ST. LOUIS CHEMICAL: THE STARTUP
BACKGROUND
Don Williams, the former Director of Sales for the distribution operation of Midwest Chemical, a large, regional chemical manufacturer and distributor, has decided to begin a chemical distribution business. Midwest Chemical, headquartered in St. Louis, was sold to a large multinational chemical manufacturer. Most of Midwest’s senior management team, including Williams, was told their services would not be required. Without adjustments, combining the two firms would result in substantial management duplication.
Don Williams is thirty-two years old and had been employed by Midwest Chemical, since graduation from Iowa State University with degree in chemical engineering. He earned an MBA from St. Louis University after attending evening classes for four years. With Midwest he moved through a number of management positions, each with increased responsibility. For the last four years he had been Director of Sales for the distribution operation.
As a result of his chemical distribution business experience and the contacts with customers and suppliers, he has decided to begin a St. Louis based chemical distribution business. Williams gained a solid understanding of the chemical industry and the distribution process while at Midwest. At Midwest he had Profit & Loss (P&L) responsibility, but his knowledge of accounting and finance is limited. To prepare for staring his new business venture, Williams met with a counselor from the Small Business Development Center (SBDC) at St. Louis University and was given a crash course in preparing and using a business plan. His business will be organized as a corporation. Williams and his father will provide initial equity capital. Williams will use the cash received from the buyout of his Midwest stock options and his severance package. His father will invest a portion of the proceeds from his recently sold business.
Williams always had aspirations of someday operating his own chemical distribution business. That “someday” is now.
CHEMICAL DISTRIBUTION
A chemical distributor is a wholesaler. Operations may vary but a typical distributor purchases chemicals in large quantities (bulk – barge, rail or truckloads) from a number of manufacturers. They store bulk chemicals in “tank farms”, a number of tanks located in a dyked area. The tanks can receive and ship materials from all modes of transportation. Packaged chemicals are stored in a warehouse. Other distributor activities include blending, repackaging, and shipping in smaller quantities (less than truckload, tote tanks, 55-gallon drums, and other smaller package sizes) to meet the needs of a variety of industrial users. In addition to the tank farm and warehouse, a distributor needs access to specialized delivery equipment (specialized truck transports, and tank rail cars) to meet the handling requirements of different chemicals. A distributor adds value by supplying its customers with the chemicals they need, in the quantities they desire, when they need them. This requires maintaining a sizable inventory and operating efficiently. Distributors usually operate on very thin profit margins. RMA Annual Statement Studies indicates “profit before taxes as a percentage of sales” for Wholesalers – Chemicals and Allied Products, (SIC number 5169) is usually in the 3.0% range. In addition to operating efficiently, a successful distributor will possess 1) a solid customer base and 2) supplier contacts and contracts which will ensure a complete product line is available at competitive prices.
SMALL BUSINESS DEVELOPMENT CENTERS
The U.S. Small Business Administration administers the Small Business Development Center (SBDC) Program to provide management assistance to current and prospective small business owners. SBDCs are a combined effort of the private sector, education community and government (state and federal) to stimulate economic growth by aiding development of new businesses. Most SBDCs are housed on university campuses and receive a portion of their operating funds from the schools. Many SBDC counselors are faculty members from a variety of academic fields.
Anyone currently operating a small business or interested in starting a business can receive free, confidential assistance from the SBDC. Counseling and training activities include preparing a business plan, examing sources of financing, preparing loan requests and in general providing guidance on how to start a business.
THE SITUATION
In the meeting with the SBDC counselor, Williams described the chemical industry, the role of a chemical distributor and thoughts on beginning his business. After his initial investigation of the St. Louis area Williams has decided to begin operations from a leased warehouse/office building located in an industrial park. The facility would be leased for five years and includes two five-year renewal options. The facility would need to be modified to handle both liquid and dry chemical repacking operations, as well as storage tanks for bulk liquids. Exact numbers have not been developed but he thinks the modifications would cost about $250,000. With the modifications and six employees, Williams estimates the facility will support an annual sales volume between four and six million dollars. Williams’ customer contacts will provide the majority of the sales and he expects first year sales dollars to exceed five million. He is very confident the estimated first year sales can be achieved and can be doubled in the second year of operation. According to RMA Annual Statement Studies, distributors report a “Sales/Total Asset” ratio between 2 and 4.
After meeting with the SBDC counselor, Williams realized that more a detailed financial plan was needed. Expected performance needed to be quantified to remove as much uncertainty about the new venture as possible. With the counselor’s assistance Williams began to project performance for the first year of operation. Together they developed operating assumptions based on Williams’ previous business experience and industry information from RMA (Robert Morris Associates). The assumptions will be used to prepare a projected beginning balance sheet and financial statements for the first year.
ASSUMPTIONS
Beginning Balance Sheet:
1. Williams estimates he will need a cash balance of at least $500,000 (possibly more) to begin operations. For planning purposes he intends to use the cash account to balance the beginning balance sheet. The high cash balance is necessary to pay for the inventory, purchase operating supplies, pay for initial advertising and promotional materials, meet payroll in the early part of the year and in general deal with unexpected startup expenses,
2. Initial inventory investment will require $600,000 (Williams expects to be able to obtain 30 day credit terms from his vendors). For planning purposes it will be assumed the initial inventory investment will be paid 30 days after operations begin. (Assume the inventory and the accounts payable appear on the initial balance sheet)
3. There will be no accounts receivable balance (nothing has been sold yet) but Williams expects to offer industry term of “net 30” to its customers.
4. Fixed assets will consist of machinery and equipment investment and will be $80,000 and will have a 5-year MACRS class life. (20%, yr. 1; 32%, yr. 2, 19%, yr. 3; 12%, yr. 4; 11%, yr. 5 and 6%, yr. 6)
5. Leasehold improvements will amount to $250,000 and will be amortized over 5 years using a straight-line amortization schedule. ($50,000 per year)
6. Accounts payable will be $600,000 (see initial inventory investment assumption).
7. There will be no liability accruals.
8. First Commerce Bank has agreed to provide a $400,000 five-year term loan @ 10% annual interest, on the condition the Small Business Administration provides a loan guarantee. (Assume this guarantee can be obtained). Only interest will be paid on the loan during the first year. If a loan reduction is possible, it will be made on the last day of the year. First Commerce has also agreed to provide a $200,000 short term loan (1 year) @ 8% annual interest to finance working capital needs on the condition that all assets of the company and Williams personal assets are used as collateral. As with the long-term loan, no reduction in principal will be made until the last day of the year. If expected performance is achieved, the bank has indicated they will renew and consider increasing the loan.
9. Williams has decided to organize the company as a corporation with 1,000,000 authorized shares and a $1 par value. Williams elected to organize the company as a corporation because he anticipated rapid growth and thought the corporation was the best vehicle for raising the large amount of capital required to finance the growth. The limited liability provided by the corporate organization form was also a desired characteristic.
10. Williams and his father expected to invest $300,000 (300,000 shares) and $200,000 (200,000 shares) in the company respectively.
Year One Income Statement:
1. Sales volume for the first year is expected to be $5,000,000.
2. The average gross profit on product sales will be 23%. The gross profit will vary significantly from product to product and package size, and Williams feels this is probably only a “ball park” number. Bulk sales will generate a low margin while packaged sales (55-gallon drums, totes and a variety of small containers) will yield a higher profit margin. For planning purposes Williams wants the gross profit to be calculated using only product cost. A distributor’s success is dependent on this margin and Williams wants his reporting systems to allow easy tracking of this key number.
3. Plant operating expenses (ex depreciation) will include:
a. Plant manager @ $35,000 per year (plus 25% for benefit package)
b. Six warehouse and yard employees @ $25,000 per year (2080 hours @ $12.00 per hour). Employee benefits (holidays, vacation, workman’s compensation insurance, social security and other benefits) are estimated to be 25% of base salary.
c. Annual facility lease expense will be $60,000. (Operating lease)
d. Utilities (gas, electric and water) are projected to be $1,000 per month.
e. Repairs and maintenance expenses are expected to be minimal but will be about $6,000 the first year.
f. Supplies (labels, cleaning material, brooms etc) are projected to require $200 per month.
g. Delivery expenses will vary per customer and type of sale but will be estimated as 1.4% of sales. Trucking firms, common carriers, will be used to deliver material to the customer.
h. Miscellaneous operating expenses are estimated to be 2% of direct operating labor. (Warehouse and yard employees, including benefits).
1. Annual plant depreciation expense will be based on equipment purchases of $80,000 (forklift and two light delivery trucks). Equipment will be depreciated using 5 year MACRS. (20%, yr. 1; 32%, yr. 2, 19%, yr. 3; 12%, yr. 4; 11%, yr. 5 and 6%, yr. 6) Since depreciation is a non-cash expense, this item will be kept separate from other plant expenses.
2. Leasehold improvements will be amortized over a five-year period using a straight-line amortization schedule. ($50,000 per year)
3. Selling expenses will include:
a. Two sales representatives, each with a base of $40,000 per year. (Plus 25% for benefit package). In addition, each sales representative will have a “travel (non auto) and entertainment budget” of $18,000 per year.
b. Eight-tenths of one percent of sales will be paid in commissions.
c. Auto operating expenses for two leased autos are estimated to be $2000 per month ($1000 per auto).
d. Two in-house sales representatives @ $20,000 per year. (Plus 25% for benefit package).
e. Promotion and advertising expenses are expected to total 1.0% of sales.
f. Bad debt expenses are expected to be .5% of sales.
1. General Administrative expenses will include:
a. Officer salaries (Williams’ salary) are projected to be $61,000 per year. (Plus 35% for benefit package).
b. A “travel (non auto) and entertainment budget” of $24,000 per year is also planned for year one.
c. Auto operating expenses for one leased auto is estimated to be $1000 per month.
d. Administrative staff (2 office workers) @ $20,000 per year. (Plus 25% for benefit package)
e. Utility expenses are expected to be $1,000 per month (mostly for telephone expenses).
f. Office supplies are expected to cost $3,000 per month.
g. Insurance expense (property, liability, casualty, etc.) is expected to be $36,000 annually.
h. Legal and professional fees are projected to be $500 per month.
i. Miscellaneous administrative expenses are projected to be $500 per month.
1. Williams is also planning to adopt an “open book management” philosophy and wants to implement an employee profit-sharing program. For planning purposes, Williams intends to share 5% of operating profit (before profit sharing) with employees.
2. Interest expense. (See opening balance sheet assumptions regarding bank financing)
3. To simplify the planning process Williams is projecting a combined state and federal tax rate of 25%.
4. In order to finance expected growth no dividends will be paid in the early years.
Ending Year One Balance Sheet:
1. Target cash balance of $20,000.
2. A DSO of 40 days will be used to project ending accounts receivable balance.
3. Williams expects ending inventory investment to be 60 days. Use Cost of Goods Sold (CGS) to calculate investment. [(CSG/360) x 60 days]
4. No additional fixed assets will be added during the year.
5. Accounts payables will be projected using an average payment of 30 days. {(CGS/360) x 30 days}
6. The short-term loan from First Commerce Bank will be used to balance the balance sheet. If more financing is needed the bank has agreed to increase short-term lending to $300,000.
7. Accrued liabilities are projected to be $20,000.
8. Williams expects no additional capital infusion during the year and does not intend to pay a dividend.
THE TASK
As an assistant to Williams, help accomplish the following:
1. Prepare the following statements:
a. Beginning balance sheet (year 0). Hint: Do not attempt to complete the ending year one balance sheet until the year one income statement is complete.
b. Income statement for the first year. Also prepareyear one sub-schedules for Plant Operating Expenses, Selling Expenses, General Administrative Expenses and Depreciation Expense.
c. Ending balance sheet for year one,
d. Cash flow statement for year one.
1. Will Williams have sufficient capital for the first year of operation? Explain
2. Explain the importance of the assumptions developed by Williams.
3. Evaluate projected performance using ratio analysis. Calculate the following ratios and evaluate performance. (Current ratio, Quick ratio, Accounts receivable turnover, Days sales outstanding – DSO, Inventory turnover – using cost of goods sold in the numerator, Total asset turnover, Times interest earned ratio, Debt ratio, Profit margin, Basic earning power, Return on assets and Return on equity)
4. Analyze projected performance, from a banker’s perspective. Why would the bank renew the short-term loan? What ratios would prove useful in this analysis? Explain.
5. Most entrepreneurs believe it is a positive indicator if expected sales can be exceeded. Explain why this may not always be the case.
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