Performance of Foster Limited - Case Study Example

CB540 Financial and Management Accounting Resit work August 2008 Question (a) REPORT Performance of Foster Ltd over the two years ending 30 September 2006 with a special focus on the Profitability and Liquidity position of the Company Executive Summary Foster Ltd has been experiencing increasing profitability while at the same time suffering from liquidity and cash flow problems. This is not surprising as it is a well known proposition in the world of business academia that profitability and liquidity share an inverse relationship. An analysis of the Company's financial statements for the years 2005 and 2006 has shown that Foster Ltd. is showing signs of overtrading and that the problems may be arising from inadequate financing and the improper management of the working capital in Foster Ltd. The rise in inventory levels is of particular significance and it is suggested that if a proper stock management plan was put in place, the Company would be able to improve its liquidity and cash flow position. It is also suggested that alternate sources of funding for the Company's expansion, such as debt finance and/or leasing of assets as opposed to relying predominantly on equity finance may have a favourable impact on Foster Ltd., in terms of liquidity and otherwise. Introduction Foster Ltd. has gone through rapid expansion over the two years that make up the subject matter of this report. This is evident from the financial statements of the Company as seen from the fact that revenue has grown by 43.75% and the investment in machinery has increased by 60% in 2006. The Company has also increased its long term funding by drawing a '1 Million loan as well as making a share issue. This expansion has reaped benefits in terms of profitability; however the liquidity and cash flow position of the Company has deteriorated. The directors themselves have felt the strain and the Cash Flow Statement prepared for 2006 clearly reflects the problem. The financial statements show further signs of the cash shortage and these will be discussed below. Overtrading is a likely cause for the Company's current unfavourable situation. This refers to the fact that the Company has expanded its sales revenue quite rapidly without securing the additional funds necessary to support the expansion. This report looks to find the underlying causes of the liquidity problem by analysing the available financial statements. Any potential causes found will be discussed and possible remedies suggested. In addition, other ways in which the liquidity position of the Company can be improved will also be considered. Foster Ltd.'s Current Profitability &Liquidity/Cash flow Position As mentioned above, the profitability of Foster Ltd. has seen a commendable increase. The Gross Profit Ratio (GP Ratio) of the Company has increased from 21.88% in 2005 to 26.09% in 2006 (see Appendix). This is a significant rise. It must be noted that just because revenue increases, profitability does not increase as the cost of sales would have increased along with the revenue. However, in Foster Ltd.'s case, the cost of sales has increase in a proportion quite considerably less than that of revenue (36% as compared to 47.35%). It is because of this difference in proportions that Foster Ltd. is exhibiting higher profitability levels. A likely reason for cost of sales increasing by a lower percentage is the achievement of economies of scale. As Foster Ltd. expands and increases production, its cost per unit decreases as it begins to enjoy the benefits of bulk discounts in raw material purchases, as well as being able to spread overhead and other fixed costs over a larger number of units thereby reducing the fixed cost per unit. Along with its GP Ratio, the Total Profit ratio has also increased from 8.75% to 8.99% (see Appendix). This may not be a sizable increase but is definitely notable. The reason for the increase in the GP Ratio not being followed through to the Total Profit ratio is that the operating expenses, and the finance and tax costs to a lesser extent, have seen an increase from 2005 to 2006. The increased depreciation charge as a result of the newly acquired fixed assets is a major determinant of the 50% increase in operating expenses. Irrespective of the size of the increase in profitability, the fact of the matter is that profits have increased. The Company earned a profit before dividend of '4.13 Million in 2006, a 47.5% increase from the previous year. This is a significant increase in profit levels and it is understandable that the directors are perplexed as to the adverse liquidity and cash flow position in Foster Ltd. The unfavourable cash flow position of the Company is easily evident from the Cash Flow Statement for the 2006 period, the cash and cash equivalents of Foster Ltd. standing at negative '790,000. The Balance Sheet for that period also shows evidence of this. The Company is having an overdraft balance, unlike in the previous year. In addition, the trade payables balance has seen a significant increase in the 2006 (163% increase). A calculation of the Accounts Payable Payment period (see Appendix) shows that the Company is now taking 53.63 days on average to pay its suppliers, as compared with the 27.74 days that was averaged the previous years. This again is a significant increase in payment period and supports the fact that Foster Ltd. is finding it difficult to find the cash to pay its suppliers and as such is delaying payment to them. This is a dangerous sign as it may lead to sullying the relationships the Company has with its suppliers and as such could have an adverse effect on the Company in the long run. The adverse liquidity position of the Company is reflected in its liquidity ratios which show a significant deterioration over the two years (see Appendix). The Current Ratio has fallen from 1.42 in 2005 to 1.01in 2006 which means that while Foster Ltd. had almost one and a half times the current assets to cover short term liabilities, it now has parity between the two with all the current assets being necessary to cover its current liabilities. The quick ratio has also, unsurprisingly, deteriorated from 0.77 to 0.34. This means that when inventory, the least liquid asset, is taken out of the picture, Foster Ltd. has only enough current assets to cover 34% of its short term liabilities. It is no wonder that the directors are feeling the strain of the cash shortage. Profitability vs. Liquidity The obvious question that the directors are asking is why there is a cash shortfall when Foster Ltd. is earning such high levels of profits. Where are all the profits going' Logically speaking, higher the profits and profitability in a given company, the more liquid it is capable of becoming. More profits coming in means more assets flowing in to the business and by inference, more liquid assets as well. So even though financial statements are prepared on an accruals basis and so all profits are not turned into cash, more profits should mean more cash (even if it is just a small proportion of the profits) in the business. However, Foster Ltd. is seeing no such cash inflow. Instead its cash position has deteriorated. The reason for this is the notion that the investment decisions that result in the increased profitability (in Foster Ltd.'s case the decision to expand production) usually have an unfavourable impact on the liquidity position of the Company. That it, when a Company such as Foster Ltd. made the decision to expand production and thereby improve profits, they did so at the expense of liquidity. Their investment in machinery, for example, resulted in a large cash outflow for the Company. The increased funding also took its toll on the cash position as the Company had to make interest payments which it did not have to make in the previous years, as well as the 47.5% increase in dividends paid out as a result of the new share issue at the beginning of 2006. This inverse relationship between profitability and liquidity was noted by Hyun-Han and Soenen (2000) when they submitted that while decisions decreasing profitability tend to lessen the chances of sufficient liquid assets being held by a company, focusing on liquidity will decrease the profitability of the firm. This submission is the vice versa of the position described above. This inverse relationship is well known and has been proven in terms of real businesses as well as academic experiments. For example, Eljelly (2004) found a strong inverse relationship between liquidity and profitability in his study of Saudi joint stock companies. His findings showed that the negative relationship was most strong in companies which had high current ratios and longer cash conversion cycles. Therefore it is evident that Foster Ltd.'s position of high profitability coupled with low liquidity is not as contentious as it may have first seemed. Analysis of the Liquidity Problems in Foster Ltd As submitted above, the likely cause for Foster Ltd.'s troubles is overtrading. This phenomenon occurs when a company rapidly expands but fails to secure sufficient finance to source the expansion. Literally, it is trading over and above its means. Without sufficient long term funding to cover the growth of the business, the company begins more and more to rely on its short term financial sources, using bank overdrafts and delays in payments to suppliers to cover cash shortfalls. The classic signs of overtrading can be described as increasing inventory levels, receivables and payables along with the decline in cash and liquid assets. An increasing overdraft balance is also a symptom. Foster Ltd. is exhibiting many of these signs of overtrading. Its inventory levels are significantly higher in 2006 as compared to the previous years. The inventory holding period has increased considerably to 53.68 days (see Appendix), which means the Company is on average holding a batch of inventory for '54 days before it is sold, as compared to the 29.2 days in the previous year. This may be sign that Foster Ltd. is finding it very difficult to sell the increased production. However, this inference is unlikely as its Accounts Receivable Collection period has remained more or less constant (see Appendix) meaning that debtors are paying on time and Foster Ltd. has not been resorting to extending credit terms just to sell more inventory. However, Foster Ltd. has showed an overdraft, unlike in the previous years and its Accounts Payable payment period has increased drastically as pointed out above. These are consequences of the liquidity and cash flow problems, rather than evidence of the causes of the problems. The causes, as mentioned above, would be the inadequate funding of the expansion and the improper working capital management, mostly in the inventory management area. As to funding the expansion, it is commendable that Foster has in fact increased its long term sources of funding through the '1 Million loan and the share issue which injected '750,000 in equity funds in to the Company. However it is submitted that this funding is probably not sufficient for the scale of expansion Foster Ltd. has invested in. The machinery alone has cost more than '6 Million and it must be remembered that these funds itself have costs in terms of interest payments and dividend distributions. As such the additional '1.75 Million in long term funds fails to cover all the costs incurred as a result of the expansion. As a result, the Company has had to use its short term funds and as such does not have enough cash in the Company for the day to day workings of the business. Furthermore, with the increase in production to a level that seems to be higher than what is demanded by the usual customers, given the increase in closing inventory and inventory holding periods, it seems that the Company is even mishandling the inadequate working capital they have in the business. Large levels of inventory holding means much wanted cash is needlessly tied up in those inventories. As Michael Goldman & Associates (2001) submit, not only is cash tied up in the inventories themselves, more cash is wasted in storing and handling them and opportunities to sell a more profitable product are missed. Obsolescence is a further cost. All these costs are cash outflows that the Company just cannot afford. Proper inventory management so as to hold only the minimum necessary to satisfy demand would free up cash so that it can be used for more valuable activities such as paying off suppliers and making interest and tax payments. Remedies for the Liquidity Problems An obvious remedy would be to increase the amount of funding in the business. Foster has opted to be almost wholly equity based, with no gearing at all in 2005 and just 4.67% in 2006 (see Appendix). Companies that are overtrading are usually highly geared and unable to get more funding and as such become stuck in a fatal downward spiral. However, Foster Ltd. does not have this problem and as such is able to remedy its situation by financing its activities through debt. Equity finance is more expensive than debt finance and it is questionable why Foster Ltd. has not explored the possibilities of significant loan finance. It is recommended that the Company increases its gearing by drawing a loan for about '5 Million which will go along way in making up the shortfall in funding and working capital requirements. The interest cover currently is a staggering 59 times. If the suggested loan is taken, interest would be '500,000 (at the rate of 10% as under the existing loan). Even then, the interest cover would be close to 12 times. In addition, interest payments are tax deductible, so in actual fact the interest cost will be less when the tax savings are taken into account. Given the high level of profits in the Company in the recent year, this tax reduction would be a welcome saving. The use of long term funding is also better than the use of over draft facilities which carry much higher interest rates. Given the fact that Foster is in the manufacturing industry and has a number of fixed assets that can be used as security to obtain a loan, the use of debt finance to get the Company back into order is encouraged. An alternative to getting a loan would be to sell the machinery that was bought in 2006 to a finance company and lease them back. This would have the same effect of a loan secured on the said machinery. The initial sales proceeds would be like a loan and the subsequent lease payments would be like interest payments and loan repayments. Given that the machinery cost '6.6 Million and has been used for a year, the amount of the "loan" would again be around the ' 5Million mark. In addition to this much needed increase in long term funding, Foster Ltd. can improve its working capital management and make the most of that funding. As outlined above, the area that needs to be looked at is inventory management. There are many inventory minimisation techniques that can be used, though it may be difficult to implement them fully in the short term. Just in time or Kanban is one such technique and Purdum (2007) submits that an electronic Kanban solution can help to reduce inventory in manufacturing companies by 43%. The key to this, she says, is to coordinate with one's suppliers and make them an integrated extension of one's company. Also, it must be noted that inventory management not only carries the benefit of reduced stock levels but may be a strategic tool that can be used to attract customers and thereby increase market share as well (Katz 2007). While it may not be feasible to effect such a inventory minimisation plan in the short run, it is suggested that Foster Ltd. at least look into the problem and make production plans in reference to customer forecasts so that at least in this respect, unnecessary inventories may not be produced and held, tying up the much needed cash in the process. Whilst the increasing Accounts Payable Payment period was said to be a consequence rather than a cause of the liquidity problems, it must be remembered that the suppliers are an important part of the business and as such must be respected and managed. Rather than just delaying payments and souring relationships, it is best that the Company contact its suppliers and inform them that payment in the recent future may be delayed and try to negotiate extended credit periods or perhaps even some discounts. This is of course easier said than done, but it is better to keep the suppliers informed and try and get some arrangement in place instead of delaying payment without warning. Of course, the payment delays should not last long if the debt finance suggested above is used. If the suggestions as to debt finance were adhered to (i.e. the taking of a '5 Million loan), the revised Cash Flow Statement would be as in Figure 1 (below). The inventory minimisation suggestion has not been included as this may not be feasible in the short run and it is not possible to estimate how much of a reduction in stock such a policy would effect. In Figure 1, the balances that have been revised have been outlined and include the interest payments (taking it as 10% of '5 Million), reduction in tax (the increase in interest payment of '400,000 at a corporation tax rate of 30% has been deducted from the previous tax balance) and the loan funds injected into the company ('5 Million). When these changes are incorporated, a positive cash inflow of '2.71 Million is seen for the period. While the figures for the current year have been used, it is submitted that the revised statement could act as a forecast for the coming period. Figure 1 Foster Ltd. Cashflow Statement for the period ending 30 September 2006 '000 '000 Cash flow from operating activities Profit/loss(-) before tax 5,900 Adjustments for: Depreciation 640 Interest expense 500 1,140 Operating cash flow before working capital changes 7,040 Increase in inventories -3,000 Increase in trade receivables -800 Increase in trade payables 3,100 -700 Cash generated from operations 6,340 Interest paid -500 Tax paid (1220-[400 x 30%]) -1,100 -1,600 Net cash flow from operations 4,740 Cash flow from investing activities Purchase of machinery (16,000 - (10,000 - 600)) -6,600 Cash flow from financing activities Dividends paid -1,180 Issue of shares 750 Issue of loan 5,000 4570 Net increase in cash and cash equivalents 2,710 Opening cash and cash equivalents 600 Closing cash and cash equivalents 3,310 Other Factors of Performance of Foster Ltd. The analysis of the performance of Foster Ltd. has been from the point of view of the officers of the Company thus far. Another important point of view is that of the investors. They may not be knowing about the liability problems of the Company and short of the problems resulting in the insolvency of Foster Ltd., they are not too concerned about it. Investors are more interested in how the Company is serving them-the return that they are getting on their investment. As such, in their eyes, the performance of Foster Ltd would be quite satisfactory, The Return on Capital Employed by the firm had increased from 24.24% in 2005 to almost 30% in 2006 which means that the Company was making better use of the monies invested in it. Equally, the Earnings per Share has also increased by 38%, signalling to the investors that the profits of the Company are increasing and the value of their investment also rising. More importantly perhaps, the dividend yield has been constant over the years, meaning that Foster Ltd. has ensured that a constant percentage of profits are distributed to shareholders by way of dividends. This tells the investors that the Company is doing fine and belies any liquidity problems that it may have. (see Appendix for ratio figures) The investors, therefore, will look positively at the Company, all the ratios being favourable from their point of view. Foster Ltd. seems to want to ensure that the shareholders are happy (given the high dividend payout despite the cash shortages) and given the fact that the director relied almost wholly on equity as the source of finance, this is not a surprising policy. Conclusion From the above analysis it is apparent that on the whole Foster Ltd is not doing so badly. It expanded too rapidly without ensuring that there was sufficient finance to fund the expansion and as such experienced liquidity and cash flow problems. However, as the firm was not geared, the use of debt finance can be used to remedy the problems as well a better management of the working capital. When the liquidity problems are resolved, the Company would be able to reap the benefits of its expansion to the fullest extent. Appendix Ratios Ratio Formula 2005 2006 Gross Profit Ratio GP/Sales x 100% 21.88% 26.09% Total Profit Ratio TP/Sales x 100% 8.75% 8.99% Return on Capital Employed (ROCE) TP/(Equity+ LT debt) x 100% 24.14% 29.84% Inventory Holding Period Inv/COS x 365 29.2 days 53.68 days Accounts Receivable Collection Period Acc. Rec./Sales x 365 20.53 days 20.63 days Accounts Payable Payment Period Acc. Pay./COS x 365 27.74 days 53.63 days Current Ratio Crnt Assets/Crnt Liab 1.42 1.01 Quick Ratio Crnt Assets - stock/ Current Liab. 0.77 0.34 Gearing LT Debt/ Equity+ LT Debt - 4.67% Interest Cover PBIT/interest - 59 Dividend Cover Profit after tax/ Dividends 3.5 3.5 Earnings per Share Profit after tax/ No. of shares '0.29 '0.40 Question (b) A Financial Forecast, as obvious from its name, is a forecast or prediction of what a company's financial performance would be in the future, for example in five, ten or twenty year's time. It is essentially a quantification of all the expectations of a company in terms of the sales revenue, operational costs etc. and how they will behave in the expected future conditions. What a company generally does is use historic data as a starting point and then modify it accordingly using models, statistical and otherwise, to suit the future expected conditions. The main uses of financial forecasting in companies are in the areas of standard setting and budgeting. For example, if the company uses standard costing as a control method, financial forecasting with be essential in order for the company to set accurate standards. All the standard values used in variance analysis (such as standard selling prices, standard costs etc.) will all be derived from the financial forecast. A Budget, as mentioned above, uses financial forecasts. When preparing budgets, the information presented in the forecast is utilised and the company decides or 'budgets' how it is going to use the available funds to achieve its organisational goals. As said in the FTC Foulks Lynch ACCA Text on Financial Management and Control (2004 p. 332), it is submitted that a "forecast is a statement of what is expected to happen; a budget is a statement of what it is reasonable to believe can be made to happen". As such, it is evident that budgets have a number of uses. The most important of these are its uses in the areas of planning and control. Budgets can be used to plan how the funds available in the company will be divided and utilised and after the funds have been so deployed, the budget can be used a control mechanism - a benchmark against which managerial and other staff performance can be evaluated. In addition, budgets act as a communication tool for top management as they can convey organisational goals to lower level managers and staff through the budget targets. Both financial forecasts and budgets may be presented to banks to influence their lending decisions as well. Financial forecast may be more persuasive as they tell the bank what the financial position of the company will be in the future based on statistical and other models which are less prone to meddling by management. As such, banks will know from the forecasts whether interest and capital re-payments can be made on time and see the other commitments on the company funds. Budgets, on the other hand, are more prescriptive than descriptive and so are more of a plan than a projection of the future and may include management hopes rather than predictions. However, if these are reasonable and realistic, it too would be a factor in the lending decision as it tells the Banks how a company is going to be operating in the future. Reference List Eljelly, A., 2004. Liquidity-Profitability Trade-Off: An Empirical Investigation in an Emerging Market. International Journal of Commerce & Management, Vol. 14, Iss. 2, p.48-61. Financial Management and Control, 2004. FTC Foulks Lynch Association of Chartered Certified Accountants (ACCA) Official Publication, Berkshire. Hyun-Han, S. & Soenen, L., 2000. Liquidity Management or Profitability- Is there room for both'. AFP Exchange, Vol.'20,'Iss.'2,'p.'46-49. Katz, J., 2007. Forecasting: Strategic Inventory Management. Industry Week, [Online] January 2007, p.36. Available at: http://www.industryweek.com/ReadArticle.aspx'ArticleID=13329 [accessed 2 August 2008]. Michael Goldman & Associates, LLC., 2001. Fix Inventory Problems Before They Balloon to a Crisis. [Online]. Available at: http://www.michaelgoldman.com/inventory_management.htm [accessed 2 August 2008]. Purdum, T., 2007. Kanban can make a Difference. Industrial Week, Vol. 256, Iss. 6, p. 23. Read More