Butler Lumber Case Study

I. Statement of Financial Problem Butler Lumber Company, a rapidly growing lumber products and retail distribution organization, faced a critical challenge that would determine its future success and level of profitability. A cash shortage due to restrictions set by its current source of funds, Suburban National Bank. Because of these restrictions, Butler Lumber began to explore other funding sources in order to enhance its current business model and satisfy the high demand of its products. As a possible solution, Butler Lumber looked to a larger bank, the Northrop Bank, which had the potential to offer the company $465,000, nearly double the amount offered by its current lender. Although the idea of moving to a larger financial institution initially sounded appealing, a major financial problem needed to be addressed. Primarily, why the forecasted figures shown on the income statement differed from the results provided on the balance sheet. II: General Framework for Financial Analysis There are several factors that can contribute to differences between a forecasted income statement and actual balance sheet results. Mainly: Changes to key accounts: As shown in Exhibit 1 & Exhibit 2, there are key accounts that appear on an organizations financial statements that may cause differences between forecasted and actual results. o The cash account. Cash demonstrates an organizations financial strength and is tied to a critical success factor: sales. Sales are the starting point on the organizations operating statements. If sales do not reach or even exceed the estimate already forecasted, then actual results will vary. o Accounts payable and accounts receivable. Both can be unpredictable and cause variations between forecasted and actual results. Included in Exhibit 1 are other accounts that may also contribute to differences between forecasted and actual results. Changes in financial risk: Depending on the direction of an organization, financial risk can play a significant role in creating discrepancies between forecasted and actual results. The way in which an organization decides to finance its operations will have a dramatic affect on end of year results. In many cases, financial changes occur throughout the year that may not have been considered in original forecasts. When this occurs, a company may shift toward relying heavily on debt to finance its activities or possibly utilizing its current equity to cover the cost of potential investment projects that may be of benefit. Other indicators of financial risk include: o Liquidity ratio Will Butler be able to liquidate enough assets to be able to pay off debt as payments are due? A satisfactory liquidity ratio is required if Butler Lumber is to continue operations. o Debt management ratio What does Butler Lumbers mix of debt to equity look like? Is the combination right? o Asset management ratio Does the company have the right amount of assets to offset sales? Is Butler effectively managing its assets? o Profitability ratio Is the level of sales high enough? Do sales exceed the cost of each unit? Are they achieving an adequate level of profitability.

Butler Lumber Case Study

III. Application of the Financial Framework Applying the frameworks laid out in Section II, we are able to see how Butler Lumber can rise up to the challenge laid before it. 1. Changes in key accounts: The most significant change occurring in Butler Lumbers balance sheet seen in Exhibit 2 is the increased use in cash to finance current operations. As can be seen, in 1988 Butler Lumber showed $58,000 in cash. Over the next two years, the cash account decreased to $41,000. As Butler Lumber was trying to keep up with increased sales throughout 1988 to 1990, it was forced to call upon its cash reserves due to limited availability of financing. Sales continued to boom, however the effect that was seen on the balance sheet was a rapid increase in accounts and notes payable. 2. Changes in financial risk: Butler Lumber was very profitable; however, its long-term success was being hindered by its lack of additional financing. Butler Lumber had elected to finance a large portion of its operations with cash, which had steadily reduced the amount of funds in its cash account throughout 1988-1991 (See Exhibit 2). Future profitability was being directly affected by financial risk. Although Butler Lumber was consistently profitable, it lacked the necessary resources to maximize the firms value through additional financing. All numbers taken from Exhibit 3 for the below ratio analysis: a. Liquidity ratio: We can see that the current and quick ratios (contributors to the overall liquidity ratio) are both declining at a rapid rate in each financial year. As this is a measurement of operational efficiency and long-term effectiveness, a steadily decreasing ratio does not bode well for the future performance of Butler Lumber. b. Debt ratio: Just the opposite of the ratio for liquidity, the debt ratio is steadily climbing. Meaning that the debt mix is either not at an effective percentage, or instead Butler Lumber is continuing to take on additional debt to continue operational functionality. c. Asset management ratio: Using the Total Assets Turnover ratio, it is apparent that Butler Lumber is fairly efficient at turning over assets and returning revenues per dollar of assets. It does seem that Butler is effectively managing its assets. d. Profitability ratio: Taking the following ratios from Exhibit 3 (operating margin, profit margin, return on total assets, return on common equity) we can see just how well Butler Lumber is managing its business and effectively profiting off its operational side. Operating margin increased in 1989, but has dropped to original levels in 1990. Profit margin has remained constant. Return on total assets is also constant. And finally, return on common equity is actually increasing slightly from 1989 to 1990. Overall, Butler Lumbers profitability ratio seems to be either constant or slightly increasing, indicating that business operations are trending in a profitable state. IV. Assumptions and Special / Mitigating Circumstances It is assumed that the historic data presented in the case is accurate and correct.

Butler Lumber Case Study

V. Conclusions and Recommendations In conclusion, Butler Lumbers financial forecasts vary from its actual results due to its need to finance current operating activities with cash, rather than with strategic debt / financing. In order to overcome this issue, it is recommended that Butler Lumber enter into a loan agreement with Northrop National Bank and discontinue its relationship with Suburban National Bank. With nearly double its current funding, Butler Lumber will be able to increase production to satisfy increasing demand, offer valuable discounts to its customers, which will increase sales, and begin to more successfully satisfy the primary goals of a thriving organization. In addition, after evaluating the different ratios that apply to debt and profitability, an infusion of cash will allow Butler Lumber to continue to maximize profitability and increase the amount of money that is dedicated to the bottom line, contributing to a increased stock price, a reduced weighted average cost of capital and maximized cash flow value. Exhibit 1: Operating Statement
Operating Statements for Years Ending December 31 1988 1989 1990 Q1 1991 Net Sales $1,697 $2,013 $2,694 $718 Cost of goods sold Beginning inventory 183 239 326 418 Purchases 1,278 1,524 2,042 660 $1,461 $1,763 $2,368 $1,078 Ending inventory 239 326 418 556 Total cost of goods sold $1,222 $1,437 $1,950 $522 Gross profit 475 576 744 196 Operating expense 425 515 658 175 Interest expense 13 20 33 10 Net income before taxes $37 $41 $53 $11 Provision for income taxes 6 7 9 2 Net income $31 $34 $44 $9

Exhibit 2: Balance Sheet

Balance Sheet at December 31 1989 1990 Q1 1991 $48 222 326 $596 140 $736 $41 317 418 $776 157 $933 $31 345 556 $932 162 $1,094

1988 Cash Accounts receivable, net Inventory Current assets Property, net Total assets $58 171 239 $468 126 $594

Butler Lumber Case Study

Notes payable, bank Notes payable, Mr. Stark Notes payable, trade Accounts payable Accrued expenses Long-term debt, current position Current liabilities Long-term debt Total liabilities Net worth Total liabilities and net worth

$105 124 24 7 $260 64 $324 270 $594

$146 192 30 7 $375 57 $432 304 $736

$233 256 39 7 $535 50 $585 348 $933

$247 157 243 36 7 $690 47 $737 357 $1,094

Exhibit 3: Butler Lumbers Balance Sheets

Key Financial Ratios for Years Ending December 1990 1988 1989 1990 Q1 1991 1.80 1.59 1.45 1.35 Quick Ratio 0.88 0.72 0.67 0.54 Inventory Turnover Ratio 7.10 6.17 6.44 1.29 Days Sales Outstanding 36.78 40.25 42.95 43.25 Fixed Assets Turnover Ratio 13.47 14.38 17.16 4.43 Total Assets Turnover Ratio 2.86 2.74 2.89 0.66 Debt Ratio 0.55 0.59 0.63 0.67 Times-Interest-Earned Ratio 36.54 28.80 22.55 19.60 Operating Margin 0.28 0.29 0.28 0.27 Profit Margin 0.02 0.02 0.02 0.01 Return on Total Assets 0.05 0.05 0.05 0.01 Basic Earning Power 0.80 0.78 0.80 0.18 Return on Common Equity 0.11 0.11 0.13 0.03

Current Ratio