Corporate Financial Management - Assignment Example

Corporate Financial Management Answer a) Financial analysis is required to assess the current financial position of the company and evaluate the profitability of the company (Stradling and Spencer, 2001). The financial analysis of a company is done to evaluate the liquidity, long term cash flow and profitability of the company. Financial statements like profit and loss and balance sheet are required to assess the current financial position of the company (Small Business Development Corporation, 2012). Income statements are required to assess the company’s revenue over a short period of period of time. A financial ratio is an index between two accounting numbers and obtained by dividing one number from another number (Gibson, 2010). The current ratio of the company determines a company’s ability to cover its current liabilities with current assets. A current ratio between 1.5 and 3.0 indicates that the company is in a healthy condition. The quick ratio determines the company’s ability to meet its current liabilities with its liquid assets. A quick ratio should be 1:1 or higher. A company with a high liquid ratio reflects that the company has greater liquidity (J.D. Stice, E.K. Stice and Albrecht, 2010). The current ratio and quick ratio of ABC Learning was as follows: Ratio June 2004 June 2005 June 2006 June 2007 Current ratio 1.49 1.57 1.81 0.27 Quick ratio 1.49 1.50 1.77 0.27 The company’s current ratio was strong in the year 2005 and 2006 which reflects that the company’s ability to meet its short term obligation during this period was good. However, the current ratio in the year 2004 and 2007 was not that strong which reflects the company’s poor ability to meet its short term obligations. The quick ratio of ABC Learning was strong in the years 2004, 2005 and 2006. This shows that the company’s liquidity during those years was strong and in the year 2007, the company’s quick ratio was poor. A strong working capital of a company reflects the company’s ability to weather hard times (Bank of Canada, 2012). Working capital is the amount of money required to facilitate business operations activities. The working capital of the company should be positive. Let us observe the working capital of ABC Learning during the tenure June 2004 to June 2007. Amount June 2004 June 2005 June 2006 June 2007 Working Capital 12947000 37436000 124819000 (1062000000) The working capital of ABC Learning was positive during the tenure June 2004 to June 2006. However, the company’s inability to meet its short term obligation and poor liquidity is reflected in the year 2007. Receivables of a company show the number of days required for the company to collect its debt (Gibson, 2010). The accounts receivable of ABC Learning was as follows: Ratio June 2004 June 2005 June 2006 June 2007 Receivables 0.78 22.7 46.43 12.02 The average collection period of the company was good in the years 2005 and 2006. However, in the year 2004 and 2007 the company’s average collection period was not good. The inventory turnover ratio depicts the company’s effectiveness in utilizing the inventory assets of the company. The inventory turnover ratio of ABC Learning is as follows: Ratio June 2004 June 2005 June 2006 June 2007 Inventory turnover ratio 0 1.83 0.91 .04 The inventory turnover ratio of the company is very low in the years 2004, 2005, 2006 and 2007. A low inventory turnover ratio indicates that the company has been overstocking or there have been certain deficiencies in the inventory system of the company. The return on investment ratio indicates the profitability on the assets of the company after excluding all the expenses and tax. The return on invest of the company is shown as follows: Ratio June 2004 June 2005 June 2006 June 2007 Return on Investment 7.4 % 4.9 % 3 % 3% The company has a good return on investment ratio in the year 2004; however the company’s return on investment kept decreasing during the tenure June 2004 to June 2007. This proves that the company was incurring losses during this tenure. The cash flow statement of the company is one of the most instrumental financial statements of the company. The cash flow statement records the cash inflow and outflow of a company. There is a big difference between the balance sheet and cash flow analysis. The cash flow statement reflects the liquidity of the company and the balance sheet reflects the profitability of the company (Zions Bank, 2005). Let us observe the cash flow statement of ABC Learning during the tenure of June 2004 to June 2007. Particulars June 2004 June 2005 June 2006 June 2007 Operating cash flow 19860000 46718000 89066000 206900000 Investing cash flow (152158000) (453965000) (851159000) (1579400000) Financing cash flow 127304000 452972000 850109000 1495600000 Net cash increase (4994000) 45725000 88016000 123100000 During the tenure June 2004 to June 2007, the cash flow in investing activities was negative compared to the cash flow in operating and financing activities. The company has invested in fixed assets like plant and machinery, building etc., but the cash inflow was less. The receipts from customers were less compared to the customer expenses borne by the company. The childcare expenses like proceeds from sale of childcare licenses and other items were huge compared to the income received during this period. Answer 1 (b) The capital structure of the company refers to the combination of debt and equity capital which a company uses to finance its long term operations (Schell and Tyson, 2011). The fund manager raises capital from different sources and allocates it in different departments of the company. The company follows basic principles that provide a system of capital so that maximum rate of return can be earned at a minimum cost. This sort of system capital is known as capital structure. The capital structure of a company depends upon various factors like size and nature of the company, asset structure and age of the company etc. An optimal capital structure implies the safest ratio between various types of securities. A sound capital structure requires the components like debt to equity ratio should be 1:1, earning interest ratio or interest coverage ratio should be 2:1 and long term loans should not be more than working capital of the company (Houston and Brigham, 2011). As per the annual report of ABC Learning 2007, the debt to equity ratio was 0.92 which is very poor. The interest coverage ratio was 2.4517 which is also very weak. The company had made huge amounts of interest charges in the year 2007. As per the annual report of 2007, the interest charge amount was $112.6 million. The long term capital was more than the working capital of the company which signifies that the company’s capital structure was not balanced appropriately. The main of the management of the company was to maintain a good credit rating. An increased credit rating would have attracted potential investors to invest in the company and increased the profits of the company Answer 1 (c) The company’s equity comprises common, preferred stock and retained earnings. The long term liabilities in a balance sheet are often termed as the debt of the company but the debt structure generally comprises long term loans, short term borrowings and two third amount of operating lease. The debt equity structure varies from company to company but generally the debt portion of the company should be lower than the equity levels (Swanson, Srinidhi and Seetharaman, 2003). The capitalization ratio compares the debt component of the company’s capital structure to the equity component of the capital structure. Usually in a debt equity ratio, the equity portion should be higher indicating the higher returns. The debt equity ratio of the company of the company was very weak in the year 2007. The debt portion of the company is lower than the equity portion; the debt portion of the company was $1453.9 million and equity portion of the company was $1901.6 million. The company’s allocation between debt and equity funds was inappropriate and the management of the company did not maintain most of its portion in the floating rate debt capital. Answer 1 (d) As mentioned before the capital structure of the company was unbalanced and inappropriate, the main reason of the management in choosing such a capital structure was lack of analysis and evaluation. When ABC Learning’s stock was listed on the stock exchange it received an overwhelming response from the investors. It was a small company with a market capitalization of AUD 25 million Australian. In the year 2006, ABC Learning had a market capitalization of AUD 2.5 million (Downie and Rush, 2006). The financial success was reflected on the share price of the company, it increased more than 300 percent in the five years since the company’s stock was listed on the Australian stock exchange in 2001. Figure 1: Share price of ABC Learning (Source: Downie and Rush, 2006) From the above charts we can observe that the share price of the company increased from AUD 3.50 to AUD 8.00 during the tenure 2004 to 2006.The market capitalization of the company increased from AUD 8 million in the year 2001 to AUD 2.6 billion (Downie and Rush, 2006). This is due to the fact that the goodwill of the company increased tremendously. The management team of ABC Learning was confident that irrespective of the economic condition, the market share of the company would increase. The company had an imbalanced capital structure where the equity portion was greater than total debt portion but the difference between the two was meager. The company should have more amount of debt financing than equity financing to shield it from the tax policies of Australia, New Zealand and USA. The company had incurred huge amounts of operational costs and suppliers costs. Answer 1 (e) Most of the management team of the company thinks that the capital structure of the company is all about securing the cheapest source of debt capital (Zenner and Shivdasani, 2005). The borrowings of the company are usually done at a lower interest rate to attain stability in the debt structure of the company but ABC Learning had secured loans and borrowings at a higher interest rate. Since obtaining loans and borrowings at a lower interest rate cannot help the management of the company in evading the tax, ABC Learning should have abided by the laws of trade off theory. The trade off theory suggests that the foundation of an optimal capital structure is one of the reasons of success for a company (Zenner and Shivdasani, 2005). The risk adjusted cost of debt capital is lower than the risk adjusted cost of equity capital. Debt financing is generally cheaper than the equity financing and is relatively easier to estimate the after tax cost of debt for various leverage issues. The trade off theory had segregated different companies based on their usage of debt capital. Companies of a larger scale should make greater use of debt capital to shield from the tax benefits. Companies with non tax benefits should use less of debt capital. Companies operating in those countries where equity financing is heavily taxed should use less amount of debt capital. Some of the companies have the tendency to use less equity financing and more debt capital to receive a good credit rating. This method is not appropriate as companies should evaluate the nature and size of business, tax policies of the country to use a balanced proportion of debt and equity funds (Zenner and Shivdasani, 2005). ABC Learning had opened its centers in various cities of Australia, New Zealand and USA; however the company struggled in maintaining these centers. In the year 2007, the company realized that the operational costs of certain centers of the company were huge compared to the revenue generated from these centers. The company should have closed some of its loss making branches and operated only the profit making ones. Answer 2(a) ABC Learning was one of the major education centers of Australia providing education facilities for children at an early age. The company provided educational facilities’ and toys to the children. They also provided high quality food and the children were kept under constant surveillance of the teachers for security purposes. The main aim of the company was to provide children with proper educational facilities. ABC Learning had its fair share of success in Australia and wanted to expand further into other countries. The want of expanding into other countries with an aggressive approach is determined as aggressive acquisition strategy. The company gradually expanded into other countries and opened around 800 centers worldwide by the end of the year 2005 (Downie and Rush, 2006). The company wanted to achieve its sales target by the year 2007. The company used most of its capital in expansion to other countries. The company could not operate its centers efficiently, and the quality of their services was detiorating. As per as a survey conducted by the Australian Institute in the year 2006, 29 percent of the staff claimed to have developed an intimate relationship with the children and the remaining 54 percent claimed to have been busy with other activities related to the company (Downie and Rush, 2006). The company started hiring employees more than their actual requirement. This was a major issue because the company could not harness the true potential of the employees. The quality of services and facilities provided to the children started degrading. As per the survey conducted by the Australian Institute in the year 2006, 37 percent of the employees claimed that the educational facilities had started degrading and 55 percent of the employees claimed that the children were not provided with nutritional food (Downie and Rush, 2006). Answer 2 (b) Shareholders are considered as owners of the company and they have the right to information. The shareholders are often interested in company decisions like whether to sell the company or purchase an asset etc. The shareholders have the right to access financial statements like balance sheet and profit and loss statement (Ernst & Young, 2008). The financial statements are certified and checked by an auditor of the company who makes sure that the company does not commit any fraudulent practices. ABC learning had witnessed an increase in its share price because of the increase in value of the intangible assets of the company. Intangible assets are assets which do not have any physical form and are expected to provide future benefits. Patents, copyrights and trademarks are examples of intangible assets. The accountants of ABC Learning do not mention the intangible assets in the accounting statement which creates a major information gap. Intangible assets are not easily quantifiable and measurable hence, the accountants of the ABC Learning increased the share value of the company by increasing the assets of the company in the balance sheet. This is also known as manipulation of assets or asset value. This happens because intangible assets are not capitalized but they are expensed. The company shareholders and the common people started losing faith in the company and eventually the company started incurring losses. Answer 2 (c) The company could have adopted the ‘The Simplex process’, which helps in identifying problems and providing remedies to the problems. This model was created by Min Basadur (Huray, 2006). This model can be applied to models of any scale. The eight stages of this model are as follows: 1. Problem finding: In this stage the managers identify and locate the problems. 2. Fact finding: The managers analyze the data and identify whether the problem really exists. 3. Problem definition: In this stage the manager needs to identify the problem which needs immediate attention. 4. Idea finding: In this stage the managers start generating problem solving ideas. 5. Selection and evaluation: In this stage the best alternative and solutions are selected. Once the idea is selected, the main duty of the management team is to develop the best solution. 6. Planning: The managers in this stage plan the implementation of the best idea. 7. Sell Idea: The managers in this stage convince the subordinates about the implementation of the idea. 8. Action: In this stage the idea or solution to the problem is implemented by the managers with the help of the subordinates (Manktelow, 2005). If the management of the ABC Learning had followed this business model, then it might not have faced difficulties. This business model not only helps in identifying the problems but also helps in generating ideas which can act as probable solutions. This business model would have surely helped the managers to curb their operational cost and increase the effectiveness of the company. Answer 3 Executive summary and conclusion ABC Learning was one of the most successful education centers of Australia and managed its operation fairly well. The company started adopting the aggressive acquisition strategy and expanded into other countries like New Zealand and USA. The company had acquired sufficient capital by the year 2005 to expand into other countries. The company had sufficient resources to expand into other countries but lacked the expertise and skill to manage its operations. The quality of educational facilities provided by the company started degrading and employees started complaining about the improper working atmosphere. The market share price of the company was high during the tenure 2003 to 2005 but the management of the company had increased the value of the intangible assets in the year 2007 which resulted in the increase of the share price of the company. This proves that the company lacked transparency and clarity. The unethical decision making of the managers of the company affected the managers, shareholders and employees of the company. Every company should follow the principles of business ethics and values or it may affect the culture of the company. Profit maximization should not be the sole objective of a company. A company should also think about the welfare of the employees, shareholders and stakeholders (Lazonick and Sullivan, 2000). References Bank of Canada, 2012. An analysis of indicators of balance-sheet risks at Canadian financial institutions [pdf] Available at: [Accessed 20 March 2013]. Downie, C. and Rush, E., 2006. ABC learning centres a case study of Australia’s largest child care corporation [pdf] Available at: < https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.tai.org.au%2Ffile.php%3Ffile%3Ddiscussion_papers%2FDP87.pdf&ei=44RJUdmhA8TQrQfo-4GICQ&usg=AFQjCNEHkoLwoa_AmjxJpbW8TIUXbIBd0w&bvm=bv.44011176,d.bmk> [Accessed 20 March 2013]. Ernst & Young, 2008. Reporting to shareholders [pdf] Available at: < http://www.ey.com/Publication/vwLUAssets/Reporting_to_shareholders/$FILE/Reporting-to-shareholders.pdf > [Accessed 20 March 2013]. Gibson, C., 2010. Financial reporting and analysis: Using financial accounting information. 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Financial analysis. Hertfordshire: Select Knowledge Limited. Swanson, Z., Srinidhi, B.N. and Seetharaman, A., 2003. The capital structure paradigm: Evolution of debt/equity choices. Connecticut: Greenwood Publishing Group. Zenner, M. and Shivdasani, A., 2005. Capital structure, payout policy, and the IPO process [pdf] Available at: < http://jsmith.cox.smu.edu/fina6228/Readings/How%20to%20choose%20a%20capital%20structure.pdf> [Accessed 20 March 2013]. Zions Bank, 2005. How to prepare and analyze a balance sheet [pdf] Available at: < https://www.zionsbank.com/pdfs/biz_resources_book-2.pdf> [Accessed 20 March 2013]. Read More