Macadams Bakery Supplies Holdings (Macadams) is a manufacturer of oven and other appliances for the baking industry. Their financial statements for 1996 highlight a very strong year. Turnover grew by 59% to R125. 3m and profit increased by 81%. An acquisition of Livanos Brothers (February 1996) took place in response to the increased demand in the local market as well as an expansion of market base in foreign markets. Depreciation of the Rand against other major currencies also supported export sales.
The company has entered a phase of rapid expansion, expanding its main factory in Cape Town by 50%. As well as opening new sales and distribution centers in Durban and Bloemfontein in the current year, with further plans to expand in to Zimbabwe in the following year. An analysis of the company’s financial statements will determine whether the company is in a position to leverage its expansion, or whether it is perhaps growing too rapidly.
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Detailed Financial Analysis Profitability
Macadams experienced a healthy turnover, which increased by 58. 5% between 1995 and 1996.
This “abnormally” high growth in turnover was due to a surging demand for their products, favorable exchange rates and acquisitions of business’s, which complimented their current product portfolio. They further expanded the operational network to service the growing market they were operating in. It should however be noted that a growth rate of 58. 5% per annum is not sustainable or realistic, and although Macadams has extended their products and services to global markets through joint ventures and M&A’s, there would be a point where there growth would become organic, or at least in line with industry standards..
Although operating and net margins have improved since 1995, the net margin remains low at 8. 5%. This indicates that despite dramatic increases in revenue, Macadams have only marginally improved the ability to generate profits. Liquidity: The income statement displays a healthy growth by Macadams; however the cash flow statement shows a contradictory picture. Macadams have a serious liquidity problem. Cash generated from operations is significantly down by 87% in comparison to the prior financial year.
The operation did not generate sufficient cash to fund its interest, taxation or dividends payments for the year. As a result these payments were made through borrowed funds. Working capital movements in 1996 adversely impacted cash generated by operating activities, with a noticeable increase in working capital of 595% from R2. 7million to R19million. This is due to an increase in inventory of 66%, to meet perceived consumer demand, which was funded by cash resources. There has also been an increase in debtors of 129%, due to increased credit sales.
Furthermore, creditors increased by 87%, which only partially offset the increase in current assets. This is a scenario of a business expanding too rapidly. There are high levels of sales and gross profits, but a serious cash flow problem created by inventory build-up, and high level of receivables. Cash is now tied up in stock and debtors. The lack of available cash in the business could impact Masadams’s ability to service their short-term liabilities.
Macadams have become less efficient in 1996. The accounts receivables increased by 129% in 1996.
Reviewing the debtor’s collection period we can clearly see the longer collection period (53 days in ’95 to 77 days in ’96) could be indicative of more relaxed credit terms, which could be MBS’s strategy to attract more sales and increase turnover. This strategy does however create a risk of bad debt and creates a problem for operational cash flow, as it currently is experiencing. It is also noted on the financial statements that Debtors have been used by ceded to the banks as security for facilities granted. Cession of debt means that the banks do not have faith in Macadam’s ability to repay its debt.
Leverage The debt ratio has increased by 9%; this was for the funding of the expansion. The additional funding taken out, mortgage loan is secured by land and buildings, and the movable assets secure the installment sale agreement. This is risky as it means should Macadams fail to make payment on either of these loans, they would lose R4. 3 million of its movable and immovable assets. Incurring debt to expand their operations and grow the business is not a bad thing, and is necessary. Despite the massive increase in debt, the interest cover ratio is still healthy.
This however, is not a cash based ratio and gives us no indication as to whether the company is able to make its cash payments to service the increased quantities of debt. For this reason the concern would be raised with respect to Macadams ability to service their debt. This concern is specific to their lack of liquid funds available in the business. DuPont analysis: With the aid of the DuPont model of analysis the following observations were made: Macadams ROE, of 30. 63%, has decreased by 1. 4% during the financial year under review.
However it could be seen as a good return on equity, as it is 10% higher than the prime interest rates at the time (20. 25% Nov 1996). Macadams have become less efficient in using its assets to generate profits. Its’ efficiency ratios demonstrate a drop from 2. 37 to 1. 90; however this could be explained by the timing of the acquisition of assets. Vacant land was acquired in September 1996, just three months before the December year-end, and new premises opened in Bloemfontein in November 1996. These assets would not yet have had the opportunity to generate the profits that may be expected in future.
Macadams profitability has increased marginally since the previous year; however their net margin is still a low 8. 50%. Macadams are not using its revenue to generate sufficient profits. In terms of leverage, the ratio has increased marginally from the 1995 financial year, to 1. 89, in line with increasing debt in terms of both long-term and short-term borrowing. Conclusion: Macadams are a promising business which is currently generating high sales volumes and generous profits. The problem with the business is the following:
- Their inability to translate their sales into cash. The drive and efforts to grow the business at a rate which is not practical to their available resources and balance sheet; this results in the following: oAccrual of high volumes of long-term and short-term debt. oHigh inventory levels as a result of their steep growth plan which they have implemented (cash on the shelves/in the store room) oIncreased overheads to operate newly established network offices to service the market. If Macadams operates their business as they are, they will eventually grow their business into bankruptcy. As a “turn around” strategy, I would implement the following initiatives to maximize the output of the business and create a more sustainable business model.
- Slow-down the growth rate which Macadams is currently experiencing.
- Limit its debt, i. e. not take out any further debt.
- Analyze the current business operations to improve operational efficiency, thus decreasing COS of sale per unit sold, and inevitably increasing gross, net and operating profit margins.
- Improve sales efforts to reduce inventory levels, and simultaneously increasing overall sales. Macadams should also review their current costs and look for cost saving initiatives. This will ensure that the revenue increase is matched with a similar increase in profits.
- Ensure the business is more liquid by having more operational cash and cash in the business; this can be achieved by decreasing the debtor’s collection period from 77 days to 30 days, and increasing their creditor’s period to 45 days.
If I had shares in Macadams I would hold on to them if the above initiatives were implemented, as this would ultimately result in an increased EPS.
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