Liquidity: The current and quick ratios have improved over the years and are higher than the industry average. In comparison between the current ratio and quick ratio it indicates that almost 50% of the company’s current assets value in 2003 is made up of inventory. Nevertheless, the quick ratio for 2003 suggest that the company has no short term liquidity problems and should have no difficulty in paying its debts as they become due.
Activity: The inventory turnover pace is constant for the last 3 years (2001 to 2003) but much slower against the industry average. The slower turnover suggests that the company may be holding large inventory. There are some dangers that the inventory could contain certain obsolete items that may require writing off.
As for the average collection period, there was no improvement instead it has increased further from 50 days in 2001 to 57 days in 2003 and it is 11 days (57 – 46) higher than the industry average. The increases in the collection period suggest that the company may be facing collection period that may lead to bad debts. Consequently there are probably little opportunity to reduce this further and there may be pressure in the future from its customers to increase the credit period. This could have been one of the reasons as to why the collection period has been on the increasing trend.
The total asset turnover ratio has been within the range of 1.5 and 1.6. In comparison to industry average, it is much lower. The lower ratio suggests that the assets are under utilised in generating sales. The other reason could be the fixed assets acquired on 2003 (approximately $402,000 in cost) have not fully contributed to the business.
Debt: With respect to leverage, the company’s debt ratio has deteriorated further and is twice the industry average. This suggests that the company is relying heavily on borrowing to finance its business operations. This has also resulted in higher interest obligation, which has caused then times interest earned ration decline further from 2.2 in 2001 to 1.6 in 2003. There is a need to control the borrowings otherwise the company may face financial difficulties in meeting its financial obligations.
Profitability: There is no significant change in the gross profit margin for the last 3 years (2001 to 2003 however the net profit margin has declined in the same period. The decline could due to high interest payment. In addition to the net profit, the return on assets and return on equity has also dropped and significantly lower in comparison to the industry average.
Market: The poor performance of the company has caused the common stock market price to drop. In fact the stock market price $11.38 is quoted at a discount of $1.56 in 2003 ($12.94 - $11.38) against book value per share of $12.94.
Question 1 c:
Summarise the firm’s overall financial position on the basis of your findings in part b.
Answer:
One of the most alarming issues is the high gearing level. The company has accumulated large amount debts which resulted in high interest payment. This has dampened the profitability of the company. Besides the high gearing issue, the company may be experiencing collection problems. The increasing trend in the collection period needs to be addressed as this may lead to bad debts and provision may have to be provided. This would further lower the profit level. The high inventory level could be due to poor production planning. It also seems that the company’s expansion plan is not in tandem with the sales and this is reflected in the low utilisation level of the assets in generating sales.
In summary, the company’s performance for the last 3 years (2001 to 2003) has not been encouraging. The drop in the market share price below the book market value is the reflection of investors’ confidence in the company’s future performance.
Question 2:
Which strategy is best: Do nothing? Follow the advice of Julie Wilson? Or follow Steve Harris’s strategy? Discuss.
Answer:
In answering the question, I am using the Cost-Volume-Profit method to identify which is the best strategy.
Do Nothing
Breakeven in unit = $10,000,000 + $5,000,000
$25 - $5
= $15,000,000
$20
= 750,000 unit
Breakeven in dollars = 750,000 x $25
= $18,750,000
Projected Income Statement
Based on the anticipated sales volume of 750,000 units, the company’s net income is zero. The sales volume is the breakeven point at which the total revenue is equal to total cash inclusive of variable cost and fixed cost.
Steve Harris’s suggestion
Breakeven in unit = $10,000,000 + $5,000,000
$20 - $5
= $15,000,000
$15
= 1,000,000 unit
Breakeven in dollars = 1,000,000 x $20
= $20,000,000
Margin of safety = $32,000,000 - $20,000,000 x 100
$32,000,000
= 37.5%
Projected Income Statement
By reducing the selling price by 20% to $20, he anticipated the sales volume to increase to 1,600,000 units from 750,000 units thus registering an increase of 113%. The breakeven point in unit increased to 1,000,000 units. The difference of 250,000 units (1,000,000 – 750,000) in breakeven point represents 33% increase. Based on the anticipated sales the company is expected to generate operating profit of $9,000,000.
Julie Wilson’s suggestion
Breakeven in unit = $10,000,000 + $8,000,000
$25 - $5
= $18,000,000
$20
= 900,000 unit
Breakeven in dollars = 900,000 x $25
= $22,500,000
Margin of safety = $37,5000,000 - $22,500,000 x 100
$37,500,000
= 40%
Projected Income Statement
Julie’s strategy to increase sales is via aggressive advertising. She anticipated the sales volume to reach 1,500,000 units level, a 100% increase in sales volume as well as in revenue. She explained that the cost will involve an additional $3,000,000 million in advertising cost and still maintain the selling price. The new breakeven point is at 900,000 units’ level an increase of 20% from 750,000 units. The company is expected to generate operating profit of $12,000,000.
Evaluation of the strategies
The strategy of doing nothing should not be adopted as the company would not be generating any profits. However if the company decided to adopt either one of the 2 strategies it would be generating profits. Therefore both the strategies need to be analysed to identify the one which the company will benefit most.
In Steve’s plan he suggested that sales of 1,600,000 units could be achieved by only reducing the selling price to $20 and all other costs remain unchanged. However, in actual fact the company stands to loss $8,000,000 [($25 - $20) x 1,600,000] in revenue if it adopted his plan. The price reduction also increased the breakeven point level to 1,000,000 units.
In Julie’s plan, she suggested that sales of 1,500,000 units could be achieved by increasing the advertising budget by an additional of $3,000 000 to $8,000,000 and the price remains unchanged. The increase in cost also increases the breakeven point level to 900,000 units.
In conclusion Julie Wilson’s strategy is the best based on the following reasons:
- Additional operating profit of $12,000,000 could be generated without reducing the selling price as opposed to Steve’s of only $9,000,000 with reduction in selling price.
- Breakeven point should be maintained at manageable level. In this respect, Julie’s strategy provides a lower level compared to Steve’s.
- Margin of safety is 40% in Julie’s strategy is higher compared to Steve’s of 32.5%. The ratio suggests that Julie’s strategy is less risky than Steve’s is.
Question 3 a:
Who are the stakeholders in this situation?
Answer:
In the context of public company activities, stakeholders are those affected by the outcome negatively or positively and those who can affect the outcome of a proposed intervention. And in this case financial statement is regarded as “Report Card” of a company which details its performance for a specific time period. In most cases the time frame known as accounting period is usually one year. In this respect the stakeholders of Five Star sales and Services Company Limited are as follow:
Management: It is very difficult to describe the needs of management, as they are the ones responsible in deciding on the accounting policies as well as preparation of financial statement. The management team would require details on the performance of the business as a whole to assess it’s performance and to plan for future growth.
Shareholders: Shareholders, the common stock holders in a company are regarded as investors. In general, ordinary shareholders take on all the risks associated with the company. Their reward is paid in the form of dividend. Their area of interest would be the profitability especially the company’s future earning capacity, return on their investment and management efficiency.
Lenders: Lenders such as banks, bondholders, preference shareholder and creditors to a certain extent are interested in the financial statements. In general, lenders rely on the financial statements to assess the company (borrower) operating and financial viability. The area of interest would be liquidity, net realisable value of assets, profitability and future growth.
Government: Government is also a stakeholder because the government is primarily the issuer and implementer of business guidelines and policies. Companies are required to adhere to the guidelines. The area of interest would be the compliance issue pertaining to preparing of the financial statements.
Employees: This group of stakeholder is interested in job security and in assessing their remuneration package. Their area of interest is likely to be the profitability of the company.
In summary, the most obvious need that virtually all stakeholders have in common, is the need for information about the business’ past and future profitability, and also its financial risks.
Question 3 b:
What are the ethical issues involved here as a result of the managing director’s request?
Answer:
In order for stakeholders and other users to assess the financial performance of a firm effectively and consistently, the preparation of accounts must be based on certain accepted guidelines. Therefore, it is the management’s responsibility to provide accurate and reliable information in their financial statements. In this respect, the company’s corporate governance, which deals with ethical issues, plays an integral part in the administration of accounting policies and preparation of financial statements. The ethical issues are as follows:
Disclosure: The doctrine requires all accounting statements to be scrupulously honest. Full disclosure of all significant information, such as changes in accounting policy along with their respective financial implications should be made. This will enable users to be aware of significant relevant information of the financial statement.
Integrity: Integrity must be part of the company’s culture. Every employee’s right, from the board of directors to the lower level of employee should be subjected to the highest standard of honesty. In the case above, the managing director himself must establish the highest standards of integrity by example.
Responsibility: It is the responsibility of the managing director to ensure that the company operates in an effective, ethical manner that produces long-term value for the company’s shareholders.
Question 3 c:
Can Nest accrue revenue and defer as many expenses as possible and still be ethical?
Answer:
Accounting policies are an integral part in deciding the treatment of revenue and expenses. This particularly is important in preparing the financial statement. One of such area would be the accruals and deferrals of revenues and expenses.
Accrual is defined as recognition of revenue prior to receipt of payment and expenses that incurred and has yet to receive bill. In the case of deferrals, the company is delaying recognition of revenues and expenses. Nevertheless, for each of these a journal entry is required to record the transactions and it is known as “Adjusting Entry”.
Nest, the financial controller, can accrue revenues and defer expenses and still be ethical under the following circumstances:
The fundamental issue that arose from the Xerox case was the revenue recognition concept. It was established in the case that revenues should not be recognised until realised and earned. Therefore based on the above concept, Nest can accrue revenues for works which was completed within the accounting period and has yet to bill the clients. He can also accrue revenue in the form of interest earned from placement of deposits with financial institutions. It can be applied in the event the interest payments due date crosses over into the next accounting period. Nest can accrue interest earned up to the end of the financial year.
As in the case of expenses, Nest can defer expenses that are meant for the following financial year. This type of payments is usually termed as prepaid expenses. Some of the expenses that can be deferred are insurance premium and business licence where the payments period of coverage or licence expiry dates falls in the next accounting year. Under these circumstances, the payments should be prorated and the portion meant for the next accounting year can be deferred to the following year.
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Horngren, C.T., Sundem, G.L. and Stratton. W.O., (2002), Introduction to Management Accounting, 12th edition, Prientice-Hall Inc. A Pearson Education Co., Upper Saddle River, New Jersey.
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