ders if he will reach the same conclusions as he begins his evaluation of Spartan's financial records. QUESTIONS 1. (a) Complete the 1995 pro forma balance sheet listed in Exhibit 3. (b) Complete the "worst case" cash flow projection for 1997 listed in Exhibit 4. 2. Do you agree that TNB should have actively sought Spartan's business at the end of 1994? Fully support your answer. (Note: When this recommen- dation was made, Pattilla only had financial information on the first three quarters of 1994. He did possess, however, a projection for the last quarter that was virtually identical to what actually occurred.) Write this one 3. Calculate the ratios listed in Exhibit 9 for the Spartan Roofing Company for 1995. 4. Evaluate the Spartan Roofing Company's situation at the present time (early 1996). What difficulties, if any, does your evaluation indicate? 5. Note that in 1995 Spartan's cash flow from operations (net income plus de- preciation) was its highest during the 1992-1995 period. Yet its need for ex- ternal funds, reflected in the large increase in its short-term bank loans, was also the greatest over the same period. Resolve this apparent paradox. 6. Use the format of Exhibit 4. (a) Prepare what you think is a "best guess" ("most likely") cash flow fore- cast for 1996. State your assumptions clearly. Do assume, however, that capital expense will be $120(000) and depreciation remains at $80(000). Defend the assumptions of your forecast. (b) Prepare what you think is a "worst case" cash flow forecast for 1996. Clearly state your assumptions. Do assume, however, that there is no change in sales from the 1995 level, depreciation remains at $80(000), and that the firm will postpone all expansion projects and incur only re- placement capital expenses of $50(000). Defend the assumptions of your forecast 7. Do a liquidation analysis on the firm for the end of 1995. That is, estimate its liquidation value and compare it to the amount of its debt obligations. It is customary in a situation like this for Pattilla to make the following, perhaps conservative, assumptions: (1) all cash on the balance sheet is used for liqui- dation expenses; and (2) receivables can be converted into cash at 60 percent of book value, inventory at 30 percent, and net fixed assets at 25 percent. PART II FINANCIAL ANALYSIS case, do you the time (early 19% 8. Based on your previous answers and information in the case, dove ommend that TNB seek Spartan's business at the present time (earl and offer a $750,000 buy-out of First City? Fully support your recome dation. (Note: Do not consider any smaller loan amount, and assume the fer would involve a six-year term loan with the principal paid in equs amounts each year.) 9. What additional information would help you make a more informed deci sion in question 8? SOFTWARE QUESTION 10. Attention instructors: Questions 6 and 8 should probably not be assigned this question is used. John Pattilla of Tennessee National Bank has to decide whether to seek Spartan's business. He is considering a $750,000 loan, which would enable Spartan to buy out First City, Spartan's present bank. The principal would be payable in equal amounts each year for the next six years (1996-2001). After some thought, Pattilla decides to analyze Spartan's cash flow in the for lowing scenarios (1997 capital spending is $50(000) in all scenarios). S.2 SIA S-2A 05 05 .024 60.00 Annual sales growth Net income/sales Average collection period Sales/inventory (AP & accruals)/sales Capital spending (1996) .02 2018 65.00 7.00 55.00 60.00 7.00 8.00 8.00 10 120.00 80.00 120.00 80.00 NOTE: AP refers to accounts payable. S-1 and S-2 represent Pattilla's best-guess (most likely) and worst-case for respectively, assuming no additional concrete information about Spartan Nu pout Spartan Roofing attilla had with SIA and S-2A are based on a recent conversation that Pattilla na Lawrence Wilson, the owner. Wilson claimed that he is going to "imple sounder credit policies," and "eliminate some production inefficiencies. Pattilla has not had time to carefully examine these claims, and won these changes would make any difference, anyway, assuming Wilson is Perform the appropriate analysis. What would you recommend to implement Wonders i n is right end your as appropriate any diffenly examine to Pattilla? CASE 8 SPARTAN ROOFING 53 EXHIBIT 1 Excerpts from John Pattilla's 1994 Report on the Spartan Roofing Company . "The company expects, and I agree that sales growth will be 37 percent, 20 percent, and 20 percent over the next three years. This will result partly from the economic growth of the overall economy but mainly from the sales gen- erated by its new macrocarbide products." "Lawrence Wilson is exceptionally strong in the technical aspects of the busi- ness and is very much involved in new product development. He has a B.S. and an M.S. in chemical engineering from MIT. On the other hand, being a technical sort, his financial expertise is somewhat limited. Nonetheless, Wilson's track record over the last 10 years speaks for itself, and we have had no reason to question his integrity." "One area of concern is the quality of the accounts receivable, given that the majority of the customers are contractors. It should be noted, however, that the majority of the contractors have been doing business with Spartan for a number of years and the company is familiar with their financial condition. In fact, its bad debt expense has never exceeded 0.6 percent in any of the last 10 years, a solid statistic considering the customer base." "The main reason for the company's poor earnings in 1994 was the large ex- penses incurred by a former salesman of the company. Lawrence hired a salesman who was very expensive but did not produce. As a result, selling ex- penses increased sharply in 1994." "From 1992 to 1994, the period I analyzed most intensively, Spartan generated sufficient cash flow from operations to meet its capital expenditure needs and its debt service. Adjusted working capital was a net source of funds for the company which partly reflects the attention given to the management of working capital. The result of all this was a large positive cash flow (see Exhibit 8) which Spartan used to repay a number of relatively expensive term loans. Whether this was a wise financial move is debatable." "Due to the working capital requirements of the large expected sales growth and the fixed-asset needs of the company, the company will not be in a posi- tion to begin repaying any of the principal on the debt until 1997." "Even my 'worst case' cash flow forecast indicates that Spartan will have suf- ficient funds to repay sizeable chunks of any new debt beginning in 1997." (See Exhibit 4.) (continued) (Continued) "I recommend we finance Spartan's working capital and med asset need. This will require up to $700,000. I also recommend that we do not amortis any of the loans for two years. The loans would be secured by the accounts ceivable, inventory, and equipment of the company, and would be personally guaranteed by Lawrence." . "I believe this to be an attractive opportunity for us, but it does involve sev eral elements of risk. The company's sales and earnings are quite sensitive to overall economic conditions and the construction industry in particular. In addition, the nature of the customer base (contractors) is suspect. On the other hand, given the company's track record, it appears that they have effectively managed these risks." EXHIBIT 2 Net Income Projections for the Spartan Roofing Company: 1995-1997 (000s) (Developed by John Pattilla for TNB in 1994) 1995 1996 1997 B.G. W.C. B.G. W.C. B.G. W.C. Sales $5,400 5,000 $6,500 5,300 $7,800 4,900 Net income $ 135 75 $162 80 S 195 74 "B.G. is the best guess" ("most likely) forecast and assumes sales will increase by 37 percent in 1995, 20 percent in 1996, and 20 percent in 1997. Net income is assumed to be 25 percent of sales. "W.C. is a "worst case forecast that assumes net income will be 15 percent of sales. EXHIBIT 3 Pro Forma Balance Sheets for the Spartan Roofing Company: 1995-1997 (000) (Developed by John Pattilla for TNB in 1994) 1995 1996 B.G. W.C. 1997 B.G. W.C. B.G. B.G. W.C. $ 40 Assets Cash Receivables Inventory Current assets Gross fixed assets $50 993 $ 40 833 694 $1,567 929 $50 883 -786 $1,510 776 $1.819 1,309 $1.669 1.309 $ 60 1,193 931 $2,184 1,339 $ 40 816 680 $1,536 1339 Com EXHIBIT 3 (Continued) 1997 1996 1995 B.G. W.C. W.C. B.G. W.C. (537) (657) (657) 652 392 (787) 552 $2.088 $1.959 52.471 $2.321 $ 66 $ 198 252 $ 166 303 190 (Depreciation) (537) Net fixed assets 392 Total assets $1.902 Liabilities and Equity Short-term debt due $ 169 Accounts payable Accruals Current liabilities Term loans Common stock Retained earnings Total liabilities and equity $1.902 $ 326 194 300 $ 820 390 $ 308 206 318 S832 425 294 $550 $ 840 425 50 $937 400 400 50 994 934 1156 1088 1351 $2.738 $1.959 1,014 $2.321 $2.471 $2.088 "B.G. refers to a "best guess" ("most likely forecast that incorporates these assumptions: (1) receivables will be 55 days of sales (2) inventory turnover will be 8.4 (43 days of sales): (3) accounts payable will be 3.9 percent of sales (round your estimate down); (4) accruals will be 6 percent of sales, and (5) capital expenditures will be $90 in 1995, 5380 in 1996, and $30 in 1997 'W.C. refers to a "worst case" forecast that incorporates these assumptions (1) receivables will be 60 days of sales; and (2) inventory turnover will be 7.2 (50 days of sales). Assumptions 3 to 5 in the "best guess" situation remain unchanged EXHIBIT 4 Worst Case Cash Flow Projections for the Spartan Roofing Company: 1995-1997 (000s) (Developed by John Pattilla in 1994) 1995 1996 $75 $ 80 $200 Net income Depreciation Cash flow operations -Adjusted working capital needs -Capital expense -Dividends Cash flow $155 332 90 380 ($267) (5242) 0 $257 (continued) EXHIBIT 4 (Continued) Adjusted Working Capital 1994 1996 1995 $ 833 $ 883 694 736 194 300 Accounts receivable Inventory - Accounts payable - Accruals Adjusted working capital Change adjusted working capital 206 318 $1,095 $1,033 332 62 "This assumes (1) net income will be 15 percent of sales; (2) receivables will be 60 days of sales; (3) inventar turnover will be 72 or 50 days of sales; and (4) accounts payable will be 3.9 percent of sales and accruals 6 percent. (See Exhibits 2 and 3 for projected net income and pro forma balance sheets.) EXHIBIT 5 Income Statements and Bad Debt Expense for the Spartan Roofing Company: 1992-1995 (000s) 1992 1993 1994 1995 $3,978 2.884 $1,094 815 53 $ 226 Sales Cost of goods Gross profit Administrative & selling expenses Depreciation EBIT Interest Earnings before taxes Taxes (406) Net income Bad debt expense $3,902 2,872 $1,030 762 61 $ 207 $3,946 2.959 $ 987 837 $5,399 4.172 $1,226 904 $95 $ 242 82 5161 $ 160 $ 163 $75 $ 96 0.1% 0.6% $ 45 0.4% EXHIBIT 6 Normalized Income Statements for the Spartan Roofing Company: 1992-1 1992 1993 1994 Sales Cost of goods 100 100 Cross profit 725 73.6 26.4 ing Company: 1992-1995 100 Administrative de selling expenses Depreciation ERIT Eamings before taxes Hotels Net income EXHIBIT 7 Balance Sheets for the Spartan Roofing Company: 1992-1995 (000) 1992 1993 1994 1995 $21 580 $85 707 476 $1,268 669 (251) 418 $1,686 $ 120 785 446 $1,351 698 (312) 386 $1,737 428 $1,029 757 (367) 390 $1,419 $ 43 1,124 773 $1,940 914 (447) 467 $2.407 Assets Cash Receivables Inventory Current assets Gross fixed assets (Accumulated depreciation) Net fixed assets Total assets Liabilities and Equity Notes payable-banks Accounts payable Accruals Current liabilities Term loans Common stock Retained earnings Total liabilities and equity $ 220 $ 162 150 157 $ 700 306 310 $1,316 157 $ 469 $ 654 $ 180 148 218 $ 546 374 50 716 $1,686 219 50 814 $1,737 859 $1,419 52.407 EXHIBIT 8 Spartan's Cash Flow 1992-1994 (000s) 1992 1993 1994 $ 96 $98 61 Net income Depreciation Cash flow operations - Adjusted working capital needs -Capital expenditures -Dividends Cash flow $ 45 55 $100 (96) $149 (80) $159 (20) 59 $189 $150 $137 Adjusted Working Capital 1992 1993 1991 1994 Accounts receivable Inventory - Accounts payable - Accruals Adjusted working capital Change adjusted working capital $707 476 148 218 $817 (80) $785 446 157 277 $797 (20) $580 428 150 157 $701 (96) 5897 PART II FINANCIAL ANALYSIS EXHIBIT 9 Financial Ratios for the Spartan Roofing Company: 1992-1995 1994 1995 1992-19 Liquidity Ratios 207 219 1.47 24 Current Quick Leverage Ratios Debt (%) Times interest earned Activity Ratios Inventory turnover (sales) 8.4 Fixed asset tumover Total asset turnover Average collection period 64 Profitability Ratios Gross margin() Net profit margin() 24 Return on net worth (3) 125 Return on total assets (5) 57 4.03 10.4 OS 5.8 The top number events the upper quantile figuremen en for each ratoare co w Ratios for all firms in the in what is considered as the middle number represents tems in the industry had to better than the median ratio and hall had per quante gure meaning 25 p ont of the firms had ratios better represents the low that of the famshad ratios won Katios for all firms in the industry are represents the median ratios all had ratios that were worse ratios better than this firms had ratios worse than this. CASE 8 SPARTAN ROOFING LOAN EVALUATION "The Spartan Roofing Company makes excellent products!" So concluded a laudatory independent report commissioned by a bank in 1996. THE SPARTAN ROOFING COMPANY The Spartan Roofing Company was established in 1951 as a sole proprietorship in Ohio. The company is an innovative manufacturer of aluminum roofing products. Its standard products include the safeguard gravel stop system, the reslet and expansion joint system, and a wide variety of roofing panel systems. The safeguard system, which is patented, is designed to correct three major problems encountered by the roofing industry-water leakage of joints, tar drippage on the exterior of the finished building, and shrinkage. The company's products are designed to favor both building owner and con- tractor. The building owner benefits because of design technology that ensures Spartan's materials will last many years with little maintenance. The contractor benefits because the materials are simple to install. As a result the firm's prod- ucts are extremely popular with the building industry, and many architects and engineers specify Spartan materials by brand name. Market studies support this claim and also indicate that Spartan could increase its market share substan- tially, given that the company has only a 5-percent share at present. Not sur- prisingly the firm is very strong in technical expertise; the engineering depart- ment is an important component of the business, and the development of new products is very much encouraged. Consequently, the company has been granted over eight patents in the last 20 years. While Spartan's technical expertise is unquestioned, the firm is a bit suspect in financial matters. Periodically it has had difficulties with such matters as in- ventory control and pricing. Historically, however, when the firm has experi- enced serious problems in an area it has been able to show improvement by the that Spartan has con fact, when one by the best-run com PART II FINANCIAL ANALYSIS following year. All things considered, there is little doubt that s. piled an impressive track record over the last 20 years. In fart evaluated Spartan in 1991 it concluded that this is one of the bi nies we have ever encountered in its size-sales category." In 1985, the firm relocated to Tennessee at the suggestion of Lawren the firm's CEO and son of the founder. The company's bank has bee since the move South, but Tennessee National Bank (TNB) has a sought Spartan's business. Since 1985 TNB has called on Wilson on 30 occasions and has made six different financing proposals. Wilson was reluctant to switch, though he almost left First City for TNB in Novemb because he was upset at First City for a reason never clear to TNB. Lawrence Wilson has been First TNB) has aggressive Wilson on more the in was always JOHN PATTILLA In December 1994 John Pattilla of TNB had written a 12-page memorandum rec ommending that the bank make a specific financing proposal to Spartan. Pattilla's analysis was quite thorough and included projections of the firm's sit. uation using a "best guess" or "most likely" and "worst case" set of assump- tions. (See Exhibit 1 for excerpts from his 1994 report, Exhibit 2 for his net in come projections, Exhibit 3 for his balance sheet projections, and Exhibit 4 for his "worst case" cash flow estimates.) Pattilla had a few conversations with Wilson to get information for the pro- jections. The final estimates, however, reflect Pattilla's assessment of the situa tion, and Wilson has never seen these numbers. Pattilla had recommended that TNB extend the company up to $700,000 in loans. The money would be used to finance Spartan's working capital and fixed-asset needs for anticipated strong sales growth from an expanding economy and the introduction of a number of new products. The company was especially excited about its new macrocarbide product line. Macrocarbide is known for its unusually long life and is therefore very useful in the roofing industry. It is now early 1996 and Pattilla has to decide whether TNB should make an- other proposal to Lawrence Wilson. As Pattilla leans back in his chair, he leafs through information on Spartan, and a number of items catch his eye. He smiles as he notices the nearly 40-percent increase in sales for 1995, an increase he pre dicted almost to the penny. Pattilla realizes, however, that Spartan musthi benefited enormously from the economic upturn, since the sales of its new ucts have not gone as well as expected. Especially disappointing were of Spartan's macrocarbide product line. It appears to Pattilla that growth is due more to an external factor outside the company's economy-than to internal factors under its control. He also note tapped the firm's line of credit with First City for over $500,000 all consistent with his 1994 projections. Pattilla knows that any involve a buy-out of First City and TNB's offer should be at Spartan's credit line with First City, or about $750,000. Patil les of its new prod- pointing were the sales tilla that the sales pany's control the o notes that Wilson 500,000, a result not at at any proposal would e at least the amount of illa had concluded his 51 CASE 8 SPARTAN ROOFING 1994 report by noting that "this represents an excellent opportunity for TNB." But now, nearly 14 months after he made that recommendation, Pattilla won- ders if he will reach the same conclusions as he begins his evaluation of Spartan's financial records. ders if he will reach the same conclusions as he begins his evaluation of Spartan's financial records. QUESTIONS 1. (a) Complete the 1995 pro forma balance sheet listed in Exhibit 3. (b) Complete the "worst case" cash flow projection for 1997 listed in Exhibit 4. 2. Do you agree that TNB should have actively sought Spartan's business at the end of 1994? Fully support your answer. (Note: When this recommen- dation was made, Pattilla only had financial information on the first three quarters of 1994. He did possess, however, a projection for the last quarter that was virtually identical to what actually occurred.) Write this one 3. Calculate the ratios listed in Exhibit 9 for the Spartan Roofing Company for 1995. 4. Evaluate the Spartan Roofing Company's situation at the present time (early 1996). What difficulties, if any, does your evaluation indicate? 5. Note that in 1995 Spartan's cash flow from operations (net income plus de- preciation) was its highest during the 1992-1995 period. Yet its need for ex- ternal funds, reflected in the large increase in its short-term bank loans, was also the greatest over the same period. Resolve this apparent paradox. 6. Use the format of Exhibit 4. (a) Prepare what you think is a "best guess" ("most likely") cash flow fore- cast for 1996. State your assumptions clearly. Do assume, however, that capital expense will be $120(000) and depreciation remains at $80(000). Defend the assumptions of your forecast. (b) Prepare what you think is a "worst case" cash flow forecast for 1996. Clearly state your assumptions. Do assume, however, that there is no change in sales from the 1995 level, depreciation remains at $80(000), and that the firm will postpone all expansion projects and incur only re- placement capital expenses of $50(000). Defend the assumptions of your forecast 7. Do a liquidation analysis on the firm for the end of 1995. That is, estimate its liquidation value and compare it to the amount of its debt obligations. It is customary in a situation like this for Pattilla to make the following, perhaps conservative, assumptions: (1) all cash on the balance sheet is used for liqui- dation expenses; and (2) receivables can be converted into cash at 60 percent of book value, inventory at 30 percent, and net fixed assets at 25 percent. PART II FINANCIAL ANALYSIS case, do you the time (early 19% 8. Based on your previous answers and information in the case, dove ommend that TNB seek Spartan's business at the present time (earl and offer a $750,000 buy-out of First City? Fully support your recome dation. (Note: Do not consider any smaller loan amount, and assume the fer would involve a six-year term loan with the principal paid in equs amounts each year.) 9. What additional information would help you make a more informed deci sion in question 8? SOFTWARE QUESTION 10. Attention instructors: Questions 6 and 8 should probably not be assigned this question is used. John Pattilla of Tennessee National Bank has to decide whether to seek Spartan's business. He is considering a $750,000 loan, which would enable Spartan to buy out First City, Spartan's present bank. The principal would be payable in equal amounts each year for the next six years (1996-2001). After some thought, Pattilla decides to analyze Spartan's cash flow in the for lowing scenarios (1997 capital spending is $50(000) in all scenarios). S.2 SIA S-2A 05 05 .024 60.00 Annual sales growth Net income/sales Average collection period Sales/inventory (AP & accruals)/sales Capital spending (1996) .02 2018 65.00 7.00 55.00 60.00 7.00 8.00 8.00 10 120.00 80.00 120.00 80.00 NOTE: AP refers to accounts payable. S-1 and S-2 represent Pattilla's best-guess (most likely) and worst-case for respectively, assuming no additional concrete information about Spartan Nu pout Spartan Roofing attilla had with SIA and S-2A are based on a recent conversation that Pattilla na Lawrence Wilson, the owner. Wilson claimed that he is going to "imple sounder credit policies," and "eliminate some production inefficiencies. Pattilla has not had time to carefully examine these claims, and won these changes would make any difference, anyway, assuming Wilson is Perform the appropriate analysis. What would you recommend to implement Wonders i n is right end your as appropriate any diffenly examine to Pattilla? CASE 8 SPARTAN ROOFING 53 EXHIBIT 1 Excerpts from John Pattilla's 1994 Report on the Spartan Roofing Company . "The company expects, and I agree that sales growth will be 37 percent, 20 percent, and 20 percent over the next three years. This will result partly from the economic growth of the overall economy but mainly from the sales gen- erated by its new macrocarbide products." "Lawrence Wilson is exceptionally strong in the technical aspects of the busi- ness and is very much involved in new product development. He has a B.S. and an M.S. in chemical engineering from MIT. On the other hand, being a technical sort, his financial expertise is somewhat limited. Nonetheless, Wilson's track record over the last 10 years speaks for itself, and we have had no reason to question his integrity." "One area of concern is the quality of the accounts receivable, given that the majority of the customers are contractors. It should be noted, however, that the majority of the contractors have been doing business with Spartan for a number of years and the company is familiar with their financial condition. In fact, its bad debt expense has never exceeded 0.6 percent in any of the last 10 years, a solid statistic considering the customer base." "The main reason for the company's poor earnings in 1994 was the large ex- penses incurred by a former salesman of the company. Lawrence hired a salesman who was very expensive but did not produce. As a result, selling ex- penses increased sharply in 1994." "From 1992 to 1994, the period I analyzed most intensively, Spartan generated sufficient cash flow from operations to meet its capital expenditure needs and its debt service. Adjusted working capital was a net source of funds for the company which partly reflects the attention given to the management of working capital. The result of all this was a large positive cash flow (see Exhibit 8) which Spartan used to repay a number of relatively expensive term loans. Whether this was a wise financial move is debatable." "Due to the working capital requirements of the large expected sales growth and the fixed-asset needs of the company, the company will not be in a posi- tion to begin repaying any of the principal on the debt until 1997." "Even my 'worst case' cash flow forecast indicates that Spartan will have suf- ficient funds to repay sizeable chunks of any new debt beginning in 1997." (See Exhibit 4.) (continued) (Continued) "I recommend we finance Spartan's working capital and med asset need. This will require up to $700,000. I also recommend that we do not amortis any of the loans for two years. The loans would be secured by the accounts ceivable, inventory, and equipment of the company, and would be personally guaranteed by Lawrence." . "I believe this to be an attractive opportunity for us, but it does involve sev eral elements of risk. The company's sales and earnings are quite sensitive to overall economic conditions and the construction industry in particular. In addition, the nature of the customer base (contractors) is suspect. On the other hand, given the company's track record, it appears that they have effectively managed these risks." EXHIBIT 2 Net Income Projections for the Spartan Roofing Company: 1995-1997 (000s) (Developed by John Pattilla for TNB in 1994) 1995 1996 1997 B.G. W.C. B.G. W.C. B.G. W.C. Sales $5,400 5,000 $6,500 5,300 $7,800 4,900 Net income $ 135 75 $162 80 S 195 74 "B.G. is the best guess" ("most likely) forecast and assumes sales will increase by 37 percent in 1995, 20 percent in 1996, and 20 percent in 1997. Net income is assumed to be 25 percent of sales. "W.C. is a "worst case forecast that assumes net income will be 15 percent of sales. EXHIBIT 3 Pro Forma Balance Sheets for the Spartan Roofing Company: 1995-1997 (000) (Developed by John Pattilla for TNB in 1994) 1995 1996 B.G. W.C. 1997 B.G. W.C. B.G. B.G. W.C. $ 40 Assets Cash Receivables Inventory Current assets Gross fixed assets $50 993 $ 40 833 694 $1,567 929 $50 883 -786 $1,510 776 $1.819 1,309 $1.669 1.309 $ 60 1,193 931 $2,184 1,339 $ 40 816 680 $1,536 1339 Com EXHIBIT 3 (Continued) 1997 1996 1995 B.G. W.C. W.C. B.G. W.C. (537) (657) (657) 652 392 (787) 552 $2.088 $1.959 52.471 $2.321 $ 66 $ 198 252 $ 166 303 190 (Depreciation) (537) Net fixed assets 392 Total assets $1.902 Liabilities and Equity Short-term debt due $ 169 Accounts payable Accruals Current liabilities Term loans Common stock Retained earnings Total liabilities and equity $1.902 $ 326 194 300 $ 820 390 $ 308 206 318 S832 425 294 $550 $ 840 425 50 $937 400 400 50 994 934 1156 1088 1351 $2.738 $1.959 1,014 $2.321 $2.471 $2.088 "B.G. refers to a "best guess" ("most likely forecast that incorporates these assumptions: (1) receivables will be 55 days of sales (2) inventory turnover will be 8.4 (43 days of sales): (3) accounts payable will be 3.9 percent of sales (round your estimate down); (4) accruals will be 6 percent of sales, and (5) capital expenditures will be $90 in 1995, 5380 in 1996, and $30 in 1997 'W.C. refers to a "worst case" forecast that incorporates these assumptions (1) receivables will be 60 days of sales; and (2) inventory turnover will be 7.2 (50 days of sales). Assumptions 3 to 5 in the "best guess" situation remain unchanged EXHIBIT 4 Worst Case Cash Flow Projections for the Spartan Roofing Company: 1995-1997 (000s) (Developed by John Pattilla in 1994) 1995 1996 $75 $ 80 $200 Net income Depreciation Cash flow operations -Adjusted working capital needs -Capital expense -Dividends Cash flow $155 332 90 380 ($267) (5242) 0 $257 (continued) EXHIBIT 4 (Continued) Adjusted Working Capital 1994 1996 1995 $ 833 $ 883 694 736 194 300 Accounts receivable Inventory - Accounts payable - Accruals Adjusted working capital Change adjusted working capital 206 318 $1,095 $1,033 332 62 "This assumes (1) net income will be 15 percent of sales; (2) receivables will be 60 days of sales; (3) inventar turnover will be 72 or 50 days of sales; and (4) accounts payable will be 3.9 percent of sales and accruals 6 percent. (See Exhibits 2 and 3 for projected net income and pro forma balance sheets.) EXHIBIT 5 Income Statements and Bad Debt Expense for the Spartan Roofing Company: 1992-1995 (000s) 1992 1993 1994 1995 $3,978 2.884 $1,094 815 53 $ 226 Sales Cost of goods Gross profit Administrative & selling expenses Depreciation EBIT Interest Earnings before taxes Taxes (406) Net income Bad debt expense $3,902 2,872 $1,030 762 61 $ 207 $3,946 2.959 $ 987 837 $5,399 4.172 $1,226 904 $95 $ 242 82 5161 $ 160 $ 163 $75 $ 96 0.1% 0.6% $ 45 0.4% EXHIBIT 6 Normalized Income Statements for the Spartan Roofing Company: 1992-1 1992 1993 1994 Sales Cost of goods 100 100 Cross profit 725 73.6 26.4 ing Company: 1992-1995 100 Administrative de selling expenses Depreciation ERIT Eamings before taxes Hotels Net income EXHIBIT 7 Balance Sheets for the Spartan Roofing Company: 1992-1995 (000) 1992 1993 1994 1995 $21 580 $85 707 476 $1,268 669 (251) 418 $1,686 $ 120 785 446 $1,351 698 (312) 386 $1,737 428 $1,029 757 (367) 390 $1,419 $ 43 1,124 773 $1,940 914 (447) 467 $2.407 Assets Cash Receivables Inventory Current assets Gross fixed assets (Accumulated depreciation) Net fixed assets Total assets Liabilities and Equity Notes payable-banks Accounts payable Accruals Current liabilities Term loans Common stock Retained earnings Total liabilities and equity $ 220 $ 162 150 157 $ 700 306 310 $1,316 157 $ 469 $ 654 $ 180 148 218 $ 546 374 50 716 $1,686 219 50 814 $1,737 859 $1,419 52.407 EXHIBIT 8 Spartan's Cash Flow 1992-1994 (000s) 1992 1993 1994 $ 96 $98 61 Net income Depreciation Cash flow operations - Adjusted working capital needs -Capital expenditures -Dividends Cash flow $ 45 55 $100 (96) $149 (80) $159 (20) 59 $189 $150 $137 Adjusted Working Capital 1992 1993 1991 1994 Accounts receivable Inventory - Accounts payable - Accruals Adjusted working capital Change adjusted working capital $707 476 148 218 $817 (80) $785 446 157 277 $797 (20) $580 428 150 157 $701 (96) 5897 PART II FINANCIAL ANALYSIS EXHIBIT 9 Financial Ratios for the Spartan Roofing Company: 1992-1995 1994 1995 1992-19 Liquidity Ratios 207 219 1.47 24 Current Quick Leverage Ratios Debt (%) Times interest earned Activity Ratios Inventory turnover (sales) 8.4 Fixed asset tumover Total asset turnover Average collection period 64 Profitability Ratios Gross margin() Net profit margin() 24 Return on net worth (3) 125 Return on total assets (5) 57 4.03 10.4 OS 5.8 The top number events the upper quantile figuremen en for each ratoare co w Ratios for all firms in the in what is considered as the middle number represents tems in the industry had to better than the median ratio and hall had per quante gure meaning 25 p ont of the firms had ratios better represents the low that of the famshad ratios won Katios for all firms in the industry are represents the median ratios all had ratios that were worse ratios better than this firms had ratios worse than this. CASE 8 SPARTAN ROOFING LOAN EVALUATION "The Spartan Roofing Company makes excellent products!" So concluded a laudatory independent report commissioned by a bank in 1996. THE SPARTAN ROOFING COMPANY The Spartan Roofing Company was established in 1951 as a sole proprietorship in Ohio. The company is an innovative manufacturer of aluminum roofing products. Its standard products include the safeguard gravel stop system, the reslet and expansion joint system, and a wide variety of roofing panel systems. The safeguard system, which is patented, is designed to correct three major problems encountered by the roofing industry-water leakage of joints, tar drippage on the exterior of the finished building, and shrinkage. The company's products are designed to favor both building owner and con- tractor. The building owner benefits because of design technology that ensures Spartan's materials will last many years with little maintenance. The contractor benefits because the materials are simple to install. As a result the firm's prod- ucts are extremely popular with the building industry, and many architects and engineers specify Spartan materials by brand name. Market studies support this claim and also indicate that Spartan could increase its market share substan- tially, given that the company has only a 5-percent share at present. Not sur- prisingly the firm is very strong in technical expertise; the engineering depart- ment is an important component of the business, and the development of new products is very much encouraged. Consequently, the company has been granted over eight patents in the last 20 years. While Spartan's technical expertise is unquestioned, the firm is a bit suspect in financial matters. Periodically it has had difficulties with such matters as in- ventory control and pricing. Historically, however, when the firm has experi- enced serious problems in an area it has been able to show improvement by the that Spartan has con fact, when one by the best-run com PART II FINANCIAL ANALYSIS following year. All things considered, there is little doubt that s. piled an impressive track record over the last 20 years. In fart evaluated Spartan in 1991 it concluded that this is one of the bi nies we have ever encountered in its size-sales category." In 1985, the firm relocated to Tennessee at the suggestion of Lawren the firm's CEO and son of the founder. The company's bank has bee since the move South, but Tennessee National Bank (TNB) has a sought Spartan's business. Since 1985 TNB has called on Wilson on 30 occasions and has made six different financing proposals. Wilson was reluctant to switch, though he almost left First City for TNB in Novemb because he was upset at First City for a reason never clear to TNB. Lawrence Wilson has been First TNB) has aggressive Wilson on more the in was always JOHN PATTILLA In December 1994 John Pattilla of TNB had written a 12-page memorandum rec ommending that the bank make a specific financing proposal to Spartan. Pattilla's analysis was quite thorough and included projections of the firm's sit. uation using a "best guess" or "most likely" and "worst case" set of assump- tions. (See Exhibit 1 for excerpts from his 1994 report, Exhibit 2 for his net in come projections, Exhibit 3 for his balance sheet projections, and Exhibit 4 for his "worst case" cash flow estimates.) Pattilla had a few conversations with Wilson to get information for the pro- jections. The final estimates, however, reflect Pattilla's assessment of the situa tion, and Wilson has never seen these numbers. Pattilla had recommended that TNB extend the company up to $700,000 in loans. The money would be used to finance Spartan's working capital and fixed-asset needs for anticipated strong sales growth from an expanding economy and the introduction of a number of new products. The company was especially excited about its new macrocarbide product line. Macrocarbide is known for its unusually long life and is therefore very useful in the roofing industry. It is now early 1996 and Pattilla has to decide whether TNB should make an- other proposal to Lawrence Wilson. As Pattilla leans back in his chair, he leafs through information on Spartan, and a number of items catch his eye. He smiles as he notices the nearly 40-percent increase in sales for 1995, an increase he pre dicted almost to the penny. Pattilla realizes, however, that Spartan musthi benefited enormously from the economic upturn, since the sales of its new ucts have not gone as well as expected. Especially disappointing were of Spartan's macrocarbide product line. It appears to Pattilla that growth is due more to an external factor outside the company's economy-than to internal factors under its control. He also note tapped the firm's line of credit with First City for over $500,000 all consistent with his 1994 projections. Pattilla knows that any involve a buy-out of First City and TNB's offer should be at Spartan's credit line with First City, or about $750,000. Patil les of its new prod- pointing were the sales tilla that the sales pany's control the o notes that Wilson 500,000, a result not at at any proposal would e at least the amount of illa had concluded his 51 CASE 8 SPARTAN ROOFING 1994 report by noting that "this represents an excellent opportunity for TNB." But now, nearly 14 months after he made that recommendation, Pattilla won- ders if he will reach the same conclusions as he begins his evaluation of Spartan's financial records