FIN3CSF Case Studies in Finance

Semester 2, 2014
Case Study 2: Financial Analysis and Forecasting


1. Analyse the strengths and weaknesses of the company Horniman Horticulture
Strengths: the core strength of Horniman lies in its ability to generate double digit
revenue growth in 2005 (15.5%), higher operating margins than benchmark, and
profitability ratios such as ROA and ROC. These figures were achieved from the
companys strategy of product development to offer a wider range of products to the
market, most of which are highly sought after by customers. In addition, there is the
firms management style, specifically Bob Browns ability to maintain good
relationships with clients and employees. Finally, Horniman was able to manage costs
well in the last few years, making profit margins steadily increase
Weaknesses: low liquidity with minimal cash balance and significant asset tied up in
the form of accounts receivable and inventory. The companys days of receivable and
inventory are much higher than benchmark, while days of payable are smaller,
indicating problems with the companys cash conversion cycle (517.4 days compared
to 381.2 days of the benchmark). Due to this liquidity problem, the company may not
sustain its current growth rate due to future liquidity shortage which may induce
borrowing and other sorts of financing that will increase the companys overall cost
of operation
2. Calculate free cash flow to the owners of the firm (FCFE) for 2005 (i.e. operating
cash flow less capital expenditure less net working capital). Calculate the cash cycle
of the business for 2005. Using these calculations explain how the company using it
cash
FCFE = NI + Depreciation Capital Expenditure Changes in WC + Net borrowing
Working capital = Accounts receivable + Inventory Accounts payable
Assume current liabilities are comprised of debt, 2005 FCFE will be as following
60.8 + 40.9 4.5 (798.3 638.4) + (47.3 43.2) = -58.6
Operating cash cycle = Days of receivable + Days of inventory = 527.2
Cash conversion cycle = Days of receivable + Days of inventory Days of payable =
517.4
Although the company had positive cash flow from operation (i.e. positive net income
add back depreciation), FCFE was negative because cash flow was drawn up to
finance working capital for the company. Specifically, receivable and inventory
increased significantly from 2004 indicates problem with the management system.
Both conversion cycles are longer than the benchmark indicating that the company is
inferior in recycling its available cash balance and liquid assets to support business
operations
3. Extend the financial statements (i.e. balance sheet and profit and loss statements)
through to 2006, assuming that Bob Brown grows revenue by 20%. Note: to make
the balance sheet balance, define cash as equal to (current liabilities + net worth)
(accounts receivable + Inventory + other current assets + net fixed assets). Assess
the financial position and need of the business in 2006
Assume that operating margins remain the same
Depreciation horizon 19 years (calculated based on the incremental depreciation
expense of capital expenditure in 2004)
Tax rate is the same as 2005
Days of receivable, inventory, and payable remain the same

The pro-forma cash balance is negative indicating that if no changes are made to the
current WC management policies, the company will either be insolvent or have to
make extra borrowings to cover for its operation
4. Analyze the companys accounts-payable policy
Accounts-payable policy: days of payable are lower than benchmark, indicating that the
company is quicker to make payment on its outstanding obligations to suppliers. While
early payments can beneficial in certain cases to enjoy trade discounts, the company will
more likely lose opportunity costs in terms of interest income because of the forgone cash
in its early payment activity. It is necessary to evaluate the benefits from both options to
determine the actual effects of this policy. Normally, it is optimal to have days of payable
close to industry average.
5. What can the company do to solve its cash problem?
To solve the problem, it is critical that the company should bring its liquidity ratios and
Working capital figures close to industry average. Specifically, Horniman has to quickly
collect outstanding receivables from customers and revise its credit sales policy to be
2002 2003 2004 2005 2006
Profit and loss statement
Revenue 788.5 807.6 908.2 1048.8 1258.6
Cost of goods sold 402.9 428.8 437.7 503.4 604.1
Gross profit 385.6 378.8 470.5 545.4 654.5
SG&A expense 301.2 302.0 356.0 404.5 485.4
Depreciation 34.2 38.4 36.3 40.9 41.1
Operating profit 50.2 38.4 78.2 100.0 128.0
Taxes 17.6 13.1 26.2 39.2 50.2
Net profit 32.6 25.3 52.0 60.8 77.8
0.3 0.39
Balance sheet
Cash 120.1 105.2 66.8 9.4 -35.8
Accounts receivable 90.6 99.5 119.5 146.4 175.7
Inventory 468.3 507.6 523.4 656.9 788.3
Other current assets 20.9 19.3 22.6 20.9 20.9
Current assets 699.9 731.6 732.3 833.6 949.0
Net fixed assets 332.1 332.5 384.3 347.9 311.3
Total assets 1032.0 1064.1 1116.6 1181.5 1260.3
Accounts payable 6.0 5.3 4.5 5.0 6.0
Wages payable 19.7 22.0 22.1 24.4 24.4
Other payables 10.2 15.4 16.6 17.9 17.9
Current liabilities 35.9 42.7 43.2 47.3 48.3
Net worth 996.1 1021.4 1073.4 1134.2 1212.0
stricter. In terms of inventory, it is necessary to perform a value chain analysis to
determine how much raw materials and finished goods to keep in storage in order to
satisfy production needs and stocking demands. Inventory of the company is currently
much higher than average, thus it is the most significant problem that drags the firms
liquidity down. Finally, with regards to payable account, the company should conduct a
scenario analysis to weight the benefits and costs of making early payments. It is advised
that the company should attempt to bring its Days of payable, as well as days of
inventory and receivable figures, close to industry average.
6. Calculate the sustainable growth of the company in 2005. Sustainable growth =
ROC leverage retention: return on capital is the net profit divided by total
capital or assets; leverage is total capital or assets divided by net worth or equity,
and retention is the fraction of profits retained in the business (i.e. 1 dividend
payout ratio).
Calculate the economic profit generated by the business: economic profit = (ROC
cost of capital) total capital or assets. Assume the cost of capital equals 10%.
Does the company earn a sufficient return on capital? Why or why not? What
economic choices does the company face? Explain

Sustainable growth rate calculation
ROC x Leverage x Retention rate = 5.4% x 1.04 x 1 = 5.6%
Economic profit = (ROC cost of capital) total capital = (5.4% - 10%) x 1181.5 = -54
The negative economic profit indicates that the return on capital that the company is
currently earning is not sufficient to justify for the requirements of capital contributors
(i.e. ROC is smaller than Required rate of return on capital). From the theory of corporate
finance, capital contributors to a company will require a minimum rate of return to justify
for their decision of making investment into the company. This rate of return will have to
be appropriate to the level of risks the company faces in its operation. The required rate
of return is also known as the marginal cost of capital. In the case of Horniman, the actual
return on capital the company achieved in 2005 was 5.4%, less than the minimum value
that investors can accept at 10%, meaning the profitability is not high enough. As the
companys net margin and growth rate is better than average, it will be difficult to further
increase the net profit earned in the following years by a significant amount. Instead, the
company can try to lower its asset base (by reducing accounts such as receivable and
inventory). A smaller denominator will increase the ROC up to the desired level. For
instance, the estimated net profit in 2006 is 77.8, thus the amount of assets to achieve a
10% ROC will have to be decreased to approximately 780 (from 1,181.5 in 2005).