Jools Furniture Industries Limited - Essay Example

?Finance Management Table of Contents Introduction 3 Analysis of business position 3 Profitability- 3 Efficiency- 4 Liquidity- 6 Solvency- 7 Suggestions for improvement- 8 Evaluation of the role of financial director 10 Findings of the audit and remedial measures- 14 Financing of investment proposal 16 Benefits of debt- 16 Disadvantages of debt- 16 Benefits of equity capital- 17 Disadvantages of equity capital- 17 Benefits and disadvantages of Retained Earnings- 17 Conclusion 18 Bibliography 21 Introduction Jools Furniture Industries Ltd is the holding company of four divisions Quality Products, Bedrooms, Kitchens and Office supplies, with each division being established as a registered limited company. Each of the division has considerable authority in all commercial and financing decisions. The only exception is that long term debt requires the approval and financing of the holding company. Analysis of business position Profitability- An important indicator of the financial health and management efficiency of the business is ‘profitability’. A rising profitability is a good business feature whereas a falling profitability is a bad one. The net profit margin shows the profit that a business is able to generate after meeting the various expenses and costs (Gitman, 2007, p.32). For the four divisions of Jools Furniture Industries Ltd this margin reflects mixed signals. In the case of Quality products division the net profit margin has improved over the last three years. In 2007 the profit margin of this division was -9.90%. In the next year the management of the division was able to cut down on the unnecessary expenditures pushing the profit margin in the positive territory. This further improved to 3.36% in 2009. For the Kitchen and Office division the net profit margin reveals a declining trend. The fall in the profit margin has been steeper in the case of Kitchen division with the net profit margin dropping by nearly 1.50% from 4.97% in 2007 to 3.51% in 2009. Bedrooms division reported more or less stable profit margin over the period. The figure was 2.48% in 2007, which increased to 3.27% in the next year after which it declined marginally to 3.22% in 2009. In terms of wealth creation all the divisions have reported positive ROI for the investors. The ROI generated by all the divisions has been more than 10% for the last two years. Quality products division reported the highest ROI for the year 2009 at 18.99%. The division reported a negative ROI of 14.9% in 2007. Kitchen division reported a ROI of 12.75% in 2009. This figure was higher in 2007 at 17.97% and it dropped to 12.87% in the following year which is a fall of nearly 5%. Despite an increase in the turnover of the division the divisional management failed to sustain the profitability margin of the previous year. Bedroom division generated the second highest ROI for 2009 at 14.63%. The return generated by this division was even better in the previous years at 16.62% and 18.18% for 2007 and 2008 respectively. Office division reported the third highest ROI of the company at 13.48%. Even for this division the return generated has dropped as compared to the last few years. Efficiency- The asset turnover ratio is an important indicator of management efficiency. A high ratio implies that the company management has been able to utilise the asset base efficiently i.e. it has been able to generate more sales (Nelson, 2008, p.370). For Kitchen division this ratio has remained over two for the last three years. In 2007 this ratio was 2.14 and it increased to 2.19 in 2009. This shows that the management of this division has used the available asset base judiciously and efficiently. With the rise in the asset base in 2008 the management reported a higher turnover i.e. the division made optimal utilisation of the available resources. In the case of Office division this ratio has improved steadily over the last three years. It increased from 1.68 in 2007 to 2.10 in 2009 which is quite impressive. This suggests that the divisional managers are continually thriving towards making the best use of the available resources. The bedroom division reported a fall in the asset utilisation ratio over the last three years and for Quality products division this ratio is merely close to ‘one’. It implies that there is ample scope for this division to raise its turnover figures. Inventory turnover ratio is also important indicator management efficiency. A high ratio implies low unsold stock and faster conversion of work-in-progress into sales and vice versa (Booker, 2006, p.2-26). This is highest in the case of Office division. For 2009 this division reported the inventory turnover ratio at 9.18 which is the highest among all the operating divisions of the company. Moreover this ratio has steadily increased over the years. It is a good sign as it means that the divisional managers do not have to maintain large volumes of unsold inventories. This helps in saving the costs associated with warehousing and storage. The cost savings help in raising the profit margin as well, as is reflected in the case of Office division. The division reported the highest profitability margin for the year 2009. The Office division is followed by Kitchen division. This division reported its inventory turnover ratio at 5.14 for 2009. It was higher in the previous years. As already said the cost saved on storage of unsold stock has improved the net profit margin of the division with Kitchen division reporting the second highest profit margin for 2009. For Quality products and Bedroom divisions this ratio is more or less similar. The former reported the inventory turnover at 3.21 for 2009. Bedroom division comes close at 3.11. Debtors’ days’ is also another indicator of management efficiency. A short collection period implies good selection of debtors. The office division reported the shortest collection period at 18 days for 209. This means that the division scrutinises the credit history of the debtor before extending credit. This is good as a faster realisation means that the funds do not remain blocked for long periods thereby saving the borrowing costs. Moreover a careful selection of debtors also helps in avoiding any probable losses arsing on account of bad debts. Followed by Office division is the Kitchen division with the second best collection period. This division reported an average collection period of 37 days for 2009. The average number of days has risen as compared to the previous year which is suggestive of a liberalised credit policy. A liberal credit policy helps in raising the volume of sales. However the management must be cautious between ‘liberal and ‘lax’ as the latter may result in unrealised sales. Quality product division reported the collection period at 27 days in 2008 however this increased substantially to 42 days in 2009. This may be one of the strategies of the division to improve the sales and profit figures. The results turned out to be favourable as evident from the rise in ROI during the period. Bedroom division reported the highest average collection period of 61 days in 2009. Liquidity- The liquidity position of a business can be assessed by computing the current ratio. This ratio reflects the liquidity strength of the company i.e. it reflects the ability of a company to take care of short term business obligations. For all the divisions of Jools Furniture this ratio has remained more than ‘one’. Ideally this ratio should be ‘two’ as reported by Kitchen division at 2.02 for the year 2009. The management of the division has steadily worked towards improving its liquidity position as reflected from the rise in the current ratio figures over the last three years. This implies that the management has sufficient back-up to take care of any unforeseen liquidity needs. Office division reported current ratio at 1.49 for 2009. This seems to be satisfactory but there is enough room for improvement in this regard. Next to this division is Quality product division with a current ratio of 1.33. Even though the management of the division has succeeded in improving it over the last two years it is not at par with the other divisions. Bedroom division also reported a current ratio of 1.27 for 2009. Though this has improved over the years there is enough room for improvement. However, the liquidity position of none of the divisions is less than ‘one’ and the steady improvement in the current ratio of all the divisions suggest reasonable liquidity strength for the company as a whole. Solvency- The gearing position of a company determines the financial solvency of the company. High level of gearing is not in the financial interest of the company and can lead to insolvency. The amount of borrowed funds is highest in the case of Quality product division. For 2007 the division reported a borrowing percentage of 53.98%. It has remained more or less the same over the last two years. There has been a marginal decline to 52.33% in 2009. This is above the 50% mark specified by the holding company and can lead to intervention in the financing decisions of the division. For the other divisions- Kitchen division and Office division this is much below the specified level. Kitchen division reported a gearing percentage of 10.29% for 2009. This division has increased its long term debt over the years. However the rise in the borrowings is accompanied by a rise in the shareholders’ funds thus keeping the gearing ratio within permissible levels. On the Office division has reduced its gearing percentage over the last few years. The percentage was 9.87% in 2007 and the management scaled this down to 7% in 2009. The division has steadily reduced its long term debt over the years. Bedroom division has not employed long term debt in its capital base. The interest coverage ratio measures the financial strength of a company in bearing the interest obligations (Finnerty, 2007, p.138). The high level of gearing of Quality product division has lowered its debt repayment capacity as evident from the interest coverage ratio of 2.11. This can be interpreted as the earnings generated by the company are enough to pay-odd twice the interest expenses. In the event of an excessive increase in debt the division stands the risk of unpaid debt obligation. This may lead to failure (Lasher, 2007, p.311). For Kitchen division and Office division the high interest coverage ratio of 10.48 and 135 respectively for the year 2009 imply that earnings generated by them are enough to take care of any financial uncertainty. The Quality product division and Office division are also engaged in export of furniture. Exports form a significant proportion of the total turnover of Quality product division at 36.6%. Previously the export percentage was even higher. Of the total turnover of ? 6,219,070 for Office division exports account for merely 5.31%. Suggestions for improvement- The profitability margin and ROI figures for 2009 has been positive for all the divisions. However for two of the divisions- Bedroom and Kitchen- the profitability has declined as compared to the previous years. Therefore the management of these divisions must try to exercise control over the administrative and operating expenses in order to retain the profitability margin of the previous years. Quality products division has raised its profitability over the years but the division is not able to utilise its asset base efficiently as reflected from the asset turnover ratio. Therefore, the divisional manager must try to improve its asset utilisation i.e. generate higher turnover on the available resources. The inventory turnover of Quality Product and Bedroom division is nearly three. This means that the two divisions high levels of unsold stock. The managers of these divisions must try to reduce the inventory level as this will also help in lowering the unnecessary costs relating to storage, facilitating a rise in the profitability margins. The average collection period is approximately 61 days for Bedroom division which is very high. Efforts must be made to bring down the average collection period as this will help the division in lowering the borrowings costs thereby raising the divisional profitability. The debt proportion of Quality product division is very high as reflected from the high gearing percentage of more than fifty. The management must try to reduce the long term debt component in the capital base as excessive amount of debt can exert pressure on the earnings of the company. It has often been seen that highly leverage companies are not able to make use of growth opportunities as they are overburdened by debt repayment obligations. The risk of high debt levels is also reflected in the high interest coverage ratio of this division. Only a fall in long term debt will help in lowering finance costs thereby strengthening the earnings generating potential of the division. Evaluation of the role of financial director David Strength, the finance director of the company, is known for his reliability and solidity. He has successfully managed the financing strategy for the expansion of the products. The present gearing limit of 50% for all the divisions is fairly reasonable. This is an important move to keep the debt within acceptable limits. As per Coleman and Cohn (2001) high levels of debt can lead to insolvency of small companies (Olawale, 2010). This may be one of the reasons for the capital structure policy of the company. As per the laid down requirements all the divisions except Quality Products division have a gearing of less than 50%. For Quality Products the gearing is a little more at 52.33%. The main reason for the inclusion of debt in the capital base is that the cost of debt funding is cheaper as compared to equity. This is on account of a lower risk and the benefit of an interest tax shield (Agar, 2005, p.178). The use of debt lowers the overall cost of capital for the firm and helps in generating a higher return on equity capital as compared to a no debt firm. However the use of debt must be contained within certain levels as excessive leverage can be a financial risk for the company. Keeping in line with this principle the financing policy of the company looks satisfactory. The finance director has made the policy such that the divisions can employ the ideal level of debt i.e. they can enjoy the benefits of debt funding without getting overexposed. Only in the case of Quality product division the debt level is higher than the required level. For the Bedroom division the long term debt is nil and even for Office division the debt level is minimal. Therefore the management can try to raise the debt level of these two divisions as incorporating some amount of debt will lower the funding cost. This will help in raising the earnings position of the company thereby raising the profitability margins generated by the respective division for the shareholders. The company also offers an incentive to the divisional managers if the ROI of the division is more than the target ROI of 10%. This will motivate the divisions to put in their best efforts towards divisional management which will ultimately be in the interest of the overall company. It will help in improving the performance of the various divisions. Moreover, the presence of monetary incentives in the form of managerial bonus encourages the managers to exercise better control over the unnecessary expenditures. The finance head needs to be stricter with the operational efficiency. The profitability margin of most of the divisions has dropped as compared to the previous years. Although the divisions have reported a positive net profit margin for the year 2009 the margin has declined over the last few years. It is important that the management of the company works towards improving the same as a further drop can lead to financial troubles. In this respect the management must try to reduce to ‘cost to sales’ amount. Any excessive administrative and overhead costs must be checked. There have been instances where despite the increase in turnover the profitability margin of the divisions has dropped. This is not a good sign as a rise in turnover must be accompanied by a proportionate rise in the profitability margin. Any lapse on this part indicates inefficient cost management. Therefore the finance department can plan the expenses in advance i.e. budgets must be drawn and later on the actual figures must be compared with the planned estimates. In the event of any unfavourable deviation corrective action must be initiated. Like, if the rise in expenses is on account of the Sales department then the manager of this department must be held accountable for it. This will make the various departments responsible for the costs incurred by them. Once the management is able to identify the reason it can take appropriate action. The concerned department in-charge can be guided in ways of cost reduction measures. As all the departments work in this direction the excessive costs can be curtailed and this will help in maintaining an uptrend in profitability. The other areas that require management attention is improvement of turnover ratios. The turnover ratio of Kitchen and Office division is at acceptable levels. However the turnover ratio of other divisions is not very convincing. The asset turnover ratio of Quality Products divisions is merely one. Despite a high asset base the turnover generated by this division is not satisfactory. The asset allocation of the Quality Products division is the highest among all the other divisions. For 2009 the total assets of the division was ?5444269. This is almost double as compared to the Office division and Kitchen division. On a lower asset base these two divisions reported an asset turnover of more than two whereas Quality product reported an asset turnover of just ‘one’ despite the high asset allocation of this division. This shows that the other divisions are generating a higher turnover on a much lesser resources as compared to Quality product division. From this it is clear that this division must generate a higher turnover on the available resources. However, the dismal asset turnover ratio over the last two years is an important management concern. Therefore efforts must be made to raise the divisional turnover. Based on the available assets the turnover of the Quality product division must also be high. For Bedroom division most of the assets are the same as 12 years back. This means that the division has not invested in new assets. It may be one of the reasons for the falling turnover of this division over the last few years. In 2007 the turnover reported by this division was ?6761300 and this dropped to ?5869000 in 2009. It is possible that the division may perform better if it invests in better and advanced equipments. The inventory turnover of the Quality product division and Bedroom division is also not very satisfactory. For 2009 the two divisions reported an inventory turnover ratio of nearly three. This is another area where the management needs to focus. The finance department of the company must look into this matter. It seems that the inventory level of the two divisions is high. This may be due to high amount of unsold stock. This is a dual edged sword if the inventory level is very high then the company has to bear additional costs relating to storage and warehousing whereas if the inventory level is low then there may arise the risk of unmet demand. Therefore it is important that the divisional managers maintain an ideal level of inventory. It seems that the current stock level of the two divisions is high which has raised the expenses of the divisions and lowered the profitability margin. By keeping the stock at reasonable levels the divisions will be able to improve their profitability margins. Another area that deserves the attention is the high average collection period of the Bedroom division. Initiatives must be taken to reduce the number of days as a faster sales realisation will lower the interest outflow on the borrowed funds. Except for the Bedroom division the average collection period of the other divisions is within acceptable levels. This has affected the profitability of this division as well, as the net profit margin of Bedroom division is the lowest among all the divisions. By lowering the collection period, reducing inventory levels and introducing advanced equipments the division will be able to overcome the profitability and turnover issues. Findings of the audit and remedial measures- The audit of the various divisions has revealed a number of shortcomings. The performance appraisal system of the head office is considered to be a barrier by the divisions in the achievement of objectives. So the head office must make certain revisions in the system to align it with the business objectives. In this regard care must be taken to ensure that the set benchmarks are neither overestimated nor underestimated. Both over and underestimation may detract the employees in the achievement of the goals. If the standards set are difficult to achieve then the workers will feel demoralised, whereas, if there is laxity in the standards then the goals may not be realised. Hence the management must work towards establishing realistic and achievable standards (Gopalakrishnan & Banerji, 2004, p.92). On the achievement of a pre-set standard the divisional employees must be rewarded in the form of monetary and non-monetary incentives. Already the head office allows bonus to the divisional manager if the ROI of the division is above the target level. However care must be taken to ensure that the divisional managers do not become complacent in their efforts. This is reflected in the ROI pattern of some of the divisions which has remained above the mark of 10% but has declined over the last few years. So care must be taken in this regard. The finance director has announced policies to encourage and motivate the divisional employees but these must be regularly revised. There have also been instances of stock misappropriation in the case of some divisions. For Office division the actual stock record does not match with the physical count of the stock. This has highlighted the disappearance of the chairs and desks in the Office division. In fact such instances have been seen in the other divisions also with the only difference being that the value of such discrepancy is less in the case of other divisions. This calls for strict regulation of the stock position of all the divisions. Loss of stock can result in losses to the business. Therefore the head office must set up a team that can take the charge of stock-in-hand. Though it is not possible to verify the stocks on a daily basis but a careful watch must be kept over the movement of stocks. The team set up for the purpose must be given sufficient authority so as to put a check to the stock frauds. The payment of salaries to the retired employees of the Bedroom division shows that the register of the division has not been updated. This is a serious issue and highlights the careless attitude of the management. This raises the overall expenses of the division and lowers the divisional profitability. It is important that such regulatory lapses are strictly dealt with. In order to survive, a business must keep a tight control over its cash outflows. Other than this the receivables of the Bedroom division is nearly 5 months old. This signifies lax credit policy. Delay in realisation from the debtors raises the risk of bad debts and defaults. It is important that the division makes its credit policy sound. There have also been some quality issues in one of the product of the company. Despite the risk that the adjustable chairs pose to the users the management has not done anything to sort out the quality issue. In such situation the management must have withdrawn the chairs from the market as an injury to a senior citizen can tarnish the market image of the company. Without considering the immediate losses the management must try and think of the long term. If a company is able to build its image then it will win the loyalty of the customers. Overall it can be said that the finance director of the company has designed significant strategies to keep a check on leverage and improve the ROI position. But it is important that the strategies are made more dynamic so that it can bring out the best in all divisions. In terms of management there have been some lapses at the divisional level. This calls for more control over the various operating divisions. Financing of investment proposal For financing the expansionary plans the Kitchen division is looking for a loan of ?1.8 million. Presently the gearing percentage of this division is 10.29%. This is within the 50% mark of the head-office. So the use of more loans in the capital base is an option that is worth considering for the divisional manager. This is because of the various benefits of debt funding. Benefits of debt- The cost of debt funding is cheaper than equity. This is the main reason that the managers want to incorporate more debt in the capital base. Moreover the interest payment on debt is a tax deductible expense thereby saving the tax outflow of the company. The issue of debt does not dilute the ownership of the company as the debt holders are the ‘creditors’ of the business and not its ‘owners’. Disadvantages of debt- Despite the above mentioned benefits the company management must maintain its debt at optimal levels as too much of leverage can be a systemic risk for the company and increases the chance of failure (Kolb, 2010, p.73).In the case of Kitchen division the existing gearing is 10% but with the incorporation of a loan of ? 1.8 million the gearing is expected to reach 54% i.e. above the benchmark set by the head-office. This can exert serious pressure on the earnings of the division. It has often been seen that too much of debt in the capital base can overburden the company with debt repayment obligations and thwarts the growth and development (Brigham & Gapenski, 1994, p.80). Alternative sources of finance- Equity capital and Retained Earnings are the other two sources of funding that can be used in place of loans. Both have their own set of merits and demerits. Benefits of equity capital- One of the main advantages of equity financing is that it does not give rise to any contractual obligations. On the equity capital the company pays dividend only if there is a surplus profit. Disadvantages of equity capital- A major limitation of equity financing is that it is very expensive. Moreover issue of excessive equity dilutes the ownership of the company. Various business projects get delayed or are not taken up in the absence f majority shareholders approval (Seidman, 2005, p.26). Benefits and disadvantages of Retained Earnings- The retained earnings or the earnings ploughed back by the company into the business form an important source of funding expansionary plans. It does not entail any financing costs as it represents the funds of the business. The Pecking order theory emphasises on the use of retained earnings before resorting other means of financing. In fact this theory considers equity as the last resort of financing (Fatoki & Odeyemi, 2010). However, this form of earnings does not come for free and the company must generate a higher return on the amount generated in the business to convince the investors. Moreover if the company retains a significant portion of the business earnings and does not declare any dividends the investors may fell dissatisfied. The Kitchen division can employ a mix of retained earnings and debt as this will enable it to enjoy the low cost of debt funding without burdening its financials unnecessarily. The use of earnings ploughed back in the business does not involve any cost and will help the division to keep the debt within permissible levels. Conclusion The financial position of a business can be evaluated from the Income Statement and Balance Sheet of a company. A falling profitability margin is not a good feature and it signifies that the company management is not able to exercise control over the operating expenses. For most of the divisions of Jools Furniture this margin has dropped as compared to the previous years. This can be controlled by improving management efficiency. The divisional managers must try to raise the turnover ratios in the case of Quality product and Bedroom divisions. For the other divisions these ratios are quite reasonable. Other than this the leverage position of Quality Product division is also quite high and requires due consideration. Excessive leverage can be detrimental for the financial health of the division. High amount of borrowings can come in the way of the business growth opportunities. Therefore, the Quality division requires a revision of its capital structure i.e. the division must try to incorporate more of equity in its capital base. 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