Butler Lumber Company

After a rapid growth in its business during recent years, the Butler Lumber Company in the spring of 1985 anticipated a further substantial increase in sales. Despite good profits, the company had experienced a shortage of cash and had found it necessary to increase its borrowing from the Suburban National Bank to $173,000 in the spring of 1985. The maximum loan that Suburban National would make to any one borrower was $175,000 and Butler had been able to stay within this limit only by relying very heavily on trade credit. Mark Butler, sole owner and president of the Butler Lumber Company, was therefore actively looking elsewhere for a new banking relationship where he would be able to negotiate a larger loan.

Butler had recently been introduced by a personal friend to George Dodge, an officer of a much larger bank, the Northrup National Bank. The two men had tentatively discussed the possibility that the Northrup bank might extend a line of credit to Butler Lumber up to a maximum amount of $325,000. Butler thought that a loan of this size would more than meet his foreseeable needs, but he was eager for the flexibility that a line of credit of this size would provide. Subsequent to this discussion Dodge had arranged for the credit department of the Northrup National Bank to investigate Butler and his company.

The Butler Lumber Company had been founded in 1975 as a partnership by Butler and his brother-in-law, Henry Stark. In 1982 Butler bought out Stark's interest for $75,000 and incorporated the business. Stark had taken a note for $75,000, to be paid off in 1983, in order to give Butler time to arrange for the financing necessary to make the payment of $75,000 to him. The major portion of the funds needed for this payment was raised by a mortgage of $50,000 negotiated in late 1982. This mortgage was secured by Butler's land and buildings, carried an interest rate of 14%, and was repayable in quarterly installments at the rate of $5,000 a year over the next 10 years.The business was located in a growing suburb of a large city in the southern section of the Midwest. The company owned land with access to a railroad siding, and two large storage buildings had been erected on this land. The company's operations were limited to the wholesale distribution of lumber products in the local area. Typical products included plywood, moldings, and sash and door products. Quantity discounts and credit terms of net 30 days on open account were usually offered to customers.

Sales volume had been built up largely on the basis of successful price competition made possible by careful control of operating expenses and by quantity purchases of materials at substantial discounts. Much of the moldings and sash and door products, which constituted significant items of sales, were used for repair work. About 55% of total sales were made in the six months from March through August. No sales representatives were employed, orders being taken exclusively over the telephone. Annual sales of $1,187,000 in 1982, $1,408,000 in 1983, and $1,884,000 in 1984 yielded after-tax profits of $21,000 in 1982, $24,000 in 1983, $31,000 in 1984.1 Operating statements for the years 1982 through 1984 and for the three months ending March 31, 1985 are given in Exhibit 1.

Butler was an energetic man, 39 years of age, who worked long hours on the job. He was helped by an assistant who, in the words of the investigator of the Northrup National Bank, "has been doing and can do about everything that Mr. Wilson does in the organization." Other employees numbered ten In early 1985, five of whom worked in the yard and drove trucks and five of whom assisted in the office and in sales.

As part of its customary investigation of prospective borrowers, the Northrup National Bank sent inquiries concerning Butler to a number of firms that had business dealings with him. The manager of one of his large suppliers, the Barker Company, wrote in answer:

The conservative operation of his business appeals to us. He has not wasted his money in disproportionate plant investment. His operating expenses are as low as they could possibly be. He has personal control over every feature of his business, and he possesses sound judgment and a willingness to work harder than anyone I have ever known. This, with a good personality, gives him an excellent turnover; and from my personal experience in watching him work, I know that he keeps close check on his own credits.

All the other trade letters received by the bank bore out the statement quoted above. In addition to the ownership of his lumber business, which was his major source of income, Butler held jointly with his wife an equity in their home. The house had cost $50,000 to build in 1973 and was mortgaged for $27,000. He also held a $50,000 life insurance policy, payable to his wife. She owned independently a half interest in a house worth about $40,000. Otherwise, they had no sizable personal investments. The bank gave particular attention to the debt position and current ratio of the business. It noted the ready market for the company's products at all times and the fact that sales prospects were favorable. The bank's investigator reported: ". . .Sales are expected to reach $2,5 million in 1985 and may exceed this level if prices of lumber should rise substantially in the near future." On the other hand, it was recognized that a general economic downturn or a return to the very tight credit conditions of 1981-82 with the resultant shortage of funds for residential mortgages might slow down the rate of increase in sales. Butler Lumber's sales, however, were protected to some degree from fluctuations in new housing construction because of the relatively high proportion of its repair business. Projections beyond 1985 were difficult to make, but the prospects appeared good for a continued growth in the volume of Butler Lumber's business over the foreseeable future.

The bank also noted the rapid increase in Butler Lumber's accounts and notes payable in the recent past, especially in the spring of 1985. The usual terms of purchase in the trade provided for a discount of 2% for payments made within 10 days of the invoice date. Accounts were due in 30 days at the invoice price but suppliers ordinarily did not object if payments lagged somewhat behind the due date. During the last two years Butler had taken very few purchase discounts because of the shortage of funds arising from his purchase of Stark's interest in the business and the additional investments in working capital associated with the company's increasing sales volume. Trade credit was seriously extended in the spring of 1985 as Butler strove to hold his bank borrowing within the $175,000 ceiling imposed by the Suburban National Bank.

Balance sheets as of December 31, 1982-84 and March 31, 1985 are presented in Exhibit 2.

The tentative discussions between Dodge and Butler had been in terms of a revolving, unsecured 90-day note not to exceed $325,000 in amount. The specific details of the loan had not been worked out, but Dodge had explained that the agreement would involve the standard covenants applying to such a loan. He cited as illustrative provisions the requirement that restrictions on additional borrowing would be imposed, that net working capital would have to be maintained at an agreed level, that additional investments in fixed assets could be made only with the prior approval of the bank, and that limitations would be placed on withdrawals of funds from the business by Butler. Interest would be set on a floating rate basis at 3 percentage points above the lowest rate charged by the bank on short-term loans. Dodge indicated that the initial rate to be paid would be approximately 14% under conditions in effect in early 1985. Both men also understood that Butler would sever his relationship with the Suburban National Bank if he entered into a loan agreement with the Northrup National Bank.

1. As Butlers financial advisor, would you urge him to go ahead with his plans for further expansion and more debt financing or reconsider both? Explain in brief.

2. As his banker, would you be willing to lend to Butler? If so, what conditions would you attach to the loan? If not, explain why, and what Butler might do to make you change your mind.

Exhibit 1 Operating Statements for the Years Ending December 31, 1982 Through 1984, and for the Three Months Ending March 31, 1985 (S000s) First Quarter 1982 1983 1984 1985 Net sales $1,187 $1,408 $1,884 $502* Cost of goods sold Beginning inventory 128 167 228 292 Purchases 894 1,066 1,428 462 1,022 1,233 1,656 754 Ending inventory Cost of goods sold Gross profit Operating expense Interest expense Net income before income taxes 167 228 292 389 855 1,005 1,364 365 332 403 520 137 297 360 460 122 9 14 23 7 26 29 37 8 Provision for income taxes Net income 5 5 6 1 $ 21 $ 24 $ 31 $6 "In the first quarter of 1984 sales were $408,000 and net income was $4,000. "Operating expenses include a cash salary for Mr. Wilson of $45,000 in 1982, $50,000 in 1983, $55,000 in 1984, and $15,0000 in the first quarter of 1985. Mr. Wilson also received some of the prerequisites commonly taken by owners of privately held businesses. Exhibit 2 Balance Sheets as of December 31, 1982-84 and March 31, 1985 (S000s) Assets 1982 1983 1984 Cash $41 $ 34 $29 Accounts receivable, net 120 155 222 Inventory 167 228 292 Total current assets 328 417 543 Property, net 90 98 110 Total assets $418 $515 $653 Liabilities and Net Worth Note payable-bank Notes payable Mr. Stark Notes payable-trade Accounts payable Accrued expenses Long-term debt-current portion Total current liabilities Long-term debt Total liabilities Net worth $102 $163 134 179 21 27 5 5 262 374 40 35 302 409 Total liabilities and net worth $418 213 $515 244 $653 Quarter