o help you revise, Velocity publishes regular model answers to practice

questions. This one is for F3. Before attempting this question, read the
article in the April edition of Financial Management Study Notes.
Fink plc, a publicly quoted company, operates a chain of bars and public
houses (pubs) throughout England. It has 58 outlets in 45 different towns
and cities, which serve a range of beers, spirits and soft drinks. None of
the company’s outlets serve food. The company’s profitability has
declined in the last two years, in common with many firms in the
industry, as the effects of a smoking ban, and the availability of cheap
alcohol in the supermarkets, have impacted. The share price of Fink has
fallen steadily from £4.55 in 2007 to a current value of £2.27. In the
same period the FTSE All-Share Index has fallen by 30%.
The directors of Fink are trying to assess the prospects for their
company. They feel that Fink is exhibiting some characteristics of
financial distress, and they realise that decisive action will be needed to
address the situation.
The summary financial statements for the company over the last three
years are as follows.
Fink plc
Accounts for the year ended 30 September
Income statements 2009 £m 2008 £m 2007 £m

Revenue 43.6 61.7 59.5

Cost of sales 26.4 35.4 31.9

Gross profit 17.2 26.3 27.6

less other operating costs 16.2 17.6 16.9

Operating profit 1.0 8.7 10.7

Finance costs 0.8 0.8 1.2

Profit before tax 0.2 7.9 9.5

Tax 0.0 2.4 3.0

Profit for the period 0.2 5.5 6.5

Statements of financial position 2009 £m 2008 £m 2007 £m

Non current assets 22.3 31.7 34.7

Current assets

Inventory 8.8 7.4 7.8

Receivables 2.4 1.7 1.6

Cash 9.8 11.7 10.6

Total current assets 21.0 20.8 20.0

Total assets 43.3 52.5 54.7

Equity and liabilities

Ordinary share capital (50p shares) 10.0 10.0 10.0

Retained earnings 12.5 12.3 9.8

Total equity 22.5 22.3 19.8

Current liabilities

Trade payables 7.8 16.4 8.6

Tax payable 2.2 3.0 7.1

Dividends payable 0.0 0.0 3.0

Interest payable 0.8 0.8 1.2

Non current liabilities – loans 10.0 10.0 15.0

Total liabilities 20.8 30.2 34.9

Total equity and liabilities 43.3 52.5 54.7

Required:
Prepare a report which analyses the current performance of Fink plc,
using the given financial and non-financial information, and recommends
what the directors should do to address the company’s situation.
(25 marks)
Note: Up to 15 marks are available for calculations.
Answer:
Time allocation:
The whole question should take 25 mins x 1.8 mins per mark = 45
minutes.
Spend no longer than 15 x 1.8 = 27 minutes preparing the calculations
first.
Calculations (present as an appendix to the report)
PROFITABILITY 2009 2008 2007

ROCE = (operating profit / capital 1.0 / 8.7 / 10.7 /

employed) x 100% (22.5+10.0) (22.3+10.0) (19.8+15.0)
3.1% 26.9% 30.8%

Profit margin = (operating profit / sales) x 1.0 / 43.6 8.7 / 61.7 10.7 / 59.5
100% 2.3% 14.1% 18.0%

Asset turnover = sales / capital employed 43.6 / 61.7 / 59.5 /

(22.5+10.0) (22.3+10.0) (19.8+15.0)
1.34 1.91 1.71

LIQUIDITY 2009 2008 2007

Inventory holding period = (inventory / cost (8.8 / 26.4) (7.4 / 35.4) (7.8 / 31.9)
of sales) x 365 x365 x365 x365
122 days 76 days 89 days

Receivables collection period = (2.4 / 43.6) (1.7 / 61.7) (1.6 / 59.5)

(receivables / sales) x 365 x365 x365 x365
20 days 10 days 10 days

Trade payables payment period = (trade (7.8 / 26.4) (16.4 / (8.6 / 31.9)
payables / cost of sales) x 365 x365 35.4) x365
108 days x365 98 days
169 days

Cash operating cycle length 34 days -83 days 1 day

Purchases should have ideally been used instead of cost of sales in the
payables payment period, if it had been given. However, using cost of
sales instead is acceptable, since it has been used consistently to
enable us to make sensible comparisons. Also, given that this is
effectively a retail company (we are not told that it brews its own beers) it
is assumed that cost of sales and purchases will be similar.

GEARING 2009 2008 2007

Debt / (debt + equity) using book values 10/(10+22.5) 10/(10+22.3) 15/(15+19.8)

31% 31% 43%

Debt / (debt + equity) using market 10/(10+45.4) 10/(10+68.2) 15/(15+91)

value for equity (W1) 18% 13% 14%

Interest cover 1.0 / 0.8 8.7 / 0.8 10.7 / 1.2

1.25 times 10.88 times 8.92 times

(W1) Market value of equity = share price x number of shares

2007: £4.55 x (10m / 0.50) = £91m
2009: £2.27 x (10m / 0.50) = £45.4m
For 2008, assume that the share price is halfway between the 2007 and
2009 prices (that is, £3.41) and that the total equity value is also halfway
between the 2007 and 2009 prices (that is, £68.2m).
STOCK MARKET RATIOS 2009 2008 2007

Earnings per share = profit after tax / 0.2 / 20 5.5 / 20 6.5 / 20

number of shares £0.01 £0.28 £0.33

P/E ratio = share price / EPS 2.27 / 0.01 3.41(W1)/0.28 4.55 / 0.33
227 12.2 13.8

Fink plc has not paid a dividend recently, so dividend yield is zero and
dividend cover cannot be computed. Also, a declining share price
coupled with no dividends paid out mean that there has been a negative
shareholder return over the last two years.
Report to the directors of Fink plc
Prepared by A.N. Accountant, 12/12/2009
Analysis of company performance
Introduction
I have been asked to analyse the performance of Fink plc, using the
accounts from the last three years as my main source of information. I
have presented calculations in an appendix to my report (above).
Analysis of profitability
The profitability of Fink plc has reduced dramatically over the last three
years, from a Return on Capital Employed (ROCE) of 30.8% in 2007 to
3.1% today.
The ROCE has been affected by a drop in asset turnover (that is, fewer
sales being generated, due to the social and legal factors affecting the
whole of the pub industry) and a dramatic drop in profit margin. The
decline in profit margin (from 18.0% in 2007 to 2.3% today) could well be
caused by the high levels of fixed costs. Sales have fallen but Fink plc
has not been able to reduce its costs, especially ‘other operating costs’,
in proportion.
Unless the firm can find a way of converting some of its fixed costs (such
as salaries and rent) into variable costs, to reduce its operating gearing,
the chances of Fink plc remaining profitable in 2010 are slim.
Analysis of liquidity
The cash operating cycle measures the time between paying out cash
for the purchases of inventory, and receiving cash for the subsequent
sale. In this case, the overall cycle length figure has been extremely
volatile over the last three years. It is difficult to draw any conclusions
from such volatile figures.
Looking behind the headline figures, there are two alarming points.
First, the inventory holding period has increased significantly in 2009. On
average, inventory is now being held for 122 days. It is not surprising
that with low sales, inventories are increasing. However, for a firm in the
pub industry, the inventories are likely to be perishable items (for
example, beer in barrels starts to deteriorate quite rapidly once the barrel
has been opened), so there may be a need to write off some of the
inventory if this situation continues (further reducing the profitability of
the company).
Second, the payables payment period has dropped dramatically, from
169 days in 2008 to 78 days in 2009. Fink plc is clearly paying its
suppliers much quicker that in the past, but arguably is still running the
risk of upsetting suppliers by paying very late. Standard terms of credit in
most industries are 30, or at most 60 days, so although Fink plc is
currently benefiting from the credit which the suppliers are involuntarily
supplying, there is a risk that supplier relationships may be close to
breakdown.
Analysis of gearing
The balance sheet gearing position has not changed significantly in the
last two years. The entity paid back £5.0m of debt two years ago, and
now has a relatively low level of debt.
However, the interest cover has dropped alarmingly (from 10.9 times in
2008 to 1.25 times in 2009). This has happened because of the drop in
profitability identified above. Even though the total amount of interest has
stayed constant, the low profitability meant that the interest cover was
only just over 1 in 2009. If the firm’s sales continue to drop, and some of
the inventory has to be written off (as discussed above), the interest
cover could drop below 1 next year.
However, the situation is not as serious as it first appears in the short
term, since Fink plc has plenty of cash (£9.8m) with which it will be able
to pay the small amount of annual interest for the next few years. In fact,
it seems strange that Fink plc is holding so much cash. A cash rich
company with a falling share price is likely to become attractive to a
predator. Fink plc should aim to reduce its cash pile, perhaps by
redeeming some of its debt or finding new investment opportunities.
In conclusion, despite the alarming drop in interest cover, the large
amount of cash on the balance sheet, coupled with the relatively small
amount of debt interest payable each year, mean that Fink plc does not
have a problem with its gearing at the moment.
Analysis of stock market ratios
The huge rise in P/E ratio in 2009 (up to 227) appears to be a blip
caused by the extremely low profitability (earnings per share) in that
year. In general, the stock market information makes grim reading for
Fink.
The share price has dropped by 50% over the last two years (from £4.55
to £2.27) which means that Fink’s shares have significantly under-
performed the market (which has dropped by 30%). Also, because of
this drop in share price, and the fact that Fink has paid no dividends, the
overall shareholder return from Fink’s shares has been negative (that is,
Fink plc shareholders are worse off now than they were two years ago).
We know that the entire pub industry is struggling, so it would be
interesting to compare Fink’s performance to the industry average
(rather than the whole market). Unfortunately, such information is not
available.
Given the current lack of profitability, and the fear that profitability might
deteriorate in future, it is likely that the Fink plc share price will continue
to drop in the near future.
Conclusion and recommendations
The main areas of concern regarding Fink plc’s current position are:
1. low profitability, partly caused by external factors in the pub industry
2. low confidence in the market in pub companies in general and Fink in particular
3. high levels of cash, making Fink an attractive takeover target,
4. poor management of working capital, and the risk that supplier relationships might be strained.
Fink needs to address these issues quickly if it is to escape the
downward spiral towards corporate failure. In particular, the key
recommendations are:
1. Expand the product range to enable Fink to fit better with its environment – the company has
sufficient cash available to enable it to undertake this new strategy. People expect to be able to
eat and drink in pubs, but Fink has only ever tried to sell drinks so far. A broader product range
should help to stabilise Fink’s sales and profitability.
2. Implement a new working capital management policy, working closely with key suppliers to
ensure that inventory levels are better monitored.
3. Communicate these positive steps to the market. Shareholder confidence will improve if the
shareholders can see that the Fink plc management are aware of the company’s problems and
are trying hard to address them.