Emma RizemanStudent ID: 12107229

Blog Link: https://accrualintentions.home.blog/

STEP 7

RM PLC has three divisions – RM Education, RM Results and RM Resources. RM Resources is further divided into TTS and Consortium.

I have chosen products from TTS, as these were the products I found the most interesting. TTS sell educational and learning products for children, as can be seen on their website: https://www.tts-international.com/

The first product I have chosen is a pack of 7 giant chalks for £3.79.

The second product I have chosen is the LED Inflatable Sensory Pool which sells for £99.95.

The third is a Seaside Village Outdoor Wooden Beach Hut in Red for £1759.95

I did not need to estimate their selling price, as this was available on the website. For simplicity, I have ignored the VAT.

I have estimated the variable costs to be 72% of the selling price.

I calculated this from the figures in the 2018 annual report. The total revenue was shown as £220977000. The expenses which I assumed to be variable costs were -Cost of sales: £129664000Selling & Distribution Costs: (part of the operating expenses) £28889000

(£129664000+£28889000) = Variable Costs of £158553000Divided by total revenue of £220977000 = 72%

In practice, some of the expenses included in these sections could still be fixed. Not all of the products would have exactly the same percentage of variable costs. Also, the variable costs would not increase at exactly the same rate with each additional unit produced. However, for the purposes of this task, I felt that it was a reasonable assumption/estimate.

Below is a table which shows my calculations of the contribution margin and contribution margin ratio.

The contribution margin is calculated by taking the variable costs away from the revenue. The remaining amount shows how much each unit sold contributes towards covering the firm’s fixed costs and generating profit.

The same table is also included on an additional tab in my Company Spreadsheet, where you can also see the formulas used for the calculations.

ProductSelling Price Variable Costs

Variable Costs Contribution Margin Contribution Margin Ratio

       Revenue - Variable

CostContribution

Margin/Revenue  (£) (%) (£) (£) (%)

Giant Chalk Assorted Colours 7 pack 3.79 72 2.73 1.06 28LED Inflatable Sensory Pool 99.95 72 71.96 27.99 28Seaside Village Outdoor Wooden Beach Hut in Red 1759.95 72 1,267.16 492.79 28

Every giant chalk pack sold contributes £1.06 towards RM PLC’s fixed costs and profit. Every LED Inflatable Sensory Pool sold contributes £27.99 towards RM PLC’s fixed costs and profit. Every Seaside Village Outdoor Wooden Beach Hut sold contributes £492.79 towards RM PLC’s fixed costs and profit.

The fixed costs could include things such as the purchase and maintenance of equipment, lease or loan payments on buildings, council rates, insurances, wages of office staff, and the research and development of new products which have not yet been sold. Fixed costs do not vary, regardless of how many units are sold.

You can see that the contribution margins for the different products are quite varied, and the products are also in quite different price brackets. It is important to remember that in this example, all products have variable costs of the same percentage; however in reality these will be different.

The lower priced products have much lower priced component parts and would be much cheaper to make. If RM PLC were to mark up the chalk by the same amount as the Seaside Village Outdoor Wooden Beach Hut, it is very unlikely that consumers would pay this price for chalk. The contribution margins are often influenced by the price of the goods themselves, as well as the amount that consumers are willing to pay for the products.

RM PLC’s website mentions that they both resell other brand’s products, and also have products that they design themselves. This could affect their costs, and therefore also their contribution margin. If they were reselling, they would save on costs such as factory labour, however they would also be paying a price which would allow their supplier to make a profit as well.

Large items such as the beach hut would also cause the firms to incur additional costs such as warehouse storage space. Smaller items such as the chalk would be able to be stored in much smaller locations, and at a lower cost.

Firms produce a range of products and services with different contribution margins, so that they are able to sell to different customers with differing needs, and also sell more products to one customer.

Even though products with low contribution margins do not provide as much profit per unit to a firm, there is often more demand for these products due to their lower price. Firms are then able to sell much greater quantities of these, which could still result in a greater profit overall.

RM PLC have a good product mix for their sector, as educational institutions such as schools and daycares require a wide variety of products with a wide variety of contribution margins. There are large items such as playground equipment which are purchased infrequently. There are also

consumables such as chalk, paper and paint, which we can assume to have a low contribution margin. These would be purchased much more frequently and in much higher quantities.

If they only sold products with high contribution margins, they would attract less customers (as not everyone has a need for these products) and make sales less frequently. Another reason that having frequent, small sales is also important, is that these points of contact provide an opportunity to market more expensive products.

There are various constraints which can affect the ability of RM PLC to be able to sell their products, including both resource constraints and market constraints.

If these are products which they produce themselves, they would be reliant upon the availability of component parts such as wood, nails and paint for the beach hut; plastic and light bulbs for the sensory pool, and gypsum which is what most classroom chalks are made of. If these items were not available they would no longer be able to produce their products. If the price of any of these resources increased, they would need to recalculate their contribution margins, to decide if producing and selling the product was still viable.

Another constraint could be market demand for their products. If consumers demanded less of a product than what they had anticipated, they may be forced to lower their prices in order to sell the products. This would lower their contribution margin, and may make them less willing to produce in the future. Alternatively, consumers may demand more of a product than what they are currently able to supply. They would then need to decide whether to increase their prices (thereby increasing their contribution margin for that product) or whether to look at expanding their facilities so that they could produce more.

They may also be affected by the UK government policies. One concern raised in the firm’s annual report was that as they predominantly supply to schools and other educational institutions, they are highly dependant upon the UK’s government funding for schools. If changes in UK government policy ever resulted in a significant reduction in educational funding, this would also significantly reduce the ability of some of their key customers to buy their products. If less products were being sold, this would mean that a higher amount of the fixed costs would have to be covered by each remaining product.

STEP 8

There are two key important events to be aware of when analysing the ratios and economic profit of RM PLC.

The first is their acquisition of “The Consortium”, which was previously the Education & Care business of Connect Group plc. This was completed on 30 June 2017. RM PLC paid £56.5million for the acquisition.

The restated financial statements show the impact of this on the company. Between 2016 & 2017, the total operating assets increased by £66.7milllion. However, cash decreased by £38.3m and borrowings increased from nil to £13.1million. This gives us a good indication of how the acquisition was funded.

2016 was the only year where the company reported a loss in their income statement. Whilst income and expenses remained reasonably consistent across the 4 years, the main anomaly that I identified was that in 2016 there were £23.6m of defined benefit pension scheme remeasurements recorded as an expense. This resulted in a negative “total comprehensive income” figure for the 2016 year, and also therefore affected several of the ratios as well.

Profitability RatiosThe profitability ratios show some good numbers. In 2018, the profit margin was 13.8%, meaning that for every pound of sales, 13.8p was turned into profit. The return on assets was 22.8%, meaning that for every pound of assets owned by the company, 22.8p of sales were generated.

There has been significant growth since 2015, which showed a profit margin and return on assets of 9% and 14% respectively. The 2016 year showed negative numbers for both, due the company reporting a total comprehensive expense as opposed to income for that year. This seems to be predominantly due to their defined benefit pension scheme re-measurements.

Out of interest I re-did these calculations in the working area, and instead used the NPAT without including the other comprehensive income, to get a better idea of the trend without this one-off occurrence. This shows a dip in the 2016 & 2017 years, before recovering somewhat in 2018; however this shows a lot more similarity in the ratios across the four years.

Efficiency (Or Asset Management ) Ratios

Days of InventoryThis shows on average, how many days inventory is held before it is sold. This increased sharply from 39 days in 2016 to 63 days in 2017, before declining again to 50 days in 2018. This is quite possibly due to the fact that Consortium was acquired during 2017, which would have brought a large increase in inventory with it. The financial statements also show an increase in inventory from £10.7m in 2016 to £19.4 in 2017, however the sharpest increase in revenue did not occur until 2018. It can be assumed that there was somewhat of a delay between when the acquisition was completed and when they started to sell their newly acquired inventory.

Total Asset Turnover RatioThis ratio shows, for each pound of assets, how much the company is making in sales. This figure remained fairly constant across the 4 years, ranging between 1.55 to 1.65, with the exception of 1.38 in 2017. This also could have been impacted by the increase in assets due to the acquisition of Consortium, and the apparent delay in starting to sell their products.

Liquidity RatiosThe Current Ratio shows, for each pound of current liabilities that the company owes, what do they have in assets. It assesses their ability to pay their short term debts. We can see that following the acquisition of Consortium in 2017, this figure dropped below 1, which means that RM PLC had more liabilities than what they did assets. In 2018, this figure increased again – whilst still below 1, it reflects that they are starting to repay their liabilities and should hopefully be back to a number above 1 soon.

Financial Structure Ratios

The equity ratio and the debt/equity ratio show us how the company is funded – is it primarily funded through issuing shares or through bank loans? The equity ratio shows us, for each pound of total assets, how many pounds of equity is there? The debt/equity ratio shows us, for each pound of equity, how much debt is there. As the debt/equity ratio is above 100% every year, this shows us that the company is primarily funded through bank loans. These numbers vary significantly from year to year, however looking at the Statement of Movements in Equity shows that the total equity varies from year to year as well. Even when the debt increased, the equity also increased by a greater percentage, which is reflected in the decreasing debt/equity ratio.

Market Ratios

The company was inconsistent with how they reported on their share price in their annual reports. In 2018 & 2017 they reported the average share price throughout the period. In 2016, they only reported the closing price. In 2015, I was only able to locate the price on which options were exercised or on which directors were remunerated. Therefore, I have used the closing prices on 30 November each year as per Yahoo Finance, in order to be consistent.

The Earnings per share divides the net profit after tax by the number of shares on issue, to show how much profit the company has made per share. I found it interesting though, that the Earnings Per Share I calculated was quite different to what was shown in the company’s annual report. For example, in 2018, I calculated an EPS of 0.36. The annual report showed adjusted diluted EPS of 0.258, statutory basic EPS of 0.207 and statutory diluted EPS of 0.206. I would be interested to find out how they calculated this and understand why my calculations are different.

The dividends per share shows the amount of dividends that shareholders received for each share that they own. My calculations for this were quite similar to the annual report, with small variances due to rounding.

There is a significant difference between the amount of dividends paid and the earnings per share. 2016 showed negative earnings per share (due to the pension scheme remeasurements). Over time, both EPS and DPS increased. However, for all years which had positive EPS figures, the company still only paid out around 20% of this as dividends. This means the company is retaining approximately 80% of their earnings to be able to reinvest in future assets. The company did indicate in their annual report that they are intending to invest in a new automated warehousing and storage facility in 2019, so the retained earnings may possibly helping to fund this.

The price earnings ratio was negative in 2016, due to the loss reported in this year. However, all other years showed figures above 5, meaning that the share was priced at least 5 times higher than it’s earnings.

According to Investopedia, the average market P/E ratio is 20 to 25 times earnings. If this is correct, we could consider RM PLC to be undervalued, and this could be a good purchase decision for an investor hoping to achieve a capital gain.

However, in her video, Maria spoke about using the P/E Ratio to determine the payback period, or how long it would take to pay back the initial purchase. I don’t believe that the earnings per share actually does this (pays back an investor). As we have seen, companies often retain their earnings without distributing these as dividends. The dividend return is what we actually get as investors, and if I were calculating my payback period for shares, I would actually look at a “Price Dividend Ratio” instead. I have calculated this additional ratio in the working area, and this shows that to repay my initial investment (assuming the shares were not sold), it would take nearly 30 years for shares purchased in 2018 to start returning any profit beyond the initial investment. So whilst RM PLC shares may have potential for capital gain, they do not appear to be a good choice for dividend investors.

Ratios Based On Reformulated Financial Statements

Return on Equity shows how much return the company is generating for each pound of shareholder’s equity. In 2016, this was a negative number due to the pension scheme remeasurements causing a loss. The number was quite high (above 80%) in 2015 and 2017, however dropped again in 2018 to 55.64%. Looking at the restated financial statements, the comprehensive operating income was quite similar in 2017 & 2018. However, in 2018 the total equity increased quite significantly as a result of retained earnings. This explains the change in the ratio.

The return on net operating assets tells us, for each pound of net operating assets, how much after-tax operating income they have made. It was interesting to see that for most years, the RNOA was significantly higher than the ROA, which suggests that operating assets are a lot more profitable for RM PLC than what their financial assets are. The exception to this was in 2015, where there was a positive figure for ROA, but a negative RNOA.

I have checked the financial statements to work out the explanation for this. In 2015 & 2016, the net operating assets was a negative figure and the financial assets were positive. In 2017 (after the acquisition of Consortium) the financial assets became negative (as they spent their cash) and their operating assets became positive. The only reason that 2016 did not also have a negative RNOA was that they also had a negative figure for operating income due to the pension scheme remeasurements.

The net borrowing cost is supposed to show the real cost to businesses of borrowing money. This ranges from -1.69% up to 15.59% in 2018. These figures seemed odd to me (both very high and very low compared to the interest rates which are usually advertised here in Australia). I checked the annual report to try and compare the interest rates disclosed there, however they only provide interest rates for deposits and receivables, but not for their liabilities.

The restated profit margin varies very little from the original net profit margin figures, with less than 1% difference each year. The restated asset turnover is quite different though. The original figures stayed relatively constant from year to year, and ranged from 1.38 to 1.65. However, in 2015 and 2016 there are negative figures, and in 2017 and 2018, the figures are 3.51 and 4.12. The reason for the negative figures in the first two years are due to the negative figures for net operating assets. However, after the acquisition of Consortium, the net operating assets increased significantly, which also led to the increased figure for asset turnover.

Economic Profit

The economic profit reflects the opportunity cost of the next best alternative – ie. how else could the company have spent their money? And how much more have they made by choosing this option rather than the alternative?

To calculate this, we first deduct the cost of capital (ie. the opportunity cost) from the RNOA. If this figure is positive, then the return on net operating assets is greater than what the company would have generated by investing in an alternative. Some companies use 10% as a standard cost of capital. However, RM PLC actually published their cost of capital for every year except 2015. Using 10% for 2015 seemed reasonable, as it also then meant the WACC rate increased by a similar amount between 2015 and 2016, as what it did between other years. The company’s economic profit showed a trend of increasing over time, going from £19.1million up to £23.3million, with the exception of a negative figure in 2016. However, as with many of the other ratios, this can be explained due to the impact of the defined benefit pension scheme remeasurements, which was a one-off non-recurring anomaly.

It should also be noted that the economic profit figures are affected by negative numbers in the previously calculated RNOA and NOA. In 2015, the RNOA was negative due to negative net operating assets. However, when this figure was then again multiplied by the NOA, it became positive. I was confused at first as to whether this figure is technically representing an economic loss or not. Although, it also seems like a positive thing that the company generated an operating income, even though they had negative assets. Almost like making ‘something out of nothing’, which is a talent.

Whereas in 2016, they actually did make a loss, although this was due to the defined benefit pension scheme remeasurements as discussed. When I quickly changed the figure for this expense to zero to see the impact, this changed the economic profit for 2016 to £20.5m, which would have been more in line with the overall trend.

My main key learning out of calculating and analysing all these ratios was the importance of researching a company before investing in it. I know that Commsec (and I’m sure many other share trading platforms) publish companies’ key financial data and ratios, and it could be tempting to make decisions based off these alone. However, as I have learnt, there can be various explanations for differences and similarities in financial figures. Sometimes they have had very different years, but the figures and ratios still work out similar through sheer coincidence. Or there may be a one-off non-recurring event that causes their figures to look quite different, however this event should be disregarded from analysis if it is unlikely to happen again. I have learnt how important it is to read about and get to know a company; understand their history and why the figures are the way they are, and make sure that any investment decisions made are fully-informed ones!

STEP 9

RM PLC are looking for new ways to diversify and expand their business, and are considering opening a large daycare centre “Little Brats Early Learning” in the London central business district. With multiple rooms, they could comfortably accommodate as many as 500 children per day, and provide a real convenience for Mums and Dads working in the CBD, as they would be able to collect their children straight after work, without having to go closer to home first. As RM PLC already manufacture and supply educational and early learning resources to daycare centres across the UK, they will be able to then supply their own centres at cost price. This would significantly reduce their operational costs and allow them to provide better facilities than their competitors, but at lower prices.

RM PLC expect to be able to successfully run “Little Brats” for the next ten years. However, their continued success after that point is highly reliant on future high employment in the London area, as well as the expectation that London families will continue to have more children. Therefore, it is difficult to predict cash flow beyond ten years. If they were to choose to close the business after 10 years, they would be able to subdivide the various rooms within the daycare into office spaces and sell them to business owners.

They are also considering investing in new technology, which will allow them to produce their own custom-designed, patented tablet, the “Illuminated Tablet” at an extremely low cost. These will be available for sale to the general public, however in a bold public relations move, they will also provide 1 million disadvantaged children with a free tablet, to assist them with completing their education. The tablets will be distributed to 200000 children per year for 5 years. Due to the increased market exposure and publicity they will receive, the company expects increased cash flow as a result. As a part of the move, they have also signed a secret deal with the Illuminati. When the tablets are distributed, they will contain software which sends subliminal Illuminati messages to the children using the devices, encouraging them to join the cult. In a secret, underground deal, the Illuminati will provide annual incentive payments to RM PLC, which they will show on their financial statements as sales revenue. At the end of the 5 year period, the Illuminati are intending to purchase the patent to the tablet and software from RM PLC and continue operating the scheme under another business name.

All costs shown below are in Great Britain Pounds.

Cash Flows for Little Brats Early Learning are comprised of fees paid by parents and government subsidies, less the operational costs of running the centre, such as insurances, purchases of resources, supplies like nappies and food, staff wages and electricity. Cash flows for Illuminated Tablets are comprised of the additional revenue generated by sale of the tablet, additional sales generated as a result of the public relations move and market exposure, and incentive payments from the Illuminati, less the operational costs of producing the tablets.

I have assumed a rate of return/discount rate/WACC of 10%.

In both examples, the initial investments will be made on 1 January 2020, and the cash flows will be received on the 31st of December each year.

Little Brats Early Learning Illuminated TabletsOriginal Cost £100m £100mEstimated Life 10 years 5 yearsResidual Value £200m £400m2020 £5m £5m2021 £10m £18m2022 £15m £26m2023 £20m £35m2024 £25m £50m2025 £30m2026 £35m 2027 £40m 2028 £45m2029 £50m

The analysis of the proposal for Little Brats Early Learning showed a positive Net Present Value of £122.29m, which means that the project should be accepted. The Internal Rate of Return is 22.9%, which is above the required rate of return of 10%. Upper management aim that any investments undertaken are paid back within 5 years, whereas the payback period for Little Brats Early Learning would be almost 6 years, at 5 years and 10 months.

The analysis of the proposal for the development of Illuminated Tablets showed a Net Present Value of £242.28m, which also means that this project should be accepted. The Internal Rate of Return is 44.6%, which is also above the required rate of return of 10%. This investment would be repaid in less than the target payback period of 5 years, at approximately 4 1/3 years.

If RM PLC is able to secure the funds to finance both of these capital investment projects, and they are prepared to be flexible on the payback period for Little Brats Early Learning, I would recommend that they undertake both of these ventures as a means of expanding and diversifying their business.

Both proposals show very high positive Net Present Values and both show Internal Rates of Return above the required rate of return of 10%. The Illuminated Tablets project would repay it’s investment in under the target period of 5 years, and whilst Little Brats Early Learning does go over this, it is by less than a year, and it will still deliver a strong long-term result, with an additional £375m cash flow to be achieved after the investment is repaid.

If funds were limited, and RM PLC were required to choose only one option, they would need to weigh up their financial return against their ethics.

From a purely financial perspective, I would have to recommend the Illuminated Tablets project, as it has a significantly higher Net Present Value. The Net Present Value is the dominant method to consider when comparing mutually exclusive projects – this method has the advantages that it considers all cash flows, adjusts for risk and is directly related to increasing wealth for the company. We do not compare Internal Rates of Return when ranking mutually exclusive projects. The Illuminated Tablets project will also pay back the initial investment faster.

However, Little Brats Early Learning still presents an opportunity for significant income and growth, and it is important for the long term success and sustainability of RM PLC that they maintain a trustworthy and reputable image in the market place. If it were to ever be discovered that they had

made secret deals with the Illuminati, this could ruin their business, and therefore from an ethical and sustainable business practices perspective, I recommend the investment in Little Brats Early Learning.

Strengths of using the above methods of making capital budgeting decisions are that the Net Present Value method makes it immediately obvious as to which is the better investment. Whilst any investment which has a positive Net Present Value should technically be accepted, if funds are limited, this method is also able to rank mutually exclusive projects.

The Internal Rate of Return is a method often preferred by executives as it considers all cash flows and considers the time value of money. Fortunately in this case, both alternatives provided internal rates of return above the required rate of return of 10%, however using this method does have a weakness in that it is unable to be used as a ranking tool when deciding between mutually exclusive projects. It can also potentially produce multiple answers.

The Payback Period method is simple and easy to understand. It shows in clear terms exactly how long it should take for a firm to generate enough cash flow to repay their initial investment. However, there are two major disadvantages in that it ignores the time value of money, and it also ignores the cash flow generated after the investment has been repaid. As can be seen in the example of Little Brats Early Learning, an additional £375m cashflow is expected after the initial investment is repaid, however the payback period method does not consider this as a benefit.

Whilst all these methods are excellent business tools to use when analysing the viability of a potential capital investment, one also needs to remember that business decisions should not always be made on a purely financial basis, although finances are certainly important. These methods have an inherent weakness in that they do not consider other important measures such as customer satisfaction, employee satisfaction, ethics, business reputation or sustainable business practices.

STEP 10