Suggested answers for General Machinery question

Important note: These are INDICATIVE answers only. They are written in bullet
point form but in answering any similar examination question, you would need to
argue your case clearly, showing

What are the key issues

Your evidence for identifying these as issues
Your reasons as to why the issue is important
Recommendations for improvement

After a decline, the companys profitability (ROI, ROCE, Operating margin) has
improved recently. However, the gross margin has dropped for five consecutive
years, suggesting that selling prices are not being increased to pass on purchase
(or production) cost increases. This deteriorating margin is a significant risk for
the company as profits have only been increased by the large reduction in
overhead in 2009. If margins continue to erode and if overheads cannot be
continually cut, profits may be at serious risk. The company needs to continue to
increase sales growth, fix its gross margins and continue to manage overheads.
Working capital has been at extremely high levels but has fallen to close to 2:1,
an improvement, but with an acid test greater than 1, is probably still too high.
This is demonstrated by the relatively high days sales outstanding (60 against
30 day terms), which even though it has improved is still too high. Inventory
represents the biggest concern to working capital as at 3.3 it represents an
average stockholding of 110 days (365/3.3). The company needs to manage its
ordering to a just-in-time basis. The cash flow statement shows that most cash
has been used in 2009, hence working capital is strained by a lack of cash and
slow debtor collections and inventory turnover. The result is too high days
purchases outstanding of 78, representing over 2.5 months. This is likely to give
the company bad credit rating and may impact its ability to maintain continuity
of supply. Asset turnover has steadily increased, a trend which needs to continue.
Gearing at 42% has increased slightly over 5 years but is at acceptable levels
(anything in the range 40-60% being very common). However, interest cover has
fallen significantly and is less than 2:1, with banks and financiers likely to
consider this as risky in terms of the companys long term ability to make
interest payments.
Shareholder ratios are somewhat erratic with a lack of consistency in dividend
per share likely to make some investors nervous. Dividend payout remains at
about a 50% level, consistent with common practice. The dividend yield is very
low compared to risk free government securities or bank interest rates. The P/E
ratio of 16 (years) is an improvement and reflects market optimism about the
companys future sustainable cash flows.
The cash flow statement reveals that net cash from operating activities, after
deducting dividend payments is very low. The major cash flow impacts are
capital expenditure of $300,000 over the last three years and borrowings of

$150,000. The balance of $150,000 has been funded from operating activities
and has been the cause of the reduction in the closing bank balance to $20,000.
This in turn has affected the working capital ratio.
The question should the company have borrowed more? is interesting because
on the surface it needs to do so to replenish the bank balance. This is because it
is less risky for non-current assets to be financed by non current liabilities.
However, further borrowing will have two impacts. By increasing the bank
balance it will worsen the working capital ratio. This is because the borrowings
would be disguising the poor credit control and inventory practices. Second,
additional cash would enable the company to pay its creditors more quickly. It
would be better for the company to fix its inventory problems and collect its
debts on time, pay its overdue creditors and then look to see how much
additional borrowing was required.
So the company faces three major issues it needs to address: Fix the declining
gross margin to maintain profitability. Fix the inventory and debtors problem to
improve cash flow. Pay its creditors on time. Whether or not the company needs
to borrow further will only be seen after the effects of these improvements are
made.