Accounting and Decision Making
CASE STUDY INFORMATION
Dyed in the Wool Limited
Dyed in the Wool Limited (“DITW”) is a long established UK company making specialist fire retardant and waterproof textiles for industrial, defence and commercial markets.
The CEO is Jim Riley, who took over from his father when he retired 30 years ago. Jim and his family own all the shares in DITW.
In recent years Jim has been worried about DITW’s core market. Defence sales are declining due to cutbacks in the armed forces, and new entrants to the market are offering stronger technological solutions for proofing fabrics. To counter the effect of this decline, two years ago Jim decided to diversify DITW’s activities, investing in a new subsidiary company, HomeSpun Limited. HomeSpun is run by Mr Riley’s nephew, and sells furniture and home textiles to retail customers from three stores in the local area.
Jim’s background is in industrial manufacturing, and whilst he has no formal retail or accounting training, he is astute when it comes to gross margins, selling prices and manufacturing costs. DITW has a history of profitability over the years and pays out substantial annual dividends to the family shareholders, but until recently cash was also retained in the company for reinvestment in equipment and production facilities. The main manufacturing site, which was acquired by Mr Riley’s father over 50 years ago, is a former WWII munitions factory with 5 acres of land and buildings with plenty of space for expansion.
However, starting up the new retail subsidiary has seen cash flow out of DITW to fund start-up losses on lease costs, staffing, advertising and buying stock for the shops. Traditionally DITW was not the best at chasing its receivables and now with the additional pressure of HomeSpun’s cash requirements, DITW has been forced to use an overdraft for the first time. In fact, the company recently asked its bank for a third increase to the overdraft limit at £900,000, trebling the original request for facilities. The bank has notified DITW that it will not approve any further amounts beyond this latest agreement and has asked for copies of DITW’s financial statements for the year ending 31 December 2012 as soon as possible.
An interim accountant was recruited 6 weeks ago at the request of the company’s bankers. The new accountant has started to analyse HomeSpun’s management accounts. He is concerned about the lack of cash compared to the profits being reported. He wants to run some stock takes in the stores against the cost of stock reported in the management accounts as well as review the “buy now pay later” policies being offered to customers on large items in the shops.
In spite of the cash difficulties, Mr Riley is pleased with DITW’s investment in the new retail venture and is determined to continue expanding. HomeSpun has a very visible local presence, and local government and press have given it significant positive coverage about job creation and local enterprise development. He wants to continue with the roll-out of new store openings and is considering investing £1m in a joint venture (“JV”) manufacturing opportunity with Pratash Furniture & Textiles in Mumbai. This JV would manufacture a range of products already sold in HomeSpun’s shops, and supply directly to HomeSpun at a lower cost than buying from existing third party suppliers – Jim Riley says it will “cut out the middleman” and improve gross profit margins.
Approximately 30% of HomeSpun’s annual sales could be supplied from the JV entity.
DITW’s Board, led by Jim Riley, has some decisions to make. The company cannot secure further overdraft funding from the bank, yet HomeSpun continues to be cash consumptive and tax and dividends in DITW are due for payment in the next three months. In addition, DITW will need to raise further funding if the expansion plans (new stores and JV opportunity) take place. Financing options under discussion include:
• OPTION 1. Seek third party investor or venture capitalist to provide £1.5m new share capital to fund the £1m investment into the JV, payment of the 2012 dividend and any immediate cash requirements in HomeSpun (forecast at £54k cash outflow for Year 3). The overdraft would continue in place under this scenario.
• OPTION 2. Approach the bank to convert the £910k overdraft into a £2m long term loan at 8% annual interest, secured on land and buildings. This would pay for the £1m investment into the JV with a small amount of surplus to fund the forecast cash outflows for HomeSpun in Year 3 at £54k.
• OPTION 3. Walk away from the JV and slowly repay the overdraft by improving working capital management and withdrawing dividend payments for the next few years (Jim Riley has already flagged up that his family shareholders will not countenance this option willingly).
The accountant has distributed an email ahead of a Board meeting as follows:
Agenda for Board meeting
1. Completion and presentation of DITW’s year end financial statements.
2. Analysis of HomeSpun’s performance against budget since launch.
3. Review of operating cash cycle and cash outflows in DITW and HomeSpun.
4. Evaluation of trading and investment implications of the JV opportunity.
5. Options for raising further funds for the business.
Relevant financial information (see Appendices 1-5) has been prepared ahead of the Board meeting and distributed to all Board members.
DITW draft Financial Statements
The draft Income Statement and Statement of Financial Position for DITW for the years ending 31 December 2012 and 2011 are reproduced below. These are in draft format pending the outcome of discussions at the Board meeting.
Income Statement for the year ended 31 December 2012:
Cost of goods sold – labour
Cost of goods sold – material purchases (13,942)
Gross profit 3,903 4,414
Distribution costs (354) (398)
Sales and marketing costs (517) (495)
Administrative costs (623) (596)
Profit before interest and taxation
Profit before taxation 727 1,333
Profit / (Loss) after taxation 505 926
Retained profit 80 176
Statement of Financial Position as at 31 December 2012:
Land and buildings 3,000 800
Plant and Equipment 1,953 2,358
Inventory 2,709 2,654
Trade receivables 2,056 1,909
Investment in HomeSpun Limited 1,451 651
Cash 9 278
Trade payables (2,699) (2,851)
Taxation payable (222) (407)
Bank overdraft (910) 0
Dividends payable (425) (750)
Net assets 6,922 4,642
Called up ordinary share capital 300 300
Revaluation reserve 2,200 0
Retained earnings 4,422 4,342
• The carrying value of land and buildings has been increased to £3 million at 31 December 2012. This figure is based on an offer of £2.5million from a property developer (which Jim felt substantially undervalued the premises) earlier in the year. Since then the property market has slowed down a little but it was suggested that the balance sheet would look stronger by increasing the valuation attaching to the land and buildings, in the context of potentially raising money for the business.
• The depreciation charge in 2012 was £317,000. A piece of equipment which was carried in the books at a cost of £520,000 less accumulated depreciation of £388,000 was sold during the year at £100,000, resulting in a loss on sale. Both depreciation charges and any loss on sale are included in “factory overheads”. The new accountant has noticed that DITW often seems to sell equipment at a loss, although Jim Riley feels the company’s depreciation policies are adequate.
• DITW owns 100% of the shares in HomeSpun Limited. DITW contributed a lump sum to start the business, and has since been topping this up with further sums as required. There is no formal loan in place, so the investment has been shown in current assets.
• One of DITW’s customers has been disputing invoices raised on a long-term contract to supply materials. As at 31 December 2012 the total outstanding balance to this customer shown in receivables was £219,750. Jim Riley is confident that this sum will be recovered in full, but £137,000 relates to amounts due over 90 days and there are rumours in the industry that the customer may have financial difficulties. No provision has been made in the accounts against any part of this receivable. Inventory includes approximately £105,000 of materials specific to this customer, which are not sold to any other customer.
• There is also some confusion over a particular batch of pre-invoiced sales. DITW raised invoices for £52,000 on 30 December 2012 for goods which were still in stock at 31 December and would only be sent to the customer in early January 2013. The invoices were shown within revenue for 2012, and an additional £52,000 shown in receivables, plus a reduction in stock value of £44,200 which matches the entry in cost of sales. The accountant wants to reverse this transaction because the stock had not been physically delivered to the customer by 31 December 2012. However, he is meeting resistance from Mr Riley, who says the only reason the stock had not been sent was due to the Christmas holiday period and that in the light of the potential fund raising, the company should be putting “its best foot forward”.
• Interest is paid as soon as charged. Both tax and dividends due are normally paid within 3 months of year end to clear the full amount outstanding.
• Regarding presentation of the financial statements, the new accountant has explained that DITW is no longer exempt from preparing consolidated accounts and that the financial statements will need to be prepared on a consolidated basis prior to external publication.
• Finally, DITW launched a successful patent protection case against a competitor during 2011. The legal outcome concluded in favour of DITW and the competitor was required to pay damages of £30,000 which have been netted off administration costs (i.e. reducing the administration costs shown) for 2012. DITW’s legal costs on the case were £27,000, which were shown within administration costs in 2011.
HomeSpun: Original budget and latest forecasts
A business plan was produced by HomeSpun’s management to support the original request for finance from DITW. The launch date for the business was 1 January 2011. The original profit and cash budgets from the business plan are shown below:
HomeSpun started trading on 1 January 2011. The sales, costs, profit, working capital balances and cash flows for the first two years of trading are shown below. All cash deficits to date – £651,000 in 2011 and £800,000 in 2012 – have been subsidised using further investment from DITW. HomeSpun’s management has used the actual results for 2011 and 2012 to develop a revised set of forecasts for the business for 2013 – 2015 as follows:
Analysis of product costings for joint venture deal
Pratash Furniture & Textiles has identified three products, A, B and C, which are believed to represent an average cross-section of the overall range that the JV entity could produce for HomeSpun. Pratash has produced cost estimates for each of A, B and C which are shown below. Ex-factory (India) costs are shown in UK £ at current exchange rates, and the possibility of exchange rate movements impacting the financial data has not yet been taken into account.
Product A B C
Direct material cost 1.30 2.05 0.67
Direct labour cost 0.80 1.20 1.12
Variable overhead per unit 0.30 0.88 0.75
Fixed overhead per unit 2.05 3.56 2.98
Total cost ex-factory (India) 4.45 7.69 5.52
Estimated transport & duty to UK
Estimated cost landed in UK 6.01 10.38 7.45
The accountant at DITW has produced the following comparison table showing the potential uplift in gross margin from sourcing the products via the JV compared to the current situation is shown as follows:
Product A B C
Selling price 19.99 24.99 22.99
Purchase price landed in UK from present distributor 9.86 13.55 12.25
Gross profit per unit 10.13 11.44 10.74
Selling price 19.99 24.99 22.99
Landed cost from JV entity 6.01 10.38 7.45
Gross profit per unit 13.98 14.61 15.54
Taking the average product cost on the sample of three JV-sourced products and comparing this with the average cost on those same products as currently purchased indicates a significant potential uplift in gross margins might be available under the JV scenario.
If the JV went ahead on 1 January 2013, these new product costs could improve gross margins on 30% of HomeSpun’s revenue for Years 3 to 5 of the forecasts.
Basic financial ratios
Revenue growth (%) = Revenue (yr 1) – Revenue (yr0)x 100
Revenue (yr 0)
Return on capital employed (%) = Profit before interest and taxationx 100
Equity plus Liabilities
Return on investment Profit before interest and taxation x 100
Gross profit margin (%) = Gross profit x 100
Net profit margin (%) = Profit before interest and taxation x 100
Inventory days = Inventory (year end) x 365
Cost of goods sold
Receivables days = Trade receivables x 365
Payables days = Trade payables x 365
Purchases (Cost of goods sold)
Current ratio = Current assets
Acid test or Quick ratio = Current assets less inventory
Debt/equity ratio (%) = Total debtx 100
Capital gearing ratio (%) = Total debt x 100
Total equity + Total debt
Interest cover (times) = Profit before interest and taxation
Dividend per share (pence) = Total dividends approved x 100
Number of ordinary shares
Appendix 5 – Present value table
As part of a business report which communicates the financial information, issues and potential solutions available to DITW ahead of the difficult decisions it must make, you are required to discuss and critically evaluate the following questions. You should use appropriate accounting and financial techniques to support your conclusions and recommendations.
1. Identify and critically discuss at least FOUR areas of subjective judgement in DITW’s financial statements for 2012. As part of your discussion, you should highlight any changes that you would recommend to ensure that the final statements are in accordance with the IASB’s Conceptual Framework and present a “true and fair” view as required by the Companies Act 2006 and GAAP.
2. Prepare the Statement of Cash Flows for DITW for 2012. Use only the financial statements and related accounting information provided by DITW in the original case study.
3. Critically evaluate HomeSpun’s performance against its original budget to date, highlighting possible reasons for the variances between budgeted and actual results. You should focus on HomeSpun’s sales, costs, profit and return on investment in your answer, and may use relevant financial ratios and variance analysis techniques to support your evaluation.
4. Calculate the operating cash cycles for each of DITW and HomeSpun in 2012. Using this information as well as the Statement of Cash Flows that you prepared in Q2, explain why DITW and Homespun are facing cash flow problems and recommend solutions for the Board which might improvecash generation in both arms of the business.
5. Differentiate between (i) absorption costing and (ii) marginal costing, discussing the reasons why DITW and Pratash Furniture & Textiles might have chosen absorption costing for the cost estimates shown in Appendix 3.
6. Critically evaluate the JV opportunity with Pratash Furniture & Textiles using an appropriate investment appraisal technique. You may assume that the JV starts on 1 January 2013 and runs until 31 December 2015, and that DITW’s cost of capital is 10%. Ignore the impact of tax. Your answer should recommend whether the proposed investment should proceed, supported by discussion of at leastTHREE other factors that the Board should take into account in their final appraisal of the investment opportunity.
7. Critically discuss the three options available to DITW for raising further funds for the business. Your analysis should highlight the effect on DITW’s liquidity, capital structure and financial risk from Options 1 (raising equity) and 2 (raising debt). You may base your calculations on the financial statements for DITW given in Appendix 1, making relevant adjustments as appropriate to each scenario.
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