Finance Essay
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SOP – Assignment – Part 2
You have managed to acquire the last two years accounts for your fierce rival LMM Ltd. Your CEO has heard that you are studying Finance at Napier University and has asked for a report on how the opposition has been performing in that time span. Total words should not exceed 2,000, excluding any calculations.
LMM Ltd
Income Statements for the year ended 31 July
2014
2013
£000
£000
Continuing operations
Revenue
22,600
19,800
Cost of sales
(10,735)
(10,890)
Gross profit
11,865
8,910
Distribution costs
(5,424)
(3,960)
Administrative expenses
(4,068)
(2,574)
Profit from operations
2,373
2,376
Finance costs
(770)
(280)
Profit before tax
1,603
2,096
Tax
(294)
(133)
Profit for the period from continuing
operations attributable to equity holders
1,309
1,963
LMM Ltd
£000
£000
Statements of financial position as at 31 July
2014
2013
£000
£000
ASSETS
Non-current assets
Property, plant and equipment
22,916
16,200
Current assets
Inventories
1,932
1,525
Trade and other receivables
1,808
1,386
Cash and cash equivalents
582
0
4,322
2,911
Total assets
27,238
19,111
EQUITY AND LIABILITIES
Equity
Share capital
8,000
8,000
Retained earnings
6,334
5,025
Total equity
14,334
13,025
Non-current liabilities
Bank loans
11,000
4,000
11,000
4,000
Current liabilities
Trade payables
1,610
1,307
Tax liabilities
294
133
Bank overdraft
0
646
1,904
2,086
Total liabilities
12,904
6,086
Total equity and liabilities
27,238
19,111
REQUIRED:
a) Write a report (no more than 2 sides of A4) with your view on how LMM has performed in the two year period. You should show supporting calculations of at least SIX ratios (for each year) to back up your findings. (60%)
b) It has been rumoured that LMM is planning an expansion of their production facilities which will cost £5.5million. Discuss how this might be financed and any problems associated with the methods you have chosen. (40%)
Academic literature should be referred to in your answers.
Donald MacAskill Sept 2014
SAMPLE ANSWER
Finance
- Write a report (no more than 2 sides of A4) with your view on how LMM has performed in the two year period. You should show supporting calculations of at least SIX ratios (for each year) to back up your findings. (60%)
In 2013, the Working Capital Ratio which is ascertained by Current Assets / Current Liabilities, in was 1.4. This increased to 2.3 in 2014. The working capital ratio is an important ratio in determining the health of the company under scrutiny (Paradi, Rouatt & Zhi, 2011, 102). It helps one determine the liquidity of a company. The liquidity represents the ability of a company to rapidly turn assets into cash in order to meet its short-term obligations as they fall due. Between 2013 and 2014, the company increased the component of liquid cash it held from 0 in 2013 to 582,000. This arrangement is beneficial to the company as it places it in a stronger position with regards to competitors, in being able to pay off its debts quicker (Paradi, Rouatt & Zhi, 2011, 100).
The Quick ratio also called the acid test ratio is an important ratio. When inventories are removed from the current assets figure, the true position of the company is cleared (Lazaridis & Tryfonidis, 2006, 28). It should not be lost that inventory is held by the organization for trading or facilitating the operations of the company. It is thus very important to determine how the cash and other items that can be easily and rapidly converted into a ready cash value. In 2013 the ratio is 0.7 and improves significantly in 2014 to 1.3. Two issues emerge in the analysis of this ratio. In 2013, when the ratio stood at 0.7 the company could have been said to have a ratio lower that the ideal position by all companies. All companies will seek to have at least a ratio of 1:1. The position of 0.7 could not be so dire if the inventory is rapidly turned-over. A high inventory turn-over makes available ready cash to the company within a short period of time (Paradi, & Zhu, 2013, 62). In 2014 the ratio improved very significantly to 1.3. This position places the company at a pedestal when it comes to taking advantage of emerging opportunities in the industry. Taking the argument that the inventory has a high turn-over, it makes the company highly liquid (Lazaridis & Tryfonidis, 2006, 30). This highly liquid position may however make the company a prime target for a takeover by a company that is looking to improve its liquidity position (Paradi, & Zhu, 2013, 62).
Quick Ratio = (Current assets – Inventory) / Current liability
The debt-to-equity ratio determines the level a company’s financial leverage (Paradi, Rouatt & Zhi, 2011, 102). This is what is arrived at when the total liabilities and divided by the shareholders equity. This is an important indicator of what proportion of a company’s assets is financed by equity and which part is by debt. When a company has a huge debt, it reduces the margins which it operates under and which allow it to respond to market stimuli by adjusting fixed charges and manipulating the earnings available for dividends (Uyar, 2009). This latitude is important as it could allow a company facing challenging stimuli adjust accordingly to ensure sustainability. The risk of using this data to orchestrate a financial crisis is not remote. In 2013 the ratio was 0.5 improving significantly to 0.9 in 2014. In both years, the company reports very robust ratios. The improvement from 0.5 to 0.9 further shows the strong position the company holds. The improvement is on the basis of the loan that grew from 4,000,000 to 11,000,000
Debt-to-equity ratio = Total Liabilities / Shareholders Equity
The return on equity ratio is important as it allows ordinary shareholders determine individually how profitable their capital is in the business venture they have invested in (Uyar, 2009). The profitability of a company is important as it has a direct effect of its shareholders. When the return on equity is calculated, it reveals the estimated profitability of the company. This return on equity reveals the amount of profit generated by the company with the money invested by the shareholders. In 2013, the return on equity was 15.07%. This fell to 9.13% in 2014. The decline in return could be attributed to the additional costs that were incurred by the company in 2014. Distribution costs and administrative costs grew significantly. Despite the increased operational costs that the company incurred, it was able to smooth this by making additional income from its operations. However, the finance costs increase with such that the profitability of the year could not cover it (Scott, & Jacka, 2011). As a result the profits fell by almost 600,000. This had the overall effect of reducing the shareholders return of equity.
Return on Equity = Net Income / Shareholder’s Equity
The net profit margin is an indication of how efficient the company is in controlling the cost surrounding its operations. When the net profit margin is high, it exhibits a company that is efficiently converting its revenues into actual profits (Reiner, Turley & Willekens, 2008). It shows that the company is able to turn its sales into income. For 2013 the profit margin was 5.8% improving to 9.9% in 2014. The increase in profit margin could be as a result of two factors. To begin with, the company increased it’s from 19,800,000 to 22,600,000. This growth is sales ensured the company had a strategy that was able to convert revenue into actual profits. The second factor could be a reduction in the operational expenses (Scott, & Jacka, 2011). The company was able to employ the same resources but milk greater profits from the same investment.
Profit margin = Net income / Net sales
Another set of ratios that examine how a company is performing are the solvency ratios. This ratios are important as they determination point the long-term risk (Reiner, Turley & Willekens, 2008). Shareholders and long-term creditors find these ratios important in assisting them make investment decision regarding the company. Given that in business, there are only two ways to finance the acquisition on an asset; debt (using borrowed funds) and equity (using funds raised by shareholders or funds retained from the company’s internal operations – retained earnings). The ratio determined for a company shows the percentage that each asset it financed by (Eljelly, 2004, 51). Ideally, the level of debt that a company takes on is a subjective issue. For a company that is has a high debt could be viewed as one that is able to leverage greatly. In the same face, for a company that relies on heavy investment in fixed plants and equipments, the level of debt financing will similarly be bigger with aspects such as insurance and advertising agencies being some of the components that will see this figure grow. Given that total debt of a company is made up of both long and short term debt. For creditors, emphasis and special interest will be on the long-term debt, specifically seeking to determine how the company used this facility (Eljelly, 2004, 51). In 2013, the 46.7% while in 2014, it was 90.0%. By taking on additional debt, the ratio grew from 46.7 to 90.0.
Debt to total assets ratio = total debt / total assets
- b) It has been rumoured that LMM is planning an expansion of their production facilities which will cost £5.5million. Discuss how this might be financed and any problems associated with the methods you have chosen. (40%)
Currently, LMM has on its books a debt of 11 million. In 2013 the debt ratio stood at 32 cents. When it raised its loan from 4,000,000 to 11,000,000 the debt ratio rose to 47 cents to the dollar. By adding an additional 5,500,000 to finance the expansion LMM will further raise its debt ratio to 68 cents to the dollar. This sudden growth of the debt ratio would be alarming to someone looking at the figures without knowledge of the industry LMM operates in. Before changing its debt strategy and adopting one that intentionally set out to manage debt over the long term as opposed to the short term, was based on a number of reasons. LMM could have been looking at managing its debt better in the long term resulting in lower costs. Though the short term would experience a growth in the overall debt, this is only an accounting growth (Paradi, & Zhu, 2013, 62).
Overall LMM will have gained by lowering its debt cost in the long term. By getting the additional loan to expand its operations, the anticipated additional capacity will mean higher economies. The expanded economies of scale will allow LMM to manage the additional debt with only raises the debt ratio marginally despite raising the debt level by almost 50 percent. This could thus be interpreted to mean the LMM operations are very efficient. This is an important factor when considering taking on additional debt to finance growth (Abdul & Mohamed, 2007, 280). Overall LMM is in a strong position in its industry. For the shareholders, the additional debt would mean better returns to them since the taxation system is kinder to debt financing for companies as opposed to refinancing or shareholders having exclusive rights to purchasing additional shares in the company.
LMM’s debt to equity ratio for 2013 was 47 cents to the dollar. When LMM almost tripled its loan from 4,000,000 to 11,000,000 the debt to equity ratio rose almost doubled to 90 cents to the dollar. By saddling LMM with the additional debt of 5,500,000 to finance its expansion then the ratio will raise to 1 dollar to the dollar. This means that debt and equity equally finance the operation of LMM (Abdul & Mohamed, 2007, 280). For the industry LMM operates in, the ratios point to a very efficient operation. Despite the upward movement of the debt to equity ratio to the current 1.0 LMM is still below the industry ratio. From its operations, LMM is able to generate profits that cover the repayment of the loans interest and principle. As stated earlier, additional debt is beneficial to LMM shareholders. Given the tax plans, LMM gains by getting debt to finance its expansion as opposed to floating shares to current shareholders exclusively (Htay, Arif, Soualhi, Zaharin, & Shaugee, 2013).
There are a few options that LMM could choose from when seeking to finance its 5,500,000 expansion in operations. There are number of loan option and designs that LMM could adopt in order to strengthen its position in the industry. A bank loan; depending on how it is designed, how it is paid out and repaid and the terms of the loan will determine the value it adds to the company.
Line-of-credit loans: This finds great favor with small businesses because all they need to do is walk into their bank, have a good talk with the credit or bank manager and if they have operated their accounts well, have a line-of-credit (over draft facility) extended (Narware, 2004,123). This arrangement is best suited for securing a business’s operating costs for working capital, meeting inventory needs or business cycle needs. Since the business only pays interest on the advanced money only, the knowledge that a pool exists which the company can access should the need arise, allows the company more room for maneuver in its operations. A line-of-credit would not be ideal for financing LMM’s expansion (Narware, 2004,123).
Installment loans: This design of loan will allow LMM to repay equal installments over the loan period (Chowdhury & Amin, Md, 2007, 77). The equal monthly installments are designed to meet both the interest and principle equitably. The repayment will determined on loan uptake and clearly captured in the loan contracts. It also allow for early repayment of loans. In some cases, it actually rewards early repayment of loans.
Balloon loans: By their nature, the interest is paid over the lifetime of the loan in equal regular installments with the principle paid as a lump sum on maturity of the loan. The balloon loans are ideal for businesses that get payments on specific periodic dates (Cascarino, 2007, ). LMM would find this arrangement most suitable given the nature of its business is such that incomes are period.
Secured and unsecured loans: LMM has the choice of either a secured or unsecured loan to finance the planned expansion. For the unsecured loan, LMM will not be required to pledge any collateral in lieu of defaulting the loan (Abdul & Mohamed, 2007, 288). This is the option available to those considered by lenders as being low risk. The definition of low risk is relative and will vary from person to person and situation to another (Raheman, & Mohamed, 2007, 280). However the perception of low risk has the advantage of having to pay very low interest on loans. On the other hand, for the secured loan, LMM will have to provide some form of collateral to secure the loan. For the expansion that LMM plans, the collateral will the equipment to be purchased. This is based on the fact that the collateral is related to the purpose of the loan (Chowdhury & Amin, Md, 2007, 77). By LMM using the loan to purchase receivable, the bank will consider this as having being used to finance growth. This classification will allow LMM access the great pool of resources the financier avails to its customers. Most banks will lend up to 75 percent of the amount due (Padachi, 2006, 51). This particular loan will thus not be ideal for LMM. Not being able to access the whole amount will undermine the planned expansion.
Bankers are looking for interest income from a loan, along with a high likelihood that the loan will be repaid (Padachi, 2006, 55). They don’t want to control the business other than making sure it meets loan covenant standards, and they take collateral in lieu of repayment only as a last resort.
References
Paradi, J. C., Rouatt, S. & Zhi, H., 2011. ‘Two-stage evaluation of bank branch efficiency using data envelopment analysis, Omega, Vol. 39, No. 1, pp 99-109
Paradi, J. C. & Zhu, H., 2013. A survey on bank branch efficiency and performance research with data envelopment analysis, Omega, Vol. 41, No. 1, pp 61-79.
Abdul R & Mohamed N., 2007. Working capital management and profitability – case of Pakistani firms. International Review of Business Research Papers, Vol.3 (2), pp. 275 – 296.
Chowdhury, A & Amin, Md. M., 2007. Working capital management practiced in pharmaceutical companies listed in Dhaka stock exchange. BRAC University Journal, Vol. IV, No. 2, 2007, pp. 75-86
Eljelly, A., 2004. Liquidity-profitability tradeoff: an empirical investigation in an emerging market, International Journal of Commerce and Management, Vol.14, No. 2, pp. 48- 61.
Lazaridis I & Tryfonidis, D., 2006. Relationship between working capital management and profitability of listed companies in the Athens stock exchange, Journal of Financial Management and Analysis, Vol.19, No. 1, pp 26 – 35.
Narware P. C., 2004. Working capital and profitability- an empirical analysis. The Management Accountant, Vol. 39, No. 6, pp 120-127.
Padachi, K., 2006. Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms. International Review of Business Research Papers, Vol. 2, No. 2, pp. 45 – 58.
Raheman, Abdul & Mohamed Nasr., 2007. Working capital management and profitability- case of Pakistani firms. International Review of Business Research Paper, Vol. 3, No.1 ,pp.279-300.
Uyar, A., 2009. The relationship of cash conversion cycle with firm size and profitability: an empirical investigation in Turkey. International Research Journal of Finance and Economics, ISSN 1450-2887 Issue 24, EuroJournals Publishing, Inc.
Cascarino, R., 2007. ‘Intenal Auditing: An Integrated Approach,’ 2nd Ed, Lansdowne, South Africa.
Htay, S. N., Arif, M., Soualhi, Y., Zaharin, H. R & Shaugee, I., 2013. ‘Accounting, Auditing and Governance for Takaful Operations,’ John Wiley & Sons, Hoboken, NJ.
Reiner, Q., Turley, S & Willekens, M., 2008. ‘Auditing, Trust and Governance: Regulation in Europe,’ Routledge.
Scott, P. R & Jacka, J., 2011. ‘Auditing Social Media: A Governance and Risk Guide,’ John Wiley & Sons, Inc, Hoboken, NJ.
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