Table 2: Revised balance sheet for year 2003
Income Statement Analysis
Sales, COGS and Gross Profit
As compared to figures in 2001, it is observed COGS increased more than 2.5 times within the last three years whereas, the increase in total sales is less than double.
Though the sales level was increasing throughout the years, it is important to note that a considerable amount of sales were made to fictitious companies owned by family members of Venables. Sales might have been inflated by these companies, thus creating the image that Venables was managing the company well. This would reduce suspicion as well as supervision from the management of CI.
Assuming the unit price of good sold remained constant, the increase in COGS would be the result of an increase in the quantity sold. The percentage change in sales is less than the percentage change in COGS, thus implying that price had been lowered. Lower prices would lead to higher quantities sold, increasing sales level.
Gross profit margin, a financial metric used to assess a firm's financial health had been decreasing since 2001.
Selling and Administration Expense
As compared to year 2001, the Selling and Administration expenses more than tripled. As a percentage of sales, the Selling and Administration expenses had been increasing steadily. Unauthorized raises and bonuses, lavish entertainment expenses as well as expensive consulting contracts undertaken by Venables had contributed to the increase in the Selling and Administrative expenses. The increase in Selling and Administrative expenses would result in a lower net income.
Net Income
Although sales showed an increasing trend from 2001, there was a sharp decline in the net income. Decrease in net income is a consequence of higher interest expenses, which were incurred from the debt financing. In addition, as explained above, increase in Selling and Administrative expenses led to a lower net income.
Net income to sales ratio was also following a downward trend. Net income to sales ratio became a negative figure when using the PPE figure from the revised balance sheet. The large parcel of land purchased in 2002 and 2003 were only expected to be worth $50million. Hence, adjustments of $28,986,000 were made to the income statement. The resulting net income was -$28,567,000. This resulted in a negative figure for net income to sales ratio. This might be a sign of financial distress.
Balance Sheet Analysis
Accounts Receivables
Value of accounts receivables in 2003 was more than three times that in 2001. As a percentage of sales, the figure for account receivables was lowest in 2002. It increased by 6% in 2003. Days receivables outstanding followed increasing trend and increased by 16% from 2002 to 2003. This implied that the company has a poor collection system. The collection of cash from debtors was slow (88 in 2003). The significant increase in days receivables outstanding might be because of increased sales to fictitious companies owned by family members of Venables. The credit policies might have been relaxed to benefit them. Liquidity problems might surface because of the inability to collect money from debtors within a short period of time.
However, if key findings by HBJ were taken into account, value of accounts receivables were reduced by almost one-third. This would reduce the total assets by nearly $1 million.
Inventories
According to the balance sheet, inventory levels remained relatively constant in the past three years. From 2001 to 2003, inventories as a percentage of total assets decreased significantly. In addition, days of inventory on hand, the possible number of day sales with the inventory on hand, in 2003 dropped drastically, from 101 days to 46 days. The low inventory resulted in the days of inventory on hand. Inventory in most retail outlets of CI had fallen to such low levels that customer had taken their business somewhere else. The loss of customers was detrimental to the company and in the long run, the company would not be sustainable.
During the same period of time, the sales level was increasing but the inventories remained somewhat constant. This was unusual as inventories and sales shared a positive relationship. Higher inventory levels were required to satisfy the higher sales level. However, this was not the case. This might imply that the sales might be made to fictitious companies.
Based on the revised balance sheet, inventories were halved, resulting in a decrease in total assets of about $2 million.
- Plant, Property and Equipment
There was an upward trend for net PPE since year 2001. However, growth of the shareholders’ equity was negative. Net PPE was financed by debt. The company was thought to overpay for the large parcels of land purchased in 2002 and 2003, which resulted in high PPE. The land was found to be in poor location and was only expected to be worth $50 million.
- Accounts Payable
Within 3 years (2001-2003), accounts payable increased by more than ten folds. The percentage increase in accounts payable is much higher than that of sales. Accounts payable had been “stretched” to a point that many suppliers had cut the company off from any further credit and put them on “cash and carry.” Subsequently, suppliers might find it difficult to trust CI again, thus CI might have to adhere to this strict credit term. This would pose as a problem in future as CI would be unable to secure goods in the absence of cash. Inability to purchase goods would adversely affect the business of CI.
- Retained earnings
Taking 2001 as the base year, both total equity and retained earnings fell. Total equity only accounted for 11.03% of the total company, while the remaining was made up of short term debts. The company structure was highly leveraged in 2003.
Taking into account the revised balance sheet, total equity in 2003 was nearly one quarter of that in 2001. Total equity was negative in 2003, hence, the company relied solely on debt financing, which was highly risky.
Cash Flow Statement Analysis
Accrual earnings may not always provide a reliable measure of the enterprise performance and health. Cash flow statement reports the entity’s cash flow and aids in the prediction of future cash flows. It also allows investors to evaluate management decisions and determine the company’s ability to pay dividends to shareholders. Cash flow statement of CI was prepared.
Ideally, the largest cash inflow of any company should come from its operating activities. Unfortunately, major sources of cash for CI were from its financing activities, not from its operating activities. Main source of cash flow was via debt financing. Large amount of cash was received from the current portion of long term debt. Cash flow from financing was almost thrice that of operating cash flow, which stood at $3.3 million in 2003. Operating cash flow was even lower than the cash injection in November 2003. Cash outflows from investing activities amounted to $13.4 million in 2003. The total cash change was negative. Operating cash flow and borrowed money were used to expand CI.
Typically, companies with this cash flow structure are companies are the expansion or growing stage. Cariboo was founded in 1978 and is highly unlikely to be still in its growing stage in 2003. Thus, the cash flow structure of CI was found to be unhealthy. The cash flow from investing was alarmingly high in year 2002. Huge amount land purchased in 2002 and 2003 resulted in the cash outflow in investing activities. However, the investment was not a wise one as the price paid for land was above the valuation.
Ratio Analysis
Liquidity Ratio
CI’s short term liquidity appeared to be decreasing significantly over the years. Decreasing current ratio and quick ratio would mean that the ability to pay off current liabilities decreased. There is no cash to cover current liabilities as indicated by the cash ratio. Accounts receivables turnover also followed a downward trend. This might be a result of looser credit terms extended to customers in hope of increasing sales. A lower account receivables turnover implies a decrease in the ability to collect cash from credit customers. This then worsen the short term liquidity of Cariboo. All the ratios above indicated that CI was having problems with short term liquidity.
This might then result in inability to pay short term bills. Also, some creditors might be less likely to offer credit due to the lack of short term liquidity of CI.
Profitability Ratio
All the profitability ratios dropped drastically since 2001. This was a clear indication that the company might not be doing well. In 2002 and 2003, ROE is still positive and hence, some investors might be misled to think that the company is still doing fine. Nevertheless, it is important to find out the reason behind the positive ROE. Positive ROE should be generated from healthy profit margin and asset turnover. This was not the case for CI. Profit margin was decreasing because of the increase in interest expenses as well as Selling and Administration expenses. Value of fixed asset turnover dropped, indicating less efficient utilization of total assets. For CI, the positive ROE was the high leverage undertaken by the company which is not a healthy sign.
Solvency Ratio
Times interest earned fell considerably, implying that the ability to cover interest payments from operating profits had worsen. Debt-to-equity ratio as well as total debt ratio increased notably, suggesting that the company might be borrowing too much. The structure of company became riskier with higher debt liabilities. High accounts payables as well as the huge surge in the current portion of long term debt were the main contributing factors.
Recommendations
Short-Term recommendations
To bail CI out of financial distress, cash injection equivalent to the total equity ($18,332,000) was required.
In order for Calgary Bank not to file bankruptcy proceedings against CI, CI would be required to pay the interest due ($5,841,000). Using the cash balance of $159,000, $5,682,000 of cash injection would be needed.
In order for Calgary Bank to continue the line of credit and long-term loans, current ratio of CI must be at least equal to 1.5. Total current liabilities in 2003 was $85,921,000 and total assets required to maintain the current ratio would be $128,882,000. A resultant cash injection of $121,898,000 would be necessary. (refer to appendix 4)
Based on the maximum cash injection, to restore CI to a “healthy” state (the way CI used to function before the crisis), a cash injection of $121,898,000 would be essential. The recommended cash infusion of $3,913,000 was inadequate to maintain operations in CI. It was even unable to meet the lowest minimum cash injection - interest expense.
As seen from above, large amount of cash injections would be necessary to ensure that CI maintains its operations. Hence, it is crucial for CI to obtain capital injection.
Capital injections can be done via various methods. Firstly, unused land could be sold off for cash. Next, Cariboo should also try to collect all accounts receivables as soon as possible. Lastly, CI could sue and seek damages from Jack Venables for breach of his fiduciary duties.
After obtaining cash, CI should negotiate with the Calgary Bank and persuade them to avoid filing for bankruptcy proceedings. Thereafter, CI should aim to attract their old customers again by giving discounts to early payments or providing better services. Subsequently, their inventory level should be increased to a satisfactory level (on par with industry norm). Credit policy with customers should also be reviewed and revised. Although it might be difficult, CI should gain back the trust of their suppliers and negotiate with the long-term suppliers to extend credit terms.
Medium-Term recommendations
A board of directors should be established. Both internal and external interest would be represented in this board. Internal interest would include the interest of the different employees in Cariboo while external interest would refer to the shareholders’ interest. By having the board, major decisions would no longer be made on an individual level.
In addition, CI could consider setting up an internal control group within the organization. This group would be able to assess all information and report directly to the owner of the business. The group would act like an “internal police force”, monitoring the process and quality of decisions made. It would also highlight any discrepancies between the current actions and the proposed business plans.
Restructuring of the business could be carried out. CI should aim to streamline processes and shut down inefficient or unprofitable part of the business. Cariboo should focus on selling a few products and reduce the range of inventories.
Lastly, compensation scheme of all the managers should be thoroughly examined. Cariboo should adopt a performance-based compensation scheme (ie: Reward those who perform well). Standard guidelines should be provided with respect to bonuses and pay raise. Balanced scorecard and performance appraisal could be used to evaluate one’s performance. 360 degree feedback (from peers, customers, suppliers and supervisors) could be adopted to have a more holistic view one’s performance. Key performance indicators should be aligned with the company’s mission, vision as well as goals. This would help to align employee’s and company’s interest.
Conclusion
An in-depth analysis of the various financial statements of Cariboo Industrial Ltd revealed a series of problems. There is a huge shortage of cash inflow and the recommended cash infusion of about $4 million was insufficient to keep the company going. The major source of cash flow was derived from its financing activities. Sales were made to fictitious companies, inflating values of accounts receivables making the income statement more appealing to investors. Accounts payable was “over-stretched” and CI began to lose the trust of their suppliers. Significant amount of funds were still outstanding by mid-2003 when Calgary Bank called CI’s line of credit and long-term loans. Immediate steps have to be taken to prevent the company from going into bankurcptcy.
Appendix
Appendix 1: Common Size Statements
Appendix 2: Trend Analysis
Appendix 3: Ratios
Appendix 4: Cash Injections
