Finance Issues during the First Five Years of a New Company - Essay Example

Finance Issues during the First Five Years of a New Company There are 5 important financial considerations during the first years of an enterprise, which are most relevant for Precision Distribution Services Limited (PDS hereafter). The first of these relates to the strengths and weaknesses as gleaned from the financial statements of the company, and their likely impacts on the essential direction with which the enterprise has been formed (2004, 2, Bhalla). The following facts are significant in this regard: 1. The company has recorded a net profit for the first time in only the fourth year of operation. The first 3 years of losses are significant considering that the business involved no project gestation period, and is in the nature of executing established contracts on a divisional structure basis. Accumulated losses of the first 3 years have only been neutralized in the last accounting period for which actual results are available. Consequently, the company has never declared a dividend, and does not even forecast one for the first year of forecasted business results. 2. The Gross Margin has improved from 18.75% in 2004 to 21.57% in 2005. The forecast Gross Margin for 2006, at 22.92% is only slightly higher than the latest achievement of 2005. However, fuel costs, which are significant for a business such as that of PDS is forecast to rise to 26.04% of revenue, as against 25.49% in 2005 and 25% in 2004. It appears that PDS is not able to secure protection against a major inflation driver in to its business contracts. However, PDS has been able to reduce variable labor expenses from 56.25% of revenue to just 52.94% in 2005, and expects the trend to continue with a forecast of just 51.04% in 2006. These are significant productivity gains in a challenging human resources environment. Similarly, staff salaries are forecast to remain constant in 2006 compared to 2005, though net profits will more than double. 3. Leased capacity utilization has improved very significantly during the past five years, considering the remarkable rise in revenues. However, depreciation at less than 5% of the gross block in vehicles seems to totally inadequate. The depreciation reserve is entirely inadequate, and distorts the profitability picture, including the basis for taxation. 4. Though the debenture loan and bank overdraft show plenty of scope for gearing compared to the Gross Block, the company does not have any immovable fixed assets. Apart from the earlier comments on the distorted depreciation reserve, the profit and loss statements make no separate mention of insurance cover, which must be crucial for a business so dependant on vehicles and road conditions. 5. Debtors at 43 days of revenue in 2005 seem excessive for the likely delivery cycle in a road transport business within the U.K. The management forecasts this to rise further to 49 days of revenue in 2006! It is possible to conclude that while the management has shown immense effectiveness in growing the business, and in improving capacity utilization, and expenses on human resources, the financial statements are not appropriately structured as yet for injection of fresh long term debt, or for private equity from any outside source. The free cash flow analysis is the second important factor of financial analysis (1994, 145, Damodaran). The 2005 picture of accumulated profit after tax plus depreciation, less change in net working capital, at just over 5 million pounds is impressive. The projection of free cash flow of 8.6 million pounds also offers many avenues for deployment. The company’s founders have diluted control in bids to finance the business during the past. The bank overdraft and the debenture loan are small compared to additional funds brought in by the promoters. None of the three founders has a controlling stake if stocks are traded openly. Convertible preferred securities (2006, 86, Claessens & Laeven) would have been ideal for PDS, but this mechanism has not been used. Control and ownership issues of the company are entangled as a result. The company is vulnerable for acquisition. Similarly, the reputation for service excellence, and the business contracts on hand would have left PDS is an attractive position for an initial public offering when it first generated a profit, but the management has not seized on this opportunity. It would appear that the company has not had a cogent corporate finance strategy until now, exposing promoter funds unduly. Business projections can be risky, especially if they are far more optimistic than justifiable by past trends (2001, 35, Oedegaard, and Bossaerts). PDS has achieved revenue growth rates consistently since its inception in excess of that projected for 2006, but this has been on a smaller base. Utilities, like salaries, are forecast to remain constant in 2006 compared to 2005, while general expenses will rise only marginally. It is not clear whether the projected doubling of revenue in 2006 over 2005 is expected from new contracts or through twice the volumes from existing contracts, but the practice of the company to form independent divisions for each major customer, raises questions as to whether projected expenses are realistic. Overall, the strength of the company seems to be primarily the appreciation of its services by customers. Though this is marketing rather than a finance matter, the remarkably consistent rise in revenues is an over-riding achievement of PDS to date. Aggressive profit reporting, principally through the low accumulation of a depreciation reserve, the failure to build sound fixed assets for leveraging debt on competitive terms, and an apparently lax policy with respect to accounts receivables, are the main weaknesses of PDS. This may not have concerned the promoters as they chose to increase their personal funding of the business to finance growth, even as they relinquished substantial degrees of control. The statement of the main promoter regarding his state of health, and his relatively advanced age, raise questions about the directions which the three people who started the company wish to take at this time. The company has opposing choices of expanding in to Europe and to parts of the Middle East through acquisition, to sell out to a bidder, and a middle path of restructuring its debts to equity ratio. The corporate finance strategy for the future will depend on major aims of the promoters, but certainly major changes are indicated in any case. Financial Options for the Second Five Years of a Company The promoters have made a statement that they would like all options to be considered, and hence the corporate finance implications of expansion, sale, and reconstruction are the three dimensions on which corporate finance alternatives must be presented for the 2007-2012 period. A first question to be resolved is how much of the funds of existing share-holders should be invested in the business (2004, 3, Bhalla). The first option is for any of 3 original promoters to invest in a controlling stake of the company (2001, 22, Bierman). Such a step would separate emotional issues of ownership from the operational imperative for clear executive control. Decisions in this regard would not only pave the way for operational efficiencies as the company grows, but will prevent harmful dissensions when a new generation inherits the present distribution of equity. The company will be in a sound position to raise long term debt from financial institutions if it realizes the 2006 projections, and if it invests in land and building assets (1997, 68, Terry). Since PDS has completed just one year of net profits after wiping out accumulated losses and since it only owns furniture, fixtures, and vehicles with questionable balances of shelf lives, professional bankers would assess lending proposals as being relatively risky. Large banks will probably not place much value on the equity holdings, and would have to take in to account the risks related to loss of existing contracts. The company may be found to be under-insured considering the nature of delivering goods by road, and there are questions related to depreciation which have been raised earlier in this report. Overall, long term loans from banks can be targeted for the 2007-2012 period, but only if concerted efforts are made to restructure the balance sheet, to achieve projections, and to prepare answers for likely questions which could arise during a loan appraisal process. Private debt and equity markets (1997, 293, Terry) continue to be options; the offer received for outright sale of the company is attractive by conventional valuation standards (1994, 11, Damodaran). The 45 million pounds offer is an attractive multiple over actual 2005 profits, especially when the possible vagaries of contracts are taken in to account. The offer from Exel Logistics Plc. This offer can also act as a benchmark if one or more of the promoters wish to exit their significant present stakes. The offer to take over Peloponese and Balkan Logistics, while attractive in terms of a Price to Earnings ratio is not opportune at this time. The focus should be for PDS to consolidate its marketing achievements in financial structuring terms, and to tighten operations in areas such as Debtors. The PDS image of premium service does not blend well with the concept of a company which competes on price. Again, this is more a marketing than a financial strategy matter, but there are real risks of stretching the management risks of PDS too thinly by expanding in to a low margin and relatively risky business in the less developed parts of Europe. One attraction of the European offer could have been to tap the Unlisted Securities Market in London (1997, 608, Terry) as it would have yielded substantial funds without further dilution of control, but this source is being wound down, and PDS is not yet ready for a regimen of disclosures as would be required for a full listing on the London Stock Exchange. Long Term Corporate Finance Strategy The long term financial strategies which PDS requires are not the same as the immediate steps needed for the 2007-2012 period. PDS, regardless of its control structure in future, needs to prepare from now for a position of global leadership in its chosen line of business. There are 4 principal steps which can be recommended. Firstly, the company must invest in productive assets, acquiring physical capacities which can generate sustained profits (2004, 2, Bhalla). PDS may continue to lease vehicles which have high obsolescence, but this operational method of managing tax liabilities should not interfere with the development of a sound and appreciating base of permanent assets. The management has to view capital expenditure as a core objective during all planning processes, and this should be an integral part of business projections (1994, 44, Damodaran). Equity is better than debt for a business without tangible assets (2003, 126, Stern, & Chew), but the situation of PDS during the first 5 years of its existence, are not relevant for its future potential. The company will have to work towards the development of balance sheets which enable it to use market sources of funds for business growth, rather than the capital of promoters alone: this has to be achieved while retaining aims with respect to management control. The reconstruction of the balance sheet for appropriate sourcing of funds (2004, 3, Bhalla) is to state the obvious, but it can be used to underscore the need to build a track record of dividends. Stock market optics will be highly influenced by this (2001, 3, Bierman). The 2005 and 2006 policies with respect to retained earnings need to change in future. PDS has not explored avenues to finance growth through its strength of customer goodwill (2003, 260, Stern, & Chew). There are strategic benefits in this regard. Logistics is a dimension of competitive advantage for most of the large customers of PDS, and the scale of finance which PDS needs is probably insignificant by the scales of operations of its large clients. PDS should try and secure advances and securities from customers, which will not only provide funds, but which will safeguard the contracts at the same time. The nature of analysis and recommendations for PDS in this report suggest the need for an organizational change, in which treasury decisions are segregated from Corporate Finance strategy (2003, 51, Stern, & Chew). Such a structure will strengthen financial controls over routine operations, while simultaneously providing a long term direction for the sourcing and application of funds. Such an approach will fortify PDS as it prepares for an era of profitability and professionalism, while continuing on the scorching path of revenue growth which has marked its corporate infancy. References Bhalla, V. K. (ed.) (2004) Contemporary Issues in Finance, Anmol Publications Pvt. Ltd. Bierman, H. (2001) Increasing Shareholder Value: Distribution Policy, a Corporate Finance Challenge, Springer Claessens, S. & Laeven, L. (2006) A Reader in International Corporate Finance, World Bank Publications Damodaran, A. (1994) Study Guide for Damodaran on Valuation, John Wiley and Sons Matos, de J. A. (2001) Theoretical Foundations of Corporate Finance, Princeton University Press Oedegaard, B. A and Bossaerts, P. L. (2001) Lectures on Corporate Finance, World Scientific Stern, J. M & Chew, D. H. (2003) The Revolution in Corporate Finance, Blackwell Publishing Terry, B. J. (ed.) (1997) The International Handbook of Corporate Finance, Lessons Professional Publishing Word Count: 2201 Read More