Analysis of Cash Flow and Operating Cycle - Assignment Example

Accounting and Decision Making Table of Contents Introduction 3 Areas of ive Judgment 3 2. Cash Flow ment of BEP 5 3. Evaluation of the trends of BEP 6 4. Analysis of cash flow and operating cycle 9 5. Costing techniques 12 6. Critical analysis of KFun 12 7. Evaluation of Opportunity 13 Reference List 16 Introduction This report is prepared to provide the Board of Bowman Entertainment plc (BEP) with an insight of whether to invest in KFun. In this context an analysis of the financial statement of BEP has been conducted. At the same time the cash flow for BEP for the year 2008 has also prepared. The operating cash cycle has been analysed critically and appropriate costing technique to be followed has been shown. The reports also analyses the position of KFun and suggest whether BEP should invest in it. 1. Areas of Subjective Judgment Valuation of Assets The valuation of the non-current assets for BEP has been increased to £4,540,000 in the year 2008 as compared to the figures of 2007, which was at £3,768,000. The noncurrent assets include license, copyrights and other properties. The license included the Harry Boulder license on which no amortization was done. Moreover, the copyright was included in intangible assets. The argument of John Bowman behind this was that merchandising of the character was done by BEP and the company is going to benefit in form of future sales. The first concern was regarding its segregation as an asset and if at all it has been classified then amortization should have been charged. Apart from this the prospects of future benefit related to these intangible assets also have not been stated. As per GAAP amortization of the intangible assets is required to be estimated over their useful life. Thus the company should have amortised the intangible assets after deciding a definite life time for them. Inventory The inventories have been shown at a value of £3,677,000 as on 2008. No provisions have been made based on latest information against these values. Provision becomes very important while doing the valuation of the inventories. If the inventories are assumed to be appreciated then it is important to add the provision to the inventory account (Quayle, 2006). Trade Receivables The trade receivable of £4,785,000 includes £123,000 payments which is due from the customers of UK. The customers of UK have been complaining regarding the quality of the product and are refusing to pay. The situation suggests that this amount which is due may change into bad debt. Income statement According to the conceptual framework of IASB, income is defined as the rise in the economic benefit for the organization in form increase in assets and decrease in liabilities that leads to increase in equity. Though in simple terms income is revenue generated but certain category of income needs to maintain certain specific standards like gains in revaluation of assets. The income statement of the BEP appears to be very short and crisp. More details need to be provided in order to show it’s relevant. The statement only shows the profit before interest and tax and sales. Moreover, tax consultant was appointed to reduce the overall tax bill. After reviewing the corporate structure and affair of the organization the tax consultant found that the sales were overstated while the VAT billing was understated due to some coding error in the invoice system. Thus, the company needs to review and check every minute detail of the accounting system in order to avoid any mistake in the financial statement. 2. Cash Flow statement of BEP STATEMENT OF CASH FLOW FOR BEP Particulars Amount (£,000) Cash Flow from operating activities Profit before interest and tax 3,102 Tax Adjustment for:   Depreciation 320 Loss on disposal on sale of assets 0     Working capital Adjustment:   Increase in inventory (1679-3677) -1998 Increase in trade receivable(2687-4785) -2098 Decrease in trade payable(944-709) -235 Cash generated from operations -909     Interest Paid -678 Income taxes paid (W1) -624 Dividends Paid (W2) -850 Net cash from operating activities -3,061 Cash Flow from Investing activities Purchase of Property, Plant and Equipment (W3) -173 Proceeds from Sale of Equipment 0 Prepayment- order deposits (537-409) -128 Net cash used in investing activity -301 Cash Flow from Financing Activities Bank loan(8400-3877) 4523 Net cash from financing activity 4523 Net increase in cash 1,161 Cash at the beginning of the period 1659 Cash at the end of the period 2,820 Working W1: Income Tax Paid Income Taxes Paid     Closing Balance 2007 624 Incurred during 2008 606 Closing Balance 2008 -606 Income Taxes Paid 624 W2: Dividend Paid Dividends Paid     Closing Balance 2007 850 Incurred during 2008 950 Closing Balance 2008 -950 Income Taxes Paid 850 W3: Purchase of Property, Plant and Equipment Purchase of Property, Plant and Equipment         Bal b/d 1755 Depreciation 320         Additions (bal) 173                 Bal c/d 1608           1928   1928 3. Evaluation of the trends of BEP Sales The sales of BEP have been seen to increase from £18,572,000 in the year 2007 to £23,862 in the year 2008. This implies that the sales of BEP have increased by 28.48%. The generation of revenue is from Harry Boulder, character range of KFun and other characters in which the business deals. Among these three other characters are seen to contribute a significant amount towards the revenue. The revenue generated by other characters is seen to increase by 44.28%. The lowest contribution was done by harry Boulder. The contribution was low because of the announcement of the unexpected retirement of the author of Harry Boulder. Though the chances of film were there from her existing books but the lack of new stories was seen to impact the sales of BEP. The contribution of KFun was also moderate. However the sign of trouble was visible after the rumour of overstating of balance sheet and struggling to meet payment will impact the business of BEP in the upcoming year. Cost The cost of sales of BEP includes the royalties paid, amortisation of copyright, purchasing cost and distribution and import cost. The cost in form of royalties paid is seen to increase by 43.83% in the year 2008 as compared to 2007. Cost for purchasing raw material has also experienced an increase by 31.39% and cost of import and distribution has increased by 39.13%. Before 2008 the author of Harry Boulder used to receive royalty of 1% on all the sales of product related to the book and the cost for licence was £25,000. But in the year 2008 the licence was renegotiated to a cost of £80,000 and a new royalty deal was created at 3%. This increase on royalty was the reason for the cost of royalty to increase. Amortisation of the copyrights was not calculated by the company; hence the cost from that was zero. The cost of purchase and distribution and import cost was also seen to increase because after the success of harry Boulder and KFun the company signed many other deals on other branded characters that increased their sales exceeding their forecasted estimations. Moreover, BEP also started to sale their merchandises across Far East, Europe and US. Overheads The overhead cost was seen to increase in 2008 by 28.26%. The overhead cost included sales and marketing cost, cost for development and design, consultancy or professional fees, director’s cost, depreciation, office, property and other costs. The consultancy fees are the only cost that was seen to decrease in the year 2008. This might be because with the expansion of the business more and more experts were recruited, which reduced the need of outside consultants. Rest all other costs were seen to increase owning to the increase in production and expansion in business. Profitability The profitability of BEP has been evaluated using gross profit margin, net profit margin and return on capital employed. Gross Profit Margin (GPM) signifies the comparison of gross profit with net sales. In this case the GPM of BEP has reduced from 41.64% to 39.35% in 2008. This can happen if the cost of purchasing inventory has increased dramatically than the selling price, decrease in selling price due to competition or products include those which are having lower margin (Gibson, 2012). In case of BEP may be the selling price has reduced or cost of purchasing inventory has increased. Gross profit margin Particulars 2008 2007 Gross Profit 9392 7734 Sales 23862 18572 GPM 39.35965 41.64333 The Net Profit Margin (NPM) signifies the efficiency of the management in dealing with the activities of the firm related to the selling, administrative and manufacturing (Sheeba, 2011). A high NPM indicates that the firm is capable of absorbing the shock of decline of selling price, demand or cost of production. The BEP is showing a lower NPM in the year 2008 as compared to 2007. Hence the firm is incapable of coping up with the internal and external problems. Net Profit Margin Particulars 2008 2007 PBIT 3102 2830 Sales 23862 18572 NPM 12.99975 15.23799 The Return on Capital Employed (ROCE) calculates the return that the company will enjoy on its invested capital. The ROCE of BEP has shown a significant decrease as compared to the figures of 2007. This decrease in ROCE is due to the increase in the inventory level (Walker, 2008). This signifies that most of the capital has been stuck up in the inventory. The level of inventory should be decreased in order to increase the ROCE. Return on capital employed Particulars 2008 2007 PBIT 3102 2830 equity 8820 4315 Liability 8400 3877 ROCE 18.01394 34.5459 4. Analysis of cash flow and operating cycle The operating cycle helps in determining the liquidity of the company. The operating cycle signifies the number of days required to change the purchase of inventory in exchange of cash, selling of inventory and collection of cash (Plewa, Jr., 1995). The operating cycle for BEP for the year 2008 and 2007 has been shown below: Inventory Turnover Particulars 2008 2007 Inventory 3677 1679 Cost of sales 14470 10838 Inventory Turnover 3.94 6.46 Age of inventory Particulars 2008 2007 Inventory 3677 1679 Cost of sales 14470 10838 Age of inventory 92.75086 56.54503 Collection Period Particulars 2008 2007 Receivables 4785 2687 Sales 23862 18572 Collection period 73.19273 52.80826 Payable Days Particulars 2008 2007 Trade Payable 944 709 Material Purchases 14470 10838 Payable days 23.81202 23.87756 Operating Cycle 142.1316 85.47573 Inventory The inventory of BEP has been seen to increase to £ 3677 in the year 2008. Higher inventory implies that the profitability of the company will increase that will enable the company BEP to meet the demand. Moreover in reduces the cash flow if it is not sold. Hence it should be turned quickly to cash. The age of inventory has increased from 56 days to 92 days. This implies that the inventory is taking more number of days to convert into cash. In this context Just in time inventory management system should be incorporated. Receivables The receivables have increased to £4785 in the year 2008, which implies that there has been an increase in the credit sales. The receivable days have also increased from 52.81 days to 73.19 days indicating that BEP has do not implemented any measure to chase up the debtors. Thus the company requires chasing its debtors and incorporating system that controls the level of receivables and analyses the credit risk of the company. Payables The payable of the company has increased to £14470. This is good for the company since for some time it may enjoy interest free loan. There is no significant change in the payable days. It has remained almost same. This implies that BEP has paid to the suppliers in the same way has they have been paying previously. Operating cycle Shorter the operating cycle better it is for the organization. Short operating cycle implies that the company is going to generate higher cash flow and profit earned will be greater. The above table shows that the operating cycle of BEP was 109.35 days in 2007 and 165.94 days in the year 2008, which signifies that the operating cycle of BEP has increased in the year 2008. This implies that the cash invested in purchasing the inventory is taking more time in selling and getting converted back to cash. Thus the firm is taking more time in realising cash. The impact is that the cash inflow from operating activities is getting hampered as a result the cash generated from operating activities is showing a negative balance. Hence, the company needs to decrease the operating cycle and convert the inventories into cash more quickly. 5. Costing techniques Absorption costing and Marginal costing Absorption costing is the process of allocation or apportionment of cost that includes both the fixed and variable costs to the operations or product. By using the technique of absorption costing all the cost are absorbed in production and the operating statement does not discriminates between variable and fixed costs. Therefore work-in-progress and valuation of stock contains both variable and fixed elements. On the other hand, in case of marginal costing the fixed costs are not absorbed in the cost of production. These costs are period costs and are written off in the costing profit and loss account of that period regardless of whether the product has been sold during that period or not. Under marginal costing the units that are completed but not sold are carried to the next period as variable cost (Lucey, 2002). Absorption costing is regarded as the best way of costing sine the value asserted is fair and true, which includes full cost of production devoted to manufacture the product. The cost of that product is carried forward and is set against the revenue from its sale. Thus it assumes that the selling price of a product should include all the costs (Armstrong, 2001). Thus BEP should use absorption costing and allocate their overheads to different production lines and divisions based on certain criteria. This will result into higher cost per unit as compared to marginal costing technique. 6. Critical analysis of KFun The profit and loss statement of KFun shows forecasted revenue of £25,036,000 for the year 2008 whereas the actual was £24,335,000. The actual revenue was 2.88% lower than the budgeted. Lowering of the revenue than the forecasted one can be due to many reasons. The primary reason for the fall in the revenue may be due to the financial crisis that started in September 2008, which caused economic turbulence. On the other hand the actual profit before interest and tax was lower by 12.67% than the estimated one. The variation in profit before interest and tax is more than the revenue because of the increase in the costs. In the cash flow statement of KFun it is shown that the company has forecasted a positive cash flow of £276,000 whereas in reality the cash flow for the year 2008 is negative £557,000. This implies that the cash outflow of the company was lower than the cash inflow during the period. Hence more money is flowing out of the business. This not necessarily implies that the company is running in loss but it may be also because mismatch in expense and income due to lack of credit management, fraud or actually loss. KFun was facing problem because of overstating the balance sheet due to which they had to face trouble in repayment of loan. This problem has also caused a problem in the telecast of their shows. Thus it can be seen that in the coming years the revenue is expected to fall, which will cause further fall in the PBIT. This in turn together with the larger loan repayment amount will impact the cash flow of the organization. But is the company regains its original position then it can generate some higher revenue both that will require time. 7. Evaluation of Opportunity To evaluate whether the BEP should acquire KFun or not Net Present Value of the investment has been calculated. The cost of capital is 9% and the initial investment will be £5,000,000 that BEP will get either in form of bank loan or in form of equity. NET PRESENT VALUE CALCULATION Year Cash Flow Discounting factor Present value 1 435000 0.917431193 399082.6 2 718000 0.841679993 604326.2 3 1494000 0.77218348 1153642 4 1870000 0.708425211 1324755 5 1690000 0.649931386 1098384 Total     4580190 Initial Investment   5000000 Net Present Value   -419810 Recommendation The calculation shows that the project will generate a negative NPV of £419810. This implies that the project should not be accepted because in the life time of 5 years starting from 2009 to 2013 BEP will not even be able to get back the initial investment. Thus they should not invest (Gallagher and Andrew, 2007). Capital structure of BEP If BEP is going to generate £5m required for the acquisition whether in form of debt or in form of equity, in either cases the capital structure of the company is going to change. If debt is taken then non-current liability will increase and in the other case equity will increase. In case of debt financing the debt equity ratio will rise to 567.84 whereas in the other case it will fall to 0.0016. Generally equity financing is preferred more than debt financing, since it increases the liquidity. In debt financing creates financial risk for the organization. It leads to generation of insufficient earnings due to which there is high probability of not paying the debts at time when they are due. On the other hand it is advantageous since interest on debt is tax free whereas dividends are taxable (Sheeba, 2011). Other factors Due to the ongoing financial crisis the market is in an unstable condition. If the market does not regain its original position then it is difficult to maintain sales and profitability in the market. The sales of BEP was hit firstly by the financial crisis and secondly by the retirement of the author of Harry Boulder. Moreover now the sales that they get from KFun are also affected. This has resulted to high level of stock for BEP. If the acquisition of KFun does not create a positive impact on the sales then the company will be ending on having more stocks, which may create unfavourable situation. The crisis situation in KFun may be much deeper than what is appearing. This implies that the whether the company has only overstated the balance sheet or there some in depth fraudulent activities going on in the company that needs to be further analysed. Inexperience of BEP in the entertainment sector is other factor that needs consideration. The inexperience may force the company to depend more on the employees of the KFun who might not be efficient and guide BEP towards profitable projects. Reference List Armstrong , M., 2001. A handbook of management techniques. London: Kogan Page Publishers. Gallagher, T.J. and Andrew, J.D., 2007. Financial management: Principles and practice. New Jersey: Freeload Press, Inc. Gibson, C.H., 2012. Financial reporting and analysis. 13th Ed. Connecticut: Cengage Learning. Lucey, T., 2002. Costing. Connecticut: Cengage Learning EMEA. Plewa, Jr., F.J., 1995. Understanding cash flow. New Jersey: John Wiley & Sons. Quayle, M., 2006. Purchasing and supply chain management: Strategies and realities. London: Idea Group Inc (IGI). Sheeba, K., 2011. Financial management. New Delhi: Pearson Education India. Walker, J., 2008. Accounting in a nutshell: Accounting for the non-specialist. Massachusetts: Butterworth-Heinemann. Read More