Interpretation of Financial Statements and Performance Management - Case Study Example

Report to the Directors of Cleenup Limited Company I. ment of the problem Cleenup Limited is considering the launch of a new product amidst threat to its long standing market share of about 12%. Developed by its own production director, the product has the potential to deliver long term profits to the company. However, the investment cost to develop the new product and the risks involve are constituting areas of great concern which company directors and shareholders sought to be guided for their collective decision. Several alternatives are proposed, and the directors would like to hear advice on the best alternative to consider. II. Objectives 1. To develop a set of strategies that will further strengthen the market share of the company in the cleaning products industry. 2. To propose a financing strategy that will raise capitalization at the same time maintain control of the company among family shareholders. III. Areas of Consideration Internal Environment: 1. Company’s good reputation and profitability have been achieved through a strong focus on the manufacturing process accompanied by rigorous cost control. 2. Company has a reputation of providing good quality products at a competitive price. 3. The company has experienced strong profit growth during the 1980s. 4. Participative management style of the directors has created a culture of commitment to the success of the company. 5. Cleenup Credo – “We will succeed if we continually strive to deliver what our customers want at as low a price as possible.” External Environment: 1. Customer base is multiple retail chains throughout EU, where Cleenup manufactures products for the chain’s own label ranges. 2. Steady market share of 12% has come under threat as customers seek quality improvement and cost reduction. Description of new product: 1. New product has attributes that would be attractive to customers. It has potentials for the domestic market, but more so for the industrial market. 2. R&D cost the company ₤350 thousand to develop the product (2006), while its patent cost ₤275 thousand (2007). 3. The product has some prospects of success by 2007, but the directors are determining yet how to account for the development expenditure in the current year. 4. There is a growing feeling among the directors and senior managers that Cleenup should carry the development through to a final product which should be manufactured and sold by the company. 5. Development cost will be about ₤2.6 million. 6. Development will take 18 months. 7. Additional plant capacity for a full-blown production will require additional an investment of ₤3 million. Characteristics of the market: Domestic market 1. The domestic market is dominated by a small number of major brands. 2. Major brands are sold through large retail chains and independent shops. 3. Major brands are sold both under brand names and as own labels of retailer chains. 4. Major brand products are sold at a premium providing higher margins than Cleenup could obtain. (But Cleenup is positioned to offer low cost alternatives to major brands.) 5. There is a current trend where retailing tends to concentrate in a decreasing number of very large chains, where there is pressure to reduce selling price. 6. Market in EU becoming more affluent, with power to buy products of perceived higher quality of major brands. Industrial market 1. Customers tend to be more technically aware. 2. While cost conscious, customers also consider the benefits to be derived from the product, especially the cost-benefit ratio. 3. High quality performance is a key factor in the premium market. IV. Framework of Analysis Cleenup Limited has initiated the discussion on a new product that has been designed by the director of the production division. But the discussion on the new product was premised on the recent analysis that the market share of the company, while steady for a number of years at 12 percent, is now becoming under serious threat from competitors and a maturing market. Hence, the main challenge is how to secure the hold of the company on the 12 percent market share. The company should come up with fresh strategies that would allow it to hold on to the 12 percent market share, and if the company would be aggressive enough, it should even aspire for an increase in its share of the pie. How can Cleenup defend or increase its market share? Several strategies include: market creation for a new product, market penetration for a current product, product differentiation for current market. According to Kotler (1994, p.383), market share can be expended by continuously searching for “new users, new uses, and more usage” for the product. Defending market share, on the other hand, would simply require a management mentality of “continuous innovation” (Kotler, 1994, p.385). Firms should avoid the temptation to be complacent, and Kotler advised not to be contented with “the way things are, and (the firms) leads the industry in developing new products and customer services, distribution efficiency, and cost cutting” (Kotler, 1994, p.385). This brings the discussion to the new product design developed by the director of production division. After investing on research and development to the tune of ₤350 thousand, and securing a patent for the design of the product at a cost of ₤275 thousand, the directors are to determine which course of action to take next, realizing the financial rewards and requirements of each option available. Vis-à-vis the financial considerations, the directors of Cleenup are considering three options: sell the patent, develop a prototype and sell the right to manufacture, and manufacture the product itself. Each option was analyzed based on its advantages and disadvantages, and how it would affect the performance, efficiency, risk and liquidity aspect of the company. A number of financial ratios were analyzed to substantiate further the conclusion and recommendations made. The financial options were a prime consideration in determining the best investment strategy, since it was explicitly required that the family shareholders would still want to retail control of the company. V. Discussion and Analysis A. Cohesive mission and strategy for Cleenup While the company’s over-all performance has brought a steady market share of 12 percent, its current market standing is threatened by a maturing market and increased competition. Defending its current position and expanding it through various product and marketing strategies should be a prime consideration for Cleenup. A second consideration is to secure the control of the company within the family shareholders. It was indicated that family shareholders wish that raising funds to finance the development of the new product must not affect their control on the company as majority owners. The company should therefore be able to come up with financing strategies that will not affect majority control of family shareholders. Given the above, how then will the three options of selling the patent, selling the right to manufacture, and manufacturing the product itself, affect the overall desire of the company to secure its market share? Sell the patent Selling the patent of the proposed product is the least risky among the three options available for Cleenup. It has already invested ₤625 thousand on the development of the product and on its patent. Aside from the prospect of recovering what it invested at a profit, it also stands to gain from the royalty to be derived from the eventual sale of the product. The only downside of this option is losing the prospect of realizing profits in the long run from the manufacture and sale of a new product. Does this option contribute to the desire to strengthen the market share of the company? It does not directly. However, it raises immediately funds for the company which it can use to finance other projects. Develop the product and sell the right to manufacture The second option for Cleenup is that, since “it has already invested so much”, it might as well develop a prototype and sell it to a prospective manufacturer, who in turn will manufacture and sell the products for profits, providing royalty to Cleenup for every item sold. As mentioned, the sale of a fully developed product to a manufacturer would give a higher return than selling only the patent and the product design. If enough interest is generated among competitors, according to one of the directors, a windfall profit between four to eight million pounds can be realized. However, this option will incur additional expenses to develop a prototype. But on the other hand, it can also raise funds for the company which it can use to finance other projects that will assure its position in the industry. Manufacture the product The riskiest of the three options is the decision to manufacture the product and sell it as Cleenup’s newest product. This option also requires longer gestation period before any steady stream of income is realized. In the short run, it may not seem a very attractive proposition, considering the following: longer development period before the product is eventually launched, additional investment requirements for additional plant capacity to manufacture the product to the tune of ₤3 million, smaller market share and slower inventory turnover during the introductory phase of the product, and new marketing efforts to support marketing strategies to introduce the new product to an existing or new target clients, such as the industrial consumers. Cleenup stands to gain though, in the long run, with the manufacture and sale of the proposed product. As assumed by the directors, the product has great potentials if manufactured and sold by the company, giving between eight to ten percent operating profit potential. A growing affluence of a market segment is also providing opportunities for a successful market penetration. The new product can be positioned as a premium product both within the domestic market and the industrial consumers given its unique product features. It does provide opportunity for the company to expand its market share, as the new product is projected to capture at least six to eight percent of the market in the next five years. B. Implications of selecting the option to manufacture and sell (Answers to the six case questions) 1.) The following company objectives are being proposed which could be used to assess the company’s performance. Given the likelihood that the company will manufacture and sell the new product, the following objectives are proposed on four aspects of company operations: Profitability – the company should be able to increase its gross profit and net profit ratios by x%. Efficiency – the company should be able to increase inventory turnover and reduce average collection period by x times. Risk – the company should increase stability of profits by reducing long-term debts and maintaining a debt to equity ratio at par with industry average. Liquidity – the company should maintain an acceptable level of liquidity by having sufficient level of current assets to cover short term liabilities. 2.) Six financial ratios have been selected to assess historical performance of the company. The relevance of such ratios to the objectives identified is also explained. Table 1. Analysis of financial ratios for Cleenup Ltd. Financial Ratio 2006 2005 2006 Industry Average Remarks1 Gross profit margin 31.1% 31.7% 29.3% Bad – internal Good – external Net profit margin 11.1% 13.5% 9.7% Bad – internal Good – external Return on capital employed 12.7% 13.6% 11.6% Bad – internal Good – external Inventory turnover 7.2 times 8 times 5.8 Bad - internal Good- external Current ratio 2.4 2.3 2.1 Good – internal Good – external Gearing (debt/equity) 114% 95% 89% Bad - internal Bad – external Analyzing Profitability According to Gitman (1987, p.95), there are two frequently used ratios to measure the profitability of the firm: the gross profit margin and the net profit margin. He cited these measures as being able to help in evaluating the firm’s earnings “with respect to a given level of sales, a certain level of assets, the owner’s investment, or share value” (1987, p.95). Gross profit margin is defined further by Gitman as “the percentage of each sales dollar left after the firm has paid for its goods” (1987, p.96). Net profit margin, on the other hand, has been defined as “the percentage of each sales dollar left after all expenses, including taxes, have been deducted” (Gitman, 1987, p.96). Comparing the past two years’ gross profit margin of Cleenup, it indicated that there was a slight decrease from 31.7 percent to 31.1 percent. Comparing the 2006 gross profit margin to industry average, on the other hand, suggested that the firm performed well above industry average by almost two percentage points. Cleenup’s net profit margin slipped by more than two percentage points from 13.5 percent in 2005 to only 11.1 percent in 2006. However, it still did well when compared to industry average of 9.7 percent. Return on capital employed for Cleenup was a good indicator compared to industry average in 2006. It did well by recording a 12.7 percent return on capital compared to industry average of only 11.6 percent. However, comparing such ratio to 2005 indicated that Cleenup slipped in 2006 by almost one percentage point. While Cleenup performed consistently above industry standards in terms of profitability (at least in 2005 and 2006), it showed that Cleenup did not do well in 2006 compared to 2005 with the decrease in the percentage points of profitability ratios. Analyzing Activity (efficiency) Inventory turnover is the most common ratio used to measure activity, which refers to “the speed with which various accounts are converted into sales or cash” (Gitman, 1987, p.89). Other common ratios are average collection period (account receivables) and average payment period (accounts/supplier payable). Inventory turnover is computed by dividing the cost of goods sold with total inventory. The resulting figure is then compared over time or with industry average to be meaningful. For Cleenup, its inventory turnover decreased from eight times in 2005 to only 7.2 times in 2006. But it has consistently outperformed industry averages both in 2005 and 2006. This means that Cleenup products are fast-moving items compared to rivals as it has better turnover than industry average. This can also be seen as an indicator of customer preference for Cleenup products over competing brands. Further probing of this ratio may lead to potential opportunities in the market. Analyzing Risk Horngren and Sundem (1990, p.732) pointed out that most stakeholders such as creditors are more interested in the debt to equity ratios to determine the “degree of risk of insolvency and stability of profits.” Risk is therefore analyzed through the amount of long-term debts the firm has been exposed to. Gitman described the debt position of a firm as “the amount of other people’s money being used in attempting to generate profits” (1987, p.93). He added further that “the more debt a firm uses, the greater its financial leverage, a term used to describe the magnification of risk and return introduced through the use of fixed-cost financing such as debt and preferred stock” (Gitman, 1987, p.93). Cleen-up’s debt to equity ratio is revealing some degree of risks to potential investors. In 2005, it registered a high debt ratio of 95 percent. In 2006, it registered an even higher debt ratio of 114 percent, way above the industry average of 89 percent. This means that the company is now being financed totally by long term debts, a very risky debt position for a long existing company. This may prove to be an unattractive position to prospective investors. Analyzing Liquidity Liquidity was defined by Gitman as the “firm’s ability to satisfy its short-term obligations as they come due”. He further added that “liquidity refers to the solvency of the firm’s overall financial position” (1987, p.88). One of the measures to indicate liquidity of the firm is the current ratio. Current ratio is calculated by “dividing the firm’s current assets by its current liabilities” (Gitman, 1987, p.89). Gitman suggested that “it is a good measure of how short-term maturing liabilities are covered by current assets such as cash and account receivables” (1987, p.89). Comparing the current ratios of Cleenup in 2005 and 2006, the company has performed well as the 2006 figure is an improvement of the current ratio in 2005. The 2006 figure also surpassed the industry average of 2.1. 3.) Discussion on how accounting policies can affect the outcome of financial ratios. Accounting itself is a “major information system” (Horngren and Sundem, 1990, p.3). It records monetary data which is used by decision makers to advance the cause of its organization. Accounting policies refer to how such data and its purpose is appreciated and properly recorded. Information inputs to any accounting system are shaped by accounting policies. Such accounting system produces financial data, including financial ratios, which now become basis for decisions by relevant stakeholders, such as creditors, investors, shareholders, and the general public. Accounting policies affect the way a particular monetary transaction is appreciated and recorded. National governments mandate all legal entities to disclose the accounting policies being used to report financial transactions. In the United States, companies are required to “to disclose the accounting policies that are most important to the portrayal of the company’s financial condition and results” (U.S. S.E.C., 2007). When comparing the performance of two companies, it is essential to know the accounting policies being adopted by each company, to be sure that apples are not compared to oranges, so to speak. While there are sets of generally accepted accounting principles, accounting policies are also a function of management decision based on subjective appreciation of transactions. Such policies would eventually impact on the financial ratios being analyzed, since ratios are computed based on financial statements, which in turn are products of accounting policies and system of a particular organization. 4.) Suitability of equity funding and borrowings to finance the project, and how financial ratios are affected by each type of funding. In order to undertake the project, additional investment of ₤3 million has to be raised, either by equity funding or borrowings. Equity funding simply means financing the proposed investment through retained earnings, plowing back to company operations such earnings to acquire the required plant capacity to manufacture the product. Borrowings, on the other hand, would mean raising the required capital through the issuance of debt instruments, either as loans, mortgages, bonds, etc. The financial ratios of the company for 2005 and 2006 indicated a debt to equity ratio of 95 percent and 114 percent, respectively, making the company’s debt position more unattractive to prospective creditors. This is quite a high number indicating a risky debt position. Moreover, industry averages in 2005 and 2006 indicated debt to equity ratio as only 78 percent and 89 percent respectively. Given these figures, financing the required investment through borrowings may not be an easy option, since creditors might place an emphasis on the risk of insolvency in refusing to finance the investment. The more feasible alternative is to finance the investment through equity funding. This is feasible in the following sense: 1.) The balance sheet for 31 May 2007 is forecast to report a shareholders’ funds totaling ₤12.7 million. 2.) Moreover, the financial statements for the same period are forecast to report a revenue of almost ₤30 million and retained profits of ₤2.1 million. 3.) There is some sort of corporate culture of regularly capitalizing retained earnings by the owners as “a demonstration of their continued commitment to the company.” 4.) The more compelling reason for opting to raise funds through equity is the common sentiment among family shareholders of wanting to maintain full control and ownership of the company. Financing the investment through borrowings increases the debt to equity ratio, and thus increasing the risk being absorbed by creditors. Financing the investment through equity reduces the debt to equity ratio with the infusion of fresh capital, making the debt to equity ratio more attractive to prospective investors. 5.) Extent to which current organizational structure will be suitable for the new activity. Cleenup has a flat organizational structure headed by a managing director. It has three line directors (production, marketing, finance) and two staff directors (administration, human resource). The flat organizational structure of Cleenup is a very straightforward structure with all directors reporting to the managing director. Peters (as cited by Kotler, 1994, p.717) proposed that “no well-managed organization would have more than five hierarchical levels”. Companies are seeing trends towards a “downsized” and “delayered” organizational structure, reducing the number of levels “in order to get closer to customers” (Kotler, 1994, p.717). Trends also indicate tendencies of companies to focus more on their core competences, and managers are made to work closely as teams to become more attuned to the changing needs of customers. Given the above, the current organizational structure of Cleenup is just right for the business. Since Cleenup has been in the business without any reported organizational problem, it can be concluded that the organizational set-up has worked well with the company. However, in relation to the new activity being proposed, it would be best if the company could constitute an ad-hoc committee that would ensure a focused attention on the new product. Such a committee which directly reports to the managing director is constituted by the heads of the different divisions so that each functional area of management is fully represented. Full representation of managerial functions in the committee will assure a smooth integration of the new product into the entire production and marketing processes of the company. 6.) Identify and justify a range of non-financial performance indicators which should be used to monitor the company’s performance. A comprehensive and strategic plan to launch the new product should be developed to guide the company as to the goals and objectives of the project, and to its eventual performance whether it meets the stated goals and objectives. The company must use this plan to measure the project performance especially on the aspects of profitability, efficiency, risk, and liquidity. Such a plan must contain a budget with which financial standards are set, and with which financial indicators or parameters can be derived to measure the actual performance of the project. Non-financial measures which can be used by the managers to monitor the performance of the new product against the stated goals or objectives are also referred to as qualitative measures or tools. Qualitative measures can also provide management with valuable information that would signal the performance of the product in the market. According to Kotler (1994): Needed are qualitative measures that provide early warnings to management of impending market-share changes. Alert companies set up systems to monitor the attitudes and satisfaction of customers, dealers, and other stakeholders. By monitoring changing levels of customer preference and satisfaction before they affect sales, management can take earlier action. (p.748) Qualitative measures which Cleenup directors should use to monitor the company’s performance in relation to the new product includes Customer-Satisfaction Tracking. This tool can be used by the company to monitor customer feedback with regard to overall satisfaction of customer needs. Customer satisfaction can also be measured through complaint and suggestion systems, surveys, and lost customer analysis (Kotler, 1994). Other non-financial measures which can be used by the company include marketing efficiency measures. This tool will actually measure the efficiency of marketing efforts to increase sales volume. Efficiency of marketing efforts can be measured particularly in the areas of sales force management, advertising, sales promotion, and distribution (Kotler, 1994). 4. Conclusion and Recommendation Cleenup Limited Company has a history of profitability and manufacturing excellence that brought a steady market share amidst increasing competition in the market. It has a committed set of shareholders that continued to plowback retained earnings to company operations. It has already mastered the requirements of the cleaning aids industry, and it could be said that its core competences lie within the manufacture of cleaning aids. There is latent potential for the company to explore. New markets are presenting various opportunities, if only Cleenup will continue to innovate and satisfy the changing needs of customers. Cleenup should be able to manage the marketing of the products well, as maturing markets require a different set of strategies. As advised by experts, “new uses, new users, and increase usage” should be studied so that Cleenup could lead the innovation in its own industry. Given the host of financial ratios from past performance, it can be gleaned that Cleenup has not maximized its potentials and would do well to be aggressive enough not only in defending its current market share but even aiming to expand such market position. Notes Internal refers to comparison made on a time-series analysis. External refers to comparison made on cross-reference analysis, usually made between the company and industry average. These methods of analysis are explained further by in Introduction to Management Accounting by Horngren and Sundem (1990, p.729). Read More