ACCOUNTING

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Solutions to case studies Solution to Case 1: Pace Leisurewear Ltd (1)

(Note: There is no single ‘correct’ solution to this case study. Various approaches could have been adopted. The plan of action proposed should flow logically from the initial analysis of the problems faced by the company.)

When analysing the problems faced by the company, the following points may have been raised:

• The lack of financial expertise within the boardroom and the apparent lack of financial controls operating within the business (e.g. the fact that the business had breached the overdraft limit on several occasions).

• The lack of proper business planning. The growth in the company appears to be uncontrolled and unpredicted. There is no evidence that the company has tried to ensure that there is capital available to finance the growth of the business. The company appears to react to the developments in the business as they arise rather than to anticipate problems before they arise.

• The relatively high dividends being paid despite the liquidity problems of the business.

Table of ratios

The following ratios provide a useful insight to the financial health of the business:

Year before last Last year

Return on capital employed (net assets) Net profit before interest and tax

Share capital+Reserves +Longterm loans ×100%

2,100 10,474

100% × 20.0%

4 618 15 600

100% , ,

× 29.6%

Return on equity (shareholders’ funds)

Net profit after longterm interest and tax Share capital and reserves

×100%

2

1248 6 874

100% , ,

× 18.2%

2 926 9 000

100% , ,

× 32.5%

Gross profit margin

Gross profit Sales

×100%

6,510 14,006

×100% 46.5%

10 792 22 410

100% , ,

× 48.2%

Net profit margin

Net profit before interest and tax Sales

×100%

2100 14 006

100% , ,

× 15.0%

4 618 22 410

100% , ,

× 20.6%

Stockholding period

Stock held Cost of sales

days × 365

2 418 7 496

365 , ,

× 118 days

5 820 11618

365 , ,

× 183 days

* based on year end stock levels

Debtor collection period (Day’s debtors)

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Trade debtors Credit sales

365 days ×

1614 14 006

365 , ,

× 42 days

3 744 22 410

365 , ,

× 61 days

Sales to capital employed ratio

Sales Total assets employed

14 006 8 600 4 356

, , , +

1.08 times

22 410 14 470 9 974

, , , +

0.92 times

Current ratio

Current assets Current liabilities

4 356 2 482 , ,

1.76 : 1

9 974 8 844 , ,

1.12 : 1

Quick assets (liquid or acid test) ratio

Current assets, excluding stock Creditors falling due within one year

4 356 2 418 2 482

, , , − 0.78 : 1

9 974 5 820 8 844

, , , − 0.40 : 1

Debt to equity ratio

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Longterm liabilities Share capital+Reserves +Longterm loans

×100%

3 600 10 474

100 , ,

× 34.4%

7 600 15 600

100 , ,

× 42.3%

Comments on the financial results The following points are significant from the results to hand:

• Pace Leisurewear has experienced a major expansion of activities. Sales last year increased by 37.5% compared to the previous year. Net profits after tax have increased by 134.5% over the same period.

• There has been an increase in the ROCE ratio, but a ROCE in excess of the interest rate had caused an even greater increase in ROE, an effective use of gearing. However, the level of gearing is now very high.

• The gross profit ratio increased significantly, accompanied by an increase in the net profit margin.

• The liquidity position has weakened considerably from what was probably a healthy position to one that looks distinctly unhealthy. It is quite clear why the continuing support of the bank is important.

• Stock is now turning over rather slowly compared with last year. However, this ratio will be affected by the need to increase stocks in anticipation of higher sales levels in the future.

• The debtors’ collection period has increased significantly over the period. Once again, however, this ratio will be affected by any increase in sales towards the end of the year.

Cash flow statement for the year ended 31 December last year £000 £000

Net cash inflows from operating activities 3,304 (see Note 1 below)

Returns from investment and servicing of finance Interest paid (912) Dividends paid (600)

Net cash outflow from returns on investment (1,512) and servicing of finance

Taxation

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Corporation tax paid (420)

Tax paid (420)

Investing activities Payments to acquire tangible fixed assets (8,670) (See note)

Net cash outflow from investing activities (8,670)

Net cash outflow before financing (7,298)

Financing Bank loan 3,000)

Net cash inflow from financing 3,000)

Net decrease in cash and cash equivalents (4,298)

To see how this relates to the cash of the company at the beginning and end of the year, it is useful to show a reconciliation as follows:

Analysis of cash and cash equivalents during the year ended 31 December last year

£000 Balance at 1 January last year 56) Net cash outflow (4,298) Balance at 31 December last year (4,242)

To explain where the opening and closing balances came from, another reconciliation can be shown, as follows:

Analysis of balances of cash and cash equivalents as shown in the balance sheet

start end Change in year £000 £000 £000

Cash at bank and in hand 56) 8) (48) Bank overdrafts –) (4,250) (4,250)

(17) (4,242) (4,298)

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Note: Calculation of net cash inflow from operating activities

£000 £000 Net operating profit (from the profit and loss account) 4,618 Add: Depreciation 2,800

7,418 Add: Increase in trade creditors (2,612 – 1,214) 1,398

Increase in other creditors (402 – 248) 154 1,552 8,970

Less: Increase in stocks (5,820 – 2,418) 3,402 Increase in trade debtors (3,744 – 1,614) 2,130 Increase in other debtors (402 – 268) 134 5,666

3,304

Since there were no disposals, the additions must be the difference between the start and end of the year fixed asset values, adjusted by the depreciation charge, e.g.:

Fixed assets, at book value, at the start of the year 8,600 Add: additions (balancing figure) 8,670

17,270 Less: depreciation 2,800 Fixed assets, at book value, at the end of the year 14,470

Plan of action In producing a plan of action, the following points may be made:

• The company should ensure that someone with financial expertise is brought on to the board of directors to take a firm control of the financing and investing activities of the business. The cash flow statement shown above reveals that the company invested nearly £8.7m in fixed assets during last year but only raised £4m in loans to fund the business. The result was inevitably a deterioration in the cash position of the business.

• The company may find it difficult to find potential investors. Although the company is highly profitable, the level of gearing is high and the company is facing a liquidity crisis. Nevertheless, there are certain investors (e.g. venture capitalists) who may still find the company attractive. They may be prepared to take on such risks in exchange for potential high returns. However, the Keeble brothers are not keen on having another large shareholder in the company which could prevent this option from being feasible. It may be possible to approach customers and suppliers to see whether they would be prepared to make small investments in the business. However, there may be disadvantages in this approach. Customers and suppliers may wish to use their shares to influence future policy of the business in a way which undermines its autonomy.

• In the absence of a large injection of funds from outside the business, it is necessary to ensure that the level of operations is more closely aligned to the

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finance available. This means that the company must take a more controlled approach to expanding the business. In the short term, it may be necessary to reduce the level of activity, or at least reduce the rate of growth in order to ensure that orders can be fulfilled. Although this policy may involve losing sales, the alternative may be that the business collapses through lack of liquidity.

• The company must also find ways of generating finance from within the firm in order to ensure that the bank’s demands are met and the liquidity of the business is improved. If customers and suppliers become concerned with the liquidity of Pace Leisurewear, it could precipitate the collapse of the business. The following steps should be considered:

— cancel the proposed dividend for the year — sell off any underutilised assets — reduce stock levels — reduce the debtors’ collection period — lease rather than buy fixed assets in the future.

• By holding sales at last year’s level and reducing stock levels and day’s debtors to the levels of the previous year, the following internal funds can be generated:

Reduction in stock level £ £

Current investment in stocks

Revised investment in stocks 5820 11,618 × 118/365 3756 2064

Reduction in debtors levels Current investment in debtors 3744 Revised investment in stocks 22,410 × 42/365 2579 1165

3229

The above figures suggest that the reduction in the overdraft as required by the bank is possible, providing the business is prepared to hold back its growth in the short term.

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Solution to Case 2: Carpetright plc

The following ratios can be used in assessing the performance and position of the business:

2001 2000 Profitability Return on owners equity (ROE) (31,715/47,609) × 100 66.6% (25,613/35,578) × 100 71.2%

Return on capital employed (ROCE)* [(44,552*) /(52,640) × 100] 84.6% [(36,557*)/(38,363) × 100] 95.3% * Interest payable ignored (assumed to be all short term interest payments)

Net profit margin (44,452)/322,917) × 100 13.8% (36,557)/304,818) × 100 12.0%

Gross profit margin (184,642/322,917) × 100 57.2% (164,208/304,818) × 100 53.9%

Efficiency Stock turnover period* (28,453/138,275) × 365 75 days (22,268/140,610) × 365 58 days * Using year end figures

Average settlement period for debtors* (11,144/322,917) × 365 13 days (11,783/304,818) × 365 14 days * Using year end figures

Average settlement period for creditors* (42,962/138,725) × 365 113 days (38,399/140,610) × 365 100 days *Using year end figures and cost of sales rather than credit purchases

Sales to capital employed* (322,917/52,640) 6.1 times (304,818/38,363) 7.9 times * Using year end figures

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Liquidity Current ratio (55,817/93,474) 0.6:1 (42,616/75,239) 0.6:1

Acid test ratio [(55,817 – 28,453)/93,474] 0.3:1 [(42,616 – 22,268)/75,239] 0.3:1

Gearing Gearing ratio (5,031/52,640) × 100 9.6% (2,785/38,363) × 100 7.3%

Investment Dividend payout ratio (20,428/31,715) × 100 64.4% (17,927/25,613) × 100 70.0%

Earnings per share* 42.0p 33.3p * per accounts

The following information concerning changes in the size of the company is also revealing:

Turnover £322,917 £304,818 % increase 5.9%

Net profit after tax £31,715 £25,613 % increase 23.8%

Net assets £47,609 £35,578 % increase 33.8%

In some respects, Carpetright plc has grown significantly over the year. Note the percentage change in the profit after tax and net assets figures over the period. However, the increase in turnover during the period was more modest.

The ratios reveal that Carpetright plc is an extremely profitable business. The ROE and ROCE of the business are very high – although there has been some decline in both over the period under review. This decline results from a decrease in the sales to capital employed ratio as the net profit margin has increased over the period. (Although sales have increased, the increase in net assets has been proportionately greater.)

There has been an increase in both the gross profit margin and net profit margin of the business over the period. The gross profit margin has increased rather more than the net

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profit margin, which suggests that the increased profitability from buying and selling carpets has been partly consumed by increased operating expenses. (Note that the distribution costs increased by much more than the increase in turnover.)

The average settlement period for debtors has remained much the same over the period (the very low settlement period suggests a high proportion of cash sales). However, there has been an increase in the average settlement period for creditors and the stockholding period. These three ratios reveal that during the year, the business received cash from customers 88 days (i.e. 13.0 + 75) after receiving the goods and paid the creditors 113 days after receiving the invoice for the goods. Thus, trade creditors were more than financing the stocks and debtors of the business.

The liquidity of the business is low but has been stable over the period under review. The acidtest ratio in the most recent year seems very low indeed and might provide cause for concern. However, this ratio may well reflect tight financial management by the business. An examination of the cash flow statement reveals that although there has been a large outlay on the acquisition of fixed assets, dividends and tax during the year, the operating cash flows were able to cover these. In any event, the business is very profitable and has little gearing and so there should be few problems in raising funds to improve the liquidity of the business if it was felt that this was a serious, or long term, problem. The business could, of course consider reducing the level of dividends in order to conserve cash. At present the dividend payout ratio is very high even though there was a decrease compared to the previous year.

An investor should have reason to be satisfied with the performance of the business over the period. The business is growing and is maintaining very high levels of ROE and ROCE. The improvement in profits over the period has led to a significant improvement in earnings per share and the dividend payout ratio is high. However, the expansion of the business combined with high dividend payouts has placed a strain on the liquidity of the business and it may be necessary for the business to consider additional funding in the future if this rate of expansion is to continue. This would mean higher levels of gearing or requiring further funds from equity investors. However, if the business continues to generate strong operating cash flows, external funding may be unnecessary.

A carpet manufacturer may feel it has much to gain from association with such a successful and growing business. However, Carpetright is likely to be demanding on its suppliers. It is interesting to note that Carpetright improved its gross profit margin during the period. This may be due to the sale of higher price/higher margin items but it may also may be due to squeezing the suppliers’ margins. The carpet manufacturer may feel this issue is worth further investigation. The average settlement period for creditors is nearly four months, which seems fairly long. There was a slight decrease in the period during the most recent year and given the liquidity problem referred to earlier, suppliers are unlikely to be paid much quicker in the future.

This case study is reproduced with permission of Carpetright plc.

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Solution to Case 3: Gadabout Travel Ltd

Cash budget for next year

Jan Feb Mar Apr May June £ £ £ £ £ £

Cash Receipts Bookings: WS 220,500 233,100 37,800 12,600

B 40,500 264,600 232,200 178,200 121,500 27,000)

261,000 497,700 270,000 190,800 121,500 27,000) Payments Airlines: T+LC* 56,000 54,500 82,500 24,000 21,000 38,500) EC* 1,200 1,500 2,100 600 600 900)

Hotels: T+LC* 84,000 81,750 123,750 36,000 26,250 48,125) EC* 1,800 2,250 3,150 900 750 1,125)

Salaries 20,600 20,600 20,600 20,600 20,600 20,600) Electricity 1,500 1,500 Rates 1,000 Repairs 100 100 100 100 100 100) Travel 3,500 3,500 3,500 3,500 3,500 3,500)

168,700 164,200 235,700 88,200 72,800 112,850)

Surplus/(deficit) for the month

92,300 333,500 34,300 102,600 48,700 (85,850)

Cumulative balance 113,500 447,000 481,300 583,900 632,600 546,750)

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Cash budget for next year (continued)

July Aug Sept Oct Nov Dec £ £ £ £ £ £

Cash Receipts Bookings: WS 22,050 34,650 113,400 126,000

B 21,600 21,600 13,500

21,600 21,600 35,500 34,650 113,400 126,000 Payments Airlines: T+LC* 93,000 111,500 63,000 EC** 2,400 2,700 1,800

Hotels T+LC* 116,250 139,375 78,750 EC** 3,000 3,375 2,250

Salaries 20,600 20,600 20,600 20,600 20,600 20,600 Electricity 1,500 1,500 Rates 1,000 Repairs 100 100 100 100 100 100 Travel 3,500 3,500 3,500 500 500 500

240,350 281,150 170,000 23,700 21,200 21,200

Surplus/(deficit) for the month

(218,750) (259,550) (134,450) 10,950 92,200 104,800

Cumulative balance

328,000 68,450 (66,000) (55,050) 37,150 141,950

* T+LC is the holidays taken plus the late cancellations, all of which must be paid in full. ** EC is the early cancellations (50 per cent of the total cancellations), 60 per cent of which must be paid.

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Budgeted Profit and Loss Account for the year ending 31 December next year

£ £ £ Sales: Holidays sold (net of agents’ commission) Winter sports (2,080 + 180) × £315 711,900 Beach (3,130 + 280) × £270 920,700

1,632,600 Hotel charges: Winter sports (2,080 + 90) × £150 325,500

90 × £90 8,100 Beach (3,130 + 140) × £125 408,750

140 × £75 10,500 752,850 Airline charges: Winter sports (2,080 + 90) × £100 217,000

90 × £60 5,400 Beach (3,130 + 140) × £100 327,000

140 × £60 8,400 557,800

Salaries 247,200 Electricity 6,000 Rates 2,000 Repairs 1,200 Travel 33,000 Depreciation 11,400

1,611,450 Budgeted net profit for the year 21,150

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Budgeted Outline Balance Sheet as at 31 December next year

£ £ Fixed assets Freehold land and building 210,000) Equipment and furniture (57,000 – 11,400) 45,600)

255,600) Current assets Prepaid rates 500 Cash 141,950

142,450 Current liabilities Accrued electricity 1,500 Trade creditors (940 winter sports × (£350 – 10%)) 296,100

297,600 (155,150) 100,450)

Share capital and reserves (79,300 + 21,150) 100,450)

Comments on the results The following five points are worth noting:

• A 20–25 per cent return on equity may or may not be considered adequate for the level of risk involved.

• The profit/contribution margin is relatively small. • There is relatively high sensitivity to changes in demand, selling price and costs. • During much of the year there are major cash surpluses. These need to be

carefully managed to gain the maximum benefit from interest receipts, without placing the funds at serious risk.

• During September and October there are overdrafts scheduled. Steps need to be taken to deal with this. An overdraft could be negotiated in advance. Perhaps better, steps could be taken to reschedule some of the payments so as to avoid these cash deficits.

Accounting policy with reference to realisation of profit The generally accepted accounting treatment of revenues is to recognise them when the period in which the work to earn them has substantially been completed, they are capable of objective measurement and it seems probable that the cash will be received.

It could be argued that this position is established in the period in which the booking is made. During that period, the bookings with the airlines and hotels will be placed, leaving only the payment to them outstanding. Thus it could be contended that the work to earn the revenue has been substantially completed. Since the price is fixed, the revenue is capable of objective measurement. Also, cash is received at the time of the customer making the booking.

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On the other hand, it is not until the customer actually takes the holiday that the work is fully completed. The process could go wrong in the meantime, leading to extra work and to extra cost. It could be argued that a prudent view should be adopted so that profit is not recognised until the holiday is actually taken. This is probably the view that would be taken in practice.

Ultimately, a major factor in the decision must be the usefulness of the information provided. If it is felt that one approach gives the more valuable information, then this is the approach that would probably be taken. This is particularly the case here because there are quite good arguments, based on accounting conventions, for adopting either policy.

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Solution to Case 4: Pace Leisurewear (2)

The Quarter to 31st March

This period sees the start of the turn around in the fortunes of Pace Leisurewear. Noticeable is the large Loss, mainly due to a total of £1.9 million being written off stock and debtors. It is reasonable to accept writeoffs on such high levels of stock in a fashion industry with rapid obsolescence, and debtor writeoffs are not unexpected given the nature of the industry. The management and shareholders of Pace would wish to be confident that adequate, but not excessive, prudence was used to determine the level of writeoffs. It is common for new management to be ultra prudent initially, knowing that any excessive provisions may be relaxed at a later date to make their own performances appear more impressive.

Operating profits (before writeoffs) remain healthy, although it can be seen that the gross profit has dropped to 42.9% (previously 48.2%), due largely to the impact of the recently accepted order from Arena, for whom Pace started making "own brand" items which would be lower price than the Pace branded items otherwise sold.

There is now a net loss of 22.3%, compared with net profits last year of 20.6% Interest expense has increased due to the high level of overdraft expense.

The overdraft has reduced to £2.536 million, which demonstrates the fundamental strength of the business, which generates substantial amounts of cash. The cash position is aided by the nonadoption of the proposed £800,000 dividend payments, which would have been unwise in the circumstances, in particular as such a payment would merely confirm a view of financial incompetence in the eyes of the bank.

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The Quarter to 30th June

Many of the figures are unchanged from the previous quarter, notably Turnover, Cost of sales and Operating expenses (except for the additional salary expense of Peter Drake, which is at an annual rate of £300,000).

Significantly both a profit and a positive cash balance are expected by the end of this quarter a reflection on the essential strength of the business and core management team. However, the company will not yet be in a position where it can pay dividends to its shareholders, and the management may consider whether dividends should be paid as soon as possible, or whether it would be more prudent to use any surplus cash to reduce the level of the bank loan before paying dividends. The debt to equity ratio remains above the level of two years ago, when it was 34.4%. It is now expected to be 42.8% by June. It remains to be seen if it is realistic to dispose of any of the fixed assets, or whether a sale and leaseback is possible for any buildings.

The challenge for the company to the future will be to increase the profitability ratios, notably the gross margin, which has dropped by 5% from last year. The management will need to consider cost reductions and / or improvements in the sales prices achieved: for example, whether lower margin contracts such as that from Arena should be accepted or not.

Jill Dempsey will be pressing for the removal of Peter Drake on the grounds of incompetence, but it is likely that such an attack would be rejected by the Board, not least because Jill appears to be running out of allies. Peter Drake might be able to leave soon, but more as a result of having successfully turned the company around and prevented its liquidation than any failure on his part. It would still be essential to employ someone in Peter's role, and a direct replacement would be required for Peter when he comes to leave. It is likely that such a replacement would cost the company less than the £300,000 a year that Peter would charge.

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Table of ratios Last year Quarter Quarter

to March to June Gross profit margin 10,792 * 100% 22,410

2,700 * 100% 6,300

48.2%

42.9% 42.9%

Net profit margin 4,618 * 100% 22,410

(1,404) * 100% 6,300

418 *100% 6,300

20.6%

(22.3%)

6.6%

Stockholding period 5,820 * 365 11,618

3,720 * 91 3,600

2,280 * 91 3,600 (based on period end stock levels * number of days in period)

183 days

58 days

58 days

Average settlement period for debtors 3,744 * 365 22,410

3,640 * 91 6,300

3,140 *91 6,300

61 days

53 days

46 days

Current Ratio 9,974 8,844

7,790 6,340

1.12 : 1

1.23 : 1

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6,606 3,854

1.71 : 1

Acid test ratio 9,974 5,820 8,844

7,770 3,720 6,340

6,606 2,280 3,854

0.40 : 1

0.64 : 1

1.12 : 1

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Solution to Case 5: Landlord: investment appraisal There is no solution for this case study as it is too open ended.

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Solution to Case 6: Blue Hills Country Park Limited Net Present Value calculation

£ £ £ £ £ £ Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10

Capital investment [W1] (240,000) Opportunity cost (barn) (30,000) Extra contribution [W2] 89,775 184,039 283,015 386,940 Extra running costs [W3] (120,080) (123,283) (126,615) (130,079) Tax rebate/(payable) [W4] 15,000 18,826 (6,752) (32,772) (45,231) Total Cash Flow (240,000) (45,305) 79,582 149,648 224,089 (45,231) 7% factor 1.000 0.935 0.873 0.816 0.763 0.713 Present Values (240,000) (42,341) 69,510 122,159 170,957 (32,249)

Net Present Value £48,036 (Note: you may spot some slight differences with your PV calculations. This is due to the rounding, to three decimal places, of the discounting factor.)

The project generates are positive Net Present Value (NPV) and should therefore be considered favourably by the Blue Hills' management. However, it is not a clearcut decision as the NPV is reasonably close to zero. Management should be aware of the likelihood of not achieving the forecast results. The sensitivity analyses are worth looking at in this regard.

Workings

[W1] Capital investment

The following capital expenditure would be incurred in Autumn Yr 5 and is therefore eligible for Capital Allowances (see Working 5) from trading year Yr 5:

£ Landscaping of "Top Field" 30,000 Aluminium track 90,000 Cost of 60 plastic toboggans 60,000 Conversion of barn in "Top Field" 25,000 Cost of winching equipment for the toboggans 35,000 Total assets 240,000

[W2] Extra contribution

Firstly consider the extra visitors:

Yr 6 Yr 7 Yr 8 Yr 9 Yr 69 Total visitors per annum (at present) 378,000 378,000 378,000 378,000 1,512,000 Visitors (if 5% compound growth) 396,900 416,745 437,582 459,461 1,710,688 Extra visitors 18,900 38,745 59,582 81,461 198,688

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You can now calculate the additional contribution that these extra visitors will generate each year. Contribution per visitor is shown here:

£ Entrance fee 4.00 less: Variable cost per visitor (0.25)

3.75 plus: Profit made from extra visitors to the shop (£2 £1) 1.00 Total contribution per visitor 4.75

So the total extra contribution per annum can now be calculated by multiplying the extra visitors by the contribution per visitor:

Yr 6 Yr 7 Yr 8 Yr 9 Yr 69 Extra visitors 18,900 38,745 59,582 81,461 198,688

Extra contribution (@£4.75/head) £89,775 £184,039 £283,015 £386,940 £943,769

[W3] Extra running costs

Yr 6 Yr 7 Yr 8 Yr 9 £ £ £ £

Extra costs (inc. 4% inflation) New staff (4 x £8,000) 33,280 34,611 35,996 37,435 Maintenance/electricity/insurance 46,800 48,672 50,619 52,644

80,080 83,283 86,615 90,079 plus: Patent fee (inflationproof) 40,000 40,000 40,000 40,000 Total 120,080 123,283 126,615 130,079

[W4] Tax calculations

Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 £ £ £ £ £

Extra contribution 89,775 184,039 283,015 386,940 Extra running costs (120,080) (123,283) (126,615) (130,079) Capital Allowances [W5] (60,000) (45,000) (33,750) (25,313) (75,937)

(60,000) (75,305) 27,006 131,087 180,924

Tax (rebate)/payable @ 25% (15,000) (18,826) 6,752 32,772 45,231

The cash flow for these tax figures will occur at the end of the following year, i.e. Yr 5's in Yr 6, Yr 6's in Yr 7 and so on.

[W5] Capital Allowances

Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 £ £ £ £ £

Expenditure/WDV b/f 240,000 180,000 135,000 101,250 75,937 Writing Down Allowance (at 25%) (60,000) (45,000) (33,750) (25,313) Scrap value (0) Written Down Value (WDV) c/f 180,000 135,000 101,250 75,937 Balancing Allowance 75,937

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Sensitivity Analysis

The Net Present Values (see the spreadsheet for the workings) for the three other situations suggested are shown below:

NPV (£) Original forecast 48,036 3% visitor growth 195,049 7% cost inflation 31,948 10% money cost of capital 21,989

Clearly the alteration to the visitor growth rate has had a dramatic effect on the NPV of the project and it is therefore very sensitive to changes in customer demand. The changes to cost inflation and cost of capital have had far less effect and in both cases the project, with a positive NPV, is still worthwhile.

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Solution to Case 7: Homeland plc

(a) Trends

2002 2003 2004 2005 Sales (£000s) 14,945 16,650 18,900 22,700 Trend 100 111 126 152

Cost of sales (£000s) 10,460 12,050 14,175 17,800 Trend 100 115 136 170

Gross profit (£000s) 4,485 4,600 4,725 4,900 Trend 100 103 105 109

Net profit (£000s) 1,260 960 896 800 Trend 100 76 71 63

Capital employed (£000s) 11,870 12,030 12,726 12,726 Trend 100 101 107 107

Ratios

Profitability GP margin 30.0% 27.6% 25.0% 21.6% NP margin (after tax) 8.4% 5.8% 4.7% 3.5% ROSF 10.6% 8.0% 7.4% 6.6%

Efficiency Sales/Capital employed 1.3T 1.4T 1.6T 1.9T Average receivables (days) 33 39 45 48 Inventories turnover (days) 61 65 70 70

Liquidity Current ratio 4.0 3.1 2.8 2.5 Acid test 2.1 1.5 1.3 1.2

Gearing Gearing ratio 4.7% 4.7%

Investment Dividend payout 63.0% 83.3% 89.3% 100.0% Earnings per share £0.63 £0.48 £0.45 £0.40

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Key points

• Since 2002, sales revenue has increased by 52% but cost of sales has increased

by 70%.

• The effect has been a relatively small increase in overall gross profit and a

significant decline in the gross profit margin.

• Both overall net profit and the net profit margin have declined each year over the

threeyear period. Both are now significantly lower than when Jack Bennett was at

the helm.

• The increase in capital employed is small in relation to the increase in sales. This

has led to an increase in the sales to capital employed ratio and raises the

question as to whether the business is overtrading.

• There has been a significant increase in the average trade receivables period

(poor controls or a liberalisation of credit to achieve greater sales?)

• There has also been an increase in the inventory turnover period (poor controls or

expectations of greater future sales?)

• The liquidity ratios show a sharp decline that must be addressed.

• Despite the declining liquidity and increasing bank overdraft, the dividend payout

ratio remained high and swallowed up the whole of the profit in 2005.

• In addition to the overdraft repayment of £337,000 ( 1 /2 of £674,000), the business

must repay a loan of £600,000 in 2006.

• Gearing levels remain low and the business has considerable debt capacity. It

appears that the freehold land is unsecured and may be used as security for a loan

if required.

Overall, the pursuit of market share appears to have been achieved at the expense of

profitability and liquidity. Unless there is some attempt to reverse this decline in

profitability and liquidity, the business may soon be in serious trouble. The business has

not invested sufficiently in the additional resources required to sustain the growth that it

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wishes to achieve. The ability of the business to meet the challenges of the new

competitive environment has been weakened rather than strengthened as a result of the

‘dash for growth’. Nevertheless, the business is not in very serious difficulties at the end

of 2005. The worrying trends that have emerged may be reversed, if appropriate action is

taken.

The real question is whether Daniel Bennett, who does not seem to be aware of the

problems, will take such action. Even if the additional funds are forthcoming, the amount

to be raised is not very substantial (£800,000) and will only cover the annual dividend

payment. It will not be enough to underwrite the ambitious growth plans of Daniel Bennett.

Although he is correct in seeking additional resources, it is not clear whether he has

identified the correct sum that is required or the most appropriate form of finance.

Furthermore, the purpose for which the finance is being raised is questionable. Priority

should be given to helping to restore the viability of the business.

(b) Key points

• Vulturus Ltd would be investing in a business where profitability, including ROSF,

has experienced significant decline. Unless there are plans to address this

problem, the business appears to offer little for an equity investor.

• Homeland plc has 2m shares in issue and its total equity at the end of 2005 is

£12.126m, which amounts to around £6 a share.

• At a figure of £8 a share, the new shares appear to have good asset backing,

particularly if the freehold land has a higher market value than the figure shown in

the financial statements

• Using a P/E ratio of 22 times, the shares of Homeland plc would be valued at

£8.80 (that is 22 x £0.40) at the end of 2005. However, it is not clear from the case

study whether the listed business mentioned is really similar to Homeland plc.

Furthermore, the shares of listed businesses enjoy a significant premium over

those of unlisted ones because of their marketability. There is no evidence from

this comparison, therefore, that the shares are ‘cheap’.

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(c) Advice

Various approaches to Homeland plc’s problems may be feasible, including the following:

• Reverse the trend in liquidity by restricting dividend payments and tightening credit

and inventory policies.

• Improve profit margins by raising prices, even if this is at the expense of lost sales.

• Investigate other approaches to increasing the scale of operations (such as a

merger or takeover).

• Consider debt as an alternative to equity, particularly if equity investors are

unconvinced by the future direction of the business.

ACCOUNTING

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