Financials Projections and Investment Decisions - Aztec Catering - Essay Example

?AZTEC CATERING ANALYIS OF FINANCIAL OBJECTIVES; FINANCIALS PROJECTTIONS AND INVESTMENT DECISIONS INTRODUCTION Aztec Catering has been successfully serving its client base for the last 40 years. This success can be attributed to considerate strategic plan of group. Aztec Catering in order to compete successfully with its main competitor Compass has been developing sound strategic and financial objectives. It also implements considerate strategy taking measures for the successful implementation of these strategies and objectives. These objectives are designed and reviewed at fixed intervals, discrepancies are identified and finally based on reviews suggestions are employed to meet the desired gaps. In same trend management of the company in the year end 2012 called up board meeting and planned company objectives for the next three years. This report is based on the review of the planned objectives. For the purpose, this report provided critical analysis of the set forth objectives along with its comparison with competitors’ objectives. Section II of the report has developed financials (comprising of income statement and balance sheet) for the next three years i.e. 2013- 2015 and has made an attempt to review level of alignment between objectives and financials. Section III of the report provides review of investment decision that company intends to make pertaining to cost of capital and its impact on shareholders wealth. Lastly, the report provides concluding remarks based on the overall review. 1- OBJECTIVE EVALUATION In the board meeting held in the ending of the current year, management has highlighted corporate objectives and future direction for the next three years. These objectives have been set based on the financial position for the current year 2012. Financial objectives for the next three years are as follows: 1- To maintain the profit margin around 24% 2- To ensure the current strong financial position is maintained 3- To satisfy shareholders by maintaining the dividend payout ratio of 50% ANALYSIS OF THE FINANCIAL OBJECTIVES Apparently the objectives appear to be suitable for the overall business. However, since the case do not provide detailed financial information, therefore, it is difficult to accept these objectives in alignment with the overall objectives across departments. For instance, maintaining profit margin at 24% refers that Aztec Catering has either plans to maintain the strong control over cost or would increase its prices to maintain to meet the objective or increase sales. Both options have their implications mainly for following factors: 1- Level of competition 2- Inflation 3- Only in case if all other things remain same Keeping under consideration, Aztec Catering is competing with Compass group which comparatively bigger business concern. Therefore, increasing price would divert its customer to the competitor and there is ample chance for Aztec Catering to lose customer base. On contrary, reducing overall cost or developing stronger control over cost items is the other option. As stated in the given option, objective of Compass group is to provide the best services to its customers refers that Compass group would provide more value added offerings to its customer. Providing value added products would increase cost while being bigger concern it can easily attain the benefit of economies while Aztec Catering in order to remain competitive has to increase its offerings as well that resultantly would rise in cost. Hence, there are all chances that cost would increase in a greater proportion than sales. Therefore, cost control appears somewhat difficult option. Considering the third option of increasing sales also require increased marketing and other activities that would also increase cost. Therefore, it with the given information it is difficult to infer the ways Aztec Catering would maintain the profit margin of 24%. The given information has also not accounted the other factors that increasing cost. For instance, for the target that have been set the given information does not provide any details about the impact of inflation accounted while setting objectives. With the change in business dynamics it has been viewed that factor posing impact on business are increasing in number with every passing day along with each factor impacting business with higher intensity than earlier. Hence, fixing corporate objectives need to account these factors in greater. For details example, other than inflation there are many other factors that are expected to have implications such as increase in tax, change in government policies especially pertaining to hygiene etc. With current business situation in UK, government in order to reduce its deficit is more prone to increase regulation and taxes on business. Such regulations have their own cost hence, needs to be considered. RISK It is ultimate aim of every business to increase profitability and enhance as well as strengthen its financial position (Kaplan, and Atkinson, 1998). However, it is much easier said than done. It needs to provide more detailed information and device more sound strategies for this objective. The given information, however, does not provide any reference to such strategy or directives. Businesses at every stage of performance are prone to certain risk and if not addressed in projections are expected to impose pressure on the business to extent of survival to be questioned. Given information does not provide any information or plan to meet the risk challenges. For instance, it does not detail if firm have any other source of income such as income from investment etc. Moreover, the business is incurring opportunity cost of keeping sizeable cash in idle. This poses dual risks to the business; first the risk of losing revenues that firm could gain in parallel by investing the cash in profitable avenues. In fact Aztec Catering is already bearing this cost. Second, if case anything goes apart from planning, then such revenue sources provides support to business in crises. Aztec Catering has incurred this risk also and has not invested in any such avenues. Hence, risks seem not being addressed to meet the planned objectives. INTERDERPATMENT CONFLICT OF INTEREST The above mentioned objectives are all based on the financial aspect and hence, does not account for the interest of other departments. For instance, in case business is to increase sales to meet its objectives, therefore, would require the investment in marketing function. This can raise the conflict of interests among the departments with finance department requiring maintaining stringent control over cost while marketing department insisting on investment in marketing activities to increase sales. The developed objectives, hence, does not provide any reflection to addressing the interest of other department thereby increasing friction can result in negative implication. CONFLICT OF INTEREST BETWEEN MANAGEMENT AND SHAREHOLDERS Moreover, the conflict of interest can also rise in later years between management and shareholders on the matter of dividend. The objective to provide shareholder equally half of the profits is concern worthy. For the three years, apart from ignoring factors that can affect growth, firm has forecasted increase in sales that would enable business to run operations smoothly and thereby distributing profits to shareholders. In later years, information provided states that firm do not expect increase in sales. At this point in time, assuming the market is saturated and hence cease of increase in sales is multiplied with increased competition; hence, requiring business to tighten its policy of retaining profits for meeting expenses and leading reduction in dividend distribution. This would raise the conflict of interest between management and shareholders. CAMPARISON OF AZTEC CATERINGS OBJECTIVES WITH THE COMPETITOR’S OBJECTIVES Aztec Caterings main competitor Compass Group that has standing round the globe and is comparatively much larger than Aztec Caterings in size and operation has the following objective: “To provide the best possible services to our customers”. Compass Group in order to meet its objectives based on its financial strength (assuming it to have sound financial muscles developed with global presence) can go length to provide innovative offerings and services. Moreover, the competitor seemingly able to meet the mentioned objective by achieving the benefit of learning curve as well as economies of scale would put pressure on Aztec Caterings in meeting its set objectives. Though both firms have set objectives set in different aspects as Compass Group’s objective reflect the corporate objective overall whereas Aztec Caterings are from financial perspective that are usually department-wise transcending of overall objective. Hence, it is difficult to infer more with comparison of two. However, Aztec Caterings’ objective achievement in competition with competitor would lend more benefit to Compass Group for being bigger concern in capacity. 2- FINANCIAL PLAN FOR THE YEARS 2013- 2015 Given below is the financial plan (two financial statements) for the years 2013 – 2015. For the purpose, information of the current year has been taken as base year. INCOME STATEMENT AZTEC CATERING INCOME STATEMENT   In Mn ?   2012 2013 2014 2015 SALES   100 120 150 190 OPERATING PROFIT (EBIT) 24 28.8 36 45.6 INTEREST @ 10% 4 4.8 6 7.6 PROFIT BEFORE TAX 20 24 30 38 TAX @ 30% 6 7.2 9 11.4 PROFIT AFTER TAX 14 16.8 21 26.6 DIVIDENT 7 8.4 10.5 13.3 RETAINED EARNING 7 8.4 10.5 13.3 Assumption for the preparation of income statement *Interest expense for the years 2013-2014 has been derived from with deriving the net of EBIT and EBT, where EBT for the underlying years have been assumed to follow same percentage as in year 2012 i.e. EBT (20)/ EBIT (20) = 83.33%. BALANCE SHEET ASSUMPTION FOR THE PREPARATION OF INCOME STATEMENT *First, long term debt calculated with respect to interest expense of 10% derived in income statement (interest exp (4)/ rate (0.10)). *Based on capital employed and sales 1:1, Total capital has been derived. Increase in share capital is net of Total Capital and retained earnings. *Assuming total asset to maintain growth consistent with its ratio to sales in 2012 (160/100= 1.6), total assets for the three years have been derived. *Cash and other current assets to follow their ratio with total current assets in year 2012, while total current assets are net of total assets and long term assets. *Long term assets for the planned years follow ratio of long term assets to total assets in year 2012. * Finally, liabilities are net figure from total equities less capital and long term debt. ANALYSIS Income statement for the year has been showing positive results. Since forecasting has been made based on sales growth year on year, entire components across planning timeline has been following the similar trend with 20%, 25% and 27% growth in 2013, 2.14 and 2015 years respectively. In case of balance sheet also, since information has been generated based sales growth year on year, trend across the timeline is same. However, information has been extracted based on given data:   2012 2013 2014 2015 % of Capital 0.375 0.375 0.375 0.375 % of Debt 0.625 0.625 0.625 0.625 Increase in share capital 36% 55% 51% Increase in debt   20% 25% 27% T. Debt to Eq. 67% 67% 67% 67% Ltd to Equity 167% 167% 167% 167% Debt to T. Asset 25% 25% 25% 25% Working capital ratio 1.666667 1.666667 1.666667 1.666667 As against the objective of the business to maintain strong financial position there are some discrepancies. Aztec Caterings aimed to maintain the debt to equity ratio below 40% is not met in current condition. Therefore, business needs to manage the capital structure based to get it aligned with objectives. Working capital ratio is giving somewhat positive sign that business will not run into liquidity risk and has strong capacity to meet its liabilities. Moreover, important information related to components of other current assets is not available to infer the impact. Maintain sizeable cash idle is costing business opportunity cost. Moreover, business can further cut its cost of capital down by trading between short term and long term liabilities. Hence, apparently based on the financials there are not issues but at the same time it does not refer to positive signals as years understudy are growth years and the issues may arise when growth would halt as expected. INVESTMENT ANALYSIS Investment decisions are mainly guided by undertaking the investment appraisal of available option using techniques such as payback period, Net present value, IRR etc. Investment options result from these able to gain generate the positive appraisal techniques are adopted. Since investment requires financing, therefore initially businesses are required to calculate the cost of capital. Cost of capital raised from equity is much higher than cost of debt. Based on the Pecking Order Theory, rational firm shall follow the path of financing beginning from retained earnings to debt and then finally to equity (McLaney, 2009). Since debt provides the tax shield, MM theory supports the fact of gaining maximum tax benefit. However, costs of increased gearing e.g. increased chances of leads to bankruptcy cost etc are ignored in this suggestion. Hence, capital structure is and shall mainly be managed at levels where cost of capital or WACC is lowest. This lowest point determines the optimal amount of debt with highest value for the firm (Gitman, 2003). Main aim of business is to increase shareholders value. To increase shareholders value following are options 1- Manage business operations that increase free cash flows by increasing revenues etc. 2- Capital management optimization such educe WACC to its minimum 3- Reduce payables to minimum 4- Realizing non-core assets at best possible price 5- Business innovations and venturing (Khan, 1993) Hence, all of above when executed with maximum efficiency increases share holders’ wealth as explained in example image below: (Mentzer, 1999) Aztec Caterings aims to increase the share holders’ value by investing in fixed assets and working capital. For the part of increasing return, Aztec Caterings has estimated an increase in sales. In order to increase value more proportionately, it shall focus on reducing the cost as well. Since, the details of cost components are not provided in the case, it is difficult to suggest factors or the component that require attention in management as well component that can offer more efficient usage. Among fixed expenses, it usually has rent utilities, insurance, advertising etc. Since, catering business require continuous movement of equipment hence, incurs higher transportation cost. Aztec Caterings can invest in managing its own fleet for transportation. This would benefit in both improved working capital component of transportation as well as would increase its own fixed asset base. Hence, this way it can gain dual benefit of increasing working capital as well as increasing fixed asset investment. For the further capital investment, following evaluation is conducted based on initial calculating of the cost of capital followed by evaluating returns based with respect to this cost. Cost of capital for the business calculated using WACC has been 6% for the years understudy: WACC 2012 2013 2014 2015     Cost of equity 12% 12% 12% 12% Cost of debt 10% 10% 10% 10% Tax 30% 30% 30% 30% weight of equity 38% 38% 38% 38% weight of debt 63% 63% 63% 63% WACC 6% 6% 6% 6% Hence, with this cost of capital, investment is appraised using NPV and IRR capital appraisal techniques: IRR & NPV  In Mn ? 2012 2013 2014 2015 Initial Investment 25 29.2 34.45 41.1 total Initial Investment -129.75   Free Cash Flows 14 16.8 21 26.6 Net cash flows -115.75 16.8 21 26.6 IRR @ 8% -23%   IRR @ 6% -23%   NPV ($55.54)       It has been assumed that 50% of the retained earnings are invested each year for fixed investment as none information is available in this regard. Therefore, project is appraised on based on the comparison of WACC and IRR. Given below is the acceptance/ rejection appraisal: ACCEPETANCE / REJECTION DECISION     IRR > WACC ACCEPT   IRR< WAC REJECT   IRR -23%   WACC 6%   Hence proposal is highly recommended for rejection   Moreover, negative NPV also asserts the decision of rejecting the investment decision. The return conditions are very unhealthy. Against the cost of capital of 6% only the returns being generated are highly negative. Even being optimistic these projections are hardly expected to meet the standards as there is long gap to be bridged. Moreover, these valuations only account for the incremental investment that business has planned to invest and hence does not account for cost of already employed capital in all. Accounting it would result NPV and IRR further driving down to negative domain. Hence, business is not generating enough returns as compare to its investment. Moreover, since sales are expected not to increase in times after understudy three years therefore, it also does not provide any expectation regarding improvement in situation. Lastly, measure of economic value added has been calculated as follows:  In Mn. 2012 2013 2014 2015 EVA ? 7.75 ? 9.30 ? 11.63 ? 14.73 Economic value added metric for Aztec Caterings has been in the positive domain, but being too low it also does not provide any appreciable sign. Though value is increasing as years pass by but keeping fact under consideration that sales are to remain consistent (assuming no decline) there are chances that return from the project shows some downward trend. Hence, investment decisions are not suggested based on the overall condition of business. Moreover, business shall invest in improving efficiency in order to gain maximum to sustain in long term with consistent sales. CONCLUSION Analysis of Aztec Caterings reveals that overall condition of the business though appears with no discrepancy but these results can only be derived upon ignoring factors that are to impact business. The positive results are also results of accounting treatment support and the financial treatment results on questioning overall performance of the business. Hence, these objectives are though attainable in span of three years only in case factors influencing are ignored. Moreover, investment options are highly not recommendable as returns generated are far below than cost incurred. Hence, business needs to review its overall operations and make some sound strategic decisions. It is also necessary in order bring business in sustainable position to survive after three years when it does not expect increment in revenue generated from sales. References Mentzer, J. (1999). ‘The Impact of forecasting on Return on Shareholder’s Value’. The Journal of Business Forecasting, available from http://bus.utk.edu/supplychain/forecasting/docs/Impact%20of%20Forecasting%20F99.pdf Friedlob, G., & Plewa, J. (1996). Understanding balance sheets. New York: John Wiley & Sons. Gitman, L. (2003). Principles of Managerial Finance. Boston: Addison-Wesley Publishing. Kaplan, R., and Atkinson, A. (1998). Advanced Management Accounting. New Jersey: Prentice-Hall. Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. McLaney, E. (2009). Business Finance: Theory and Practice. New Jersey, Pearson Education Read More