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 reglet 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
contractor. 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 products 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 substantially, given that the company has only a 5-percent share
at present. Not surprisingly the firm is very strong in technical expertise; the
engineering department 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.
50 PART 11 FINANCIAL ANALYSIS

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
inventory control and pricing. Historically, however, when the firm has
experienced serious problems in an area it has been able to show improvement
by the following year. All things considered, there is little doubt that Spartan
has compiled an impressive track record over the last 20 years. In fact, when
one bank evaluated Spartan in 1991 it concluded that "this is one of the best-
run companies we have ever encountered in its size-sales category."
In 1985, the firm relocated to Tennessee at the suggestion of Lawrence
Wilson, the firm's CEO and son of the founder. The company's bank has been
First City since the move South, but Tennessee National Bank (TNB) has
aggressively sought Spartan's business. Since 1985 TNB has called on Wilson
on more than 30 occasions and has made six different financing proposals.
Wilson was always reluctant to switch, though he almost left First City for
TNB in November 1993 because he was upset at First City for a reason never
clear to TNB.

JOHN PATTILLA
In December 1994 John Pattilla of TNB had written a 12-page memorandum
recommending that the bank make a specific financing proposal to Spartan.
Pattilla's analysis was quite thorough and included projections of the firm's
situation using a "best guess" or "most likely" and "worst case" set of
assumptions. (See Exhibit 1 for excerpts from his 1994 report, Exhibit 2 for
his net income 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
projections. The final estimates, however, reflect Pattilla's assessment of the
situation, 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
another 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 predicted almost to the penny. Pattilla realizes, however, that
Spartan must have benefited enormously from the economic upturn, since the
sales of its new products have not gone as well as expected. Especially
disappointing were the sales of Spartan's macrocarbide product line. It appears
to Pattilla that the sales growth is due more to an external factor outside the
company's control—the economy—than to internal factors under its control.
 CASE 8 SPARTAN ROOFING 51

He also notes that Wilson tapped the firm's line of credit with First City for
over $500,000, a result not at all consistent with his 1994 projections. Pattilla
knows that any proposal would involve a buy-out of First City, and TNB's
offer should be at least the amount of Spartan's credit line with First City, or
about $750,000. Pattilla had concluded his 1994 report by noting that "this
represents an excellent opportunity for TNB." But now, nearly 14 months after
he made that recommendation, Pattilla wonders 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
recommendation 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.)
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
depreciation) was its highest during the 1992—1995 period. Yet its need
for external 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
forecast 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 replacement 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.
52 PART 11 FINANCIAL ANALYSIS

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 liquidation 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.
8. Based on your previous answers and information in the case, do you
recommend that TNB seek Spartan's business at the present time (early
1996) and offer a $750,000 buy-out of First City? Fully support your
recommendation. (Note: Do not consider any smaller loan amount, and
assume the offer would involve a six-year term loan with the principal paid
in equal amounts each year.)
9. What additional information would help you make a more informed
decision in question 8?

B SOFTWARE QUESTION
10. Attention instructors: Questions 6 and 8 should probably not be assigned
if 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
following scenarios (1997 capital spending is $50(000) in all scenarios).

Annual sales growth .05 .02 .05 .02

Net income /sales .024 .018 .028 .02
Average collection period 60.00 65.00 55.00 60.00
Sales/inventory 8.00 7.00 8.00 7.00
(AP & accruals)/sales .10 .10 .10 .10
Capital spending (1996) 120.00 80.00 120.00 80.00

Note: AP refers to accounts payable.

S-l and S-2 represent Pattilla's best-guess (most-likely) and worst-case

forecasts, respectively, assuming no additional concrete information about
Spartan Roofing.
S-IA and S-2A are based on a recent conversation that Pattilla had with
Lawrence Wilson, the owner. Wilson claimed that he is going to "implement
sounder credit policies," and "eliminate some production inefficiencies."
 CASE 8 SPARTAN ROOFING 53

Pattilla has not had time to carefully examine these claims, and wonders if
these changes "would make any difference, anyway, assuming Wilson is
right."
Perform the appropriate analysis. What would you recommend to Pattilla?
Defend your advice.
54 PART 11 FINANCIAL ANALYSIS

EXHIBIT
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
generated 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
expenses incurred by a former salesman of the company. Lawrence hired a
salesman who was very expensive but did not produce. As a result, selling
expenses 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
(continued)
 CASE 8 SPARTAN ROOFING 55

sales growth and the fixed-asset needs of the company, the company will
not be in a position to begin repaying any of the principal on the debt until
1997."
• "Even my 'worst case' cash flow forecast indicates that Spartan will have
sufficient funds to repay sizeable chunks of any new debt beginning in
1997." (See Exhibit 4.)
1
(Continued)

• "I recommend we finance Spartan's working capital and fixed asset needs.
This will require up to $700,000. I also recommend that we do not amortize
any of the loans for two years. The loans would be secured by the accounts
receivable, 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
several 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."

(continued)
56 PART 11 FINANCIAL ANALYSIS

EXHIBIT

(continued)

Cash $50 $60

 CASE 8 SPARTAN ROOFING 57

Receivables 833 993 1,193 816

Inventory 694 776 736 931 680

Current assets $1,510 $1,567 $1,519 $1,669 $2,184 $1,536

Gross fixed assets 929 929 1,309 1,309 1,339 1,339
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.a w.c,b B.G. W.C. BOG. W.C.

Sales $5,400 5,000 $6,500 5,300 $7,800 4,900

Net income $135 75 $162 80 $195 74
a
B.G. is the "best guess" ("most likely") forecast and assumes sale will increase by 37 percent in 1995, 20 percent in
1996, and 20 percent in 1997. Net income is assumed to be 2.5 precent of sales. b W.C. is a "worst case" forecast that
assumes net income will be 1.5 percent of sales.

EXHIBIT 3
Pro Forma Balance Sheets for the Spartan Roofing Company: 1995—1997 (OOOs)
(Developed by John Pattilla for TNB in 1994)
1995 1996 1997

B.G.a W.C. W.C.

Assets

$21738
'B.G. refers to a "best guess" ("most likely") forecast that incorporates these assumptions:(l) 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

(continued)
58 PART 11 FINANCIAL ANALYSIS

EXHIBIT

EXHIBIT 3
(Continued)

1995 1996 1997

B.G.a w.c.b B.G. W.C. B.G. W.C.

(Depreciation) (537) (537) (657)

(657)
Net fixed assets 392 652 552 552
652
Total ass& $1,902 $1,959 $2,471 $2z736 $2,088
Liabilities and Equity
Short-term debt due $169 $326 $198 $308 $166

Accounts payable 194 252 303 190

Accruals 390 —318 294

Current liabilities Term $820 $832 $937 $550

loans 155 155
Common stock 50 50 50 50 50 50
Retained earnings 994 934 1 156 1 014 1351 1
088
(round your estimate down); (4) accruals will be 6 percent of sales; and (5) capital expenditures will be $90 in 1995,
$380 in 19%, and $30 in 1997.
b
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 (ooos)
(Developed by John Pattilla in 1994)

1995 1996 1997

(continued)
 CASE 8 SPARTAN ROOFING 59

Net income $75 $74

Depreciation 80 120 130

Cash flow operations $155 $200 $204
— Adjusted working capital needs 332 62

— Capital expense 90 30
— Dividends
Cash flow ($267) ($242) $257

(continued)
60 PART 11 FINANCIAL ANALYSIS

EXHIBIT
4
(Continued)

Adjusted Working Capital

1994 1995 1996 1997

Accounts receivable $833 $883

Inventory 694 736

— Accounts payable 194

— Accruals 318

Adjusted working capital $701 $1,033 $1,095

Change adjusted working capital 332 62

*This assumes (1) net income will be 1.5 percent of sale; (2) receivable will be 60 days of sales; (3) inventory
turnover will be 7.2 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 propcted net income and pro forma balance sheets.)

EXHIBIT 5
Income Statements and Bad Debt Expense for the Spartan Roofing Company:
1992-1995 (ooos)

1992 1993 1994 1995

Sales $3,978 $3,902 $3,946 $5,399

Cost of goods 2 884 2 872 2 959 4 173
Gross profit $1,094 $1,030 $ 987 $1,226
Administrative & selling expenses 815 762
_53
EBIT $226 $207 $95 $242
Interest 44 20

Earnings before taxes $160 $163 $75 $162

Taxes (40%)
Net income $96 $98 $97
 CASE 8 SPARTAN ROOFING 61

EXHIBIT
Bad debt expense 0.1% 0.6% 0.4% 0.9%

EXHIBIT 6
Normalized Income Statements for the Spartan Roofing Company: 1992—1995

1992 1993 1994 1995

Sales 100 100 100 100

Cost of goods 725 73.6 75 77.3
Gross profit 27.5 26.4 25 22.7
Administrative & selling expenses 20.5 19.5 212 16.7
Depreciation 1.6
EBIT 5.7 5.3 2.4 4.5
Interest
Earnings before taxes 4.0 4.2 1.9
3.0
Taxes (40%) 026
Net income 2.4 2.5 1.1 1.8
7
Balance Sheets for the Spartan Roofing Company: 1992—1995 (000)

1992 1993 1994 1995

Assets

Cash $120 $21

Receivables Inventory 707 785 580 1,124

Current assets $1,268 $1,351 $1,029 $1,940

Gross fixed assets 669 698 757 914
(Accumulated depreciation) (251) (312) (367)
Net fixed assets (447)
Total $1,686 $1,737 $1,419 $2,407
Liabilities and Equity
Notes payable—banks $180 $220 $162 $700
Accounts payable Accruals 148 157 150
62 PART 11 FINANCIAL ANALYSIS

EXHIBIT
Current liabilities $469 $1,316

Term loans 374 219 41 85

Common stock 50 50 50 50
Retained earnings _116 _814
Total liabilities and equity $1,686 $1,737 $1,419 $2,407

EXHIBIT 8
Spartan's Cash Flow 1992—1994 (000s)

1992 1993 1994

Net income $96

Depreciation $98
Cash flow operations $149
— Adjusted working capital needs (80) $159
40 (20)
— Capital expenditures $100
29
— Dividends $189 (96)
Cash flow $150 59
Adjusted
Working Capital $137

1991 1992 1993 1994

AccounG receivable $580

$707 $785
Inventory
476
— Accounts payable 157 150
— Accruals 277 157
Adjusted working capital $817 $797 $701
Change adjusted working capital $897 (80) (20) (96)

9
Financial Ratios for the Spartan Roofing Company: 1992—1995

Industry
Averagea
1992 1993 1994 1995 1992-1995

Liquidity Ratios
 CASE 8 SPARTAN ROOFING 63

EXHIBIT
Current 2.32 2.07 2.19 1.6
1.2
15
Quick 1.45 1.38 1.28 1.0

Leverage Ratios
38
Debt (0/0) 55 .50 36 55
71
11
Times interest earned 3.42 4.75 5
2
Activity Ratios
13.6
Inventory turnover (sales) 8.4 8.7 9.7
6.5
16.4
Fixed asset turnover 9.52 10.1 10.1
5.5
2.9
Total asset turnover 2.36 2.25 2.78 2.3

37
Average collection period 6-4 72 53 49
61
Profitability Ratios
32
Gross margin (%) 28 26 25 26
23
3.6
Net profit margin (%) 2.4 2.5 1.1 2.4
1.6
25
Return on net worth (%) 12.5 11.3 4.9 13
9
Return on total assets (%) 5.6 3.2 5.8

a
The three numbers for each ratio are computed in the following way. Ratios for all firms in the industry are arran in
ratio: that is, half the
firms in the industry had ratios better than the median ratio and half had ratios that were worse. The top number
represents the upper quartile figure, meaning 25 pement of the firms had ratios better than this.
The lower number represents the lowest quartile; that is, 25 percent of the firms had ratios worse than this.