Posted: February 2nd, 2015

Financial Statments

Paper, Order, or Assignment Requirements

 
INSTRUCTIONS TO STUDENTS

Phase 2 – Case Study

Case-Study Information

The Case Study has been made available from the reading week of your course. You can

begin to work on the assessment from that date onwards. At 09.00 on the morning of the

controlled assessment (January 9, 2015) further information regarding this case (including

all the specific question requirements) will be made available.

You are expected to consider this supplementary information and to include it in your final

submission. The completed assessment must be uploaded onto Turnitin by 16.00 on the day

of the controlled assessment.

Explanation of the assessment criteria and how the marking scheme works

Your assignment will be marked according to the Level Assessment Criteria for Level 4. The

criteria are designed to test your knowledge of concepts i.e. your understanding of relevant

financial terms, ideas, theories, notions and principles and your ability to apply those

concepts in a practical situation. You will also need to show your understanding of what

elements should be included in a professional report.

Word count policy

The maximum word count for the report is 1500 words (excluding headings, references and

appendices). The examiner will stop marking your submission at the point it reaches this

word count. Candidates should show how many words they have used on the front of their

assignment

It is best to allocate your word count in direct proportion to the weighting of the marks – so for

example, if one section has 30% of the marks allocated and as such you should aim to

allocate 30% of your word count to this section, i.e. approximately 450 words.

Referencing and the Harvard system

During the course of writing an essay, a report or an assignment, you would normally

support your points and your arguments by referring to the published works of others. The

nature of this assessment means that it is expected you will have minimal or no

referencing.

If you are going to reference the work of others, for the purposes of this assessment these

references may be from work presented in journal or newspaper articles, government

reports, books or specific chapters of books, or material from credible sources on the

Internet (Wikipedia is not a credible academic source).

Giving a reference is the practice of referring to the work of other authors in the text of your

own piece of work. Within your assignment, each time you use the work of others it needs to

be referenced back to the ‘Bibliography’ at the end of the work; this gives the full details of

the source item and should enable it to be traced. Referring accurately to such source Understanding Financial Statements – Assessment

Page 3 of 17

materials is part of sound academic practice and a skill that should be mastered – it’s

important to give credit to others whose ideas you have used.

The Harvard referencing (Author, date, title) is the mandatory approach and a full

explanation as to how this system works is available in the Assessment section of the VLE.

Advice on plagiarism and collusion

Copying material i.e. plagiarism, from a third party source is a serious offence and may

result in your work not being accepted. Plagiarism involves presenting work as though it

were your own or using ideas of another author without acknowledging the fact.

Collusion takes place when two or more students submit work that is too similar i.e. similar in

words, content and style, such as might be put down to coincidence. Make sure that the

work you submit is your own or is appropriately referenced. If in doubt you should speak to

your tutor or the module leader.

Writing your report

The report should be presented in a professional manner. The writing should be clear,

concise and persuasive. The report should be well structured and the tone used should be

business-like.

Please use Headings and Sub-Headings throughout the report to provide the reader with a

logical flow of content. You may use presentation aids such as colour and diagrams to

support the text where appropriate.

Candidates are advised to use a professional format for their work e.g. Ariel font type, font

size 11 or 12 and 1.5 line spacing to provide an overall proportion of 25% white space.

Understanding Financial Statements – Assessment

Page 4 of 17

Indicative requirements

The format of your assessment is as follows.

Question 1 will cover the purpose and key features of Sandell Arnold’s financial statements,

it will be split into 3 sub-requirements labelled ‘a to c’ which will total 12 marks, which will be

released at phase 3.

Questions 2-5 are set out below (but will also be released again at phase 3 along with

question 1 to provide you with the full set of requirements).

  1. Auditing and Corporate Governance (14 marks)

Consider the comments made by Sandell’s external auditors and the Non-executive

Director in Exhibit four in Sandell’s governance arrangements.

  1. Explain what type of modified (Not-so-Clean) audit report, the external auditors would

give Sandell if the accounting treatment of the £30 million damages remains

unresolved.

(2 marks)

  1. If Sandell revised their financial statements for the £30 million damages in line with

Exhibit 5, the external auditors would give Sandell an unmodified (Clean) audit

report.

  1. Explain why the external auditors have changed their opinion on Sandell’s

financial statements when compared with part 2(a).

  1. Describe ONE reason why companies prefer receiving clean audit reports.

(4 Marks)

  1. Review the narrative in Exhibit 4 from the Non-Executive Director relating to the

decision to increase director’s remuneration by 50%.

  1. Identify and explain TWO corporate governance deficiencies demonstrated by the

board’s decision to approve this remuneration increase.

  1. Describe TWO pieces of corporate governance good practice which Sandell

could put in place to make better quality decisions about director’s remuneration

going forward.

(8 marks) Understanding Financial Statements – Assessment

Page 5 of 17

  1. Interpretation of the Income Statement (35 marks)
  2. Use the case study information to analyse and comment on FIVE movements in

Sandell’s Income Statement (financial performance) during the year 2013 compared

to 2012.

Use the additional financial information in Exhibit 2 and the relevant ratios shown in

Exhibit 3 to enhance the quality of your analysis.

For each item you select to analyse and comment upon

  1. Ensure you use an appropriate financial technique (Ratio, Trend analysis)

to ascertain the movement between 2013 compared to 2012;

  1. Reflect and comment upon whether the movement is having a positive or

negative impact on Sandell’s financial performance; and

iii. Use the case study to identify and explain at least ONE reason why the

movement in part 3a(i) has happened.

(25 marks)

  1. Using the revised financial statements set out in Exhibit 5: (You cannot answer all

of this question until Phase 3)

  1. Calculate a revised net margin ratio (show your workings via a separate

Appendix to your report);

  1. Explain how the net margin ratio helps assess a company’s financial

performance; and

iii. Compare your calculation in 3b(i) with the present net margin ratio

(Exhibit 3) and discuss whether the Chief Executive’s statement that the

company has managed to improve its profitability since 2012 remains

valid.

(10 marks)

  1. Interpretation of the Statement of Financial Position and Statement of Cash Flows

(35 marks)

  1. One of the main reasons that £22 million of operating profit earned by Sandell is only

producing £2 million of operating cashflow is due to how the company is managing its

working capital.

  1. Identify which parts of the Statement of Cashflow show how working capital is

being managed;

  1. Identify and use appropriate working capital ratios to illustrate movements in

working capital for 2013 as compared to 2012;

iii. Use the ratio’s in 4a(ii) above to calculate the Operating Cash Cycle (OCC)

for 2012 and 2013;

  1. Comment on whether the movement in the OCC calculated in 4a(iii) is having

a positive or negative impact on Sandell’s cashflow; and

  1. Use the case study to identify and explain at least TWO reasons why the

OCC movement (in part 4a(iii)) has occurred. Understanding Financial Statements – Assessment

Page 6 of 17

(15 marks)

  1. Consider this quote from the sector briefing in Exhibit 4:

“This is a considerable expansion of the company’s operations and therefore Sandell

has been required to seek external finance to support this investment, they have

managed to raise some equity funding from the AIM market, some debt funding

through bank loans but it is generally known that the funding secured has not

been sufficient to cover this total investment.”

Identify and describe how Sandell’s Statement of Cash Flow supports the part of the

quote highlighted and demonstrates that the investment in Western Europe has not

been fully supported by external financing.

(5 marks)

  1. Using the revised financial statements set out in Exhibit 5: (You cannot answer all

of this question until Phase 3)

  1. Calculate revised interest cover and gearing ratios (show your workings via a

separate Appendix to your report);

  1. Explain how the interest cover and gearing ratios help assess a company’s

long-term financial condition; and

iii. Compare your calculation in 4c(i) with the present interest cover and gearing

ratios (Exhibit 3) and discuss what impact losing this court case (and paying

£30 million damages) will have on the company’s solvency.

(15 Marks)

  1. Professional report format (4 marks)

Marks are allocated for setting out your answer in the format of a professional business

report.

(4 Marks)

TOTAL: 100 MARKS

The report should be no longer than 1500 words (excluding headings, references and

appendices), a suggested format in which to incorporate your answer is set out below. Understanding Financial Statements – Assessment

Page 7 of 17

Suggested report format

To: Parveen Rostom

From: Made up name (not your own)

Date: Assessment Day

Title: To complete

Introduction: To complete

Executive summary: To complete

Main Report:

Include Subsections/Paragraphs etc for each of the 4 main areas listed below

Part one – Purpose and key features of Sandell’s Financial Statements

Part two – Auditing and Corporate Governance

Part three – Interpretation of the Income Statement

Part four – Interpretation of the Statement of Financial Position and Statement of

Cash Flows

Understanding Financial Statements – Assessment

Page 8 of 17

CASE STUDY – SANDELL ARNOLD PLC

Background – Sandell Arnold plc

A friend of yours, Parveen Rostom, has approached you seeking some advice. She has

been offered the position of Sales Director within a company called Sandell Arnold (referred

to from now on as Sandell)

Sandell is a building merchant, which has been trading for more than 40 years supplying a

range of materials to the building and construction industry. This includes ironmongery,

plumbing and heating, landscaping materials, timber and sheet materials, painting and

decorating, dry lining and insulation, doors and joinery, and hand and power tools.

A few years back, in 2011, Sandell become a plc and is listed on the UK’s Alternative

Investment Market (AIM), which seeks to raise capital for smaller but fast growing

companies.

The growth which Sandell desired has not yet happened and therefore Parveen has been

offered a very generous remuneration package to implement a new aggressive sales

strategy to support Sandell’s expansion into new Western European markets. However

Parveen has been with her current employer for six years and wants to ensure her future

would be secure.

Your role

Though Parveen is a friend, she has approached you because you are a Financial Analyst

who is a specialist in the building and construction industry.

You have agreed to analyse the financial performance and position of Sandell and produce

a report for Parveen which sets out your findings and makes a recommendation as to

whether she should accept or reject the offer to become Sandell’s Sales Director.

To assist you with this task you have put together a pack of information as follows:

Exhibit 1: Extracts from Sandell Arnold’s Financial Statements for 2013, including the

Income Statement, Statement of Financial Position and Statement of

Cashflows.

Exhibit 2: Additional Financial information which supports the Financial Statements in

Exhibit One.

Exhibit 3: Key ratio analysis for 2012 and 2013 of Sandell Arnold’s financial statements.

In addition to this pack, you have

Exhibit 4: Your Notes from various document reviews and industry discussions.

One further exhibit will also be provided at phase 3.

Exhibit 5: Revised financial statements which reflect the impact of losing the case for

damages.

Understanding Financial Statements – Assessment

Page 9 of 17

Exhibit 1: Extracts from Sandell Arnold’s Financial Statements for 2013

Financial Statements

 

Sandell Arnold plc Income Statement for the year ended 31/12/13

2013 2012

£’m £’m

Revenue 252 248

Cost of Sales (203) (223)

Gross Profit 49 25

Other operating income 7 0

Overheads

Administration expenses (16) (11)

Distribution costs (18) (13)

Operating Profit/(Loss) 22 1

Finance costs (12) (8)

Profit/(Loss) before Tax 10 (7)

Income Tax expense (2) (1)

Profit/(Loss) for the period 8 (8)Understanding Financial Statements – Assessment

Page 10 of 17

Sandell Arnold plc Statement of Financial Position as at 31/12/13

2013 2012

£’m £’m

ASSETS

Non-current Assets

Property, Plant and Equipment 278 198

Current Assets

Inventories 53 44

Trade and other receivables 36 24

Cash and cash equivalents 0 6

89 74

Total Assets 367 272

EQUITY AND LIABILITIES

Equity

Share Capital 60 45

Retained Earnings 109 103

Total Equity 169 148

Non-current Liabilities

Long-term borrowings 111 91

111 91

Current Liabilities

Trade payables 48 33

Bank overdraft 39 0

87 33

Total Liabilities 198 124

Total Equity and Liabilities 367 272Understanding Financial Statements – Assessment

Page 11 of 17

Sandell Arnold plc Statement of Cashflows for the year ended 31/12/13

£’m £’m

Cashflows from operating activities

Operating Profit 22

Adjustments for:

Depreciation 2

24

(Increase)/Decrease in inventories (9)

(Increase)/Decrease in trade and other receivables (12)

Increase/(Decrease) in trade payables 15

Cash generated from operations 18

Interest paid (12)

Income tax paid (2)

Dividend paid (2)

Net cashflow from operating activities 2

Cashflows from investing activities

Purchase of Property, Plant and Equipment (82)

Net cashflow from investing activities (82)

Cashflows from financing activities

Proceeds from issue of share capital 15

Proceeds from long-term borrowings 20

Net cashflow from financing activities 35

Net increase/(decrease) in cash and cash equivalents (45)

Cash and cash equivalents at the start of year 6

Cash and cash equivalents at the end of year (39)

2013Understanding Financial Statements – Assessment

Page 12 of 17

Exhibit 2: Additional Financial information which supports the Financial

Statements (set out in Exhibit one)

 

Sandell Arnold plc Supporting Notes to the Financial Statements for the year ending 31/12/13

Note 1 – Extract of supporting notes for the Income Statement

2013 2012

Administration expenses £’m £’m

Employee expenses 6.2 4.5

Directors remuneration 1.4 0.9

Bad Debt charges 1.2 0.1

Utility costs 1.3 1.2

Legal and Professional fees 1.1 0.5

Depreciation charges 2.0 1.5

Sundries 2.8 2.3

16.0 11.0

Distribution costs

Distribution & Transport costs 12.4 7.2

Marketing & Advertising costs 5.3 5.3

Other distribution costs 0.3 0.5

18.0 13.0

Note 2 – Extract of supporting notes for the Statement of Financial Position

Statement of changes in Equity (Extract)

Retained earnings column only 2013 2012

£’m £’m

Opening balance 103 111

Profit for the year 8 (8)

Dividend Paid (2) 0

Closing balance 109 103

Retainsed EarningsUnderstanding Financial Statements – Assessment

Page 13 of 17

Exhibit 3: Key ratio analysis for 2012 and 2013

Profitability

ROCE Profit b Tax/Int

Equity + Debt* 22 x 100 = 6.90% 1 x 100 = 0.42%

169 + 150 148 + 91

* Includes bank overdraft

Gross Margin

Gross Profit 49 x 100 = 19.44% 25 x 100 = 10.08%

Revenue 252 248

Net (Operating) Margin

Operating profit 22 x 100 = 8.73% 1 x 100 = 0.40%

Revenue 252 248

Liquidity

Current Ratio

Current Assets 89 = 1.02 74 = 2.24

Current Liabilities 87 33

Quick Ratio

CA – Inventories 89 – 53 = 0.41 74 – 44 = 0.91

Current Liabilities 87 33

Inventory Days

Inventories 53 x 365 = 95.30 44 x 365 = 72.02

Cost of Sales 203 223

Receivable Days

Receivables 36 x 365 = 52.14 24 x 365 = 35.32

Revenue 252 248

Payable Days

Trade payables 48 x 365 = 86.31 33 x 365 = 54.01

Cost of Sales 203 223

Solvency

Gearing

Debt* 150 x 100 = 47.02% 91 x 100 = 38.08%

Debt + Equity 150 + 169 91 + 148

* Includes the bank overdraft

Interest cover

Profit b Tax/Int 22 = 1.83 1 = 0.13

Finance costs 12 8

2013 2012Understanding Financial Statements – Assessment

Page 14 of 17

Exhibit 4: Your Notes from various document reviews and industry discussions.

As a financial analyst in the construction industry you have various contacts across the

sector both inside and outside the company with whom you have been able to hold various

discussions and from whom you have been able to obtain various document.

The extracts from these have been set out below.

Review of Sandell’s annual report – Chief Executive’s review

The Chief Executive’s report was very positive in both reviewing the 2013 year and looking

to 2014 onwards, the following statements were specifically of interest to me:

  • In 2013 the company had a focus on improving profitability, which it managed to achieve

through securing new supplier relationships that year.

  • It meant that the company was able to declare and pay a dividend to shareholders for

the first time since the global financial crisis occurred in 2008.

  • Now that profitability issues have been fixed, the focus of the company in 2014 onwards

is growth and the expansion of the company into new markets in Western Europe, the

infrastructure for which has been put in place during 2013.

Discussion with Sandell’s operations manager about the new supplier relationships

put in place in 2013.

Key points from that discussion are set out below:

  • With the issues around the company’s financial performance (in particularly its

profitability) we sought to retender the supply of timber and ironmongery materials to us,

which are two of our main product lines making up around 60% of our revenue across

the last 10 years.

  • It was a very competitive tendering process, which a supplier called Ashwell won due to

the low price they were offering to supply goods to us. This was on average 10% lower

than our previous suppliers of these materials.

  • However since the Ashwell contract commenced in January 2013 we have had various

problems with it including:

o An issue with quality which has meant we have been provided with a higher

proportion of faulty goods, this has included split timber and ironmongery of

incorrect dimensions.

o These quality issues have resulted in two business issues, firstly unhappy

customers, who when receiving faulty goods are disputing the invoices that follow

and are either slow in paying the invoice or are not paying the invoice at all, Understanding Financial Statements – Assessment

Page 15 of 17

which we then have to write off as bad debt.

o Secondly, because the goods are faulty it means we have to pick up the items

from the customer sites and deliver new product so effectively we are having to

make a number of deliveries twice.

  • We do have penalty clauses in the contract with Ashwell which are linked to quality and

because of these issues they have had to pay us around £7 million in compensation

during 2013.

Review of a construction industry sector briefing covering Sandell.

The briefing focused on Sandell’s expansion plans into Western Europe, the key points of

interest are listed below:

  • Sandell has an established presence in the UK construction industry (with 10 distribution

centres) and has now identified Western Europe as a potential new market to access

and obtain growth from.

  • During 2013, Sandell focused on putting infrastructure in place across this new market

from which it will then seek create sales, this infrastructure included:

o 4 new distribution warehouses in Rouen (France), Koln (Germany), Utrecht

(Netherlands) and Bern (Switzerland)

o A fleet of Lorries to enable distribution to each new warehouse.

o Additional employees to staff the above functions, taking the company’s

workforce from 100 to 130 employees.

o Purchasing inventory to ensure various product lines are available at each new

site.

  • This is a considerable expansion of the company’s operations and therefore Sandell has

been required to seek external finance to support this investment, they have managed to

raise some equity funding from the AIM market, some debt funding through bank loans

but it is generally known that the funding secured has not been sufficient to cover this

total investment.

  • To date this investment has resulted in minimal return (around £4 million of sales in

2013) but the scope for growth from this new market is considerable (pessimistic

estimates put potential annual sales from these markets at around £80-100 million per

year). Therefore an aggressive and effective sales strategy is needed to benefit from this

opportunity. Understanding Financial Statements – Assessment

Page 16 of 17

  • Sandell has been seeking to put a Sales director in place to since the middle of 2013 to

develop this strategy and are hoping to make an appointment shortly.

Notes from discussion with Sandell’s external auditors regarding the 2013 financial

statements.

The audit is near to completion, the key points are set out

  • We have one remaining audit issue which is in regard to the accounting treatment of a

claim from one of Sandell’s main customers. The background for which is set out below.

  • A major customer, a House Builder, is suing Sandell, claiming that it has supplied faulty

goods. The customer had to rectify some of its building work when investigations

discovered that a building material, recently supplied by Sandell was found to contain a

hazardous substance.

  • Sandell’s legal team has stated that Sandell is very likely to lose this case, though the

timing of payment and the amount of damages to pay is presently uncertain, a reasonable

estimate has put the likely amount at around £30 million.

  • Presently Sandell’s directors have not made any disclosure of this in the financial

statements on the basis that it is uncertain and that they feel confident that they would be

able to seek damages from Ashwell (who supplied the original materials).

  • The external auditors think that Sandell should make a provision in their financial

statements for this £30 million of potential damages.

  • The external auditors consider this matter to be material and therefore are considering

issuing a modified audit opinion (known as a ‘not so clean’ audit report from the syllabus)

if the matter remains unresolved.

  • Sandell’s finance team are keen to obtain a ‘clean’ audit report and therefore are

presently producing amended financial statements (which will be provided in exhibit 5) to

reflect this £30 million provision.

Notes from discussion with a Sandell Non-Executive Director (NED) regarding

Directors Remuneration

Sandell’s board voted to increase directors’ remuneration in 2013, the decision for which this

NED had some concerns. Key points from this discussion set out below:

  • Sandell have been seeking to put in place a Sales Director since the middle of 2013, as

this position has been deemed a key factor in establishing the company in new markets Understanding Financial Statements – Assessment

Page 17 of 17

in Western Europe.

  • At present the company’s board is made of 5 executive directors and 1 non-executive

(NED).

  • The other directors were aware as to how generous the remuneration package was for

this new post (50% higher than other directors) as the company were keen to secure

someone with the talent and experience to fill this post.

  • Because the level of remuneration was higher, it was felt that the remaining directors

needed their remuneration packages increased to bring them in line with this new post.

  • At the meeting this NED raised a concern that the 50% difference was all performance

related pay (linked to success in growing the Western European Market) but the increase

proposed for the other directors to bring them in line was on basic salary (which is not

performance related).

  • The Board meeting noted this concern, but when it was voted on the results were 5 in

favour of the increase and 1 against. So the NED felt he was effectively outvoted.

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