CIMA SCS: AutoAuto Financial Analysis

The below article on the CIMA August 2017 SCS exam AutoAuto has been kindly provided by the good people at Viva Tuition.

CIMA SCS August 2017

The August 2017 Strategic Case Study deals with AutoAuto, an electronics and design company that sells to large car manufacturers. In this article we’re going to look at the financial statements presented in CIMA’s pre-seen for both AutoAuto and one of its main rivals, Primnav.

Income Statement Analysis – AutoAuto

AutoAuto’s Consolidated Statement of Profit or Loss signals trouble in the form of falling revenues and an even bigger decline in net profits in 2017.

Revenues declined 7% in 2017 while net profit fell by 19%.

We can really only speculate as to why this might be, but there is reason to suspect that AutoAuto lost one or more of its major car manufacturer customers in the past year.

Numerous references are made throughout the pre-seen as to the size of AutoAuto’s customers and also to the company’s reliance on relatively few of these. It’s also plausible that one or more of these large car manufacturers put pressure on AutoAuto to lower its prices and this has negatively affected their revenues and profits in 2017.

Whereas some years ago the four products that AutoAuto currently sells would have been considered cutting-edge and they could have charged a premium price for each, these products have all started to become commonplace in the industry, affecting AutoAuto’s ability to charge high prices for them.

This is another possibility for the poor performance in 2017.

AutoAuto – Research & Developement down

Looking elsewhere in the income statement, it’s concerning that the company’s research and development expense has declined by 7% in 2017. A company like AutoAuto relies on its intellectual property which forms the basis for future product developments and assures their continued growth.

The company’s researchers are being asked to do more with less now.

Income Statement Analysis – Primnav

Primnav’s income statement makes for far happier reading.

Revenues rose by almost 9% in 2017 while their net profit rose by almost 7%. The fact that Primnav’s revenues are over twice as high as AutoAuto’s may very well be a result of the fact that they serve the aftermarket (i.e. end consumers and garages) whereas AutoAuto does not.

Primnav has also taken care to ramp up its R&D expenditure over the year – the spent 22% more on R&D in 2017 than in 2016 which means they are preparing for the future by innovating and generating fresh ideas.

Statement of Financial Position – AutoAuto

The Consolidated Statement of Financial Position for AutoAuto again shows signs for concern. Total assets rose by just 0.2% in 2017 with indications that the company may be divesting physical assets as property, plant and equipment have fallen by 6% over the last year.

AutoAuto needs to take care that it does not fall into a vicious cycle whereby a lack of investment leads to weak or negative revenue and profit growth which in turn leads to less being available to make the necessary investments to position the company well for the future.

The one bright spot is that AutoAuto has paid down long-term debt over the last year with gearing (long-term debt / [long-term debt + equity]) falling from a very high 64% in 2016 to a more sustainable 50% in 2017.

Statement of Financial Position – Primnav

Primnav’s Consolidated Statement of Financial Position indicates that they are investing much more aggressively, with total assets rising 9.8% in 2017.

A good chunk of that investment has gone into intangible assets, meaning that Primnav is acquiring intellectual property in the form of patents, software etc all of which are playing an increasingly important role in a car industry in which software competence and the electrical components that go into cars are key differentiators.

Primnav issued shares in 2017 and it’s noteworthy that they pay out a very generous 85% of net profits in the form of dividends to their shareholders. This may make them an attractive stock to own as investors are guaranteed a yearly payout which may make attracting equity funding easier.

Financial Analysis Summary

In summary, there are reasons to be concerned for AutoAuto.

They may need to consider moving into aftermarket sales to generate another revenue stream. The pre-seen indicates that the company is positioning itself for big developments in the area of self-driving vehicles and it has already invested significantly in this area. However, the return on those investments are far from guaranteed and may be a long way off. It seems AutoAuto is noted for the quality of its products but those products are becoming common features of today’s vehicles. The company needs to innovate to survive and I’m concerned that their lack of investment in R&D expenditure and intangible assets over the last year may hurt them in the long-term.

This article was a snippet of what’s available from VIVA Tuition’s SCS AutoAuto materials for the upcoming August exam.

You can also visit their YouTube channel for more information.

Working Capital Ratios

The CIMA F1, F2 and F3 papers ALL consider financial ratios and how to interpret them. It can be a broad subject when looking at all types of ratios, their audience and how to draw meaningful conclusions from them.

Let’s take a look at the interested users and what type of financial ratios they would be concerned with.

ratio

I’ve highlighted the Suppliers user group and the working capital ratio as that’s the area I will focus on next. Generally speaking, though, there are TWO main areas for financial ratios:

  • Financial Performance: ratios based on the income statement that can be split into profitability ratios and shareholder investment ratios.
  • Financial Position: ratios based on the balance sheet (or SOFP), these can split into activity (day-to-day), liquidity (ability to meet current liabilities) and solvency (ability to meet long term debt) ratios.

Up next, I will look at the working capital cycle that a company’s suppliers (and management) would be interested in. This falls under the activity ratios in Financial Position as it’s concerned with current assets and liabilities.

Financial Position – Activity Ratios

The purpose of the working capital cycle is to ensure the business has enough cash to continue operations and produce goods. It involves managing the relationship between inventories and receivables (short term assets) against the payables (short term liabilities).

Inventory Days

This ratio tells us how long (on average) a company holds on to their inventory. The higher the number, the more likely we are able to meet customer demands but this also means we are keeping capital tied up in inventory longer and this could cause obsolescence and wastage.

 It’s calculated by dividing the inventory over the operating costs and multiplying it by 365 days. In the example below, you can see that the inventory days has improved in 2015 by 5 days, this is mainly due to holding less inventory in stock (43k from 60k).

inv

Accounts Receivable Days

Much like the inventory days, this ratio will tell us (on average) how long a company takes to collect it’s receivables. The lower the number the better in terms of recycling cash back into the working capital cycle.

However, collecting the debt too quickly could cause a  strain on the customer relationship so this factor needs to be considered.

It’s calculated by dividing the receivables balances on the SOFP over the total revenue for the year and multiplying it by 365 days. 

Below, you can see the receivables balance has increased in 2015, so has the receivable days (up to 79), therefore this is a concern and should be addressed.

inv1

Accounts Payable Days

Again, the accounts accounts payable days ratio is calculated in the same manner as above. And the result is interpreted in the same manner too, but this time the higher the number, the more cash we will have on hand as we are paying our suppliers later.

Here the company should make sure they use their sensitising payment terms to the full extent without damaging the relationship with the supplier. 

Again, it’s the mirror image of the above ratio and is calculated by dividing the payables balance in current liabilities over the total operating costs and multiplying it by 365 days.

Here you can see our working capital cycle will have improved as they are now taking 61 days to pay their suppliers rather than 45 days – which has a positive affect on cash flow.

inv2.JPG

Working Capital Cycle

Finally, the working capital cycle can be calculated now we have the above three ratios. To calculate it you need to do the following:

  •  Inventory Days + Receivable Days – Payable Days = Working Capital Cycle

inv3.JPG

Conclusion

Using all of the information above, you can see the working capital cycle has improved from 51 days in 2014 to 47 days in 2015.

This is despite taking longer to collect receivables in 2015 (79 days from 62 days), it appears the positive impact of taking longer to pay suppliers (61 days from 45 days) and holding less inventory in stock (29 days from 34 days) has improved the working capital cycle to 47 days.

Which fundamentally means, in 2015, it took 47 days to turn raw materials into cash. Meanwhile, these ratios above highlight the fact that this can be further improved if better credit control procedures are put into place to reduce the accounts receivable days from 79.