Managing Financial Resources in Elim Limited - Case Study Example

 Managing Financial Resources in Elim Limited Task 1: Analyse and evaluate the financial performance of Elim a) The purpose of the main financial statements and how Elim Ltd. may benefit from the main financial statements. Financial statements are logical and organized collection of data, set according to consistent accounting policies and procedures. For Elim Ltd. balance sheet is a financial tool, which would help their stakeholders to examine the company’s strength in terms of its assets and liquidity (Hampton 70). Income statement, on the other hand, is a tool which, with the help of revenue, cost and expense accounts, depicts whether the company is making enough money through its operations (Hampton 72). In other words, Elim Ltd income statement shows the level of profitability which the company can achieve, along with highlighting the factors that affect the overall operational profitability. Lastly, cash flow statements are also considered as important tools to assess a company’s financial performance, by showing the movement of funds in and out of the company’s accounts (Hampton 76). Hence, this helps the management to easily assess its liquidity and working capital management. (b) The differences between the formats of financial statements for different types of business and how the differences lead to low quality of accounting. The format of financial statements of a company depends upon the nature of its business. Primarily income statement is the one which shows slight changes in format from service concerns which show cost of sales, to manufacturing concerns which show cost of goods sold. Moreover, there are two formats of incomes statements; one is the classification of expenses by their functions, which assists management to display a picture of their operational efficiency (White and Sondhi 35). The other format is classification of expenses on the basis of their nature (White and Sondhi 35) which displays cost and expense components to help understand the relationship between sales and expenses (Hampton 36). The difference in format at times is employed as a tool to hide operational inefficiency, for e.g. IBM changed their income statement presentation in 2000 from separately showing gross profit, operating income and net incomes, to simply showing gross profit and net income (White and Sondhi 36), probably because, they did not want to highlight the operational inefficiency on their financial statements. Hence, it can be assumed that changes in format do lead to deteriorating of quality of information and derived analysis to rate a company’s performance. c. Impact of finance on the financial statements in light of Elim Taking into account Elim’s capital structure, it becomes evident that 43% debt financing and 57% equity financing is available to the company. The impact of short run debt will create more liabilities on their balance sheet, which will not worsen their liquidity position as presented by current ratio, because they already have excessive current assets. To finance its acquisition and market penetration, the company can raise finances by long term debt and equity. It has 35% debt which means that the company has future borrowing capacity, however, it will increase its interest expense, hence, the need to increase revenue and control costs becomes all the more dire with this financing option. Elim Ltd can also float common shares in the market to raise funds, which will increase their equity; moreover, retained earnings can also increase if dividends are not paid until the projects get into their growth phase to generate returns. 1(d) Elim Ltd financial analysis 2008 Following paragraphs shed light on the financial performance of Elim by analysing the performance of different ratios during the financial year 2009. Gross profit margin and operating profit margin ratios indicate the company’s operational efficiency and its ability to remain profitable even if the cost of raw materials rises, prices fall or sales decline (Hampton 109). Elim’s gross profit margin is 40% which is slightly lower than industry average of 42%. But the worrisome issue is Elim’s operating profit margin, which at 6.7% is almost half of the industry average of 15%. This identifies the fact that the management is not able to control the operational cost of business, which in turn ruins the net profit margin and ROE for the company. Return on Equity (ROE) indicates the company’s ability to generate return on investors’ funds; the greater it is, the better (Hampton 112). Elim’s ROE is -1.8% which shows a disastrous situation for the company, when compared with industry average of 8%. The reasons behind such a low level of ROE can be attributed to the fact that the company is incurring high operating cost. Stock turnover in days indicates the number of days in which inventory is sold out and restocked (Brigham 72). Elim’s stock turnover is 243 days which is a lot higher than the industry average of 180 days, this implies that the company is holding excessive inventory and is engaging funds in unproductive usage. Debtor turnover in days indicates the number of days that the company has to wait after making a credit sale to receive cash (Brigham 73). Elim’s debtor turnover is 243 days which is a lot higher than the industry average of 132 days. This ratio cannot be completely analyzed without having complete information about the company’s credit policy. However, the company should reduce its debtor turnover in days to match the industry performance. Credit turnover in days indicates the time taken by the company to pay its short term creditors (White and Sondhi 121). Elim’s credit turnover is 393 days which is higher than the industry average of 210 days. Thus, the company should increase its ability to retire short term debt quickly. Sales to fixed assets or fixed assets turnover ratio indicates the company’s ability to utilize it fixed assets to generate sales (Brigham 74). Elim’s fixed assets turnover is 0.5 times which is lesser than industry average of 1.2 times. This implies that the company is not utilizing its assets efficiently, along with not maintaining the right amount of assets required to carry out the operations smoothly. Therefore, the management must focus on more efficient utilization of assets so that the return can increase. Gearing ratio indicates the ratio of debt and equity in the capital structure of a company (Hampton 118). This ratio is important because it helps analyze the company’s financial risk and ability to borrow in future. For Elim, gearing ratio is 35% which is lesser than the industry average of 42%. Keeping the industry average in mind where other players might be enjoying financial leverage with a higher debt ratio, it can be concluded that the management is being conservative in relying upon debt and is losing a chance of enjoying financial leverage, which in turn can increase ROE. Interest coverage indicates the company’s ability to cover interest expense through its operating profits (Brigham 78). The interest coverage for Elim is 0.67 times which is tremendously lower than the industry average of 3.2 times. The reason behind such low interest coverage can be attributed to very low operating profits as compared to the industry. Hence, the management must improve its operational efficiency by controlling cost, to increase their ability to cover interest expense. Current and quick ratios indicate the company’s ability to retire short term liabilities by employing its current assets (Brigham 71, 72). In other words, it is a measure of firm’s liquidity. Elim’s current ratio is 1.7 which is higher than the industry average of 1.3. This implies that the company is having excessive investment in current assets. Moreover, when excluding inventories to calculate Quick ratio which is 1.2 times, higher than industry average of 0.8, it becomes evident that Elim is surely having unproductive liquidity in the shape of unused of funds. In a nutshell, Elim Ltd has to employ cost cutting measures so that they can improve their operational efficiency, ROE and in turn strengthen their financial position. Task 2: Analyse the implications of finance as a resource within Elim Ltd. 2(a)The decisions that have to be made and their respective information needs. Elim is faced with strategic decisions that include taking cost control initiatives, developing a new product and growing the distribution network of the company by acquiring distributors. For each decision, the management will need various types of information that can help them make sound and prudent decisions. For controlling cost, the management will have to identify the cost centers along with studying the relationship between sales and expenses. This will enable them to understand how much their company incurs to produce the given level of sales. Moreover, Elim’s management will have to identify what elements make up their cost and how much significance do those elements hold in their operational activities. For the second decision of developing a new product, the management will have to carry out an internal and external analysis of their company. Internal analysis will let them get a clear idea about their strengths and weaknesses. The external analysis will let them carry out competitors’ analysis and market analysis which will equip them with information regarding opportunities and threats in the external environment. To make a sound decision regarding acquisition, they must have a clear idea about the financial performance, their market accessing ability of each alternative. Moreover, they will have to dig into the after-math of acquisition, in other words, the return on investment made in acquisition must be satisfactory enough to justify this decision. 2 (b) The importance of financial planning for Elim Ltd. Financial planning can equip Elim’s management to forecast and prepare themselves, in order to deal with changes in external and internal factors. It will also help them to assess the sources of funds, which would be required to meet future cost and expenses, in the shape of marketing for the new product or investing money in strengthening the acquired distributors. Last but not the least, it will also enable them budget their activities so that they can monitor and control their operational costs. Task 3: Make financial decisions based on financial information 3(a) Preparation and analysis of 2009 budgeted balance sheet and income statement To forecast, the following assumptions are held true: 1. Sales will increase by 25% 2. Cost of goods sold and operating expenses will increase by 20% keeping the cost control measures in mind. 3. Fixed assets will not increase because the management is already underutilizing the assets 4. $2 dividends per share will grow by 2% 5. 27.5 m funds will be raised 40% by long term debt at 15% and 60% by common stock 6. The current market price is $10 per share 7. Revaluation reserves will increase by 20% Analyzing the budgets The following table displays the projected ratio and the percentage change from FY 2008 to 2009.       % change   projected 2009 2008   Gross profit margin 42.51% 40% 6.28% Operating Profit margin 10.43% 6.7% 55.64% ROE 0.70% -1.08% 35.08% Stock turnover 253.47 days 243 days 4.31% Debtor turnover 243.98 days 243 days 0.40% Creditor turnover 409.78 days 393 days 4.27% Fixed assets turnover 1.60 times 0.5 times 220.86% Gearing ratio 37.33% 35% 6.67% Interest coverage 1.18 times 0.67 times 75.91% Current ratio 1.73 times 1.7 times 1.52% Quick ratio 1.21 times 1.2 ties 0.68% The analysis of the data makes it evident that if the company would be able to achieve its target of 25% increment in sales, the financial performance will surely improve. Most importantly, ROE along with operating profit would show a promising performance. Not only this assets management would also improve resulting in better liquidity and working capital management. Operational efficiency will strengthen its borrowing capacity by showing 75% increase in interest covering ability. All in all, it can be predicted that if the company remains successful in pursuing the set objectives, the company will come out of financial turmoil. The graphical presentation as following will also make the comparison easy to assess. 3(b) Unit costs calculations of the Optimare and Ultimare The following tables display the unit cost calculations for Ultimare and Optimare.       Ultimare  $ explanation revenue 30,000,000.00 250,000 x 120 less cost     fixed cost 2,000,000.00   variable cost     raw material per pack 9,000,000.00 36 x 250,000 packing cost per pack 3,750,000.00 15 x 250,000 delivery cost per pack 1,250,000.00 5 x 250,000 commission 1,500,000.00 0.05 x 30 m marketing expenses 600,000.00 0.02 x 30 m total cost 18,100,000.00   Profit 11,900,000.00 R- TC taxation 3570000 0.3 x 11900,000 Net Profit 8,330,000.00   unit cost 72.4 8330000 / 250,000 Optimare at$ 50 per unit  $  Explanation Revenue 15,000,000.00 300,000 x 50 less cost     fixed cost 3,500,000.00 2000,000 + 1,500,000 variable cost     raw material per pack 4,950,000.00 16.5x 300,000 packing cost per pack 3,600,000.00 12 x 300,000 delivery cost per pack 1,500,000.00 5 x 300,000 commission 750,000.00 .05 x 15000000 marketing expenses 300,000.00 .02 x 15000000 total cost 11,100,000.00   Profit 3,900,000.00 R- TC taxation 1,170,000.00 3900000 x 0.3 Net Profit 2,730,000.00   unit cost 37 11100000 / 300000 After, analyzing the unit cost for each product, it becomes evident that developing a new product is a not a viable option because despite the increment in fixed cost, because Ultimare’s market penetration would be able to derive $11.9m sales, whereas Optimare’s will have sales of $ 3m. Hence, the management should focus on market penetration instead of new product development. 3(c) Assessing the viability of each acquisition using investment appraisal techniques, NPV and IRR. The following tables show IRR and NPV being calculated for each project.             Project A   at 15% at 27% 27.50% 27.15% 0 4000         1 500 434.7826 393.7008 392.1569 393.2363 2 3000 2268.431 1860.004 1845.444 1855.618 3 3600 2367.058 1757.484 1736.889 1751.271 total   5070.272 4011.188 3974.489 4000.125 NPV   1070.272 11.18834 -25.5106 0.125324           Project d   AT 15% at 45% at 50% 0 0       1 3000 2608.696 2068.966 2000 2 2500 2268.431 1189.061 1111.111 3 3000 1972.549 984.0502 888.8889 NPV   1632.284 104.1453 0 I believe, project A and D should be chosen on the basis of IRR and NPV, because both these projects show the highest IRR and NPV values. Project A has IRR of 27.15% and NPV of $ 1, 071 at 15%. Project D has IRR of 50% and NPV of $1623 at 15%. Task 4: Explore the sources of finance available to Elim (a)Identify the sources of finance available to Elim Ltd in light of its respective short and long term financing needs The short term needs for Elim arise because of poor liquidity and working capital management. The long term financing needs arise so that the company can take long term initiatives of expanding their market along with aiming for vertical acquisition. Keeping the current financial position of the company, it is evident that Elim is in need of short term financing to improve its working capital management because it keeps its funds engaged in inventories. Therefore, they can opt for short term financing methods like receivables factoring, inventory financing, self liquidating bank loans and line of credit (Mathur 327). For the long run, the management has both debt and equity financing options available. The debt to equity ratio of the company is 35% which is lower than the industry average, which means Elim can raise additional funds by debt. Moreover, it can also issue common and preferred shares or can employ their retained earnings to finance its growth strategy. (b)Assess the respective implications of the identified sources. For Elim, short term financing needs in the shape of pledging receivables and inventory will help them utilize their mounting receivables and inventories to support their operational cash requirements. Self liquidating bank loans and lines of credit are unsecured short term financing methods which would enable the company to acquire funds, particularly during the launch of their new product, because during such times, sudden need of funds can arise. For long run financing, Elim can issue bonds or stocks that can help them finance their acquisition strategy. The increment in debt obviously would result in increased interest payments but once the market share gets increased, operational efficiency will improve and the company will be able cover the finance cost. Moreover, it is a safer mode of financing because as per the industry practice, Elim is maintaining low debt to equity ratio. At the same time, the company can also issue additional shares or for initial phases of the project it can make use of its retained earnings as well. (c)Assess and compare the costs of the identified sources of finance. The short term financing sources for Elim that have been identified have certain costs associated with them. For e.g. pledging receivables will make the current ratio of the company get adversely affected and relying upon this source might not be safe always, because, one might not be able to find the right party to deal with, in times of dire need. Next comes, inventory financing which can make the inventory get damaged if not appropriately taken care of. Coming to self liquidating bank loans, the management has to bear interest charges on such loans whose rate varies on the basis of supply and demand of short term funds (Hampton 430). Another unsecured short term financing is by getting a line of credit which makes it an obligation for the company to place 5 to 20% of the outstanding balance of loan in the lending bank’s account (Hampton 432), hence, the effective cost of borrowing increases. In case of long term financing, debt will increase the cost of the capital for the company. Lending institutions impose restrictive covenants which force the management to get hand-cuffed while making decisions and devising strategies (Shapiro and Balbirer 415). Moreover, debt financing can be very costly and risky if inflation increases or operational efficiency decreases. Cost of issuing shares include diluting management control and diluted earnings per share and in turn lower share price, because the number of shares outstanding in the market will increase (Shapiro and Balbirer 414). For preferred stock financing, the management will have to pay dividends like interest every year, come what may. With retained earnings financing, the company might lose investors’ interest because of lower or inconsistent dividend payments (Shapiro and Balbirer 416). Moreover, if the firm is not making enough profit, the level of retained earnings will fall, hence, it cannot be very safe mode of financing. (d)Select and justify the appropriate sources of finance for the acquisition project of Elim Ltd. To finance acquisition project of Elim Ltd, I believe, a mix of long term financing sources can be opted for. For e.g. the company can invest its retained earnings in the pre-introduction phase of its life cycle, and later on issue shares to raise funds. The reason behind suggesting such combination is a fact that initially, the company will not have to incur floatation cost for debt or shares, if it will make use of its retained earnings. But since this source of financing is not a reliable one, the company must switch to common stock financing. Issuing shares definitely has floatation costs and diluted management control, but the biggest advantage is the fact that company will not have to necessarily pay dividends to shareholders every year. Once the project will start to generate revenue, the dividend payout would increase which would satisfy the common share holders. Works Cited Brigham, Eugene. Fundamentals of Financial Management. 7th ed. Florida: Dryden, 1997 Hampton, John. Financial Decision Making: Concepts, Problems and Cases. 4th ed. New Jersey: Prentice Hall, 1998. Mathur, Iqbal. Introduction to Financial Management. 8th ed. London: Collier Macmillan, 2000. Shaprio, Alan and Sheldon Balbirer. Modern Corporate Finance. 3rd ed. Singapore: Pearson Education, 2003 White, Gerald and Ashwinpaul Sondhi. The Analysis and Use of Financial Statements. 7th ed. New Jersey: John Wiley & sons, 2003. . Appendix Explanation of Calculations while forecasting the budgeted statements The dividend amount for Pass 1 is calculated as 2 x 1.02= 2.04 $ per share. Before finding out the additional funds, the number of shares outstanding is 10 million. Therefore, 10 x 2.04 = 20.4 (dividends amount). The additional funding requirement is 25.35 whose 40% is debt financed, hence, 10.14 m is added to long term debt at 15% interest rate, increasing the interest by (10.14 x 0.15) $ 1.5. The rest of the additional funding is done by issuing common stocks worth $ 15.45m. Assuming that the market price is $10 per share, the company will have to issue 15.21/10= 1.521 m additional shares. Therefore, the final dividends paid on these number of shares is 1.521 x 2.04 = 3.10 will added to dividends, hence dividends = 23.5 Read More