:1 was never achieved in any of the years  It points to narrow margin of safety for creditors

 The ratio indicates whether debtors are being allowed

excessive credits  A higher credit may suggest general problems with debt collection or the financial position of major customers  Days Receivables is increasing which indicates poor collection policy  Ideal Days Receivables allowed was 30 but we are getting 43 for 1990 which necessitates better credit collection policy

 If sustainable growth is higher than internal growth rate,

need for external funds will be less  Company will be able to fund its growth requirements  Internal growth rate vs Sustainable growth rate In all the years, the sustainable growth rate is higher than the internal growth rate of the company, which indicates that the company will sustain for a long period of time and indicates a positive scope. Hence, it makes sense to go for bank loans and it is convincing as well for the bank to grant required loan amount

PROFITABILITY RATIO  Net profit margin It has been low over the years, with merely 1.8% in 1988 and shows a decrease over the years accounting to mere 1.6% This suggests poor capacity of the company to withstand adverse economic conditions and comparitively low operating efficiency of the firm

1) To buy out Stark’s (former partner) interest he took a loan of $ 70,000 Payment of installments ( 11 % interest + $7000 annual payment) reduces available cash 2) To fund the growth of the company funds were needed. 3) To decrease reliance on trade credit. Currently he is unable to avail discounts on purchases made because of lack of cash, with larger funds he can take advantage of discount by making payment within 10 days

 Accounts payable to sales increasing

 Accounts receivable to sales increasing  Quick and current ratio is decreasing  Projected sales high compared to what actually the

company can achieve on the basis of the trend over last few years(assuming for 1st quarter sales are 22.5%)  Out of $465,000, $247000 will be used to pay previous bank loan and $7000 to pay as part of loan previously taken to pay his initial partner

 Decrease in accounts payable and paying suppliers

immediately to avail the option of 2% discount  Quantity discounts and day’s receivable needs to be reduced  Operational efficiency has to be increased to better the profit margin  Decreasing his personal withdrawings which is almost twice of net income, this will help in increasing the profit margin