Financial Decision Making

Executive Summary:

Starbuck targets Roast limited for acquisition. It would be considered favourable for both the parties. The company Roast limited has a lot of customers who have been loyal to the company since a long time. The company shows a positive growth rate and the operations of the business are successful. This report consist analysis of Roast limited. It measures both financial and the operational performance of the firm. The report also includes a detailed study regarding the expansion of the company’s business in Italy and Romania. The financial decisions of the company are also evaluated and studied here.  Roast limited’s financial position and reports show that it is capable of conducting a profitable business in future also. Some of the areas in which problems are faced by the company named Roast limited is also reviewed and proposals to solve the issues are also given.

Part 1: Review of the industry

In the UK, the coffee market has a huge impact on the GDP of the country. The traditional strategy of the business includes wide networks and a huge number of suppliers and distributors from various countries. There is a huge market of coffee in UK because the citizens have adopted the Coffee culture very nicely. In the UK economy, it is approximately £17.7 billion contributions to the GDP that had been provided by the coffee business. Starbucks, Costa coffee and café Nero are the three major players in the coffee market of UK. In 2018 almost there were approximately 25,500 coffee shops in United Kingdom. According to an estimate it is stated that the by 2023 the coffee shops in United Kingdom will rise by 10,000. There is an 8.7% growth in the coffee shops each year in United Kingdom. The growth process speeds up every year. Because of such a wonderful rate of growth it attracted large number of investors towards it. In 2018 one of the major players was replaced. Coca Cola replaced Costa Coffee. The preference of customers has changed over the period of time. Now they tend to prefer those brands which provide better value and have a better name in the market. The retail sector had made the coffee more popular, and the customers preferred it more than any other beverages, due to the geographic and climatic conditions. Each year the consumption of coffee increases from 70 million to 95million from the previous consumption. 7.5% of man force of UK is engaged in the coffee industry. Though a variety of coffee types are preferred by the customers in the UK, it has been found that green coffee is the healthiest preferred coffee by the customers. In the year 2017-2018, it had been estimated that green coffee had been the most preferred product in the retail segment.

Part 2: Business performance analysis

2.1)  profit and Loss Analysis

The company has shown a significant growth in the rates of revenue. The revenue grew from £2022 thousands to £2534 thousand. Expanding the business has proven fruitful for the company. The revenue collected from Romania was £350 thousand which was 25.3% of the total growth revenue of the company. The profit was increasing and showed a margin of 5.2%. The rate of change in revenue is more than that of gross profit. The reason behind this the increased cost of selling goods. There was an increase in the cost of selling made because of the changes made in the laws related to supply chain. Gross profit margin has decreased over the two financial years but the net earning margin has shown a positive sign. It showed a double growth in the two consecutive financial years. There was an increase in net earnings because of an increase in two operational costs. One of the major contributions was that from the employees. The salary that is paid to the employees fell by £4.42 thousand. The reason of this decrease is that most of the employees were to other companies. The reason for this shift was an increase in the out sourcing activities of various service departments. The market price of oil fell which drastically reduced the energy cost. Another operational cost that increased was the legal costs. In the preceding year a large number of legal costs were incurred for setting up and expanding the business in Romania. Some of the expenses increased in 2018 as compared to 2017. Depreciation expenses showed an increase by 10.8 thousand pounds in 2018. The bad debts also rose in comparison to 2017. There was an increase in bad debt because one of the main customers was fighting a financial battle and needed some extra credit period. There was an increase in the cost of debt by four times. The cost of debt rose because of an increase in borrowing for financial expansion. The financial expansion was for setting up the business in Romania. There was an increase in long term debt from £100 thousand to £275. There was increase in the amount of interest. It is estimated that there was increase in interest due to an overdraft. Overdrafts contribute to more interest expenses as compared to long term debts and other borrowings. The performance level of the company was more than satisfactory. It was able to manage its expenses properly and was even able to generate a good amount of profit from its operating activities.

2.2) Statement of Financial Position

Financial position can be very well estimated from the cash flow statement of the company. Roast Ltd. has shown a positive cash flow statement and the financial position of the company is quite satisfactory. Retained earnings showed a increase an amount of 81 Pounds. An increase in the retained earnings was a positive sign for the shareholders as they will get more share of profit than before. There was increase of 48% in the total assets of the company. Assets are an important part of any financial statement and the increase in their value contributes to a positive brand value. There was rise in the value of fixed assets because of acquisitions which were made in the country Romania. The inventory was increased by 150%. Inventory increased because the supply chains were made more advanced. There was also an increase which was marked in current assets. The current assets increased by 28%. An increase in long term borrowing resulted in the increase of capital employed. The capital employed increased by 150% as compared to previous year. Long term borrowing was taken to increase the business in Romania. The overall financial position was very good. Expanding the business to Romania was very good idea. It helped in generating a lot of profit for the firm. However, the management should take some steps in regard to the liquidity position of the company.

(Check the Appendices For calculation)

The current ratio is more than one for both the years. It shows that the liquidity position of the firm is good.

It can be marked that quick down has fallen down drastically. Even the company is not in a position to pay its short term liability through the use of its liquid assets. The management should review its working capital properly and should focus on reducing the amount of inventory turnover.

The increase in financial and long term borrowing has increased the gearing ratio for the company.  

2.3)  Cash Flow Statement

The statement of cash flow is important for business to understand the revenue and the control of the revenue. The financial statement can be analysed for the organization to understand cash inflows and outflows.

Calculation operating cash cycle of Roast Ltd.

There was a fall in the cash reserve by £207 thousands. The cash and cash equivalent for the company was £134 and it fell at the end of the year. It went to an overdraft of £ 73 thousands. The operational activity generated negative cash flow as there was increased requirement of working capital. Investing activities also contributed to a negative cash flow. The main investing activity which was done in the year was procurement of fixed asset for expanding the business in Romania. The main way through which the company was able to cover its costs was long term financing. They used long term financing money to meet all its expenses. The cash flow was not even sufficient to cover the current short term obligations.

Operating cycle = accounts receivable + inventory period – accounts payable period

For year 2018(all amounts in £ ‘000)

DIO + DSO – DPO

27.4+5-21.5= 10.9

(DIO)

Average inventory/cost of goods sales*365

Inventory average= 299/2= 149.5

149.5/1990*365 = 27.4

(DSO= Days sales outstanding)

Average receivable/Total credit sales*365

Average accounts receivable= 55/2 = 27.5

For year 2017

14.5+22.5+16.7= 53.7

(DIO

Average inventory= 120/2= 60

60/1505*365= 14.5

(DSO)

27.5/1990*365= 5

(DPO= Days payable outstanding)

Average accounts payable/cost of goods

sold*365

Average payable = 235/2= 117.5

= 117.5/1990*365= 21.5

93/1505*365= 22.5

DPO

Average payable= 138/2= 69

69/1505*365= 16.7

Administration should consider different dividend policies before they issue dividend. Shareholders generally three types of views regarding policy of dividend. First view is that they require good dividend annually, second thought is that they want capital gains and want a maximisation of wealth. And the last view that shareholders have that they should get a say in the management decisions. The company must take decisions in such a manner that it satisfies the view an interest of shareholders. Roast has a solid dividend policy and they are even able to satisfy the shareholders of the company. The management takes decision regarding the dividend policy by studying the interests and wants of the shareholders properly.

Part 3: Financial Sources and Appraisal of Investments

3.1. Investment appraisal

Management Forecast

Management forecast plays an important role in determining whether the company must move forward with the investment or not. Management forecast is a method which is used to estimate the profitability and predicts the possibility of cash flows in the organisation. Roast limited invested and expanded its coffee business in Romania. The managers of Roast limited used the method of management forecast to predict the profitability that can be earned through expanding. The management made estimates regarding the revenue which can be earned from the expanding. The estimates were made for a period of five years. Businesses do not like the plan of going forward with the business that requires a high amount of cash investment. But Roast limited decided to go forward with the plan even when the investment required a huge capital requirement in cash. The cash investment which was required for expanding business in Romania was 500 million pounds. The management made a projection that the investment will generate revenue of around 600 million pounds in the first year, 112million pounds in the second year and it would take multi folds in the third year generating revenue of 224 millions in the third year. There is one major drawback of this method. This process is a bit hectic. It requires the management to hire an expert that can make accurate predictions. Even ratios need to be calculated in this method. Ratio calculations play an important role in deciding about various estimates. In case there is a wrong forecast made the business will suffer a huge amount of losses. If inappropriate predictions are made then business will lose the chance to make decisions and invest in a profitable investment. Sometimes even if the predictions are against the investment managers go forward because of their high motive. This eagerness results in huge looses.

Investment Appraisal Techniques

Pay Back period

Payback period means the time which is taken by the venture to recover the cost of its investment. Roast limited has used its forecasted cash flows to calculate the payback period for their company. Payback period is a straight forward method. This is the reason it is adopted by most of the businesses to know about their return on investment. It is an easy to understand method. The calculations included under this method are also very simple and easy. By adopting this method business can go forward for investments easily. This method will give an idea about the time by which they can recover the cost. Payback period has one of the biggest advantages of providing with comparison. More than one project can be compared to each other. And the investment which has the least payback period and gives a high rate of profitability rate should be selected. Businesses can easily decide whether to go forward with the investment or not.

Drawback

Though the method is easy to understand is not that significant in the decision making process. This method does not consider time value of money and as we know value of money is never same with changing time. With the changing situations the value of money may increase or decrease resulting in profit or loss respectively. The 500 million dollars that Roast limited invested in the year will definitely weigh less if it is considered after two years. It means the previous cash flows are valued higher than their actual price. The payback period method does not take other factors into consideration. It does not even takes business life into account. And many a times a speedy recovery does not means profitability or success of the investment. It does not even consider other factors related to the investment. These were the various drawback of this method.

Accounting rate of return

Accounting rate of return gives a straight forward decision for any business venture. It is also known as average rate of return. This method gives information about the money that is expected on every amount that is invested. Generally the accounting rate of return is expected to be 10%. But, for Roast limited it is far better than the expectation. The accounting rate of return for the company is 18%. The information required to calculate accounting rate f return is available easily. It is a method that is easy to use as well as calculate. It can be used for comparison. One business can use it to compare with another firm.

Drawback

The major drawback of this method is that it does not takes time value of money into consideration and as we know value of money is never same with changing time. With the changing situations the value of money may increase or decrease resulting in profit or loss respectively. The 500 million dollars that Roast limited invested in the year will definitely weigh less if it is considered after two years. It means the previous cash flows are valued higher than their actual price. This fact will make the calculation irrelevant. This method does not even consider the importance of liquidity. It only focuses on the profitability of the business. The business should maintain liquidity also. Without liquidity profitability will be not that much effective. If liquidity is not good then business will lose its creditability and have working capital issues in the organisation.

Net present value

The major drawback with other two methods was that they do not take time value into consideration. But the main advantage of net present value method is that it takes time value into consideration. It means higher cash flows of an earlier period will be valued higher in respect to the lower cash flows of a later period. Hence, it is one of the most suitable methods to calculate the viability of an investment. The net present value of Roast limited is 110 where the cost of capital is 5%. If the net present value is positive it means that the investment will bring positive returns today and in future also.

Drawback

Net present value involves cost of capital. Cost of capital is a very confusing thing. It involves a lot of calculation and is difficult to understand. There is a lot f judgement involved in cost of capital. It is believed that a lower cost of capital will bring a positive outcome. Hence proper care and attention should be paid while calculating cost of capital under this method. This method is over ally very satisfactory excluding this one major drawback. 

It can be concluded that Roast limited should make decisions regarding its investments and should move forward with it. As per the methods the investments are showing a positive return. With all the chances of benefit some risk is associated. The management should carefully analyse the potential risk before investing.

3.2) Sources of finance

Roast limited is a company that is interested in expanding considering its interest in expanding it should carefully chose its sources of finance. The source they select will play a significant role in their chances of success. They have chosen long term financing. They hae used long term financing for the purpose of expansion in Romania. The other sources of finance that can be considered are stated below.

Angel investors

Angel investors are outstanding and have excelled successfully in their field. They generally prefer to put money in small businesses and they are very god players. They play a significant role in the industry of wealth. Angel investors are very experienced. Taking finance from them will bring additional benefit of experience to the firm. It will add no extra cost and even will not become a liability as this source of money does not need paying back. Hence, it will not create a financial burden and there would be no need to calculate the cost of capital.

Limitations

The angel investors will take a stake in the business. Nothing comes for free. If they are providing the finance for free then stake would be the cost of capital that the company has to bear. They need a say in the decision making process. They demand a right of saying and interfering in the external matters of the business. This may create some problems and chaos. They even may want to run the business in way that owners do not want to. It may also lead to incurring of huge losses sometimes. The company may be experienced but it is not necessary that every person who takes part in the decision making process will be that much experienced.

Bank loans

Banks are one of the good sources for taking loans. They are one of the most commonly used sources of finance. They provide loans to both small and large companies. Even the criteria for taking loans can be easily met. They follow proper documentation that there would be no trust issues. They insure that there is no confusion between the bank and the borrower. This is the reason why they keep everything clearly defined.

Limitations

Every coin has two sides. Banks also have some kind of limitations as a source of finance. Borrowing money from back requires payment on a timely basis without fail. These timely payments are known as interests. Interests are the additional amount that is paid and it is not a part of the principle amount. It is separate from the loan amount that is taken. Banks require a proper proof that they will get their money back. They do not lend money that easily. The chances that banks will lend money to poor or economically backward people are very low. They look at credit point and recognition before lending money. They even take mortgage before lending money. They ask to keep some assets which can be used for repayment if the borrower does not have money. This can create lot of pressure on the business and as a result it may be forced to sell its assets for repayment. Moreover, banks are a costly source for financing.

Conclusion

Roast limited is highly geared and it can easily get loans from banks. The company Roast limited has a lot of customers who have been loyal to the company since a long time. The company shows a positive growth rate and the operations of the business are successful. The company has shown a significant growth in the rates of revenue. The revenue grew from £2022 thousands to £2534 thousand. Expanding the business has proven fruitful for the company. The revenue collected from Romania was £350 thousand which was 25.3% of the total growth revenue of the company. Gross profit margin has decreased over the two financial years but the net earning margin has shown a positive sign. Depreciation expenses showed an increase by 10.8 thousand pounds in 2018. The bad debts also rose in comparison to 2017. There was an increase in bad debt because one of the main customers was fighting a financial battle and needed some extra credit period. There was an increase in long term debt from £100 thousand to £275. It is estimated that there was increase in interest due to an overdraft. The performance level of the company was more than satisfactory. It was able to manage its expenses properly and was even able to generate a good amount of profit from its operating activities. Roast Ltd. has shown a positive cash flow statement and the financial position of the company is quite satisfactory. Retained earnings showed a increase an amount of 81 Pounds. An increase in the retained earnings was a positive sign for the shareholders as they will get more share of profit than before.  The overall financial position was very good. Expanding the business to Romania was very good idea. It helped in generating a lot of profit for the firm. However, the management should take some steps in regard to the liquidity position of the company. The current ratio is more than one for both the years. It shows that the liquidity position of the firm is good. The increase in financial and long term borrowing has increased the gearing ratio for the company.  The management made a projection that the investment will generate revenue of around 600 million pounds in the first year, 112million pounds in the second year and it would take multi folds in the third year generating revenue of 224 millions in the third year. The accounting rate of return for the company is 18%. The overall performance of Roast limited is good in all aspects.

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Appendix:

For 2018 (all amounts in £ ‘000)

Gross Profit Margin

= 544/2534 = 21.46%

Operating profit Margin

= 127/2534 = 5.01%

For 2017

= 517/2022 = 25.57%

51/2022 = 2.52%

For 2018 (all amounts in £ ‘000)

Current Ratio

Current ratio = current assets/current

liabilities

447/308 = 1.45

For 2017

347/238 = 1.46

For 2018 (all amounts in £ ‘000)

Quick ratio

Current assets - Inventory/Current liabilities

447-299/308 = 0.48

For 2017

347-120/138= 1.64

For 2018 (all amounts in £ ‘000)

Gearing

Long term debt/capital employed

=275/1135= 24.22%

For 2017

100/879= 11.38%

For 2018 (all amounts in £ ‘000)

Cash and cash equivalent / current liabilities

As cash and cash equivalent is zero

For 2017

= 134/138 = 0.97

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