Financial Ratio Analysis for Burganz - Case Study Example

Case Study (Accounting) - BUSINESS FINANCE Introduction There' are different phases in the economy such as boom, depression, recession, etc. The performance of the economy here is not cyclical as in the case of developed countries exhibiting business cycles, as the economy depends basically on growth rate of agriculture. Thus one important factor is die fiscal policy which incorporates government expenditure and taxation, borrowing, deficit financing etc. which influences both the public and private sectors in the economy. The industrial growth in general norm Particular influence he corporate performance. Corporate performance depends on a number of variables, both internal and external to the company. The major internal factors are: (i) efficiency of capital use productivity of total capital employed Growth of Gross Block and its capacity utilization (ii) Sales turnover and operational efficiency (iii) Profitability of the operations (iv) return on capital employed (v) expansion plans and internal reserves built tip and (vi) Tax planning and accounting practices etc. Let’s analyze the cases. Case 1 Introduction The long-term goals prefer mostly companies with a solid past performance and continued good performance in future. Such companies are called growth companies, or Blue Chip Companies as Burganz. Of the factors which influence the share prices, the most important one is corporate fundamentals, namely, company's intrinsic worth, net asset value or book value. The corporate performance is thus the single largest force, influencing share price. This is studied by the ratio analysis referred to below, funds flow analysis — namely sources and use of funds — and trend analysis of growth rates of important parameters like sales, gross block etc. All the proposals are important and require considerable attention since they relate to the future development of the company. The reliable proposal up for consideration is: The proposal 3 i.e. to relocate to a new factory on a site the company already owns in Melbourne. Features of Burganz The factory Burganz is currently operating in Adelaide was established 5 years ago at a cost of $10 million. This cost is being depreciated over its expected economic life of 10 years. The factory has been well maintained by Burganz and the company estimates this plant will remain capable of full-scale production for another 10 years. The company expects that this plant in Adelaide would have a current salvage value of $4 million and a value of $100,000 in 10 year’s time. The upgrade of the factory in Adelaide under proposal 2 or the relocation to Melbourne under proposal 3 both involve considerable expenditure. Both of these proposals require new production equipment that will have a 10-year economic life. These proposals require the scraping of the existing factory in Adelaide. The major difference between the new installations of proposals 2 and 3, is the Melbourne factory would make greater use of automation and modern surf board making equipment. GENERAL PREPARATION The objective of new product marketing may be an investigation of buyer characteristics, trial and usage rates, purchase frequencies, product applications, results of altering marketing inputs, response from the trade, etc. But, the major purposes of it are: I. To obtain reliable forecasts of sales volume. 2. To obtain information that can help correct any problems with the new product or its marketing plan. The first objective is far more important. The role of product marketing is in planning a national introduction and setting capital budgets. Therefore, projection of national sales takes primacy. At the end of 10 years Burganz believes the equipment associated with proposal 2 would have a scrap value of $1 million and that related to proposal 3 would be worth $2 million. These salvage values are believed to be realizable even though the equipment for each proposal would have been written off for tax purposes. After the relocation to Melbourne proceeds, the company will have to use for its Adelaide site as its sales liaison office and as substantial product plant. All values and savings are based on today’s prices. Proposal 3: Cost of facilities: $24 million Annual production savings: $7 million 2009 sales of Burganz are expected to be $ 12 million and thereafter sales are forecast to grow by 5 percent a year, slightly faster than the inflation rate. The market risk premium is expected to be 8 percent and the return on government bonds is 6 percent. Burganz’ managers used a weighted average cost of capital of 15% when evaluating the capital budgeting process, it is felt that this would be an appropriate discount rate in this instance. Assume the tax rate applicable to Burganz is 34 percent. Inflation is currently 3.5% and expected remain at this level for the next 10 years. STRATEGIC SOLUTION TO THE PROBLEM Burganz has outlaid $1.5 million on a feasibility study evaluating each of the above proposals. The cost of the feasibility study already undertaken for each proposal is: Proposal 1 $0.25 million Proposal 2 $0.5 million Proposal 3 $0.75 million Proposal 1 requires no changes to the existing factory and involves no capital expenditure. The factory is currently on a 50-acre piece of land in Adelaide owned by Burganz’ local equity partner, which is, at present, leased at $250,000 per year which is simply will turn to a financial liability in the near future depends on the sales volume. Thereafter, the rent is expected to grow in line with inflation at 3.5 percent a year. Its current market price is estimated at $20 million though the owners have no intensions on selling this prized land. As the ongoing strategy, the sales can be increased as per the existing set up to capitalize for the new proposals’ fund collection. Proposal 2 requires considerable expenditure in procuring and installing new equipment. This proposal will introduce some savings through the introduction of new surfing equipment manufacturing technology and can proceed without interrupting operations during the upgrading of facilities, but Burganz needs to increase the working capital immediately by $25,000. Thereafter, working capital is forecast to be 5 percent of sales each year. Moreover, it won’t make any sudden output even after we spend this much money. Hence here comes the importance of Proposal 3 which requires the installation of new factory in Melbourne. The company owns the site which is currently rented out to a neighboring firm. Next year (2009) the rental charge will be $200,000 per year and thereafter the rent is expected to grow in line with the inflation at 3.5 percent per year. This installation can proceed in parallel with the continued operation of the existing plant in Adelaide. No delays are expected, as the existing plant will not be closed down until the new facilities are fully operational, but the new factory would also require an immediate increase in working capital of $40,000, thereafter it is forecast to be 5 percent of sale each year. The new facility will use state of the art technology. This technology will employ computerized surfing equipment making robots that are suited to large production runs and automatic production line quality control. The capital costs are high for this proposal, however big savings are expected. As a strategic plan,How this can be effectively done? Sales can accrue from one-time purchase of a product, infrequent purchases of a Burganz product, or frequent purchases of a Burganz product. In case of one-time purchase, sales won't become zero so long as new buyers keep entering the Burganz product's market. Sales will come to zero when all one-time purchasers have bought the product (once). This can happen with any product, consumer or industrial, durable or non-durables. Sales from infrequent purchases of a Burganz product, include sales from replacement due to wearing out of the product or its obsolescence. Therefore, both the first-time as well as replacement sales should be estimated. In case of sales from frequent purchases of a consumer or industrial non-durable, repeat-purchase sales also contribute. Repeat purchases prove that the product is satisfying to a per cent of the customers. Proposal 3 will also manufacture a greater range of surfing products. The big feature of proposals 2 and 3 is these new facilities are expected to provide big savings in operating costs. But on the contrary there is no booming results which can be expected in the near future. By implementing proposal 3 the company can make a giant leap within 2-3 years by boost up the sales in the whole region. CASE 2 GENRAL MARKET TREND At any point of time, there may be industries which are on the upswing of the cycle called sunshine industries and those which are on the decline called sunset Industries. There are some growth industries like electronics and computers which are the key industries. As referred to earlier, performance of a company has been found depend broadly up to 50% on the external factors of die economy and industry. These externalities depend on the availability of inputs, like proper labor. It should be assessed in terms of their capabilities, popularity, honesty and integrity. In the case of new industries and new managements, there will be no track record and the management has to carefully assess the project reports and the assessment of financial institutions in this regard. The capabilities of management will depend upon tax planning, innovation of technology, modernization, expansion of R & D, etc. A management with a shrewd plan for the expansion and diversification, make tax planning, increase the retained earnings with a consistent dividend policy so that the future expansion plans are put on a sound basis. A good management will also ensure that their shares are well distributed and liquidity of shares is assured and trading is fair and just in the market with no malpractices like cornering of shares or insider trading. For this purpose, the projected demand, input availabilities, unutilized capacities, the alternative growth strategies, methods of reducing of cost, economics of scale and the position of competitors in the market arc to be probed into. A company has to be assessed in terms of its strategies to meet the challenges as they emerge and its future prospects should be assessed before an investment is made. Derina Limited operates within the health-care and biotechnology sector and is a world leader in medical technology, with particular emphasis on the development of hearing aids and ear implant devices to hearing-impaired individuals throughout the world. It has been one of the major success stories on the Australian share market over the last five years, experiencing enormous growth in sales revenue and operating profits and providing substantial returns for investors over this period. The company’s share price has increased from an initial issue price of $2.50 in December 2002 to a price of $30 per share in December 2007. The extent of this share price increase, even excluding dividend distributions paid to shareholders over this period, is representative of this success. Although the operating performance and growth of Derina has been outstanding, there are still questions regarding the extent of this share price appreciation and whether it can be fully explained by the fundamental company performance characteristics. As mentioned above, Derina shares quickly increased in price following their IPO on the Australian Stock Exchange, and have continued to climb in price in the following years, reaching a share price high of over $30.00 per share during 2006. The following table provides a range of operating and performance information for Derina Limited for the financial years from 2002 to 2007: Financial Information for Derina Limited for the financial years ending 30 June 2002 2003 2004 2005 2006 2007 Earnings per share ($) .217 .216 .266 .323 .394 .600 Dividends per share ($) .125 .125 .155 .2 .3 .41 Cash flow per share ($) .39 .125 .285 .511 .217 .382 Average annual P/E ratio 14.1 16.9 20.3 29 41.8 55.5 Book value ($) .37 .47 .64 .67 .84 1.07 Share price ($) 3.87 4.3 6.27 12 28.76 39 Beta coefficient .392 .551 1.019 .579 .515 .623 Retention rate of earnings .424 .421 .417 .381 .378 .319 Sales revenue ($million) 72.275 71.913 91.698 127.181 144.158 220.095 Profit after tax ($million) 10.863 10.809 13.285 16.327 20.167 31.205 Shares issued (millions) 50 50 50 50.536 51.149 52.01 Return on total assets (%) 22.518 21.076 19.222 19.686 21.507 23.221 Return on equity (%) 58.859 46.377 41.393 47.95 47.087 56.167 It has been one of the major success stories on the Australian share market over the last five years, experiencing enormous growth in sales revenue and operating profits and providing substantial returns for investors over this period. The company’s share price has increased from an initial issue price of $2.50 in December 2002 to a price of $30 per share in December 2006. The extent of this share price increase, even excluding dividend distributions paid to shareholders over this period, is representative of this success. Although the operating performance and growth of Derina has been outstanding, there are still questions regarding the extent of this share price appreciation and whether it can be fully explained by the fundamental company performance characteristics. Factors are consistent with the trend in share-price change for Derina. Ratio analysis is a quick and easy way to analyze different companies’ financial performance. Ratio analysis can be used to look into group performance and market trends. There are many users of financial statements and for each one of them there is a different area of performance in a company they are interested in. Some of these users include: Government, Managers, The public, Employees, Creditors/ Suppliers/ Lenders, Trade Unions, Shareholders, Board of Directors For Financial ratios to be effective and reliable to all the users, the financial statements have to be prepared with uniformity to enhance comparability. As this is not true in most cases, it is advisable to use financial ratios in conjunction with other alternative interpretative techniques available. After the study of published accounts, ideas can be immediately revealed about both the companies. These companies have been making profits for 2 years. This can lead us to a more detailed review, hence the need for financial ratios. Financial ratios help to direct the users’ attention to identify a number of areas e.g. the most/least performing areas, showing situations that require further investigation, showing the future and current profitability of a company, they may also outline the impact of different items in the financial statements have on each other. (Increased debtors could be directly affected by increased sales, relationship between assets and profits, etc) It is actually difficult to reach a conclusion about the performance of both these companies without more details of similar companies in the same industry. The intrinsic valuation similar to Derina’s closing share price Return on capital employed is the standard measure of profitability in a company. The return on capital employed is directly affected by net profit margin and asset turnover. The Return on capital employed is around 62.10% in 2006 and has slightly increased to around 64.50% in 2007 as far as Derina is concerned .But earlier it was 69 and 74 respectively. This increase could be in the form of rise in selling prices or reduced manufacturing costs. The change in net profit shows how well the overhead expenses are being controlled in the company. There is a decrease in net profit margin from 15.48% in 2007 to 15.15% in 2007. This could be due to a number of reasons. According to Financial report 2006 and 2007, we can observe that the administrative and distribution expenses have increased so it will cause the operating profit to fall. There is a fall in the gross profit percentage from 27.9% in 2006 to 27.8% in 2007 therefore there was an increase in costs of sales. As a result, it may mean a fall in operating profit. Moreover, we can see there was a slight increase in overheads in 2006 relative in 2007. The increase in overheads needs to be investigated further as it is slightly rising over the years. Return in capital employed measures management efficiency and it is affected by asset evaluations, depreciation, expenses and prices. This needs to be further explored to determine which factors are contributing to a lower return in capital employed. Interest cover is both very high in 2006 and 2007. In 2006 the ratios shows the operating profit covered the interest 24.31 times and 21.8 times in 2007. As a result, they had no problems with its interest obligation since it was a net receiver of interest: the interest it earned was greater than the interest it might have to pay. However, we can see there was a slight decrease in interest cover ratio in 2006 and 2007, meaning that there would have to be a fall in profit in 2007 compared to 2006. However, this is a disadvantage for the company. The company will take longer in receiving their money from debtors. As a matter of fact it will take the next two months to receive it. Inventory turnover illustrates how long a company takes to sell their stock. The decrease in stock may be an advantage for them, as lower inventory turnover usually indicates the business is more efficient; and that high level of stocks will typically result in liquidity problems. The dividend yield for them has decreased by almost 2%. The dividend yield expresses the shareholder’s dividend as a percentage of the market value of a share. A low dividend yield might persuade investors to dispose of shares and invest the proceeds elsewhere. The dividend cover ratio indicates the proportion of available profit which is distributed by the organization. As the dividend cover has increased, this shows that the company can easily afford to pay the dividend. The earnings per share are concerned with the profit available to ordinary shareholders after tax and extraordinary items. It tells an investor how much profit each share has earned during an accounting period. From this ratio, we see that there is an improvement in the profit performance in shareholders. Recommendations for the Problem According to the details, we can see that the firm had improved its performance over the period of ten years. We believe that they will get better in the future. For example, the revenue over the 10 year period shows that they have increased each year. This is an important factor, as it shows that it is making a profit. On the other hand, there is some disadvantage that we will recommend: As we analyzed the liquidity ratio above, both have a problem with increasing their debtor over the two year previous. Therefore, they need to improve their liquidity position by controlling its debtor. The efficiency ratio reveals that there is a problem on the repayment of credits; the ratio should not be more than 30 days. This is again due to a heavy cost of goods in both years. There is an operating risk that exists, where there is factor which could cause sales to fluctuate. However, I think that the company has a great performance that shows the profit increasing in year to year. Reference 1. Biz/ed (2008), Financial Ratio Analysis [www] Available from: http://www.bized.co.uk/compfact/ratios/index.html [Accessed: 2May 2008 2. Missale, Alessandro (2000) Corporate Fund Management. Oxford: Oxford University Press. 3. (CUSUMANO MA & MARKIDES CC 2001. Strategic thinking for the next Economy San Francisco: Jossey-Bas) Read More