Root & Cook Ltd (RCL): Financial Analysis And Investment Decision-making – A Case Study

Part 1: Financial Analysis of RCL

The issue presented in the case study is that Root & Cook Ltd (“RCL”) operates in a number of factories in Manchester, Halifax and Leeds. The business had been doing well as there had been enough orders from the last year. However, the particular reason for concern had been that the debt position of the firm had been worsening since the previous year. The shareholders have been concerned with the particular fact that the debt of the company had increased to £157 million from £120 million of the previous year.

This particular study aims to reflect on the aspect of financial particulars like profit and cash flow, working capital management and the receivables, inventory and payables.

The financial performance of a firm can be determined by the utilization of the key performance indicators. Moreover, the financial health of a company can also be determined by the state of the shareholders of the respective company. The shareholders and the stakeholders of the company being satisfied of the returns they get from business indicate that the particular firm is doing well and that there is no major reason for concern (Ciftci and Darrough 2015).

The case study that has been provided focuses on a firm that deals in garden tractors for the purpose of domestic use in gardens that are large in size. The particular issue that has been reflected in the case study is that the particular organization RCL though has been displaying an operating profit that is relatively high the firm has been dealing in a huge amount of debt that amounts to £157 million in the present year.

It should be noted here that the difference between the cash and profit is crucial. In case of a new business the cost that is required for manufacturing a particular product can only be incurred when the product deals in profit. The common concept of profit per unit refers to the financial component of sales minus cost and expenses. However, the primary reason for the companies going bankrupt is that in spite of earning enough profits from business they lack the sufficient amount of cash. The management of these business houses have not focused on the amount of cash that is available in business and have blocked the required amount of money in the assets thus could not pay up for the expenses. It can also be stated in this particular study that a business for the purpose of surviving the crests and troughs of the markets must acquire sufficient cash resources for meeting the financial obligations that may arise in the future. To be more precise, the difference between cash and profit can be explained with the help of an example. For instance, Company A manages to earn a profit of $4736 in a single month. Now, this particular amount of profit does not necessarily signify the fact that the firm has $4736 as cash in its account. This is because this particular amount includes the amount of sales that have been carried out on credit. This means a portion of the profit is still unrealized. Thus, the total amount of cash available in business is different from the profit incurred by the firm.

The Difference between Profit and Cash Flow

Working capital can be defined as the capital that is required by a business for the regular trading operations. This means that the capital that is required for carrying out or financing the operations in the regular course of business is known as the working capital. Working capital can be computed as current assets minus the current liabilities of business. It is made up of inventories, trade receivables and trade payable (Edwards, Kravet and Wilson 2016).

Inventory on the other hand, refers to the stock of products that is maintained by business and managed according to the current level of demand in the market. Receivables refer to the amount of sales that has been done on credit and the payment of which is still due. Thus, the business will receive such an amount hence, known as receivables. Payables on the other hand, refers to the expenses or financial obligations that are still unpaid by business (Edwards, Kravet and Wilson 2016).

The changes in the working capital can affect the cash flow. This is because the changes in the working capital will affect the net sales revenue that is incurred by the firm in a specific time period, which will in turn affect the cash flow. Cash flow fundamentally refers to the inflow and outflow of cash in business. Therefore, the change in working capital will be particularly affected by this (Ball et al., 2016).

The primary issue that has been mentioned in the case study is that RCL has been operating in via three major factories in Manchester, Halifax and Leeds. The annual turnover of the company for the last financial year had been £220 million.

The issue had been that the stakeholders of the business had been concerned about the factor that the debt position of the company had increased from £120 million to £157 million.

Therefore, as can be deduced from the provided case study the primary problem that has been reflected from the issues faced by RCL is that there has not been enough inflow of cash into business. This means that even if the operating profit of the firm has been £18 million, the debt position of the firm is increasing at an accelerated rate. It must be noted here that a firm obtains enough loans from the outside third parties in order to capitalize the business and other investment projects of the firm. This means that the operating profit that has been obtained is either not properly reflected or should be more, in order to compensate for the funds that have been borrowed from the outside lenders. Thus, the problem can be related to the issues that have been discussed in the preceding paragraphs. This is because the issue presented in the case study reflects the fact that there has been enough profit but not enough cash in business. Moreover, it has further not been clarified that what portion of the operating profit consists of the receivables which refers to the amount that the firm will receive. Moreover, an increase in the

Working Capital Management and Impact on Receivables, Inventory, and Payables

The steps that can be incorporated for the better management of the working capital by the administration of RCL are as follows:

• Required improvement in the accounts receivables collections – The accounts receivables as described in the earlier part of the study refers to the receivables that a particular accounting firm has still not received from the debtors. The proper management of the working capital can be carried out by ensuring that the firm receives timely payments from its customers or debtors. In case of RCL, the firm should arrange for a collections team that is motivated and ensures timely collection of the due payments (Frankel and Sun 2018).
• Improvement in regards to the accounts payables – The payments on the part of the firm should be properly negotiated with the creditors of the firm in order to reduce the outflow of liquid cash from business. Moreover, the particular areas that may result in the outflow of cash should be properly handled in order to minimize the payment amount as much as possible. In case of RCL, the probability of a legal suit should be handled carefully in order to minimize the cost (Castellucci caes at al., 2017).
• The reduction in the amount of expenditure – the reduction in the potential expenditures of the firm is another potential solution in regards to the management of the working capital. This can be explained by a particular instance of reducing the costs or expenditures in regards to the equipments needed, office supplies and the implementation of the desired technology in the firm (Frankel and Sun 2018).
• Possible analysis in regards to the risk of credit – this is an essential process in regards to any firm selling their product on credit. This means that a firm selling their products up to a certain credit limit should at first conduct a background check on the customer as to whether he or she will be able to make payment for the obtained amount of credit. The adjustment in the credit profiles, terms of credit and introduction of penalties or incentives will likely help to reduce the risk of credit (Castellucci caes at al., 2017).
• Tax opportunities – RCL should also review its tax structure in order to make sure that the firm does not miss out any opportunity in regards to the payment of the taxes.

Capital budgeting – key steps and process

Capital budgeting refers to the particular process that is employed by any business for the purpose of determining and evaluating the possible expenditures or investments that are large scale. The expenditures in regards to which the capital budgeting techniques are utilized include the projects such as long-term investment projects. Moreover, these techniques often help in the ascertainment of the fact that whether the investment projects result in the optimum returns that will help to rank the projects on the basis of such profitability (Abor 2017). The steps that should be considered while determining the effectiveness of an investment project are as follows:

• The objectives of the organization should be identified
• The projects that are to be chosen must be suitable to the objectives of the organization
• The relevant data in regards to the project should be collected
• The evaluation of the options by utilizing the different capital budgeting techniques should be conducted. Moreover, the optimum returns from the investment projects should also be determined in order to rank the projects according to their profitability
• The implementation of the decision
• The variations in regards to the established plan should also be considered in order to prepare for any alterations in the plan

The purposes of the capital budgeting techniques is primarily the accurate selection of the project that will result in optimum returns thus, ensure a higher degree of profitability that can be acquired from the selected investment project.

The different investment appraisal methods that are utilized for calculation of the viability of the projects are as follows:

• Payback period
• Net Present Value
• Internal Rate of Return

The payback period is a particular capital appraisal method that obtains the required results facilitating the calculation of the particular time length that will be mandatorily needed for the inflow of the stream of cash in regards to an investment project that will be equal to the original cash outlay. The payback is a potential capital investment appraisal method and is an widely used method of capital budgeting. The payback period methods employs a lesser degree of pure arithmetic which increases the applicability of the method. Moreover, the payback period might be important to the organizations that face the issue of cash flow constraints. A limitation of the pay back approach is that it does not take into account the funds that have been already invested in regards to a long term project and the interest that has been charged on the borrowed funds (Abor 2017).

The net present value refers to the particular technique that is an advanced technique in regards to the payback approach. The net present value of a project refers to the value that is equal to the present value of the cash that is flowing into business minus the present value of the cash that is flowing out of business and has been discounted at the cost of capital. There is a probable decision rule that helps in determining the fact that whether a particular investment proposal will be accepted or not. If the NPV of a particular project is positive, the project should be accepted; the NPV being negative, results in the rejection of the project. However, a zero NPV indicates the fact that the selected project will be able to just extract the cost of capital without resulting any amount of surplus. The particular benefit of NPV is that it is one of the most practical capital budgeting solutions. However, this particular method employs a huge amount of assumptions, which makes its base weaker (Goyat and Nain 2016).

Assessment of Debt Position and Acquisition of New License

The Internal rate of Return method refers to the rate of discount which is employed for discounting the present value of the cash flows that has been generated by the project that equalizes the present value of the invested capital in order to make the NPV of the project, zero. The primary advantage of IRR is that it considers the time value of money. However, a particular disadvantage of IRR is that does take into account the actual dollar value of benefits (Upadhyay, Sen and Smith 2015).

The alternative capital budgeting options that can be utilized for the purpose of determining as to which particular investment project has to be chosen depends on the techniques that are employed for the purpose of ensuring which investment project is more profitable.

Below is an instance of the evaluation of the investment options. The payback period method has been utilized as follows:

 
The above table depicts the fact that the total finance budgeted for the investment project in Reading has been £20 million and that for Bristol has been £16 million. This means that the inflow of cash for the first, second and third year has been fixed at £5, £11 and £4 for Reading and £5, £11 for Bristol. The pay back periods that have been aimed are 3 years and 2 years respectively. This has reflected the fact that the investment project in Bristol appears to be more profitable in comparison to the investment project in Reading.

Next, the viability of the projects has been determined on the basis of the Net Present Value method. The table that has been shown below depicts the fact that the inflow of cash from the Reading project has resulted in a negative NPV which results in the rejection of the project.

The viability of the project in Bristol has also been analyzed in the following table:

The result that has been obtained from the above prepared table, depict the fact that the NPV has been positive in nature. This means that the investment project in Bristol can be selected in comparison to the project in Bristol.

The internal rate of return also reveal the fact that the investment Project in Bristol would have been more profitable in nature. This can be deduced from the following table:

The above table justifies the fact that a particular discount rate of 20% would result in a positive NPV of £6,360. However, a particular discount rate of 24% would result in a negative NPV, which would result in the rejection of the investment project.

Part 2: Investment Decision-making for New Manufacturing Venture

The issue that has been presented in the question depicts the fact that the shareholders of the company had, successfully resolved the particular business structure in RCL that had been exposed to the risk of a high degree of debt position. Next, the management of the company had been considering expanding the business and has been considering the options in regards to a factory site in Bristol and that in Reading.

It must be noted here that the particular business venture in Reading would involve construction on a site that will, in probabilities incur a cost of £20m and would have a life of 9 to 10 years before further renovation would be required. Bristol, on the other hand would involve a cost of £16m and would operate for a period of 5 to 6 years.

Now the viability of the projects have been analyzed with the help of the three capital budgeting techniques. The numbers have been assumed and it has been found out that the investment project in Bristol would have been a more profitable option. This is because the payback period technique had revealed that the investment project in Bristol would have resulted in the optimum returns in a time period of 2 years. Therefore, it can be primarily concluded that the investment project in Bristol would have been a more profitable option.

References

Abor, J.Y., 2017. Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.

Alkhamis, N., Noreen, U., Ghonaim, L., Alghonaim, S., Ibrahim, S. and Alturki, R.A.A., 2017. Capital Budgeting and Capital Structure Decisions in Saudi Arabia. Advanced Science Letters, 23(1), pp.330-332.

Ball, R., Gerakos, J., Linnainmaa, J.T. and Nikolaev, V., 2016. Accruals, cash flows, and operating profitability in the cross section of stock returns. Journal of Financial Economics, 121(1), pp.28-45.

Castellucci, V., García-Terán, J., Eriksson, M., Padman, L. and Waters, R., 2017. Influence of sea state and tidal height on wave power absorption. IEEE Journal of Oceanic Engineering, 42(3), pp.566-573.

Ciftci, M. and Darrough, M., 2015. What Explains the Valuation Difference between Intangible?intensive Profit and Loss Firms?. Journal of Business Finance & Accounting, 42(1-2), pp.138-166.

Delkhosh, M., Malek, Z., Rahimi, M. and Farokhi, Z., 2017. A comparative study of information content of cash flow, cash value added, accounting earnings, and market value added to book value of total assets in evaluating the firm performance. International Journal of Accounting and Economics Studies, 5(2), pp.112-117.

Edwards, A., Kravet, T. and Wilson, R., 2016. Trapped cash and the profitability of foreign acquisitions. Contemporary Accounting Research, 33(1), pp.44-77.

Frankel, R. and Sun, Y., 2018. Predicting accruals based on cash-flow properties. The Accounting Review.

Goyat, S. and Nain, A., 2016. Methods of Evaluating Investment Proposals. International Journal of Engineering and Management Research (IJEMR), 6(5), pp.278-280.

Kostevšek, A., Klemeš, J.J., Varbanov, P.S., ?u?ek, L. and Petek, J., 2015. Sustainability assessment of the locally integrated energy sectors for a Slovenian municipality. Journal of Cleaner Production, 88, pp.83-89.

Upadhyay, S., Sen, B. and Smith, D., 2015. The cash conversion cycle and profitability: A study of hospitals in the state of Washington. Journal of Health Care Finance, 41(4).

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