A family-owned manufacturing tool producer has managed to maintain stable sales numbers throughout recent years even while the Housing market as a whole was on a negative trend. While this should translate into higher profit margins, the exact opposite trend has occurred. The solution to Strong Tie’s financial problems is an increase in prices of goods and salary cuts. Beginning in 2006 where Strong Tie has Sales of 16. 2 million, the company maintained healthy sales between the 16 and 17. 5 million. However Operating Income decreased by 29% and then another 75% the following year.
Two main factors led to this trend: COGS and Depreciation. After analyzing the way Strong Tie has managed their goods. Their Raw Material Turnover was close to par with benchmark numbers at 27 days which means they have been converting the raw materials into finished goods on exceptional timing. The days in Work in Progress was also progressing at a healthy rate going from 4. 5 days in 2006 to nearly 1 day in 2008. In other words, they were able to finish goods at faster rates. With these two healthy rates, there should have been increasing profits, however one variable was stopping it from happening; Days in Finished Goods.
Strong Tie’s most profitable year was 2006 where days in finished goods was 45 which was close to on par with the benchmark of 51. But by 2008, Strong Tie had finished goods flying off the shelves by 26 days. If customers are buying the products this fast, the prices of these goods are way too low which has resulted in a substantial loss of profit. Therefore the first recommendation would be to increase prices substantially. Depreciation on the other hand was expected to occur but the cost nearly doubled in 2006 from 396k to 720k in 2008 most likely from a major breakdown of equipment and repair costs.
Depreciation costs may also have derived from Strong Tie investing on new automated feeders and packaging equipment. So while the balance sheet shows increasing rates of depreciation and selling expenses, expect those costs to lower once again. This investment also has the potential to speed up the rate at which raw materials are converted into finished goods. With more finished goods to sell at higher prices, Operating Income will see a growing trend. Another cause of concern in Strong Tie is the extra dividends that are being paid along with the Salary bonuses.
First off the 1 million dollar bonus to the three daughters equates to about 350k per daughter. That type of salary is not justifiable to three employees and is negatively affecting the retained earnings to the business. The 500k being paid every year to someone that has no relationship to the business at all is also a waste of potential gains. Two recommendations here would boost retained earnings significantly. First off the salary of the three daughters needs to be significantly lowered. It would be preferred to hire new employees to fill that position and get paid reasonable wages.
Second, it would be in the company’s best interest to seek out a new shareholder for the 500k in dividends being paid every year. Current shareholder needs to be replaced with someone with vision for the company that attends the roundtable meetings and contributes their input to the overall goals of the company. One topic that has the potential to become an issue is the financing of the credit agreement with the Bank of Nova Scotia. Financing is guaranteed only if Strong Tie is able to maintain a variety of benchmarks. First a current ratio of 1.5 or higher was needed.
The company started out strong in 2006 with a ratio of 5 but has declined to 3. 13 in its most recent year. This decreasing rate is not too threatening however because the use of resources will be more efficiently used with the new equipment and automatic machinery that has been purchased. The company needed to follow a Long-term debt to Total Capitalization Ratio of 40% or less and has been able to but again is getting closer to that benchmark. The reason for that was the risk that it has taken undergoing the same investment in new capital.
The one area that Strong Tie is currently struggling with in the benchmarks they need to maintain is Cash Flow Coverage. They need to maintain over 1, but that number dropped to . 57 in 2008. One of the reasons why this number has dropped below the requirement is because of the increasing cost of depreciation that has been accumulating that is being paid for. Once the company raises its prices on how much they sell their goods for will the Cash Flow Coverage go back to its requirement since Depreciation costs should already be on the process of lowering with the new equipment.
Strong Tie’s investment in automation currently has the company on edge at the moment with its net income, but in time that investment will pay off. While the demand for houses in the market went down significantly during this period (2006-2008), Strong Tie has maintained stable sales numbers partly because of how low the prices have been. While 2008 was Strong Tie’s weakest year from an income standpoint, lenders (particularly Bank of Nova Scotia) should not worry as long as Strong Tie increases the prices of goods so that the Cash Flow Coverage ratio returns to normal.
While financing may appear to be in danger currently, the current capital will hold the spine together of this company until these changes are made. Finally the last major changes needed are to the salaries being paid to Johnstone’s three daughters and a potential new shareholder. Once this annual cost of 1. 5 million is eased and with increased prices to sales goods we will see Strong Tie becoming profitable again.