The Friendly Card Inc.: Business Case

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Introduction

In early 1988, Friendly Cards Inc. based in Reading, Connecticut confronted three decisions that promised to impact operating costs, revenue growth and equity position. In the main, however, all three decisions also needed to take into account explicit warnings about the steadily-worsening debt-to-equity position of the company. That same year, the bankers on which Friendly relied for working capital to smooth out the extreme seasonality of the greeting cards business laid down an ultimatum. Credit for the 1988 Christmas and 1989 spring holiday peak season would not be forthcoming unless these twin conditions were met:

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  1. The bank loans outstanding at any time could not exceed 85% of Friendly’s accounts receivable.
  2. Friendly’s total liabilities could not exceed three times the book value of the company’s net worth.

For her part, Friendly President Wendy Beaumont aimed to hold Friendly’s ratio of all interest bearing debt/equity to a maximum of 2 to 1. These three considerations effectively form the primary cost/benefit criteria against which to analyze the three decisions that must be made.

Cost-Cutting and the Envelope-Making Machine

The main objective of Friendly Card Inc. in purchasing the machine is to increase its profit. As the machine will help the company in reduction of lead time, operations costs and increase its productivity, it is imperative for the company to purchase the machine (Pryor para.1). The machine will not only help the company increase its profit but will also help it diversify market since it will be able to produce a variety of envelopes meeting demand of various customers.

Counting the savings from not having to purchase envelopes, but adding back the expenses associated with operating the envelope machine and storing the envelopes during slack sales periods (Case exhibit 4), such a cost-saving acquisition immediately boosts 1988 revenue by a healthy 51% from prior year and at least 20.5% in the two years that follow (see Appendix 5, this paper).

Balance sheet analysis of this decision (Appendix 6, this paper) take into account: a) Inventory reduced by the savings from not having to purchase envelopes but with the cost of in-house production added back; b) Fixed assets rises by the depreciation chargeback for the new machine; c) Counting the incremental after-tax net income presumed to go into cash reserves, the total asset-side of the balance sheet shrinks slightly to $20.787 million; d) The cost of acquisition enters the liabilities side under “long-term debt” since the economic life of the envelope-making machine is reckoned at eight years; e) Current liabilities are unchanged; f) The incremental income also enters “retained earnings”.

With reference to the aforementioned decision criteria, acquiring an envelope-making machine satisfies the requirement for the degree to which receivables could fund outstanding bank loans since plugging the $500,000 loan into the outstanding loans item raises the ratio to “just” 0.79, still lower than the 0.85 benchmark recommended by Friendly’s creditor banks. However, the banks’ recommendation not to exceed three times the book value of the company’s net worth is immediately breached in the first two years of operating the envelope machine. As well, Wendy’s self-imposed aim to hold Friendly’s ratio of all interest bearing debt/equity to a maximum of 2 to 1 will not be realized for the foreseeable future.

Diversification into Studio Cards

There are various strategies that a business may opt for in bid to improve its competitive advantage as well as increase its performance. These strategies include product diversification and market diversification. Product diversification may be achieved by the business through changing the products it sells in the market as well as through introduction of new products in the market. This can be achieved through purchase of equipment that facilitates modification of products, new sources of supplies, as well as development of new products. In market diversification, this is where the business looks for new markets where it can extend its services or products to. All these methods of business diversification have various costs that every business organization that intend to apply them necessarily incurs (99 Consulting.com para. 2). For Friendly Card Inc., the option to purchase Creative Design Inc. represents the opportunity to diversify into studio cards, gain higher margins, increasing dollar sales overall, compete with similar lines from the major greeting-card companies and thereby gain market share. This is in line with the recommendation of Zvi, Kane and Marcus (243) about acquisitions not only mitigating the press of competition but also enlarging market share in a very competitive business. Friendly Card Inc. contemplates on acquiring Creative Designs Inc. which is a firm that has been focusing on production of studio cards. To make the decision on whether to acquire it, the company has to evaluate some of the potentials that the business has (Ross, Randolph & Jaffe 148). Creative Designs Inc. focuses on production of studio cards. Acquiring the company would help Friendly Card Inc. in diversifying its products. This means that the company will be able to produce a variety of cards making it possible for it to increase its market share. Based on analysis conducted by Ms. Beaumont, acquiring the company will also help in reducing its cost of goods sold.

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This means that Friendly Cards Inc. will be able to make higher profit than the company used to make. Other operation expenses are also expected to be reduced by about ten percent meaning the profit will be high. With the sales of the company being expected to rise and bearing in mind the nature of its balance sheet, suppliers will be willing to offer the company credit than they had done before. This will facilitate in running the company. The company has not utilized bank credits and other debt capacities implying that Friendly Cards Inc. will be able to make use of these resources to fund the company. All these potentials that the company has prove that acquisition of the company will lead to Friendly Cards Inc. increasing its profit (Schwartz para. 3).

To see what impact the acquisition would have on combined retained earnings/net after-tax income, one takes into account: a) Ms. Beaumont’s admission that net sales at Creative will be static for the first year under new ownership but ought to grow by 6% annually in 1989 and 1990; b) Her confidence that COGS could be reduced by 5% and other operating costs by 10% in the first year; and, c) Thereafter, COGS and other operating costs would maintain the ratio to net sales of 1988 and grow solely in proportion to revenue. The result (Appendix 7, this paper) suggests that, even after paying out the usual dividend rate Creative Design used to (except to Friendly Card stockholders this time), the Midwestern acquisition would add no less than $210,000 to the projected $966,000 in Friendly net income for 1988 before any other management moves are made.

Consolidating the balance sheets as a “tax-free” stock swap is straightforward enough except that Friendly has to issue new treasury stock equivalent to 198,000 shares (versus the 5,800 carried on the books as of end-1987). But this should be balanced out by the acquisition of CD assets.

The results (Appendix 8, this paper) confirm that the more solid balance sheet of Creative Design would help Friendly meet its creditor-banks’ requirements for total liabilities not to exceed three times book value of net worth (0.6 would be attained after the merger), bank loans would drop to 73% of accounts receivable instead of the 87% Friendly showed at the end of 1987. And Wendy’s aim to bring Friendly’s ratio of all interest bearing debt/equity to a maximum of 2 to 1 would be closer than ever (down from 3.13 to 2.34).

The West Coast Equity Infusion

For Friendly Card Inc. to maintain its projected growth, it requires to have enough funds. To attain this, the only possible option for the company is to raise additional equity capital. As of early 1988, a friend in the investment banking firm of Stoddard, White & Driscoll was of the opinion that it would be difficult to get sizeable buying support at even $8 per share in the over-the-counter market. However, a firm offer came along from West Coast Investors to purchase 200,000 shares at 48 per share. Though Wendy would realize an equity infusion of just $1,520,000 owing to having to pay a 5% finder’s fee, this looks attractive because it would drive the ratio of all interest bearing debt/equity to 0.41 immediately and even lower in two years’ time versus the President’s own goal of a 2:1 ratio. Moreover, deducting the net equity infusion from projected borrowing for the three-year period would keep bank loans outstanding from exceeding the bankers’ benchmark of 85% of Friendly’s accounts receivable. And, after temporarily breaching the three times book value of Friendly net worth in 1988, chances are good that the liabilities to equity ratio would drop to 2.9 and 2.7 in succeeding years.

Conclusion

For Friendly Cards Inc. to meet its objectives, it has three alternatives that presented themselves. First the company need to purchase envelope producing machine for it to be able to reduce on operations costs it has incurred for many years. To increase its market share and reduce competition, it needs to acquire Creative Designs Inc. Finally, for it to be able to have enough money to support its projects and bearing in mind the current state of the economy, the equity infusion from a group of West Coast investors bore consideration. Going purely by the three criteria articulate in the beginning of this paper, it does seem that the third option is most attractive.

Appendices

Ratio Analysis for Friendly Inc.

Appendix 1: Profitability ratio

Ratio Computation 1985 1986 1987 1988 1989 1990 Change
Net profit margin Net income after tax/Revenue 2.4% 3.24% 4.82% 4.95% 5.20% 5.45% Increase
Return on assets Net income/total assets 2.89% 3.13% 4.79% 5.01% 5.31% 5.61% Increase

Appendix 2: Activity Ratios

Ratio Computation 1985 1986 1987 1988 1989 1990 Change
Total asset turnover Net sales/ Total assets 1.19 0.97 0.99 1.01 1.02 1.03 Improved
Inventory turnover Cost of goods sold/current inventory 2.28 2.35 1.89 1.91 1.91 1.91 Improved

Appendix 3: Leverage Ratios

Ratio Computation 1985 1986 1987 1988 1989 1990 Change
Total debt ratio Total liabilities/total assets 74.99% 83.90% 82.50% 80.15% 77.88% 75.87% Decrease
Times interest earned (Net income +interest)/interest 1.39 1.68 1.83 1.90 2.02 2.18 improved

Appendix 4: Liquidity Ratios

Ratio Computation 1985 1986 1987 1988 1989 1990 Change
Current ratio Current Assets/Current liabilities 1.33 1.21 1.18 1.15 1.14 1.13 Deteriorated
Quick ratio (Current assets-inv.)/Current liabilities 0.74 0.77 0.68 0.66 0.65 0.64 Deteriorated

Appendix 5: Impact of Envelope Machine on Projected Income Statement

Actual Data Projected Data
1985 1986 1987 1988 1989 1990
Net income $195 $413 $784 $ 966 $1,209 $1,525
Increase in profit after taxes 218 218 218
Net income benefit of envelope machine $1,184 $1,427 $1,743
Revenue growth over prior year 51.02% 20.52% 22.14%

Appendix 6: Impact of Envelope Machine on Projected Balance Sheet

Combined Projected with Envelope Machine
1987 1988 1989 1990
Assets
Cash $ 328 $ 546 $ 546 $ 546
Notes and accounts receivable 8613 8613 8613 8613
Inventory 7088 6,737 6,737 6,737
Prepaid expenses 254 254 254 254
Total current assets $ 16,283 $16,150 $16,150 $16,150
Fixed and other assets 4575 4,637 4,575 4,513
Total assets $ 20,858 $20,787 $20,725 $20,663
Liabilities
Bank loans $6,320 $6,320 $6,320 $6,320
Accounts and trade notes payable 3557 3557 3557 3557
Accrued expenses 1231 1231 1231 1231
Current portion of long-term debt 483 483 483 483
Other 696 696 696 696
Total current liabilities $12,287 $12,287 $12,287 $12,287
Long-term debt 3458 3958 3896 3834
Total liabilities $15,745 $16,245 $16,183 $16,121
Common stock and paid-in capital 1273 1273 1273 1273
Retained earnings 3840 4058 4276 4494
Net Worth 5113 5331 5549 5767
Total liabilities and net worth $20,858 $21,576 $21,732 $21,888
Ratio Data
Bank loan/receivables 0.73 0.73 0.73 0.73
Total liabilities/equity 12.37 12.76 12.71 12.66
Interest-bearing debt/equity 2.72 3.11 3.06 3.01

Appendix 7: Impact of Friendly Management on Projected Income Statement of Creative Designs

Projected Data
1988 1989 1990 RATIOS TO NET SALES
Net Sales $5,000 $5,300 $5,618
Cost of goods sold 2,921 3,097 3,282 0.58
Gross Profit on sales $2,079 $2,203 $2,336
Expenses
Selling, delivery, and warehousing $1,080 $1,145 $1,213 0.22
General and administrative 315 334 354 0.06
Total expenses $1,395 $1,479 $1,567
Earnings before interest and taxes $684 $725 $768
Interest 100 106 112 0.02
Income before federal income taxes $584 $619 $656
Provision for federal income taxes 104 110 117 0.02
Net income $480 $509 $539
Dividends 269 285 303 0.56 (ratio to net income)
Retained earnings $210 $223 $236

Appendix 8: Consolidated Balance Sheet: Creative Designs + Friendly Cards

Consolidated CD FC
1987 Actual 1987 Actual 1987
Assets
Cash $ 328 $ 88 $ 240
Notes and accounts receivable 8,613 1,600 7,013
Inventory 7,088 1,500 5,588
Prepaid expenses 254 62 192
Total current assets $16,283 $3,250 $13,033
Net fixed assets 3,683 1,250 2,433
Other assets 892 892
Total assets $20,858 $4,500 $16,358
Liabilities
Bank loans $6,320 $250 $6,070
Accounts and trade notes payable 3,557 500 3,057
Accrued expenses and other items 1,231 1,231
Current portion of long-term debt 483 50 433
Other 696 450 246
Total current liabilities $12,287 $1,250 $11,037
Long-term debt 3,458 1,000 2458
Total liabilities $15,745 $2,250 $13,495
Common stock 19,858 400 58
Paid-in capital 2,696 815
Retained earnings 3,840 1,850 1990
Net Worth 26,394 2,250 2,863
Total liabilities and net worth $ 42,139 $4,500 $16,358
Bank loan/receivables 0.73 0.16 0.87
Total Liabilities/Equity 0.6 1.00 4.72
Interest-bearing debt/equity 2.34 0.58 3.13

Appendix 9:Friendly Cards, Inc, Pro Forma Balance Sheet, Assuming Sale of New Common Stock

(Liabilities and Equities Side of the Balance Sheet Only)

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Liabilities and Equity 1988 1989 1990
Bank Loans $7,586 $9,321 $11,404
Accounts and trade notes payable 3,705 4,417 5,320
Accrued expenses and other items 1,462 1,744 2,100
Current portion of long-term debts 450 450 450
Other 250 250 250
Total Current Liabilities $13,453 $16,182 $19,524
Long-term debt 2,008 1,558 1,108
Total Liabilities 15,461 17,740 20,632
Common stock + paid-in capital 1,963 1,963 1,963
Retained earnings 2,956 4,165 5,690
Net Worth 4,919 6,128 7,653
Total Liabilites and Net Worth $20,380 $23,868 $28,285
Ratios
Bank loan/receivables 0.90 0.93 0.95
Total liabilities/equity 3.14 2.89 2.70
Interest-bearing debt/equity 0.41 0.25 0.14

Works Cited

99 Consulting.com. Amalgamation Advice. 2009.

Pryor, Austin. Make Sure Your Investment Decision-Making Is Inside-Out. 2009. Web.

Ross, Stephen, Randolph, Westerfield & Jaffe, Jeffrey. Modern Financial Management, 8th edition. New York: McGraw-Hill, 2008.

Schwartz, Harvey. The Financial Implications of Amalgamation: The Case of the City Of Toronto. 2001. Web.

Zvi, Bodie, Kane, Alex & Marcus, Alan. Essentials of Investments, 7th Edition. New York: McGraw-Hill, 2008.

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