Low Fell Engineering Ltd - Assignment Example

Low Fell Engineering Ltd Task We will examine the profitability of Low Fell Engineering in the light of the information obtained from their Income statement and balance sheets. The ratios themselves do not provide us a way to properly analyze the company itself. For instance, a return on equity of 2 % might look miserable but it can be a decent figure if we know that all other companies in the industry have suffered from huge losses due to a faltering economy. Therefore it is important to compare these ratios with those of competitors or industry standards. Let us examine the profitability of Low Fell Engineering using different ratios and compare them with the ratios of similar businesses. Gross Margin = Gross profit / Sales Valves: Gross Margin (2009) = 1,475,960/ 3,069,750 = 48.08% Gross Margin (2010) = 1,620,400 / 3,375,820 = 48% Industry Standard = 50% The company is performing satisfactorily with regards to gross margin of valves. Although it is slightly lower than the industry but it is not an issue of great concern for the organization. Pumps: Gross Margin (2009) = 1,582,600 / 2,728,620 = 58% Gross Margin (2010) = 1,603,970 / 2,864,240 = 56% Industry Standard = 60% In this product category, the industry has outperformed the company and has been able to generate a better gross profit margin. Pipe-work: Gross Margin (2009) = 928,360 / 1,450,570 = 64% Gross Margin (2010) = 959,670 / 1,547,850 = 62% Industry Standard = 65% The company has a close gross profit margin in pipe-work segment with respect to industry but yet it is lower than the industry. Net profit before interest and tax to sales = Net profit before interest and tax / Sales Net profit before interest and tax to sales (2009) = 659,650 / 7,248,940 = 9.1% Net profit before interest and tax to sales (2010) = 629,700 / 7,787,910 = 8.09% Industry Standard = 9.5% The company’s performance is not matching the industry standards and its net profit before interest and tax to sales has decreased from year 2009 which is not a promising sign for the company. Net profit before interest and tax to capital employed = Net profit before interest and tax / Average Capital Employed Net profit before interest and tax to capital employed (2010) = 629,700 / (5,875,460 + 6,022,180) / 2 Net profit before interest and tax to capital employed (2010) = 629,700 / 5,948,820 = 10.59% Industry Standard = 8.0% We have only taken equity as a capital because interest has yet not been accounted in the net profit figure. The company has outperformed the industry with respect to return on equity as it might be operating efficiently as compared to other companies. Labor cost to sales = Labor Cost / Sales Labor cost to sales (2009) = 1,480,100 / 7,248,940 = 20.42% Labor cost to sales (2010) = 1,554,580 / 7,787,910 = 19.96% Industry Standard = 18% The proportion of labor costs are much higher for Low fell engineering as it might have a workforce which is more productive or experienced. Overhead cost to sales = Overhead Cost / Sales Overhead cost to sales (2009) = 402,810 / 7,248,940 = 5.56% Overhead cost to sales (2010) = 432,470 / 7,787,910 = 5.55% Industry Standard = 42% This is the figure which has a profound impact on the return on equity of the company and proves how why Low Fell Engineering is efficient as compared to the other companies. Current Ratio = Current Assets / Current Liabilities Current Ratio (2009) = 5,887,480 / 646,020 = 9.11 times Current Ratio (2010) = 6,337,720 / 689,540 = 9.19 times Industry Standard = 9 times The current ratio measures a company’s ability to pay short term obligations of its creditors when they are due. Low Fell Engineering has a slightly better current ratio than the company thus it gives a good impression to the investors who are willing to invest in the stock of the company. Acid Test Ratio = Current Assets - Inventory / Current Liabilities Acid Test Ratio (2009) = 5,887,480 – 634,480 / 646,020 = 8.13 times Acid Test Ratio (2010) = 6,337,720 – 628,480 / 689,540 = 8.28 times Industry Standard = 8 times The acid test ratio is similar to current ratio but it does not incorporate the Cost of inventory or stocks since it considers them to be the least liquid. The acid test ration of Low Fell Engineering is also better than the industry standards signifying that they have a strong ability to meet their short term dues. Stock turnover = Cost of Sales / Average Inventory Stock turnover (2010) = 3,603,870 / (628,480 + 634,480) / 2 Stock turnover (2010) = 3,603,870 / 631,480 = 5.71 times Industry Standard = 12 times The stock turnover of the company is below the benchmark level and it has not been able to turn over its inventory as well as other companies which can be an overwhelming concern since it can increase the cost of inventory. Areas of Concern: The company needs to be concerned about their low stock turnover which is increasing their cost of inventory and thus reducing their gross profit margin. To improve the turnover, they need to optimize their supply chain, make the production process lean and build strong relationship with the suppliers or vendors. A good supplier enables to deliver stock in a timely and low cost manner which can minimize the cost of sales (Bierley, 2008). Task 2 1) Purchasing the machinery for cash Cash = £100,000 Scrap Value at the end of the use = £10,000 Period of use = 5 years Cost of Capital = 10% Cost of the machinery today = 100,000 – 10,000 / (1+.10)5 Cost of the machinery today = 100,000 – 6,209.21 Cost of the machinery today = £93,790.79 2) Purchase under a hire purchase contract, involving an initial deposit and two annual payments Initial Deposit = £40,000 Annual Payments = £40,000 at the end of 1st and 2nd year. Scrap Cost at the end of the use = £10,000 Period of use = 5 years Cost of Capital = 10% Cost of the machinery today = 40,000 + 40,000 / (1+.10)1 + 40,000 / (1+.10)2– 10,000 / (1+.10)5 Cost of the machinery today = 40,000 + 36,363.364 + 33,057.85– 6,209.21 Cost of the machinery today = £103,212 3a) Leasing machinery, five annual hire charge (In case of a finance lease) Payments due at end of each year = £25,000 Scrap Cost at the end of the use = £10,000 Period of use = 5 years Cost of Capital = 10% In a finance lease, the risk and ownership of the asset it transferred to the lessee (Pietersz, 2005). Therefore, at the end of the period the lessee can sell the asset at the scrap Cost. Thus, in the case of a finance lease the Cost of the machinery will be Cost of the machinery today = 25,000 / (1+.10)1 + 25,000 / (1+.10)2 +25,000 / (1+.10)3 + 25,000 / (1+.10)4 + 25,000 / (1+.10)5– 10,000 / (1+.10)5 Cost of the machinery today = 22,727.27 + 20,661.16 + 18,782.87 + 17,075.34 + 15,523.03 – 6,209.21 Cost of the machinery today = £88,560.46 3b) Leasing machinery, five annual hire charge (In case of a operating lease) Payments due at end of each year = £25,000 Scrap Cost at the end of the use = £10,000 Period of use = 5 years Cost of Capital = 10% In an operating lease the ownership of the asset is not transferred to the lessee thus he can not sell the asset at the end of the period. Cost of the machinery today = 25,000 / (1+.10)1 + 25,000 / (1+.10)2 +25,000 / (1+.10)3 + 25,000 / (1+.10)4 + 25,000 / (1+.10)5 Cost of the machinery today = 22,727.27 + 20,661.16 + 18,782.87 + 17,075.34 + 15,523.03 Cost of the machinery today = £94,769.67 Best Option: Since the case does not explicitly mention that the lease is operating of finance therefore if we assume that it is a finance lease than it will be the most feasible option. Otherwise buying on cash will be the best option since it has the lowest cost. Appendix Low Fell Engineering Ltd – Revenue account for the year ended 31 October 2010 £ 2010 2009 Sales Cost of Sales Gross Profit Sales Cost of Sales Gross Profit Sales: Valves 3,375,820 1,755,420 1,620,400 3,069,750 1,593,790 1,475,960 Sales: Pumps 2,864,240 1,260,270 1,603,970 2,728,620 1,146,020 1,582,600 Sales: Pipework 1,547,850 588,180 959,670 1,450,570 522,210 928,360 7,787,910 3,603,870 4,184,040 7,248,940 3,262,020 3,986,920 Less: Expenses Wages and salaries 1,554,580 1,480,100 Overheads 432,470 402,810 Rent and Rates 210,000 201,000 Insurance 65,480 61,590 Depreciation 280,000 280,000 Heat, Light and Power 615,690 517,700 Administration 178,460 172,380 Advertising 54,830 56,460 Consumable Materials 120,430 112,360 Sundries 42,400 42,870 3,554,340 3,327,270 Net Profit 629,700 659,650 Less: Interest paid 148,680 152,460 Profit before Tax 481,020 507,190 Less: Provision for Tax 144,300 152,160 Profit after Tax 336,720 355,030 From previous year 1,875,460 1,710,430 2,212,180 2,065,460 Less: Proposed: Preference dividend 100,000 100,000 Ordinary dividend 90,000 190,000 90,000 190,000 Balance 2,022,180 1,875,460 Low Fell Engineering Ltd – Balance Sheet as at 31 October 2010 £ 2010 2009 Cost Depn Net Book Value Cost Depn Net Book Value Fixed Assets Land and Property 2,500,000 650,000 1,850,000 2,500,000 600,000 1,900,000 Plant and Machinery 1,320,000 660,000 660,000 1,320,000 528,000 792,000 Furniture and Equipm’t 420,000 168,000 252,000 420,000 126,000 294,000 Motor Vehicles 280,000 168,000 112,000 280,000 112,000 168,000 4,520,000 1,646,000 2,874,000 4,520,000 1,366,000 3,154,000 Current Assets Stock 628,480 634,840 Debtors 1,066,840 1,032,730 Bank 4,640,900 4,218,410 Cash 1,500 1,500 6,337,720 5,887,480 Current Liabilities Creditors 355,240 303,860 Provision for Tax 144,300 152,160 Proposed Dividends 190,000 190,000 689,540 646,020 Net Current Assets 5,648,180 5,241,460 8,522,180 8,395,460 Long-term Liabilities Loans 2,500,000 2,520,000 Net Assets 6,022,180 5,875,460 Financed by: Share Capital sOrdinary of £1 2,000,000 2,000,000 5% £1 Preference 2,000,000 2,000,000 4,000,000 4,000,000 Reserves Profit & Loss Account 2,022,180 1,875,460 6,022,180 5,875,460 Comparative efficiency with similar businesses Gross Margins: Valves 50% Pumps 60% Pipework 65% Other ratios: Net profit before interest and tax to sales 9.5% Net profit before interest and tax to capital employed 8.0% Labour cost to sales 18% Overhead cost to sales 42% Current ratio 9.0 times Acid test 8.0 times Stock turnover 12.0 times References Bierley, J. J. 2008, Inventory Turnover, Available from site: http://www.vitalentusa.com/learn/turnover.php Pietersz, G. 2005, Finance lease, Available from site: http://moneyterms.co.uk/finance-lease/ Read More