- Subcontractor
- Main contractor to subcontractor
- Well managed company
And also recommending them to…
- Investors
- Suppliers supplying goods on credit
2.1 Appraisal
An appraisal of Chudley Construction’s profit & loss account and balance sheet will allow one to begin to understand the financial position of the company at a certain time for when the accounts were published. Inadequacies in the information provided will be highlighted and improvements to accounting procedures will be proposed and substantiated.
2.1.1 Profit & Loss Account
The profit & loss account provided does not state when it was published, therefore I have assumed that it was published for the same period as the balance sheet i.e. “last year”.
“Last year” is unspecific as it may have been published in the last month, tax year or possibly at the beginning of the year. The earlier the accounts were published the more they will exclude recent activities and potentially provide inaccurate representation of current affairs. Clarity is key in these circumstances and the date the accounts were published should be stated, for this example I will assume they have just been published and are therefore the latest information; this also applies for the balance sheet discussed later on in this section.
After everything has been accounted for, £24,000 of the gross profit is retained from the gross profit of £100,000 which equates to 24%. If banks were to increase the cost of borrowing finance, the future of Chudley Construction could be put in jeopardy, assuming future business was reminiscent to that reported by the profit & loss account provided.
Dividends in the profit & loss account are 500%, a substantial amount in today’s terms. However, as so few shares have been taken up, the dividends only accrue to £1,000. The more shares Chudley Construction sell, the more pressure will be on them to revise their dividend per share in order to survive. The fact Chudley Construction has only sold 200 out of 1,000,000 shares tends to indicate they are not an attractive proposition.
2.1.2 Balance Sheet
The balance sheet provided shows the liabilities and assets of Chudley Construction. You can see that the majority of the money i.e. £400,000, is tied up in stock and work-in-progress (WIP). This could be broken down into more detail as stock and WIP are different and the composition of this sum is not known. The £400,000 of stock and WIP is notional only until converted to cash. It is essential to have accurate debtor profiles and to know how WIP is valued (at cost or sale values) and whether the debtor is a safe bet, for a return on investment and this is why Chudley Construction should carefully choose with whom they conduct business.
Depreciation of £5,000 is accounted for with regard to the fixed assets worth £100,000; again this is not broken down into detail and may consist of a number of assets, such as premises, vehicles etc. The accounts do not state how the depreciation has been calculated; there are various methods used to calculate this and these provide different results on the balance sheet.
The balance sheet states that Chudley Construction owe creditors nearly double what debtors owe them, which is not favourable. No information with regard to the profile of the debtors has been provided, i.e. how long the debtors have owed Chudley Construction and when they should be expecting payment. The same goes for creditors, the information does not tell us who owes Chudley Construction money and when it is due.
Chudley Construction is mainly funded by loans and overdrafts accruing to a total of £320,000. This is costing the company a substantial amount of money in bank charges and I would strongly advise they countered their overdraft with the money in their revenue reserves because this would reduce bank charges.
2.2 Ratio Analysis
I have carried out ratio analysis where possible for Chudley Construction to help us further understand the financial figures provided. All formulae and workings used to calculate the ratios can be found in appendix 2. Due to insufficient information, I was not able to calculate all ratios, and some assumptions were made when calculating the ratios, these are listed at the front of appendix 2.
“Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position” (Atrill et al. 2001 p141).
I have split the ratios into five categories; profitability, efficiency, liquidity, gearing and investment. These five different types will now be discussed in more detail.
2.2.1 Profitability
Four ratios were calculated in order to better evaluate the profitability of the Chudley Construction:
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Return on Ordinary Shareholders’ Funds (ROSF) = 39.1%
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Return on Capital Employed (ROCE) = 30.7%
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Net Profit Margin = 8.0%
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Gross Profit Margin = 10.0%
ROSF compares profit available to the shareholders, with the shareholders’ stake in the company, which can be particularly useful for potential investors. ROCE, another measure of business performance expresses the relationship between net profit and long-term capital. Net profit margin and gross profit margins are both proportions of sales revenue.
2.2.2 Efficiency
Efficiency ratios examine the way resources are managed, two ratios of which were calculated:
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Average Settlement Period for Debtors = 36.5 days
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Sales to Capital Employed = 3.8 times
Average settlement period for debtors is a calculation which indicates how long, on average; customers take to pay their debts. Sales to capital employed also referred to as the asset turnover ratio, evaluates how effectively assets are employed in producing sales revenue.
I was unable to calculate three efficiency ratios, as I was not provided with ‘average stock’, ‘credit purchases’ and ‘number of employees’. These efficiency ratios were:
- Average Stock Turnover Period - The average period for which stock is held.
- Average Settlement period for Creditors - This indicates how long, on average, the business take to pay its trade creditors.
- Sales per Employee - This indicates the average amounts of sales generated per employee for the entire workforce.
2.2.3 Liquidity
Liquidity is the ability to turn assets into cash. A number of profitable companies go into liquidation because of their lack of liquidity, and this emphasises its importance. Two ratios were calculated:
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Current Ratio = 2.6 times
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Acid Test Ratio = 0.5 times
The current ratio compares ‘liquid’ assets with short-term liabilities whereas the acid test uses the same calculation but excludes stock. The higher the ratios the more liquid a company is, however this is not always preferred because if a business demonstrates a high ratio it may suggest that funds are not being used productively.
I was unable to calculate the operating cash flow to maturing obligations ratio as I was not provided with the operating cash flow. This ratio provides another way of assessing the ability to meet maturing obligations.
2.2.4 Gearing
Gearing happens when a business receives finance from outside parties, such as a loan provided by a bank; and is an important factor when assessing risk. Two ratios were calculated:
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Gearing Ratio = 76.9%
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Interest Cover Ratio = 2.3 times
The gearing ratio compares the long-term liabilities to the long-term capital structure of a business. The other ratio for interest cover calculates the amount of profit available to cover interest payments.
2.2.5 Investment
A number of ratios exist which can help investors assess the potential return on their investment, three of which I have calculated:
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Dividend per Share = £5.00 per share
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Dividend Payout Ratio = 4.0%
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Earnings per Share = £120 per share
Dividend per share gives an indication of how much cash an investor will receive for their shareholdings. Dividend payout ratio illustrates the amount of earnings that a business will pay out in the form of dividends to it shareholders.
I was unable to calculate three investment ratios, as I was not provided with ‘market value per share’ and ‘operating cash flow’. These investment ratios were:
- Dividend Yield Ratio - This allows potential shareholders to assess the cash return they can expect per share compared to the shares market value.
- Operating Cash Flow Per Share - This provides shareholders a good guide as to whether a business can afford to pay dividends, particularly in the in the short run.
- Price / Earnings Ratio (P/E) – This compares the market value per share with the earning per share; and is a good measure of future market confidence.
2.3 Advice on Chudley Construction…
The next section of the report will offer advice on whether or not I deem Chudley Construction a suitable company to conduct business with, for a number of potential investors. It will also discuss the information you would need to make an informed decision.
2.3.1 Recommended as a subcontractor?
I have devised a model (see figure 1) which can be used to help select potential subcontractors or main contractors. The model poses questions in four key areas; financial, technical quality, reliability and workability.
Figure 1: Model for Selecting a Subcontractor / Main Contractor
There are a total of 10 questions in the model, all of which are marked out of 10 (10 strongly agree – 1 strongly disagree) and accumulate to a total score out of 100. Generally, the higher the score, the better the subcontractor. All questions in the model are equally weighted and a main contractor may wish to weight the model to help reflect what they consider to be the main priorities.
Unfortunately we have been provided with insufficient information to complete the model in figure 1 and therefore have to base our recommendations on the financial information provided earlier, which is insufficient to provide any kind of recommendation.
2.3.2 Recommended as a main contractor to a subcontractor?
As previously stated, the model illustrated in figure 1 can be used to help decide whether a subcontractor should work for a main contractor.
A subcontractor will want to know if the main contractor is financially sound, so there is no risk of not getting paid. The subcontractor will also be interested in the main contractor’s payment method which may follow a similar route to the main contractor; “traditionally the construction client expects the contractor to carry out a month’s work which is then valued and certified and the certificate is later honoured by cheque” ( Cooke et al. 2004 p233).
With regard to technical ability, the subcontractor will want to know if the main contractor has enough skilled managers to organise and plan the project. “All construction work must be programmed to ensure that activities are sequenced in the correct order” (Vore et al. 1997 p33). The master programme will be made available to all parties, so they understand where and when they fit into the project and how long they have to complete their part of work.
A subcontractor will also be interested in various other issues, such as the health and safety record of the main contractor. Workability of the main contractor is another issue, will they help resolve issues, for example, if a subcontractor is delayed due to lack of resources, will the main contractor assist?
Due to lack of further information it is impossible to complete the model in figure 1 satisfactorily; the primary data that has been provided is insufficient to confidently base a recommendation on.
2.3.3 Recommended to investors?
Chudley Construction report that sales have reached record highs for the year and are set to continue increasing in the next three or so years as they have secured £5,000,000 of orders for the next 3-4 years. The question you have to ask yourself is, whether or not this workload is sustainable i.e. can they afford to conduct more business as they already owe loans and overdraft totalling £320,000.
We know 200 shares were in issue when the accounts were published, but we do not know who owns these shares; there could be 200 individuals, but most likely fewer. The more shares one person holds, the more power – and this may be the reason why the dividend is currently 500%.
“The planning and control of construction organisation’s finances are crucial to its long-term well-being and survival” (Griffith et al. 2000 p3). We have not been provided any information regarding planning or control systems employed by Chudley Construction and are therefore in no position to comment on whether they are ahead or behind budget and what their future plans are.
I was only able to calculate three out of six ratios which relate to investment in section 2.2.5. We do not know the market value per share or the history of the business and therefore any recommendations I provide would be unfounded.
If we had calculated the dividend yield ratio or price earnings ratio we could have compared them with some benchmark data I have obtained from the Financial Times as shown in figure 2 and 3.
Figure 2: Dividend Yield Ratios
Source: Financial Times (2nd December 1999)
Figure 2: Price / Earnings Ratios
Source: Financial Times (2nd December 1999)
Figures 2 and 3 indicate average levels of ratios from a range of different industries. The dividend yield ratio for construction is approximately 3.5 and the price / earnings ratio is roughly 14.
2.3.4 Recommended to a supplier supplying goods?
A supplier supplying goods to Chudley Construction will only be interested in receiving payment for the goods they supply. The supplier will want to know that the company is financially sound, so they are guaranteed payment. Potential suppliers will also be interested in when Chudley Construction can afford to pay their debts and will therefore be interested in the average settlement period for creditors, however I was unable to calculate this due to lack of information provided.
Liquidity would equally be a concern if Chudley Construction was interpreted as a risky investment; this indicates a firm’s ability to turn assets into cash which may be required if cash flow was running particularly tight. Otherwise Chudley Construction may have to factor their debt, which means “the sale of trade debt at a discount to an agency which assumes the task of recovering the debt and accepting the credit risk.” (Hore et al. 1997 p76)
Once again based on the information provided I am not really able to offer any advice on whether or not a supplier should supply goods to the company.
2.3.5 Recommended as a well managed company?
Financial analysis is just one of the aspects that you should consider when attempting to find out if a company is well managed. I would advise auditors to carry out a thorough audit which assesses management styles, strategic decision, staff morale etc. The audit would have to look at all levels of hierarchy in the organisation.
I personally question some decisions Chudley Construction have taken, such as having a £60,000 revenue reserve whilst having loans and other debts, surely the company would be better off settling these debts, especially as they are so high. Another issue to consider is the size of the dividend which is currently 500%. Isn’t this amount a little excessive? I suspect this decision was made by a majority shareholder who wants to be grossly rewarded. If the company was going to gain new investors you would expect the dividend to be revised and become less, to cope with potentially an increased dividend payout ratio.
I have a number of suspicions with regard to the information provided - but cannot prove these and therefore have to be wary when offering advice. Yet again I am not in any position to offer advice on whether or not Chudley Construction is well managed, I have raised some issues which are not encouraging, however they could be perfectly justified.
3.0 CONCLUSIONS
The report interprets the information provided for Chudley Construction’s balance sheet and profit & loss account, and highlight’s the inadequacies. The information provided was insufficient to provide a confident response to the brief.
I feel that the information provided was overall well appraised and interpreted. Chudley Construction has very little cash in hand and is currently being funded substantially by loans and an overdraft facility. From the information provided, I feel Chudley Construction would be a risky investment to all businesses and investors as a lot of money is currently tied up in stock and WIP.
I must state that if I was provided with further information, my interpretation of the information may change, as there may be reasons for the financial performance. There are also a host of ways of reporting accounting information, and Chudley Construction may have adjusted accounting records for income and expenditure to enhance financial reporting. A review of the most recent management accounts i.e. the day-to-day financial accounts might throw more light on the strengths or weaknesses of this company. The acid test indicates this business is struggling for cash whilst trying to grow too quickly.
This report should be treated with the utmost caution due to the limitations of information provided, and should therefore not be used to make any final decisions. It is merely an interpretation of what little information has been provided and tends to raise as many questions as answers.
4.0 RECOMMENDATIONS
In order to improve this report, I would ensure that I obtain as much information as possible, not just financial, but also how the company was run and operated. I would advise auditors to investigate how the business operates. It would also be beneficial to gain access to historical records, along with forecast business plans etc to see how Chudley Construction plans to grow.
The report could have compared the performance with other companies in the construction industry, by making use of the ‘Financial Analysis Made Easy’ (FAME) database. The FAME database would have allowed me to benchmark Chudley Construction’s performance against similar sized construction companies; however I felt that benchmarking the limited information provided would be of little relevance.
I was only provided with limited information for one accounting period, and would benefit, if provided with historical results to see how Chudley Construction has performed in the past. At present all we have been provided with is a recent snapshot.
References
Books
Atrill, P. and Mclaney, E. (2001) Accounting and Finance for Non-Specialists 3rd Edition. Harlow: Pearson Education.
Cooke, B. and Williams, P. (2004) Construction Planning, Programming & Control. 2nd Edition. Oxford: Blackwell Publishing Ltd.
Griffith, A., Stephenson, P. and Watson, P. (2000) Management Systems for Construction. Harlow: Pearson Education.
Vore, A.V., Kehoe, J.G., McMullan, R. and Penton, M.R. (1997) Construction 1 – Management - Finance - Measurement. Hampshire: The Macmillan Press Ltd.
Newspapers
(1999) Industry Ratios Financial Times 2nd December 1999
Websites
Financial Term Explained - Free Glossary (http://www.businessballs.com/finance.htm) (Online) (Accessed April 28th 2007)
