ABC Learning Analysis - Case Study Example

ABC Learning Centres Limited and TeaserMalts Case Name: Institution: Case Study: ABC Learning Centres Limited Question 1: Business and accounting ‘red flags’ which would have warned analyst and investors According to Kruger’s (2011) article on Sydney Morning Herald, some community childcare operators were struggling to breakeven, but ABC Learning was recording 30% to 40% of profits from ordinary activities. The profitability should have raised a red flag to investors and business analyst to look at how it makes its profit despite operating in the loss-making sector of child care. In the same article, Steve Trzcinski notes that his daughter’s community childcare center in Adelaide spent 80% to 90% of its operating revenues in staffing and has the same fee structure as ABC Learning (Kruger, 2011). The comparison of ABC Learning performance to those of its counterparts in the industry would have helped in raising a red flag early before its collapse in 2008. Therefore, industry comparison of company performance is crucial in evaluating financial soundness and arriving at an investment decision. The resignation of top management employees in an organization can signal investors and analyst that an organization is having financial or management issues. For example, Craig Howard, the senior taxation manager resigned four (July) before the company collapsed. According to The Sydney Morning Herald (2009), the resignation was as a result of company inability to pay Australian Taxation Office (ATO) close $15million debt seven months before it collapsed. The resignation of senior taxation manager would have raised more questions on the reason behind his action. Further, the company failed to honor its commitment to pay the debt as agreed which was then $18million. The inability of the company to meet its financial obligation as it falls due is one of the major indicators of the company under financial distress. The investors and analyst were not able to identify this aspect which would have helped them in raising ‘red flag’ on the company going concern. The company made huge acquisition of intangible assets which impacted negatively on shareholder return. The return on equity (ROE) dropped drastically in 2005 and 2006 where it recorded 6.6% and 4.4% respectively. The ROE improved in 2007, but it was still low compared to prior years (McRobert, 2009). The increased investment in intangible assets impaired company profitability since they were not generating income. The company had purchased $2.4billion of childcare licences. The acquisition limited the ability of the company to cross-sell other services. Also, the company had huge maintenance cost which impacted on company profitability in 2005 and 2006 (McRobert, 2009). The investors and analyst would have detected financial distress of the company by deeply analysing repercussion of huge investments on intangibles and increased maintenance cost and it would have warned them against any further investment. The ABC Learning books of accounts showed that the company is highly geared and thus increasing company inability to meet its debt obligation. The high gearing ratio depicts company with high chances of becoming bankrupt. On the other hand, low gearing ratio Shows Company with financial stability since it can pay its debt. The gearing ratio of less than 50% is recommended and 10% geared company being more stable since it can pay its debt ten times with the shareholder equity. The ABC Learning showed high gearing of 3.37:1 in 2001 when the company got listed and improved in 2005 and 2006. It then worsens in 2007 when it recorded 2.03:1 which shows that the company debt was two times more than its equity. The company decision to issue redeemable convertible preference shares in 2004-2006 and redeemable convertible reset notes in 2007 would have been arrived at because the shares were not attractive since it was highly geared (McRobert, 2009). Therefore, investors and analyst would have raised ‘red flag’ on making any further investment back in 2004 when gearing was at 2.30:1. According to McRobert (2009), presented and adjusted value of net operating cash flow to current liabilities shows huge discrepancies. The modified values indicate a poor net operating cash flow to current liabilities and overstatement of cash flow from operations to servicing the debt. The presented values show exaggerations of operating cash flows and thus hiding the financial struggle of the company. The article critics that auditors failed to give an honest opinion over the years that the company struggled in increasing its cash flow to finance the financial obligation. For example, in 2006 the company overstated net operating cash flow presented record that shows financial fit company but adjusted value showed that the company was able to raise cash flow that covered only 64.2% of its liabilities. The dilemma comes on who to blame for the misinterpretation of the figures on presented financial report which are used by investors and analyst in making financial decisions. Therefore, users of financial information must look beyond accounting numbers. The use of only financial information might lead to investing in risky companies who use creative or cosmetic accounting to hide their financial difficulties. Question 2: Importance of financial ratios The company requires regular examination and evaluation of its financial position and performance. The ratios provide a wide range of methods to examine and evaluate the financial fitness of the company. The importance of financial ratios is well understood when broken down into its subsequent classes which entail liquidity, sales and assets (activity), financing and debt (leverage) and profitability ratios (Horngren et al, 2005). The liquidity ratio provides an indication of company ability to meet its short-term obligation and provide vital information about the strength of the business. The ratios under this class include current asset ratio and acid or quick ratio. The ratios are usually used when the company is seeking to raise short-term debt to find overall financial fitness to take in more debt (Horngren et al, 2005). The sales and assets (activity) ratios measure the efficiency of the company i.e. the extent on which the company uses its assets to generate value for the shareholders (Horngren et al, 2005). For instance, the account receivable turnover ratio measures how the business manages its account receivable account i.e. the period which the business is required to collect debt or proportion of debt to the company sales. Additionally, the stock turnover shows how the company manages its inventory. The leverage ratios provide the basis of measuring long-term financial soundness of the company. The most common ratio is a debt to equity ratio which divides long-term debt with the total equity. The resulting solution indicates the amount of debt that is covered by the company’s equity. The high debt to equity ratio signifies high risk of bankruptcy while low ratio shows financially sound institution. The leverage ratios are useful for the investors in determining the future of potential investment to avoid debt eating into their shareholdings (Horngren et al, 2005). Lastly, the profitability ratios evaluate profits to equity or assets of the company. For instance, the return on asset ration evaluates the ability of the company to produce a profit from the available assets. On the other hand, return on equity measures earned profit against the funds invested in the form of equity. Additionally, the ratio shows assets management and the strength of company’s capital structure (Horngren et al, 2005). In conclusion, it is evident that financial ratios are important in determining the financial fitness of the company. Though, it should be noted that using single period values or year-end values is prone to errors and thus failure to give a true picture of the company performance and position. Also, the financial ratios work best if the investors and analyst compare them with other firms in the same industry or with the same business model. Question 3: Ratios which would have indicated worsening position of ABC Learning As noted above, it is clear that the analysis of financial ratios of the company would have helped investors and analyst in determining the financial soundness of the company before it collapsed in 2008. The analysis carried out by McRobert (2009) showed that the company had experienced financial difficulty way back in 2004. The issue that might have blurred the use of these ratios can be associated with failure of directors to present books of accounts that shows true and fair position and performance of the company. Also, failure of the auditors to provide honest opinion plays a major role in evaluating company financial fitness using ratios. The ratios that McRobert notes the following ratios; return on equity, net operating cash flow to current liabilities, total liabilities to shareholders’ funds and cash interest, operating lease rental cover and total intangibles to shareholders’ funds. The return on equity measures the efficiency of the management in using shareholders’ funds to produce a profit. The increase in the return on equity signifies that the management is operating efficiently in fulfilling its mandate to maximize shareholder wealth (Penn, 2011). The analysis of the company’s return on equity showed that ABC Learning experienced weak REO in 2005 and 2006 when it fell drastically and experienced a slight increase in 2007 (McRobert, 2009). The drop in this ratio would have warned the investors and analyst that the company was experiencing financial difficulty. Consequently, net operating cash flow to current liabilities demonstrates company inability to generate enough cash flows to service its short-term obligations. The company faced financial difficulty in 2001 to 2004 and 2006 to 2007 where it recorded less than 100% (McRobert, 2009). The company was the only stable net operating cash flow in 2005 where it generated 146% of the adjusted operating cash flow to current liabilities (Revans, 2011). Additionally, the interest and lease cover of the company was low during the period expect in 2005 where it had more than two. The ratio shows the number of times the earnings of the company can cover its lease rental and interest. High interest and lease rental cover signify that the company’s financials is stable and can meet its obligation and retain enough cash to pay dividends and remain with cash for future investment (Altman & Hotchkiss 2010). The low ratios of ABC Learning would have been a clear warning that the company was not making enough profit that enables it to pay attractive dividends and make future investments. Lastly, other going concern models such as z-score model would have been used in determining the company going concern. The model combines five ratios which include earnings before interest and tax (EBIT) to total asset, working capital to total assets, retained earnings to total assets, the market value of equity to total liabilities and sales to total assets (Altman, 2000). The result more than 3 shows that the company is stable financially. Question 4: Challenges of using financial statements The ABN Amro faces a lot of challenges as part of the users of financial information due to manipulation of accounts by directors (Beaver et al, 2005). The audit report produced by Pitcher Partners and Earnest and Young showed huge discrepancies on the financial fitness of the company. The conflicting reports have put Pitcher in doubt for its reports. KPMG was appointed to assume a neutral position in harmonizing the two reports and reaching an amicable opinion (Kruger, 2009). Therefore, the use of financial statements by investors in determining firms under stress is difficult if the audit report is compromised (Beaver et al, 2005). The auditors are supposed to express their opinion preparation of the financial statement if they portray the true and fair position of the company. Therefore, if the auditor fails to spot errors in company books of accounts, the user of the same information is not immune too. Though, there are other factors apart from financial statements that can be used to determine company under stress which include high employee turnover from senior staff and conflict between its lenders or creditors. The reasons of accounts manipulation include executive incentives linked to performance entice directors to manipulate accounts (Beaver et al, 2005). Also, the loophole provided in GAAP standards gives management to create a favorable picture of their financials without being noticed since it provides them with significant flexibility in reporting (Beaver et al, 2005). Lastly, the author notes that the close relationship between independent auditor and client would impact the opinion since they might liaise to conceal true and fair picture of the company. The concealment makes it hard for investor or analyst to detect financial distress of the company by using only financial statements. Case study: Strategic Management Accounting Impact of changes in the cost and profit structure The recommendation made by the marketing department brings changes on various aspects of sales, production and utilisation capacity of firms’ resources. The first impact was on net sales per unit which reduced by 0.4 to $2.915. The reduction has a negative impact on profitability and returns on investment of the company. Increasing efficiency compensates the negative consequences and reducing the costs. The company reduced its prime cost by 20% which changed from $1.25 to $1 per unit. Consequently, the sales increased by 25% as a result of increased margin of supermarkets by 0.4 to 1.885 per unit since the product will be brought back to prime shelves. The increased sales will force the company to increase its production to meet the rising demand in the market. The increased production will, in turn, improve manufacturing utilisation from the current capacity of 69% to 86.5% and warehouse utilisation from 54% to 67.5%. Additionally, the increased production will increase total variable cost but reduce fixed cost per unit by $0.216. Reduction of fixed cost per unit impacts on company profitability positively (Grant, 2016). Also, it improves company return on investment to 57.4% which surpasses the target of 25% set by Jupiter Australia Limited. The sheet below summarises the calculation carried out to arrive at results used in the analysis above. Budget Comparative Before After Total Assets: ‘TeaserMalt’ Factory - Bendigo, Victoria $52,000,000 $52,000,000 Total Sales (Volume)(50 pack units) 60000000 75000000 Regular Retail Price (per unit) (price sold in supermarket) $4.950 $4.950 Retail Margin (per unit) (Supermarket Gross Profit per unit) $1.485 $1.885 Gross Sales Value (per unit) (Price received by ‘TeaserMalts’) $3.465 $3.065 Supermarket Rebates (per unit)(Paid by ‘TeaserMalts’) $0.150 $0.150 Net Sales Value $3.315 $2.915 Prime Costs $1.250 $1.000 Manufacturing Costs $1.200 $0.984 Logistic Costs $0.650 $0.533 Total Costs (per unit) $3.100 $2.517 Gross Profit (per unit) $0.215 $0.398 Total Gross Profit $12,900,000 $29,850,000 ROTA 24.81% 57.40% Manufacturing Capacity 69% 86.25% Warehouse Capacity 54% 67.50% Before After Manufacturing Costs (Per Unit) $1.200 $0.984 -Fixed (90%) (Per Unit) $1.080 $0.864 -Variable (10%) (Per Unit) $0.120 $0.120 Logistic Costs (Per Unit) $0.650 $0.533 -Fixed (90%) (Per Unit) $0.585 $0.468 -Variable (10%) (Per Unit) $0.065 $0.065 Total Manufacturing Cost $72,000,000 $73,800,000 Total Logistic Cost $39,000,000 $39,975,000 Impact of changes in the cost and profit structure of ChockoBalls The calculation below shows the impact of changes in the cost and profit structure of TeaserMalt had on ChockoBalls Manufacturing Costs (Per Unit) -Fixed (90%) (Per Unit) (1.20*0.9) = $1.080 {(1.08*60,000,000)/75,000,000} = $0.864 {(1.08*60,000,000)/25,000,000} = $2.592 {(0.864*75,000,000)/13,750,000} =$4.713 -Variable (10%) (Per Unit) (1.20*0.1) = $0.120 $0.120 $0.120 $0.120 Total $1.200 0.984 $2.712 $4.833 Logistic Costs (Per Unit) -Fixed (90%) (Per Unit) (0.65*0.9) = $0.585 {(0.585*60,000,000)/75,000,000} = $0.468 {(0.585*60,000,000)/25,000,000} = $1.404 {(0.864*75,000,000)/13,750,000} =$2.553 -Variable (10%) (Per Unit) (0.65*0.1) = $0.065 $0.065 $0.065 $0.065 Total $0.650 $0.533 $1.469 $2.618 Total Manufacturing Cost (60,000,000*0.585) =$72,000,000 (0.984*75,000,000) = $73,800,000 (2.712*25,000,000) = $67,800,000 (4.833*13,750,000) =$66,450,000 Total Logistic Cost (60,000,000*0.650) =$39,000,000 (0.533*75,000,000) = $39,975,000 (1.469*25,000,000) =$36,725,000 (2.618*13,750,000) = $35,993,750 ChockoBalls Sales volume: Before change; Sales = = 25,000,000 After Change Sales=25,000,000-(0.75*(75,000,000-60,000,000)) = 13,750,000 The decrease in sales caused by ‘TeaserMalts’ strategy impacted negatively on Chockoball's manufacturing and logistics cost. The sales reduced from 25million units to 13.75million units. The fixed cost per unit will increase while the variable cost remains constant (Horngren et al, 2005). The manufacturing cost increased from $2.712 to $4.833 per unit. Also, the logistics cost increased from $1.469 to $2.618 per unit. The total manufacturing and logistics cost increased by $1,350,000 and $731,250 respectively. The increased in fixed cost will impact company profit which can force it to reduce supermarket margin and thus its products withdrawn from prime shelves. The sheet below elaborates step by step calculation used in arriving at the analysis above. Recommendation to the Committee The company should adopt the strategy brought forth by the marketing department since it achieves objectives of the Jupiter Australia Limited. The strategy achieves the following key objectives; Increased market share by 25% which increases sales from 50million units to 75million units. Increased volume of sales increases profit and return to the supermarket which then moves the company product to prime shelve. Improved return on investment from 24.81% to 57%.The range between recommended (25%) and achieved (57%) return on investment gives the company room to adjust its costs and price structure to stimulate demand in the market. The company can further increase supermarket margin to encourage supermarket to promote its product or reduce retail price. The reduction of the prices should be with consideration of other companies to avoid instances of a price war. Increased utilisation of company resources i.e. increased manufacturing and warehouse capacity to 86.25% and 67.5% respectively. The strategy will bring back the company into profitability and take back the market leadership. Reference: Altman, E. I. (2000). Predicting financial distress of companies: revisiting the Z-score and ZETA models. Stern School of Business, New York University, 9-12. Altman, E. I., & Hotchkiss, E. (2010). Corporate financial distress and bankruptcy: Predict and avoid bankruptcy, analyze and invest in distressed debt (Vol. 289). John Wiley & Sons. Beaver, W. H., McNichols, M. F., & Rhie, J. W. (2005). Have financial statements become less informative? Evidence from the ability of financial ratios to predict bankruptcy. Review of Accounting Studies, 10(1), 93-122. Grant, R. M. (2016). Contemporary strategy analysis: Text and cases edition. John Wiley & Sons. Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. (2005). Introduction to management accounting. Upper Saddle River, New Jersey: Prentice Hall. Kruger, C. (2009). Lessons to be learnt from ABC Learning's collapse. The Sydney Morning Herald. Retrieved 28 March 2017, from http://www.smh.com.au/business/lessons-to-be-learnt-from-abc-learnings-collapse-20090101-78f8.html Kruger, C. (2011). Numbers finally start to add up as operators go back to basics. The Sydney Morning Herald. Retrieved 28 March 2017, from http://www.smh.com.au/business/numbers-finally-start-to-add-up-as-operators-go-back-to-basics-20110121-19zy6.html McRobert, A. (2009). ABC Learning Centres Limited-did the annual reports give enough warning?. JASSA, (1), 14. Penn, H. (2011). Gambling on the market: The role of for-profit provision in early childhood education and care. Journal of Early Childhood Research, 9(2), 150-161. Revans, R. (2011). ABC of action learning. Gower Publishing, Ltd.. The Sydney Morning Herald,. (2009). Groves warned on tax months before ABC collapsed, court hears. The Sydney Morning Herald. Retrieved 28 March 2017, from http://www.smh.com.au/business/groves-warned-on-tax-months-before-abc-collapsed-court-hears-20091208-kh5l.html Read More