Professional Level – Essentials Module, Paper P3
Business Analysis June 2012 Answers
Tutorial note: the financial ratios given in the following analysis have been calculated using definitions specified in Accounting and
Finance by Peter Atrill and Eddie McLaney. Correct, acceptable alternative ratio calculations will be given credit.
1 (a) The following financial analysis focuses on the profitability and gearing of Hammond Shoes manufacturing division.
Profitability: The effect of cheap imports appears to be reflected in the profitability of the company. Revenues and gross profit
have both fallen significantly in the four years of data given in Figure 1. In 2007 the company reported a gross profit margin
of 23·5% and a net profit margin of 8·2%. This has declined steadily over the period under consideration. The figures for
2009 were 20·0% and 4·7% and for 2011, 17·9% and 2·9% respectively. There has been a general failure to keep costs
under control over this period. Sales have fallen by $150m in four years – almost an 18% decrease. In contrast the cost of
sales has decreased by only $75m, a decrease of about 11·5%. This probably reflects the problem of reducing labour to react
to lower demand, particularly in a country where generous redundancy payments are enforced by law and in an organisation
which sees the employment of local labour as one of its objectives. The Return on Capital Employed (ROCE) has dropped
substantially, from 24·14% in 2007 to 6·45% in 2011.
Gearing: The capital structure of the company has changed significantly in the last four years and this is probably of great
concern to the family who are averse to risk and borrowing. Long-term borrowings have increased dramatically and retained
earnings are falling, reflecting higher dividends being taken by the family. Traditionally, the company has been very low
geared, reflecting the social values of the family. The gearing ratio was only 6·9% in 2007, but has risen to over 22·5% in
2011. During this period, retained profit has fallen and an increasing number of long-term loans have been taken out to
finance activities. Overall, gearing may still appear quite low and indeed this is probably the view of the senior management
of the company. However, the speed of these funding changes is a concern, particularly when trade receivables and trade
payables are considered.
One of the values held by the family is the importance of paying suppliers on time. In Arnland, goods are normally supplied
on 30 days credit. In 2007, Hammond Shoes, on average, exceeded this target, paying on 28 days. However by 2009 this
value had risen to 43 days and by 2011 to 63 days. During the same period, trade receivables, from the selected data
provided, appear to have come down slightly (from 38·65 days in 2007 to 36·50 days in 2011). It is difficult to escape the
conclusion that Hammond Shoes is increasingly using suppliers as a source of free credit on top of the loans they have taken
from the banks. Financing costs have risen significantly over the last four years, affecting profits and also causing the interest
cover ratio to fall dramatically from 14 to 1·33.
The financial analysis essentially supports the descriptive analysis provided by the business analysts. Profits are falling, with
the firm unable to cut costs sufficiently quickly. The company is increasingly dependent on external finance which is likely to
cause disquiet amongst the owning family (on ethical grounds) and may concern suppliers.
Investment analysis:
The two scenarios developed by the senior managers also reflect the pessimism of the company. There seems to be universal
acceptance that in the next three years the company will still experience low sales even after the company invests in the new
production facilities. Beyond that, managers only see a 30% chance of higher sales resulting and this depends upon
favourable changes in the business environment.
For both scenarios, the net benefits of the first three years are $5m per year, giving a total of $15m.
For the next three years, managers suggest that there is a 0·7 chance of continuing low demand, leading to net benefits
staying at $5m per year, giving a further benefit of $15m total, with an expected value of $10·5 ($15m x 0·7). Higher
demand would lead to net benefits of $10m per year, providing a total of $30m, but with an expected value of only $9m
($30m x 0·3).
Thus the expected benefits of the project are only $34·5 ($15m + $10·5m + $9m), which is below the proposed investment
of $37·5m. Only if the second scenario materialises after three years will the investment (in broad terms) have been justified.
This scenario would return $45m.
However, it has to be recognised that the projection only covers the first six years of the new production facilities. The factory
was last updated twenty years ago and so it seems reasonable to expect net profits to continue for many years after the six
years explicitly considered in the scenario, but it must be recognised that predicting net benefits beyond that horizon becomes
increasingly unreliable and subjective.
(b) This question does not require the candidate to use a specific framework for generating strategic options. A number of
possibilities exist. The TOWS matrix, the strategy clock and the Ansoff matrix all come to mind. Each of these frameworks has
sufficient facets to generate the number of options or directions required to gain the marks on offer. For the purpose of this
answer, the TOWS matrix is used, because it fits so well with the SWOT analysis produced by the consultants. However, the
focus is on the options generated, not the framework itself and so other frameworks may be as appropriate.
The TOWS matrix is a way of generating directions from an understanding of the organisation’s strategic position. It builds
directly on the work of the SWOT with each quadrant identifying options that address a different combination of the internal
factors (strengths and weaknesses) and external factors (opportunities and threats).
