Statement of financial problem. Should Northrop National Bank extend a line of credit to Butler Lumber up to a maximum amount of $465,000?
Butler Lumber
Case Study
BA 6420
Instructor: Dr. Robert Malko
Student: Brent Nordgren
I. Statement of financial problem.
Should Northrop National Bank extend a line of credit to Butler Lumber up to a maximum amount of $465,000?
II. A framework of analysis.
I am using the Indirect Statement of Cash Flows method to analyze the Butler Lumber case. When a company seems profitable but is in serious need of a cash infusion, often the problem stems from poor cash flow. Calculating the cash flow coming in and going out will explain "Where did our money come from?" and "Where did our money go?" Likely, it will discover how a company's cash was generated during the period and how that cash was used-or misused. A statement of cash flows provides details as to how the cash account changed during a period. It also helps to understand how events and decisions impacted cash flow during each period. A statement of cash flows provides important information from a cash-basis perspective and complements the income statement and balance sheet, and provides a more complete picture of a company's operations and financial position. The Indirect Statement of Cash Flows method begins with net income and then details the adjustments made to arrive at cash flows from operations.
III. Application of Financial Framework.
Indirect Statement of Cash Flows
Butler Lumber 1989 through 1st Quarter 1991
Operating Activities for
989
990
st Qrt 1991
Net Income
$34,000
$44,000
$9,000
Add:
Increase in Accounts Payable
$68,000
$64,000
Less:
Increase in Accounts Receivable
($51,000)
($95,000)
($28,000)
Increase in Inventory
($56,000)
($93,000)
($138,000)
Decrease in Accounts Payable
($13,000)
Cash flow from operations
($5,000)
($80,000)
($170,000)
Because a statement of cash flows provides details as to how the cash account changed during a ...
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Butler Lumber 1989 through 1st Quarter 1991
Operating Activities for
989
990
st Qrt 1991
Net Income
$34,000
$44,000
$9,000
Add:
Increase in Accounts Payable
$68,000
$64,000
Less:
Increase in Accounts Receivable
($51,000)
($95,000)
($28,000)
Increase in Inventory
($56,000)
($93,000)
($138,000)
Decrease in Accounts Payable
($13,000)
Cash flow from operations
($5,000)
($80,000)
($170,000)
Because a statement of cash flows provides details as to how the cash account changed during a period, the period of 1988 for Butler Lumber becomes an initial starting point from which we can begin a comparison. Because of the shift from partnership to a corporate form of organization, I don't have figures from '87 and cannot accurately reflect changes from '87 to '88. Changes from '88 to '89 begin the cash flow comparison in the chart above.
In the chart above, I have listed each relevant area where cash flow may be a major concern. There appears to be a growing tendency by Butler Lumber to end each period with a negative cash flow. It also appears that this tendency to end each period with a negative cash flow is growing at an alarming rate. As we can see, from 1989 to 1990, the negative cash flow worsened from $5,000 to $80,000-a whopping 1600% increase. Then, the period from the end of 1990 to only the end of the first quarter of 1991, the negative cash flow more than doubled again!
IV. Mitigating Circumstances and Assumptions:
By examining the statement of cash flows, we discover a major concern in three areas:
(1) Inventory, (2) accounts receivable, and (3) accounts payable. All three are moving in a negative, undesirable direction; but inventory is escalating at a greater overall rate and seems to be out of control by the end of the first quarter of 1991. The greatest contributing factor causing Butler Lumber's debt and cash-shortage problem is that they are purchasing much more inventory than they are using. Having too much cash invested in their inventory is their main problem but they have some offshoot problems that tend to be growing out of their inventory problem:
. One way that companies fund a cash-shortage problem is to keep their accounts payable high. This is an easy way to "borrow" short-term money, but when a company is slow to pay its bills and owes a significant amount of money, they potentially damage their credit and their business relationships with their suppliers.
2. Without adequate cash, Butler can't pay their accounts within the 30-day term allowed by vendors and this further adds cash-shortage pressures because they then must incur additional finance charges.
3. Because they are cash poor, they can't take advantage of the discounts available for payments made within 10 days of purchase. The extra discounts would help increase their cash flow and their income.
V. Conclusion and Recommendation:
Butler Lumber has the potential to be a profitable and successful company. The level of growth they've been experiencing may be new territory for them and the less than perfect way they've dealt with it might explain why there has been a huge increase in inventory. Thus far, Mr. Butler has not demonstrated a savvy business acumen for adjusting to the significant growth. I have identified the following conclusions and recommendations:
. Northrop National Bank should help Butler by making a loan under certain prescribed conditions: (a) A loan would help to ensure an influx to Butler's cash flow position, but conditional provisions requiring Butler to be proactive in accomplishing recommended goals and deadlines would be in order; (b) The loan amount of $465,000 is probably too high. The loan amount should be established to help Butler reduce inventories and increase cash flow, but not be so large as to entice Butler to ignore the ensuing problem. Forecasted analysis would still be required; (c) Even though Butler may resist, it would not be unreasonable for Northrop to require collateral, such as property;
2. Butler should significantly reduce inventory and implement better control. (a) One of the conditions of the loan should require Butler to propose a new system and implement a plan that would make better use of their inventory. They need to analyze their inventory turnover ratios and compare them with and keep them in line with industry averages to ensure the numbers are not unreasonable or unachievable. (b) An alternative approach to reducing inventory might include hiring sales personnel who would help convert inventory into profitable sales.
3. Butler should be more aggressive in collecting their accounts receivable. This would provide more cash and, in turn, help Butler to take advantage of available discounts from their vendors. This too would further increase their cash flow and reduce the need to borrow unreasonable amounts of money.
4. Mark Butler should retain less in personal salaries and other perquisites. This would demonstrate to Northrop National that he is personally making serious attempts to increase cash flow, get out of debt, and gain control of other emerging problems. Besides, personal taxes on his income is at a fairly high rate when it rises above $50,000. This is another area where he could increase cash flow while showing that he is truly doing "whatever it takes" to fix the problems facing Butler Lumber.
