Financial Management & Control - Honeywell Plc - Case Study Example

Running Header: Financial management & Control Financial management & Control Course Name Professor’s Name Institutional Affiliation City and State Where Institution is Located Date Table of Contents Running Header: Financial management & Control 1 Financial management & Control 3 Part A ‐ Honeywell Plc2 Introduction 3 Profitability 3 Liquidity 4 Gearing 5 Efficiency 6 Conclusion 7 Part 2 ‐ Honeywell Plc2 Working Capital Cycle 8 Part B ‐ Thompson Ltd Break-even analysis 9 Break Even Analysis 10 References: 12 Appendix 14 Appendix A: Profitability 14 Appendix B: Liquidity 14 Appendix C: Gearing 15 Appendix D: Efficiency 15 Appendix E: Working Capital Cycle 17 Appendix F 17 Financial management & Control Part A ‐ Honeywell Plc2 Introduction The board of directors of Honeywell Plc having looked into the company’s financial statement for the last two years have raised concerns about the company’s profitability and liquidity. In a bid to establish whether their concern are warranted or not, the following report has been prepared for them. The report uses financial ratios analysis as attached in the appendix to establish the truth about the company’s profitability, gearing, efficiency and liquidity. The findings of the report indicate that the directors concerns are indeed true and hence makes some recommendation to the directors on how to improve the company’s performance. It is hoped that the report will be useful to the management in taking steps that will strengthen the company’s performance. Profitability 2015 2016 ROCE 26.58% 18.33% ROSF 11.37% 6.95% GPM 63.71% 56.95% OPM 49.95% 38.48% Refer to Appendix A for calculation There is a significant decline in the company’s profitability for the year 2016 compared to 2015. The company’s ROCE for instance declined by 8.25% over the two years indicating declining efficiency by the company in using its capital employed to generate profit. The decline is attributed to the decline in profitability. The company’s return on shareholders’ funds similarly declined by 4.42% between 2015 and 2016 signalling declining returns to shareholders. This is also attributed to declining profitability (Myaccountingcourse.com, 2017). The company’s gross profit margin has also significantly declined by 6.76% over the two years. The decline is attributed relative decline in gross profit which was as a result of significant increases in manufacturing costs during the year 2016. The company’s operating profit margin also significantly declined between 2015 and 2016 by 11.47%. The decline is mainly attributed to general increase in operating expenses especially the significant increase in bad debts written off from $70,000 in 2015 to $325,000 in 2016. The general conclusion thus is that the company’s profitability significantly declined in 2016 compared to 2015 with the decline associated with challenges in the operating environment which saw the cost of sales and the operating expenses significantly increase in 2016 when compared to 2015 (Lang and Owens, 2010). It is thus suggested that the company comes up with cost cutting strategies so that the increase in sales can result in increased profitability in future. Liquidity 2016 2015 Current ratio 1.31 1.63 Quick ratio 0.64 1.05 Refer to Appendix B for calculation There has been a significant decline in the company’s liquidity between 2015 and 2016. The company’s current ratio for instance declined by 0.32 between the two years. The decline resulted from the relative increase in the company’s current liabilities in 2016 especially the bank overdraft of $1,100,000 in 2016 (Lan, 2017). Similarly, there was a significant decline in the company’s quick ratio in 2016 compared to 2015 by 0.41. The decline is mainly attributed to the significant increase in inventory from $1,220,000 in 2015 to $2,200,000 in 2016. Thus, the company ought to come up with better inventory management strategies so as not to hold too much inventory but instead release the capital for use in the company’s operations thus which may help in avoiding costly overdrafts. In conclusion, the company’s liquidity has declined over the two years and this exposes the company to liquidity risks should those owed demand to be paid at short notice (Maricica and Georgeta, 2012). Thus, the company ought to come up with strategies to increase liquidity levels such as holding optimal levels of inventory thus availing much needed cash to reduce current liabilities and hence liquidity risk. Gearing 2016 2015 Gearing ratio 34.19 21.37 Interest cover ratio 3.52 7.18 Refer to Appendix C for calculation The gearing position of the company deteriorated in 2016 compared to 2015 hence signalling an increase in the associated risk. For instance, the company’s gearing ratio increased by 12.82% in 2016. This resulted from the significant increase in the loan stock from $3,895,000 in 2015 to $8,000,000 in 2016 (demonstratingvalue.com, 2017). On the other hand, the company’s interest cover ratio significantly declined by 3.66 times in 2016 which is associated to declining profitability as well as the significant increase in interest obligations owing to the increased borrowing. Although the company is still able to meet its long-term financial obligations of both interest and principal repayment, this trend if allowed to continue will quickly put the company into the risk of liquidation in future. As such, the company ought to come up with ways of financing that will not worsen the company’s gearing at such a high rate. In this regard, the company could for instance pay less dividend or issue more capital since this does not put the company’s gearing at risk. Efficiency 2016 2015 Receivables collection 68.74 days 55.69 days APPP 106.46 days 132.21 days Inventory turnover 167.29 days 126.51 days Refer to Appendix D for calculation The company’s efficiency generally declined in 2016 when compared to 2015 although its efficiency regarding settling of payables significantly improved. The company’s took longer to collect its receivables in 2016 compared to 2015 by 13.05 days. This is attributed to the significant increase in the company’s receivables over the two years. This may have resulted from change of terms for customers or relaxing of terms in a bid to increase sales as witnessed by increase in sales (Barnes, 2007). Alternatively, it is an indication of weakening credit control by the company. Since this is hurting the company’s liquidity as witnessed by lack of cash and the bank overdraft in 2016, the company ought to review its current credit control strategy to ensure improvement in receivables collection. Similarly, the company’s inventory turnover days significantly declined by 40.78 days meaning it now takes 40.78 days longer to convert its inventory to sales than it took in 2015. This could be attributed to increasing inventories in 2016 which could signal poor inventory control. Thus, the company should review its inventory control strategies to ensure only the necessary inventory is held releasing the additional capital for other aspects of the company’s operations (Tensing, 2014). On the centrally, the company now takes shorter to settle its payables by 25.75 days compared to 2015. This may be a good sign since it is likely to improve the company’s relationship with its suppliers and hence should be encouraged. The company should thus use the same strategy to improve its efficiency on inventory turnover and receivables collection which would in turn increase profitability hence reducing the risks outlined above. Conclusion Arising from the financial ratios analysis on the company’s financial performance for the years 2015 and 2016, it has been established that the company’s performance as far as profitability, liquidity, efficiency and gearing is concerned did indeed deteriorate in 2016 when compared to 2015. The report has thus made recommendations on each element on what the management may need to do in a bid to improve the company’s performance. Part 2 ‐ Honeywell Plc2 Working Capital Cycle Determination of the company’s working capital cycle; 2016 2015 Working Capital Cycle 92.31 days 41.17 days Refer to Appendix E for calculation The working capital cycle significantly increased from 41.17 days in 2015 to 92.31 days in 2016 which is an increase of 51.14 days. This means that the company took far much longer to convert its net current assets and current liabilities to cash in 2016 compared to 2015. This shows that the ability and efficiency of the company to manage its short term liquidity position declined. In other words, the company took 51.14 days longer in 2016 to free up its cash stuck in working capital in 2016 compared to 2015 (efinancemanagement.com, 2017). This resulted in worsening liquidity position as stated above since the company had less cash to meet its current obligations resulting in significant relative increase in current liabilities compared to current assets which saw the company’s liquidity position decline. It can thus be concluded that the increased working capital cycle resulted in worsening liquidity position for the company in 2016 compared to 2015 as indicated by the calculated liquidity ratios below. Part B ‐ Thompson Ltd Break-even analysis 2014 Selling price £400 (per unit) Variable cost (unit) £180 Break even point revenue (unit) £10,050 Break even point revenue ($) £4,020,000 Margin of safety (unit) £9,950 Margin of safety ($) £3,980,000 profit 8000000-5811000=2,189,000 Refer to Appendix F for calculation 2015 Selling price £460 Contribution Margin Ratio £0.55 (Same as last year) Fixed costs £3,011,000 Break-even point revenue (unit) £11,901.19 Break-even point revenue ($) £5,474,545.45 Margin of safety (unit) £8,098 Margin of safety ($) £3,725,545.55 Profit 920000-8,071,000 = 1,129,000 Refer to Appendix F for calculation The 15% increase in selling price will change the selling price from $400 in 2014 to $460 per unit in 2015. Bearing in mind the increase in fixed costs by $800,000 in 2017, the breakeven point in units will increase from 10,050 in 2014 to 11,901.19 units in 2015. On the other hand, the breakeven point in revenue will increase from $4,020,000 in 2014 to $5,474,545.45 in 2015. The margin of safety will however decline from 9,950 units in 2014 to 8,098 units in 2015 (Investopedia.com, 2017). The margin of safety in revenue will also decline from $3,980,000 in 2014 to $3,725,545.55 in 2015. This means that the above changes will result in a decline in the company’s profitability from $2,189,000 in 2014 to $1,129,000. However, given that the changes are necessitated by changes in the operating environment such as increase in fixed as well as variable costs, changes in prices cannot be avoided (Gallo, 2017). However, it is clear that the 15% increase in prices may not be desirable for the company since it will not retain the company’s profitability in 2015 at its 2014 level. Thus, the management needs to consider a greater increase in prices to such a level that the profitability will be maintained. However, in so doing, other factors also need to be considered. Such factors include the competitors and how the increase will affect sales. If the prices can be further increased without affecting units to be sold negatively, then the management ought to consider a further increase (Lim, C2017). Break Even Analysis There are a number of assumptions that underlie the break even analysis. These assumptions include the fact that the break even analysis assumes that the selling price per unit of the product in question is constant throughout the entire relevant range (Enyi, 2017). However, this may not always be the case and if the prices were to change, this can lead to the wrong calculation of break-even point. This is because with every change in price, the break-even point is also likely to change. Another assumption is that the break even analysis assumes that costs are linear throughout the entire relevant range meaning that variable costs per unit is constant same as total fixed costs. However, this may not always be the case (Laitinen, 2011). As production increases beyond a certain level, there is likelihood of increase in fixed costs. On the other hand, variable costs will tend to decrease with the increase in level of production since the company is expected to reach efficiency in production as the level of output rises. Finally, break-even analysis assumes that in manufacturing companies, it is possible to segregate fixed and variable costs but in real life, this may not be the case since some cost elements may be both fixed and variable (semi-fixed) and this may make it difficult to calculate break-even point (Ott, 2001). The above assumptions could be described as unrealistic and hence make the application of the break even model within the context of today’s globally diversified business environment difficult. Despite the above shortcomings of the break-even model, it is still widely used today in a variety of businesses mainly for strategy formulation. Businesses use the model in determining the point of profitability. This will include such issues as how much revenue the company needs to generate to cover all its expenses, the product or services that are likely to generate profit and which products and services might be selling at a loss. The model is also applicable today in the formulation of pricing strategy since it helps the company in targeting the amount of profit it intends to generate (Ronald, 2004). In addition, it is used in developing a company’s best strategy for moving forward by helping analyse the best ways to improve the organizational performance. This could be through such initiatives as reduction of costs or changing prices so as to arrive at the best results for the company. References: Myaccountingcourse.com, 2017, Financial ratio analysis, Retrieved on 31st August 2017, from; http://www.myaccountingcourse.com/financial-ratios/ Lang, M&, Owens, E2010, Accounting for management, New York, McGraw-Hill. Lan, J2017, Financial ratios for analysing a company’s strengths and weaknesses, Retrieved on 31st August 2017, from; http://www.aaii.com/journal/article/16-financial-ratios-for-analyzing-a-companys- strengths-and-weaknesses.touch Maricica, M&, Georgeta, V2012, Business failure risk analysis using financial ratios, Social and Behavioural Sciences, vol. 6, no. 5, pp. 45-67. demonstratingvalue.com,2017, Financial ratio analysis, Retrieved on 31st August 2017, from; https://www.demonstratingvalue.org/resources/financial-ratio-analysis Barnes, P2007, The analysis and use of financial ratios: A review article, Journal of Business, Finance and Accounting, vol. 14, no. 4, pp. 449-461. Tensing, R2014, Financial statement and ratio analysis, Retrieved on 31st August 2017, from; http://www.freepressjournal.in/finance/financial-statements-ratio-analysis/313610 efinancemanagement.com, 2017, Working capital cycle, Retrieved on 31st August 2017, from; https://efinancemanagement.com/working-capital-financing/working-capital-cycle Investopedia.com, 2017, Break even analysis, Retrieved on 31st August 2017, from; http://www.investopedia.com/terms/b/breakevenanalysis.asp Gallo, A2017, A quick guide to breakeven analysis, retrieved on 31st August, 2017, from; https://hbr.org/2014/07/a-quick-guide-to-breakeven-analysis Lim, C2017, Break even analysis, Retrieved on 31st August 2017, from; https://open.library.ubc.ca/cIRcle/collections/ubctheses/831/items/1.0093639 Enyi, P2017, Another look at the assumptions of the breakeven analysis- A case for joint products, Retrieved on 31st August 2017, from; http://www.academia.edu/1425061/Another_Look_at_the_Assumptions_of_the_Brea keven_Analysis_-_A_Case_for_Joint_Products Laitinen, K2011, Extension of break-even analysis for payment default prediction: Evidence from small firms, Investment Management and Financial Innovations, vol. 8, no. 4, pp. 1-0. Ott, S2001, Understanding non-profit organizations: Governance, leadership and management, Westview Press. Ronald, R2004, Improving leadership in non-profit organizations, London, Rutledge. Appendix Appendix A: Profitability Profitability: ROCE, ROSF, Gross and net profit margin 2015 ROCE = 4,845,000 / ( 3,330,000 + 7,000,000 + 3,895,000) = 26.58% ROSF = 1,630,000 / (7,330,000 + 7,000,000) * 100% = 11.37% Gross profit margin = (6,180,000 / 9,700,000) * 100% = 63.71% OPM = (4,845,000 / 9,700,000) * 100% = 49.95% 2016 ROCE = 4,290,000 / (7,330,000 + 8,070,000 + 8,000,000) = 18.33% ROSF = 1,070,000 / (7330,000 + 8,070,000) * 100% = 6.95% Gross profit margin = (6,180,000 / 9,700,000) * 100% = 56.95% OPM = (4,290,000 / 11,150,000) * 100% = 38.48% Appendix B: Liquidity 2015 Current ratio = 3,460,000 / 2,125,000 = 1.63 Quick ratio = (3,460,000 - 1,220,000) / 2,125,000 = 1.05 2016 Current ratio = 4,300,000 / 3,270,000 = 1.31 Quick ratio = (4,300,000 - 2,200,000) / 3,270,000 = 0.64 Appendix C: Gearing 2015 Gearing ratio = [3,895,000 / (7,330,000 + 7,000,000 + 3,895,000)] * 100% = 21.37 Interest cover ratio = 4,845,000 / 675,000 = 7.18 2016 Gearing ratio = [8,000,000 / (7,330,000 + 8,070,000 + 8,000,000)] * 100% = 34.19 Interest cover ratio = 4,290,000/1,220,000 = 3.52 Appendix D: Efficiency 2015 Inventory turnover = 1,220,000 / 3,520,000 * 365 days = 126.51 days Receivables collection days = 1,480,000 / 9,700,000 * 365 days = 55.69 days Payable payment days = 1,275,000 / 3,520,000 * 365 days = 132.21 days 2016 Inventory turnover = 2,200,000 / 4,800,000 * 365days = 167.29 days Receivables collection days = 2,100,000 / 11,150,000 * 365 days = 68.74 days Payable payment days = 1,400,000 / 4,800,000 * 365days = 106.46 days Appendix E: Working Capital Cycle 2015 Average inventory holding period = [(1,050,000 + 1,220,000) / 2] * 365 days 3,520,000 = 117.69 days Average settlement period for trade receivables = (1,480,000 / 9,700,000) * 365 days = 55.69 days Working Capital Cycle = 117.69 + 55.69 - 132.21 = 41.17 days 2016 Average inventory holding period = [(1,220,000 + 2,220,000) / 2] * 365 days 4,800,000 = 130.03 days Average settlement period for trade receivables = (2,100,000 / 11,150,000) * 365 days = 68.74 days Working Capital Cycle = 130.03 + 68.74 - 106.46 = 92.31 days Appendix F 2014 Selling price (per unit) = £400 Variable cost (unit) = (£100 + £20 + £25 + £20 + £15) = £180 Break even point revenue (unit) = Fixed Cost UCM = £2,211,000 (£400 - £180) = £2,211,000 £220 = £10,050 Break even point revenue ($) = Fixed Cost Contribution Margin Ratio = £2,211,000 (£400 - £180) / £400 = £2,211,000 £0.55 = £4,020,000 Margin of safety (unit) = £20,000 - £10,050 = £9,950 Margin of safety ($) = (£20,000 * £400) - £4,020,000 = £3,980,000 2015 Selling Price = £400 * 1.15 = £460 Contribution Margin Ratio = £0.55 Fixed costs = (£925,000 + £750,000 + £536,000) = £3,011,000 Break even point revenue ($) = Fixed Cost Contribution Margin Ratio = £3,011,000 £0.55 = £5,474,545.45 Break even point revenue (unit) = £5,474,545.45 £460 (unit) = £11,901.19 Margin of safety (unit) = £20,000 - £11,902 = £8,098 Margin of safety ($) = (£20,000 * £460) - £5,474,545.45 = £3,725,545.55 Read More