Analysis of Summer Bodysuit Ltd - Coursework Example

?Report on Summer Bodysuit Ltd. The report as required by the Board of Directors has been prepared with reference to the following requirements basedon the working results for the current year and the previous year and the balance sheets for the corresponding period as at the close of the years, and submitted for the consideration of the Board. The information as furnished by the Board during the discussions in the recent meeting held with them has been appropriately considered for the purpose of analysis. 1. To prepare a detailed plan of action for dealing with the financing problem currently faced by the company. 2. To study whether bank’s request for a significant reduction in the overdraft facility granted to Summer Bodysuit Limited is reasonable. Structure of the organization The financial problems in a company arise mainly due to weakness in the structure of the organization. Jill Dempsey and Mike Greaves have good experience in the company’s business. The business model, designing and manufacturing of casual and leisure clothes aiming particularly at the younger and higher-income market, is in line with their experience. However, the weakness in the organization structure lies in lack of proper system for financial management. Financial management is a specialized area which needs expertise for efficiency in business operations. Keeble brothers’ involvement in the day to day business activities has been very limited. The business has grown well over the period of time and the order recently received from Arena, a chain of casual and sportswear stores is seen particularly important. The draft accounts from the Auditors confirm the company’s success. But, lack of suitable system for working capital management and planning in capital investment has landed the company in the current financial difficulties. Relationship with the bank and planning for the future The bank wants the company to reduce the overdraft by half over the next six months. The company had breached its overdraft limit on several occasions over the past few years. The management is aware of the fact that the patience of the bank has been wearing thin. The largest shareholder of the business is Keeble Estates Ltd, owned by David and John Keeble. Neither they are in a position to make further investments nor willing to accept investments from new investors, fearing loss of influence over the company. It is in this backdrop the analysis is done to make suitable recommendations for taking necessary actions to overcome the current financial difficulties. Business operations Dechow et al (2010) state, “the quality of a ?rm’s earnings depends on both the ?rm’s ?nancial performance and on the accounting system that measures it.” Prima facie the company has not accorded the deserved attention to accounting in the organization. The management has embarked on investment spree without making necessary arrangements for the additional working capital needed for its operations. David et al (2007) states that “overcon?dent managers underestimate risk and therefore take actions with excessive risk”. Evaluation of the business prospects involves analysis of several factors relating to the business. Schrand and Zechman (2009) state that “the overconfident managers make optimistic forecasts and in order to meet these forecasts, exhibit higher levels of fraud and earnings management.” Though the results do not in any way suggest fraud its management of finance calls for critical analysis. Gross profit margin during the last two years has been at 14.99% and 20.61% respectively which reflects the soundness of the business proposals of Jill Dempsey and Mike Greaves. The increase in capital investment and consequently working capital required additional investments which are met primarily through bank overdraft. “An overdraft facility enables businesses to obtain short-term funding - although in theory the amount loaned is repayable on demand by the bank” (Riley, 2012). The bankers are now asking the company to reduce the overdraft level significantly. Keeble brothers, who are the majority shareholders in the business are not in a position to bring in additional investments required at this crucial time. Cronqvist and Fahlenbrach (2007) state, “Our hypothesis is that large shareholders differ from each other along important dimensions such as their beliefs, skills, sophistication, or risk preferences. Different shareholders may, for example, have different beliefs about how to monitor management and what set of corporate policies will maximize expected returns.” In this case, the Keeble brothers position acts as a deterrent to solve the issues faced by the management on account of their inability to bring in additional funds and unwillingness to accept investment by any new shareholder. Analysis of the performance of the business, the financing decisions taken by the management with regard to capital investment and working capital management and leveraging in capital structure of the company are undertaken for recommending suitable course of action, the company could adopt under the circumstances. Profitability Financial analysis is the selection, evaluation, and interpretation of financial data, along with other pertinent information, to assist in investment and financial decision making. (Drake, n.d.) The company is in growth trajectory and with the order from Arena it is expected that the sales of the company is likely to increase rapidly over the next few years and it will establish Summer Bodysuit as a major player in the market. Apart from the gross profit margin as indicated above, the other important financial ratios related to profitability given below are really impressive. ROCE Net income/Capital employed (1248/12956) x 100 PY 9.63% (2926/24444) x 100 LY 11.97% Net profit margin after tax Net income/Sales (1248/14006) x 100 PY 8.91% (2926/22410) x 100 LY 13.06% It is important to note that the capital investment during the year has increased substantially. The effect of these investments will be fully reflected in the results only from the subsequent year. Therefore, for the purpose of valuation of shares, 75% increase in sales for the next year is considered. “More profitable firms have, ceteris paribus, more internally generated resources to fund new investments. If their managers follow a pecking order, they will be less likely to seek external financing.” (Fama and French, 2002) However, the Annexure – I shows that there is heavy dependence on overdraft for long term capital investments, which is not advisable Cash flow management Management of cash flow in the day to day operations calls for establishment of full-fledged accounts department to increase its efficiency in financial management. Hribar and Yang (2010) state “overconfident CEOs of 477 large U.S. companies between 1980 and 1994 have a heightened sensitivity of corporate investment to cash flow.” The company which is in full expansion mode has to have strict control over cash flows. It involves collection, payment to the suppliers, interest payments, salaries and wages as well as payments related to expansion activities undertaken by the company. Working capital Padachi (2006) states, “small businesses are not very good in managing their working capital.” The company’s working capital management needs to be strengthened in view of the scale of operations and robust growth of the business. Samiloglu and Demirgunes (2008) states, “the account receivables period, inventory period, and leverage affect company profitability negatively”. The important metrics relating to working capital are given below: Current ratio PY LY Current assets/Current liabilities 0.63 1.11 Receivables - collection period Trade debtors/Sales x 365 (in days) 78.59 117.62 Payables - payment period Trade Creditors/Cost of sales x 365 (in days) 59.11 82.06 Nobanee and AlHajja (2009) suggest that managers can increase profitability of their companies by shortening the cash conversion cycle, the receivable collection period and the inventory conversion period. It could be observed from Annexure – I that there is slackness in collection which is reflected in the increase in collection period. Hill et al. (2010) observe that “increases in sales growth and sales volatility cause companies to manage operating working capital more aggressively.” In this case, the payment period has also increased substantially. But, this reflects the tightness in financial position in the company. This will affect the credit worthiness of the company, since the company can bargain in pricing only when it is prompt in settling the payments. Nakamura and Palombini (n.d.) state “The discussion about the determinants of working capital management is not a simple theme. Most studies about working capital management aimed to understand its relation with company’s profitability, assessing the impact of working capital policies on value creation to shareholder.” However, delay in payments leads to delay in supplies as well as paying higher prices for the purchases made. The improvement in current ratio is comfortable, though it is caused due to slackness in collections. Doshi and Verity (2004) states, “In many industries, for example, payment terms are based on the date of invoice, meaning that speed of invoicing affects costs. In these situations, capturing delivery data is important. Simple changes, such as issuing handheld computers to delivery drivers or improving telephone connections, may release millions in working capital.” Establishing accounts department will reduce the pressure on Directors due to working capital problems and enable them to concentrate on core activities of the business, designing and marketing. Capital investment The company didn’t get anything from the old machines it got rid of. It is assumed that the depreciation has been worked out in a fairly reasonable manner taking into account the life of certain old machines. The depreciation at 2.6 million works out to more than 30% of the plant and machinery value. We can work out the investment on plant and machinery made during the year as below. Plant and machinery Book value (LY) 14470 Add: Depreciation 2600 Total 17070 Book value (PY) 8600 Machineries bought 8470 As per the above calculation, the company has bought machineries worth 8,470,000 during the year. Afza and Nazir (2007, p. 20) states “firm may be able to reduce the investment in fixed assets by renting or leasing plant and machinery, whereas the same policy cannot be followed for the components of working capital.” Sale and lease back of the machineries involve sale of machineries to the financier and leasing it back for business operation. This option could be considered if there is no other alternative available for the company to proceed with. Srivastava and Srivastava (2011) states, “While making an investment decision, the company has to take into account the returns expected by the investors, as they provide the money to the corporate.” The return on investment in the project in this case justifies the capital investments fairly. Leverage and Debt servicing Baker et al. (2007) state that “optimistic CEOs over invest and tend to choose higher leverage.” Relatively heavy capital investments have been made during the year on plant and machinery. The company has mainly relied on overdraft facilities for capital resources for this purpose. Helliar et al. (2005) state that “loss aversion leaders seek to avoid the worst-case scenarios.” Here, the various constraints involved in respect of working capital and availability of external resources in case of emergencies have not been taken into account after proper analysis, and this is responsible for the current state of affairs in the business. Kisgen (2006) states “the level of debt affects the credit rating in a negative way. The following financial ratios are relevant for the purpose of analysis in this respect.” Gearing PY LY Total debt/Total equity (including reserves) 0.88 0.58 Interest cover Earnings before interest and tax (EBIT)/Interest 4.86 5.06 Though debt-equity ratio has deteriorated during the year, it is not alarming considering the overall economic situation prevailing in the country. The interest cover has improved substantially, and it is expected to improve further due to growth in future. Based on the draft accounts for the last year, the bankers may not be persistent in their demand for reduction in overdraft at the cost of the company’s future operations which is basically very promising. Dividend payments Keown (2004, p. 393) states “The corporate choice to pay or not to pay a cash dividend to stockholders and the further choice to increase the dividend, reduce the dividend or keep it at the same dollar amount represent some of the most challenging and perplexing areas of corporate financial policy.” The company is suffering due to scarcity of funds and one of the reasons for this problem is the dividend policy adopted by the company, which is not in tune with the established norms. In dividend policy, according to a survey among the CFOs “an important factor is the availability of investment opportunities for firms to pursue (77.8%)” (Baker, 2009, p. 87) When there is good growth in the business, and the return on capital employed is superior, the management should plough back the profits earned into the business for its developmental needs in tune with the increase in demand for its products and services in the market. Citing a survey Sautner and Weber (2009) state that, “the overconfidence of top executives affects various corporate decisions, including the dividend policy of the firm.” When the company is running in huge overdraft, outflow on account of dividends to the extent of 22.22% [(800/3600) x 100] is not justified. “Dividend yield is negatively associated with measures of growth options.” (Baker, 2009, p. 58) Large shareholders’ responsibility Gomes and Novaes (1999) state that “the large shareholders of firms with majority blocks are often at the helm of their companies and do not necessarily have the same interests as minority shareholders” and argues that their bargaining powers prevent efficient decisions. They have responsibility to come to the rescue of the company at the times of emergencies and exigencies. Shleifer and Vishny (1986) states, “Since we believe that large shareholders can significantly influence the share valuation, we explore the possibility that they are compensated for monitoring through dividends.” The dividend policy adopted by the company has greatly benefited the Keeble brothers. Critical analysis of the cash flow position at the time of declaring dividends would have mitigated the problems to a greater extent, because the dividends for the earlier year would also have been avoided in view of the capital investments planned. Keeble brothers have made it clear that they are not in a position to inject fresh funds into the company as their parent concern Keeble Estates has been experiencing financial difficulties. In fact they would like to sell their stake in Summer Bodysuit if there is a buyer at the right price, which seems to be not possible under the current general economic situation. However, drastic and immediate action by the board as desired by them could be taken only with their support by way of pledging their shares in bank and/or giving personal guarantees if required. Recommendations After carefully considering the various factors involved and capital structure in the business, the following recommendations are made for the consideration of the board of directors of Summer Bodysuit Ltd. Pledging of the new assets The old machines discarded are covered under bank loan. The investments in new machines are made without bank loan, but mainly through overdraft facilities. Therefore, the company can pledge the new machines to the bank and convert the overdraft to term loan. The will also lead to reduction in interest outgo, since the rate of interest on loans will be lower compared to overdraft interest. Pledging of shares by the Directors Shaw and Sajai (2011) state that, “more and more companies are pledging their shares as collateral against long term debts.” In order to convert the overdraft to term loan, the bank is expected to ask for collateral. The promoters could offer their shares of the company as collateral for the bank loan. The total value of the shares of the company works out to 25,857,000 as per the Annexure – II against the value of 9,000,000 as per the books. We have considered 75% increase in sale for the first year in view of additional investment on machinery during the year and substantial increase in sale expected due to orders from Arena. In all the subsequent years (nine years) the sale is increased by 10% each year which is very reasonable. We have considered additional investments nominally that may be required over the period of time. Interest rate and the rate of normal return expected on capital investment are considered at 10% for the workings which is very reasonable. Therefore for an overdraft of 4.25 million, shares worth 25.87 million should be acceptable to the bank. In that case, pledging of new machinery is not required. Leasing of plant and machinery In this case, the company can get back the investments made on plant and machinery by selling them to the financier and simultaneously use the plant and machinery for its operations through leasing. The sale proceeds could be used for clearing the bank overdraft and working capital purposes. However, the proposition of leasing could be costlier compared to bank loan. This option could be considered only if the bank is not willing to cooperate in providing necessary loans as required. Efficiency in collections Efficiency in working capital management calls for establishment of full-fledged accounts department. Scaling up of the business needs to be supplemented with efficient system for billing and collection. For ensuring control over the expenditure, a proper reporting system should be in place to relieve the management of the day to day activities related to working capital. Factoring of accounts receivable To tide over the situation temporarily in an effective manner, the management could consider transfer of the task of collection to a factoring agency. This will immediately reduce the pressure on management in respect of collections and also release the capital tied up to accounts receivable. “Factoring of accounts receivable is used by many businesses which are in need of working capital. By simply selling account receivables or invoices for products or services provided to a "factor" a business can obtain almost immediate access to capital.” (BMA, 2006) Credit arrangements with the suppliers “When a supplier allows a designer to purchase on credit, the designer is working with a supplier’s money, or what is called trade credit.” (2002, Piotrowsky, p. 76) This is a strategy of transferring the financing responsibility to the suppliers. This will reduce the working capital requirements substantially. Open cash credit on inventory When overdraft is converted into loan, the company may avail Open Cash Credit against inventory for its working capital needs. This is the normal arrangement in which the banks are giving credit based on the company’s investment on inventory, and the company has to submit periodical stock statements, say, monthly to the bank. Bank’s overdraft facilities The bankers are primarily worried about the cash flows related to the operations of their customers’ businesses. The customers’ ability to repay the loans, their willingness to comply with the formalities and transparency in their business dealings are the important criteria followed by the banks in lending and providing overdraft facilities to the customers. The company had breached its overdraft limit on several occasions over the past few years. Since the accounts are not maintained on day to day basis regularly, it might raise the question of transparency in the minds of the bankers. The assets pledged to bank have been partly or fully discarded during the year. The company needs to keep the bankers informed of this fact when the collateral provided to the bankers has become useless. It is the responsibility of the management, on disposal of the pledged assets to fulfill the bank formalities by providing new assets in lieu of old assets for pledging. Overdraft facilities provided by the banks are short term in nature and cannot be permanently depended upon. The interest on overdraft will be higher than the normal interest rates applicable to loans. “Overdrafts are generally meant to cover short-term financing requirements - they are not generally meant to provide a permanent source of finance” (Riley, 2012). However, from the bankers’ point of view it is riskier than the term loan where they could get refinance. Therefore, the bank’s request for a significant reduction in the overdraft facility granted to Summer Bodysuit Ltd is perfectly justified. However, the bank could be persuaded to reconsider their decision based on the draft accounts for the year which is yet to be submitted to the bank and Annexure – II attached herewith showing valuation of shares. Conclusion Jill rightly believes that the company can convince the bank with draft accounts to withdraw their demand. The Directors can offer their shares as collateral for the term loan, if the bank is acceptable to this proposal. This proposal could be supplemental with personal guarantee by the Keeble brothers, if necessary. Alternatively, the new plant and machinery could be pledged and the overdraft converted into term loan. These proposals will result in reduction in interest outgo considerably in future. Sale of machines and lease back could be considered as a last option if the bankers are not willing to cooperate with the company in converting overdraft to term loan. The total value of the machines works out to 14.47 million. This includes the machines acquired during the year for 8.47 million which are not covered under any loan. This would be sufficient to raise the required funds to clear the overdraft in a short time as required by the bank. The additional working capital could be raised by open cash credit on inventory or factoring of accounts receivable. 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The Wall Street Journal, 16 August, 2011 [online] Available at: [Accessed 27 November 2012] Shleifer, A and Vishny, R.W., 1986. Large Shareholders and Corporate Control. Journal of Political Economy, Vol. 94, No.3, The University of Chicago. Srivastava, P.K. and Srivastava, S., 2011. COST OF CAPITAL AND DECISION MAKING. Gurukul Business Review (GBR), Vol. 7 (Spring 2011), pp. 113-118, [online] Available at: [Accessed 29 November 2012] Appendices Annexure - I Summer Bodysuit Ltd: Fund Flow Statement in '000 Sources of Funds Operating Profit 4618 Cash 48 Loan Notes 3000 Increase in Trade payables 1398 Increase in Other payables 714 Bank overdraft 4250 Total 14028 Application of funds Non-current assets 5870 Increase in Inventory 3,402 Increase in Trade receivables 2,130 Increase in Other receivables 134 Dividends 800 Interest 912 Tax 780 Total 14,028 Valuation of shares: (Expected return/Normal return) x Investment (28.48/10) x 9079 = 26857 Read More