Problem: Evaluate the financial plans to determine whether or not the organization has met its financial goals. If any of the goals have not been met, modify financial plans based on organizational performance goals. Prepare a 700-word paper describing your evaluations and modifications. Include your recast pro forma financial statements with your paper.
Case scenario:
It was a cold, raw Saturday afternoon in mid-January 2003. But inside, Paul Smith relaxed, leaned back in his chair, and warmed himself by the crackling fireplace in his northern California home. He was relatively pleased with the preliminary pro forma financial statements he was looking at. As chief financial officer of Western Building Supply, Inc. (WBSI), it was his job to lead the company through its annual financial planning exercise. This process, begun three months ago, involved extensive meetings with more than 60 business unit vice presidents, during which he obtained estimates that were ultimately rolled into a comprehensive three-year forecast for WBSI covering the years 2003 to 2005. He smiled as he glanced at the income statement. Both sales and net income were expected to just about double over the next three years. He felt that everything must be on track and that his bonus was ensured for the foreseeable future.
Business Strategy and Industry:
The past few years had been extremely good for Western Building Supply. The company specializes in providing construction services and high-quality business materials to residential builders and contractors in 14 western states and 3 southern states. Spurred on by 40-year lows in interest rates, the construction industry has boomed, and along with it, Western’s business. WFBI fabricates roof and floor trusses, purchases and pre-assembles doors, and distributes preassembled windows. They also participate in the turnkey framing and shell construction market. The company’s target customers are professional builders and contractors who are high-volume, repeat customers who require specialized engineering, manufacturing, and installation services, on-time job-site deliver and volume purchasing and trade credit. WSBI does not compete with the large chain do-it-yourself retailers who generally sell to retail consumers in small quantities and with limited services. Therefore, Western is able to develop and cultivate long-term relationships with homebuilders and contractors who generate a large volume of repeat business. This works to Western’s advantage because the industry is generally characterized by a large number of small, privately owned companies ranging from single crew framing and shell contractors to larger multicrew businesses.
Product Mix:
Over the years, Western Building Supply had been steadily decreasing their reliance on commodity wood products and increasing their business mix toward construction services. Wood product prices are subject to significant volatility that directly affects sales. Currently, prices are the lowest they have been for the last nine years and are expected to remain low for the remainder of at least this year, if not next year as well. Still, wood products accounted for nearly one-third of total sales last year, down from 36 percent the year before. On the other hand, construction services and manufactured building components accounted for 54 percent of total sales last year, up from 48 percent the year earlier. This business is relatively more attractive than lumber and building materials distribution because it has higher operating margins on less invested capital, is subject to less price volatility, and is subject to more fragmented competitors.
Customers:
Western focuses on two principal customer categories in the residential construction market: large, high-volume production homebuilders with national or multiple-market operations, and local custom-design and smaller production homebuilders. High-volume
homebuilders accounted for 19 percent of sales last year, versus only 9 percent the year before. In contrast, local homebuilders accounted for 66 percent of sales, down from 73 percent in the year earlier period. The final customer category includes commercial and industrial contractors. These customers accounted for 15 percent of sales last year and 17 percent the year before. Because local homebuilders are still the largest customer category, Western employs a sales force of 370 field sales representatives that are supported by 270 inside salespeople. In total, Western employed 6,900 as of the most recent year end. Only 284 of these were represented by a union.
Evaluation of Financial Plans:
Now that the pro forma financial statements were completed, it was time to take a short breather before putting the statements through a stress test. These tests involved evaluating the pro formas in Table 2-9 to determine whether they met the firm’s performance and financial goals. Smith knew these goals all too well because his incentive compensation was dependent on the company meeting them. He also knew that the Western would not be inclined to issue any new common stock in the foreseeable future. Specifically, the company’s financial goals were as follows:
• Annual growth rate of net income of 20 percent or more
• Net profit margin of 2.0 percent or greater
• Return on invested capital of 7 percent or more
• Debt to capital ratio less than 60 percent, where capital is computed as notes payable + current maturities of long-term debt + long-term debt + total equity
Before getting back to his spreadsheets, Smith thought he would relax a bit more, drink another glass of wine, and enjoy the warmth of his fireplace.
Required:
• Construct common size income statements and balance sheets for 2001 to 2005.
• Calculate annual percentage changes for both the income statements and balance sheets for 2002 to 2005.
• Compute financial ratios for Western for 2001 to 2005. Use the ratios given in the text for the FoodCo example.
• As a result of your analysis, describe any problem areas you find.
• Make one pass at changing assumptions and modifying the pro forma financial statements so that the financial goals are met.
Describe the type of changes Western Building Supply could make that are consistent with your changed assumptions.
• Write a two- to three-page paper describing your analysis and results.
FIN 404: Advanced Topics in Financial Management, Section Two
Page 93
Table 2-9
Western Building Supply, Inc.: Historical and Pro Forma Financial Statements
Income Statement (millions) 2001 2002 2003 est 2004 est. 2005 est.
Sales $1,319 $1,517 $1,857 $2,449 $3,523
Cost of sales $924 $1,066 $1,317 $1,750 $2,532
Gross profit $395 $451 $540 $699 $991
Selling, general, and administrative
expenses $319 $365 $437 $566 $810
Depreciation expense $22 $26 $34 $46 $67
Earnings before interest and taxes $54 $60 $69 $87 $114
Interest income $0 $0 $0 $0 $0
Interest expense $16 $23 $23 $25 $39
Pre-tax income $38 $37 $46 $62 $75
Income taxes $15 $14 $18 $25 $30
Net income $23 $23 $28 $37 $45
Dividends $5 $5 $5 $7 $9
Balance Sheet (millions) 2001 2002 2003 est 2004 est. 2005 est.
Assets
Cash $10 $11 $14 $19 $28
Short-term investments $0 $0 $0 $0 $0
Accounts receivable $152 $177 $221 $298 $463
Inventories $110 $130 $164 $222 $326
Other current assets $15 $18 $22 $29 $42
Total current assets $287 $336 $421 $568 $859
Gross property, plant, and equipment $307 $365 $453 $620 $912
Accumulated Depreciation $102 $128 $162 $208 $275
Net property, plant, and equipment $205 $237 $291 $412 $637
Other non-current assets $87 $100 $123 $162 $234
Total Assets $579 $673 $835 $1,142 $1,730
Liabilities & Owners' Equity
Accounts payable $89 $104 $129 $172 $250
Notes payable $47 $109 $222 $451 $916
Current maturities of long-term debt $3 $3 $3 $3 $3
Other current liabilities $4 $5 $6 $8 $11
Total current liabilities $143 $221 $360 $634 $1,180
Long-term debt $154 $151 $148 $145 $142
Other non-current liabilities $13 $14 $17 $23 $32
Total liabilities $310 $386 $525 $802 $1,354
Common stock $112 $112 $112 $112 $112
Retained earnings $157 $175 $198 $228 $264
Total equity $269 $287 $310 $340 $376
Total liabilities and owners' equity $579 $673 $835 $1,142 $1,730