Financial Analysis and Management - Assignment Example

 Q. Many businesses fail through poor cash flow, even whilst their published accounts show a profit on trading activities. Explain why this might be the case and explain what managers can do to avoid becoming insolvent through periods of high sales growth. Cash flow is one of the most important indications of the liquidity and solvency of a business enterprise. While conventional wisdom tells us to focus on the income statement and the balance sheet as indicators of the financial status of a business enterprise, the more prudent investor will never forget to look at the cash flow statement that must be included with the annual report of the business at the end of every financial year. In recent times, the statement of retained earnings and the cash flow or funds flow statement has been assuming an increased level of importance even though the income statement and balance sheet may be showing a commendable level of performance. This is because liquidity problems are first indicated through a reduction of cash flow from operations. It is also important to remember that in the accrual basis of accounting, it is possible to include profits that have yet to be earned in sales that have been made in advance, though there is a possibility of sales returns or even cancellation of orders previously booked by buyers. Sometimes change of fashions or sudden exchange rate fluctuations make a consignment unprofitable for a buyer and he may want to cancel his order in the absence of a firm and irrevocable letter of credit. But this is the exception rather than the rule. Also the use of certain reporting methods can appear to inflate the profits and revenues earned by a business. The comparatively recent case of Enron, in which profits were booked as the difference between sales price and cost of goods sold is an example. Enron also used the marked to market technique of reporting its income for some of its businesses, which was adjudged as the present value of net future cash flows. The use of special purpose entities was also used to overstate revenues or hide losses. The company focused on what would increase its share price and value to investors and falsified its accounting records to meet these ends. Even its auditors Arthur Andersen were found professionally negligent in the carrying out of their duties, looking the other way probably due to the huge fees they pocketed. But all hell broke loose when the truth became known and one of America’s largest corporate entities had to bite the dust (McLean & Elkind, 2003, 75). Indeed, the cases of Enron, World.com, Tyco in the USA, Parmalat in Italy (Ferrarini & Guidici, 2005, 19) in which the company continued to scour the debt markets to raise cash while millions was siphoned off by the Tanzi family and Robert Maxwell and the House of Maxwell in the UK show how easy it is to falsify accounts to paint a rosy picture when the reality is that the business is holding on like a pack of cards waiting for the next ill-wind to blow. Maxwell proceeded to eat up his employees’ pension funds and then conveniently committed suicide by drowning in the ocean while on his yacht (Burns, 2009, 1). In the USA the Sarbanes Oxley Act of 2002 was enacted stating rules for corporate governance, ownership limits for directors and other measures directed towards limiting chances of fraud or misreporting (www.soxlaw.com). In the UK the Combined Code of Corporate Governance was put into action by the Financial Reporting Council in November 2006. However there is no underestimating the ingenuity of the human mind. There have been cases where the CEO has appointed his own handpicked committee for the purposes of corporate governance and obviously this pays off when he departs with a sizeable compensation on leaving even though the firm may be in dire straits because of his wrong or ill-timed decisions. There has hardly been any action taken against the banking community that caused the sub-prime mortgage crisis in the USA and led to a worldwide depression in 2007-2008. The world is still reeling from its effects as the future of the Euro is in doubt and many new as well as experienced workers in the USA and UK have still not been able to resume their lifestyles as before the recession. No wonder there was such a hue and cry all over the civilized world in the shape of the Wall Street type protests in New York, London, Melbourne and other cities. The banks are allowed to take advantage of the situation every business cycle and it appears that the consumer can do very little about it. Although the US Government bailed out certain important sectors of the economy like the banking, insurance and automobile companies, there was no redress for the consumers who lost their houses, cars and other material possessions. They even lost their jobs and had to live on welfare. Components of the Cash Flow Statement The primary importance of a cash flow statement is that it shows how cash receipts and cash payments flowed through the organization throughout the year. This involves not only the cash used for the day to day operations, but also that used in financing and investing activities. The major items of cash flow from operations could be cash received from customers, interest and dividends received, cash paid to suppliers and employees, interest paid and income taxes paid. Non-cash expenses such as depreciation are added back to the net income and similar is the case with non-operating gains and losses. There are two ways of computing the cash flow from operations: the direct method and the indirect method. Under the direct method the specific inflows and outflows from the affected accounts are computed from an analysis of debits and credits. Under the indirect method, we start with accrual based net income and make the necessary changes to arrive at net income from operating activities (Meigs & Meigs, 1993, 899). Regarding the cash flow from investing and financing activities, computations can once again be made be looking at the relevant asset and liability accounts. For example, credit entries in fixed asset accounts show the cost of assets sold, while debit entries in liability accounts show the amount of debts repaid. Likewise credits to a liability account represent an increase in borrowing. Cash can be raised through financial activities such as issue of capital stock, while decreases in cash flow could result from payment of dividends (Wood & Sangster, 2011, 512). Avoiding Insolvency During Periods of High Sales Growth Indeed, the state of accounts as reported in financial statements such as the Income Statement and Balance Sheet can often be misleading. Assets may be overstated and liabilities understated, the true value of which may only be evident in an emergency or forced sale. In periods of high sales growth, businessmen may erroneously overstate their profits. On the other hand, one of their borrowers may go out or business and they may be unable to recover any dues from him. Thus it pays to strike a balance between sales done on cash and credit. Reducing the credit terms may result in decreased sales, but at least better and timelier cash recoveries would be made. On the other hand, having more lenient terms to please borrowers could result in monies being stuck up in credit for long period of time, while it is difficult to stay afloat. A prudent businessman would not allow others to take advantage of easy credit while his business is suffering. The famous W.G Grant & Company, Linen Manufacturer in Scotland (1862-1972) was forced to close down after 110 years of existence just because of lenient credit policies that drove it to insolvency and bankruptcy. Given Data: Company A B C Gross profit margin % 15 22 40 Net profit margin % 9 10 12 Return on capital employed % 15 13 16 Return on shareholders’ funds % 20 13 12 Stock days 18 25 45 Debtor days 9 32 65 Creditor days 9 42 55 Earnings per share 15p 20p 25p Price earnings ratio 16 12 19 Dividend Yield % 7 8 4 a) A Comment on the Companies’ Profitability: Every business that comes into existence has some objective. While for non-profit organizations, these might be service to humanity and meeting basic needs of communities, for commercial enterprises it is most certainly the profit motive that is the focus of attention for the owners and management. Let us assume for the purposes of comparison that all three companies A, B and C belong to the same industry sector. It would make sense to compare results of those companies that are in the same industry sector and thus are faced with the same opportunities and threats from the external environment, while the internal structure and organization of a particular firm would signify its strengths and weaknesses. Industry averages as computed by financial dailies like the Financial Times and rating agencies such as Dunn & Bradstreet, Standard and Poor and Value Line can also serve as a good baseline by which to compare and contrast the results of a particular firm (Weston et al, 2006, 73). Looking at the given data for the three companies, we can see that the ratios concerning profitability are the Gross Profit Margin and the Net Profit Margin. Company A has a Gross profit margin of 15 percent, while Company B has a Gross profit margin of 22 percent and Company C has a Gross profit margin of 40 percent respectively. To make more useful comments about the Gross Profit Margin percentage, we should be comparing these percentages with the Industry Averages for the particular sector. But it is safe to say that while Company A’s performance is at the lower end, Company B seems to be average while Company C seems to be marvelous. Maybe Company C is the industry leader among the three firms, and stands to make the best gross profit margins because of high quality and demand for its goods. Or maybe it has better control over its costs or can demand these at lower rates due to the volume of orders placed. Employing techniques such as Just in time inventory, Economic Order Quantity, Value Chain added activities and other cost saving methods would certainly help it earn a sizeable gross profit margin percentage like 40 percent. Moving on to the Net profit margins for the three firms, we see that Company A has a Net profit margin of 9 percent, while Company B has a Net profit margin of 10 percent and Company C has a Net profit margin of 12 percent respectively. Indeed, it looks here that most of the differences have evened out and there is little difference between the three firms. Maybe Company A being of smaller size has a smaller workforce and facilities enabling it to have better control over its expenses. On the other hand Company C could have expanded its operations and production facilities by borrowing from banks, which would increase its interest payments and debt-equity ratio as well. Company B once again stands midway between the other firms with a Net Profit margin of 10 percent. We can conclude this segment by stating that the difference in percentages of gross and net profit is (15-9) 6 percent for Company A, (22-10) 12 percent for Company B and (40-12) 28 percent for Company C. These percentages in fact represent the share of earnings that are used up by selling and administrative expenses. This clearly shows that Company A has the best control over its expenses while Company C has the least. Probable reasons for this have already been outlined above. b) A Comment on the Companies’ Working Capital Management: Working capital may be defined simply as the difference between a firm’s total current assets and total current liabilities at any given point in time. It is the working capital that forms the basis for a firm’s operating activities in its daily business routine. Paucity or inadequacy of working capital can indicate cash flow problems, ineffective credit policies and the like. On the other hand too much of money might be tied up in current assets such as marketable securities and inventories which may be overstated and its true value only recognized in the event of a forced sale or emergency. Excess of current liabilities can also depress the working capital ratio. The important thing is that this also reflects negatively on the debt-equity ratio of the firm (Woodcock, 1985, 33). Effective working capital management is evidenced by ratios such as Return on Capital Employed (ROCE) and Return on Shareholder Funds (ROSF). Looking at these ratios we see that Company A has an ROCE of 15 percent, while Company B has an ROCE of 13 percent and Company C has an ROCE of 16 percent. The return on capital employed is computed as: Net Profit After Tax/ Capital Employed. Capital can be worked out as the difference between Total Assets and Total Liabilities. It gives a much better picture than Return on Assets (ROA) (Investopedia.com). We see that the ROCEs of Company A, B and C are rather close, with Company C having the highest ROCE of 16 percent, followed by Company A with ROCE of 15 percent and Company B with ROCE of 13 percent binding up the rear. Amazingly it is Company B here with the lowest ROCE indicating that its use of capital in earning profits has not been so optimal. Companies A and C have been employing their capital more productively and consequently have higher ROCEs of 15 and 16 percent respectively. Next we look at the Return on Shareholder Funds (ROSF) for the three firms. Company A has an ROSF of 13 percent while Company B has an ROSF of 20 percent Company C has an ROSF of 12 percent respectively. The return on shareholder’s funds is computed by: Net Profit After Interest and Taxes / Shareholder’s Interest. Shareholders interest can be computed by Net Profit – Dividends and Interest Paid to Preference Shareholders. We see that Company B has the highest ROSF of 20 percent followed by Company A with ROSF of 13 percent and Company C with ROSF of 12 percent. This shows that Company B is the best off followed by Company A and Company C. We can conclude that the management of Company B has given their ordinary shareholders the best rate of return on their investment compared to the other two companies (Investopedia.com). Now let us take a look at some other components of working capital management such as Stock Days, Debtor Days and Creditor Days. It can be seen that Debtor Days or Accounts Receivable Turnover is 9 days for Company A, 22 days for Company B and 65 days for Company C. There is thus a vast difference in the performance of the three firms. If we use a 360 day base year, we will see that Company A manages to recover its receivables (360/9) 40 times per year, compared to (360/22)16 times for Company B and (360/65) just 5 times for Company C. This shows that Company A has the best credit policy or managers. Company C has the worst performance of the three while Company B is midway. Next we look at Creditors Days or Accounts Receivable turnover. Accounts Payable Turnover is 9 days for Company A, 42 days for Company B and 55 days for Company C. Again using a 360 day base year, we see that Company A manages to clear its accounts payable (360/9) 40 times per year, compared to (360/42) 8 times for Company B and (360/55) just 6 times for Company C. This shows that Company A has the best repayment policy or management as well. Amazingly both its receivables and payables are 40 days which is an exact match. Company C once again has the worst performance of the three firms while Company B is midway. We finally look at Stock Days or Inventory Turnover which is 18 for Company A, 25 for Company B and 45 for Company C. Adding Days in Stock to Days in Receivables give us an idea of the Operating Cycle which is the time taken to convert inventories to sales and then sales back again into inventories; it is (18 + 9) 27 days for Company A, (25 + 32) 57 days for Company B and (45 + 65) 110 days for Company C. It shows an Account Payable turnover of (360/18) 20 times for Company A, (360/25) 14 times for Company B and (360/45) just 8 times for Company C. But overall we can see that Company A has the most efficient operating cycle of just 27 days, followed by Company B’s 57 days and 110 days for Company C (Pocok & Taylor, 1992, 171). c) A Comment on the Investment Ratios: The investment ratios here are the ones that are important for a shareholder or investor. These are the Earnings per share (EPS), the price earnings (P/E) ratio and the dividend yield percentage. The EPS for Company A, B and C is 15p, 20p and 25p respectively-so it is clear that Company C is giving the best return to the common shareholder and Company A the least while Company B is midway between the other two firms. The Price Earnings Ratio or P/E relates the EPS with the current price of the share. From the data sheet we see that Company A has a P/E of 16 times, Company B has a P/E of 12 times and Company C has a P/E of 19 times. While we could say from a comparison that Company C has the best performance indicator here followed by Company A and B respectively, it would be better to look at the industry average for this performance indicator as well (Mathur, 1979, 32). Taking into consideration the dividend yield percentages, we see that Company A has a yield of 7 percent, followed by Company B with 8 percent and Company C with 4 percent respectively. So in terms of dividend paid out, we find that Company B has the best performance, followed by Company A and Company C respectively. If you were going to buy one of these companies’ shares, which one would you choose? Explain your reasons. Prospective investors look at the purchase of equity investments either from a short term or dividend yield point of view or a long term capital gain point of view. If I were going to buy one of these companies’ shares from a short term perspective, I would choose the shares of Company B. This is because it has a dividend yield of 8 percent, the highest of the three firms. If on the other hand, I was interested in a long term perspective, I would definitely go for the shares of Company C, as it has a P/E ratio of 19 times as well as an EPS of 25p, which it the best of the three firms in this regard (Rao, 1992, 27). References Burns, J. The Big Lie: Inside the Maxwell's Empire: Questions raised by Maxwell's last hours. Published 19 June 1992. 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