n early January 2009, David Johnstone received the draft 2008 financial statemen
ID: 2797341 • Letter: N
Question
n early January 2009, David Johnstone received the draft 2008 financial statements for Strong Tie and began to question the company’s 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 company’s 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 company’s 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 company’s 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 company’s website or in a paper catalogue located in stores — 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, Lowe’s, 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 Tie’s 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 company’s 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. Johnstone’s 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.
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 company’s financing in danger?
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 7.00Explanation / Answer
Answer:
1) how profit is holding up: with the analysis of the company last three years it can be seen the sales only grew by 1% in the last three years or in the period of 2006-2008 as compared to sales of 7% in the period of 2007-2008. Th cost on other hands increased sharply in this period which has dented the profitability of the company at gross profit level. The gross profit margin has gone down from 36% to 28% in 2006 to 2008 as compared to the benchmark of 32% in 2008.
with the higher increase in the depreciation cost and selling and admin expenses, the operating income as recorded 58% cagr ( compounded annual growth) decline in the period of 2006-2008. The lower increase in sales vis- a - vis higher operational cost, company has recorded 14% OPM( operating profit margin) in 2006 and moves further down to 3%in 2008 which tad lower than the industry average of 16% 2008.
with the decline in other income and higher outlay in interest expenses company recorded in below 1% net profit margin as compared to industry average of 10% in 2008.
with this, we can conclude that the profitability of the company is not in good shape due to lower sales and higher operational and non-operational cost. This also highlights the fact that company needs to rework on the strategy to look for a new market so that profitability of the company can be bring at par to the industry level.
2) As per the trend of three years, it seems the year on year growth in the cost of goods sold had been paying off there was marginal or decline in the cost from 2007-2008. However, since the sales have recorded 5% decline in the period of 2007-2008, the cost-cutting mechanism didn't pay any benefit to the company. Although in the long term with the continuation of lower cost through automation and focussing on a diffrent market company can reap the benefits of high profitability
3.)on the face of it, it seems yes the current problem in the housing market is going to weigh down on the demand for connectors in the near term. Moreover, the existing lower Chinese products will also eat margins in the coming years. so the company needs to focus on the quality of products which they are known for so that they can override the competition in the longer run. with a better product and higher quality margin can be maintained which can lead to better profitability in the longer term.
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