Question

QUESTION 6:

Duke Co is a retailer with stores in numerous city centres. On 1 January 2008 Duke Co acquired 80% of the equity share capital of Smooth Co, a service company specialising in training and recruitment. This was the first time Duke Co had acquired a subsidiary.
The consideration for Smooth Co consisted of a cash element and the issue of some shares in Duke Co to the previous owners of Smooth Co.
Duke Co has begun to consolidate Smooth Co into its financial statements, but has yet to calculate the non-controlling interest and retained earnings. Details of the relevant information is provided in notes (i) and (ii).
Extracts from the financial statements for the Duke group for the year ended 30 June 2008 and Duke Co for the year ended 30 June 20X7 are provided below:

Duke Group Duke Co
30 June 2008 30 June 2007

R 000 R 000

Profit from operations 14,500 12,700
Current assets 30,400 28,750
Share capital 11,000 8,000
Share premium 6,000 2,000
Retained earnings Note (i) and (ii) 9,400
Non-controlling interest Note (i) and (ii) Nil
Long-term loans 11,500 7,000
Current liabilities 21,300 15,600

The following notes are relevant:
(i) The fair value of the non-controlling interest in Smooth Co at 1 January 2008 was deemed to be R3·4m. The retained earnings of Duke Co in its individual financial statements at 30 June 2008 are R13·2m.
Smooth Co made a profit for the year ended 30 June 2008 of R7m. Duke Co incurred professional fees of R0·5m during the acquisition, which have been capitalised as an asset in the consolidated financial statements.
(ii) The following issues are also relevant to the calculation of non-controlling interest and retained earnings:
– At acquisition, Smooth Co’s net assets were equal to their carrying amount with the exception of a brand name which had a fair value of R3m but was not recognised in Smooth Co’s individual financial statements. It is estimated that the brand had a five-year life at 1 January 2008.
– On 30 June 2008, Smooth Co sold land to Duke Co for R4m when it had a carrying amount of R2·5m.

(iii) Smooth Co is based in the service industry and a significant part of its business comes from three large, profitable contracts with entities which are both well-established and financially stable.
(iv) Duke Co did not borrow additional funds during the current year and has never used a bank overdraft facility.
(v) The following ratios have been correctly calculated based on the above financial statements:

2008 2007

Receivables collection period 52 days 34 days
Inventory holding period 41 days 67 days

Other than the recognition of the non-controlling interest and retained earnings, no adjustment is required to any of the other figures in the draft financial statements. All items are deemed to accrue evenly across the year.
Required:
(a) Calculate the non-controlling interest and retained earnings to be included in the consolidated financial statements at 30 June 2008.
(b) Based on your answer to part (a) and the financial statements provided, calculate the following ratios for the years ending 30 June 2007 and 30 June 2008: Current ratio; Return on capital employed; Gearing (debt/equity).
(c) Using the information provided and the ratios calculated above, comment on the comparative performance and position for the two years ended 30 June 2007 and 2008. Note: Your answer should specifically comment on the impact of the acquisition of Smooth Co on your analysis.

Answer 1

Duke Co

(a) Calculation of NCI and retained earnings:

Non-controlling interest

$000

NCI at acquisition 3,400

NCI% x S post acq 700 (20% x ($7m x 6/12) )

NCI% x FV depn (60) (20% x ($3m/5 x 6/12))

NCI% x URP   (300) ( 20% x $1·5m)

Total $3,740

Retained Earnings

$000

100% x P RE 13,200

P% x S post acq 2,800 (80% x ($7m x 6/12))

P% x FV depn (240) ( 80% x ($3m/5 x 6/12))

P% x URP (1,200) (80% x $1·5m)

Professional fees (500)

Total $14,060

NCI = $3,740,000 and retained earnings =$ 14,060,000

(b)

	Formula	2008	2008 working	2007	2007 working
Current ratio	=Current assets / Current liabilities	1.4 : 1	=30,400/21,300	1.8 : 1	=28,750/15,600
ROCE	=EBIT / Capital employed	31.3%	=14,500 / (11,000+6000+14060+3740+11500)	48.1%	=12700/(8000+2000+9400+7000)
Gearing	=Debt/SHs Equity	33%	=11500 / (11000+6000+14060+3740)	36.1%	=7000 / (8000+2000+9400)

(c) Analysis

Performance

The ROCE has declined significantly from 2007. However, rather than being due to a reduction in profit from operations which has increased slightly ($14·5m from $12·7m), it is due to a significant increase in capital employed which has gone from $26·4m to nearly $50m. This will be partly due to the fact that Smooth Co was acquired through the issue of shares in Duke Co.

The ROCE will look worse in the current period as it will only contain six months’ profit from Smooth, but the entire liabilities and non-controlling interest at the reporting period

As Smooth Co made a profit after tax of $7m in the year, six months of this would have made a significant increase in the overall profit from operations. If excluded from the consolidated SOPL, it suggests that there is a potential decline (or stagnation) in the profits made by Duke Co.

Position

The current ratio has decreased in the year from 1·8:1 to 1·4:1. Some of this will be due to the fact that Smooth Co is based in the service industry and so is likely to hold very little inventory. The large fall in inventory holding period would also support this.

An increase in trade receivables is perhaps expected given that Smooth Co is a service based company. This is likely to be due to Smooth Co’s customers having significant payment terms, due to their size.

This increase in receivables collection period could mean that Smooth Co has a weaker cash position than Duke Co. While the size of the customers may mean that there is little risk of irrecoverable debts, Smooth Co may have a small, or even overdrawn, cash balance due to this long collection period.

The gearing has reduced in the year from 36·1% to 33%. This is not due to reduced levels of debt, as these have actually increased during the year. This is likely to be due to the consolidation of the debt held by Smooth Co, as Duke Co has not taken out additional loans in the year.

This increase in debt has been offset by a significant increase in equity, which has resulted from the share consideration given for the acquisition of Smooth Co.

Conclusion

Smooth Co is a profitable company and is likely to have boosted Duke Co profits, which may be slightly in decline. Smooth Co may have more debt and have potentially put pressure on the cash flow of the group, but Duke Co seems in a stable enough position to cope with this.