itsacrrualworld.files.wordpress.com · Web viewAustin Reed Cut Smoke Blue Jacket - tailor made using premium wool and other high end materials Blue linen trousers - tailor made using

ACCT11059 ACCOUNTING, LEARNING & ONLINE COMMUNICATION

Haitham Haddad

Central Queensland University

Assignment 2

STEP SEVEN: CONTRIBUTION MARGIN ANALYSIS

A global innovative tailoring provider, Bagir Group specializes in developing, manufacturing and marketing of high quality men and women’s tailored fashions. Bagir Group leverages their Global Presence, Vertical Structure & Innovation in order to provide consumers with the ultimate wearing experience combining fashion, comfort, performance and value.

Bagir Group Ltd (or ‘the firm’ as I will most commonly refer to it as) produces approximately 3M units of clothing per year, it then sells these products to the brands they are licensed by or to retail stores to be then sold to consumers. The three products I have chosen for this step are as follows:

1. Austin Reed Cut Smoke Blue Jacket - tailor made using premium wool and other high end materials

2. Blue linen trousers - tailor made using premium wool and other high end materials3. Blue Spot Tailored Fit Standard Collar Shirt - tailor made using premium wool, cotton and

polyester materials

The reason I have chosen the aforementioned products is because the firm does not sell many other products, it just specialises in selling different but similar products to the ones mentioned.

The sales price of each product:

1. Suit jacket = $292. Suit trousers = $223. Suit shirt = $14

Due to not knowing the selling price as the firm does not sell direct to consumers I have estimated their selling price by using the following equation which I designed myself. Then through qualitative analysis I have determined which products would be more or less expensive based on the materials and level of complexity required.

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The variable costs I have chosen include; materials consumed, subcontractors and subcontracted work, other manufacturing expenses and the cost of transportation and storage.

The variable cost percentage I have attributed to each product:

1. Suit jacket = 75%2. Suit trousers = 65%3. Suit shirt = 40%

The variable cost of each product:

1. Suit jacket = $21.752. Suit trousers = $14.303. Suit shirt = $5.60

Contribution margin for each product:

1. Suit jacket = $7.252. Suit trousers = $7.703. Suit shirt = $8.40

Contribution margins

The firm operates by manufacturing high end fashion clothing and then selling those products to the brands that license them or to other retail stores. Due to the general public not being able to purchase their products straight from the manufacturer I had to estimate their selling prices. I did not feel comfortable with just plucking numbers out of thin air so I went over the annual reports for the firm and did several Google searches and designed a way to estimate the selling price through quantitative and qualitative analysis. For the quantitative analysis I used the formulas mentioned above, below the sales costs. I used the result of that formula as the basis for the average cost of products sold to customers and then adjusted that figure depending on what their customers were selling it at.

The variable costs I decided to include where materials consumed, subcontractors and subcontracted work, other manufacturing expenses and the cost of transportation and storage. I thought these costs were quite obviously a variable cost because they all change depending on the level of production for a product.

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To determine the variable cost percentage I calculated the total variable costs p.a for the firm and then divided that by the total revenue p.a x 100. I then adjusted the variable cost of each product by using that figure and adding or subtracting a few percent depending on the type of material and level of complexity required to manufacture the garment.

Just by looking at the bottom two rows of the graph above you can quickly and easily identify that three selected products have a standard deviation of $0.47 however, have very different contribution margin ratios. If the firm just sold suit shirts the firm could achieve quite a high profit margin compared to the other two products. Why does it not just specialise in producing suit shirts considering it provides the highest level of profit margins? I think one of the primary reasons would be brand management. The firm controls quite a large share of the high end men’s and women’s clothing manufacturing market and has quite a few high profile brands who license the firm to manufacture their products. Considering this, I assume that if the firm reduced their product base to just suit shirts then their clients are likely to start looking for another manufacturer who can provide them the whole deal as having more than one manufacturer or a manufacturer for each item would not only be more costly but leaves the manufacturers exposed to litigation for claims related to quality control and the like if there are several manufacturers manufacturing products for the same brand. The aforementioned reasons are why I think the firm does not just sell the products with the highest profit margin and keeps a balanced product sales volume mix.

Resource and market constraints

There are many resource and market constraints the firm faces due to the nature of the clothing manufacturing industry itself and the geographic locations of the manufacturing establishments.

Majority of the firms products are made from high end wool. So the primary resource constraint the firm may face is a lack of supply or increase in demand for wool. If the price of wool rises than the cost of materials rise as well and the contribution margins for their products are reduced. A potential strategy to mitigate this risk is to sell products with a higher percentage of polyester. The major concern with this strategy is the firm currently only has 3% of their products containing polyester. Polyester is more commonly used in cheaper suits and the use of high end materials is one of the key selling points for the firm. Due to the limited amount of products it sells with different materials, the firm would have no choice but to pass the cost on to their customers.

The firm faces several market constraints including geo-political instability in the regions in which the firms manufacturers operates, war, poor employee relations, negative brand management and most significantly the firms’ competition. The firm has several major competitors but its biggest rival is Prominent Europe Ltd. The key difference in the products produced between the firms is Prominent Europe Ltd offers both formal and casual wear products where Bagir Group Ltd offers only formal wear. If Prominent Europe Ltd were to take over a portion of the formal wear market Bagir Group Ltd already has then this may pose a significant risk to the profits of Bagir Group Ltd. A potential strategy to mitigate the risk would be for the firm to ensure competitive prices are maintained by either improving the cost efficiency of production operations or by reducing the contribution margin of the products offered.

In conclusion, the firm is limited in modifying their sales volume mix as their products are made from similar materials and have similar contribution margins. When resource and market constraints are

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applied to the firm the firms’ options are to either reduce contribution margins, improve production cost efficiencies or pass on the increase in costs to their customers.

STEP EIGHT: RATIO DISCUSSIONS

I am scared but excited to start this step. I thought an approximate 3000 words were a good amount to write for some of the other reflections so when I saw the exemplar had almost 6000 words I started to panic. How on Earth am I supposed to write 6000 words on anything?

Financial statement ratios are something that have always been a little foreign to me however I have always been interested in them as I know having the ability to determine what financial statement ratios mean can significantly assist me when I decide to choose what shares I want to invest in; to feel confident in the growth of the firm in question.

Similarly, managers of a firm (or at least the accountants who advise them) need to be able to review, analyse and interpret data (or ratios in this circumstance) and then make conclusions to assist managers or any other interested party in making decisions in matters related to a firm.

From writing some of the other steps I know there are going to be items that are going to stand out and really influence the ratios for the firm such as; the $13,305,000 gain on extinguishment of debt, the massive loss in 2015 and the mega turnaround in profit for 2016.

Profitability

What is the net profit margin and what can we learn from it? After listening to Maria comment on it in the week 9 lecture and doing a few Google searches I quickly understood it to be the amount of profit per every dollar of sales after all costs all costs are covered expressed as a percentage. In my firms’ case, I understand the results to mean that in 2013 for every $1 of sales the firm made a loss of $0.01.

You do not have to be an expert to understand the importance of this ratio. When looking at the ratios for the past several years you can quickly determine how a firms’ profitability is tracking or if in this case it is even making a profit.

15.5% -15.5% -3.3% -1.2%

The figures above are my firms’ net profit margin for 2016 to 2013 respectively. By looking at these figures you can see that the margin was progressively worse from 2013 to 2014 and then had a significant drop in 2015. What caused such a negative net profit margin? In 2015, my firm had a measly $7,337,000 gross profit. Whilst some people reading this may think that it is quite a bit of profit but when you compare that to total revenue of $75,207,000 it really is not much. The gross profit for the firm is less than 10% of total revenue and this is supposed to cover the remaining costs such as selling and marketing expenses, the selling and marketing costs alone cost over and above the gross profit margin by $2,127,000 not to mention the other costs such as general and administrative expenses and develop costs.

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The selling and marketing costs were only marginally above the average for the other three years so it is not solely responsible for such a negative profit margin. Almost every item listed under the costs of sales in the 2015 financial statements was higher than the average of the other years. The cost that stood out as being more than marginally higher than the rest was the cost of subcontractors and subcontracted work. The cost of subcontractors and subcontracted work in 2015 cost $8,760,000 more than 2016. Whilst the total cost was still significantly less than the cost of subcontractors and subcontracted work in 2013 and 2014 the total revenues for those years were much higher. I would argue that this cost is one of the primary drivers for such a high negative net profit margin.

After going back through the 2016 financial statements trying to find other key drivers for such a high negative profit margin in 2015 and then such a large swing in profit for 2016 I found the following comment in the highlights for 2016;

Gross margin increased strongly to 16.4% in 2016 compared with 11.6%** in 2015 – driven by a mix of cost efficiencies and higher margin sales

I discovered the reduced cost efficiencies were mainly due to focusing on three manufacturing locations namely Egypt, Ethiopia and Vietnam and streamlining and improving their product base.

An interesting point to note on the higher margin sales is whilst researching the contribution margins for the previous step I came across a document on the internet that stated the minimum profit margin for each product must be 18% above all direct costs associated with manufacturing the product.

I understand the return on assets ratio measures the ability of a firm to generate profit on its assets. For 2013 to 2015 Bagir Group Ltd continually returned a progressively worse return on assets ratio. For a reason I am yet to realise, for every year the return on assets ratio is almost exactly double the net profit margin. I do not think this is a coincidence so it must be directly linked to sales margins or something similar.

A potential way managers could use this ratio is to calculate the ratio for their competitors and then determine if there is a competitor within the industry who has an above average return on assets. The managers can then study that firm to determine what that company is doing to provide a higher than average return on assets compared to industry and potentially adopt a similar strategy.

Efficiency ratios

I had quite a bit of trouble calculating the days of inventory ratio. Whilst the example in the lecture was quite simple the difficulty I had was that the items required to be used in the calculation were amalgamated amongst other costs in the financial statements so I could not link it directly. To negate this issue I went back to the original financial statements and calculated the costs I had to use as a percentage of the amalgamated total cost and then subbed that in to the equation. My drama then was that there were several calculations to be done within the calculation itself. Fortunately, the other unit I am currently undertaking is essential statistics and I used the lessons learnt from that (and some trial and error) to work out how to do the calculation. After using three brackets to determine the order of operations I came to the answer I was after and confirmed it with my calculator.

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As the name suggests, I understand the ratio measures the average time inventory is held on to before it is sold. Bagir Group Ltd days in inventory ratio varies between 100 to 200 days or 3 to 6 months. Due to the firm having production operations across the globe and selling to retailers instead of consumers themselves I believe is the reason for such high amount of days in inventory. Moreover, I assume the firm operates on a periodic basis with transporting its inventory from its manufacturing plants to its customers which might vary by 1 or 2 months depending on demand thus explaining the high days in inventory even when the firm is going quite well like in 2016. I assume in industries that market and sell direct to consumers will have on averages less days in inventory compared to industries that manufacture products and sell to retailers instead.

By way of comparison, if a firm had lower days in inventory compared to the industry average this may reflect high demand for their products but it also may reflect that the firm might not have enough inventory to keep meeting that demand.

I understand the total asset turnover to be quite similar to the return on assets except the total asset turnover measures how much sales are generated from a dollar of assets compared to how much net profit is generated from a dollar of assets. I do not understand why this figure is expressed as a normal number instead of as a $ or %.

Whilst this figure gives an observer a good overview of the revenue generating ability of the firm from its assets it disguises all the other costs, thus providing a limited and potentially masked value.

Liquidity

After typing ‘current ratio explained’ in to Google a long list of websites and videos appeared offering to help explain. There were also lots of forums where people had asked other people to help them explain the ratio. After going through a few of the websites and watching some of the videos I came to the realisation this is a very important ratio, especially for creditors. After watching the lecture I learnt from Maria that creditors often place covenants on debtors that stipulate that if the debtor goes below a certain ratio than certain conditions may take effect.

I understand the ratio illustrates the ability of a firm to repay its short term debts, I also read that it is often referred to as a firms working capital. Fortunately, my firm has had a positive current asset ratio throughout the last four years which suggests that it had and currently has the ability to repay its short term debts. Bagir Group Ltd’s current ratio actually grew higher throughout the last four years culminating at 2.4 for 2016 despite the downturn in profit for 2015. This suggests to me that whilst the firm did have quite a substantial loss in 2015 it was not likely to default on its loans.

I also understand the current ratio can be interpreted as for every dollar of liabilities the firm has how many dollars of assets does the firm have to pay for it.

Some may argue that the current ratio is a good tool to measure a firms’ business performance compared to others in the industry. I would argue that it is actually quite flawed. Consider the following example:

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Is Company A really in a better financial position than Company B? Company B has 20 times the amount of cash than Company A. If the current ratio is suppose to assess the financial position of a firm and its ability to repay its debt, does it actually do that effectively if it does not differentiate between cash and inventory within assets. An alternate equation that does include the amount of cash in assets is (cash + receivables / current liabilities). This would give a new current ratio of .5 and 1.1667 for Company A and B respectively. These new results seem more appropriate to assess the financial position of a company and its ability to repay its short term debts.

Financial structure

After calculating the debt/equity ratio for Bagir Group Ltd I initially was not quite sure what it meant. The figures for 2016 to 2013 respectively are as follows:

53.2% 8546.4% 313.6% -198.0%

I went back over the week 9 lecture and learnt that in general what it means is that for every dollar of equity the firm has, is financed by $x. Now looking at the figures for my firm I can see that in 2016 for every dollar the firm has in equity it was financed by $0.53. I think that is pretty good and according to the internet it is. In 2015, it had $85.46 in debt for every $1 of equity, which is not so good. This is a reflection of the poor financial performance of Bagir Group Ltd that year.

I also understand that the result of the debt to equity ratio is used to asses risk in a firm. The level of risk is proportional to the percentage. The higher the percentage the higher the risk, the lower the percentage the lower the risk but what is an acceptable risk? What is considered healthy? Does it vary from industry to industry? The consensus on the internet is a 2:1 ratio is considered healthy, that is for every $1 in equity there should be no more than $0.50 in debt. In my firms’ case 2016 is the closest to the 2:1 ratio it has been in four years.

Another thing I am unsure of is what a negative ratio means in this circumstance? I have calculated the debt/equity ratio for 2013 as follows: Total liabilities $71,507,000 / total equity (36,108,000) x 100 = (198%). A point to note is that the firm did not go public until 2014 so it only had a limited amount of equity to begin with which was mainly sourced from private funding and the boards vested interest. When I remove the negative from the equation I still get 198% but as a positive

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number instead. After staring at my financial statements and ratios for about 10 minutes trying to understand what it meant to have a negative ratio and not coming to any meaningful conclusion I decided to post a question on the unit Facebook page and scour the internet for an answer whilst waiting and hoping one of my peers or Martin would reply to my post and answer my question.

So, after a solid 30 minutes of research online and no response on Facebook I have all but given up. My understanding for 2013 will now remain that for every $1 in equity the firm does not have, it is financed in debt by $1.98

When I typed in ‘equity/assets ratio explained’ in to YouTube and nothing matching my search came up I knew this was going to be another hard one not even considering I had another negative ratio as well for 2013. Maria made a small comment in the lecture saying that for Wesfarmers in 2016 is funded 56.3% by equity when she was explaining how to calculate the equity ratio. In another words, I understand it to be a measure of how much the firm is financing its assets using equity.

65.3% 1.2% 24.2% -102.0%

Looking at the figures above for Bagir Group Ltd’s equity ratio you can quickly identify that these ratios are consistent with financial performance of the firm reflected in the aforementioned ratios. When I look at the ratio for 2013 I am again confused. If the ratio is suppose to measure the portion of assets that is funded by equity and you think of assets as a pie graph than how is it possible to have a figure over 100% let alone negative 102%? In reality does this just mean a firm’s assets are not funded by equity at all and the ratio is arbitrary? The 2014 ratios illustrates how little equity is actually funding the assets and even more so for 2015 at just 1.2%. If I was a creditor I would be getting quite worried.

Calculating the opposite values of the equity ratio obviously highlighted the portion of assets which is funded by debt or an alternative source of finance other than equity. As you can see for all years except 2016 the firm was highly leveraged. Maria mentions in the lecture that she gets worried when a firms debt is over 40%. As you can see she would be highly stressed if she was looking at my firms ratios. Considering my firm was highly leveraged in 2015 and had a negative net profit for the year I would be highly worried if I was a creditor or investor. Fortunately for them, the firm turned this ratio around for 2016 bringing it fewer than 40% whilst also being quite profitable.

34.73% 98.84% 75.82% 202.00%

Market ratios

Before I comment on the ratios individually I would like to say that determining the market price per share was a much more arduous and complex process than originally thought. The market share prices are not listed in any of their financial statements so I set out to do some research to find out manually what they were for the past four years. As it turns out Bagir Group Ltd is listed on the London stock exchange but its financial statements are in $USD.

To determine each year’s share price on the 31st December for each year I first found the listed stock on the London stock exchange and wrote down the price for the stock for the 31 st December for

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each year. The stock price was quoted in GBX so I converted it to GBP which was straight forward. Now because my firms financial statements were listed in $USD I had to convert the stock price from GBP on their respective dates to $USD but before I did that I found a graph on Google with the historical exchange rates between GBP and $USD and then wrote down the exchange rates for the last four years on the 31st December. I then converted the share price from GBP to $USD. It was definitely a lot harder than just being told the share price for each year. It took me a while but I felt like I had learnt and accomplished something afterwards. The only year I did not actually do this for is 2013 because it was only privately funded at that point and its share price was listed in NIS, so all I had to do was convert it to $USD using the exchange rate for NIS to USD on the 31st December in 2013.

The first market ratio being earnings per share I think is quite simple to understand. I believe it to be the value added (or subtracted) to the shareholders divided by the amount of shares or ‘pieces’ a firm is broken in to. Earnings per share for Bagir Group Ltd are as follows:

$ 0.11 -$ 0.23 -$ 0.09 -$ 0.39

Considering the average share price for the past four years is 0.11 the earnings (and losses) per share are quite substantial. In the first year the firm went public being 2014 investors lost $0.09 per share, followed by a bigger loss in 2015. The gain of $0.11 in 2016 was marginal compared to the losses already Incurred. Below is a graph of the entire history of BAGR listed on the London stock exchange and illustrates the lack of investor confidence. Even though the firm made a big turnaround in profit for 2016 the stock has continued to decline. If you look just above the vertical line above 2016 below you will notice there was a slight increase in the stock price. I assume this was in anticipation of the release of the interim results for the six months ending 30 th June. As you can also see the stock price went down just as quick as it came up.

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I understand that the difference between earnings per share and dividends per share is the amount of profit a firm wishes to retain; the balance is paid out in the form of a dividend. In my firms’ case, when it makes a profit it just subtracts that profit entirely from the accumulated deficit and when it makes a loss it adds it to the accumulated deficit. I also understand that some firms when they have a bad year can actually pay more in dividends than they had in earnings per share. Why would a firm do this? I suppose some firms want to remain consistent with their dividend payout as not doing so may cause a lot of investors to sell the shares causing the firms shareholders equity to reduce proportionately.

Bagir Group Ltd’s dividend policy is as follows:

The Board intends to adopt a progressive dividend policy to reflect the expectation of future cash flow generation and the long-term earnings potential of the Company. Based on the above expectations, the Directors intend that the Company will (in accordance with the provisions of the Companies Law) pay dividends annually, made up of an interim dividend and a final dividend to be announced at the time of the interim and final results in approximate proportions of one third and two thirds, respectively, of the total annual dividend. The Board may revise the Company’s dividend policy from time to time in line with the actual results of the Company. Under the terms of the Debt Agreement with Bank Leumi and Discount Bank, the Company has undertaken that, except with the consent of Bank Leumi and Discount Bank, the aggregate amount of dividends which it will distribute in relation to any particular financial year will not exceed 55 per cent. of the annual net profits, save that the figure in relation to the financial year ended 31 December 2014 shall not exceed 70 per cent. (instead of 55 per cent.).

Whilst this policy seems fair and quite progressive Bagir Group currently has an accumulated deficit to the tune of ($73,204,000) and will not be paying a dividend until this accumulated deficit turns in to retained earnings. This lack of dividend may be one of the primary reasons the firm has a lack of investors.

The price earnings ratio is a term I have not come across before. In the lecture Maria initially says that the lower figure the better and 120 is way too high for her to invest in. That did not really tell me what it means though. She then explains that one of her students explained it to her as the amount of years it will take to earn your money back. After listening to that I thought to myself; how on earth does it mean that? I decided to just sit and think about it for a few minutes. Not long after starting to just sit and think had a light bulb kind of moment and realised what that student was getting at and I thought that was actually a perfect way to describe it! Good on that student! I now realise what she meant is that for every year of earnings per share how long will it take to reach market price.

Considering the above I can immediately two flaws; the first being that it only considers the earnings ratio for that year alone. To be more accurate, instead of using the earnings ratio for that year it could use the average for the past five years combined with the average forecasted for the next three years and just use the market price you bought it at or the current market price if you have not bought yet. The second flaw is that as discussed earlier the earnings per share ratio is focused on value add rather than actual cash in your pockets like dividends so the price earnings ratios calculated is almost arbitrary unless you calculate the average earnings ratio over a few years or use the dividend ratio instead.

Bagir Group Ltd’s price earnings ratios are as follows:

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0.45 (0.24) (2.10) (0.36)

I guess for my firm that concept does not work as logically as it did for the Wesfarmers example. Looking at the ratios for 2013 to 2015 it is basically saying that if it continues the same earnings ratio each year than it will in reality never earn you back market price per share. The 2016 figure is a lot more hopeful and is actually saying that you if you bought the share at market price you would earn your money back in 164 days. Pretty good return on investment I would say! Maria also mentioned in the lecture that he average price earnings ratio is between 15 and 25 across all industries. As you can see Bagir Group Ltd falls way outside that average.

Ratios Based on Reformulated Financial Statements

The return on equity was explained well by Maria and I understand it to be the profit made in a year compared to the amount of shareholders equity, expressed as a percentage. Maria also said that you can think of it like an interest the bank may pay you for depositing money with them. Bagir Group Ltd’s return on equity ratios are as follows:

46.96% -2756.67% -24.45% 3.40%

2013 seems like a pretty low return considering the risk involved in the business. Most banks will probably offer 3.40% guaranteed return in one of their term deposit options and that is essentially with no risk. Why would an investor buy shares in a company that is retuning such a low return on investment? In the following two years you can see that investors actually lose a considerable amount of value in the firm and it is actually costing the investors to have their money deposited with the firm. As with the rest of the ratios I have gone through so far there is light at the end of the tunnel being 2016. A whopping 46.96%! Now that is a good return on investment but as the saying goes if you want big returns than you have to take on big risk. Whilst 46.96% is quite a significant return it is not reflected in the stock price or the dividend payout. It is an arbitrary return.

Return on net operating assets I understand to be almost the same as the return on assets ratio mentioned previously the difference being that this ratio uses operating income and net operating assets thus seeing the figures for what they really are. These figures to me are like cutting the fat off steak and just looking at what is left.

The return on assets originally calculated is listed on top and the new return on net operating assets is listed on the bottom:

30.5% -32.1% -6.4% -3.4%14.97% -62.92% 1.00% 17.70%

As you can see using the new figures, the return on assets was actually worse than originally calculated for 2015 and 2016. There is quite a significant turnaround in 2013 and the return has just become less bad for 2014.

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The net borrowing cost seems like a really important ratio to calculate. I guess it is basically expressing the interest rate payable for a firm. When I originally did the calculations I had a few negatives because I had listed my net financial expenses as negatives and I did not really understand how it made sense as a negative so I went back over the lecture and realised that you are supposed to change negative numbers to a positive. My only drama now is that for 2016 I actually had net financial income instead of net financial expenses. What am I supposed to do with that? Let’s think about it logically. If the aim of this ratio is to determine the cost of borrowing in percentage and it is like an interest rate than I can understand why it would be a positive number if a firm had net financial expense after tax because that is the interest rate paid. If I actually received money from my debt more than paid (I.e. having NFI instead of NFE after tax) then I want to find out how much I actually earnt from having finance expenses. Considering this concept, I know believe I should have a negative net borrowing ratio for 2016.

Before I changed it to a positive I decided to look up other student’s ratios and financial statements to see if anyone else had the same problem. I looked at the first students I found and went straight to the bottom of their restated financial statements to see if they had NFI for any of their years, they did for two out of four. I clicked on the ratio sheet to see how they calculated it and I noticed that all their net borrowing cost figures were all in negatives and they either forgot or had not realised that they are supposed to b positive numbers if your firm had NFE after tax. I made a note to let this person know of their mistake and continued on looking for another example. At this stage there were only about five already posted on blogs, Facebook and Moodle and none of them had NFI after tax. What about Danielle Bradleys, the exemplar from last terms? I was glad to find out that she did in fact have NFI after tax for three years and calculated them as a negative in her ratios. Surely the exemplar would be correct right? I decided to just go with it and my figures turned out as follows:

-99.86% 14.97%The 2013 rate seems quite reasonable for an interest rate; it is basically what I am paying on my home loan. I am not sure what the average business loan for firm is but I would assume it is closer to the figures for 2014 and 2015 due to the higher risk a bank has to take on compared to giving a home loan to a regular couple on a decent wage who is less likely to default on their loan then a firm.

As you can see I have listed the 2016 net borrowing cost as a negative for the reasons mentioned earlier. It is quite hard to believe that the bank was paying the firm an interest rate of 99.86% right? What actually happened that caused this is the banks forgave $13,305,000 in debt in return for shares. This is considered finance income for the firm and is the reason for such a high net borrowing cost.

The profit margin appears to have the same relationship with net profit margin as return on net operating assets had with return on assets. The difference is as follows with the net profit margin on top and the new profit margin calculated on the bottom.

15.45% -15.49% -3.28% -1.23%3.08% -12.50% 0.26% 2.70%

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For the years 2013 to 2015 you can see that the profit margin has actually improved. On the contrary has lost a whopping 12.37% on their profit margin. How can this be? Majority of the firms profit came from finance income most notably the gain on extinguishment of debt as mentioned earlier. So when you only include the operating profit, it actually did not generate that much profit.

To compare the newly calculated asset turnover to the previously calculated total asset turnover I have copied the former on top and the latter below:

1.97 2.07 1.96 2.814.85 5.03 3.81 6.54

As you can quickly see here, the firms’ ability to generate sales from assets is much more efficient overall calculated this way. I am starting to realise the importance of restating financial statements and understanding why you separate finance from operating it is like the difference between the fat and the bones. You need to get rid of the fat and meat so you can really see what is hiding under there for better or worse. (I thought of a much more crude analogy to help describe this concept than this but I think the fat and meat on the bones will do just fine).

Economic profit

An economic profit or loss is the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used.

I found the above definition on the internet and thought it was a really simple yet eloquent way to explain the concept of economic profit.

Now to get in to the crux of it, after all economic profit is really what matters at the end of the day right? In my own words, economic profit is what the firm has generated from its assets after the opportunity cost is accounted for. Fairly important I would argue as we have not considered the opportunity cost up until this point. I have left the opportunity cost at 10% as suggested by Martin because I have not yet found a reason for me to think another figure is more appropriate.

The economic profit for Bagir Group Ltd is as follows:

656.4 (10,898.5) (2,289.6) 1,170.8

Overall pretty terrible I would say! As you can see the economic profit gets worse and worse from 2013 to 2015 and then has quite a massive turnaround in 2016. What has caused these mega losses and mega turnaround?

First of all, I would like to review the profit margins to see if they are proportional to the economic losses and profit above.

3.08% -12.50% 0.26% 2.70%

I think I have found one of the primary drivers for the economic profit and losses. The profit margins here are directly proportional to the economic profit and losses. The 2013 profit margin is slightly

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not as proportional as the rest so I will keep an eye out for another driver for the economic loss for 2013, but what drives profit margins? Operating income (OI) and sales; now as I look back over the sales they do fluctuate quite a bit throughout the four years by a total standard deviation of $14,857,000. The OI also fluctuates quite severely as shown in the row second from the top below:

64,071 75,207 96,982 99,490 1,976 (9,404) (254) 2,691 3.08% -12.50% -0.63% 1.11%

656.4 (10,898.5) (2,289) 1,171

If the profit margin is calculated by dividing OI by sales what can we learn here? In 2015 you can see that the economic loss is proportional to the negative profit margin. The same can be said for 2016 except as an economic profit. Upon first looking at the profit margin of -0.63% for 2014 I thought that it cannot be the only reason as to why it had such a large economic loss, but after careful study of the figures, I realised that -0.63% will be much greater for 2014 compared to 2015 and 2016 due to the large increase in sales revenue for 2014 which is amplifying the percentage. 2013 has a profit margin of 1.11% but an economic loss of (418.2) so as stated previously there must be something else driving this figure.

Net operating assets (NOA) averaged 15M for all years except 2014 were it was 10M above average. This increase in NOA has blown out the economic loss buy a further $1,294,000 than if the NOA was in line with the average. Considering the NOA was constant throughout the other years I will not consider it a driver for those years.

The final potential driver is the difference between the RNOA and the weighted average cost of capital (WACC). Considering the WACC remains constant throughout I will only consider the RNOA as the potential culprit. The RNOA is shown below:

14.97% -62.92% 1.00% 17.70%

As you can see, the RNOA has assisted with the economic profit in 2016 as it out weights the opportunity cost by 4.97%. The RNOA for 2015 has obviously driven compounded the economic loss; the same can be said for 2014. Last but not least and the final driver I have been looking for that has caused 2013 to experience an economic loss despite a positive profit margin is the RNOA. Because the RNOA for 2013 is 2.75% below the opportunity cost it has turned what could have been an economic profit in to a loss.

Overall, the firm has a bad few years culminating in a mega loss in 2015. Fortunately, the firm made a massive turnaround in 2016 by achieving 10M in net profit through narrowing its product base, increasing profit margins and focusing on three key areas to manufacture its products. Whilst there are numerous news articles out there describing the terrific turnaround the firm made in 2016 it consistently leaves out one crucial fact. Whilst the firm did in fact make some massive positive changes, that fact is that majority of its net profit actually came from its gain on extinguishment of debt not from revenue generating assets. Considering this new fact I assume that the firm will still

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make a profit next year but instead of a 10M profit like last year I think it will make a net profit of around 1 – 2M, which is what it would have made without the gain on extinguishment of debt.

What a massive task! I think it actually took me about an hour or so to complete the ratios and probably more like 12 hours writing the discussion not including the final edit. I am absolutely buggered but I really enjoyed the process and learnt a lot. I really tried focusing on enjoying and appreciating the process instead of just focusing on finishing which really helped. After completing such a mammoth task I think I am ready to take the next step and make a capital investment decision for my firm.

STEP NINE: CAPITAL INVESTMENT DECISION

Bagir Group Ltd’s current business model is to manufacture garments and sell them to the brands that license them or to other retailers, as such the firm does not currently own any of their own retail stores. The managers of the firm are trying to decide if this would be a profitable investment and if so, what location would be the most profitable. The firm is currently considering two prospective locations; New York City and London.

If the firm were to open a store in either of the locations mentioned it would purchase commercial property in a high traffic and central location within their respective cities instead of leasing a store in a shopping centre. Due to this, the initial cost will be a lot more expensive than opening a store in a shopping centre however, will have a much higher residual value than that of a store in a shopping centre. Due to the prime location, inflation and forecasted demand for commercial property in the area I have priced the residual value accordingly.

Whilst the firm currently has no intention of closing the store’s after any specific period of time, if they were to prove less profitable than originally thought, than the firm may decide close the store and sell the property however is satisfied in giving the investment 10 years to prove its profitability.

The cash flows of both stores are made up of; garment purchases and a tailoring service less staff wages and other operational costs. The ongoing costs do not include the cost of rent as purchasing the property is part of the investment decision.

* The store/s would be purchased on 1st January 2018 and the cash flows for each year are expected no later than the 31st December.

* All figures relating to the decision are below and expressed in $USD and represent the actual figures shown.

* The discount rate applied is 10%

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Data summary

Retail store London

NPV = $2,028,637

IRR = 24.0%

Payback period = 4 years & 255.5 days

Retail store NYC

NPV = $1,269,671

IRR = 20.1%

Payback period = 5 years & 182.5 days

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Recommendation

Currently the UK has higher demand than the US for the firms’ products however the cost of living, property and salaries are proportionately higher in the UK and I have ensured the original cost, residual value and cash flows reflect these findings.

Both options produce a positive NPV and IRR, both options also have the original cost paid back within the time frame of the investment. The NPV for the London store is $758,966 more than the NYC store, the IRR is 3.9% higher and the payback period is 292 days less.

The firm currently manufactures its garments in Ethiopia, Vietnam and Egypt. These three locations are far closer to London than they are to NYC thus reducing the cost of freight. Brexit negotiations may prove a threat to the tariff free trade routes to the UK and the current politically instability in the US caused by President Trump and his obvious dislike for free trade may also prove a threat to the free trade routes to the US. Both threats are yet to be realised and I assume their effect would be similar so I have allocated equal weight to them when considering my recommendation.

In conclusion, if the estimated cash flows prove realistic than both options are highly profitable, however due to the firms large accumulated deficit and poor performance in recent years I would recommend adopting a risk adverse strategy and only pursue the investment of the London store.

Strengths and weaknesses of analysis

The biggest weakness of the analysis is the estimation of expected cash flows. The firm has never opened one of their own stores before therefore making it extremely hard to estimate the potential profits. Whilst 1 in 6 British men currently own a suit manufactured by the firm, majority of them would have a different brand label on them, thus presenting a risk that many of the firms’ current customers may not actually be aware that they are wearing a Bagir manufactured suit and rather the brand it has on it. If the industry as a whole experienced a market downturn than the lack of cash flow will increase the payback period and decrease the NPV. Lastly, an increase in the price of wool would increase the cost of manufacturing. The firm would then have to decide to either pass the cost on to consumer or reduce their profit margins thus reducing cash flows or increasing prices and potentially losing customers to competitors.

By way of comparison, a notable strength of the analysis is the inclusion of the risk of tariff free trade routes. Whilst equal weight was given to both decisions, the mentioning of the risk during the infant stages of the decisions provides the managers an opportunity to assess the risk in further detail before making a decision. The payback period is less than half the time of the projected life span, as such; if the cash flows are lower than estimated the firm has approximately another 5 years to pay

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back the original cost of the investment and produce a profit. The final strength of the analysis would bet the computation of the quantitative differences between the investment decisions thus providing a measurable difference between investment options.

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