LABRST 2G03 Lecture Notes - Final Good
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In early January 2009, David Johnstone received the draft 2008 financial statements for Strong Tie and began to question the companyâs performance when compared to previous years. How were profits holding up, given the intense price competition in the industry? Were attempts to lower costs through more automation paying off? Were the current problems in the U.S. housing market going to continue to reduce demand for connectors? How would lenders react to this poor performance? Was the companyâs financing in danger?After discussing the matter with company accountant Audrey Johnstone, it was decided that an outside consultant should be hired to provide an independent analysis of the companyâs recent performance and to provide suggestions for future action.
COMPANY BACKGROUND:Strong Tie Ltd., located in Winnipeg, Manitoba, designed and manufactured the standardized and customized structural connectors used to reinforce wood joints in the construction of decks, fences, houses and other structures. Strong Tie was a family-owned corporation founded in 1946 by Bill Johnstone to capitalize on the high demand for housing as returning World War II veterans married and began families. Bill Johnstone died in 1975 but passed the business on to his son David, who continued to operate the business along with his three daughters, Ellen, Elizabeth and Audrey. David served as CEO, while Ellen Johnstone, P.Eng, was responsible for product design and production; Elizabeth Johnstone, CSP, managed marketing, sales and distribution; and Audrey Johnstone, CA, managed the companyâs finances. The Johnstone family was a pillar of the Winnipeg business community, making sizeable donations to local charities and sport teams.
The standardized connectors were designed in Winnipeg based on input from architects, draftsmen and builders. The production process was highly automated with metal cutting, stamping and drilling machines completing most of the tasks. Human intervention was required to transfer work-in-process between stations, to feed machines and to pack, store and distribute the end products. This automation had allowed production to remain in Canada to date despite fierce competition from low-wage countries, particularly China. Customized connectors were produced based on specifications provided by the customer.
Production of these units was more labour-intensive, but margins were still significantly higher as contractors were prepared to pay a premium to have their special needs met.
Strong Tie prided itself on its product design capabilities. Designers in Winnipeg consistently generated an array of new standardized connectors that improved on existing products or addressed newly identified industry needs. These products were described in detail in terms of dimension, strength (load-bearing weights and steel gauge) and installation on the companyâs website or in a paper catalogue located in stores â both were of very high quality. Strong Tie also had a reputation among construction professionals as providing innovative solutions to unique design requests and being able to produce customized products in a timely manner at a reasonable price.
Standardized products were distributed through all national home improvement chains in North America including Home Depot, Loweâs, Rona, Home Hardware, Eagle and Sears. Most local chains catering to contractors also carried the standardized products and accepted requests for customized connectors, which they then forwarded to Strong Tie. Strong Tie was estimated to have a 60 per cent market share, which had fallen from 70 per cent in recent years. Universal Connector, a U.S. firm based in Ohio, was estimated to have a 30 per cent and growing share; it offered a similar array of standardized products and customized design services. The remainder of the market was served by five Chinese producers whose market share had grown considerably in the last five years, although they had yet to enter the customized product segment. Universal Connector had closed a number of its U.S. manufacturing facilities in recent years and replaced them with new facilities in China, which put considerable downward pressure on industry prices. Currently, Strong Tie priced its products at a premium to its competitors because of its industry leadership.
All sales were on terms Net 60. Large accounts such as Home Depot had a reputation of stretching their payments past the due date because of their buying power, while contractors frequently delayed payments due to cash flow problems. All purchases, which were primarily steel, were on terms 2/10, Net 60. Metal prices varied considerably, and the trend over 2006 to 2008 was for these prices to rise due to increasing demand from emerging market countries, particularly Brazil, Russia, India and China. Strong Tie had attempted to adopt just-in-time inventory practices to help reduce its raw material, work-in-process and finished goods inventory levels.
The Johnstone family maintained excellent relations with its unionized workforce, which was represented by the United Steel Workers of America. They prided themselves on paying generous wages and providing their workers with excellent health care, disability and pension benefits. The company had never had a strike and was currently negotiating a new collective agreement to take effect in three months on April 1, 2009.
In recent years, Strong Tie had been investing heavily in factory automation to improve its competitiveness. Automatic feeders and packaging equipment had been purchased to further reduce labour costs, and new computers and software had helped to speed up the design of high-margin customized connectors. A new, more automated warehouse had also been constructed.
FINANCIAL STATEMENTS: Exhibits 1 and 2 contain the income statements and balance sheets for Strong Tie for the last three years.
FINANCIAL BENCHMARKS: Reliable industry average information was not available for Strong Tieâs Chinese competitors, but comparable ratios were available for Universal Connector, a public company, in 2008. These ratios are contained in Exhibit 3.
FINANCING: Strong Tie had a $2,000,000, five-year, revolving credit agreement with the Bank of Nova Scotia, which was used to finance the companyâs working capital requirements as well as a number of individual term loans to finance fixed assets.
The revolving credit agreement was committed, so as long as the loan conditions were met, financing was guaranteed. The loan had to be secured 100 per cent by accounts receivable and inventory. The receivables were primarily with large retail chains that were in good financial health, so the Bank of Nova Scotia was prepared to lend 90 per cent of their value. They were also willing to lend 60 per cent of the value of the finished goods and work-in-process inventory because of a strong re-sale market and the short production process. The bank would only lend 40 per cent of the value of raw materials inventory due to general instability in the commodities market. The revolving credit agreement had to be paid down to zero at least once per year.
All loans required that the company maintain a Current Ratio of 1.5 or higher, a Cash Flow Coverage Ratio of 1.0 or higher and a Long-term Debt to Total Capitalization Ratio of 40 per cent or less. Audited quarterly and annual financial statements also had to be provided to the bank each quarter.
As the sole owner of the corporation, David Johnstone did not take a salary, but his three daughters received over $1,000,000 in salary and bonuses each year. Preferred dividends of $500,000 were paid out to Mr. Johnstoneâs sister Katherine, who chose not to participate in the management of the business but was promised a regular income by her late father in lieu of receiving a share of the business. These dividends had to be paid unless the company entered bankruptcy.
| exhibit 1 | |||
| income statement | |||
| 2006 | 2007 | 2008 | |
| net sales | 16,200.00 | 17,450.00 | 16,500.00 |
| cost of good sold | 10,445.00 | 11,956.00 | 11,950.00 |
| gross profit | 5,755.00 | 5,494.00 | 4,550.00 |
| selling and admin | 3,054.00 | 3,130.00 | 3,379.00 |
| depreciation | 396.00 | 720.00 | 756.00 |
| operating income | 2,305.00 | 1,644.00 | 415.00 |
| other income | |||
| interest income | 21.00 | 10.00 | 2.00 |
| other exp. | |||
| interest exp. | 246.00 | 291.00 | 407.00 |
| income before taxes | 2,080.00 | 1,363.00 | 10.00 |
| income taxes | 624.00 | 409.00 | 3.00 |
| net income | 1,456.00 | 954.00 | 7.00 |
| Exhibit 2 | Balance Sheet | ||
| 2006 | 2007 | 2008 | |
| current assets | |||
| cash | 234.00 | 122.00 | 61.00 |
| temporaru inve. | 1,034.00 | 488.00 | 99.00 |
| accounts receivable | 3,250.00 | 3,450.00 | 2,854.00 |
| raw materials inventory | 1,025.00 | 1,350.00 | 1,395.00 |
| WIP inventory | 200.00 | 38.00 | 42.00 |
| finished goods inventory | 2,030.00 | 1,700.00 | 1,200.00 |
| prepaid exp. | 182.00 | 143.00 | 188.00 |
| total current assets | 7,955.00 | 7,391.00 | 5,839.00 |
| fixed assets | |||
| land plant and equip. | 4,893.00 | 7,076.00 | 9,590.00 |
| Less: accum Dep. | 1,380.00 | 2,100.00 | 2,856.00 |
| net land plant and equo | 3,513.00 | 4,976.00 | 6,734.00 |
| total assets | 11,468.00 | 12,367.00 | 12,573.00 |
| current liabilities | |||
| account payable | 534.00 | 543.00 | 500.00 |
| income taxes payable | 54.00 | 35.00 | 23.00 |
| current portion of long term debt | 1,000.00 | 1,145.00 | 1,340.00 |
| total current liabilities | 1,588.00 | 1,723.00 | 1,863.00 |
| long-term Liabilities | 3,190.00 | 3,500.00 | 4,059.00 |
| shareholdrs equity | |||
| common share | 1,350.00 | 1,350.00 | 1,350.00 |
| retained earnings | 5,340.00 | 5,794.00 | 5,301.00 |
| total shreholders equity | 6,690.00 | 7,144.00 | 6,651.00 |
| total liabilities and shareholcers equity | 11,648.00 | 12,367.00 | 12,573.00 |
| exhibit 3 | benchmark ratios | |
| curernt ratio | 4.00 | |
| cash ratio | 0.50 | |
| raw material turnover in days | 31 days | |
| WIP turnover in days | 3 days | |
| finished goods turnover in days | 51 days | |
| a/r turnover in days | 63 days | |
| a/p turnover in days | 11 days | |
| cash converseion cycle | 137 days | |
| fixed asset turnover | 4.10 | |
| total asset turnover | 1.70 | |
| long-term debt to total capitalization | 35% | |
| cash flow coverage | 2.00 | |
| gross profit margin | 32% | |
| operating profit margin | 16% | |
| net profit margin | 10% | |
| ROA | 17% | |
| ROE | 28% | |
THE REQUIREMENT QUESTION
How were profits holding up, given the intense price competition in the industry? Were attempts to lower costs through more automation paying off? Were the current problems in the U.S. housing market going to continue to reduce demand for connectors? How would lenders react to this poor performance? Was the companyâs financing in danger?