Financial strengths and weaknesses of Primax, Alpha and Beta; - Essay Example

? Case Study Table of Contents Table of Contents Executive Summary 2 Performance comparison of three companies 3 Liquidity Ratios 3 Solvency Ratios5 Activity Ratios 5 Profitability Ratios 6 Possible improvements in Alpha by Primax 7 Possible improvements in Beta by Primax 7 A proper budgetary approach in the enlarged business 8 Adoption of Balanced Scorecard approach for smooth integration Beta 10 References 12 Executive Summary This project analyses in detail financial strengths and weaknesses of Primax, Alpha and Beta; three firms engaged in manufacturing furniture. While Primax among them is most financially sound the other two firms are not doing that well financially. Primax wishes to acquire either of the two firms and hence wishes to do an in-depth study of the financial strengths and weaknesses of these two firms. This project also identifies the best budgeting approach for the new merged entity and suggests zero-based budgeting to be most appropriate as that would eliminate previous years’ inefficiencies that might have seriously impeded profitability of these organizations. Finally, this project elaborates how a Balanced Scorecard approach would help in smooth integration of these two business entities. Performance comparison of three companies One of the most popular tools of identifying financial strengths and weaknesses of an enterprise is through Accounting Ratio that could be used by a financial analyst to qualitatively evaluate the financial status and level of performance of an organization. (Harkins 2003). For the purposes of this Case Study, it would be more appropriate to adopt a Cross-sectional Analysis as all these firms are essentially engaged in manufacturing furniture. (Mohanty 2009). Liquidity Ratios Short-term Creditors are mainly interested in liquid position of a business firm since their claims are to be met within the accounting year. Liquidity or short term solvency means the ability of the enterprise to meet short-term obligations as and when they become due. There are two types of Liquidity Ratios: 1. Current ratio 2. Quick ratio Current Ratio = (Current Assets)/(Current Liabilities) Current Ratio of Primax = 3399/1098 = 3.10 Current Ratio of Alpha = 525/745 = 0.70 Current Ratio of Beta = 636/853 = 0.75 There is a Bank Overdraft of 315 in case of Alpha. Some accountants contend that Bank Overdraft should be treated as a long-term liability since that arrangement with the bank is is almost permanent (so long as the enterprise is a going concern). On the other hand, some accountants that contend that Bank Overdraft should be treated as a current liability since this facility may be withdrawn by the bank at any time. As a conservative measure of short-term financial position, Bank Overdraft has been considered as a current liability in the current instance. The current ratios of both the firms are nearly same but when compared to that of Primax both of them are well below the desired level. However, there could be firms that have low current ratios but work efficiently as is the case in fast food industry. This is so because current ratio does not analyze the quality of current assets which might contain obsolete stocks or slow paying and doubtful debtors. In the current instance it is observed that while Alpha has cash worth 43, Beta does not have any cash balances. Hence, though current ratio of Alpha is lesser than Beta, from a broader perspective, between the two; Alpha is in a better position than Beta (C. C. D. Consultants Inc. 2009). Quick Ratio = (Current Assets – Stock)/(Current Liabilities) Quick Ratio of Primax = (3399-1102)/1098 = 2.09 Quick Ratio of Alpha = (525-306)/745 = 0.29 Quick Ratio of Beta = (636-224)/853 = 0.48 If we consider Primax’s quick ratio as a benchmark, both these firms fall woefully short of that, but of the two, Beta seems to be in a better position provided of course its trade receivables are all good without any possibility of bad debts or slow recovery. Solvency Ratios Solvency Ratios evaluate long-term capability of a business firm to regularly pay interest on long-term loans it has taken and whether it has the capacity to pay back the loans when they mature. The actual outflow however depends on the agreement to pay either in lump-sum or in installments. The most popular solvency ratio is: Debt-Equity Ratio = (Long-term Debts)/(Shareholders’ Funds) Debt-Equity Ratio of Primax = 2000/6817 = 0.29 Debt-Equity Ratio of Alpha = 0/1796 = 0 Debt-Equity Ratio of Beta = 300/763 = 0.39 Alpha represents an extreme situation where there are no long-term debts at all and Beta is also in a good position when compared with Primax. But of the two, Alpha is undoubtedly in a far superior position than Beta. Activity Ratios These ratios measure the level of efficiency of a firm in utilizing the resources it has at its disposal and the most popular ratio in this regard is Capital Turnover Ratio which is measured as: Capital Turnover Ratio = (Net Sales)/(Capital Employed) where, Capital Employed = Net Fixed Assets + Trade Investments + Current Assets – Current Liabilities Capital Turnover Ratio of Primax = 23915/(6516 + 3399 – 1098) = 23915/8817 = 2.71 times Capital Turnover Ratio of Alpha = 2007/(2016 + 525 – 745) = 2007/1796 = 1.12 times Capital Turnover Ratio of Beta = 4138/(1280 + 636 – 853) = 4138/1063 = 3.89 times It is obvious that Beta is far more efficient than Alpha in this regard. However, it has a ratio that is considerable higher than that of Primax and it may indicate a situation of over trading or undercapitalization which might be the case as its trade receivables form almost 65% of its current assets. Profitability Ratios The most widely used ratios are Operating Profit Ratio and Net Profit ratio. Operating Profit Ratio = Operating Profit/Net Sales Operating Profit Ratio of Primax = 3959/23915 = 17% Operating Profit Ratio of Alpha = 62/2007 = 3% Operating Profit Ratio of Beta = 509/4138 = 12% This ratio indicates an average operating margin earned on a sale of ?100 and what portion of is left over to cover non-operating expenses to pay dividends and create reserves. Higher the ratio, the more efficient is the operating management. From the figures available and considering Primax as a benchmark it might be concluded that while Alpha is woefully short of desired levels, Beta can reach the acceptable limits with a little more cost reduction. Net Profit Ratio = Net Profit after Tax/Net Sales Net Profit Ratio of Primax = 3037/23915 = 13% Net Profit Ratio of Alpha = 22/2007 = 1% Net Profit Ratio of Beta = 143/4138 = 4% This ratio also evaluates a firm’s capacity to withstand adverse economic conditions when selling prices are declining, costs of production are rising and the demand for the output falling. Quite obviously, a higher ratio indicates a greater capability of a firm to tide over unfavorable market conditions. As compared to Primax, Alpha is in a real bad position and Beta, though better than Alpha, is still way below the desired level. Possible improvements in Alpha by Primax Alpha need a total overhaul as its costs of production need to be drastically cut down in order to make it healthy. It should also take urgent steps to lower its inventory of finished goods. The idle cash it holds is also unproductive. It should take relevant steps to invest it profitably in its operations. It might also go for debenture issues, though it would be difficult to find buyers given its poor profitability ratio, as that would help ease working capital shortage and also create a possibility of higher returns on equity. Possible improvements in Beta by Primax Beta is in a better position than Alpha but still it has to lower its production costs as that is the only way it could increase its profitability. It has to also take urgent steps to recover money from its debtors as such a large volume of debtors cause an unnecessary pressure on the working capital. The taxation dues also seem rather high for a firm of this size. The reason for it needs to be investigated and proper tax planning should be done. Trade Receivable also should be reduced to ease pressure on working capital and retained earnings could either be used to pay dividend or for further investment in business. The number of motor vehicles also seems to be rather high for a firm of its size and some of the money realized from disposal of redundant vehicles could be used to acquire better machinery. A proper budgetary approach in the enlarged business Irrespective of which business Primax would finally acquire, it has to put in place a proper budgetary system in the enlarged business. It must also be remembered that though all these three firms are operating in the furniture sector, the outputs of these firms cater to different customer groups. Moreover, it has been observed that both at Alpha and at Beta the cost og goods sold is pretty high in relation to net sales. Therefore, cost control is of primary importance in these two firms and Primax being a specialist in manufacturing furniture for hotels and other commercial places might not in the best position to judge the appropriateness or otherwise of an expenditure. So, zero based budgeting approach would be the most appropriate for the enlarged commercial entity. It is a normal practice for conventional budgeting processes to consider previous years’ actual relevant expenses as something sacrosanct and get started with this year’s budgeting on the basis of those expenses. This is surely a speedy process where all that a manager has to do is to mark up or mark down (though that happens rarely) previous year’s expenses while preparing budget for the current year. This in effect is a regularization of previous year’s inefficiencies and an arbitrary mark up on expected rise in prices in raw material, labor and other related heads of expenditure. While this can be acceptable in relatively stable firms that operate in monopoly and oligopolistic markets where there is hardly any scope of competition from new entrants, it simply cannot be the norm in a newly created business entity that operates in the highly competitive market for readymade furniture (Horngren and Foster 1991). In direct contrast to incremental budgeting where previous period’s actual data is either increased or decreased by some percentage across the board without any reference to the actual working conditions at the shop floor, supply status in input market or the degree of competition in the product market; zero based budgeting starts from scratch (that justifies its name of Zero Based) where each expenditure needs to be justified before it is approved. Previous period’s actual expenditure has got no relevance in determining current period’s approved expenditure. A budgeting method that is so thorough quite obviously discourages carrying forward of previous period’s inefficiencies but one must also appreciate the fact that there will be substantial volume of paperwork involved as each manager has to justify every single rupee they spend. Such a rigorous approach to expenditure automatically ensures all wasteful or avoidable expenditures are ruthlessly pruned and all inflated forecasts are brought back to proper size. Zero based budgeting forces managers to search for the most cost efficient method of completing a particular job and allocates resources in the best possible manner as every manager critically evaluates the cost of every unit of resource and the benefit expected from it before channelizing it for a particular use (Phyrr 1973). However much this system might lead to efficient utilization of resources, there are also certain drawbacks of zero based budgeting. As a manager has to justify each and every expense, items like research and development that not only have a considerable gestation period but also are highly uncertain as regards the probable returns, tend to get ignored while production enjoys the maximum focus. Repairs and especially preventive maintenance also tend to get overlooked in such form of cost management and might result in serious production breakdown at some point in future. In the current scenario, however, there is not much scope for research and development though there is enough space for innovation and creation of new and attractive designs. But there is always a risk whether or not those designs would be accepted by prospective customers. So, managers might tend to give innovation a cold shoulder and stick to only the tried and tested products. This might harm the enlarged business firm in the long run (Cooper and Kaplan 1998). Adoption of Balanced Scorecard approach for smooth integration Beta Complete dependence on financial figures to measure efficiency of a business enterprise might not always be a good idea especially in these trying times of global economic downturn and cutthroat competition to corner the steadily decreasing market pie. Robert Kaplan and David Norton appreciated the dangers of overdependence on financial figures and has introduced the concept of Balanced Scorecard that considered financial performance as only a part of the overall performance of an enterprise that consisted of other three other equally vital but non-financial performance indicators (Kaplan & Norton, 2004). An enterprise can hope to survive and prosper only if all these four performance areas are suitably addressed. The balanced scorecard of Kaplan and Norton consists of: 1. Learning and Growth Every organization must have in place a system of continuous training and development of its human resource since innovation is the key to survive and succeed in the highly competitive environment of modern day markets. Managers must also be suitably trained to identify areas where investment in training and development is likely to generate highest return. However, the entire program can succeed only when internal communication system is as direct and as free from ‘noise’ as possible as impediments in upward communication might stifle employees’ enthusiasm and initiative in learning new techniques and processes. This is more so if two enterprises merge together to form a bigger enterprise. As it is, there will surely be some sort of a clash of cultures between employees of the two organizations and if communication lines are not smooth such clash might jeopardize the very existence of the merged entity. 2. Business Process Any business consists of a series of interrelated processes that operate in tandem to produce the final output that the consumer wants. Kaplan and Norton have identified certain groups or bundle of activities that should be considered as independent units for the purpose of evaluating the efficiency of the entire business process. These independent units are: operations management, customer management, innovations, regulatory compliance and social responsibility in that order of importance. Efficiency of a business enterprise in each of these sectors should be independently measured and the overall efficiency of the business enterprise would be calculated as a weighted average of these independent measures. 3. Customer Unless an enterprise can satisfy its customers it cannot exist. The best way to do it is to identify the most profitable group of customers and focus marketing efforts in wooing this group. However, the costs of such an exercise should never exceed the tangible benefits obtained from it. 4. Financial Balanced Scorecard stipulates managers must collect and collate all relevant financial data and wherever necessary ensure that they are properly and timely entered in the centralized data processing unit for retrieval and further analysis by suitably qualified personnel. Every enterprise has in place a management accounting department for such further analysis. The responsibility of line managers would be to collect and input all data that will be notified to them in advance. As this approach does not give importance only to financial parameters but also accords equal importance to strategic non-financial parameters it is probably called a balanced scorecard (Hubbard, 2007). As it incorporates other areas that are equally vital for smooth functioning of an organization, especially if the organization has come into existence after merging two separate organizations, balanced scorecard approach is the only way management of the merged entity should adopt. References C. C. D. Consultants Inc. Current Ratio interpretation. 2009. http://www.ccdconsultants.com/documentation/financial-ratios/current-ratio-interpretation.html (accessed January 25, 2011). Cooper, Robin, and Robert S. Kaplan. "The Promise - and Peril - of Integrated Cost Systems ." Harvard Business Review, Volume 76, Number 4, 1998: 109-119. Harkins, Jacob. "What Is Ratio Analysis?" wiseGeek. 2003. http://www.wisegeek.com/what-is-ratio-analysis.htm (accessed January 25, 2011). Horngren, Charles T., and George Foster. Cost Accounting: A Managerial Emphasis. Englewood Cliffs: Prentice Hall, 1991. Hubbard, Douglas W. How to Measure Anything: Finding the Value of Intangibles in Buisness. John Wiley & Sons, 2007. Kaplan, R. S., and D. P. Norton. "Measuring the strategic readiness of intangible assets." Harvard Business Review 82(2), 2004: 52-63. Mohanty, R. K. Ratio Analysis. 2009. www.iibf.org.in/uploads/caiibfmramodule_c.ppt (accessed January 25, 2011). Phyrr, Peter A. Zero-Base Budgeting: A Practical Management Tool for Evaluating Expenses . New York: Wiley, 1973. Read More