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Health and Fitness Group (June 2008 Q1)

The Health and Fitness Group (HFG), which is privately owned, operates three

centres in the country of Mayland. Each centre offers dietary plans and fitness programmes to clients under the supervision of dieticians and fitness trainers. Residential accommodation is also available at each centre. The centres are located

in the towns of Ayetown, Beetown and Ceetown. The following information is available:

(1) Summary financial data for HFG in respect of the year ended 31 May 2008. Ayetown

$000 Beetown

$000 Ceetown

$000 Total $000

Revenue:

Fees received Variable costs

Contribution Fixed costs Operating profit

Interest costs on long-term debt at 10% Profit before tax

Income tax expense Profit for the year

Average book values for 2008: Assets Non-current assets Current assets

Total assets

Equity and liabilities: Share capital Retained earnings

Total equity Non-current liabilities

Long-term borrowings Total non-current liabilities

Current liabilities Total current liabilities

Total liabilities Total equity and liabilities

1,800 (468)

––––––

1,332 (936)

–––––– 396

1,000 800

–––––– 1,800

––––––

80 ––––––

80 ––––––

2,100 (567)

––––––

1,533 (1,092) ––––––

441

2,500 900

–––––– 3,400

––––––

240 ––––––

240 ––––––

4,500 (1,395) ––––––

3,105 (2,402) ––––––

703

3,300 1,000

–––––– 4,300

––––––

480 ––––––

480 ––––––

8,400 (2,430) ––––––

5,970 (4,430) –––––– 1,540

(180) –––––– 1,360

(408) ––––––

952 ––––––

6,800 2,700

–––––– 9,500

––––––

2,500 4,400

––––––

6,900 ––––––

1,800 –––––– 1,800

––––––

800 ––––––

800 ––––––

2,600 –––––– 9,500

––––––

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(2) HFG defines Residual Income (RI) for each centre as operating profit minus a

required rate of return of 12% of the total assets of each centre. (3) At present HFG does not allocate the long-term borrowings of the group to the

three separate centres.

(4) Each centre faces similar risks.

(5) Tax is payable at a rate of 30%. (6) The market value of the equity capital of HFG is $9 million. The cost of equity

of HFG is 15%.

(7) The market value of the long-term borrowings of HFG is equal to the book

value.

(8) The directors are concerned about the return on investment (ROI) generated by the Beetown centre and they are considering using sensitivity analysis in order to show how a target ROI of 20% might be achieved.

(9) The marketing director stated at a recent board meeting that ‘The Group’s

success depends on the quality of service provided to our clients. In my opinion, we need only to concern ourselves with the number of complaints

received from clients during each period as this is the most important performance measure for our business. The number of complaints received from clients is a perfect performance measure. As long as the number of

complaints received from clients is not increasing from period to period, then we can be confident about our future prospects’.

Required:

(a) The directors of HFG have asked you, as management accountant, to

prepare a report providing them with explanations as to the following:

(i) Which of the three centres is the most ‘successful’? Your report

should include a commentary on return on investment (ROI),

residual income (RI), and economic value added (EVA) as measures of financial performance. Detailed calculations regarding each of these three measures must be included as part of your report;

Note: a maximum of seven marks is available for detailed calculations (14 marks)

(ii) The percentage change in revenue, total costs and net assets

during the year ended 31 May 2008 that would have been required in order to have achieved a target ROI of 20% by the

Beetown centre. Your answer should consider each of these three variables in isolation. State any assumptions that you make. (6 marks)

(iii) Whether or not you agree with the statement of the marketing director in note (9) above. (5 marks)

Professional marks for appropriateness of format, style and structure of the report. (4 marks)

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(b) The Superior Fitness Co (SFC), which is well established in Mayland, operates

nine centres. Each of SFC’s centres is similar in size to those of HFG. SFC also provides dietary plans and fitness programmes to its clients. The directors of HFG have decided that they wish to benchmark the performance of HFG with that of SFC.

Required:

Discuss the problems that the directors of HFG might experience in their wish to benchmark the performance of HFG with the performance of SFC, and recommend how such problems might be successfully addressed. (7 marks)

(36 marks)

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PREDICTING CORPORATE FAILURE

A company could fail and go into bankruptcy. There may be certain leading internal and external factors to detect corporate failure.

Leading internal factors to detect corporate failure would be include both financial and non-financial factors. Such as declining company business, declining profitability, decreasing market share and sales volume after being adjusted for

inflation), increased in gearing, decreasd in liquidity position, poor dividend policy payouts, frequent changes in top management, failure to react quickly to market changes, lack of planning and poor strategic management.

Leading external factors to detect corporate failure would include adverse changes to the external environmental factors such as PESTEL will easily cause a decline to

an industry.

The enforcement of law and customers expectation regarding the ban of the use

materials that contain CFCs and production method that cause the emission of CO2 will hence cause a failure on such traditional industry (e.g. traditional refrigerator manufacturing industry, traditional TV manufacturing industry, etc) that have such criteria.

Companies may become overly confident with their past strategies resulting in the lack of innovation and flexibility to keep up with changes. Miller referred to this as the Icarus Paradox in that companies forget what had made them successful and

this resulted in failure. Miller noted four distortions that lead to corporate failure:

1. Leadership failure – past success and achievements may result in arrogant and over confidence to ignore changing customer requirements.

2. Cultural domination – successful and profitable departments may become intolerable to new ideas leading to lack of innovation and inflexibility.

3. Power games and politics – senior managers and management may become overly concerned with amassing powers and office politics to the demise of the company.

4. Corporate memory – past experiences, processes and cultures may be inadequately applied to new problems leading to corporate failure. In addition to the above, other factors resulting to corporate failure include

unsustainable over expansion, over trading, expansion into diversified and unfamiliar industries, focusing on impractical and costly business ventures as well as failing to satisfy customers and employees.

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MODELS FOR PREDICTING CORPORATE FAILURE

Historical financial statements are used by analyst and management to determine

the health of the company and to decide of additional fundings are required. A

failure of the company to secure additional financing, may it be debt or equity, will

result in bankruptcy.

Gearing ratios

Gearing ratios (Debt / Equity or Debt / Capital Employed) and interest cover (PBIT /

Interest payable) are indicative of the company’s long-term financial difficulties.

Liquidity ratios

Liquidity ratios such as Current ratio (Current Assets / Current Liabilities) and Quick

ratio (Current Asset less Inventories / Current Liabilities) as well as statements of

cash flows are indicative of short-term cash flow position and the ability of the

company to repay it’s suppliers and creditors on a operational basis.

Profitability ratios

Profitability ratios such as Gross Profit margin (GPM), Return on Capital Employed

(ROCE) are useful ratios to understand the company’s performance. Deteriorating

GPM and ROCE indicates potential problems.

Beaver failure ratio

The Beaver failure ratio predicts that 70% of companies with a score of less than

0.3 are likely to fail within five years.

Beaver failure ratio = Operating cash flows

Short & long term debts

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Altman’s Z Score

According to Edward Altman (1968), a company with Z score of:

- less than 1.8 will fail

- between 1.8 and 2.7 is grey area

- more than 2.7 will not fail

Altman’s Z score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where: A – working capital / total assets

B – retained earnings / total assets

C – PBIT / total assets

D – market value of equity / book value of debt

E – revenue / total assets

The above are weightings with C (ROCE or profit utilisation) having the highest

weighting. The Z score has not been widely accepted as it is neither final nor

exclusive. However, it may be developed for specific industries such as banking

industres and accountancy firms for risk assessments and loan grading.

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Argenti’s A Score

The Argenti model is a qualitative model used to predict corporate failure which is based on non-accounting or qualitative variables. The model suggests that there are three connected areas that indicate likely failure: defects, mistakes made and

symptoms of failure. Each of these areas is divided further and an assessor gives scores under each of these headings. A score of more than 25 is considered to indicate that the company

is at risk of failing. The scores in the three areas themselves are also of interest as high scores in mistakes made indicate poor management. Failing companies often score highly, around 60.

The Argenti score has, therefore, attempted to quantify the causes and symptoms associated with failure. Its predictive value has not been adequately tested, but a misclassification rate of 5% has been suggested.

The Argenti’s A score (1976) can be classified into the following:

1. Defects – The Early Indicators

● Management Defects

o Autocratic and dominating Chief Executive Officer (particularly if also

Chairman)

o Passive board of directors

o Lack of strong Financial Director

o Poor management team

● Accounting Defects

o Lack of budgetary control

o No cashflow forecasts

o No costing system

o Poor response to change

2. Mistakes Made - The Subsequent Mistakes

● High gearing (both financial and operational gearing)

● Overtrading

● Failure of a big project

3. Symptoms of Failure – The Immediate Indicators

● Financial indicators forecasting poor results

● Deteriorating ratios

● Poor Z score

● Creative Accounting

● Non-financial signs - high staff turnover, high product returns, declining staff

morale and declining product quality

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Blaina Packaging Co (Dec 2007 Q5 extract) The directors of Blaina Packaging Co (BPC), a well-established manufacturer of cardboard boxes, are currently considering whether to enter the cardboard tube

market. Cardboard tubes are purchased by customers whose products are wound around tubes of various sizes ranging from large tubes on which carpets are wound, to small tubes around which films and paper products are wound. The cardboard

tubes are usually purchased in very large quantities by customers. On average, the cardboard tubes comprise between 1% and 2% of the total cost of the customers’ finished product.

JOL Co was the market leader with a share of 30% three years ago. The managing director of JOL Co stated at a recent meeting of the board of directors that: ‘our loss of market share during the last three years might lead to the end of JOL Co as an organisation and therefore we must address this issue immediately’.

Required:

(b) Discuss the statement of the managing director of JOL Co and discuss six performance indicators, other than decreasing market share, which might indicate that JOL Co might fail as a corporate entity.

(10 marks)

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RM Batteries Co (Dec 2010 Q5)

RM Batteries Co (RMB) is a manufacturer of battery packs. It has expanded rapidly in the last few years under the leadership of its autocratic chairman and chief

executive officer, John Smith. Smith is relentlessly optimistic. He likes to get his own way and demands absolute loyalty from all his colleagues.

The company has developed a major new product over the last three years which has necessitated a large investment in new equipment. Smith has stated that this more efficient battery is critical to the future of the business as the company operates in a sector where customers expect constant innovation from their

suppliers. However, the recent share price performance has caused concern at board level and there has been comment in the financial press about the increased gearing and

the strain that this expansion is putting on the company. The average share price has been $1·56 (2008), $1·67 (2009) and $1·34 (2010). There are 450 million shares in issue.

A relevant Z-score model for the industry sector is: Z = 1·2X1 + 1·4X2 + 3·3X3 + 0·6X4 + X5

Where

X1 is working capital/total assets (WC/TA); X2 is retained earnings reserve/total assets (RE/TA);

X3 is Profit before interest and tax/total assets (PBIT/TA); X4 is market value of equity/total long-term debt (Mve/total long-term debt); and

X5 is Revenue/total assets (Revenue/TA). A score of more than 3 is considered safe and at below 1·8, the company is at risk

of failure in the next two years.

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The company’s recent financial performance is summarised below:

Summary Income Statements

2008 2009 2010 $m $m $m

Revenue 1,460 1,560 1,915 Operating Costs 1,153 1,279 1,724

–––––– –––––– ––––––

Operating profit 307 281 191 Interest 35 74 95

–––––– –––––– –––––– Profit before tax 272 207 96

Tax 87 66 31 –––––– –––––– ––––––

Profit for the period 185 141 65 –––––– –––––– ––––––

Statements of Financial Position 2008 2009 2010

$m $m $m

Assets Non-current assets 1,120 1,778 2,115 Current Assets 235 285 341

–––––– –––––– ––––––

Total Assets 1,355 2,063 2,456 –––––– –––––– ––––––

Equity and Liabilities

Share capital 230 230 230 Retained earnings reserve 204 344 410 Long-term borrowings 465 991 1,261 Current liabilities 456 498 555

–––––– –––––– –––––– Total equity and liabilities 1,355 2,063 2,456

–––––– –––––– ––––––

A junior analyst in the company has correctly prepared a spreadsheet calculating the Z-score as follows:

2008 2009 2010

Share price ($) 1·56 1·67 1·34

No of shares (millions) 450 450 450

Market value of Equity ($M) 702 752 603

x1 WC/TA –0·163 –0·103 –0·087

x2 RE/TA 0·151 0·167 0·167

x3 PBIT/TA 0·227 0·136 0·078

x4 Mve/Total long-term debt 1·510 0·758 0·478

x5 Revenue/TA 1·077 0·756 0·780

Z 2·746 1·770 1·452

Gearing [debt/equity] 107% 173% 197%

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Required:

(a) Discuss the strengths and weaknesses of quantitative and

qualitative models for predicting corporate failure. (6 marks)

(b) Comment on the results in the junior analyst’s spreadsheet. (5 marks)

(c) Identify the qualitative problems that are apparent in the company’s structure and performance and explain why these are relevant to possible failure. (5 marks)

(d) Critically assess the results of your analysis in parts (b) and (c) alongside details of RMB’s recent financial performance and suggest additional data that should be acquired and how it could be used to assess RMB’s financial health. (4 marks)

(20 marks)