Analysis of Summer Bodysuit Ltd - Essay Example

? Financial Reporting Introduction Summer bodysuit Ltd (SBL) is a startup company, which a designer and manufacturer of casual and leisure clothes aimed particularly at the younger, higher-income market. It is led by Jill Dempsey as the managing director and Mike Greaves as the production director. The two entrepreneurs seem to be going places as their products have been received very well in the market, and the sales seem to increase drastically. Nevertheless, despite their good prowess in designing and marketing the company’s products, the company is undergoing serious cash flow problem especially because the financial affairs of the company are not run well. This problem is so serious that the bank has requested the company to reduce its overdraft for the next six months, hence worsening its already ailing cash slow. As a member of Drake Management Consultants, who have been mandated to advise the company regarding financial issues, I have undertaken to write this report, citing the key problems and offering some recommendations regarding the problems that the company is undergoing. Analysis of the company’s financial statements Return on capital employed (ROCE) The ROCE for Summer Bodysuit Ltd (SBL) has increased from 15.9% to 23.8%, which is a favorable trend. This shows that the business has efficiently invested its resources to create profits. However, the management should be careful to ensure that this rate is maintained at a higher rate than that of borrowing; otherwise its benefit may not be realised (Baker and Wurgler 30). Year before last Last year Profit before Tax 1,668 3,706 Capital Employed 10,474 15,600 ROCE = ((Profit before Tax) / (Capital Employed)) * 100. 15.9% 23.8% Return on Equity (ROE) It is remarkable that ROE has increased from 0.38 to 0.54, because this shows that the company’s profitability is on an upward trend, hence an assurance to the shareholders that their capital is being used efficiently to make profits. This trend should be maintained by continuing to invest in profitable opportunities, though the management should be very careful not to engage in investment decisions that can slow down this positive trend in the future. Net Income 1,248 2,926 Shareholder's Equity 3,274 5,400 ROE = Net Income/Shareholder's Equity 0.38 0.54 Gross Profit Margin The company’s gross profit margin has increased slightly, from 46% to 48%. Although, a slight increase in this ratio is a positive indication of financial health, the management should work hard to ensure the cost of sales is reduced at a more increasing rate so that the company’s growth can be speeded up. Incidentally, as the company work out on strategies that can increase the firm’s revenue, it should not be forgotten that reducing marginal cost of sales is also very essential. Furthermore, what is left after netting cost of sales from the revenue is used for paying for additional expenses as well as for future savings (Barry 256). Year before last Last Year Revenue 14,006 22,410 COGS 7,496 11,618 0.46 0.48 Net Profit Margin The Net profit Margin has increased from 8.9% to 13%, which is financially very healthy; if this trend continues in the future, the company is likely to grow in leaps and bounds. The management should be on the lookout for the costs that could be increasing at a greater rate than the revenues and control them because this could cause the growth in the net profit margin to decelerate in the future (O’Connor 758). Year before last Last year Net income 1,248 2,926 Revenue 14,006 22,410 Net profit margin = (net income/ revenue)*100 8.9% 13% Inventory Turnover Ratio The company’s inventory turnover ratio has declined from 5.79 times to 3.85 times. This declined trend can cause alarm if it is as a result of any goods selling slowly. However, if it is caused by a company’s new strategy that has led to increased inventory, and which will lead to overall growth, then this should not be a cause of alarm. However, the management should ensure that the inventory is always maintained at an optimum level to avoid incurring more cost of holding stock or experiencing a shortage of inventory, which leads to losing of revenue. Year before last Last year Sales 14,006 22410 Inventory 2,418 5820 Inventory Turn Over Ratio 5.79 times 3.85 times Current ratio The current ratio has reduced from 1.76 to 1.28, a trend that portends danger to the liquidity position of the company if it continues in the future. This is possibly caused by the increased bank overdraft and other sources of debt finance. Reduction of this ratio means that the company’s ability to pay its short-term obligations is at stake. It also means that the company is likely to incur excessive expenses in the form of interest rates. To alleviate troubles that emanate from this ratio, the management would want to find ways of increasing inventory turnover or getting timely payment on the company’s receivables. Debt-to-equity ratio The company’s debt-to-equity ratio has increased from 0.88 to 1.72, meaning that the company has been very aggressive in financing its growth using borrowed capital. As much as this could be a growth strategy, the management should be more cautious because this may lead to volatile earnings because interest expenses are likely to increase significantly. Nevertheless, the company is likely to generate more earnings, if it uses a lot of debt to finance its operations, in which case the management could argue that those earnings could be foregone if the debt is not used. Furthermore, if the earnings were to increase at a higher rate than the debt interest, then it can be prudent to use them because the shareholders are going to benefit. Therefore, the management should be careful not to use debt capital if its benefit does not outweigh its cost because this can lead to bankruptcy, whereby the shareholders lose their wealth (Schmidgall and DeFranco 339). Year before last Last year Total liabilities 6082 15444 Shareholders’ equity 6874 9000 Debt-to-equity ratio 0.88 1.72 Problems that the Company Is Facing Issue 1: Shortage of cash Summer Bodysuit Ltd (SBL) is undergoing a serious cash shortage, which is putting it at a risk of losing lucrative opportunities. In the past, it seems the company was depending largely on bank overdraft to finance its operations, but unfortunately this source of finance seems to become elusive as the bank has lost the company’s credibility confidence due to breach of overdraft policies and perhaps because of holding too much debt as indicated from the financial reports. This cash shortage comes in the wake of a big order from Arena, a company that is seen as very important because if it became a regular customer, the sales of the company are likely to increase rapidly over the next few years and would establish Summer Bodysuit as a major player in the market. Therefore, if SLB will not manage to secure the much sought after cash to finance its operations, then it will undoubtedly lose a prime growth opportunity. This problem has really perturbed Mr. Jill as the company’s managing director, and none of his attempts to marshal funds seems to be measured up. His attempt to convince the major shareholders, David and John Keeble has hit a dead end as these investors are still nursing their financial woes following a recent recession that hit their land speculation business. In fact, rather than risk more cash in SLB, they would rather dispose of their shares in the SBL, only that it is hard to get a buyer currently. Keeble brothers have also put more obstacles to the company because they are not ready to allow the company to sell shares to more investors because they would like to safeguard their influence (Leary and Roberts 2575). Although Jill is very committed to convince the bank that SBL has important orders that need cash so the bank can soften its stance, it is almost clear that the bank will not accept to drop its request to the company to reduce its overdraft by half for the next 6 months, especially considering that SBL had breached its overdraft limit several times in the past. This is a major source of finance; it is likely to be a major setback and the management must think of an alternative source of finance. If no source of finance will be forthcoming any soon, then the company is set to miss out on crucial investment opportunities and this will affect its growth prospects. Issue 2: High Leverage The rate at which SBL is increasing its reliance on borrowed money is alarming. Last year, for example, the company’s debt-to-equity ratio was 1.72, indicating that the company’s debt capital outweighed equity capital, a capital structure that is very dangerous - if it goes unchecked, it is likely to result the company into bankruptcy. This can happen if the company is burdened with too much interest expense paid in return for using the borrowed capital. In a balanced capital structure, a company should not hold more debt capital than equity capital because this is too risky. Following the recent order from Arena, which the company could not finance from its internal sources or equity, the management is attempting to rely on overdraft facility (Welch 339). This, unfortunately, is not the right move as the company is already highly leveraged and adding more debt finance will cripple the company with interest expenses. It is very unfortunate that neither the major equity financiers, Keeble brothers, nor any of the equity shareholders is in a position to finance the company through additional equity, which is much needed in order to correct the ailing capital structure. Any attempt to obtain borrowed capital, whether from a bank or from any other financier is likely to bring the company to its knees. Therefore, the management has a daunting task of seeking alternative sources of capital (Dann 237). Issue 3: Lack of competent financial management staff One of the biggest problems that are haunting the company is the lack of finance, yet there are no competent financial advisors in the company. Surprisingly, Mike, who is the production Director and who does not possess any experience in finance is entrusted with financial matters. To make the matter worse, the company asked the auditors for financial advice whenever a problem occurred, which greatly compromised their independence. It is also revealed that no staff in the company has adequate experience in fiance. The misadvised financial decisions that have led the company even to the extent of being denied financed by the bank can largely be attributed to lack of competent advice from a person who is experienced in financial matters. Issue 4: Problems emanating from the key shareholders It has emerged that the major shareholders of SBL are Keeble brothers, who holds substantial proportion of the equity shares and hence wielding exceedingly high influence in the company affairs. This has emerged to be a major obstacle especially when the company experienced a cash shortage and then thought of floating shares to more investors - this could not be possible because Keeble brothers were not ready to cede their influence. Their domination also appears to be very risky because they are undergoing other financial woes in their land speculation business, a problem that is preventing them from injecting more funds in the SBL. In short, their heavy influence holds SBL affairs at ransom and their action or inaction can adversely affect its operations. Recommendations Issue 1 The issue of shortage of cash is the biggest problem that is facing SBL. This problem is not only resulting from the fact that SBL is a startup company and hence expected to undergo cash shortage just like any other new company, but it is also linked to poor decision making. The poor decision making in this company can also be linked to lack of ideal financial experts to advise the management on financial matters. Therefore, the company should start by seeking new and competent financial experts to head the financial department. Consequently, the management should approach the issue of sourcing of cash more prudent to avoid wrong decisions such as over relying on bank overdraft for financing of the company’s operations. It should be realized that the company is highly leveraged and hence alternative sources of finance should be sought. For example, the management can negotiate with its suppliers to be allowed more extended and flexible trade credit, a source of finance which is ‘interest free’ and hence suitable for addressing the company’s current credit problems. In addition, the Keeble brothers, who are the company’s major shareholders, should be convinced of the importance of allowing the company to extend shareholding to more investors so the company can get more funds to plug its damning cash deficit. If they can be approached in a more tactical manner, including involving experts in the negotiations, possibly Keeble can relieve their hardened positions regarding the company’s shareholder for the sake of its prospects. Issue 2 The issue of high leverage is a serious financial problem which must be addressed lest the company is declared bankrupt. This should start with employment of competent and experienced staff to head the finance department. The new team should be charged with the responsibility of maintaining the company’s financial accounts, and putting on adequate measures to ensure that the company’s financial position is healthy. This will include ensuring that the company’s capital structure is balanced and that the level of debt is not too high or too low, among other financial roles (Taylor 62). Issue 3 As discussed above, a competent and experienced staff is necessary particularly to head the company’s financial affairs. A potential candidate who is fully qualified in financial management matters and widely experienced should be selected to fill these positions. This will also involve introducing of a fully fledged finance department, which should be independent of the audit department. Issue 4 The shareholders make crucial decisions in the company, and hence their influence should be balanced. As it was discussed earlier, Keeble brothers should be convinced to let the company extend its ownership to other shareholders such that its affairs will not be left at their mercy. A six month action plan 1st month: Convene a board meeting to discuss the critical problems that the company is undergoing. In the meeting, important resolutions such as employment of new staff to work in the finance department, opening of shareholding to more investors, alternative sources of cash such as trade credit among other issues, should be discussed. 2nd Month: A committee to foresee the implementation of the resolutions of the first month should be selected. 3rd month: Implementation of the key resolutions should commence. This should begin by instituting a new finance department, which will help in the implementation of specific recommendations regarding financial matters. 4th month: The process of implementation of major projects such as floating of new shares should start including the publishing of prospectus and complying with all the important legal requirements. 2 5th month: A review committee should be instituted to review the progress of implementation of the reforms. 6th month: The review committee should table its report regarding the progress of the implementation process together with its recommendations. The board should convene meeting to discuss the progress, to make amendments where necessary and to chart the way forward to ensure the success of the process. QUESTION TWO Would you support the bank’s request for a significant reduction in the overdraft facility granted to Summer Bodysuit Ltd.? Full justification required to support your position. As justified from the financial statements ratio analysis conducted in part 1, SBL is already highly leveraged and reduction in the bank overdraft can only help to reduce the negative consequences that normally results from use of very high debt in a company’s capital structure. Incidentally, as discussed in an earlier section, debt capital increases debt-to-equity-ratio, hence raising the company’s expenses on interest expenses. Despite the increased interest expenses could be justifiable when the benefits generated from the borrowed funds outweighs the cost of borrowing such funds, the scenario could be different and indeed counterproductive when the cost is more than the potential benefits. As revealed from this case study, SBL has exceeded bank overdraft limits in several occasions in the past, evidence that it could be starting to bite more than it can be able to chew. Exceeding of overdraft will possibly burden the company with too much interest expense and possibly the company may be declared bankrupt if it fails to meet its interest dues (Byoun 3070). The company’s managing director is seemingly disturbed by the fact that the bank is denying the company an opportunity to enjoy hefty profits if they continued to engage with Arena, a company that is thought to be a source of absolute highest level of profitability in the future. We may want to agree with Jill, however, the managing director must keep in mind that there is also a risk that comes with over relying on one client to make a hefty investment especially with borrowed money. Supposing this client fails to pay the company its dues in a timely manner or disengages with it after the ‘big’ investment has been committed, then the company will have to experience a serious financial problems since it will be hard to repay its loans together with the incurred interests – this will, for the worst, result in the company being declared bankrupt and subsequently liquidated. Furthermore, besides the good profitability trends, as seen from the financial ratios analyzed in an earlier section; SBL management should keep in mind that there are a number of other factors that the bank will want to assess when extending credit beyond some levels. For example, the potency of the company’s capital base is an important factor considered by banks because it is the source that they revert to in the event that the company defaults on its borrowed capital. Unfortunately, the company’s capital base is relatively weak, considering that the biggest shareholders are undergoing financial difficulties while the key management of the company has not held a substantial amount of shares. It would, therefore, be risky for the bank to continue extending excessive overdraft facilities to SBL, and hence I support their stand that their client should reduce it for the next six months. Conclusion This report has highlighted analyzed the financial statements, cited the major problems, offered some recommendations and explained the reasons why the bank is justified in its request to the company to reduce its overdraft for the next six months. Essentially, the major problems that the company is undergoing include high leverage, lack of competent finance staff, shortage of cash to finance its operations, and weak capital base. It is has especially been recommended that the company should recruit new and competent finance staff to foresee major reforms in the capital structure of the company. The report has also stressed the importance of inviting other investors to invest in the company among other sources of finance that can help address the company reduce its reliance on borrowed capital. Reduction of overdraft has also been found justifiable. Works Cited Baker, M. and Wurgler, J. “ Market timing and capital structure”, The Journal of Finance 57 (2002): pp.1-30. Print. Barry, E. Financial Accounting, Reporting and Analysis. London: International Edition publishers, 2010. Print. Byoun, S. “How and When Do Firms Adjust Their Capital Structures Toward Targets?” The Journal of Finance, 63.3 (2008): pp. 3069 - 3096. Print. Dann, L.Y. “Highly leveraged transactions and managerial discretion over investment policy: An overview”, Journal of Accounting & Economics, 16.1 (1993): pp. 237-240. Print. 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