Financial Management and Credit Risk - Essay Example

Table of Contents Table of Contents 1 Executive Summary 2 Main Report 3 Situation 3 Complication 3 Question 4 Analysis 4 Butler’s current financial standing: Key financial ratios 4 Credit risk as assessed by 5c’s of credit 9 Credit score 11 Risk assessment of the company after additional debt financing 12 New capital structure 12 Impact of leverage 12 Answer to case questions 13 Why does Mr. Butler have to borrow so much money to support this profitable business? 13 Do you agree with his estimate of the company’s loan requirements? How much will he need to borrow to finance his expected expansion in sales (assume a 1991 sales volume of .6 million)? 13 As Mr. Butler’s financial adviser, would you urge him to go ahead with, or to reconsider, his anticipated expansion and his plans for additional debt financing? 14 As Mr. Dodge, would you approve Mr. Butler’s loan request, and, if so, what conditions would you put on the loan? 14 What are the alternatives open to Mr. Butler if Mr. Dodge refuses his request for an increased credit line? 15 Recommendation 15 Working capital management 15 Exhibits 18 Butler Lumber Company financial ratios 18 Executive Summary Butler Lumber Company aims to expand its operations in 1991. During the year, Mark Butler, the owner and president of the company contemplates utilization of additional debt financing in order to support expansion. Because it has reached its loanable limit in its current bank, Suburban National Bank, it plans to avail of additional line of credit from Northrop National Bank amounting to 465,000. However, this increase in additional financing calls for a lot of considerations for the company. One of these includes the overall perceived risk of the company which affects its credit rating. This can significantly both increase the interest rate that is charged to the company as well the additional strain to the company’s earnings. While the company proves to be profitable, other financial measures show its many weaknesses, especially on the part of its working capital and cash conversion cycle. By probing at the current financial standing of the company, the company’s financial position is seen. With this, the implications of the subsequent financing activities can be determined as regards the overall health of the firm. The company is then faced with a decision of whether to pursue the additional debt financing. If Butler Lumber Company is not going to avail of the financing, it has to at least address and avail of some options of financing to meet its financing need. These alternatives are explored in the subsequent portions of this case study, which include strengthening cash generation from the profitable operation of the company through better working capital management, as well as other equity financing means. Main Report Situation Butler Lumber Company’s main line of business is in retailing lumber products within the local area of a large city in the Pacific Northwest. Mark Butler, the company’s sole owner and president is contemplating an increase in debt financing for its expansion. Butler Lumber Company currently has an existing relationship with Suburban National Bank, where it gets its additional funding in the form of loans. However, as Mr. Butler reaches the loan limit of 250,000, he is pondering on availing additional financing for his company’s expansion with a revolving credit line of 465,000 from Northrop National Bank through George Dodge. This is in order for him to secure financing that will address his company’s shortage of funds. Complication As the loan has not yet been approved, Butler Lumber Company’s financial position is yet to be determined by Northrop National Bank before Mr. Dodge can decide on giving the additional financing to Mr. Butler. Additional financing on the part of Mr. Butler definitely has major advantages, but this can significantly impact the firm’s financial position. When the additional financing aims to cover the additional expansion on Butler’s operations, this can also pose some significant changes in the capital structure of the company and its future ability to avail more funding. Also, the additional payments for interest expense have a significant effect on the company’s earnings. Question Should Mark Butler continue to avail the additional debt financing for the company’s expansion? If not, what options does Mr. Butler have in order to meet the financing needs? Analysis Butler’s current financial standing: Key financial ratios Firm liquidity Current ratio From 1988 up to 1991, Butler experiences a downward trend in its current ratio—from 1.8 in 1988, to 1.59 in 1989, to 1.45 in 1990 and 1.35 in 1991. This means that for every dollar of current liability, Butler has 1.35 of current assets in 1981. The company’s major source of cash is its operations. Although this consideration may not reflect the firm’s standing in 1991 because the sales are made in April to September, a declining trend is still evident among the previous years. Acid-test ratio The acid-test ratio, or the ratio of current assets less inventories to current liabilities of Butler Lumber Company, as evident in the current ratio, also faces a downward trend. In 1988, the company’s acid-test ratio is 0.88, which means it has 0.88 dollars in cash and accounts receivable to cover a dollar of liability. It continues to worsen each year: 0.72 in 1989, 0.67 in 1990, and 0.54 in the first quarter of 1991. The company’s major source of cash is its operations. Although this consideration may not reflect the firm’s standing in 1991 because the sales are made in April to September, a declining trend is still evident among the previous years. Average collection period For the past three years, the average collection period of the company continues to lengthen. From 36.78 days in 1988, to 40.25 days in 1989, to 42.95 days in 1990. For the first quarter of 1991, the average collection period of the company is not reflective of the true collection period because the average credit sales is not computed on an annual basis, or in a matter of 365 days to get the daily average. But the trend for the collection period is increasing, which could have an implication in the company’s generation of cash. Accounts receivable turnover The accounts receivable turnover goes hand in hand with the average collection period. As the average collection period increases over the course of three years, accounts receivable turnover also decreases. Butler Lumber Company’s accounts receivable turnover is 9.92 in 1988, down to 9.07 times in 1989, down to 8.5 times in 1990. This means that the company collects only 8.5 times of its accounts receivable during the year 1990. Inventory turnover Inventory turnover, or the rate the inventory is replenished has a downward, then upward trend over the years. Inventory turnover in 1988 is 5.11; in 1989, 4.41; and 4.67 in 1990. Operating profitability Operating income return on investment The operating income return on investment experiences a decrease from 1988 to 1989, then an increase to 1990. In 1988, the operating income ROI of the company is 8.42%; in 1989, 8.29%; and in 1990, 9.22%. Operating profit margin Operating profit margin continues to increase over the years—29.46% in 1988, 30.3% in 1989 and 31.92% in 1990. This upward trend only shows how profitable Butler Lumber Company is in terms of accounting income. Total asset turnover Efficiency in the company in terms of utilization of assets in order to generate sales experiences a decrease from 1988 to 1989, then an increase from 1989 to 1990. In 1988, total asset turnover for the company is 2.86; in 1989, 2.74; and in 1990, 2.89. This means that for every dollar of assets, it generates 2.89 dollars in sales in 1990. Fixed asset turnover Fixed asset turnover on the other hand continues to increase over the years—from 13.47 in 1988, up to 14.38 in 1989 and 17.16 in 1990. This increasing trend essentially signifies an increase in efficiency in terms of the company’s utilization of fixed assets in terms of revenue generation. Financing decisions Debt ratio The company started with a debt ratio of 54.55% in 1988. Over the years, the company has utilized more debt financing as its business expands. In 1989, the company has 58.7% of its financing in debt; 62.7% in 1990; and 67.37% in the first quarter of 1991. Times interest earned ratio Times interest earned ratio or the ratio of interest coverage through net income for the company decreases over the years. Over the past three years, the decreasing trend in ratio shows the risk that is associated with financial leverage of the company. In 1988, the ratio is 3.85; 3.05 in 1989; and 2.61 in 1990. This shows a decreasing ability of net income to cover interest payments for the period. Return on equity Return on equity The company’s return on equity experiences a decrease from 1988 to 1989, then an increase from 1989 to 1990. Return on equity in 1988 is 11.48%; 11.19% in 1989; and 12.64% in 1990. Credit risk as assessed by 5c’s of credit Character Mark Butler’s character is reflected by raves from trading partners and business people he has engaged business with. Judging from Mark Butler’s character, the loan has relatively little risk Capacity to pay In terms of capacity to pay, Mark Butler’s only source of income is the business. Aside from it, Mr. Butler’s other personal source of financing can be his equity in his house. In terms of capacity to pay, the loan has a relatively higher risk. Capital In 1990, the company has 62.7% of its financing in debt, which means only 37.3% remains for equity. This equity or the company’s capital is relatively smaller than the debt part, which makes this additional loan accompanies a higher risk. Collateral The company has 157000 in its fixed assets in year 1990. As for the amount the company intends to borrow, the amount of the fixed assets, which is not even entirely properties that can be used as collaterals, is far less than the amount of loan. This signifies a higher risk for the loan. Condition As reflected in the company’s financial ratios, Butler Lumber Company continues to be profitable over the years. However, this profitability does not mean overall success in business, as there are a lot of flaws in the company’s financial statements. The liquidity trend is downward, and the dependence on debt financing in order to grow the business is increasing, which increases the risk of lending to the company. The increasing debt financing signifies a slower growth in terms of internal financing or through retained earnings. While the company remains profitable, its ability to meet its obligations in terms of the strength of the cash that its operation generates is weak. This signifies a higher risk for the loan. Credit score Z1990 = 3.3 (EBIT/total assets) + 1.0 (sales/total assets) + .6 (market value of equity/book value of debt) + 1.4 (retained earnings/total assets) + 1.2 (working capital/total assets) Z1990 = 3.3 (86000/933000) + 1.0 (2694000/933000) + .6 (348000/585000) + 1.4 (109000a/933000) + 1.2 (776000/933000) asum of the company’s net income for 1988, 1989 and 1990 Z1990 = 4.71 Butler Lumber Company has a z score of 4.71 in 1990, which is higher than 2.7 or the bankruptcy score, as discussed in Arthur Keown’s book “Financial Management: Principles and Applications” (711). Risk assessment of the company after additional debt financing New capital structure When the debt ratio is already at 67.37%, an additional revolving credit line of more than 400,000—more than 50% of the current level of assets will make the firm’s risk increase drastically because of its dependence in debt. With this increase in debt, the impact of financial leverage will make loans more expensive for the firm. Impact of leverage Because of the increase in risk due to firm’s heavy dependence on debt financing, loans will be more expensive for the company. This increase in leverage also poses certain risks for the firm itself, especially when downtimes occur, even though the company has protection, the interest payments will increase and leverage will rapidly decrease the firm’s earnings. The times interest earned ratio of the firm is already at a declining rate—as the years progress the company’s ability to meet interest payments by net income decreases. With this additional debt financing, times interest ratio will also be greatly affected. Answer to case questions Why does Mr. Butler have to borrow so much money to support this profitable business? Mr. Butler has to borrow so much money in order to support his profitable business because his company is unable to generate cash on a faster rate from its operations. Because the time in order to convert the inventories to sales, then to cash itself is long, in order to meet its obligations, he has to resort to borrowing and availing debt financing instead. Do you agree with his estimate of the company’s loan requirements? How much will he need to borrow to finance his expected expansion in sales (assume a 1991 sales volume of .6 million)? Approximately more than 400,000. During the course of three years, the cost of goods sold rests at 71-73% of sales. Given a 3.6 million in sales in 1991 as a forecasted figure, this represents some 2.63 million in cost of goods sold for the year. Assuming that both the initial and the ending inventory are at 500,000, a 90-day revolving credit in order to avail of the additional purchases will amount to something slightly more than 400,000. This is the amount Mark Butler has to borrow from the bank in a 90-day period. As Mr. Butler’s financial adviser, would you urge him to go ahead with, or to reconsider, his anticipated expansion and his plans for additional debt financing? Definitely not. Many businesses which are very profitable go out of the industry because of poor financial and working capital management. If Mr. Butler proceeds with the additional debt financing, here’s a list of implications regarding his financial position: additional financing will increase the debt ratio so much that the firm becomes very risky on the part of creditors, as it is perceived to rely so much on debt; the times interest earned ratio signifies the declining strength of the company’s ability to meet interest payments by the net income, so the additional interest payments will eat the earnings of the company. Given these, I would tell Mr. Butler to reconsider the anticipated expansion and plans for additional financing. There are financing policies yet to be enacted in order to ensure the health of the business before he can go on the expansion. As Mr. Dodge, would you approve Mr. Butler’s loan request, and, if so, what conditions would you put on the loan? The company’s current financial position, although profitability is at an increasing rate, other ratios have downward trends and are not so favorable. By the time Northrop assesses the business, George Dodge will find out that the firm already utilizes a huge portion of financing through debt. If I were Mr. Dodge, I would not approve Mr. Butler’s loan request. This is the more beneficial thing for both parties to do. Even if Northrop can absorb so much risk in approving Mr. Butler’s loan, Mr. Dodge will later see that the additional debt financing will put the firm into a shakable financial position. If Mr. Dodge plans to pursue, he will have to charge Mr. Butler higher interest rate in order to compensate the risk, which will put Mr. Butler at a much further disadvantage. What are the alternatives open to Mr. Butler if Mr. Dodge refuses his request for an increased credit line? Since the additional financing is for the company to address short-term financing needs, Mr. Butler can first improve its working capital management in order to free up some cash if debt financing is not available. By speeding up collections, the firm can generate more cash from its collections which it can use in order to support its short-term financing needs. Recommendation Working capital management The major recommendation for Butler Lumber Company is to enact policies regarding working capital management which will improve its cash conversion cycle, therefore being more able to utilize cash generated from the operations versus dependence on financing. By decreasing the collection period and increasing the average accounts receivable turnover, the company frees up some cash from its investment in accounts receivable. This increase in cash from operations can support the company’s short-term financing needs. This urgency to enact policies concerning working capital management of the company is apparent in the company’s working capital terms. The cash conversion cycle becomes longer too because the terms for trades payables are shorter too. Therefore, in order to address shortage, better working capital management should be utilized. However, this does not come for free—this will have an impact on profitability as a trade-off, because of the shorter collection policy. But, in order to lower dependence on debt financing, generation of cash from collections, especially because the operation is profitable, is the major alternative for this kind of financing need. When the company’s financial position is strong again, such that creditors will perceive it as a lower risk for investment, can the company utilize debt financing for expansion. Other alternatives include equity financing, by selling shares to private investors. However, if Mr. Butler has bought his brother-in-law’s shares in order to gain 100% control of the business, this may not be an alternative to Mr. Butler. Although, in essence he can forgo some portion of equity in order to raise financing without giving up maximum control over the firm. Exhibits Butler Lumber Company financial ratios FINANCIAL RATIOS     1991 1990 1989 1988 1. FIRM LIQUIDITY   Current ratio 1.350725 1.450467 1.589333 1.8 Acid-test ratio 0.544928 0.669159 0.72 0.880769 Ave. collection period 175.383 42.94915 40.25335 36.77961 AR turnover 2.081159 8.498423 9.067568 9.923977 Inventory turnover 0.938849 4.665072 4.407975 5.112971     2. OPERATING PROFITABILITY   Op. income return on investment 0.019196 0.092176 0.08288 0.084175 Operating profit margin 0.029248 0.031923 0.030303 0.029464 Total asset turnover 0.656307 2.88746 2.735054 2.856902 A/R turnover 2.081159 8.498423 9.067568 9.923977 Inventory turnover 0.938849 4.665072 4.407975 5.112971 Fixed assets turnover 4.432099 17.15924 14.37857 13.46825     3. FINANCING DECISIONS   Debt ratio 0.673675 0.62701 0.586957 0.545455 Times-interest earned 2.1 2.606061 3.05 3.846154     4. RETURN ON EQUITY   return on equity     0.02521 0.126437 0.111842 0.114815 Bibliography Keown, A. J., Martin, J. D., Petty, J. W., Scott, Jr., D. F. (2005) Financial Management: Principles and Applications. New Jersey: Pearson Education, Inc. Read More