Ratios - Exercise
Contents The New Scenario... 3 FaBAssessor the initial position... 5 Your immediate assessment & blank tables... 7 The step by step analysis... 13 Working through a proposal... 19 Correcting the Gross Margin... 20 Introducing a rational stock holding/ purchasing policy... 21 Revising the funding structure... 23 Proposal summary... 26 Postscript... 27 2 P a g e
The New Scenario Ratios trend exercise You receive a new franchisee proposal from The World s Best Bicycles Inc. (WBB). This would supersede the current proposed agreement. You ask Tim (r business adviser) to help analyse the proposal to identify any disadvantageous elements and formulate a reasoned argument for any modifications might wish to negotiate. WBB s proposal clearly quantifies the revenues and costs for an initial five year term. The agreement will be reviewed during the fifth year with a view to extending it for a further five but that is outside the scope of this discussion. The context of the proposal is: 1. That WBB have signed an exclusive arrangement with all cycle clubs in r region and will guarantee a specified quantity of annual sales. In return must agree to provide a dedicated service i.e. not dilute r WBB customer focus by other commercial activity. The effect of this agreement being that r sales will be tied and restricted to the annual sales specified by WBB 2. WBB will provide a loan of 3000 to cover half of the shop fitting cost. The loan will be over 10 years at 10% interest with one payment per year. 3. All transactions between WBB and will be on credit and payments and receivables will be 60 days. WBB have suggested an initial schedule of the metrics from r perspective Figure 1- Projected data for five years Yr1 Yr2 Yr3 Yr4 Yr5 Selling Prices 180 190 200 210 220 Purchase Prices 100 108 116 124 132 Buy pattern 800 900 950 1000 1100 Sales Agreed 700 800 900 1000 1100 Fixed Overheads 42500 45000 50000 55000 60000 Variable Overhead % 10 10 10 10 10 Overheads Paid % 95 95 95 95 95 You to invest 15000 WBB Loan 3000 Principal Repayments 380 415 455 500 550 Interest 600 560 520 475 425 Purchase of Equipment 6000 *Depreciation Rate % 20 20 20 20 20 *Will be on the reducing balance method 3 P a g e
Tim suggests that the first step need to take is to log on to www.fabeducation.com as will be using FaBAssessor to assess the projections. The application is simple to use but Tim advises that to watch the FaBAssessor analysis video before starting to use the application. Once have viewed the video r opening task is to create the initial file on FaBAssessor using the data provided by WBB. Once this is done Tim will give a template to go through the five years projections step by step so can make a decision on the merits of the proposal and prepare a reasoned argument to support any modifications require. 4 P a g e
FaBAssessor the initial position You and Tim agree that the following screen shots from r file in FaBAssessor accurately represent the metrics provided by WBB. Figure 2 - Profit & Loss Accounts and cash flow summary for 5 years 5 P a g e
Figure 3 - Balance Sheet for 5 years Figure 4 - Ratios over the 5 years 6 P a g e
Your immediate assessment & blank tables You immediately notice that the WBB obviously expect to secure additional funding as there are cash deficits in each of the first four years. But Tim advises to: 1. Continue to read the financial statements to identify any obvious issues 2. Systematically review each of the ratios to build a comprehensive analysis and avoid being transfixed by one or two big issues to the exclusion of everything else 3. Develop the analysis into a coherent action plan for negotiation with WBB Tim provides the following set of tables to guide r analysis of the sixteen ratios shown in FaBAssessor. He suggests that work through each of the tables and meet him the following day to review them and formulate r response to WBB. Table 1 - Net Profit to Sales -1% 3% 4% 4% 5% 7 P a g e
Table 2 - Gross Profit to Sales 44% 43% 42% 41% 40% Table 3 - Net Profit to Total Assets -3% 7% 10% 13% 15% Table 4 - Net Profit to Capital Employed -2% 22% 26% 27% 27% 8 P a g e
Table 5 - Overheads to Sales 44% 40% 38% 36% 35% Table 6 - Current Ratio (Times) 1.63 1.5 1.61 1.92 2.36 Table 7 - Quick Ratio 1.1 0.86 0.9 1.16 1.53 9 P a g e
Table 8 - Interest Cover (Times) -1.5 6.93 12.14 18.76 27.49 Table 9 - Stock Days 52 88 93 78 67 Table 10 - Debtor Days 60 60 60 60 60 10 P a g e
Table 11 - Creditor Days 60 60 60 60 60 Table 12 - Debt to Equity 19% 12% 7% 4% 2% Table 13 - Equity to Total Assets 40% 34% 38% 48% 58% 11 P a g e
Table 14 - Sales to Total Assets (Times) 3.55 2.87 2.82 3.03 3.12 Table 15 - Sales to Fixed Assets (Times) 26.25 39.58 58.59 85.44 123.09 Table 16 - Sales to Current assets (Times) 4.1 3.09 2.96 3.15 3.2 12 P a g e
The step by step analysis Table 17 - Net Profit to Sales -1% 3% 4% 4% 5% Gradual improvement Completely driven by volume and the reducing level of overheads relative to sales. Hindered by a declining Gross Margin. Even though the trend is positive the margin is low and will not offer a great return over the five years. Improve Table 18 - Gross Profit to Sales 44% 43% 42% 41% 40% Declining a reduction of about 10% over the five years Only selling or purchase price can influence this ratio so the cause has to be that the rate of increase in purchase price is greater than the rate of increase in selling price. This could be a deal breaker as it undermines the viability of the project. Since WBB have signed the agreement with the customers (cycle clubs) there won t be any leeway on selling price so will have to negotiate purchase prices that protect r 44% gross margin i.e. 100: 106: 112: 118: 123 Table 19 - Net Profit to Total Assets -3% 7% 10% 13% 15% Improving but at a decelerating rate The rate of Net Profit growth is greater than the rate of growth in Total Assets but as all the profits are being retained in the business the build-up of Current Assets is cumulative the ratio will stagnate and even decline. (See the ratios trend for Sales to Current Assets) None! The slowing down in the rate of growth merely indicates a build-up of cash easily remedied by a distribution by way of dividends to. Could indicate an opportunity to explore the funding structure in terms of the amounts of money invest by way of shares and directors loans. You would not be liable for tax when the company pays back any loans provide whereas may be liable for income tax on dividends. 13 P a g e
Table 20 - Net Profit to Capital Employed -2% 22% 26% 27% 27% Improving but at a decelerating rate. As in Table 19. The determinants are Net Profit and Capital Employed which includes retained profits so the ratio is subject to the same distortion as described in Table 19. None! The slowing down in the rate of growth merely indicates a build-up of retained profits easily remedied by a distribution by way of dividends to. Table 21 - Overheads to Sales 44% 40% 38% 36% 35% Declining and therefore positive Sales increasing at a faster rate than overheads None None other than to validate that the projected level of overheads is realistic Table 22 - Current Ratio (Times) 1.63 1.5 1.61 1.92 2.36 Declines in year two indicating a potential liquidity issue but then increases to the point where it is excessive by year five. 14 P a g e This is determined by the items in the current assets and current liabilities and the growth in stocks and cash greatly exceeds the growth in creditors. The liquidity ratios have to be viewed in the context that the company has a negative cash position for the first four years. You need to redesign the funding policy of the business to remove the danger in year two and the bloating in later years. Because r sales levels are preordained cannot use the increased working capital for expansion as would normally be an option for businesses so it will serve no useful purpose in the business. Review the funding plan for the business to cover the dip in liquidity in year two, the negative cash position for the first four years and the buildup of unproductive assets in years four and five
Table 23 - Quick Ratio 1.1 0.86 0.9 1.16 1.53 As for the current ratio. This ratio is designed to highlight a potential issue with liquidity where the cash flow cycle of converting stock to debtors and then debtors to cash could mean that the current ratio would provide a false sense of security where stocks constitute a disproportionate share of the current assets. In this case the issue is the absence of cash rather than excessive stocks so the ratio is not particularly informative. The fact that it is less than 1 would not be unusual and the trend indicates increased cover. The same as described in table 22 As in Table 22 Table 24 - Interest Cover (Times) -1.5 6.93 12.14 18.76 27.49 Positive trend as the impact of interest on profit diminishes significantly over the five years. Increasing net profit and reducing interest amounts None None Table 25 - Stock Days 52 88 93 78 67 Erratic The determinants here are sales and purchases. The purchases are out of alignment with the requirements for sales. The ratio indicates an asymmetrical buying policy and results in unnecessarily high stocks Correct the purchasing pattern to reduce stock levels. A quick test on FaBAssessor shows the following purchasing pattern would be adequate: 786: 812: 912: 1012: 1112 15 P a g e
Table 26 - Debtor Days 60 60 60 60 60 Fixed by agreement Credit sales and days taken by customers to pay. None WBB allow matching credit terms to You None Table 27 - Creditor Days 60 60 60 60 60 Fixed by agreement Credit purchases and days taken to settle with suppliers. None None Table 28 - Debt to Equity 19% 12% 7% 4% 2% Declining and therefore indicative of increasing security and borrowing capacity Long term borrowing against share capital and retained profits (reserves) The business had a low gearing (less debt than equity) from the start and the gearing continued to decline as increasing profits were kept in the business and the loan was progressively repaid. The low gearing but negative cash position indicates that the business funding structure is poorly thought through. Review the funding structure as part of the overall assessment of the project. 16 P a g e
Table 29 - Equity to Total Assets 40% 34% 38% 48% 58% Increasing and indicative of growing independence from external borrowing sources. Increasing owners funds as the source of funding for short and long term assets. As described in table 28 As described in table 28 Table 30 - Sales to Total Assets (Times) 3.55 2.87 2.82 3.03 3.12 Significant drop in year two and three but recovering in years 3 and 4. The year on year growth of total assets exceeds that of sales in years 2 and 3 but this is reversed in years 4 and 5. The disproportionate growth in total assets in year two adds to previous indicators that there is an anomaly in year two requiring investigation. Investigate the disparity between sales growth and asset growth in year two. Table 31 - Sales to Fixed Assets (Times) 26.25 39.58 58.59 85.44 123.09 Increasing and unambiguously positive Growing sales and declining fixed assets due to depreciation and absence of capital expenditure. None other than ensuring that the predicted lifespan of the fixed assets is accurate and that there will be no unplanned capital expenditure None 17 P a g e
Table 32 - Sales to Current assets (Times) 4.1 3.09 2.96 3.15 3.2 Flat u curve Down then up matching the pattern of sales to total assets. The answer to the persistent issue with years 2 and 3 the dramatic year on year increase in stocks (over 100%) and debtors (37%) in year two compared to circa 20% increase in sales. The policy for cash collection (Debtors days) is clear and aligned with the credit terms provided by WBB but the stocks levels may be open to negotiation. The funding demanded by the increase in stocks and debtors in year two could undermine the project. Refer to table 25. The stock levels in year two must be reduced and a coherent stock holding policy agreed. 18 P a g e
Working through a proposal An obvious problem with the proposal is the one noticed immediately i.e. the cash deficit in the first four years. You don t want to approach a bank to borrow the cash (maximum deficit of over 13k in year three) and have an additional 10k that could invest. Before making any decisions about this need to work through the two other significant issues emerging from the analysis: 1. The declining Gross Profit Margin 2. The erratic stock holding/purchasing pattern 19 P a g e
Correcting the Gross Margin You recorded in table 18 that the purchase prices required to maintain the 44% gross margin were: 100: 106: 112: 118: 123 This change delivers the following situation reducing the maximum cash deficit to just over 10k and clearing the problem in year 4. Figure 5 - Revised Profit and cash at 44% GM 20 P a g e
Introducing a rational stock holding/ purchasing policy In table 25 developed a revised purchasing policy and note that this all but eliminates the cash deficit: Figure 6 - Introducing a rational Purchasing Policy 21 P a g e
Figure 7 - Revised Gross Profit and Inventory Patterns The graph clearly shows the success of r action to hold the gross margin but does indicate a better than expected effect on stock days. After further analysis identify why a near 45 day unit closing stock target would lead to an even better figure in the financial ratios. It comes down to the accounting principle of valuing stocks at cost which produces the following valuation schedule: Had the closing stock units for, say, year five been valued at the purchase price prevailing in that year the value of closing stock would have been 16482 and given a ratio based on the values of 45 days i.e. 16482 / 135300 * 365 22 P a g e
Revising the funding structure Ratios trend exercise In table 19 noted the need to take a more flexible approach to the funding of the business and avoiding locking in more cash than was needed. You explore the modified projections in FaBAssessor and come up with a revised funding plan where provide all the capital required. Figure 8 - The Revised Funding Plan This removes the need for WBB to provide a loan strengthening r negotiating position and completes a robust sustainable business model Figure 9 - New Profit and Loss Account 23 P a g e
Figure 10 - New Balance Sheets 24 P a g e
Figure 11 - New ratio Analysis 25 P a g e
Proposal summary Ratios trend exercise 1. Adjust the annual pricing to maintain a 44% gross margin 2. Implement a rational stockholding policy of 45 days leading to the buying schedule of 786: 812: 912: 1021: 1112 3. Eliminate the WBB loan and amend the funding plan as follows: - You provide 1000 by way of share capital - You provide 20000 by way of loan - The loan is repaid on the following schedules o 5000 in year 3 o 10000 in year 4 o 5000 in year 5 - Interest will be paid on the loan as follows; o 1000 in years 1,2 and 3 o 500 in year 4 o 100 in year 5 26 P a g e
Postscript Ratios trend exercise You reached agreement with WBB on all points. You did note minor issues with the new plan e.g. the gearing in year one and the bloated liquidity ratios but the gearing is hardly an issue given that are the provider of the loan and WBB have no issue with using dividend distributions to keep the balance sheet trim and reward for r efforts. You also explored the valuations for the business which looked particularly favourable but exploring that can wait for another day. 27 P a g e