Financial Analysis for Custom Snowboards - Essay Example

? XXXX XXXX Custom Snowboard Inc 28/10/11 Custom Snowboards Inc Report A In analysing the level of risk presented by the project that Custom Snowboards Inc is seeking funding for, the bank may consider a wide range of issues. In the first instance, the bank may consider the company’s current capital structure, taking into account the overall level of debt funding to equity. On the whole higher levels of gearing may lead the bank to consider that the company represents a greater level of risk than one with a lower level of gearing (Tennentt, 2008). At present the company is funded with $750 of debt to $903.8 of equity representing a debt to equity ratio of 0.83 or 83 cents of debt funding for every $1 of equity funding. Other considerations may consider the liquidity of the company, while many companies have a great business model and represent a good long term investment, many fail simply due to an inability to meet short term cash flow needs (Brealey et al 2006). At present, the liquidity position of Custom Snowboards Inc would appear to be healthy with a current ratio of 6.12 and an acid test of 3.91. The concern here on the behalf of the bank may be that Custom Snowboards Inc is not actually making best use of its current assets, rather than a concern over the liquidity of the company at this stage (Arnold, 2007). Further issues which the bank may consider is the long term prospects of the company, here the bank may choose to analyse both various measures of profitability as well as the underlying sales of the company which ultimately driver profitability. At present, the bank may highlight key concerns over both falling sales revenue and sharp falls in the operating and net profit margin. 2 In attempting to reduce perceived levels of risk, Custom Snowboard Inc may undertake a number of measures: Payback Debt – As has been noted, at present the company may be seen as having too high a level of liquid assets, indicating that the company is not using its assets in an efficient way. One way to reduce the perceived risk of the company would be to use such assets to reduce the amount of debt the company has. This would have a double effect on the company, on the one hand, the debt to equity ratio would reduce, making the company a less risky proposition for investors from a capital structure perspective. In addition, the liquidity ratios would be reduced to what the literature (Arnold, 2007) defines a more reasonable level. Overhead Reduction – One of the issues for Custom Snowboards Inc has been that while sales have fallen in recent years, fixed overheads have remanded the same thus resulting in a falling gross profit margin and presenting investors with a profitability risk. In seeking to address the problem, Custom Snowboards Inc should begin a program of overhead rationalisation. Here the company should seek to undertake a significant program of cost cutting with the aim of reducing overhead costs in line with the reduction in sales revenue seen. 3 In considering weather Custom Snowboards Inc is able to pay back the principal and loan it may be prudent to analyse a number of key ratios and tends. At present the company is paying an interest charge of $75,000 per year, if the company were to take on an additional $1m of debt at 6.75% this would add an additional cost of $67,500 PA to the company’s interest charges. Recent years have already seen key ratios declining with the net income ratio falling from 1.7% to 0.5%, and times interest earned reducing from 2.91 to 1.53. It is believed that by increasing the amount of debt in Custom Snowboard Inc’s capital structure and thus adding greater costs of financing, these key ratios will be reduced further thus questioning whether the company can afford the additional interest charges and principal payments. In considering the net income ratio and times interest earned, it should already be noted that in year 14, Winter Sports outranked Custom Snowboard Inc significantly with a net profit margin of 5.14% against 0.5% and a times interest earned ratio of 5.1 against 1.53. The operating profit margin may also be considered, while this analyses the profitability of the company before interest charges are taken into account, a fall in the rate from 3.4% to 1.8% suggests that the business is suffering from significant problems with managing its expenses (Arnold, 2007). If the trend continues, again this may bring into question the ability of the company to repay an additional loan charge. Report B 1 Past performance would seem to be disappointing for Custom Snowboard Inc, the past year has seen profitability fall significantly, largely as the function of falling sales revenue and slight increases in fixed costs and expenses. As such, if the company is to maintain profitability, it must engage in a number of projects aimed at either increasing sales revenue, such as a possible expansion into Europe. Or embark on a radical cost cutting program to increase profitability through increased control of expenses. While past performance is often an indicator of future performance, it may be seen that the problems being experienced by Custom Snowboards Inc are largely the function of poor performance in the economic environment (OECD, 2010). As such, it may be seen that future performance of the company is inextricably linked to the recovery or further degeneration within the economic environment. 2 At present one of the issues for Custom Snowboard Inc is that of rising costs which have compounded falling sales to deliver a poorer level of profitability. The most notable cost increase has been seen in the administrative payroll which has risen from $210,000 in year 12 to $250,000 in year 14. As such this suggests that Custom Snowboard include should undertake a rationalisation of staff exercise, especially in the current climate of falling sales. In addition, Custom Snowboard Inc currently exports 20% of its product into the European market. By considering a range of ways of moving production into the European market, this may result in the opportunity to make a large operational saving in logistics costs. 3 Having considered the options from a financial perspective, it would appear that the acquisition option with European SnowFun Inc represents the best return as it retains the highest NPV at $732,522. There are however, internal and external risks for the company in choosing such an option. The key risk may be seen as the raising of the funding itself, here Custom Snowboards Inc would need to buy 300,000 shares at $2.40 each giving the acquisition a cost of $720,000 plus an additional $200,000 to allow for working capital making the total cost of the acquisition $920,000. As such, Custom Snowboard Inc will need to find a way of financing such an acquisition which may place significant stresses on the organisation through the cost of either additional debt or equity based funding. In reducing the risk, Custom Snowboard Inc may choose to opt for a higher degree of equity funding, while equity funding is often seen as more expensive (Brigham and Ehrhardt, 2005) it is possible for a company to suspend dividend payments should liquidity problems be experienced. This however is not an option which can be applied to interest charges in relation to debt based sources of finance. 4 In considering the returns of a potential acquisition in the European market, there are two key areas. In the first instance the company should consider the potential for a greater number of sales in the first place. This will largely be the derivative of acquiring European SnowFun Inc’s existing customer base. However, the company should also consider future potential of further expansion using the assets acquired in the deal. The second set of returns to be considered are those associated with cost savings. Here it may be seen that Custom Snowboard Inc has a significant opportunity to move production of 20% of its export business into productive assets closer to the European market, as such this could result in a significant cost saving for the business. Additionally, the company may consider a rationalisation of head office activities once the acquisition has been made, this may help the company to improve its operating profitability level which has in recent years fallen significantly. 5 While a singular option of acquiring SnowFun Inc has been chosen as the best strategy for Custom Snowboards Inc, the CEO must select between the following options as summarised below: Option 1 – The company may choose to opt for a wholly owned FDI expansion into the market and build its own plant within the European region. Option 2 – The company could choose to merge with SnowFun Inc gaining entry into the market but losing a degree of control, even though Customs Snowboards Inc would be the senior partner Option 3 – The company could choose to acquire SnowFun Inc, a more expensive option than merging with SnowFun Inc but allowing Custom Snowboards Inc to maintain full control over operations and profits. Option 4 – The company could opt to enter a licensing agreement with SnowFun Inc so as to add additional value to Custom Snowboards Inc products being sold into the European market. 6 Having conducted the previous analysis of Snowboard Inc’s financial position, it is the recommendation of this report that a 30% debt to equity capital structure be adopted for the purpose of the project. While the literature (Brigham and Ehrhardt, 2007) highlights the fact that debt funding is often cheaper than equity funding due to the long term obligation of equity funding. It is believed that at the present time, pressures upon the profitability of Custom Snowboards Inc make the taking on of a higher proportion of debt funding represents a significant risk for both the company and investors. When analysing the results it would appear that a 30% debt to equity solution yields a positive EPS every year between year 15 at 0.06 to year 19 with an EPS of 0.333. While there is still a degree of risk attached to the funding mix, the company would only be required to pay an additional interest charge of $20,250 per year in comparison to $67,500 for a 100% debt funded solution or $54,000 per year for a 80% debt funded solution. However, in considering the proposed funding mixed, the CEO should consider carefully the long term nature of the source of funding. In effect, once issued new equity is a perpetual obligation with shareholders expecting a return over the life time of the company. While debt funding may be more expensive, the company would be released from any further obligations after successfully repaying the principal and interest. Bibliography Arnold, G. 2007. Essentials of corporate financial management. Harlow: FT Prentice Hall. Bodie, Z, Kane, A, Marcus, A, J. 2009. Investments. 8th ed. Boston: McGraw Hill. Brealey, R, A, Myers, S, C, Franklin, A. 2006. Principals of corporate finance. 8th ed. London: McGraw-Hill Brigham, E, F, Ehrhardt, M, C. 2005. Financial management theory and practise. 11th ed. Australia: South-Western Publishing. OECD. 2010. OECD Economic outlook. 2010. Vol 2. No. 88. Nov. OECD. 2009. OECD Economic outlook. 2009. Vol 2. No. 86. Nov. Tennent, J. 2008. The economist guide to financial management. London: Profile Books. Read More