Powell Travel Taking Off or Crashing - Case Study Example

Powell Travel Ltd Taking off or Crashing The hints at our initial findings on Powell Travel Ltd., a business that specialises in providing winter sports holidays and summer outdoor activity holidays. There are four tasks required in relation to Powell's business activity from October 2006 to March 2007. We assume no taxes are paid, since no mention was made of taxes, so all our findings for net profits are "before tax" figures. Task 1: Cash Forecast, Profit and Loss, and Balance Sheet The Cash Forecast for the business can be summarised from Table 1 as follows: Summary from Table 1 POWELL TRAVEL LTD. CASH FLOW (Oct 2006 to Mar 2007) Cash Levels Oct Nov Dec Jan Feb Mar Beginning 30,000 (280,000) (430,000) (540,000) (250,000) (100,000) Cash In 30,000 90,000 360,000 1,170,000 810,000 540,000 Cash Out (340,000) (240,000) (470,000) (880,000) (660,000) (480,000) End (280,000) (430,000) (540,000) (250,000) (100,000) (40,000) Powell will be short of cash every month and in the amount of 40,000 by March 2007. This means that its business activity during the period would not generate enough cash to pay for all the forecast expenses, in the expected amounts and on the desired schedules. For example, it would not have enough cash to pay creditors the 180,000 due in October, to pay the salaries of staff on time until perhaps January 2007 when a cash inflow of over 1 million is expected, and even to pay its promotional expenses. Note from Table 1 that the 42,000 depreciation, since it is not a cash transaction, is not included in the cash forecast as an outflow from the business during the period. The beginning cash balance includes the 30,000 in cash on 30 September 2006. The beginning and end balances reflect the cash balances at the start and end of the month. From the forecast, we see that the business will be short of cash, but as we see in the Profit and Loss Report, this does not necessarily mean that it is not profitable. The Profit and Loss Report for Powell can be summarised from Table 2 as follows: Summary from Table 2 Profit and Loss for the period Oct '06 to Mar '07 Total Sales 3,000,000 Cost of Sales incl. Overhead (2,810,000) Gross Profit Margin: 190,000 6.3% Interest & Depreciation (52,000) Net Profit before Tax: 138,000 4.6% If the cash forecast showed a negative amount, how could there be a net profit at the end of the period The answer is that the Profit and Loss (P&L) Report captures the business activity during the period, which is profitable (note the gross and net profit margins of 6.3 and 4.6 percent respectively). The cost of sales includes payments for activities required to generate the sale, to which we add agents' commissions, direct (flight and hotel) and variable costs, administrative overhead, and penalties if booking target volumes of 10,000 holidays are not reached. Two cash transactions are not in the P&L because they refer to past business activities (like paying a 180,000 loan in October 2006 and the 20,000 principal for a previous loan by March 2007) or investments (fixed asset investment of 50,000 in March 2007) that will generate returns over the coming years. Loan repayments and investments in fixed assets are balance sheet transactions and not included in the P&L. The Balance Sheet as in Table 3 before adjustments on 31 March 2007 is as follows: Summary from Table 3 BALANCE SHEET 31-Mar-07 30-Sep-06 Fixed Assets 568,000 560,000 Current Assets (40,000) 30,000 Trade Creditors 0 (180,000) Loans (90,000) (110,000) Total net assets: 438,000 300,000 Share capital 100,000 100,000 Reserves 200,000 200,000 Profit and Loss 138,000 Total shareholders funds: 438,000 300,000 The balance sheet includes figures from Tables 1 and 2 and shows where profits during the 6-month period were used. The negative cash flow of 40,000 from our cash forecast is included as current assets column. This overdraft can be booked as advances from owners that need adjustments (as a current liability or additional equity). We have also added the net profit before tax of 138,000 from the P&L to total shareholders funds to balance the business profits that increased the company's net assets. The profits were used to pay current liabilities and part of the long-term loan principal, and to fund a fixed asset purchase. Main Financial Problems of Powell Ltd Based on the cash forecast, the profit and loss, and the balance sheet, we can identify some financial problems of Powell Ltd by calculating financial ratios used by businesses in evaluating financial performance (Brealey and Myers, 2002; Pike and Neale, 2003). FINANCIAL RATIOS Current ratio 0.17 Liquid interval ratio, in months 0.07 Gross Profit Margin 6.3% Net Profit Margin 4.6% Gearing Ratio 1.1 1. Lack of liquidity: a business must have enough cash (liquid) to pay its obligations. Powell cannot pay creditors in October and salaries (administrative expenses) until December 2006. The current ratio, current assets over current liabilities, measures liquidity. A current ratio above 1.0 means the company has cash to pay for amounts due within the year. Powell's current ratio is 0.17, which is too low and is therefore not good. As we have seen from the cash forecast, it is short of cash to pay its obligations right in the first month. 2. Poor cash flow management: Cash management can ease the situation by postponing payments to creditors and payments for promotional expenses until 2007. There will also be no cash for the business (working capital) by end-March 2007 unless additional funds are invested or part of the reserves is used (selling ownership to others to raise cash). The Liquid Interval Ratio, the number of months average cash flow can sustain average operating expenses, predicts this cash flow problem. We calculated it by dividing the average cash inflow by the average cash outflow. The result of 0.07 (months) means that Powell generates enough cash to fund 2 days of expenses. This is extremely tight, more so because it gets a downpayment of only 10 percent of the selling price (that the agent gets as commission) and gets paid 60 days after the booking at least, while almost all of its expenses are in cash. A business should have enough cash that would allow it to operate for at least a month or even more (Yardeni, 1978, p. 550). 3. Low profitability: Powell's profit margins (the ratio of profits over sales) are rather low, with a gross profit margin of 6.3 percent and net profit margin of 4.6 percent. We can compare (Shapiro, 2003, p. 475-478) the gross profit margin of other similar companies (in percentages): Leisure and Hotels (9.6), Retailing (11.4), Discount Airlines (27.5), travel agencies (61), and Accounting Software (89.5). Powell's 6.3 percent figure is slightly higher than that of the capital-intensive international airlines industry (5.6 percent). A similar story is Powell's low net profit margin in an industry where 16 percent is the standard. 4. High gearing ratio: Gearing is the relationship between long-term liabilities and the capital (shareholders' funds) employed. This relationship ought to be in balance, with shareholders' funds being significantly larger than long-term liabilities. Powell's gearing ratio of 1.1 means it has as much debt as shareholder capital. A company like Powell that earns in cash and spends cash as soon as it is earned would be better with a gearing ratio below 1 (Pike and Neale, 2003, p. 226). 5. Poor pricing policies and low target volumes: Powell could have a problem with pricing (too low) and volume (too little). Perhaps, the problem of Powell Travel Ltd goes beyond the financial measures and concerns its business model. It can increase prices, aim for higher returns, cut down costs, and make promotions (high at 45 per holiday) more cost-effective in generating sales. Task 2: Project Evaluation The second task requires the evaluation of two projects, 1 and 2, based on estimated profits. Table 4 shows our calculations that we can summarise as follows: Summary from Table 4 PROJECT EVALUATION Criteria Proj 1 Proj 2 Payback Period (years) 2 2 Accounting Rate of Return 49% 46% Net Present Value, in 687,700 656,480 Based on Payback Period, both projects are equally attractive. However, Project 1 has a higher accounting rate of return and net present value compared to Project 2. This means that Project 1 give higher returns on the 1 million investment. Accounting Rate of Return gives us the return in percent on the annual book value of the asset that will be depreciated on a straight-line basis over the life of the project. The net present value (NPV) shows the value today of the stream of cash flow from the project given the company's (Powell Travel Ltd) 12 percent cost of capital. The NPV is the sum of the discounted annual cash flows (net profits plus depreciation). The discounted cash flow is calculated by multiplying the value of the cash flow by the given discount factors. Note that we added the amount of 250,000 in depreciation to the given data on net profits (revenues less expenses and depreciation) since the calculation of accounting rates of return and NPV considers the cash available (revenues less expenses) without taking depreciation into consideration. The NPVs to the nearest 1 are also indicated in the summary above. Our recommendation, therefore, is for Powell Travel Ltd to go ahead with Project 1. Task 3: Analysis of Powell Travel Ltd's Business Options We now consider the options available to Powell Travel Ltd using different sets of assumptions. Table 5 presents to us our answers that we summarise as follows: Summary from Table 5 SCENARIO ANALYSIS Scenarios Parameters Answers A Break even point 9,576 Margin of Safety 4% B1 Selling price at 200,000 profit (gross) 302 B2 Selling price at 200,000 profit (net) 307 C1 Volume for ROCE of 15% (Investorwords) 9,714 C2 Volume for ROCE of 15% (DTI) 9,604 D Price up 10% and Variable cost up 15% 274% Net profit before tax 378,000 These scenarios give us different views about the business capability of Powell Travel Ltd and give the management several options to make the business more profitable and avoid the problems revealed by the cash forecast, P&L, and the balance sheet. The Break-even Point of 9,576 holidays booked and paid represents the volume of trips sold that will give a zero net profit after tax. The Margin of Safety of 4 percent means that Powell Travel Ltd must meet 96 percent of its sales volume target of 10,000 holidays during the period. Otherwise, the business will just break even where total income equals total expenses including depreciation. The 50 percent penalty for not hitting the target in flights and hotel bookings has been included in our computations. We investigated two scenarios for the selling price of a holiday that will give a profit of 200,000 because there are two profits we can consider, gross or net. Scenario B1 forecasts gross profit - the income after deducting the cost of sales including overhead and promotions - to reach 200,000 at a selling price of 302. Scenario B2 forecasts net profit - income after deducting interest and depreciation from gross profit - to reach 200,000 at a selling price of 307. We assume the same volume of 10,000 holidays sold. Scenario C determines the number of holidays needed to give an annual return on capital employed (ROCE) of 15 percent. ROCE is the ratio of the profit before interest and tax divided by the capital employed (CE), which has many definitions (BizEd, 2006). One (Investorwords, 2006) defines CE as the fixed and current assets less current liabilities, while the DTI defines CE as the total net assets. These definitions give us two targets: 9,714 at a CE of 410,000 (Scenario C1) and 9,604 at a CE of 300,000 (Scenario C2). Scenario D asks for the effects of a 10 percent price increase and a 15 percent variable cost increase. The result is that net profits before tax will rise by 274 percent (!) to 378,000 which will give Powell a gross profit margin of 13 percent and a net profit margin of 11.5 percent, almost double and triple the previous values, but still below standard. If Powell can adjust the price and cut down on costs, or even make some of its expenses like promotions more cost-effective (at least lower than 45 per head), they can earn higher margins. Task 4: How Powell can raise Money We now discuss how Powell can raise 1 million for a major expansion project. There are basically two ways - equity or debt - to finance a business investment. Equity involves an investment by the owners of cash and tangible or intangible assets to be used in the business. The ownership share of each investor will depend on how much of the equity is contributed by each one. There are many possible sources of equity, among which the more common ones are personal savings, home loans, listing in the stock market, government fund assistance to small businesses, or venture capital. Several businesses start with the personal savings of the owners who wager everything they have on the chance that the business succeeds. When it does not, the investor loses everything. Others take out a loan on their home and invest the cash in the business as equity, even if the money is actually a debt owed to a bank. Listing on the stock exchange is a good way to get cash from several investors, but only established companies can do this successfully since investors and government regulators usually investigate the history of the business and the capability of its management. For most new businesses, this is not a viable option. Venture capitalists are investors who love to take risks, but they charge high "fees" from the business owners. Venture capitalists have good financial sources and can help management, so the chances of success are higher, but high fees also make this the last option for several business owners. The other option is debt, borrowing money from the bank or others. Unlike equity where the share in the business profits depends on the share in ownership (e.g., an investor who owns 20 percent of the business expects 20 percent of the profits, if there are any), lenders do not own part of the company and only expect to be paid the face value of the debt plus the interest payments due. Say a bank or any other institution or individual lends Powell Travel 1 million at 5 percent for five years, the bank expects to recover the 1 million principal and 50,000 annually in interest payments until the end of the five years. In contrast, a 20 percent equity investor would get 20 percent of all profits from Powell Travel until the company either closes down or the investor sells his or her share in the business. As a rule, the term (number of years to pay) of the loan should be at least as long as the time it takes the investment to yield profits (get a four-year loan for a four-year project). Therefore, equity is risky for the investor who can lose everything, but is more rewarding if the business does well. Debt is less risky for the lender but not as rewarding. Powell can also combine debt (that may be convertible to equity) and equity. The final decision depends on how good the business is and how much risk Powell's owners can take. Reference List BizEd (2006) Return on capital employed. biz/ed website. Retrieved 27 May 2006, from: http://www.bized.ac.uk/compfact/ratios/ror3.htm Brealey, R.A. and Myers, S.C. (2002) Principles of corporate finance (7th ed.). New York: McGraw Hill. Investorwords (2006) Return on capital employed, a definition. Investorwords.com website. Retrieved 27 May 2006, from: http://www.investorwords.com/5770/Return_on_Capital_Employed.html Pike, R. and Neale, B. (2003) Corporate finance and investment: decisions and strategies (4th ed.). New York: Prentice Hall. Read, C. and Kaufman, S. (Eds.) (1997) CFO: Architect of the corporation's future, by the Price Waterhouse Financial & Cost Management Team. New York: Wiley & Sons. Shapiro, A. (2003) Multinational financial management (7th ed.). New York: Prentice Hall. Yardeni, E. E. (1978) A portfolio-balance model of corporate working capital. Journal of Finance, 33 (2), p. 535-552. Table 1. Cash Flow Forecast for Powell Travel Ltd. (Oct 2006 to Mar 2007) POWELL TRAVEL LTD. CASH FLOW (Oct 2006 to Mar 2007) Cash Flow, in Oct Nov Dec Jan Feb Mar Downpayment 30,000 90,000 90,000 90,000 Agents (30,000) (90,000) (90,000) (90,000) Balance 270,000 1,080,000 810,000 540,000 F&H (150,000) (600,000) (450,000) (300,000) Variable Cost (20,000) (80,000) (60,000) (40,000) Promotions (100,000) (150,000) (150,000) (50,000) Admin Cost (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) Depreciation 0 Interest (10,000) Principal (20,000) Creditors (180,000) Fixed Assets (50,000) Month Bal. (310,000) (150,000) (110,000) 290,000 150,000 60,000 Cash Begin. 30,000 Cash end-mo (280,000) (430,000) (540,000) (250,000) (100,000) (40,000) Table 2. Profit and Loss Statement (Oct 2006 to Mar 2007) POWELL TRAVEL PROFIT AND LOSS For the period Oct '06 to Mar '07 Income Total Sales 3,000,000 Cost of Sales (2,810,000) Flight & Hotel (1,500,000) Agents Commissions (300,000) Variable (200,000) Administrative (360,000) Promotions (450,000) Gross Profit: 190,000 6.3% Int/Tax/Dep/Amort (52,000) Interest (10,000) Depreciation (42,000) Net Profit before tax: 138,000 4.6% Table 3. Adjusted Balance Sheet as of 31 March 2007 POWELL TRAVEL LTD. BALANCE SHEET for the period ending 31-Mar-07 Changes 30-Sep-06 Fixed Assets 568,000 8,000 560,000 [a] Current Assets -- Cash (40,000) 30,000 [b] Total current assets: (40,000) 30,000 Trade creditors 0 (180,000) 180,000 [c] Net current assets: (40,000) (150,000) Loans (90,000) 20,000 (110,000) [d] Total net assets: 438,000 300,000 [f] Share capital 100,000 100,000 [e] Reserves 200,000 200,000 Profit and Loss 138,000 138,000 Total shareholders funds: 438,000 300,000 [f] Notes to the balance sheet: [a] Fixed assets went up by 50,000 but depreciation cost was 42,000. [b] The minus 40,000 balance from the cash flow statement shows lack of liquidity. [c] Trade creditors were fully paid during the period. [d] Principal payment of 20,000 in March 2007 brings down total loans to 90,000. [e] Share capital and reserves are assumed not to be touched. [f] Total net assets balances total shareholders funds. Table 4. Comparison of Two Projects PROJECT EVALUATION All amounts in Data: Year 0 Year1 Year 2 Year 3 Year 4 Profits Project 1 (1,000,000) 220,000 420,000 370,000 210,000 Project 2 (1,000,000) 270,000 470,000 270,000 140,000 Cash Flow = Profits + Depreciation Project 1 (1,000,000) 470,000 670,000 620,000 460,000 Project 2 (1,000,000) 520,000 720,000 520,000 390,000 Payback Payback Project 1 (1,000,000) (530,000) 140,000 760,000 1,220,000 2 years Project 2 (1,000,000) (480,000) 240,000 760,000 1,150,000 2 years Accounting Rate of Return Net Book Income Return Book Value 1,000,000 750,000 500,000 250,000 0 2,500,000 Project 1 220,000 420,000 370,000 210,000 1,220,000 Yearly Ret. 22% 56% 74% 84% 49% Project 2 270,000 470,000 270,000 140,000 1,150,000 Yearly Ret. 27% 63% 54% 56% 46% Net Present Value NPV Rates 0.893 0.797 0.712 0.636 Project 1 (1,000,000) 419,710 533,990 441,440 292,560 687,700 Project 2 (1,000,000) 464,360 573,840 370,240 248,040 656,480 Table 5. Scenario Analysis POWELL TRAVEL LTD. FINANCIAL SCENARIOS Scenarios: Base Case A B1 B2 C2 C3 D Data 200 208,000 201,000 15.0% 15.0% 274% Volume 10,000 9,576 10,000 10,000 9,554 9,604 10,000 Price 300 300 302 307 300 300 330 Downpayment 10% 10% 10% 10% 10% 10% 10% Agents Comm. 10% 10% 10% 10% 10% 10% 10% Balance 90% 90% 90% 90% 90% 90% 90% Flight & Hotel 150 150 150 150 150 150 150 Variable Cost 20 20 20 20 20 20 23 Promotions 450,000 450,000 450,000 450,000 450,000 450,000 450,000 Admin Cost 402,000 402,000 402,000 402,000 402,000 402,000 402,000 Depreciation 42,000 42,000 42,000 42,000 42,000 42,000 42,000 Net Admin 360,000 360,000 360,000 360,000 360,000 360,000 360,000 Loan interest 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Loan principal 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Creditors due 180,000 180,000 180,000 180,000 180,000 180,000 180,000 Fixed Assets 50,000 50,000 50,000 50,000 50,000 50,000 50,000 Penalty 50% 50% 50% 50% 50% 50% 50% Capital Employed 300,000 410,000 Income Gross Sales 3,000,000 2,872,800 3,020,000 3,070,000 2,866,200 2,881,200 3,300,000 Cost of Sales (2,810,000) (2,820,600) (2,812,000) (2,817,000) (2,821,150) (2,819,900) (2,870,000) Flight & Hotel (1,500,000) (1,436,400) (1,500,000) (1,500,000) (1,433,100) (1,440,600) (1,500,000) Agents Comm. (300,000) (287,280) (302,000) (307,000) (286,620) (288,120) (330,000) Variable (200,000) (191,520) (200,000) (200,000) (191,080) (192,080) (230,000) Administrative (360,000) (360,000) (360,000) (360,000) (360,000) (360,000) (360,000) Promotions (450,000) (450,000) (450,000) (450,000) (450,000) (450,000) (450,000) Penalties 0 (95,400) 0 0 (100,350) (89,100) 0 Gross Profit: 190,000 52,200 208,000 253,000 45,050 61,300 430,000 Margin %: 6.3% 1.8% 6.9% 8.2% 1.6% 2.1% 13.0% Interest & Dep. (52,000) (52,000) (52,000) (52,000) (52,000) (52,000) (52,000) Interest (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) Depreciation (42,000) (42,000) (42,000) (42,000) (42,000) (42,000) (42,000) Net Profit: 138,000 200 156,000 201,000 (6,950) 9,300 378,000 Profit Margin %: 4.6% 0.0% 5.2% 6.5% -0.2% 0.3% 11.5% Safety Margin 4.2% ROCE 15.0% 15.0% Brief Description of Scenarios: [A] Break-even point and margin of safety [B] Selling price for gross profits (and net profits) of 200,000 [C] Return on Capital Employed (2 definitions of Capital Employed) [D] Effect on profits from price and variable cost increases Read More