Management and Control of Financial Resources - Case Study Example

Management and Control of Financial Resources Table of Contents Table of Contents 2 Problems highlighted by ratio analysis 3 Global Economic Outlook 4 Business Forecast of Canada Corporation Ltd- 6 Improvement actions 6 Company Expansion Programs Analysis 8 Calculation of Payback period 9 Suggestions 9 Reference 11 Annexure- 13 Problems highlighted by ratio analysis Liquidity position- The current ratio of Canada Corporation Ltd has deteriorated over the last three years. This was 250% in 2007 and has come down to 162.5% in 2009. Current ratio highlights the liquidity position of the company. The low current ratio signifies that the liquidity position of Canada Corporation Ltd is weak and it is not capable of meeting its short term obligations (Brigham & Houston, 2007, pp.103). Another commonly used liquidity ratio is Quick ratio or Acid-test ratio which is computed by subtracting the Inventories from the current assets and dividing it by current liabilities. Acid-test ratio of Canada Corporation Ltd is 75% or 0.75 which is less than one. This signifies that the company cannot meet its current liabilities signifying a case of caution (Investopedia, 2010). Activity ratios- The receivable turnover ratio of the company is 3.2 which is roughly half as per industry norms of 6.0. This ratio measures the effectiveness of the company in granting credit and collection of debt. The low ratio of Canada Corporation Ltd implies that the credit policy of the company is lax i.e. credit is being granted without an accurate assessment of the debtors credit record. The inventory turnover ratio of the company is 1.7 which is less than half the industry norms of 4.0. The low ratio signifies that the sales of the company are poor resulting in high level of inventory. This indicates inefficient inventory management. The Tangible Asset turnover ratio of the company is 0.67 implying that the company is not able to utilize its asset base effectively. Tangible asset turnover ratio is a measure of firm’s efficiency in asset utilization. The low turnover ratio of Canada Corporation implies that the company is not able to generate sales. Solvency position- The long term debt to total capitalization is 54.5% signifying that the company uses large amount of debt in the capital mix. This is not in the financial interest of the company as overexposure to debt may lead to financial burden thwarting the future growth prospects of the business. Profitability position- The gross-profit margin and the net profit margin of the company is 40% and 10% respectively. The net profit margin is less as compared to the industry norms of 15%. A low net profit margin indicates that the management of the company needs to exercise control over the administrative and other overhead expenses. As evident from the ratio table all the ratios have deteriorated over the last three years except Return on equity (ROE). The company reported ROE of 25% in 2007 that went up to 30% in the following year and fell marginally to 29.30% in 2009. This shows that the company has generated wealth for its shareholders. The rise in the ROE may be due to a fall in the equity base of the company. It can also be due to a rise in the profits of the company. It is possible that the profits of the company moved up but it failed to maintain the pace with the rise in the sales resulting in a decline in the net profit margin. Global Economic Outlook A V-shaped economic recovery forecasted in the middle of the global financial fiasco is now underway. The process of recovery initiated last year in countries like China, Indonesia and India and gradually spread to other emerging and advanced economies. The Asia-Pacific region is expected to outdo the 8 percent growth forecast. This will be led by a real growth rate of 10 percent by China (Mussa, 2010). The process of recovery will be slow in the advanced economies. In countries like US the biggest growth drivers will be business investment, government spending and foreign consumers; and the rebound is expected to be risk laden. This is the same in the case of Japan as the country’s economic revival appears fragile due to record unemployment levels, falling wages etc. Despite this the Japanese economy is likely to exhibit a growth but there may be a decline in the growth momentum. China has performed much better than the other countries in the recent global phenomenon. This has been added by massive monetary and fiscal expansions (Deloitte, 2009). The industry of household appliance has gained competence in economically developed regions of China like Pearl River Delta. It is a leading manufacturing centre in the country. The “National Development and Reform Commission of the State Council of the People’s Republic of China” released an outline relating to the reform and development of the Pearl Delta region. This plan is mainly aimed at transforming this region into a highly competitive region with high standards (Teng, 2010). The plastic goods are widely used by the various components of the national economy and is an integral part of our lives. It is predicted that the 21st century will be a century of plastic and China will be the largest plastic market. Along with the continuous rapid economic development in China, the plastic industry will keep developing at high speed in the long term. It is widely believed that the price of the plastics has decoupled from the crude but there is still a co-relation. The price of oil is difficult to predict as it is based on market factors. With the rising price of oil the price of plastics produced from oil will also move up. Any mismatch between global demand for oil and its supply has a profound effect on various industries including plastics. Business Forecast of Canada Corporation Ltd- As plastic industry is an industry with low entry barriers, strong bargaining power of the suppliers and buyers, it is exposed to strong competitive threats from substitutes and intense competition from the market rivals. A global brand can enhance the confidence of the customers. It is prudent to establish branches in other countries, especially in the countries that are already engaged in selling the products of the company. The expansion of the company in the inland of China can increase the competence of the company over other foreign competitors. China ranks among the fastest growing countries in the world; therefore the company is expected to grow extensively in the coming years. Improvement actions The inventory turnover ratio of the company is low indicating poor sales performance. This can be improved by raising the level of sales. Higher sales will result in lower inventory accumulation which in turn will raise the inventory turnover ratio of the company. But care must be taken with regard to lost sales. The company must try to maintain the ideal stock such that it is neither overburdened nor is the production process hampered. The Receivable turnover ratio of the company is also low signifying poor credit policy. To improve this, the company management should conduct a re-assessment of the credit policies. Granting credit to the creditworthy customers will ensure a timely collection from the debtors. Before granting credit the company must look into the credit history of the customers. To boost collection the company can also introduce the system of ‘cash discounts’ as this will result in prompt payment. The low return on assets can be improved by raising earnings or by reducing the asset base. It is also possible that the company has large amount of unused assets. By disposing it off the company can improve the liquidity position and improve the return prospects as well. The overall liquidity position of the company can be improved by speeding up the receivable collection and lowering the current liabilities of the business. For better cash control the company can make use of the optimum cash holding method. The idle cash can be invested by the company in profitable ventures. This will raise the business earnings and improve the returns generated by the company. The profitability position of the company can be improved by lowering the administrative and selling expenses. To control the excess marketing expenses the company can set up departments with the authority to direct the resources. The debt position of the company is higher than the industry norms. This is not a good sign as it can create pressure on the earnings of the company. The high interest expenses often come in the way of the business growth prospects. Therefore the company must try to reduce the debt burden by repaying the debts. It is recommended that the company changes the capital mix by lowering the leverage position. Canada Corporation Ltd. is regarded as a medium-size company and it has great potential to expand into a more mature enterprise with the utilization of the local resource of production, supply chain and sales channels. Company Expansion Programs Analysis For setting up new offices the company can consider the inland market as this will give it access to a large number of customers. This will also facilitate cost reduction relating to delivery, advertisement etc. Before initiating any new investment the company must appraise its financial viability. This can be done using various methods like Net Present Value (NPV), Payback etc. An investment should be taken up only if the present value of the anticipated cash flows is more than the cash outflow. In this situation the NPV of the project is positive and it is profitable. Similarly, Payback indicates the time taken to recover the initial investment in the project. If this falls within the acceptable time frame then the project is selected otherwise it is rejected. Besides analysing the project profitability another area that needs consideration is the procurement of finance. It has to estimate how much finance will be needed and raise the same from the most economical sources. Like if the interest rate in the market is high then it can make use of Retained earnings or it can opt for Rights issue. For the purpose of business expansion the company can set up new offices in Shanghai, Beijing and Chungxin. This will help the company to strengthen its brand image and will also lower the costs. But the high cost of acquisition decreases the efficiency in the production of money income. The merging of the local PRC companies is another way of expansion. This will facilitate the use of additional resources, lower the cost of material, labour and transport. The scale of production can be expanded resulting in greater economies of scale. But there are certain inherent risks to merger. Like the culture of two companies may be difficult to integrate. Moreover, the geographical separation creates problems relating to control. The widely differing economic and social conditions make the interactions more complicated. Calculation of Payback period Suppose the company buys 2000 sq m of space in Shanghai for setting up new offices at the rate of $1114 per sq m (Jing, 2008). Therefore, the initial cash outflow of the company is $2228000. Assuming the net cash flows for five years is $1200000 for Year 1, $1200000 for year 2, $800000 for Year 3, $900000 for Year 4, $1000000 for Year 5. Based on this the company will recover $1200000 in the first year and the remaining amount of investment in second year. The exact time taken to recover the money invested in the new investment is 1.85 years. Suggestions The financial performance of Canada Corporation Ltd has deteriorated over the last three years as indicated by the falling profitability margins. Together with a fall in profit margins the assets utilization ratio and turnover ratios of the company have also declined over the period. The management of the company can improve the profits by exercising control over the overhead costs. For improving the realization from debtors the company can create a new department for Credit Control. This will help in assessing the credit background of the customer before selling goods on credit basis. This department can analyse the financial statements of the company to get an idea about its financial strength. If the company whom the company expects to sell exhibits strong ratios and has good payable track record then the company can go ahead with the sales. But if it is found that the prospective client has payables due for long period then care must be taken regarding credit sales. For the expansion plans the company can use the fixed budget compilation method as this is based on normal achievable business volume and is used in fixed expense budget. The rolling budget compilation method and probability method can also be used. Both of them are suitable for company expansion project. Efforts should be made at improving the accounting assessment system. This system should be based on the financial goal of the company. The assessment of the Accounting Department can be made on the cost control and the tax budget situations. The company should have a scientific decision-making system so that it can recognize the sales opportunity and improve performance. Targets can be set for the various departments and all the units must be motivated towards the achievement of the set target. Any deviations of the actual results from the desired performance must be rectified through better resource management, training etc. Although the Pearl River area is a leading manufacturer in China, there is a great demand in the inland areas. Catering to this demand can give additional incentives to the company. The delivery cost and overhead can be reduced in the inland areas because the wage level and expense is low. It is suggested that our company needs to enhance marketing in inland China and increase the cash turnover by selling in large volumes. The Chinese market can be divided into four areas of east, west, north and south. Therefore it is a good strategy to set up four selling offices in each area of China. Reference Brigham, F.E. Houston, F.J. 2007. Fundamentals of financial management. Cengage Learning. Investopedia. 2010. Acid-Test Ratio. Available at: http://www.investopedia.com/terms/a/acidtest.asp [Accessed on June 17, 2010]. Deloitte. 2009. The shape of the recovery in 2010. Global Economic Outlook. Available at: http://www.deloitte.com/assets/Dcom-Global/Local%20Assets/Documents/Deloitte%20Research/dtt_dr_economicoutlook_Q409_281009.pdf [Accessed on June 17, 2010]. Jing, J. 2008. Shanghai house sales see declining trend. China Daily. Available at: http://www.chinadaily.com.cn/bizchina/2008-07/23/content_6869761.htm [Accessed on June 17, 2010]. Mussa, M. 2010. Global Economic Prospects for 2010 and 2011. Peterson Institute for International Economics. Available at: http://www.iie.com/publications/papers/mussa0410.pdf [Accessed on June 17, 2010]. Teng, S.L.A. 2010. The international financial crisis - impact on Asia and lessons for Macao. Bank For International Settlements. Available at: http://www.bis.org/review/r100527d.pdf [Accessed on June 17, 2010]. Annexure- Canada Corporation Ltd. Balance Sheet December 31, 2009 Assets Liabilities and Shareholders’ Equity Cash Accounts receivable Inventory Fixed assets, net Excess over book value of assets acquired Total assets $ 1,000,000 5,000,000 7,000,000 15,000,000 2,000,000 $ 30,000,000 Notes payable Accounts payable Accrued wages & taxes Long-term debt Preferred stock Common stock Retained earnings Total liabilities & equity $ 4,000,000 2,000,000 2,000,000 12,000,000 4,000,000 2,000,000 4,000,000 $ 30,000,000 Canada Corporation Ltd. Statement of Income and Retained Earnings Year Ended December 31, 2009 Net Sales: Credit Cash Total Costs and expenses: Cost of goods sold Selling, general, & administration expenses Depreciation Interest on long-term debt Net income before taxes Taxes on income Net income after taxes Less: Dividends on preferred stock Net income available to common stock Add: Retained earnings at 1/1/73 Subtotal Less: Dividends paid on common stock Retained earnings at 12/31/73 $ 12,000,000 2,000,000 1,400,000 600,000 $ 16,000,000 4,000,000 $ 20,000,000 16,000,000 4,000,000 2,000,000 2,000,000 240,000 1,760,000 2,600,000 4,360,000 -360,000 $ 4,000,000 Canada Corporation Ltd Ratio Comparison Table           Ratio 2007 2008 2009 Industry Norms           1.       Current ratio 250% 200% 162.50% 225% 2.       Acid-test ratio 100% 90% 75% 110% 3.       Receivables turnover 5.0X 4.5X 3.2 6.0X 4.       Inventory turnover 4.0X 3.0X 1.7 4.0X 5.       Long-term debt/Total capitalization 35% 40% 54.50% 33% 6.       Gross profit margin 39% 41% 40% 40% 7.       Net profit margin 17% 15% 10% 15% 8.       Rate of return on equity 25% 30% 29.30% 20% 9.       Return on assets 15% 12% 6.60% 10% 10.    NOP rate of return 18.30% 17.50% 20% 17.50% 11.    Tangible asset turnover 0.9X 0.8X 0.67 1.00X 12.    Overall interest coverage 11X 9X 7.6 10X           Read More