Great Lakes Industrial Supply, Inc. Chuck Kolias, Chief Financial Officer of Great Lakes Industrial Supply, Inc. was preparing for a meeting with his companys bank later in the week. At that meeting, Mr. Kolias intended to present a request that the bank grant Great Lakes Industrial Supply a five-year loan to finance anticipated growth in the company and the expansion of the companys warehouse facilities. In preparation for his meeting, Mr. Kolias had gathered some recent financial statements for Great Lakes. (see Excel template and Exhibit 1). Company Background Great Lakes Industrial Supply, Inc (Great Lakes) was a rapidly growing distributor of industrial hoses, fittings and related supplies in the upper mid-west United States. Supplies were sold to industrial clients through a chain of 12 outlets located throughout Ohio, Pennsylvania Michigan, and Illinois. These outlets kept sufficient inventory on hand to service immediate customer demand, but the bulk of Great Lakes inventory was managed at a central warehouse outside Cleveland, Ohio. Individual stores could be easily serviced by this warehouse, which could usually fill orders from individual outlets within 24 hours. For the year ended December, 2019, Great Lakes had sales of $23,505,000. Net income for that period was $1,190,000. During the previous three years, sales had grown at a compound annual rate in excess of 20%. This record was a reflection of Great Lakes reputation for excellent service and competitive pricing, which yielded high levels of customer satisfaction. Past Relationship with SkyBank In 2015, Great Lakes had borrowed funds from SkyBank to build a warehouse. This loan was being repaid in equal annual installments of $125,000. At the end of 2019, the balance due on the loan was $875,000. Also, in 2015, Great Lakes established a line of credit at SkyBank. The company had not yet borrowed any money under this credit arrangement. The Current Financial Need Great Lakes had decided to expand its warehouse facilities to accommodate future growth. Indeed, the current warehouse facilities were practically bulging at the seams. During the next 18 months, Great Lakes planned to invest $2,400,000 on its expansion, $2,000,000 of which would be spent during 2020 (no other capital expenditures were planned for 2020 and 2021). This expansion would fulfill the companys anticipated needs for several years. The warehouse construction project was expected to be completed in early 2021. Therefore, Great Lakes would not be able to deduct any depreciation on the new building in 2020. However, Mr. Kolias was told by his accountant that in 2021, Great Lakes could recognize a depreciation expense of 5% of the warehouses total cost. The dollar value of Great Lakes depreciation expense on its other assets in 2020 and 2021 would be the same as it was in 2019. The warehouse expansion project was designed so that disruption of the companys current operations would be minimized. However, management expected that by the end of 2020, Great Lakes would temporarily have to decrease its inventories to a level of $1,625,000, significantly lower than the $2,190,000 shown on the balance sheet at the end of 2019. This cutback in inventories was expected to last only until the warehouse construction project was completed in early 2021. Mr. Kolias had estimated that, by the end of 2021, inventory would rise back to the proportional relationship to sales that it had in 2019. Other than this temporary drop in inventory in 2020, the warehouse expansion was not expected to affect Great Lakes operations in any other material respects. Operating margins were expected to be consistent with recent past experience (the temporary drop in inventory would not affect cost of goods sold as a percentage of sales, for example). Likewise, current accounts other than inventory were expected to maintain steady relationships to sales. Cash balances, for instance, would be maintained at a level of 3% of sales during the next two years. Although the Federal statutory marginal corporate tax rate was 35%, the average tax rate on Great Lakes pretax income had typically been higher than this due to miscellaneous local taxes. The higher overall level of taxation was expected to continue in the future at rates consistent with the most recent past experience. In view of this anticipated stability, Mr. Kolias expected Great Lakes dividend payout policy to remain unchanged in the foreseeable future. Great Lakes had preliminary discussions with SkyBank about borrowing money to finance the warehouse expansion and the growth of the business. The proposed terms of the financing called for taking down (i.e., borrowing) the loan in two separate parts on an as-needed basis: one in 2020 and one in 2021. The loan would be repaid in four equal annual installments. The first installment payment would take place one year after the construction of the warehouse was completed (i.e., in 2022). The interest rate was set at 10% per year. Mr. Kolias Task In preparation for his meeting, Mr. Kolias intended to develop a set of pro forma financial statements for the company. He and his staff had projected a 20% increase in sales each year in 2020 and 2021 from $23,505,000 to $28,206,000 and $33, 847,000, respectively. Mr. Kolias first priority was to predict what the rest of the income statement and the balance sheet for the firm would look like at the end of 2020 and 2021.

Exhibit 1 Financial Statements for Great Lakes Industrial Supply, Inc.

(amounts are in $000)

For years ending 12/31 2017 2018 2019

INCOME STATEMENT

Net sales $ 16,230 $ 20,355 $ 23,505

Cost of sales 9,430 11,898 13,612

Gross Profit 6,800. 8,457 9,893

Administrative expense 5,195 6,352 7,471

Depreciation 160 180. 213

Net interest expense 119 106 94

Pre-tax income (EBT) 1,326 1,819 2,115

Income taxes 546 822 925

Net income $ 780 $ 997 $ 1,190

Dividends $ 155 $ 200 $ 240

BALANCE SHEET

Assets

Cash balances $ 508. $ 609 $ 706

Accounts receivable 2,545 3,095 3,652

Inventories 1,630 1,838 2,190

Total current assets 4,683 5,542 6,548

Gross plant & equipment 3,232 3,795 4,163

Accumulated depreciation 1,335 1,515 1,728

Net plant & equipment 1,897 2,280 2,435

Total assets $ 6,580 $ 7,822 $ 8,983

Liabilities

Current maturities long-term debt $ 125 $ 125 $ 125

Accounts payable 1,042 1,325 1,440

Accrued expenses 1,145 1,432 1,653

Total current liabilities 2,312 2,882 3,218

Long-term debt 1,000 875 750

Common stock 1,135 1,135 1,135

Retained earnings 2,133 2,930 3,880

Total shareholders' equity 3,268 4,065 5,015

Total liabilities and Equity $ 6,580 $ 7,822 $ 8,983

Assignment:

3	Assess the financial health of Great Lakes Indusrial Supply, Inc. in past and forecasted periods. Specifically, calculate the financial ratios defined in the worksheet financial ratios and interpret the results.
	Will Great Lakes Industrial Supply be in a stronger or weaker financial condition two years from now?
4	Suppose that the proposed terms of the bank credit included a covenant (a contractual obligation that binds the borrower to specific actions or outcomes as a condition for extending a loan) that read as follows: "The company must maintain net working capital (defined for purposes of this loan as accounts receivable plus inventories minus accounts payable) of at least $4 million. For purposes of this covenant, net working capital will be measured at the end of each fiscal year." Is Great Lakes likely to be able to satisfy this covenant in both 2020 and 2021?