Spectrum manufacturing

QUESTION:

Spectrum Manufacturing Company is public limited liability. The company was incorporated on 15th June 2000 in United Kingdom. The Company manufactures and sells a range of products in the United Kingdom and overseas countries and complies with the national and international regulations. The Company has subsidiaries in the United States of America, France, Germany, Japan and China.

The Board of Directors of the Group Company has a global focus as it is consisted of members from various countries with highly skilled and diversified experience. The Directors acknowledge and respects the significant role of the Company's Shareholders as several of them are institutional Shareholders are from major industrialised Countries.

The Strategic plan of the Company is to acquire three textile companies and four commercial companies in Russia, Singapore, Japan and Germany. The Company also plans to establish six branches in India, Spain, Singapore and South Africa.

The financial Statements of the Company for three years ended 31 December, 2006, 2007, 2008 have been presented for analysis.

Profitability Ratios:

Profitability ratios tell us about the profit of an organization earned over a particular period. It evaluates how well a business has performed, it analyse the relationship between profit and sales of an organization. Profitability ratios also indicate the overall performance of the management.

Importance and shortfalls of gross profit ratio

Importance of GP Ratio

Gross profit ratio indicates how efficiently an organization is producing goods and what changes can be made in the price of goods or services to avoid losses. To find gross profit cost of goods sold (COGS) is deducted from total sales and higher gross profit reflects the sound position of the company. Higher the gross profit the more will be net profit which can be found by deducting all operating and interest expenses.

Shortfalls Gross Profit Ratio

This ratios dose not tells the complete picture of the profit, because it only gives the figure of gross figure and doe not talk anything about the Net Profit.

Any share holder does not make any decision of his investment upon the figures of Gross Profit. So showing this ratio to share holders we cannot bring any investment from Invertors or neither we can show gross profit's figure to financial institutions for any other agency.

Critical Analysis

From the above calculations we can see the companies' Gross profit reduced by 8.33% in the second year, but again the company has significantly increased the gross profit by 27%. Which shows the company has changed its control over Cost of Goods and Labour costs? They might have changed the internal control system of inventory.

Net Profit Ratios:

This is an important ratio to reflect the profitability of organization. It shows relationship between total sales and net profit which is found all deducting expenses from sales revenue and expressed in percentage.

Importance and Shortfalls of Net Profit Ratio

Net profit ratio indicates overall profitability of the organization. This is the ratio that investor will be ultimately looking for. Low net profit indicates problem in the operations of organization. An organization with high net profit ration will be in a better position to overcome adverse economic conditions and can get competitive advantage over competitors. Although profit ratios are good indicator of organization's of financial position and firms with higher profitability ratios are considered good but one need to look at other aspects such as investment and capital introduced by the owners.

Shortfalls of Net Profit Ratio

Net profit ratio only shows the profit figure of the same year, but through we would not be able to predict the future earnings, which might raise in the future because of the good investment policies of the company for example instalment of new plant and machinery. So this is the short fall with the net profit ratio.

Critical Analysis

From the above variance calculations we can see that the companies Net profitability is falling down from in 2006-07 it falls 29% which shows the adverse position of company, clearly give an idea that the company has no control over its expenses specially the operating expenses, share holders dividend control and tax planning side of the company. Further the company has increased its profit but the ratio still tells us its not very satisfactory position in year 2008.

Operating Profit Ratios

This ratio reflects how much profit is being generated after deducting operating expense from gross profit or COGS plus operating expenses are taken out from total revenue. It is expressed in percentage

Importance and Shortfalls of Operating Profit Ratio

Operating profit ratio reflects the operational efficiency of the organization and it can be affected by a number of factors. In this way extra caution is required when evaluating operating profit ratio. In manufacturing industry operating profit ratio between 75-80 percent is standard.

Short comings

IT only shows the operational side of any business but the outsiders or inverting companies company cannot consider these figures for investing decisions through this figure. In nutshell this information is not for any benefit to the investing companies.

Critical Analysis

From the variance in the first year we can see that the company has bear the loss in its Operating profit ratios to 25.50% which shows sharp decline in the Profits. At the same time we have seen form the above calculations that the company has again gained the profit in comparison to the last year and Sharpe increase we have observed in year 2007 08. The company has experienced the 7.6%.

From the above analysis we can say that the company has no consistency in its opera inions. I think has to impalement a strict policy towards the Material and operating expenses and at the same time an internal control system needs attention.

Return on Capital Employed Ratio (ROCE Ratio):

This is important ratio which shows how much profit organization is generating on the capital employed by the investor in the business. It tells us about the relationship between capital employed and return on that capital. There are two types of capital employed Gross Capital employed and Net Capital Employed. In this we can two ratios. Return on gross capital employed in which gross capital is formed of total assets and net capital employed is total assets less liabilities.

Importance and shortfalls of ROCE

ROCE ratio is most effective of profitability in order to analyse the performance and efficiency of the business. ROCE tells us how effectively management has utilized the assets of organization over a specific period. It helps managers to take decisions.

Shortcomings of the ROCE

The main shortfall of the ROCE is that it dose not show the long-term impacts of the investments made by the owners/investors. For example if the company has invested the 25% more in its capitals it will going to produce the profit as the same proportions because the results of the investments is a long term investment hence the real income generation will begin after couple of years instead of next year. In nutshell we can say that ROCE will not depict the long term investment policies of the company straightaway, but it's the tool to measure the year to year performance of the company.

Critical Analysis

From the above calculations of the spectrum Manufacturing Ltd, we can see the sharp fall in the ROCE, the percentage of ROCE in the second year 2007 falls by 33.33% on the other hand the company has invested around £ 2000 million in the same year, instead of generating more profit. The companies profit had been declined y 33.33%.

In the next year 2008 the company had invested another £ 1000 million pounds but again we have noticed the is again lost a major portion of its profit as compared ROCE from 33.33 % to 40.28%. Overall the Spectrum Manufacturing is sharply decreasing its profit in recent years, besides the company has invested millions of pounds.

Leverage Ratios

Leverage ratios compares and contrast finances employed by the owner in the business and finances brought into business from other sources such as debt.

  • Debt to Asset Ratio
  • Debt to Equity Ratio
  • Debt to Net worth Ratio
Importance and Shortfalls of Leverage Ratios

Leverage ratios reflect the relationship between capital employed by people who provide credit and capital employed by the owners of organization. Leverage ratios show to which extent creditor's money is protected by the owners of organization. A low leverage ratio shows that more capital or resource have been employed by the owner and can access to more capital if required in future.

Critical Analysis

From the above calculations of the spectrum Manufacturing Ltd, we can see, the percentage of Debt to Asset Ratio in the second year 2007 increased by 31.91%. In the next year 2008 the company had invested another £ 1000 million pounds but again we have noticed there is again lost a major portion of its profit as compared ROCE from 33.33 % to 40.28%.

Overall the Spectrum Manufacturing is sharply decreasing its profit in recent years, besides the company has invested millions of pounds.

Liquidity Ratios:

Liquidity Ratios tells us about the liquidity position of the firm e.g. how effectively organization is receiving its receivable and how effectively it is paying its short term liabilities to suppliers. To find how much a firm's liquidity we can employ

Acid Test Ratio

Current Ratio

Net Working Capital Ratio

Importance of CAs Ratio

Current assets ratio indicates an organization's capacity to meet its present short term liabilities. A higher current ratio indicates strong position of the organizations and shows organization can meet its current obligations effectively.

Importance of Acid Test Ratio

Acid test ratio also known as quick asset ratio and indicates extremely liquidate assets available to pay the short term liabilities. Usually any value below 1 to 1 indicates an influential "dependency" on stock or other current assets to liquidate short term liabilities.

Critical Analysis

From the above ratio calculations of Spectrum Manufacturing Ltd, we have seen that the company's Quick asset ratio in the year 2006 is very high, which means the company has around double the current assets then the liabilities.

Then In the following years this has been declined by 68.28%, and stud to 117.28% which is still good but if we see the performance its indicates that company has less power to pay its short term liabilities. Similarly in the year 2008 the ratio has decreased to 101.13%.

From the above trend analysis we have seen the graph of the Quick Assets has declined and it looks like in the following years most probably it tends to decline, which is alarming to the companies decision makers.

Similarly all other tests of Liquidity Ratios we have calculated shows the same trend i.e. decline in Liquidity ratios, hence we can conclude that directors need an urgent need to inject more cash or try to reduce short term borrowings in order to attract more share holders other wise the company will lose prospectus stakeholders in future.

Financial & Non-Financial Techniques Spectrum Manufacturing Can Use

Financial Techniques:

Traditional financial ratios are useful as it Summaries quite Complex according to information of Spectrum Manufacturing Company Ltd as it points out limited indicators, and covering profit, liquidity, growth and risk of a Spectrum Ltd. These four more financial analyses include,

Liquidity Ratios

Liquidity Ratios indicate how effectively the organization has managed its currents assets such as working capital and these are Current ratio, Quick ratio, and Working capital ratios.

Activity Ratios

Activity ratios are used to try to measure the effective ness of a firm in using are Net asset turnover ratio, Shareholder period, Debtor Collection period and Creditor payment period.

Collection Period Ratios (Days)

These ratios are help full in analysing the collectibles of account receivable, or how fast a business can increase its Cash supply.

Investment Ratios

Shareholders and potential shareholders are primarily concerned with assessing the level of return they might gain from an investment in a particular company. These ratios are necessary as the value of shares can vary quite considerably.

Non-Financial Techniques:

'In today's worldwide competitive environment companies are competing in terms of Product, Quality, Reliability, after-sales Services and Customer Satisfaction'. (Chairman FTSE 100 Company, 2003)

Not all an entity's business activities can be express in monetary terms. Although the overriding objectives of most business organisation are to maximise profit the exceptions are those corporation, wholly owned government statutory institutions and their agencies. Therefore the use of only financial ratios and other financial techniques based on financial statements cannot necessarily reflect true and accurate measure of all their performance.

Therefore Spectrum Manufacturing Company Ltd can be used following non-financial techniques to measure the performance

  1. Production performance
    • Number of Suppliers
    • Manufacturing lead times
    • Output per person
    • Adherence to delivery dates met
  2. Service Quality
    • Client turnover
    • Proportion of Deliveries time
    • Proportion of repeat Business
  3. Marketing Effectiveness
    • Number of Customers
    • Client contact hours per Sales person
    • Trend in market share
  4. Personnel
    • Staff turnover
    • Training time per employee
    • Days Lost through absenteeism
    • Number of Complaints received

Explain the term "Agency Theory". Discuss the implications of agency theory with regard to the Board of Directors of Spectrum Manufacturing Company with the Shareholders

Agency Theory

A group of concepts deriving from the relationships between the principle and agents due to the conflict of interested. The shareholder of a company wants increase of their wealth in form of increase dividends and agents such as directors wants more power and increased benefits. Agency theory was firstly introduced in information economics which tells us relationship about the two parties in which one party delegate responsibility to other party (Ouchi, 1979). As roots of agency theory can be trace back to economics agency theory emphasis that the people within a company are 'utility maximizes, striving to obtain that which is in their individual best interest and which may not be in the best interest of the organization' (Eisenhardt, 1989).

Implications of Agency Theory with regard of the Board of Director

Spectrum has a diversified shareholders and board of directors. Most of their shareholders are institutional and board of directors are from different parts of the world.

From the above ratio calculations and on the basis of financial statements there are major issues to be considered before going for expansion in various parts of the world.

Assuming this acquisition is going to happen in one financial year.

  • They haven't got enough retained earning or cash reserves for a big expansion like this. Even if they go for it, purely on the basis of a loan that will increase gearing of the company which will increase the risk. As it is known that high risk brings high returns could lead to more increase of shareholders expectations.
  • Sales figure shows that it has decreased a lot (23.44%) which lead to a less profit for the period. But they have maintained a higher dividend which has increased from previous year (26.84%). With this rate of increased expectation from shareholders could lead to a disaster in future years. If the sales figure carry on decreasing in future they might struggle to carry on paying dividend.
  • All other ratios like liquidity ratio is good (1.83) shows the company can manage its debts in any given situation till now. The debt recovery days are very high (78 days) which could lead to more interest Expense. Payables days are 81 days which is also high could lead to supplier's disappointment. Also they have a high inventory holding.

Overall acquisition of three textile and four commercial companies could be lethal if they do it in one financial year. But if they do it by organic growth it will be less risky and better for the company. Depending on the director's motive e.g. Acquisition for more power and growth instead of increasing shareholder wealth. It can also be argued that as the board members are from different part of the world (e.g. Germany and France) where different type of board structure is used like two tier, where it also consider shareholders view in decision making. But in UK it doesn't, the directors takes the decision with their own initiative regardless of shareholders view. It needs to make sure that board members are aware of UK combined code which is principle based not rule based.

Explain the term "Dividend Policy" What are the three main positions on the question Does Dividend policy matter?

DIVIDEND POLICY

THE POLICY

Dividend constitutes the cash flow that accrues to equity holders whereas retained earnings are one of the most significant sources of funds for financing the corporate growth. This determines what portion of earnings will be paid out to shareholders and what will be retained in the business to finance long-term growth.

STABLE DIVIDEND POLICY THEORY

The stability could take three forms:

  • Keep dividends at a stable amount but allow its payout ratio to fluctuate, or Maintain stable payout ratio and let the rupee dividend fluctuate, or
  • Set low regular dividend and then supplement it with year-end "extras" in years when earnings are high. As earnings of the firm increase the customary dividend will not be altered but a year-end "extras" will be
  • Declared.

Source: thisisvj.googlepages.com/D IVIDENDPOLICY.doc

Main Positions on the Question Does Dividend Policy Matter

Spectrum Ltd has increased in EPS, as compared to the pervious years. Interestingly we have seen regardless the loss in the recent years company has paid more dividend, which is good in the sense if the company wants to attracts more shareholders in the future, but at the same time the companies retained earnings/ reserves will remain same or even they might decline as well, so its very important decision for the companies director to take all these thing into consideration before making the divined policy. Under mentioned I have high lighted few major basis of dividend policy to be considered before declaring the dividend.

  • Net Profit basis.
  • On the basis of shareholders reserve.
  • Effective Tax planning helps paying more dividends.
it's generally held by several analysts that debt financing is often encouraged relative to equity financing.

Comment on this viewpoint. Discuss three main Sources of financing Public Company.

Debt Financing

Debt financing consist of loans that organizations obtained from different source to finance their operations and must be paid some time in future. Loans for short term or long term period depend on the Businesses needs and requirements. Major source of debt financing includes banks and government agencies and international capital markets. Businesses prefer to use debt financing as it gives them benefits in tax reductions. However debt financing limits the organization's future liabilities of loan repayment as lenders do not holds owner ship in the organizations or company. Debt financing depends on the financial position of the organization. Blue chip organizations can raise good amount of capital because of their strong financial position.

Disadvantages of Debt Financing

Difficult for new businesses to raise required capital.

Difficulties in repayment for new businesses due to irregular cash inflows

Makes new businesses more vulnerable to economic shocks as Sky bus failed due high fuel prices in USA.

Too much debt makes organization less attractive and makes them risky ventures

Source of finance for Public companies:

  • Public institutions and their Agencies.
  • Borrowing from Private Sector( e.g. Private Banks, International Markets )
  • International and Foreign Bond Markets.
  1. Public Institutions and their Agencies.
  2. Some international public financial institutions, such as the World Bank Group, international Monetary Fund, European Investment Bank and number of other multilateral development financial institutions offer loans to the private sector projects that are considered to be financially viable, and at the same time fulfilling the economic and social development objectives of institutions.

  3. Borrowing from Private Sector
  4. some financial institutions such as the commercial banks to financial projects that have low credit rating or inadequate collaterals, arguably with the increase in sources of funding, several private institutions are actively providing loan investments to medium and large business. The main sources of the funds are as follows.

    • Commercial Banks
    • Loan from foreign commercial banks tends to be more stable than portfolio flows. Debt, especially from commercial banks can be a valuable tool to the maintenance of operational effectiveness of the borrowing business as it allows them to grow without foregoing the benefits of concentrated ownership such as, stronger monitoring of management.

    • International Debt Markets
    • The competing demand for debt to finance major investment project in place of equity capital especially when the share prices are too low has widely recognised .Modigliani and Miller (1958) explain that if the stock market is inefficient, financing programmes become relevant in a number of ways. That is if the prices of equity are too high, shareholders benefit because they can issue overvalued equity. On the other hand if equity prices are too low, it will be preferable to issue debt. Consistent with these statements, it is argued that companies with high credit rating granted by internationally recognised credit rating agencies such as standard and poor and moody benefit by borrowing from international debt markets.

  • International and Foreign Bond Markets
  • These markets provide long-term capital for investments in plant and machinery. Four different bonds can be issued in international and foreign bonds markets. These are domestics, global bonds, foreign bonds and Eurobonds. The bonds are distributed through syndications of banks.

    Source: Dr.Joseph Agholor Corporate Finance Handout Chapter-5 P (60-62)

    Bibliography:

    • Denzil Waston and Antony Head (2006), Corporate Finance: Principles and Practice, 4th Edition, Prentice Hall
    • Dr.Joseph Agholor Corporate Finance Handout Chapter-5 P (60-62)
    • Galen Arnold (2008), Corporate Financial Management, Prentice Hall
    • Richard A Bealey, Stewart Myers, and Alan J.Marcus (2006), Fundamentals of Corporate Finance, McGraw-Hill
    Online Journal:
    • Ouchi.W. (1979), A Conceptional Framework for the design of Organizational Control Mechanisms. Management Sciences, 25(4), 833-848
    • Eisenhardt.K.M. (1985), Control: Organizational and Economic approaches. Management Sciences, 31(2), 143-149
    • Eisenhardt.K.M (1988), Agency and institutional explanations of Compensation in retail Sales, Academy of Management Journal, 31(3), 488-511
    • Eisenhardt.K.M. (1989) Agency theory: An assessment and review, Academy of Management Review, 14(1), 57-74
    Websites Visited:
    • http://www.accountingformanagement.com/expense_ratio.htm
    • http://www.bookrags.com/research/debt-vs-equity-financing-eom/
    • thisisvj.googlepages.com/D IVIDENDPOLICY.doc
    • http://www.investorwords.com/6489/dividend_policy.html
    • http://library.highpoint.edu/html/hplib/ratio.html
    • http://www.midcapcpas.com/liquidity_ratio.htm
    • http://www.midwestacademy.org/Proceedings/2005/papers/Akdere_Azevedo%20Agency%20Theory.doc
    • http://www.peerpapers.com/essays/Non-Financial-Performance-Indicators/82124.html
    • http://www.referenceforbusiness.com/management/Comp-De/Debt-vs-Equity-Financing.html

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