FINANCIAL MANAGEMENT DISCUSSION

BUTLER LUMBER COMPANY

A. Introduction
The Butler Lumber Company had been Iounded in 1981 as a partnership by Mark Butler
and Henry Stark. In 1988, Butler bought out Stark`s interest and incorporated the business.
The business was located in a growing suburb oI a large city in the PaciIic Northwest. The
company`s operations were limited to the retail distribution oI lumber products in the local
area, it achieves largely high volumes oI sales on the basis oI successIul price competition.
Butler Lumber Company`s rapid growth is resulting in good proIit, however, the
company had experiences a shortage oI cash and had Iound it necessary to increase its cash
Ilow either Irom creditors or investors.

B. 0 Issu0s
There are some key issues relating oI Butler Lumber Company :
1. What is general condition oI Butler Lumber Company PerIormance?
2. Why does Butler Lumber Company need to borrow money?
3. How much Butler Lumber Company Iund needed? Is there any internal Iund can cover
the shortage oI cash?
4. Should Northrop National Bank Receive Butler Lumber Company proposal oI
borrowing money ? How much the bank should give the company ?

C. Analsis
1. G0n0ral P0rformanc0 of Butl0r Lumb0r Compan
t a glance, the key issue occurs because although The Butler Lumber Company
(BLC) is a proIitable company, but had experienced a shortage oI cash and had Iound it
necessary to increase its borrowing. To ensure that the company is a proIitable
company, then it needs to analyze its general perIormance Irom its Iinancial statement.

2

Tab0l 1. Incom0 Stat0m0nt - Common Siz0 Anals0s
1988 1989 1990 Average

neL sales 100 100 100 100
CosL of goods sold
8eglnnlng lnvenLory 11 12 12 12
urchases 73 76 76 76
86 88 88 87
Lndlng lnvenLory 14 16 16 13
1oLal cosL of goods sold 72 71 72 72
Cross roflL 28 29 28 28
CperaLlng expenses 23 26 24 23
L8l1 3 3 3 3
lnLeresL expense 1 1 1 1
L81 2 2 2 2
rovlslon for lncome Laxes 0 0 0 0
neL lncome 2 2 2 2

Common size analyses oI its income statement shows that net income percentage
oI sales (Net ProIit Margin) is 2 in average. This net proIit margin come Irom 3 oI
its operating perIormance (EBIT) and -1 oI its Iinancing perIormance (Interest
Expense).
Tabl0 2. Balanc0 Sh00t - Common Siz0 Analsis
Description 1988 1989 1990 Average
% % % %
Cash 10% 7% 4% 7%
Accounts receivable, net 29% 30% 34% 31%
nventory 40% 44% 45% 43%
Current assets 79% 81% 83% 81%
Property, net 21% 19% 17% 19%
Total assets 100% 100% 100% 100%
Notes payable, bank 0% 20% 25% 15%
Notes payable, Mr. Stark 18% 0% 0% 6%
Notes payable, trade 0% 0% 0% 0%
Accounts payable 21% 26% 27% 25%
Accrued expenses 4% 4% 4% 4%
Long-term debt, current portion 1% 1% 1% 1%
Current liabilities 44% 51% 57% 51%
Long-term debt 11% 8% 5% 8%
Total liabilities 55% 59% 63% 59%
Net worth 45% 41% 37% 41%
Total liabilities & net worth 100% 100% 100% 100%

3

Company main investing driver is its current asset, because it contributes 81 in
average to its total assets. On the Iinancing side, its current liability is the largest portion
oI its Iinancing structure that contributes 51 in average.
In general, the company can create proIit Irom its operational activities. However,
current liabilities is not enough to cover its current assets, thus 30 in average its
current assets is covered by its long term debt (8) and net worth (22). It is an
indication that the company could Iace higher cost oI capital.
In addition, its trend oI cash provided is going down Irom 10 in 1988 became
4 in 1990 while its account receivable and inventory trends are going up. Statement oI
Cash Flow Ior period 1989-1990 also shows that the company has negative value (-$14
in 1989 and -$17 in 1990) Irom cash Ilow Irom operating activities. It is an indication
that the company could Iace shortage oI cash because it is not operating on its Iull
capacity.
2. R0ason for Butl0r Lumb0r Compan borrow som0 mon0
The annual purchase oI the inventory Ior the 1988 to 1990 and 1st quarter oI 1991
is $1.278.000, $1.524.000, $2.042.000, $660 respectively and assumes that BLC didn`t
take any discount so that the realc(true) purchase value each year is $1.253, $1.494,
$2.002, $647 than the cost oI trade credit will be $25, $30, $40, and $13 Ior each year.
The total cost oI trade credit Ior the three year and 1at quarter oI 1991 is $118. Given
that BLC only take very Iew purchase discount so the cost oI trade credit on their
inventory is quite big. ssumes that BLC only take 5 oI their trade credit, it means
that BLC has cost oI $112,1 ((100-5)x118) on their inventory. This is a quite
signiIicant amount oI money Ior their bussiness, they just need $3 more to pay oII Mr.
Stark.
Tab0l 3. Cost of Trad0 Cr0dit

1988 1989 1990 1st 1991
Annual
purchase
$1.278.000 $1.524.000 $2.042.000 $660
True (real)
annual
purchase
$1.253 $1.494 $2.002

$647
Cost of
trade
credit
$25 $30 $40 $13

4

So, BLC need more cash to make them able to generate trade discount Irom their
supplier. By having enough cash they could settle their note payable-trade within 10
days, so they get 2 discount. By assuming BLC taking all oI the trade discount they
will get trade discount amounted 42.000 Ior the reamain quarter oI 1991.
The cash needed is used minimally to pay the credit trade within 10 days. So it is
better Ior BLC to get(borrow) money Ior 20 days because they usually able to pay in 30
days Ior the trade credit.
It must be take into account that the additional cost rate oI borrowing is less than
37,2 (nominal annual cost) or 44,6 (eIIective annual cost).
3. Additional Funds N00d0d
The result oI both permanent need due to growth and seasonal Iactors, Butler
Lumber Company need Ior Iund. It was indacated Irom increase in sales, so there should
be an anticipation Ior the inventory requires in the next periode.
ssumed that none oI a company`s ratios will Iluctuate. We can use The dditional
Fund Needed (FN) Formula

AN = (A
-
S

)AS - (
-
S

) AS -S
1
(RR)

-
assets that are tied directly to sales, hence must increase iI sales are to increase.
Note that designates total assets and designates those assets that must increase iI
sales are to increase. When the Iirm is operating at Iull capacity, as is the case here,
. OIten, though, and are not equal, and either the equation must be modiIied or
we must use the projected Iinancial statement method
L
-
Liabilities that increase spontaneously. L is normally much less than total
liabilities (L). Spontaneous liabilities include accounts payable and accruals, but not
bank loans and bonds
N proIit margin, or proIit per $1 oI sales
RR retention ratio, which is the percentage oI net income that is retained
S
1
total sales projected Ior next year
dditional Iunds
Needed
Required sset
Increase
Spontaneous liability
Increase
Increased in Retained
Earnings


3

AS change in sales
To obtain the sales Iorecasting in the year 1991, we can use the annual growth between
the year 1988 ($1.697.000) through the year 1990 ($2.694.000). From this, we get the
annual growth in sales is about 26 a year. So we can assume sales in year 1991 is
$3.600.000.
FN $ (933/2.694.000)(3.600.000-2.694.000) ((25639)/ 2.694.000)(3.600.000-
2.694.000) (36000,01631)
$ 313.770 - $ 99.209 $ 58.680
$155.880
With the FN Iormula we can conclude that The Butler Lumber Company needs new
Iinancing around $155.880.
. Bank P0rsp0ctiv0 : Butl0r Lumb0r Compan P0rformanc0
Regarding to the proposal oI Butler Lumber Company, the Northrop National Bank
should examine the liquidity and the solvency oI the company. The result could be
determined as Iollow:
a. Liquidity
It is important Ior the bank to examine the liquidity oI a company in order to
measure the short-term ability oI the company to pay its maturing obligations and to
meet unexpected needs oI cash. There are several ratios that could be applied to
measure the liquidity as Iollow:
i. Current Ratio
Current ratio is a measure Ior evaluating a company`s liquidity and short-term debt-
paying ability.
Curr0nt Ratio
Curr0nt Ass0ts
Curr0nt Liabiliti0s

Tabl0 . Curr0nt Ratio of Butl0r Lumb0r Compan

Y0ar
Curr0nt Ratio
(times)
1988 1.8
1989 1.58
1990 1.45
6

First Quarter 1991 1.35
Projected 1991 1.30

ii. Quick or cid Test Ratio
Quick or cid Test Ratio is a measure oI a company`s immediate short-term
liquidity.

"uick or Acid T0st Ratio
Curr0nt Ass0ts - Inv0ntori0s
Curr0nt Liabiliti0s

Tabl0 5. "uick or Acid T0st Ratio of Butl0r Lumb0r Compan

Y0ar "uick or Acid T0st Ratio (times)
1988 0.88
1989 0.72
1990 0.67
First Quarter 1991 0.55
Projected 1991 0.60

b. Solvency
Solvency ratios measure the ability oI a company to survive over a long period oI
time. It is regarding to its ability to pay interest as it comes due and repay the Iace value
oI debt at maturity.
i. Debt Ratio
Debt Ratio is the percentage oI the total assets that creditors provide. It provides the
indication oI the company`s ability to withstand losses without impairing the interests oI
creditors.

D0bt Ratio
Total Liabiliti0s
Total Ass0ts


Tabl0 6. D0bt Ratio of Butl0r Lumb0r Compan

Y0ar
D0bt Ratio
(percent)
1988 54.54
1989 58.70
1990 62.70
First Quarter 1991 67.37
Projected 1991 65.11
7


ii. Time-Interest-Earned
Time-Interest-Earned measures the extent to which operating income can decline
beIore the Iirm is unable to meet its annual interest costs.

Tim0-Int0r0st-Earn0d
EBIT
Int0r0st charg0s

Tabl0 7. Tim0-Int0r0st-Earn0d of Butl0r Lumb0r Compan

Y0ar
Tim0-Int0r0st-Earn0d
(times)
1988 3.85
1989 3.05
1990 2.61
First Quarter 1991 2.10
Projected 1991 4.05

Bank would Iocus on short term liquidity that not more than 5 years, because its current
ratio and its times interest earned are more than 1, it means that its assets and its earning are
in liquid position and could pay their debt when it is mature. However, its debt ratio is quiet
risky, because it was reaching 63 in 1990 and even 67 in the Iirst quarter in 1991.
From bank perspective, although its liquidity is possible to pay its current liabilities, but
iI the bank give more Iund, then its liquidity ratio could decrease and its debt ratio could
increase signiIicantly. Consequently, there is possibility that the bank would reject
borrowing proposal oI Butler Lumber Company.

D. Alt0rnativ0 Solutions
To support BLC proIitable business, Mr. Butler need additional Iund and he was planning
to get the Iunds by borrowing money Irom the National Bank. The Iorth issue occurs iI the
Bank won`t lend the BLC a loan, how they increase their Iunds. The alternative is making
partneship with other person. BeIore the investor decide to invest their money in Butler
Lumber Company, it is important to see long term Iinancial perIormance oI the company.
Free cash Ilow (FCF) and ROIC are two important measurement to assess Butler Lumber
Company PerIormance.

8






Tabl0 8. FCF for Butl0r lumb0r Compan (thousands of dollar)
DT Formulation 1988 1989 1990
Projected
oI 1991
Net Operating Working Capital current assets-current liabilities 208 221 241 244
Total net operating capital
net operating working capital
operating long-term assets
334 361 398 460
Net Operating ProIit Iter
Taxes (NOPT)
EBIT (1-tax rate) 42.5 51.85 64.5 112.5
Net Investment in Operating
Capital
Total net operating capital
current year-Total net operating
capital previous year
27 37 62
Free Cash Ilow
NOPT-Net investment in
operating capital
24.85 48.8 50.5

Company`s operation intrinsic value is determined by its stream oI Iuture cash Ilow,
then one way to evaluate iI the manager can creating value to the company is whether
manager can increase today and Iuture cash Ilow. NOPT oI Butler Lumber Company shows
increasing Irom 42,5 thousand in 1988 to 68,8 thousand in 1990, it means that the company
operation can generate cash Ilow up to 68 thousand iI it held no debt and have no Iinancial
assets.
Free cash Ilow also shows increasing Irom about 100 Irom 24,85 thousand in 1989 to
48,8 thousand in 1990. It means the company can reserve 48,8 thousand that is available to all
creditors and investors in 1990. Company`s interest payment in 1990 was 33 thousand, then
there is about 15 thousand available to the investors.
nother way to determine whether the company growth is proIitable is using Return in
Invested Capital (ROIC) Which is NOPT divided by Total net operating capital. II ROIC
exceed rate oI return by investors (WCC Ior company), then the Iirm is adding value.
Tab0l 9. ROIC for Butl0r Lumb0r Compan
9

Description 1988 1989 1990
Projected
1991
NOPT
42.5 51.85 68.8 112.5
Total Net Operating Capital
334 361 398 460
ROIC 12,72 14,36 17,29 24,5

WCC oI the company is the bank interest rate (11) because Butler Lumber
Company is a sole owner Iirms, then the cost oI capital just related to cost oI debt. Butler
Lumber Company growth is creating value because its ROIC exceeds its WCC.

E. R0comm0ndation
Suggest that Butler`s should take the loan about $155.880 in an attempt to grow the
business. But, it would make debt ratio oI the company is riskier and also create deIault
possibility.
One other way that the company can do is make a partnership with other investors to get
$155.880, this option would decrease debt ratio and minimize deIault possibility.

F. Impl0m0ntation Consid0ration
Mark Butler should consider one alarming Iact about his business is the lack oI a sales
staII, but by adding another an experienced salesman that is working Ior a base salary
plus commission, they can grow the revenues even more. By having this person work on
commission, this will eat into the proIit margin Ior the materials he is selling. So it is
strategically important Ior him to have access to this capital because oI the nature oI his
cyclical business.

10


Key issues :
1. Need additional Iunds to expand its business/support its proIitable business How
Much? Use FN
2. Had Experienced a shortage oI cash, so need to increase the supply oI cash Why ?
Use Proportion oI C CL and NC LTD and Cash Flow ? --- Zainul...
3. Need to consolidate debt, Should Bank Receive BLC Proposal ? Creditor Focus oI
Short Term Payment (More Than 5 Years) Use Liquidity, Solvency Ratio and MV
Problems (Key Issues)
4. II the Bank won`t give BLC money, then should BLC issuing stock ? What is the stock
prize should be ? how many shares ? Do the investor want to buy it shares ? Use FCF,
MV, EV ( To show that the company creates value or not)
nalysis :
The key issue occurs because although The Butler Lumber Company (BLC) is a proIitable
company, but had experienced a shortage oI cash and had Iound it necessary to increase its
borrowing. The maximum loan amount Irom the Suburban National Bank is $250,000 which
does not meet the needs oI BLC in running the business and the Suburban also asking guarantee
oI the real property Irom BLC in order to secure the loan. The company is seeking a line oI
credit Irom Northrop National Bank that would extend the credit up to maximum amount oI
$465,000 and might meet BLC Ioreseeable needs with the Ilexibility that a line oI credit would
provide.
Condition : The BLC has little to oIIer in security the loan. The company owned land, two large
storage buildings that erected on this land and it was secured in late 1988 to make the payment oI
$105,000 to Henry Stark.
...
lternative solution :
1. Ratio nalysis
11

Name oI Ratio Formula Number oI ratio
1988 1989 1990 1991
Current ratio
JJJ JJJ
JJJ obJ

%

= .%

%

= .%

= .
%
%
= .
Quick ratio
oJ
JJJ obJ

%

= .%%

= .
%

%
= .
Current
Inventory
Turnover
IJJ J JJ JJ
oJo JJJJ

=

Return on
ssets (RO)
I
oJo Jo oJJJ


Return on
Equity (ROE)
IJIJ
Jo q


Operating
proIit Margin
I
JoJ


Net ProIit
Margin

oJ


verage
Inventory
Period
JJJJ oJ
IJJ J JJ JJ






....
Recommendation :
1. Suggest that Butler`s should take the loan in an attempt to grow the business. One
alarming Iact about his business is the lack oI a sales staII, but by adding another
an experienced salesman that is working Ior a base salary plus commission, they can
grow the revenues even more. By having this person work on commission, this will eat
into the proIit margin Ior the materials he is selling. But the net impact to the BLC will
be positive. dvise Mr. Butler to select the LOC Ior up to $465,000 because he can take
out as little as he needs. He does not need all $465,000 this quarter, but he may need
some in the Iirst and last quarters oI the year because he obtains 55 oI his revenues in
12

the second and third quarters. So it is strategically important Ior him to have access to
this capital because oI the nature oI his cyclical business.




Tab0l 9. WACC for Butl0r Lumb0r Compan
Description 1988 1989 1990
1st quarter
oI 1991
Debt Percentage (Wd)
55 59 63 67
Tax Rate (T)
0,35 0,35 0,33 0,28
Cost oI Debt (rd) 11 11 11 11
WCC (Wd(1-T)rd} 6,03 6,47 6,91 7,35