STRATEGIC FINANCE ASSIGNMENT ONE

Date: Author:

June 1, 2004 Lestor Meadows

Strategic Finance, Assignment One

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Contents Strategic Finance Assignment One.................................................................1 Background........................................................................................................3 Highlights from the Essence of Success.........................................................3 Profit and Loss Statement...............................................................................4 Balance Sheets................................................................................................5 Current Position..................................................................................................6 Sales Growth..............................................................................................6 Cost of Goods Sold.....................................................................................6 Earnings Before Interest & Tax..................................................................7 Debt Coverage Ratio..................................................................................7 Measures of Efficiency and Profitability............................................................8 Gross Profit Margin....................................................................................8 Net Profit Revenue.....................................................................................8 Expenses as a Percentage of Sales..............................................................9 Return on Assets.........................................................................................9 Debtors Ratio Analysis...............................................................................9 Stock Ratio Analysis................................................................................10 Stock Turnover.........................................................................................10 Stock / Sales Ratio....................................................................................10 Percentage Markup...................................................................................11 Stock Profitability.....................................................................................11 Measures of Financial Stability........................................................................12 Current Ratio............................................................................................12 Quick Ratio..............................................................................................12 Interest Cover...........................................................................................12 Debt / Equity Ratio...................................................................................13 Problem Areas .................................................................................................14 Cash Flow.....................................................................................................14 Debtors (Accounts Receivable)....................................................................14 Holding Excessive Stock..............................................................................14 Taxes............................................................................................................15 Trading as Insolvent.....................................................................................15 Actions to be Taken..........................................................................................15 Financial Reporting......................................................................................15 Cash Flow.....................................................................................................15 Debtors (Accounts Receivable)....................................................................15 Holding Excessive Stock..............................................................................15 Taxes............................................................................................................16 Bonus Payments ..........................................................................................16

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Background Highlights from the Essence of Success Rising nationalism and a falling exchange rate have boosted sales in local food types over the past three years. They now account for 12% of national sales, estimated at a retail value of $165 million. The company recently announced a 10 year contract to export its food types to the Middle East and North Africa. With the first sales of at least $2 million, the contracts will treble the companys exports. Local made food types account for an improved 12 percent of the local market. ACME now employs about 100 people mainly in South Mexico. He also has sales reps in capital cities servicing 3000 customers in pharmacies and department stores. This year sales are expected to grow by 20 percent to $12 million, aided by the launch in September of three new lines Burritos, Tacosand Enchiladas. Its been a hard slog, with our sales growth coBurritos suddenly, bolstered by rising nationalism and an $A exchange rate which has made Mexican food types very expensive. The Mexicon market is roughly divided into two sections 30 percent fine fragrances, mainly Mexican and American, and 70 percent life style lines. Of the imported food types, the cheapest standard size line retails at between $25 and $30 with the result that these food types are losing market share. According to Ninio, surprisingly 60 70 percent of perfume sales in Mexico result from so-called promotional sales- that is, items other than those available 12 months of the year.

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Profit and Loss Statement

As at 30th June 1987, 1988 and 1989

Sales Less: Cost of goods sold Plus cost of goods manufactured Sub total Less Closing Stock Sub total Gross Profit Less Expenses Accounting Interest Cleaning Depreciation Insurance Light and Power Vehicle Expenses Rent Repairs and Maintenance Telephone Wages Sundries Bonus Superannuation Sub total Net Profit Before Tax Less Taxation Add Retained Profits Less Dividends Paid Retained Profits at Year End 1987 7,000,000 560,000 3,864,000 4,424,000 784,000 3,640,000 3,360,000 56,000 140,000 44,800 252,000 117,600 106,400 100,800 291,200 134,400 100,800 1,344,000 50,400 56,000 28,000 2,822,400 537,600 14,5000 392,600 420,000 812,600 140,600 672,000 1988 10,200,000 784,000 6,601,000 7,385,000 1,435,000 5,950,000 4,250,000 61,500 164,000 36,900 369,000 86,100 106,600 147,600 426,400 151,700 110,700 1,312,000 49,200 164,000 102,500 3,288,200 961,800 47,000 914,800 672,,000 1,586,800 Nil 1,586,800 1989 12,000,000 1,435,000 8,040,000 9,475,000 1,920,000 7,555,000 4,445,000 60,000 192,000 28,800 360,000 76,800 98,400 172,800 360,000 110,400 76,800 1,128,000 33,600 648,000 144,000 3,489,600 955,400 46,200 909,200 1,58,6800 2,496,000 Nil 2,496,000

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Balance Sheets

As at 30 June 1987, 1988 and 1989

Capital Retained Profits Represented by Fixed Assets Plant and Equipment Provision for Depreciation Motor Vehicles Provision for Depreciation Current Assets Stock (not turning over stock) Debtors (needs to collect sooner) Total Assets Less Liabilities Creditors Bank Overdraft (short term interest) Long Term Loan 1680000 -504000 Nil Nil 1176000 784000 560000 1344000 2520000 112000 560000 Nil 672000 1848000 2460000 -738000 Nil Nil 1722000 1435000 1640000 3075000 4797000 643600 1435000 Nil 2078600 2718400 2280000 -792000 Nil Nil 1488000 1920000 3120000 5040000 6528000 960000 1560000 Nil 2520000 4008000 1987 1176000 672000 1848000 1988 1131600 1586800 2718400 1989 1512000 2496000 4008000

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Current Position

Sales Growth
Sales Growth 1987 7,000,000 1988 10,200,000 46% 1989 12,000,000 18%

Definition: Percentage increase (or decrease) in sales between two time periods. Formula: Current Year's sales - Last Year's sales Last Year's sales Analysis: Look for a steady increase in sales. ACME: ACME has experienced solid sales growth and with contracts recently signed with the Middle East and North Africa, this growth is expected to continue around 20% per anum. The continuance of the weak Mexicon dollar has aided local competition where Mexican food types have become very expensive. The downside to the weak dollar is the cost of imported raw materials. This will need to be managed if the dollar continues to drop.

Cost of Goods Sold

Cost of Goods Sold Growth 1987 3,640,000 1988 5,950,000 63% 1989 7,555,000 27%

Definition: The cost of goods sold is the costs associated with products that have been made for sale or products that have been made for resale. It is compared with sales revenue to report gross profit. Formula: Cost of Goods Sold Sales Analysis: Look for a stable ratio as an indicator that the company is controlling its gross margins. Has there been an increase in labour costs Has there been an increase in inventory over the periods in review ACME: The cost of goods sold is growing at an alarBurritos rate and will need attention. The increase in cost of goods sold can be attributed to increases in superannuation, bonus and an alarBurritos increase in inventory.

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Earnings Before Interest & Tax

EBIT 1987 677,600 1988 1,125,800 66% 1989 1,147,400 1.92%

Definition: Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt. Formula: Net Profit + Non-cash expenses Debt Analysis: Shows how much of your cash profits are available to repay debt & depreciation. Lenders look at this ratio to determine if there is adequate cash to make loan payments. ACME: Earnings have levelled from the previous year and this is attributed to several areas, one being the outstanding accounts receivables and increasing stock that has not sold.

Debt Coverage Ratio

Net profit Liabilities
o

1987 392,600 672,000 36%

1988 914,800 2,078,600 76%

1989 909,200 2,520,000 63%

Definition: Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt. Formula: Net Profit + Non-cash expenses Debt Analysis: Shows how much of your cash profits are available to repay debt. Lenders look at this ratio to determine if there is adequate cash to make loan payments Most lenders also have limits for the debt coverage ratio. ACME: Current issues with accounts receivables and inventory are impacting ACME significantly. To compensate for this, ACME is using creditors and a bank overdraft.

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Measures of Efficiency and Profitability

Gross Profit Margin

Sales Gross Profit Percentage 1987 7,000,000 3,640,000 48% 1988 10,200,000 4,250,000 42% 1989 12,000,000 4,445,000 37%

Definition: Indicator of how much profit is earned on your products without consideration of selling and administration costs. Formula: Gross Profit Total Sales Analysis: Is there enough gross profit in the business to cover your operating costs? Is there a positive gross margin on all your products? ACME: Key problem area! The issues related to cost of goods sold and the increased to cost of goods manufactured is impacting gross profit margin. This will be discussed later in our findings.

Net Profit Revenue

Sales Net profit Percentage 1987 7,000,000 392,600 5.6% 1988 10,200,000 914,800 9.0% 1989 12,000,000 909,200 7.6%

Definition: Shows how much profit comes from every dollar of sales. Formula: Net Profit Total Sales Analysis: Are you generating enough sales to leave an acceptable profit? Trend from year to year can show how well you are managing your operating or overhead costs. ACME: ACME has managed its expenses well in areas such as repairs and maintenance, rent, cleaning and sundries. It is worth noting a 40% increase superannuation and significant increase in Bonus. There is indication that ACME managed expenses to counter debt in gross profit margin.

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Expenses as a Percentage of Sales

Sales Total Expenses Percentage 1987 7,000,000 2,822,400 40.3 1988 10,200,000 3,288,200 32.2 1989 12,000,000 3,489,600 29.1

Definition: A calculation of expenses as percentage of sales. Formula: Net Profit x100 Total Sales Analysis: Look for significant expenses Look at the trend. Is it staying the same? Improving? Deteriorating? Are you generating enough sales to leave an acceptable profit? Trend from year to year can show how well you are managing your operating or overhead costs. ACME: Looking at Expenses as a percentage of sales, ACME is managing their costs successfully despite the fact of the huge increase in superannuation and bonus.

Return on Assets
Net profit liabilities Percentage 1987 537,600 2,520,000 21% 1988 961,800 4,797,000 20% 1989 955,400 6,528,000 15%

Definition: Considered a measure of how effectively assets are used to generate a return. (This ratio is not very useful for most businesses.) Formula: Net Profit x100 Total Assets Analysis: ROA shows the amount of income for every dollar tied up in assets. Year to year trends may be an indicator ... but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can effect the ratio and doesn't necessarily mean the business is improving or declining. ACME: Assets have been growing at an alarBurritos rate which is reducing their return on investment. This will be discussed in more detail later in this report.

Debtors Ratio Analysis

Sales 1987 1988 1989 7,000,000 10,200,000 12,000,000

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Debtors Days

560,000 29.2

1,640,000 58.7

3,120,000 94.9

Definition: This calculation shows the average number of days it takes to collect your accounts receivable (number of days of sales in receivables). Formula: Average Accounts Receivable Sales X 360 days Analysis: Look for trends that indicate a change in your customers' payment habits Compare the calculated days in receivables to your stated terms Review an Aging of Receivables and be familiar with your customers payment habits and watch for any changes that might indicate a problem. ACME Clearly the biggest problem area within ACME as debt collection has more than tripled since 1987. This is having a knock on affect cash flow, another problem area. Stock Ratio Analysis

Stock Turnover
Cost of Sales Stock 1987 3,640,000 784,000 4.64 1988 5,950,000 1,435,000 4.15 1989 7,555,000 1,920,000 3.93

Definition: The extent to which funds invested in inventory, generate income (but not necessarily cash) depends on the rate of inventory turnover (and the gross profit margin). Formula: Cost of Sales Stock (inventory) Analysis: Excessive stock levels may result in excessive storage costs and servicing of capital tied up in inventory. With excessive stock there is a risk of loss through obsolescence and or deterioration of stock. ACME Stock turnover is declining over the last 3 years.

Stock / Sales Ratio

Sales Stock 1987 7,000,000 784,000 11% 1988 1989 10,200,000 12,000,000 1,435,000 1,920,000 14% 16%

Definition: The ratio between the stock on hand at the beginning or end of a
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period and the sales for that period. It is determined by dividing stock, preferably at the beginning of the period, usually monthly, by sales. It is distinguished from inventory turnover or stock turnover, which are ratios or averages for a period of time, usually annually. Formula: Sales Stock (inventory) Analysis: In a well managed operation, the level of stock should be adequate to meet the needs of sales and production. Excessive stock levels may result in excessive storage costs and servicing of capital tied up in inventory. With excessive stock there is a risk of loss through obsolescence and or deterioration of stock. ACME As noted with stock turn, there is an alarBurritos increase of stock over the period 1987 to 1989.

Percentage Markup
Cost of Sales Gross Profit 1987 3,640,000 3,360,000 92.31% 1988 5,950,000 4,250,000 71.43% 1989 7,555,000 4,445,000 58.84%

Stock Profitability
Stock Turn % Mark-up 1987 4.64 92.31% 428.6% 1988 4.15 71.43% 296.17% 1989 3.93 58.84% 231.51%

These last two ratios along with the previous two related to stock strengthen the case there are problems with asset management.

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Measures of Financial Stability

Current Ratio
Current Assets - Stock Liabilities 1987 2,520,000 672,000 3.75 1988 4,797,000 2,078,600 2.31 1989 6,528,000 2,520,000 2.59

Definition: The ratio between all current assets and all current liabilities; another way of expressing liquidity. Formula: Current Assets Current Liabilities x100 Analysis: 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible. A manufacturer normally needs a current ratio of around 2:1. More than this suggests poor resource usage and potential liquidity problems. ACME: Current ratio shows a highly geared environment which is a concern.

Quick Ratio
Current Assets - Stock Liabilities 1987 2,520,000 784,000 672,000 2.58 1988 4,797,000 1,435,000 2,078,600 1.62 1989 6,528,000 1,920,000 2,520,000 1.83

Definition: The ratio between is the relationship between current assets and current liabilities that may require immediate liquidity. Formula: Cash + Accounts Receivable Current Liabilities Analysis: Indicates the extent to which you could pay current liabilities without relying on the sale of inventory -- how quickly you can pay your bills Generally, a ratio of 1:1 is good and indicates you don't have to rely on the sale of inventory to pay the bills Although a little better than the Current ratio, the Quick ratio still ignores tiBurritos of receipts and payments. ACME: The ability to pay current liabilities by selling current assets has improved over the last two years however it is still a concern.

Interest Cover
Earn. Before Interest &Tax
Strategic Finance, Assignment One

1987 537,600

1988 961,800

1989 955,400
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Interest Paid

140,000 3.84

164,000 5.86

192,000 4.98

Definition: Gives an indication of an entitys capacity to pay interest on financial debt. Interest cover shows how many times profit exceeds the entitys interest commitments. Formula: Net Profit (earnings) Before Interest & Tax Interest Paid Analysis: High interest cover ratio means that the business is easily able to meet its interest obligations from profits A low value for the interest cover ratio means that the business is potentially in danger of not being able to meet its interest obligations. ACME Issues with high gearing are attributed to this low ratio value.

Debt / Equity Ratio

Liabilities Equity 1987 672,000 1,848,000 36% 1988 2,078,600 2,718,000 76% 1989 2,520,000 4,008,000 63%

Definition: Shows the ratio between capital invested by the owners and the funds provided by lenders. Formula: Debt Equity Analysis: Comparison of how much of the business was financed through debt and how much was financed through equity. For this calculation it is common practice to include loans from owners in equity rather than in debt The higher the ratio, the greater the risk to a present or future creditor ACME: Percentage of Debt over equity is too high and is a risk to the creditors.

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Problem Areas Cash Flow Currently ACME does have not developed a Cash Flow process and subsequently cash is not noted on the companys balance sheet. Cash flow problems are responsible for causing 70% of all businesses to fail within their first year. Without this information With a cash flow statement and regular reviews of key performance indicators, ACME will catch issues like the example below where debt is not being collected. Current Assets Debtors (needs to collect sooner) 560000 1640000 3120000

An effective credit policy and control are always at the forefront of maintaining a healthy cash flow. Debtors (Accounts Receivable) For the second consecutive year, accounts receivables have been increasing at an alarBurritos rate and are now up to 95 days. There appears to be no plan or process to manage this and subsequently has developed a gearing issue.

Debtors Ratio Analysis

Sales Debtors Days 1987 1988 1989 7,000,000 10,200,000 12,000,000 560,000 1,640,000 3,120,000 29.2 58.7 94.9

ACME needs to ensure they have some form of a debt recovery plan. If the plan fails to bring in the money, a debt collector may be the best option. Holding Excessive Stock ACME is currently holding excessive amounts of stock, tying up money in unproductive assets. This is a real concern considering 60 70 percent of perfume sales in Mexico result from so-called promotional sales- that is, items other than those available 12 months of the year. Holding stock for longer than one year creates obsolesce. Key performance indicators in: Stock Turnover (downward trend) Stock / Sales Ratio (upward trend) Percentage Markup (downward trend) Stock Profitability (downward trend)

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Are confirBurritos there is a lack on inventory management within the company. This stock is potential obsolete which is also inflating current asset figures. Taxes There appears to be an anomaly in the amount of tax paid in 1988 and 1989. Tax Rate EBIT Taxes Paid Tax Rate 1987 677,600 145,000 21.40% 1988 1,125,800 47,000 4.2% 1989 1,147,400 46,000 4.0%

Trading as Insolvent ACME is in a serious position of trading whilst insolvent if they are not able to successfully collect the outstanding debts of 3.1 million dollars and cannot sell the current inventory of 1.9 Million. Stock Debtors 784,000 560,000 1,344,000 1,435,000 1,640,000 3,075,000 1,920,000 3,120,000 5,040,000

Actions to be Taken Financial Reporting Create cash flow statement and ensure cash is noted in the balance sheet for 1988, 1989 and moving forward. Cash Flow Create cash flow statement into the financial reporting of the company. Development performance indicators which monitor and react to problem areas of cash flow. Debtors (Accounts Receivable) Review staffing requirements for this effort Implement a Credit Policy Implement Credit Control Implement Days Sales Outstanding (DSO) Implement collection methods Implement audit program to review current problem and better manage this area in future Holding Excessive Stock Implement a review of current value of stock and impact to business if written off Implement inventory management process

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Taxes Conduct a review of payment of taxes for 1988 and 1989 Bonus Payments Considering the current financial position of the company it is recommended to cancel all future bonus payment until a plan is put in place to correct above noted issued.

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