Micro Tiles Limited

Case 1: Look Before You Leap

In June of 2014, Bill Madden considered expanding his micro tiles business. He planned to invest $2.0 million in 2016 to produce more and better quality plaster or metal tiles and lithographs. These silver and golden ornate tiles can be hanged individually or displayed as a collection of various themes (i.e., sports, outdoors, wildlife, music, actors, religion) on living, dining, bedrooms or family room walls. Although Bill had ten years of experience as an artist in designing and developing these products, he had little experience in managing a business. He realized that this was his greatest weakness and was preventing his business from growing to its full potential. He therefore asked his son, Robert, who had graduated in engineering and held a masters degree in business administration, to join his firm. Robert had six years of experience with a major consumer products company.

Management's Background

Prior to starting his business, Bill Madden had worked for twenty-five years in communications services for several federal government departments. When he took an early retirement in 2003 at the age of 50, he decided to realize his dream of starting his own business. At the time of incorporation in 2008, sales began to accelerate and the company moved from a hobby business to a full-time operating entity. That year, he decided to move the operating facilities from the basement of his house to a small space that he rented in an industrial park. Bill enjoyed the artistic side of the business. He liked to draw images. His friend, Harry Freeman, also a former federal public servant joined him in 2008. He was responsible for sales and general administration.

When Bill started his business, he sold his reproductions through small independent kiosk operators and even rented some himself on a short-term basis. He also advertised his products in catalogues to a wide-range of retail outlets particularly in the giftware business. As revenue continued to soar in 2014, he realized that he needed to invest money into his business and make his production operations more automated. Both Bill and Harry felt that they needed professional help since they had no qualifications and experience in managing a business that required skills in the field of marketing, human resources, production, and finance. For that reason, they asked Robert, Bill's 31-year-old son to join the business and become president of Micro Tiles. Bill would be responsible for the product design a key factor in the success of the business. Harry would be responsible for sales and marketing activities, and Robert, as president, would be responsible for general administration.

Micro Tiles Limited

In 2014, Micro Tiles Limited was showing substantial growth. Revenue went from $1.0 million in 2011 to $2.0 million in 2014 (see appendix A). This huge gain was a result of some sales agreements that Bill had signed with several giftware retailers. His catalogues also helped his business to gain some recognition. A wide variety of consumer outlets and consumers were becoming acquainted with Micro Tiles products. Even some major retailers began to show an interest in carrying his product lines.

Bill signed a sales agreement in March, 2014with a major retailer. The retailer would market Bill's products on a trial basis in several stores across Canada. After several months, the consumer response appeared to be positive and Micro Tiles was becoming recognized as a leading monthly sales consignment supplier. This helped generate a 48% sale increase in 2013 (from $1,058,000 to $1,564,000).

As the relationship with several retailers matured, Micro Tiles introduced several changes in the way of manufacturing and marketing the products. In the past, the company created a tile followed by a promotional plan. Now, the development of new products would be based on consumer research and social trends. For example, the company would develop new product lines as a tribute to a successful sport's heroes. Retailers and consumers both showed considerable interest in this marketing scheme and this was considered the cornerstone of Micro Tiles' success.

Marketing Strategy

Based on the data published by various industry sources, the memorabilia market was in a growing phase. The size of the market and the demand for products regarding "themes" or "celebrities" encouraged some medium-sized retailers to buy these types of products. Smaller retailers such as gift shops and even major department stores started to carry this line that they described as "commemorative" items. When Bill talked to store managers, they all showed an interest for tiles with NASCAR, basketball, Olympics, sport fishing, and other specialized baseball and hockey themes.

Since 2003, Bill was responsible for all activities in his business, a sort of jack-of-all-trades. He designed, produced, and sold the products and thus became very knowledgeable about his products, the market, the retailers, and consumer tastes. Bill learned that:

• Each product has its own shelf life (i.e., 6 months) and a lot depended on the location before it reached full maturity.
• Products that did not meet sales objectives within a prescribed time frame were considered a "flop" and removed from the store shelves.
• Floor store location was considered vital to a product's success and turnover.
• Slow-moving products lost their "premier" floor location.
• Slow-moving products significantly tied up cash flow.
• Distributors were considered too expensive. They wanted a 100% mark-up.

With this background, Bill adjusted his marketing strategies.

Distribution Strategy

In order to product effective and efficient service,Micro Tiles distributed its products through a courier company. The process was simple:

• Individual department stores placed orders directly with Micro Tiles.
• Micro Tiles would keep sufficient inventory on hand to meet product demand for the more popular tiles.
• The courier accepted a total of 10 tiles per case.
• The courier picked up the packages and delivered them directly to the retail stores.

The company was able to ship the products for less than any department store's distribution and warehousing facilities. Micro Tiles adopted this distribution strategy since it was considered the most cost-effective method.

Products and Pricing Strategy

Micro Tiles had a "standard" product line that was offered through its catalogue; a total of 25 images. These 12" 15" images were considered standard size and made of either plaster or metal. All products had original designs. Once a model was created, it went into production. Each item was hand-finished with appropriate solutions before shipment. Over the years, this process was perfected and the quality of each reproduction was considered "flawless" or using conventional business terminology, "zero-defects". The per-unit cost (including shipping and packaging) was in the $20.00 range and sold for $59.95 less commission.

Micro Titles developed their first "premium" products with several hockey, golf and baseball idols. Although the production process of these items was the same as the standard products, incremental costs associated with marketing each piece had to be taken into account. For instance, the licensing cost for producing the image of a hockey idol was $5 per unit.

A list of product lines such as Canadian hockey images, NASCAR images, golf images, basketball images, etc. was designed and presented to several retailers and they were very interested. These images would be considered the imperative for the company's sales efforts and future success. The traditional product line would be marketed jointly with the new images. These niche products were considered to have exceptional marketability and expected to boost sales volume.

Robert's Vision and Plans

Robert spent several weeks listening to his father's objectives and plans and was encouraged by what he heard. However, after looking at the company's 2011 to 2013 actual financial statements, he had some reservations about the financial strength of the business. Robert was working as a product manager for an international consumer products company and was earning a good salary; he liked the financial stability. He was married and had two children.

Robert decided that before he "leaped" into his father's business, he would closely examine the profile of each financial statement to determine whether or not it was possible to make Micro Tiles a profitable venture. There was nothing much that he could do about the 2014 estimated year-end financial results. The company was already in its fourth quarter and based on some rough estimates, Robert estimated that it would end the year with a $47,000 profit, just $6,000 more than the previous year.

Robert had little reservations about the sales estimates. He felt that revenue would continue to increase in view of the good quality product lines and the good working relationships that Bill had nurtured over the years. However, he felt that the operating costs were a big obstacle for the company's success. Robert made the following statement in a meeting with his father Bill and friend Harry Freeman:

"I'm very interested in joining the company. However, I have to be assured that I will be given "carte blanche" about how this business should be managed. We have to make some major changes in our cost structure. I'm glad that in a more automated production process was installed in 2014. If we use that production process effectively, we could considerably improve the company's bottom line. I have made some financial projections for the year 2015 and would like to review them with you. If you agree with these plans, I think that we have a good chance of turning the financial statements into a healthier state. The challenge will be to change the way we do things. This will have to take place now. If we succeed and are patient, I firmly believe that Micro Tiles will become a leader in the giftware and memorabilia industry. My intention is to increase our return on sales for 2015 and plan for a major $2.0 million investment in 2016."

The following paragraphs describe the planning assumptions for the statement of income and the statement of financial position for the year 2015.

Financial Statements

Micro Tiles' three financial statements: the statements of income, the statements of changes in equity and the statement of financial position for the years 2011 to 2014 are presented in Appendix A. Although revenue doubled between the years 2011 to 2014, the company's profit for the year remained relatively flat. Bill was able to increase the company's revenue but had problems in keeping his costs in line.

The statement of financial position indicated that total assets increased substantially from $450,000 in 2011, to $1,132,000 in 2014. In 2011, approximately 67% of the company's assets were financed by debt, a ratio that remained unchanged during the four-year period. This meant that every time assets were purchased, 67% was financed by debt, and the rest, equity.

In 2014, Bill decided to invest $300,000 in his business to purchase new production equipment in order to meet product demand and more importantly, improve plant efficiencies. Bill re-mortgaged his house and obtained $100,000 from the bank for the purchase of these assets.

Financial Projections

When Robert considered joining the company in October of 2014, he realized that his first task was to bring about changes in the business that would have positive effects on both the statement of income and the statement of financial position. If the company wanted to invest $2.0 million to expand its operations in 2016, he knew that some cash would have to be generated internally. He could not continue relying on 67% external funding. This meant going through a cost-reduction program in addition to reducing the level of working capital accounts such as inventories and trade receivables.

Statement of Income Planning Assumptions

Robert's first objective was to boost operating efficiencies. He wanted to improve the company's return on revenue from 2.3% in 2014 to 9.0% in 2015. He was confident that this could be realized by substantially cutting back on production costs. Based on some preliminary figures, he estimated revenue to increase by 8% in 2015, or reach $2.2 million.

In 2014, cost of sales as a percent of revenue was 76.6% and he wanted to bring it down to 64.0% by 2015. Here are Robert's 2015 cost of sales estimates for individual expense items:

Purchases $850,000

Freight in 84,000

Labour 460,000

Depreciation/amortization 25,000

As far as marketing activities are concerned, Robert wanted be more aggressive. Distribution costs for 2015 were estimated as follows:

Salaries $ 70,000

Commissions 80,000

Travelling 35,000

Advertising 30,000

Depreciation/amortization 10,000

The administrative expense projections for 2015 were to remain flat compared to 2014. However, as a percentage of /, these expenses would also show an improvement in efficiencies. Finance costs would show a substantial increase in view of the extensive debt financing obtained from the bank for the purchase of new assets. He estimated administrative expenses and finance costs to be as follows:

Salaries $ 120,000

Leasing 40,000

Depreciation/amortization 25,000

Other charges 13,000

Financing costs 110,000

Statement of Changes in Equity Planning Assumptions

The only four numbers to be inputted in the statement of changes in equity (retained earnings) are:

In the first template under the year 2011:

- under common shares, for the balance at the beginning of year: $25,000.

- under retained earnings, for the balance at the beginning of the year for retained earnings: $87,000

In the second template under the year 2013:

- under common shares, common shares issued: $25,000.

- under retained earnings, for the balance at the beginning of the year for retained earnings: $171,000.

Statement of Financial Position Planning Assumptions

There were two major improvements that Robert wanted to realize in 2015. Reduce the level of investments in inventories and trade receivables. His objective was to increase the inventory turnover (based on cost of sales) from 5.3 times to 8.1 times in 2015. This target was also based on industry averages and benchmarks. He also wanted to reduce the average collection period from 71.1 days in 2014 to 47 days in 2015. This objective was based on some financial benchmarks that he had obtained from his banker.

With these changes in inventories and trade receivables, he felt that he could increase Micro Tiles' internal cash flow which would then help finance the purchase of the $300,000 non-current assets.

The current asset accounts were estimated as follows:

Inventories $ 175,000

Trade receivables 285,000

Prepaid expenses 4,000

Cash and cash equivalents $ 25,000

Short-term deposits 100,000

As previously indicated, Robert expected to invest an additional $300,000 in non-current assets in 2015. As a result, the estimated accumulated depreciation/amortization would increase by $60,000. Goodwill would be maintained at the $14,000 level.

On the equity and liability side of the statement of financial position, Robert wants to reduce working capital loan and long-term debts. His strategy was to improve the company's debt-to-total assets ratio in order to have some leverage for obtaining additional financing in 2016 that would be used for the $2.0 million investment. The following are his estimates for the year 2015:

Share capital $ 125,000

Non-current liabilities 270,000

Trade and other payables 235,000

Short-term borrowings 120,000

Accruals 36,000

Micro Tiles' weighted average cost of capital for the years 2013 to 2015 is estimated at 10%.

Break-Even Point Cost Assumptions

Robert felt that the company's break-even points for the years 2013 and 2014 were not healthy and by going through a cost reduction program, he was aiming for a significant improvement in 2015. He estimated that 75% of the cost of sales for "labour" to be variable and the other 25%, fixed.

Cash Budget Assumptions for the Year 2015

Robert understood that the only way to realize his 2015 financial objectives would be to follow his monthly expenses like a hawk; therefore he decided to prepare a cash budget. Instead of waiting for quarterly or year-end results, he wanted to follow every cost item as the year progressed. The monthly revenue and cost breakdown is as follows:

$000s Revenue Purchases Labour Commissions Travel

January $150 $60 $30 $6 $2

February 160 60 32 6 2

March 170 80 35 6 3

April 200 80 40 7 3

May 200 80 50 7 3

June 200 90 48 7 4

July 230 90 50 8 4

August 220 70 45 8 4

September 190 60 35 7 3

October 180 60 35 6 3

November 160 60 30 6 2

December 156 60 30 6 2

Total $2,216 $850 $460 $ 80 $35

As far as revenue is concerned, 20% of the customers paid on a cash basis and 80%, the month after. For purchases, 50% was paid on a cash basis and the rest, the following month.

Monthly breakdown for other costs are as follows:

Freight in: $7,000 (Jan. to Dec.)

Salaries-Distribution: $5,000 (Jan. and Feb.) and $6,000 (March to Dec.)

Advertising: $2,000 (Jan. to April and Nov. to Dec.) and $3,000 (May to Oct.)

Salaries - Administration: $10,000 (Jan. to Dec.)

Leasing: $3,000 (Jan. to Aug.) and $4,000 (Sept. to Dec.)

Other - Administration: $1,000 (Jan. to Nov.) and $2,000 (Dec.).

Finance costs: $7,000 (Jan. to May), $9,000 (June to Aug.) and $12,000 (Sept. to Dec.)

Beginning bank balance: $70,000

Question: Make an analysis of the company's financial statements for the years 2011, 2012 and 2013 (actual), 2014 (year-end estimates), and 2015 (forecast). This information can be drawn from the following templates:

Template 4: Statement of Sources and Uses of Funds

Template 5: Statement of Cash Flows

Template 6: Vertical Analysis of the Statement of Income

Template 7: Horizontal Analysis of the Statement of Income

Template 8: Vertical Analysis of the Statement of Financial Position

Template 9: Horizontal Analysis of the Statement of Financial Position

Template 10: Financial Ratios

Template 11: Du Pont System

Template 12: Cash Flow and EBITDA

Template 13: Economic Value Added

Template 14: Sustainable Growth Rate

Template 15: Financial Health Zone