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Financial issues to revise • Downward pressure on profit margins • The concerns highlighted in the balance sheet • Line 152 – Sophie is considering applying for a bank loan – and knows she can do so with a good interest rate. • She needs to prepare a business plan and consider her budget for the new holiday packages (line 91)
Sources of Finance • Sophie already took out a bank loan initially at the start to fund the new venture “Les Maisonettes” - €300,000 to be paid back in 2026. (Line 15) • In 2004 – conversion from sole trader to LTD. • The classes are providing a large source of income for Sophie. But she had to take out an additional 5 year bank loan of €15,000 for equipment and start up costs. • Share capital – see balance sheet
Gearing Using the following formula calculate LM’s gearing ratio (see appendix four): Loan capital/capital employed * 100
Gearing • 43.1% for 2005 • 34.4% for 2008 Using the Raffo book – what does this tell you about its gearing level?
Don’t forget Les Maisonettes is growing – so there will be effects on costs and profit margins as this business grows.
The 4 options Study each option and consider its impact on Sophie’s financial situation. Answer this question: Using appropriate financial ratios, analyse the profitability, liquidity and activity of LM.
The 4 options • Overall, Sophie is pleased with her small business and the success. But she is concerned about its future direction and potential market share. • She consulted with her parents, her bank manager and her employees and identified four options.
Option One Retain the present focus of her business but improve operations and profitability. Impact on Finance?
Impact of option One on finance √ This will improve cost control – it will allow her to reduce her costs overtime. √Improved marketing will lead to increased revenue √Creating a more flexible workforce will reduce her costs and will allow her to be more competitive. √ This will improve profitability of LM.
Option Two Develop an education centre to promote the ideals of sustainable tourism and fulfil the objectives of the AFE. This means modifying existing accommodation, cutting outdoor activities, converting one barn to an education centre and restaurant operations will be restricted to guests at LM. IMPACT ON FINANCE?
Impact of option Two on Finance √ This will support her move for eco-tourism so may attract eco-tourists to her – increased revenue. √ She can now consider marketing to the 18-30 group of eco-tourists she wanted to target. √ Cost savings by being more energy efficient and carbon neutral. X This will cost money to implement. X Cutting outdoor activities means loss of revenue, as they are a good source of income. X Restricting restaurant operations to guests will reduce their potential customers – so loss of revenue.
Option Three Reposition LM as a luxurious eco-tourist retreat, develop a new USP and targeting higher income market segment. High quality locally sourced produce will be offered and a range of services such as saunas etc. Impact on Finance?
Impact of Option Three on Finance √ Targeting high income segment will bring in more revenue. This move could make LM very profitable. √ The services will add an extra source of income. √ The quality will be a big focus and so will improve its image – increased revenue. X She will need substantial investment to upgrade and expand existing facilities. X She will need to invest a great deal into recruiting and training staff, so her costs will increase. X This move could increase her gearing, which is currently low, but an increase could mean more interest payments for her. This will not make her very competitive.
Option Four Sell the whole business to a timeshare operator who will redevelop the business. Money goes to her parents’ retirement and some will go towards renovating the shop. This means she loses control and ownership of LM.
RATIO ANALYSIS ANALYSING THE FINANCIAL SITUATION OF LES MAISONNETTES
Ratio Analysis • Ratios are used to interpret financial accounts. • Ratio Analysis can be used to assess the financial performance of a business. • Ratios can be used to analyse three separate issues on the operations of a business: • Performance: which compasses profitability and productivity • Liquidity: which refers to the ability of the business to generate cash for operating the business as and when required • Shareholder: which concerns the variables that just the shareholders are likely to be interested in.
Q: What are the advantages and disadvantages of using ratio analysis? The main advantages of ratio analysis will be: • You will be able to look at trends • Ratios can be used to forecast and plan, summarise data, to identify problems before they become acute and to assess performance. • You can do an inter-firm comparison • You can see and analyse trends • You can make future predictions based on your findings • You can find areas with high problems and try to find ways to solve them
Disadvantages of Ratios • However, ratios should be used with caution. Ratio analysis does not provide a complete means of assessing a company’s financial performance. There are problems with using ratios. The main disadvantages of ratio analysis are: • They only highlight the problem but not provide a solution. • Based on historical information and does not take into account positive factors within a business such as location, quality of staff etc. all of which can affect performance. • Ratios do not take many factors into consideration. • They do not measure non-monetary factors. • When making comparisons between ratios overtime, it is necessary to take into account the following: • Inflation • Any changes in accounting procedures • Changes in the business activities of the firm • Changes in general business conditions and the economic environment.
Profitability Ratios • These ratios focus on the firm’s profit. • We will look at profit in relation to the value of sales revenue. • GPM: known as mark-up. This shows the gross profit made on sales turnover. • NPM: helps to measure how well a business covers its overheads. If the difference between the gross profit and net profit is small, then overheads are low. • ROCE: an important ratio. It tells what returns the firm has made on the resources made.
Analysis of Les Maisonnettes’ profitability • The level of profitability has reduced at LM. • There is a large difference between the GPM and NPM, showing the difficulties Sophie is facing with controlling overheads. • A reduced NPM is not a good sign, showing she has less profit to distribute to shareholders and to reinvest in the business. • The drop in ROCE does not show LM to be a safe investment.
Analysis of Les Maisonnettes’ profitability • Her overheads are clearly not being spread over a greater level of sales. • She is not benefiting from economies of scale. She needs to improve productivity and lower costs. • The ROCE has decreased, this means that sales growth has been slower than the rise in capital. • The ROCE will drop due to reduced gross and net profit. • It seems that LM has poor cost control in terms of direct costs.
Causes’ of LM’s declining profitability • It could be because she has only relied on word of mouth promotion – and she needs to alter her marketing strategy. • The costs of the activities are high. (Her expenses increased by 8000 euros in 3 years (see appendix 3). • Sales declined and cost of sales increased (appendix 3) • She was charging the same amount all year and not taking advantage of peak season. • Competition (Sanctuary) and other external factors such as the housing market, weather conditions. • Health and safety regulations meant increased costs for her. • No business website – not taking advantage of online bookings.
How can profitability improve? • Improve her marketing strategy to increase sales revenue. Strategies such as sales promotion may help to boost sales. • Reduce costs – such as labour costs (but this may impact on morale and productivity – customer service) • Reduce indirect costs – overheads - without damaging effects to the firm.
Liquidity Ratios • Liquidity ratios measure how assets of a business can be converted into cash. • A business must make sure it has enough liquid assets to pay any immediate bills that arise. • These ratios are concerned with the short-term financial health of the business. • They are concerned with the firm’s working capital and whether or not it is being managed effectively. • Too much and it may not be making the most efficient use of its financial resources.
Analysis of LM’s Liquidity • It is generally accepted that a current ratio of 1.5 to 2.0 is desirable – this will allow for a safety margin. • In 2005, LM’s current ratio was in a comfortable position at 1.75:1. However, in 2008, it had declined to 0.55, showing insufficient working capital. This means that as a result of the ratio being below 1:1, the short term debts of the business are greater than its liquid assets, which is not a good position to be in.
Analysis of LM’s Liquidity • This means that LM does not have enough working capital – it could be over-borrowing or over trading. • As a general rule, the ATR should be at least 1:1. This means that, in 2008, LM’s ratio fell to 0.22:1, and this is not a good sign. This shows that Sophie may be experiencing working capital problems, and if this continues, she could face a liquidity crisis. • ATR shows that she could be unable to cover short-term debts
Solutions to LM’s liquidity problems • Increase its current assets relative to its current liabilities. OR • Reduce its current liabilities relative to its current assets. • In LM’s case, it is her short term borrowing that has increased drastically by 15,000 Euros – and this will have to reduce in order to improve liquidity. • She should also consider reducing short term creditors.
Efficiency Ratios • Also called activity ratios. • These are used to measure how effectively a business employs its resources. • They look at how well a firm’s financial resources are being used.
Summary of LM’s Efficiency • Stock turnover has reduced, which is not a good sign for LM. This means less stock is sold and less profit generated. Sophie is not benefiting from purchasing economies of scale. • LM’s debtors days ratio is low, which is good, but increasing. This means that it takes upto 4 days for debtors to pay. But too low a ratio is not good either, as customers may seek other suppliers if the credit period given to them is uncompetitive. It could also suggest that there are not enough firms buying on credit. Good credit control should be within 30-60 days. • Creditors’ days should also be between 30-60 days. LM’s is very high. This could mean that LM is taking too long to may have a harmful effect on her cash flow.
Solutions to LM’s efficiency • Develop a closer relationship with customers, suppliers and creditors. • Improve levels of stock control in the business. • Improve credit control, which will help improve its working capital. • Increase turnover using the same assets, so that assets work more effectively is a way to improve asset turnover.
You must also revise • Advantages and disadvantages of bank loan as a source of finance? • What additional sources of finance would you recommend for Les maisonettes? • Revise what a business plan and what should be included in it and why it is used? • You need to revise budgeting!! • You need to revise the meaning of all ratios and apply them to LM. • You need to learn and revise WORKING CAPITAL.