The question required consideration of both the monetary performance and the financial position, from the perception of a potential lender. As with previous questions, candidates were required to identify ratios that would be related to the scenario, correctly calculate them and then form an opinion of the entity's position from a precise perspective.
Recommended Approach
The question was typical of what candidates have seen in preceding diets - reviewing monetary performance and position but within the bounds of a specific situation - in this case a lending application. The candidates should have considered which ratios would have been of interest to an impending lender and focussed on them - ensuring they had adequate coverage for financial performance and position. Staying focussed on the situation was essential - no requirement for further information, or commendation of improvements.
(a) Report to lending department
Re QW - application for $50 million
Review of financial performance and position of QW
Date - 1 March 2013
The annual report highlights a 44% increase in revenue as a result of the entity's expansion, which is indeed the case; however this has been accomplish at the expenditure of profitability. The unpleasant margin has fallen from 29.8% to 27.6%, a drop in the margin of 2.2% in the year, suggesting lower selling prices have been used to be a focus for new customers.
At first glance it appears that on the whole profitability has recovered slightly from the drop in the gross margin, as the profit for the year margin has fallen from 7.5% to 5.9% (a drop in margin of 1.6%). though much of the profit for the year is attributable to the share of profits from the correlate. Excluding the associate's revenue results in the profit for the year margin falling to 4.1%, in general drop of 5.4% in the margin, which is worrying. This significant drop in profit is due mainly to an increase in distribution expenses, which have increased 77% in the period. It looks like the increase has been geographical with either goods been shipped further or new distribution centres being set up. Inventories at the year-end have increased considerably, suggesting it is more likely to be the latter. The additional economics costs have also contributed to inferior profit, with interest on both new long-term borrowings and the introduction of an overdraft in the period.
The revenue on capital employed (excluding the associate) has also fallen, although this could be partially affected by the revaluation in the year. There is no doubt, however that the comments from the CEO are overly positive, as the extension has had a negative impact on the financial performance of the operating business of QW. In addition, receivables have improved, likely to be the extension of credit offered to attract new custom. This is suitable when an entity has the working capital to allow it, but this is not the case for QW.
The gearing has increased considerably from 41.7% to 68.0% resulting from the improved loans and short-term borrowings. This is in spite of a revaluation in the year and gains recorded through reserves which has boosted equity in the period. QW has used up its cash resource and moved to overdraft which is common throughout periods of expansion, however to invest $22 million ($27 million - $5 million of profit during the year) in another entity during this period shown to be rather a naive move by the management, as it is clear the cash is needed for an increasing working capital necessity. A closer relationship with AB may make safe distribution channels or more competitive material costs, which could improve future profitability, although there is no evidence of this so far.
The interest cover would be a apprehension if the loan was granted, as the majority of the cover is produces by the associate, an entity for which we have no monetary details. This creates an additional risk. It is surprising that the entity has not taken the opportunity to produces cash by selling its investments, which are clearly performing well and would therefore be sold relatively easily.
The CEO also stated on future profitability being produces by the investment in non-current assets that take place in the year. However the PPE balance has not increased considerably and much of the movement could be due to the revaluation in the year. The other investments, the associate and AFS investment, could generate gains but not income and activity. The comments by the CEO are not necessarily a balanced show of the performance and position in the year and therefore a level of professional uncertainty is required. The results of this examined questions whether QW is under competent and careful stewardship and as a result the recommendation would be not to proceed with the application.
(b) (i) QW has altered its accounting policy in the year in respect of PPE. The move to revaluation impacts on both monetary position (in terms of gearing) and monetary performance (in terms of ROCE, depreciation and profitability). This results in the two years of monetary information not being directly comparable. In addition, the entity has changed its structure with the introduction of an associate. This influence the comparison of the profitability ratios and asset turnover ratios - as this is a non-current asset that does not generate income.
(ii) The narrative elements are not particularly audited although they should be reliable with what is reported in the monetary statements. The problem is the focus of the comments - QW revenue is up 44% - what is implicit, is that performance and profitability have been adversely affected. The statements can be exactly correct but not necessarily balanced which is naturally designed to draw the readers' attention away from negative features and therefore cannot necessarily be relied ahead.
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Appendix 2012
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2011
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(Workings in $000)
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Gross profit
GP/revenue x 100%
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80/290 x 100 = 27.6%
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60/201 x 100 = 29.8%
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Operating profit
Operating profit/revenue x 100%
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32 (ie: 80-16-32)/290 x 100 = 11.0%
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28 (ie: 60-14-18)/201 x 100 = 13.9%
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Profit for year
PFY/revenue x 100%
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17/290 x 100 = 5.9%
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15/201 x 100 = 7.5%
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PFY without associate
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(17 - 5)/290 x 100 = 4.1%
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Return on capital employed
Profit before finance costs/capital employed x 100% (all exc assoc)
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(32/ (122 +70 + 13 -27) x 100 = 18.0%
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28/(96 + 40) x 100 = 20.6%
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Gearing
Debt/equity
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70+13/122 x 100 = 68.0%
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40/96 x 100 = 41.7%
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Gearing
Debt/debt + equity
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83/(83 + 122) x 100 = 40.5%
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40/(40 + 96) x 100 = 29.4%
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Interest cover
Profit before finance costs and associate/finance costs
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(24 + 13 -5)/13 = 2.5 times
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(21 + 7)/7 = 4.0 times
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Receivables days
Receivables/revenue x 365 days
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49/290 x 365 days =
62 days
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27/201 x 365 days =
49 days
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Inventories days
Inventories/cost of sales x 365
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29/210 x 365 days=
50 days
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13/141 x 365 days =
34 days
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Payables days
Payables/cost of sales x 365
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20/210 x 365 days=
35 days
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15/141 x 365 days=
39 days
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Quick ratio
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78 - 29/33 = 1.5
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45 - 13/15 = 2.1
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