Case 136: Butler Lumber Company* After a rapid growth in its business during recent years, the Butler Lumber Company in the spring of 2011 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 $247,000 in the spring of 2011. The maximum loan that Suburban National would make to any one borrower was $250,000, and Butler had been able to stay within this limit only by relying very heavily on trade credit. In addition, Suburban was now asking that Butler secure the loan with its real property. Mark Butler, sole owner and president of the Butler Lumber Company, was therefore looking elsewhere for a new banking relationship where he would be able to negotiate a larger and unsecured loan. Butler had recently been introduced by a friend to George Dodge, an officer of a much larger bank, the Northrop National Bank. The two men had tentatively discussed the possibility that the Northrop Bank might extend a line of credit to Butler Lumber up to a maximum amount of $465,000. 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. After this discussion, Dodge had arranged for the credit department of the Northrop National Bank to investigate Mark Butler and his company. The Butler Lumber Company had been founded in 2001 as a partnership by Mark Butler and his brother-in-law, Henry Stark. In 2008 Butler bought out Starks interest for $105,000 and incorporated the business. Stark had taken a note for $105,000, to be paid off in 2009; to give Butler time to arrange for the financing necessary to make the payment of $105,000 to him. The major portion of the funds needed for this payment was raised by a loan of $70,000, negotiated in late 2008. This loan was secured by land and buildings, carried an interest rate of 11%, and was repayable in quarterly installments at the rate of $7,000 a year over the next 10 years. The business was located in a growing suburb of a large city in the Pacific Northwest. The company owned land with access to a railroad siding, and two large storage buildings had been erected on this land. The companys operations were limited to the retail 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 April through September. No sales representatives were employed, orders being taken exclusively over the telephone. Annual sales of $1,697,000 in 2008, $2,013,000 in 2009, and $2,694,000 in 2010 yielded after-tax profits of $31,000 in 2008, $34,000 in 2009, and $44,000 in 2010.1 Operating statements for the years 20082010 and for the three months ending March 31, 2011, are given in Exhibit 1. EXHIBIT 1: Operating Statements for Years Ending December 31, 20082010, and for First Quarter 2011 (thousands of dollars) a ln the first quarter of 2010 sales were $698,000 and net income was $7,000. b Operating expenses include a cash salary for Mr. Butler of $75,000 in 2008, $85,000 in 2009, $95,000 in 2010, and $22,000 in the first quarter of 2011. Mr. Butler also received some of the perquisites commonly taken by owners of privately held businesses. Mark 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 Northrop National Bank, has been doing and can do about everything that Butler does in the organization. Other employees numbered 10 in early 2011, 5 of whom worked in the yard and drove trucks and 5 of whom assisted in the office and in sales As part of its customary investigation of prospective borrowers, the Northrop National Bank sent inquiries concerning Mark 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 a good 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 this opinion. In addition to owning the lumber business, which was his major source of income, Butler held jointly with his wife an equity in their home. The house had cost $72,000 to build in 1989 and was mortgaged for $38,000. He also held a $70,000 life insurance policy, payable to his wife. She owned independently a half interest in a house worth about $55,000. Otherwise, they had no sizeable personal investments. The bank gave particular attention to the debt position and current ratio of the business. It noted the ready market for the companys products at all times and the fact that sales prospects were favorable. The banks investigator reported: Sales are expected to reach $3.6 million in 2011 and may exceed this level if prices of lumber should rise substantially in the near future. On the other hand, it was recognized that continuation of the current general economic downturn might slow down the rate of increase in sales. Butler Lumbers sales, however, were protected to a considerable degree from fluctuations in new housing construction because of the relatively high proportion of its repair business. Projections beyond 2011 were difficult to make, but the prospects appeared good for a continued growth in the volume of Butler Lumbers business over the foreseeable future. The bank also noted the rapid increase in Butler Lumbers accounts and notes payable in the recent past, especially in the spring of 2011. 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 Starks interest in the business and the additional investments in working capital associated with the companys increasing sales volume. Trade credit was seriously extended in the spring of 2011 as Butler strove to hold his bank borrowing within the $250,000 ceiling imposed by the Suburban National Bank. Balance sheets at December 31, 20082010 and March 31, 2011, are presented in Exhibit 2. EXHIBIT 2: Balance Sheets at December 31, 20082010, and March 31, 2011 (thousands of dollars) The tentative discussions between George Dodge and Mark Butler had been about a revolving, secured 90-day note not to exceed $465,000. 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 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 2 percentage points above the prime rate (the rate paid by the banks most creditworthy customers). Dodge indicated that the initial rate to be paid would be about 10.5% under conditions in effect in early 2011. Both men also understood that Butler would sever his relationship with the Suburban National Bank if he entered into a loan agreement with the Northrop National Bank. Questions 1. How well is Butler Lumber doing? 2. What has been the companys financial strategy? Why does Mr. Butler have to borrow so much money to support this seemingly profitable business? Has he been managing his companys cash flow wisely? 3. Do you agree with Mr. Butlers estimate that he will need up to $465,000 in 2011. How much will he need to borrow to finance his expected expansion in sales in 2011 (assume sales volume hits $3.6 million)? To answer these questions, construct pro forma income statements and balance sheets for 2011 and make the following assumptions: Mr. Butler reduces the payables period to 10 days Discounts are recorded as a separate line item on income statements The tax rate is a flat 34% Interest expense in 2011 is based on bank debt of $465,000 Bank debt is also used to repay any trade notes payable 4. How much will Mr. Butler need over the next few years if sales grow at 25% per year? 5. Would you recommend that Mr. Butler proceeds with his expansion plans?