Leisure Outfit Ltd (LOL) - Assignment Example

 Leisure Outfit Ltd (LOL) Introduction Leisure Outfit Ltd (LOL) is a very recent company that is making effort to set its foot in the retail outfit industry and as a result of which the company has undertaken loan and overdrafts from bank along with raising of equity share capital. It was also gathered that the managerial members have also made significant investment thereof. Each director has invested significantly in the company along with the investment by Keeble Estates. The company is currently undergoing a phase of financial difficulty as it has large number of orders to fulfil and it has taken overdraft facilities from bank for meeting cost. The bank currently wants the overdraft amount to be reduced over the tenure of next six months. In this regard, the paper presents a comprehensive analytical report to the board of directors of the company on the financial position of LOL so that the roots to the problem is understood and resolved accordingly. Two problems have been detected so far with respect to the company and these are excessive dependency on over-draft and cash management. It is expected that this situation will affect firm’s short term and long term solvency as well. Considering this factors, the ratio analysis was considered appropriate for evaluating financial position and profitability of the company. The cash position of the company will also be compared between both the years so as to understand where the firm has been investing most of its cash. Ratio analysis Liquidity assessment The liquidity assessment is best conducted with the help of current ratio and acid test ratio. The current ratio points towards proportionate financial relationship between current assets and current liabilities. The current assets of LOL has improved from £4356, 000 to £9974, 000 which can be considered healthy but deeper analysis suggest sharp decline in cash position of the company. In addition, inventory has also increased significantly over the year. The ratio has shrunk from 1.76 to 1.13 indicating illiquidity. The other reasons for the decline were determined to be high overdraft that the company received from the bank and almost doubled trade payable. Considering other factors being justifiable, the issue related with sharp decline in cash require significant attention of the management (Penman 1-35). In addition to that, the acid test ratio revealed that the ratio has declined from 0.78:1 to 0.47:1 which is again another concerning area. The main reason was determined to be high amount of stocked inventory. Inventory is illiquid and therefore is not considered in acid test ratio as it represents immediate liquid position of the company. Based on this assessment, it can be suggested that the firm is not undertaking appropriate inventory management policy (Penman 1-35; Davies and Crawford 39-48). Solvency assessment The solvency of LOL has been critically examined by means of debt to equity ratio and debt service ratio, which is otherwise referred as interest coverage ratio. The debt to equity ratio has amplified from 0.52 to 0.73 between the two discussed accounting periods reflecting substantial increase in debt compared to equity. Increase in debt accentuates future obligations of a company and thereby affects its profit. However, it is wrong to generalise that high levered firms have instable capital structure. If a firm can meet the debt related expenses in a convenient manner then its capital structure is not a matter of concern. In this respect, the interest coverage ratio was determined to be fairly healthy as it has increased from 4.86 to 5.06 (Ryan 21-29; Davies and Crawford 39-48). The interest coverage ratio plays an important role in determining leverage position of LOL because if the business concern earns sufficient profit to cover the interest expenses then it can be suggested that it does not have a volatile capital structure. The interest coverage ratio of the company was observed to have improved suggesting that the operating profit has increased considerably when compared to the increase in the interest expenses of LOL. Overall, it can be agreed that the long term capital structure of the company is stable and it is earning sufficient profit to cover the non-operational expense such as interest charges (Davies and Crawford 39-48). Activity and asset utilisation assessment Activity and asset utilisation implies the efficiency with which resources are being utilised by the firm to earn maximum profitability and sales. Activity assessment indicates towards ability of the company to collaborate its activities in such a manner that no resource or asset remains idle at any point of time. The asset management and efficiency of activities at LOL has been measured by determining total asset turnover ratio, working capital turnover ratio and inventory turnover ratio (Campbell, Jardine and McGlynn 15-25). The asset turnover ratio is mainly calculated to understand the degree to which all assets are being utilised appropriately for generating revenue. The asset turnover ratio of LOL has taken in consideration both current and fixed assets of the company. The total asset turnover of the company has declined from 108 percent to 91 percent suggesting slowdown in activities. However, 108 percent indicates overutilization of resources; which may cause early breakdown and depreciation in the long run. Therefore, the latter value can be considered acceptable for the company (White et al. 25-29). LOL was observed to have invested approximately £5870, 000 last year for acquiring additional non-current assets. Considering the size of the fund, it becomes imperative to evaluate role of fixed asset of the company in revenue generation. The ratio reveals that there is a drop of 8% from the previous year despite new asset purchase. It entails that certain parts of the fixed assets are remaining idle and are not being utilised appropriately (Campbell, Jardine and McGlynn 15-25). The working capital of the company was determined to have reduced marginally. However, the turnover ratio indicates substantial improvement considering moderate growth in revenue. It can be gathered from this assessment that the working capital utilisation has improved significantly and the same is reflected in the sales turnover. Since revenue is affected by different number of costs and factors, therefore it can only be agreed partially that the firm is managing its working capital efficiently. Declining working capital can affect the company’s daily transactions and consequently, it is recommended that the firm should make effort to improve the same (Davies and Crawford 39-48). Inventory management is an essential aspect of working capital management and it was gathered from the financial data of LOL that last year the company had high level of stocked inventory. Inventory management is considered efficient if the stocked inventory is excessive. As balanced inventory level helps in minimising the cost thereof. The efficiency of inventory management has been assessed by means of inventory turnover ratio and it was determined to have declined from 5.79 to 3.85. The declining ratio suggests that the company is unable to convert its inventory into revenue appropriately resulting to high cost of inventory handling and warehousing. Another reason for high inventory can be inability on the part of operations department to determine the optimum quantity required (Penman 1-35; Davies and Crawford 39-48). Profitability analysis Profitability can be analysed in terms of capital as well as in terms of sales. Profitability of the business concern has been evaluated using operating and net profit margins, return on total asset, return on capital employed and return on equity. The operating profit margin is presumed as an indicator of firm’s operational efficiency. At LOL, it was observed that the operating efficiency of the company has improved by 6 percent. This development suggests that the operating costs have been moderately optimised by the company. Similar trend was noticed in the net profit margin of the company where the margin has improved by 5 percent over the previous year (White et al. 25-29). The net profit is determined after deducting all direct and indirect costs (operating and non-operating costs) and it was observed that among non-operating costs, tax for the last year compared to the last-to-last year was almost double. Therefore, it can be concluded that the net profit of the firm has declined to some extent because of certain uncontrollable costs (Cullen 25-38). Return on total asset has been calculated to determine if the firm is maximising its resource usage for profit generation. The ratio has improved from 16 percent to 19 percent but this cannot be considered as an optimum utilisation of assets. Instead, it can be suggested that the assets are being underutilised at LOL (White et al. 25-29). The return on equity and that on capital employed has improved fairly indicating that the firm is making appropriate utilisation of the available fund and investors will be benefited by investing in the firm. Additionally, it was also observed that a significant amount of revenue is distributed by the firm as dividend and the same has increased from £600,000 to £800,000 reflecting efficient dividend policy (Davies and Crawford 39-48). Problem assessment and detailed action plan Based on the assessment, it was determined that the company is facing short term financial instability due to inefficient inventory management, cash management and large amount of overdraft. Another issue that was identified during the assessment is that inappropriate utilisation of available assets and heavy investment in fixed assets. It was perceived that significant amount of fund of the company is blocked with accumulated inventory and in fixed assets, majority of which are not being utilised. Besides the overdraft issue, the firm need to take significant action for improving its short term financial position. For this purpose, the firm must optimise its cost by determining relevant and irrelevant costs. Also, it should minimise its inventory level and produce optimally after detailed consultation with its distributors. If the bank remains adamant at reduction of overdraft by half in next six months then by the end of the sixth month, the company will have to pay £2125, 000; the amount stands at approximately £355, 000 per month. Three way-outs were determined for rescuing the firm from this emergent situation and these ways are: The firm can pay-off the bank by using its reserve of retained earnings. It is understandable that retained earnings are set aside for future expansion but clearing bank payments is also essential for retaining firm’s creditworthiness. The second alternative is selling of idle assets that are presently being not used by the firm. The company can also sell less frequently used machineries and alternatively, can opt for hire purchase of machineries. The returns of LOL are very strong and this can be utilised by the firm for raising additional capital from potential investors. It is expected that potential investors will be interested in the company after assessing its growth and return rates. Views regarding bank’s decision The bank’s decision regarding major reduction in the overdraft facility of the company cannot be supported in the light of the growth phase that LOL is presently going through. The company is slowly recovering from the impact of economic downturn and also it has been approached by Arena with a large ordering amount. At this situation, the firm requires significant amount of cash in hand which can be availed by means of the overdraft. It was also gathered that the cash position of the company has declined between the last two accounting periods, possibly because of investment in additional plants (Diamond and Verrecchia 1325-1359). The bank should have been more considerate in their approach considering the company’s growth phase and healthy returns. The solvency ratios of the firm are adequate and the profitability ratios indicate that the company is using the aggregate capital in an appropriate manner. Therefore, technically the bank cannot claim that the firm is under the threat of insolvency. The only issue that the firm is facing currently is immediate liquidity situation. The company is moderately illiquid because of accumulated inventory which can be resolve with better inventory and cash management. Banks are heavily responsible for supporting growing sectors and business organisations by providing them adequate financial support. In context of LOL, it was gathered that the bank management is more concerned about securing their fund. They are not interested in the fact that if the company pays off the overdraft amount even by half within six months then it will not be able to meet the new production requirements. Based on the overall assessment, therefore, it can be concluded that the bank should have been more considerate regarding the payment of overdraft as the financial position of the company is relatively stable and consistently improving (Saunders, Cornett and McGraw 35-47). Works Cited Campbell, John D., Andrew KS Jardine and Joel McGlynn, eds. Asset management excellence: optimizing equipment life-cycle decisions. Florida: CRC Press, 2011. Print. Cullen, Rowena. Does performance measurement improve organisational effectiveness? A post-modern analysis. Northumbria: Northumbria international conference on performance measurement in libraries and information services, 1998. Print. Davies, Tony and Ian Crawford. Business accounting and finance. New York: Pearson, 2011. Print. Diamond, Douglas W. and Robert E. Verrecchia. "Disclosure, liquidity, and the cost of capital." The journal of Finance 46.4 (1991): 1325-1359. Print. Penman, Stephen. Financial statement analysis and security valuation. New York: McGraw-Hill, 2007. Print. Ryan, Bob. Finance and accounting for business. Connecticut: South-Western/ Cengage Learning, 2008. Print. Saunders, Anthony, Marcia Millon Cornett and Patricia Anne McGraw. Financial institutions management: A risk management approach. New York: McGraw-Hill/Irwin, 2006. Print. White, Gerald., et al. The analysis and use of financial statements. New Jersey: Wiley, 2003. Print. Appendix Table 1 (Source: Author’s creation) Read More