HERIOT-WATT UNIVERSITY

ACCOUNTING – DECEMBER 2016

Section II
Case Studies

Case Study 1

‘Great news!’ exclaimed Mike Corleone, as he stuck his head around the door of Magna
Deville’s office, grasping some papers.

Mike Corleone was Chief Executive of New York Technobank Inc. (NYTB), a venture
capital investing business founded by his famous father, Ryvita Corleone. Ryvita had
come across from Italy in the 1970s and had foreseen the growth of technology
businesses in USA. In particular, he had focused on investing the large surpluses from his
olive oil business into new start-up technology companies.

Magna Deville was an investment analyst with NYTB and had worked with Mike for
many years, so she was used to his unusual greetings.

Before Magna could respond, Mike continued, ‘We’ve got the latest numbers in from
both Galveston Imaging and Maine Infrared. We need to get started on them as soon as
possible – we can’t do both of them so we need to decide which we prefer – then, we’ll
make them an investment offer they can’t refuse.’

Magna stared at Mike and recalled, with limited enthusiasm, the number of past occasions
when he had become so excited about similar propositions, many of which had
floundered. Her current workload was such that she did not welcome the prospect of the
extra activity needed to provide a financial assessment of both companies.

‘You don’t look so keen,’ scolded Mike. ‘They’re both in great shape and I’m certain that
they’d be terrific investments for us. Remember that there may be opportunities to link
both of them to our other investments in Las Vegas and Mexico.’

Mike’s eyes brightened, as he dropped his papers on Magna’s desk.

‘Here are their financial statements for 2016. You’ll need these for the Board paper [see
Appendix 1]. Oh, didn’t I tell you? We’ll be discussing this investment at tomorrow’s
Board Meeting. So we’ll need your analysis before then.

‘By the way, I want you to focus on their liquidity, their profitability and their efficiency
performance,’ added Mike as he departed. ‘Oh yes, and do give me your opinion on
which is a better bet for us.’

Magna glared at him and then set to work.

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APPENDIX 1

Galveston Maine
Imaging Inc. Infrared Inc.

SUMMARY INCOME STATEMENTS

2016 2016
$’000 $’000

Sales 9,853 8,900

Cost of sales 4,825 5,800
Gross profit 5,028 3,100
Selling and distribution costs (880) (700)
Administrative expenses (2,850) (950)
Operating profit 1,298 1,450
Interest payable (310) (164)
Profit before taxation 988 1,286
Taxation (300) (400)
Profit after taxation 688 886
Dividends (150) (50)
Retained profit for the financial year 538 836

BALANCE SHEETS 2016 2016

$’000 $’000

Non-current assets 8,100 7,210

Current assets
Inventories 1,050 2,150
Debtors 2,620 1,050
Cash at bank 768 500
4,438 3,700

Current liabilities
Creditors 980 890

Net current assets 3,458 2,810

Total assets less current liabilities 11,558 10,020

Creditors: Amounts due in

excess of one year (1,000) (100)
10,558 9,920

Share capital and reserves

Ordinary share capital 7,000 5,000

Retained profits 3,558 4,920
10,558 9,920

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Required:

1. Assess the liquidity positions of both companies in 2016, using appropriate

ratios, and comment on their relative performance.
(6 marks)

Liquidity Assessment & Ratios

Galveston Maine
Imaging Inc. Infrared Inc.
Current ratio (times)

Current assets 4,438 3,700

Current liabilities 980 890

4.53 4.16

Quick ratio (times)

Current assets - inventory 4,438 - 1,050 3,700 - 2,150

Current liabilities 980 890

3.46 1.74

Comments:
Both companies have strong current ratios, well in excess of the 2 times indicator.
These mean that both have sufficient resources to meet short-term obligations.

Both companies have healthy quick ratios, again ahead of the ‘standard’
requirement of 1 times. However, there must be some concern at the level of
inventory held by Maine. Its inventory accounts for 58% of current assets: further
investigation would be needed to identify any slow-moving inventory of old
materials and products.

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2. Assess the profitability achievements of both companies in 2016,
using appropriate ratios, and comment on their relative performance.
(15 marks)

Profitability Assessment & Ratios

Galveston Maine
Gross profit margin (%) Imaging Inc. Infrared Inc.

Gross profit 5,028 3,100

Sales 9,853 8,900

51.03% 34.83%

Comments:
With 51.03% gross profit margin for Galveston against only 34.83% for Maine, it
seems clear that Galveston has scope for much higher profits if sales volume can
be increased.

Maine appears to operate in a more competitive sector or have higher direct

materials and labour costs.

Profit margin (%)

Profit before taxation 988 1,286

Sales 9,853 8,900

10.03% 14.45%

Comments:
Maine has produced a much better performance in 2016 – with 14.45% profit
margin, as compared to only 10.03% for Galveston, whose administrative
expenses are huge in 2016. Further investigation would be needed into the
reasons for Galveston’s higher selling & distribution and administrative expenses.

Return on total assets (%)

Profit before taxation 988 1,286

Total assets 12,538 10,910

7.88% 11.79%

Comments:
Again, Maine has achieved more than Galveston in 2016 in terms of using its
assets – 11.79% is significantly better than 7.88%. There must be some concerns
with the levels of non-current assets and debtors within Galveston – both much
higher than Maine’s equivalents.

Return on capital employed (%)

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Profit before taxation 988 1,286
Capital employed 11,558 10,020

8.55% 12.83%

Comments:
In terms of ROCE, Maine’s achievement is solid with 12.83% well ahead of
8.55%. While Galveston’s profit is affected badly by the high selling and
administration costs, ROCE takes account also of its debt funding of £1m as
against Maine’s £100,000 – suggesting that Galveston should be performing
better.

Return on owners’ equity (%)

Profit after taxation 688 886

Owners’ equity 10,558 9,920

6.5% 8.9%

Comments:
The ROE comparison yields a similar perspective – with Maine’s performance
well ahead of Galveston. As a shareholder in Galveston, there would be concerns
with the 2016 profitability.

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3. Assess the efficiency achievements of both companies in 2016, using
appropriate ratios, and comment on their relative performance.
(9 marks)
Efficiency Assessment & Ratios
Galveston Maine
Inventory turnover ratio (times) Imaging Inc. Infrared Inc.

Cost of sales 4,825 5,800

Inventory 1,050 2,150

4.6 2.7

Comments:
The inventory turnover ratio comparison raises considerable concerns about
Maine’s decisions in both purchasing raw materials and manufacturing work-in-
progress & finished goods. While Galveston’s inventory turnover ratio is
adequate, Maine’s holding of over four months’ inventory requires further
investigation.

Average collection period (days)

Debtors 2,620 1,050

Sales per day 9,853/365 8,900/365

97 43

Comments:
The average collection period comparison reveals a major flaw in Galveston’s
performance, as its customers are taking 97 days to settle their invoices – as
compared to a respectable 43 days for Maine. This delay must be impacting on
Galveston’s cash inflows and steps need to be taken to shorten the average
collection period through tighter credit controls and changes in terms &
conditions of sale.

Non-current assets to current assets ratio (times)

Non-current assets 8,100 6,210

Current assets 4,438 3,600

1.83 1.73

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Comments:
Both companies have similar performance levels in terms of their ratios of non-
current assets to current assets. At 1.83 times for Galveston and 1.73 times for
Maine, they indicate that both businesses need to maintain significant investment
in non-current assets. Further investigation might focus on whether leasing or
other finance arrangements could reduce the cash tied up in non-current assets.

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4. Prepare a recommendation to the Board Meeting based on your
assessment above, including any other relevant observations.
(5 marks)

Board recommendation

The following observations are relevant to the decision to choose either Galveston
or Maine:
• The need to compute the same ratios for prior years to identify any patterns of
ratio movement
• Urgent need to recognise the causes of the high selling and administration
overheads in Galveston and if they are one-off in nature due, e.g. to large
product development expenditure
• Concerns with high inventory levels in Maine and the reasons why
• Abysmal debt collection practices in Galveston

Recommendation

Conclude that, subject to satisfactory explanations for Galveston’s issues noted

above, its high gross profit margin suggests that it might be the better long-term
investment.

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Case Study 2

Dallas Olgas Group Inc. is an energy supplier to a wide range of industrial customers in
the south-east of the USA.

Its sales activities are carried out in three geographical divisions – the Gulf Coast,
Louisiana and Florida. The company has fully staffed sales offices based in each of these
divisions. However, the group headquarters and manufacturing and distribution divisions
are located in Dallas, Texas.

The Group CEO of Dallas Olgas Inc. (Robby Ewing) is reviewing the current draft of the
budget for next year (see Appendix 1) with the Divisional Manager of the Florida division
(Don Johnson) and indicates his concern that his division is loss-making. The Divisional
Manager of Gulf Coast division (Glen Campbell) is also attending this meeting, but is
happy to sit back and let Robby and Don discuss the problems of Don’s division.

‘We really can’t start the year with a budget like this, Don,’ complained Robby. ‘The
Board will never approve it. We need to see some healthy profit numbers. If this goes on,
we’ll need to consider closing down this division to improve group profits.’

‘Yes, Robby, but these forecasts include our share of Group HQ Costs and Central R&D
and you know that we’ve have always had reservations about the way that these are
shared out,’ retorted Don.

‘OK, but we have to pay for Group HQ and Central R&D,’ stressed Robby. ‘Arnold [the
Group CFO] knows what he’s doing in his cost allocations.’ Don halted the discussion,
sensing that he was making little progress.

‘So, what do you think about the Houston airport project tender, Robby?’ interrupted
Glen.

Glen was referring to an invitation to tender that his division had received from Houston
airport. He had some real concerns about the project’s profitability and its costs (see
Appendix 2).

‘It looks OK to me,’ responded Robby. ‘Is it included in your budget?’

‘Not yet, it would be extra sales,’ clarified Glen. ‘And extra costs too. I am really
concerned that the gross profit margin is so low.’

‘Maybe, but, look, I need to get off to my next meeting. Let’s get back together later today
to continue this discussion. Go and have a chat with Arnold – he’ll be able to help you
see things more clearly,’ suggested Robby.

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APPENDIX 1

Dallas Olgas’s accounting system is set up to assess profitability for each of its three
divisions. The budget for the current year to 31 March 2017 is being prepared with the
following budgeted divisional results:

Divisions Gulf Coast Louisiana Florida Total

$000 $000 $000 $000

Sales 3,600 5,200 4,200 13,000

Cost of sales 2,400 3,750 3,350 9,500
Gross profit 1,200 1,450 850 3,500

Marketing costs
Sales commission 216 520 336
Sales administration 40 55 80
Advertising 55 65 75
Travel expenses 70 100 40
381 740 531
R & D costs 100 100 100
Group HQ costs 274 396 320
Group marketing 42 40 48
797 1,276 999 3,072

Profit/(Loss) 403 174 (149) 428

The following information is also available:

1. The costs for the Central R&D facility are shared on an equal basis between the
three operating divisions.
2. All of divisional marketing costs (except sales commission) are fixed and specific
to each division.
3. Sales commission is variable with sales revenue.
4. All of the Group HQ costs are unavoidable and have been apportioned to the
three divisions on the basis of relative sales value.
5. Group marketing costs have also been apportioned by Arnold to the three
divisions according to his own view of each division. However, 50% of total group
marketing costs is actually variable with group total sales.
6. Cost of sales includes variable costs only.

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APPENDIX 2

The details of the Houston airport project are as follows:

Sales Contract Value $395,000

Estimated Cost of Sales $375,000

There will be no additional fixed costs in the supply of this project. However, there will
be the usual additional variable costs involved.

Required:

1. Identify the relevant revenue and costs related to the Florida division and
compute the impact of closing it on the group results.
(7 marks)

Assess relevant revenue and costs of the Florida division

$'000

Sales 4,200
Less: Relevant costs

Cost of sales 3,350

Divisional marketing costs 531
Share of Group marketing costs (0.5% × $4,200,000) 21
(see Note 2 below)
3,902
Contribution to Group profits 298

Conclusion: Group profits will be reduced by $298,000 if this division is closed.

Alternative solution

Profits – Gulf Coast 403

Profits – Louisiana 174
Less:
Reallocated fixed costs from Florida division
R&D costs -100
Group HQ costs -320
Group marketing costs ($48,000 – Variable $21,000)

Revised Group profit 130

Current Group profit 428

Decrease in Group profit 298

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 2. Review the Houston airport project and comment on Glen’s concern
about its profitability.
(8 marks)

Assess Houston airport project and its profitability

$’000

Sales 395
Less: Relevant costs

Cost of sales 375

Salesman commission – 6% (see Note 1) 24
Group marketing costs (see Note 2) 2
401
Contribution -6

Note 1 Sales commission – variable : 216,000/3,600,000 = 6%

Note 2 Group marketing costs as % of sales = 130,000/1,300,000 = 1%

Therefore, the variable % on sales = 0.5%

Conclusion: Glen is correct to be concerned as the project generates a negative

contribution of $6,000 on a sales value of $395,000. Thus, this
contract should be rejected.

3. ‘Managements often regard the budgeting process as an unwanted

diversion from their focus on daily operations.’

Discuss this comment, outlining the benefits and drawbacks of the

budgeting process.
(10 marks)

Budgeting process – see Module 12.3

Advantages Disadvantages
Coordination Time taken
Planning Lack of top management commitment
Motivation Form of punishment
Control Blurred responsibilities
Moving goalposts
Rewards inefficiency

© Heriot-Watt University, December 2016

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