Question

Analyse the financial statements that have been prepared by Home Range Ltd’s financial director. In particular, comment on the following aspects of the company:

i. Areas of concern in financial performance, focusing mainly on information from the income statement

ii. Areas of concern in financial health, focusing on ratios dependent on the income statement and the balance sheet

iii. Areas of concern in cash flow management, focusing on information available from the cash flow statement.

Assess the value of Clare Lombardo’s parent’s recent concern that ‘the company has not spent its significant cash resources wisely in the past year’ (the year to 31 December 2017). What practical steps should Clare Lombardo now undertake in order to help to maximise the value of the business for resale in about 3 years?

Case study

Home Range Ltd

Clare Lombardo comes from a family that has bought, renovated and sold or rented houses as a side-line to their main forms of employment for a number of years. This family interest has proved to be a profitable small business. Her father is an electrician by trade but has developed skills in other areas such as basic plumbing and carpentry. This has greatly reduced the cost of ‘doing up’ old properties. Clare’s mother works as a part-time bookkeeper so she has enough spare time to keep proper financial records for the business.

Clare’s favourite subject at school was Art. While still at school Clare discovered a knack for helping her parents to tastefully furnish renovated properties in preparation for their sale or rent. After school Clare studied interior design while helping run her parent’s business.

About 20 years ago Clare was left money by a grandparent. She used this to open her first Home Range shop in an exclusive part of London. It sells high quality home furnishings and accessories to mainly wealthy customers who have limited time.

Clare’s luck, good taste and business acumen has proved very successful. She formed the private company Home Range Ltd 18 years ago, and it has grown to consist of a chain of 25 stores in wealthy parts of London and the south east of England. The retail outlets have been complimented by an effective and profitable website.

Clare is the majority shareholder while her parents own the remaining shares in the business. Clare has recently decided she wants to sell the business in about three years. She is conscious that her parents are growing old and she also want to spend more time with her young family.

Clare’s parents have decided to retire from formal employment in the next few months. They will still run their property business. While they are essentially passive shareholders in Home Range Ltd, Clare still relies on them for common sense advice she can trust.

Home Range Ltd has been particularly profitable since the global financial crash beginning in 2007. It appears to Clare and the financial director of the company that the luxury goods market has not been affected by cuts in government expenditure. In the year ending 31 December 2016 the company achieved a record return on equity of 35%. This has generated some media interest in Home Range Ltd as well as a number of serious offers to buy the company.

Clare now wants to invest more in the company to continue to make it grow in profitability for the next 3 years so she can maximise its value for the planned sale. On the 1^st January 2017 the business took out a further bank loan of £1.2 million to expand the business with as little risk as possible. In the last year, Clare has relied mainly on advice of the company financial director to invest particularly in buying goods with a higher profit margin and to spend more on marketing. Her parents have recently challenged the views of the financial director and advised Clare that the company has not spent its significant cash resources wisely in the past year.

Clare now needs to properly understand the implications of the latest financial statements below to see if the company is on the right track, and if her parent’s recent advice is justified.

Home Range Ltd Income Statement

For the years ended 31 Dec 2017 and 2016

	Year to 31 Dec 2017		Year to 31 Dec 2016
	£k	£k	£k	£k
Sales revenue		106,872		88,476
Less: cost of goods sold:
Opening inventory	6,246		5,168
Purchases from wholesalers	61,256		40,626
	67,502		45,794
Less closing inventory	8,792		6,246
Cost of goods sold		58,710		39,548
Gross profit		48,162		48,928
Less expenses:
Salaries and other costs	17,562		16,154
Rent and office services	636		628
Insurance	97		94
Distribution and postage costs	325		310
Marketing and advertising expenses	1,137		864
Office administration	171		164
Energy and other utilities	272		264
Depreciation	704		682
Audit, Accounting & Legal Costs	46		43
Interest on bank loan	48		12
Interest on bank overdraft	0		0
Total Expenses		20,998		19,215
Interest received		1,350		1,290
Profit before taxation		28,514		31,003
Corporation tax		5,703		6,201
Profit after taxation		22,811		24,802

Home Range Ltd Balance sheets at 31st December 2017 and 2016

	Year to 31 Dec 2017		Year to 31 Dec 2016
	£k	£k	£k	£k
Non-current assets
Property		13,659		14,400
Computers and equipment		412		328
Vehicles		248		234
Total non-current assets		14,319		14,962
Current assets
Inventory	8,792		6,246
Receivables	4,051		1,612
Other current assets	48		46
Cash at bank	100,158		79,188
Total current assets	113,049		87,092
Current liabilities
Payables	11,124		9,398
Corporation tax	5,703		6,201
Other tax liabilities	349		273
Bank overdraft	0		0
Total current liabilities	17,176		15,872
Net current assets/working capital		95,874		71,220
Total assets less current liabilities		110,193		86,182
Long-term liabilities
Bank loan		1,600		400
Net Assets		Total108,593		Total85,782
Equity
Share capital		1,000		1,000
Reserve: retained earnings		107,593		84,782
Total Equity		Total108,593		Total85,782

Home Range Ltd Cash Flow Statements For the years ended 31 December 2015 and 2014

	Year to 31 Dec 2017	Year to 31 Dec 2016
	£k	£k
Operating activity:
Operating profit	27,212	31,003
Interest paid on overdraft	0	0
Corporation tax paid	(6,201)	(6,485)
Add back non-cash expenses:
Depreciation	704	682
Loss/(Profit) on disposal of non-current assets	0	0
Changes in cash invested in Working Capital:
(Increase)/Decrease in Inventory	(2,546)	(1,078)
(Increase)/Decrease in Receivables	(2,439)	(472)
(Increase)/Decrease in Other current assets	(2)	8
Increase/(Decrease) in Payables	1,726	1,854
Increase/(Decrease) in Other tax liabilities	76	94
Net cash inflow/(outflow) from operating activities	18,530	25,606
Investing activity:
Purchase of non-current assets	(62)	(47)
Proceeds on disposal of non-current assets	0	0
Net cash generated (consumed) by investing activity	(62)	(47)
Financing activity:
New Bank Loan	1,200	0
Interest paid on bank loan	(48)	(12)
Interest received on bank deposit	1,350	1,290
Net cash generated (consumed) by financing activity	2,502	1,278
Change in Cash Balances	20,970	26,837
Opening cash balance (overdraft) at 1st January	79,188	52,351
Closing cash balance (overdraft) at 31st December	Total100,158	Total79,188

Answer 1

Areas of concern from income statement:

• Reduction in gross margin
• Reduction in net margin

Areas of concern from income statement and balance sheet:

• Working capital has increased hugely because of increased receivables
• Day Sales Outstanding (DSO) has increase thus indicating collection of money for sales being an issue.
• Debt has also increased.
• The return on equity has decreased.

Areas of concern from cash flow:

• The major cash is going to fund working capital requirement and not building assets for business growth
• The fixed assets acquisition (capex) is only £62000 out of an opening cash balance of £ 79188000 which suggests very weak capex and this could be detrimental to future business growth.

As remedial steps Clare should do the following:

• Reduce credit sales to free up working capital
• Ask for longer credit period from suppliers.
• Optimize the supply mix to reduce cost of goods sold
• Invest aggressively to acquire new assets which would fuel further business growth