|Programme||MSc Management with Streams|
|Module name||Financial Decision Making|
|Schedule Term||winter 2020|
|Student Reference Number (SRN)||BP0231062|
|Report/Assignment Title||Financial analysis title|
Date of Submission
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Student Reference Number: BP0231062 Date: 24/September/2020
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BPP School of Business and Technology
The intention of the below written financial analysis report is to form a basis for decision making for the acquisition of Roast Limited by Starbucks.
The process begins with an assessment of the UK coffee house to understand the history of the industry and come up with the available opportunities.
A thorough cross-check across the various lines of the financial documents of Roast limited will help in identifying the trends in the financial performance of the company. assets of the company will be evaluated to identify if they have increased or reduced during the year.
Financial leverage will also be assessed to identify if the company if highly or lowly leveraged.
Roast Limited is set to be acquired by Starbucks and this report will help Starbucks to be acquired.
Other than the statement of financial position and the income statement of Roast limited, other financial areas to be assessed is the dividend policy, the cash and cash equivalent for the capital investment where the company is planning to invest 500,000 pounds.
Some of the capital budgeting techniques that will be used to appraise the investment project include the net present value, the accounting rate of return, and the payback period.
- Coffee consumption in the United Kingdom dates back from 1600 and the culture has grown huge to today’s leading consumers of coffee.
- The country’s coffee industry generates millions of pounds to the economy of the country (Ali and Khalid, 2019, pp 27-43).
- The revenues collected by the government of the United Kingdom from the coffee industry amounts to more than 1.5billion pounds.
- Thus, the country’s coffee market is one of the largest in the whole world.
- The country’s population has developed a coffee taking culture thus making the beverage an inseparable part of their lives.
- High-quality coffee brands dominate the country’s coffee market and thus, there is a lot of research in the coffee industry (Anwaar, 2016, pp. 34-40).
- The majority of people consume coffee in their homes compared to those who take from the cafes.
- The United Kingdom is one among the many countries that celebrate International Coffee Day since the country is a major stakeholder in world coffee consumption.
- The coffee market in the United Kingdom is regulated by the British Coffee Association.
- Some of the stakeholders in the coffee supply chain in the United Kingdom include importers, processors, distributors among others (Atmoko, Defung, andTricahyadinata, 2018).
- Coffee Extracts and Chicory Extracts Regulations of England contains the laws governing the coffee industry.
- Mc Donald and Starbucks are some of the biggest coffee companies in the United Kingdom and they have thrived as a result of good organizational leadership.
- The country’s coffee industry is facing some current challenges which include falling sales due to coronavirus disease attack.
Roast Business Analysis Report
Roast limited recorded a higher net profit in 2018 than in 2017. The net profit rose from 36,000 to 81,000. The company had higher sales in 2018 than in 2017.
The company had a higher amount of operating expenses in 2018 than in 2017 because of increased operating activities. This resulted in reduced earnings before interest and tax.
The cost of finance of the company increased from 6000 to 26000 because there were more operating activities in 2018 than in 2018.
Roast limited encountered a higher operating profit of 127000 in 2018 than the one it had recorded in 2017. This is because income from operating activities had increased due to an increase in sales.
The operating expenses for the year 2018 rose to 477,000 from 466,000 pounds. The company had more sales in 2018 than in 2018 thus income generated from operating activities was higher. The corresponding indication is that there is an increase in the capacity of the business to have more sales and even more potential customers.
The operating income for the company was higher by 60,000 in 2017 than in 2018 because the cash flow from operating activities had increased.
Sales costs increased in 2018 compared to 2019. Carriage inwards and carriage outwards was more in 2018 than in 2018.
Gross profit in 2018 was higher than in 2017 because sales in the year were more than the sales made in 2017. More sales in 2018 led to a higher gross profit.
The gross profit margin is the ratio of the variable cost of a company from its revenues. Gross profit margin is the profit left when all the variable costs are eliminated. The gross profit margin is calculated as follows.
Profit margin = gross profit /sales x100
(2534000-199000) / 2534000 = 0. 21
The company has a gross profit margin of 0.21
This ratio will be used to determine if Roast Limited is profitable through its operating activities. All the costs will be deducted to establish the amount before interest and tax.
Operating profit margin = operating profit / total revenue.
Operating profit = 127,000
Total revenue = 54,000
Therefore, 127000 /544,000 = 0.23.
The net operating margin for the company is higher than the recommended minimum of 20 %. The organization is thus generating some profit after all the costs are deducted.
This ratio is only used to make a comparison of one company alone at a time due to the variability of the financial structures in these companies.
Net profit margin = net rev /total rev x100
Net rev. =81,000
Total rev. = 544,000
Therefore, 81000/544000* 100% =14.9%
Shares of the investors should be converted into financial earnings and the rate at which this is done is measured as the return on stakeholder’s equity. Efficiently operating companies have a high return on stakeholders and it is a good option for investment.
Low returns on the stakeholder’s investment indicate that the company is not operating efficiently and thus it does not fully use the investors’ money into fully profitable activities.
Net income = 81,000
Average equity = (860,000 + 77900)/2 = 819,500
As a result, stock return = 81,000 / 819500=0.99
The company is operating efficiently and the investors’ money is being used to generate good returns.
It indicates the ease of repaying the interest of the company’s financial debts. The most preferred interest coverage ratio should be above 2 and it indicates safe investment.
Therefore, EBIT =127000
Interest expenses =26,000
The interest coverage ratio is 127,000/26000=4.9
It indicates if the cash flows of Roast Limited are enough to provide money for the debts. The debt service coverage ratio should be at least 1.25. For Roast Limited, the debt service coverage ratio is; –
Operating income/debt service
Operating income = 235,000
Debt service coverage ratio = 127,000/235000=0.54.
The debt service coverage ratio for the company is below the suggested figure and thus the cash flows are not enough to pay for the debts.
An increase in net assets indicates that the company is making asset financing. Roast limited had an increase in long term asset worth from 670,000 to 996,000. It indicates that there is long term financing.
An increase in current assets indicates an increase in short term financing. The current assets of Roast Limited increased from 347,000 to 447,000.
An increase in net assets indicates an increase in business financing. Roast Limited has an increase in net assets from 1,017,000 to 1,443,000. An increase in net assets as a result of an increase in the short term and long term financing.
An increase in equity indicates more asset financing. In 2018 total equity increased to 860,000 from 779,000.
Roast limited has a high current ratio of 0.63. This indicates that the company has a high proportion of current assets.
Current assets = 447000
Therefore, quick ratio = (447000-299000)/ 235000 =0.63
Roast Ltd has high liquidity.
The financial leverage of a company is measured using its debt ratio. A high debt ratio in the company indicates high floatation while a low debt ratio indicates low floatation. Roast limited has the following floatation.
Total liabilities = 538,000
Total assets= 1443000
Debt ratio is thus, 538000/1443000 =0.37
As a result of the above calculation, the debt ratio of Roast limited is high and thus indicates a high floatation.
The inventory turnover of roast limited indicates the number of inventory purchases that are made in one year. If properly utilized, the company can reduce the costs that are associated with the storage of the inventory.
These costs include the warehousing costs and the holding costs that are associated with the holding of the stock. For Roast limited, inventory coverage ratio for 2018 was;
Cost of goods sold = 1990000
Average inventory = (299000+120000) /2 =209500
Therefore, 1990000 /209500 = 9.54 times
The company buys stock 10 times per year.
The duration taken to sell the whole stock purchased is called day’s sale inventory and is calculated by dividing 365 days by the inventory turnover ratio.
365 days /9.54 = 38 days.
The company completes selling its stock within a maximum of 38 days.
Debt to equity ratio
This is the ratio given to total liabilities when they are divided by total assets.
Total liabilities = 538000
Shareholder’s equity =860000
538000 /860000 =0.63.
The low debt to equity ratio shows that Roast Limited is unable to get funds from creditors.
Roast Limited ended the year 2018 with a cash and cash equivalent of 159,000 as shown below.
Operating activities = 24000
Investment activities (358, 000)
Financing = 175,000
Cash and cash equivalent 159,000
Roast limited has a cash operating cycle of 68 days.Ir refers to accounts receivable plus inventory period.
Inventory period= 38 days
a/c receivable time = 30 days
therefore 38 + 30 = 68 days.
After purchasing the stock on credit, the company canfully pay its creditors after 68 days since this is the time it will take to collect all the debts.
This is the method that a company uses when sharing out dividends to the investors. A profit-making company may decide to pay or not pay dividends to its investors while a loss-making company does not pay any dividend to its investors.
According to the information given, Roast Limited made a loss, and thus it was appropriate for the company not to pay out the dividends.
Management of Roast Limited can use three methods to evaluate the effectiveness and viability of their expansion investment.
Since the investment project that is being undertaken by the company is so huge and a little mistake may lead to a huge financial loss, the use of capital budgeting methods is thus necessary.
In this scenario, three capital budgeting methods have been used. The methods include the payback period, the net present value, the accounting rate of return.
According to the information given, the payback period of the company is 4 years. This means that the amount invested will be generated by the cash flows of the investment in 4 years.
The shorter that payback period, the better the investment and the longer the payback period, the riskier it is. The payback period has both advantages and disadvantages.
- It is very easy for an investor to understand and calculate the payback period of a project from the projection of the cash flows.
- The method helps to determine if the project is risky or not. This is because it indicates the duration that a project will take to repay itself back. Thus projects with shorter payback periods are easily identified.
- The project which is highly liquid can easily be differentiated from projects that are less liquid. Liquid projects have less fixed assets compared to current assets.
- Cash flows that are collected after the payback period are not accounted for and thus the profitability of the project is not considered. The method assumes that the project generates zero revenues after the payback period.
- The future value of the money invested is not calculated by the method and thus the returns of the money invested are not considered.
The accounting rate of return for the capital expected to be 10%. On the other hand, the actual rate of return is 18%. Thus, the actual rate of return of the project is higher than the expected rate of return.
The project is thus profitable and investing in it would be appropriate. The accounting rate of return has the following advantages and disadvantages.
- It is easy to compute the accounting rate of return of a project.
- It is a simple and easy method to understand.
- Depreciation and income after tax are taken care of when using this method to budget for a capital project.
- Different projects can be compared using this method. This helps the investor to make the most appropriate financial decision.
- Different results concerning the project are obtained when the calculation is done using a return on investment thus creating confusion for the investor.
- The time value for money is ignored by the method.
- The method considers lower interest rates over a long time to high-interest rate for a short period of time. this increases the risk of investment.
- The method fails to include the external factors affecting the investment.
The investment project has an NPV of 110,000. The payback period is 5 years at an interest rate of 5%. The amount invested is 500,000.
The discounting rate of the project is too low to generate the amount invested within 5 years. The method has the following advantages and disadvantages.
- When using the NPV method, the project has a higher worth because the time value for money is considered by the method.
- The method can be used to differentiate risky investments from non-
- Risky investments can easily be identified using this method.
- The poor calculation may lead to the company losing since the cost of capital requires accuracy in estimating.
- it is difficult to compare different projects with different investment amounts.
Roast Limited can acquire dentures as a source of funds for its new investment. Debentures are bonds that are unsecured by collateral and as a result, they are given to companies depending on their ability to repay back money borrowed.
The company can get debentures either from the host government or from other companies (Cheng et al, pp.2331-2341).
The company can acquire various types of debentures which include convertible bonds which can be converted into equity shares of the issuing corporation once roast Limited has acquired them.
Others include non-convertible debentures which cannot be converted to equity of the issuing company. Debentures as a source of funds have various features such as interest rate which is the amount of money charged on the principal borrowed, credit rating, maturity date as well as pros and cons.
Debentures also have a risk to their investors since a company may fail to honor the repayment obligation (Fleten et al, 2016, pp. 498-506).
Below are some of the advantages that are associated with debentures when they are used as a source of funds for companies that are expanding their investments.
- Debentures are a cheap source of funds for companies. Thus by acquiring dentures would ensure that Roast limited will pay a lesser amount of interest than when if the funding was done through the bank loan or creditors’ financing.
- Debentures issued to another company do hat have any voting rights. As a result, they cannot be used to control the shareholding of the borrowing company (Gbadebo, 2020, pp. 200-214).
- Interest payment for debentures is tax-deductible. This makes it less costly compared to other sources of financing such as equity and preference shares.
- When debentures are used to finance a business, the company does not include its profits in that debentures.
- Using debentures as a source of funds does not confer a personal liability to any shareholders of a company. As a result, only the assets of a company that acquired the debenture can be auctioned for the process of repaying back the defaulted debentures (Miao, Teoh, and Zhu, 2016, pp. 473-515).
On the other hand, debentures have various disadvantages such as when they are used as a source of finance for investment in a company.
Below are the disadvantages that Roast limited will acquire when it uses debentures as a source of finance.
- Secured debentures pose a threat to the assets of the company. This means that if the debentures are not repaid, the assets of the company can be recovered and auctioned to fund the debenture repayment.
- The acquisition of debentures is limited to the borrowing capacity of a company. This reduces the potential for expansion of the company since it cannot get an amount it requires if the amount is beyond its borrowing capacity (Wijaya, Mursito and Djumali, 2020, pp 69-85).
- Redeemable debentures put the company on the obligation to repay back the money on an agreed specified date. The obligation is inflexible thus putting the company at risk during circumstances of hard finances.
- The cash flows of the company acquiring debentures are affected since the company does not have any chances of making flexible plans. The debenture agreement on the rate of repayment cannot be altered after the agreement is sealed (Wijaya, Mursito, and Djumali, 2020, pp 69-85).
A bank loan refers to the money given to businesses by banks for investment or for expansion. Bank loans are used to fund operations if business or expansionstrategies.
Banks charge interest on loans because money has its time value. Bank loans are a suitable option for the financial structure of businesses that have to require huge funding. Bank loans have the following advantages and disadvantages.
- Bank loans are usually flexible and businesses can negotiate with the bank on installments. This allows the borrowing company to repay the loan using installments that correspond to the company’s earning behavior.
- Bank loans are available in many places since commercial and investment banks are found in almost every town and city (Ali and Khalid, 2019, pp 27-43).
- Banks do not control the usage of money after the money has been borrowed by the company. This is unlike the investors who must make sure that the money they have invested in a company is accounted for in its use.
- The interest charged on the bank loans by banks is reasonable. This is because each bank tries to come up with the best ever financial products and thus they offer competitive interest rates.
- After the full repayment of the loan, the business enjoys all the money that was being used as an installment as a net profit for the business (Anwaar, 2016, pp. 34-40).
- Banks usually sets guidelines for businesses to acquire loans. If these businesses fail to meet these guidelines, they do not qualify for the loan. This limits the chances of a Roast limited to get a loan if it does not meet the set guidelines.
- Bank loans are secured using the assets of the business. Loan default leads to the business losing the assets to the bank as a way of repaying back the assets (Atmoko, Defung, and Tricahyadinata, 2018).
- A bank may fail to give out all the money that the business had requested. A bank may at times fail to approve a loan.
- Bank loans are repaid with an interest rate and at times, the business is affected during hard economic times.
- The company that is borrowing loans from the bank is required to prepare and present various types of financial documents for it to qualify for a loan. This makes the process to belong and a lot of accuracy and precision is required.
The analysis of Roast Limited using various financial ratios and inferences from various lines of the financial statements will help Starbucks company to make a well-informed decision when making an acquisition.
From the above results, the assets of the company increased in 2018. This was caused by an increase in both the long-term and short-term financing in the business. The company also had increased operating activities that led to an increase in operating income.
The increase in operating activities also led to an increase in operating costs in the form of more purchases, more carriage inwards, and carriage outwards. As a result of more financing, the company had more cost of finance in 2018.
The various financial ratios calculated from the above report indicates the financial status of the company and how well Roast Limited is performing. This will help in financial decision making by the Starbucks that is planning to acquire the company.
The cash and cash equivalent of Roast Limited has been used to show the current money that the company had at the end of 2018.
Capital investment appraisal of the project that is being assessed by the company shows that there are a number of capital investment evaluation methods that are necessary for an evaluation to ensure that the project taken will not cause a massive financial loss in the company.
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