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)

Selected Student Answer

Relevant ratio are:

Current ratio: current assets/current liabilities

Quick ratio: current assets less inventory/current liabilities

Galveston

Current ratio: 4438/980 = 4.53 times

Quick ratio: (4438 – 1050)/980 = 3.46 times

Maine

Current ratio: 3700/890 = 4.16 times

Quick ratio: (3700 - 2150)/890 = 1.74 times

Current ratio should be 2.0 generally, and quick ration should be above 1.0
generally, to make sure company can fulfil their short-term obligations.

Both companies have rather good ratios, with Galveston coming out on top.
Especially the quick ratio is much better for Galveston, due to the large inventory
of Maine, which amounts to 58% of its current assets. This means that Galveston
is much stronger, even if sales would temporarily go down, since it has not tied up
that much cash in its inventory.

2. Assess the profitability achievements of both companies in 2016, using

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

Selected Student Answer

Relevant ratios are:

Gross profit margin (GPM): gross profit/total sales

Profit margin (PM): profit before tax/total sales
Return on total assets (ROTA): profit before tax/(non-current assets + current
assets)
Return on capital employed (ROCE): profit before tax/(equity + non-current
liabilities)
Return on equity (ROE): profit after tax/equity

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 Galveston

GPM: 5028/9853 = 51.0%

PM: 988/9853 = 10.0%
ROTA: 988/(8100 + 4438) = 7.88%
ROCE: 988/(10558 + 1000) = 8.55%
ROE: 688/10558 = 6.52%

Maine

GPM: 3100/8900 = 34.8%

PM: 1286/8900 = 14.4%
ROTA: 1286/(7210 + 3700) = 11.79%
ROCE: 1286/(9920 + 100) = 12.83%
ROE: 886/9920 = 8.93%

Comments:

Galveston has a much better GPM of 51.0 (to 34.8) implying a better
transformation process and an efficient production machinery.

However, due to much higher overhead costs, especially in admin expenses but
also in selling and distribution costs, Galveston’s profit margin plummets to a
modest 10% compared with Maine’s stronger 14.4%.

The higher interest paid by Galveston, as result of its larger non-current liabilities
(long-term creditors), also plays a role in lowering the profit margin of Galveston.

The good profit margin of Maine is probably a result of efficient trimmings of its
overhead, suggesting efficient management, and a low amount of long-term
creditors.

The good profit margin, and higher absolute profit, also helps in making Maine
come out on top for the ROTA, ROCE and ROE ratios. A ROE of 8.93% for
Maine (compared to 6.52% for Galveston) promises a good investment. ROTA
and ROCE is also better for Maine, suggesting that the money put into the
company comes to good use.

3. Assess the efficiency achievements of both companies in 2016, using

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

Selected Student Answer

Relevant ratios are:

Inventory turnover (IT): cost of sales/inventory

Average collection period (ACP): (debtors/total sales) × 365
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 Non-current assets turnover (NAT): non-current assets/total sales

Galveston

IT: 4825/1050 = 4.6 times

ACP: (2620/9853) × 365 = 97 days
NAT: 8100/9853 = 82.2%

Maine

IT: 5800/2150 = 2.7 times

ACP: (1050/8900) × 365 = 43 days
NAT: 7210/8900 = 81.0%

Galveston has a better inventory turnover ratio of 4.6 times (to 2.7 times) which
implies better control of production and purchasing. We have remarked about the
high inventory level of Maine for the liquidity ratios, and it plays a role here also.

Maine is however much better at collecting debts (ACP 43 days compared to 97

days) implying better and more efficient collection practises. We have remarked
on the efficient management and efficient overhead of Maine earlier, and it plays a
role here as well.

For non-current assets turnover, the companies are fairly even, at 82.2% for
Galveston to 81.0% for Maine. Since the absolute amount of non-current assets is
also similar, this ratio does not say much in favour of either company.

4. Prepare a recommendation to the Board Meeting based on your assessment

above, including any other relevant observations.
(5 marks)

Selected Student Answer

In all, I would go for Maine due to its efficient management and processes, but it
must work on improving the efficiency of its production/purchasing and it must
strive to lower its inventory levels.

Galveston might also be a good buy, primarily to its high GPM and efficient
purchasing/production machine. But it must make a large effort in more efficient
administration and other overheads and it must work to improve its debt
collection procedures.

Both companies have good liquidity especially the quick ratio of Galveston is very
good.

The ROE of Maine is already better and could improve further given the
recommendations above.

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A close call, but in my book, Maine comes up slightly on top. And if I’m wrong,
Mr Corleone will probably provide feedback immediately.

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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)

Selected Student Answer

Florida
Sales 4200
Less cost of sales 3350
Gross profit 850

Sales Commission 336

Fixed Marketing Costs 195
Share of Group Marketing Costs 42

Net Profit before Overhead Costs 277

If Florida is shut down, the other two divisions will have to carry Florida’s
previously allocated share of R&D, HQ and marketing costs.

Let’s see how that unfolds ……

After shut down of Florida:

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 Gulf Coast Louisiana Total
Sales 3,600 5,200 8,800
Cost of sales 2,400 3,750 6,150
Gross profit 1,200 1,450 2,650

Marketing costs
Sales commission 216 520
Sales administration 40 55
Advertising 55 65
Travel expenses 70 100
381 740
R & D Expense 150 150 300
Group HQ costs 405 585 990
Group marketing* 50.5 58.5 109
986.5 1,533.5

Profit/(Loss) 213.5 -83.5 130

* Group marketing costs are semi-variable. 50% corresponds to 0.5% of sales,

plus an equal share of fixed 65.

With Florida shut down, total group marketing costs decline by 0.5% of Florida’s
revenue = 4,200 × 0.5% = 21.

New allocation is outline above.

Floridas contribution of profits with 277 comes straight off the groups net
performance.

Advise should be to try and allocate overheads better, perhaps reduce some costs?
Anyways, for now they need to keep Florida in the mix.

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

Selected Student Answer

Houston

Sales 395
Less est. cost of sales 375

Gross Profit 20

Sales commission 23.7

Group Marketing costs 2

Net Loss from undertaking the project, after paying the regular 6% sales
commission observed in Gulf Coast, and 0.5% towards Group Marketing, will be
$5,700.00

In my opinion, Glen is absolutely correct in his concern for the project. The only
profit to be made is for the sales rep who gets his 6%. After that, Dallas Olgas
Group would be making a loss.

Recommendation, re-negotiate a better/acceptable deal, or otherwise don’t engage

in the project.

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)

Selected Student Answer

Budgets

Budgeting can indeed be time consuming and cementing inefficiencies of the past,
allowing them to continue.

Uninspired budgeting also prevents innovation and room for thinking big – or
outside the box (budget).

However, done wisely, budgets provides both senior and lower level managers
with a plan for the upcoming period on how to allocate resources, what targets are
to be met, etc.

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A budget will provide a clear line of sight for those accountable for performances
measured in the budget.

As briefly touched upon, a budget cannot measure everything that goes on in a

company, but it can ‘moneterize’ some activity.

It is a foundation for evaluation on various performance, relative to the budget.

As such it can also be a motivator.

So it takes time to ‘do’ a budget properly, and it is in itself a resource consuming

task. However, once accomplished, its benefits I think will outweigh its
drawbacks.

The extensive use of budgets in the private as well as not-for-profit/government

sectors seem to support my argument.

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