Evaluation of Financial Performance of the Clothes for Tots Ltd - Case Study Example

Clothes for Tots Ltd Case Study Report Terms of Reference (Introduction) Clothes for Tots Ltd is a growing enterprise, and such abusiness need clear guidelines for making decisions during the growth stage of the business life-cycle, considering that this is the critical stage that defines the future prospects of the business (Bodie, Kane and Marcus, 402). In this respect therefore, it is important that a business makes its growth and expansion decisions based on real and tangible financial values, which then helps the business determine its next course of action. Financial ratios help to simplify the process of analyzing a business financial position, and make the reported financial statements more meaningful and useful to the business and its stakeholders (Averkamp, n.p.). Therefore, this discussion seeks to determine the health of Clothes for Tots Ltd (CFT), by looking at its financial ratios, with a view to establishing its current strengths and weaknesses, and thus make recommendations on the company’s future strategies. Evaluation of Financial Performance - Ratio analysis summary and your opinions The evaluation of the financial performance of Clothes for Tots Ltd (CFT) seeks to establish the profitability of the company currently, while also seeking to establish the sustainability of the business profit into the future (Williams, et al, 133). In applying the financial ratios to evaluate CFT’s current financial performance, it will be possible to determine whether the company has a healthy financial status to take it into the future. Ratio analysis summary and your opinions The Sales Growth for the Clothes for Tots Ltd (CFT) is 0.184. This serves to indicate that sales of the company have grown by a reasonable margin, at 18.4% increase in sales from the year 2011 to the current year, 2012. The growth of sales for the business by 18% within a period of one year serves to indicate that the business is in the right track in pursuing its growth and expansion agenda. The percentage increase in sales between two financial periods for a business, serves to indicate the rate of growth of the business in the market share and the customer base that the business serves (Demonstrating Value, n.p.). Thus, an annual growth is sales by 18% is a clear indication that CFT company has entered the growth stage of the business life-cycle with the right foot, and with further prospective for expansion to USA and China, the business growth and sales is poised to increase even further. However, the Operating Self-Sufficiency ratio for the business is at 1.102, an indication that the business revenues are not very high, compared to the expenses. The Operating Self-Sufficiency ratio is a financial ratio that is used to assess the ratio at which the revenues for a business are able to cover its operating costs (Averkamp, n.p.). In this respect, the Operating Self-Sufficiency ratio measures how well the business can be able to continue its operations by financing its operations out of its generating revenues, without the involvement of borrowed funds (Demonstrating Value, n.p.). In this case, CFT Company is not well suited to cover its operating expenses, and cannot therefore continue with its operations without borrowing more funds, considering that its generated revues compared to the total operational expenses are at a ratio of 1.102. This means that the business own generated revenues can cover its operating expenses only once. The Operating Self-Sufficiency ratio further serves to indicate the levels of risks that a business is exposed to, considering that a business that highly depends on borrowed funds to run its normal operations is at high risk of stalling and closure, should the investors fail to continue investment in the business (Demonstrating Value, n.p.). Therefore, the business risk involved in the CFT Company is high, since the company is not able to run its operations without depending on the external funding. Moreover, the Operating Expense Ratio for CFT Company is 0.266, which is a relatively high value. The Operating Expense Ratio is a financial ratio that compares the revenues of a business to its expenses, to measure how efficient the business is in utilizing its resources (Averkamp, n.p.). Thus, considering that the rate of generating revenue by CFT Company, compared to the rate at which it utilizes the resources generated is at 26.6%, the business is not efficient in its resource utilization. Thus, since the CFT Company cannot be able to run its operations effectively without the external funding, and considering that the business is not efficient in its resource utilization, CFT Company needs to strategize on how to improve the efficiency of using its resources and how to generate more revenues, so it can run its operations without depending on external funding (Demonstrating Value, n.p.). Further, the Gross Profit Margin and the Net Profit Margin for CFT Company also indicates positive figures, with the Gross Profit Margin Ratio being 0.359 and the Net Profit Margin being 0.043. The Gross Profit Margin measures how much money a business is making out of the sale of its products, without considering the indirect costs (Bodie, Kane and Marcus, 427). The measure of the success of a company’s product in the market is whether the product is able to cover both the direct and the indirect costs involved in its production, and still retain some profits. Thus, the Gross Profit Margin is supposed to be a positive value, and a value that is more than the value of the indirect costs. Therefore, considering that he Gross Profit Margin for CFT Company is 35.9%, the company’s product is generating good returns. Additionally, considering that after both the direct and the indirect costs are covered the company still manages to retain a gain in Net profit of 4.3%, the company is generating value through its products. Nevertheless, considering the difference between the Gross Profit Margin at 35.9% and the Net Profit Margin at 4.3%, the company seems to be consuming more in indirect costs, and thus lowering its overall gain in terms of net profit (Demonstrating Value, n.p.). This way, the issue of indirect costs for the business needs to be addressed, such that the costs can be reduced, to increase the net profit for the business. The Return on Assets and the Return on Equity Ratios are the other important financial ratios that serve to indicate the financial health f a business (Averkamp, n.p.). The Return on Assets and the Return on Equity Ratios for CFT Company are 0.040 and 0.189 respectively. While the Return on Assets serves to measure the value that a business generates from the investments made on its assets, the Return on Equity Ratios measures the rate at which the business creates value for its investors (Demonstrating Value, n.p.). Therefore, the Return on Assets and the Return on Equity Ratios measures the ability of a business to turn its assets into profits, and in this case, the CFT Company has been able to turn its assets into profits at the rate of 4%. While this indicates a positive value for the business, converting the assets of a business to profits at a rate of 4% only, indicates the failure of the business to maximize on its opportunities to convert assets into profits (Demonstrating Value, n.p.). This way, the business needs to strategize on how to improve its rate of utilizing the available assets to generate profits. On the other hand, the Return on Equity Ratio for CFT Company is at 18.9%, meaning that it is able to give the investors a return of 18.9% on their value of investment, which is a good return for invested resources. In this respect, the investors who have already invested or those who may seek to invest in this company are guaranteed of good results. Analysis of Working Capital problems/issues/challenges and recommendations for improvement The working Capital problems for a business are evaluated in terms of different financial values, in order to arrive at a conclusive determination of the nature of the working capital problems and their possible causes. The Accounts Receivable Turnover, Accounts Payable Turnover and Inventory Turnover are essential financial values that serve to indicate how well or poorly cash is flowing in and out of the business (Demonstrating Value, n.p.). The Accounts Receivable Turnover for the CFT Company is 2.204, which is a relatively low value. This indicates that the time period between when sales are made and when the cash is received is relatively longer (Demonstrating Value, n.p.). On the other hand, the Accounts Payable Turnover for CFT Company is 3.815, which is a relatively low value, indicating that the time spent between when the goods are received and when they are paid is longer, an implication that the company might have cash flow problems (Averkamp, n.p.). In addition, the Inventory Turnover, measures the rate at which the stock bought by the business is sold. The Inventory Turnover for CFT Company is 1.665, which is a relatively low value, and a low value of the Inventory Turnover ratio indicates that a business is selling its stock slowly (Demonstrating Value, n.p.). Therefore, it is due to the slow rate at which CFT Company is selling its stock that it has some cash flow problems, making it take more time between when the company sells its stock and when it receives payments, thus delaying in paying its suppliers. Further, the Current Ratio/Working Capital Ratio, Quick Ratio and the Debt to Equity Ratio also serve to indicate how well or problematic the cash flow system of a business is. The Working Capital Ratio and Quick Ration for CFT Company are 1.280 and 0.628 respectively. The Working Capital Ratio is a financial ratio that serves to indicate the ability of a business to meet its short-term obligations such as salaries, electricity bill and other current expenditure using its short-term assets (Demonstrating Value, n.p.). A low Working Capital Ratio indicates that a business may be having liquidity problems, where it may not have enough cash to cover its short-term expenses. Considering that a Working Capital Ratio of 2 is regarded as desirable, the CFT Company may be having problems of insufficient cash to cater for the short-term expenses, since it has a low Working Capital Ratio of 1.28. Another indication that CFT Company may be having cash flow problems is the low Quick Ratio, considering that a desirable quick ratio level, which measure the ability of a business to cover its short-term expenses without having to sell its inventory, should be 1 (Demonstrating Value, n.p.). Therefore, the low Quick Ratio of 0.628 shown by CFT Company serves to indicate that it cannot pay its short-term expenses without having to sell its inventory, meaning that there is a cash flow problem, where the business has less cash to cover such expenses. Finally, the Debt to Equity Ratio is a financial ratio that serves to indicate the level of a business debt compared to its own assets (Averkamp, n.p.). The Debt to Equity Ratio for CFT Company is 0.790, which is an indication that the debts that the company holds are high. The most desirable Debt to Equity Ratio is where the business has twice equity/total assets compared to its debt. Thus, the 0.790 Debt to Equity Ratio for CFT indicates it might have some difficulty paying its debts. Recommendations for improvement In view of the cash flow and working capital problems identified above, it is recommended that CFT Company reduces its debts, to reduce the risk of inability to pay debts on the event of a business problem. Further, it is recommended that CFT Company increases its cash liquidity by holding more liquid cash into the business, to be able to pay the short-term expenses and thus solve its working capital problems. In addition, CFT Company should increase its inventory turnover, through reaching more markets, to ensure it sells its stock fast, so as to eliminate the problem of shortage of cash and the inability to pay the suppliers in time. Finally, CFT should work towards reducing the time gap between when goods are sold and when they are paid, to ensure that is quick flow of cash into the business, and thus eliminate the cash shortage the company faces. Evaluation of Ventura plc investment proposal The proposal for Ventura plc investment into CFT in exchange of 55% of the ordinary share capital in the company is a noble idea, considering that from the financial evaluation, CFT Company is not in a good position to finance its growth and expansion strategies. The merit of venture capital, as opposed to other means of external financing is that; venture capital provides large sum of equity finance (Williams, et al, 147). The advantage associated with the venture capital investment is that, Ventura plc investment will provide CFT Company with enough finances to execute the strategy of adding a new line of product through starting the manufacture of the wooden toys. Further, the Ventura plc investment will provide CFT Company with enough finances to exploit its market expansion strategies, through being able to venture into the USA and the China Market. In addition, the financing from Ventura plc investment will come alongside expertise in the management of the investment, since Ventura plc investment will become part of the business ownership (Bodie, Kane and Marcus, 421). Most importantly, the advantage associated with the financing from Ventura plc investment is that; CFT will not be required to repay the money borrowed. Nevertheless, the disadvantage associated with the Ventura plc investment is that, CFT will lose part of control of the company, since Ventura plc investment will become the major shareholder by owning 55% shareholding, and thus will have more control on the business (Williams, et al, 212). Consideration of and Evaluation of four alternative sources of external finance Foreign direct investment CFT Company can seek financing from foreign direct investors, who are moistly foreign based multi-national companies that invest in different parts globally (Williams, et al, 187). The advantage of FDI is that, CFT Company will be able to access large sums of financing, and thus be able to solve its cash flow and working capital problems, while also being able to exploit the opportunities of a new line of product and market expansion to China and USA. The challenge involved is the inaccessibility and complex process of attaining the funding. Bank loans CFT can borrow money from banks to solve its working capital and cash flow problems, and invest in the new line of product while expanding into other markets. The advantage is that; the company will get large sum funding to achieve its goals. The problem is that such funding might be vulnerable to interest changes (Bodie, Kane and Marcus, 434). Stock market funding CFT can access funding from the public through selling some of its shares to the public. The advantage is that the company will access enough funds by selling up to 49% of the stake in the company, and retaining 51%, which gives the owners control of the business (Bodie, Kane and Marcus, 436). The disadvantage is that the company will cease to be a family business. Financing from friends and family CFT can borrow money from friends and family to execute its new product line and market expansion strategies. The advantage is that; the company owners will retain the ownership and identity of the company as a family business. The disadvantage is that the amounts available for such funding could be insufficient to meet the intended purpose (Williams, et al, 247). Conclusion and recommendations to Directors In conclusion, CFT Company is facing cash flow and working capital problems that would need external investment, to enable the company manage to expand its market to USA and China, as well as introduce the new line of product, in the form of wooden toys. While there are several methods of accessing such external financing such as FDI, bank loans, family and friend borrowing, as well as stock market financing, it is recommended to the directors that they pursue the stock market financing option. This is because; this type of external financing will help the company retain control and identity of the company as a partial family business, through selling up to 49% stake to the public, while enabling the company to access enough money for its strategies. Works Cited Averkamp, Harold. “Financial Ratios (Explanation)”. Accounting Coach, 2013. Retrieved March 6, 2014 from http://www.accountingcoach.com/financial-ratios/explanation/2 Bodie, Zane, Kane, Alex and Marcus, Alan J. Essentials of Investments, 5th ed. McGraw-Hill Irwin, 2004. 403-459. Print. Demonstrating Value. “Financial Ratio Analysis”, December, 2013. Retrieved March 6, 2014 http://www.demonstratingvalue.org/resources/financial-ratio-analysis Williams, Jan et al. Financial & Managerial Accounting. McGraw-Hill Irwin, 2008. 130-266. Print. Appendix Ratio Analysis Profitability Sustainability Ratios Sales Growth = Current Period –Previous Period Sales Previous Period Sales 13,500 -11,400 11,400 = 0.184 Operating Self-Sufficiency =Sales Revenue Total Costs 13,500 12250 =1.102 Gross Profit Margin = Gross Profit Total Sales Total Sales 4,840 13,500 =0.359 Net Profit Margin = Net profit Sales 547 13,500 =0.043 Return on Assets = Net income Total Assets 547 13,800 =0.040 Return on Equity =Net Profit Average Shareholder Equity 547 2897 =0.189 Operational Efficiency Ratios Operating Expense Ratio = Operating Expenses Total Revenue 3,590 13,500 =0.266 Accounts Receivable Turnover = Net Sales Average Accounts Receivable 4,840 2,169 =2.204 Inventory Turnover = Cost of Sales Average Inventory 13,160 7900 =1.665 Accounts Payable Turnover = Cost of Sales Average Accounts Payable 13,160 3451 =3.815 Total Asset Turnover = Revenue Average Total Assets 13,500 8375 =1.612 Fixed Asset Turnover = Revenue Average Fixed Assets 13,500 2482 =5.440 Liquidity Ratios Current Ratio/Working Capital Ratio =Current Assets Current Liabilities 8,837 6,903 =1.280 Quick Ration = Current Assets -Inventory Current Liabilities 8,837-4500 6,903 =0.628 Working Capital = Current Assets – Current Liabilities 8,837-6,903 =1,934 Net Working Capital Ratio = Current Assets – Current Liabilities Sales 8,837-6903 13,500 =0.143 Adequacy of Resources = Current Assets + Accounts Receivable Monthly Expenses 8,837+4337 1,021 =12.903 Leverage Ratios Debt to Equity = Total Debt Total Assets 10,903 13,800 =0.790 Long-term debt to assets ratio = Long-term Debt Total Assets 4,000 13,800 =0.290 Interest Coverage =Interest Expense 610 3590 =0.170 Read More