HERIOT-WATT UNIVERSITY

ACCOUNTING – MARCH 2020

Section II

Case Studies

Case Study 1

‘I’ve no idea where to start,’ stated Bradley Steven. Bradley was talking about his former
employers, Miami Software Solutions Inc (MSS). Bradley had just taken over as CEO of
Eastside Communications Inc. and was sitting in a meeting with Tina Lapidi, its CFO,
and Frankie Le Havre, its Vice-President of Marketing.

They were asking him about his previous company’s financial performance. Both Tina
and Frankie saw MSS as a possible takeover target in the future and they were beginning
to build their bank of information on the company. Tina had just received a set of MSS’s
accounts (see Appendix 1) and was planning to examine them in some detail.

‘MSS always seemed to be struggling on cash flow, extending its banking facilities on a
regular basis,’ observed Bradley. ‘Work-in-progress was really high as well, and customers
were taking ages to pay their bills,’ he added.

‘What about MSS’s capital expenditure?’ queried Frankie. ‘I heard that it had fitted out a
completely new building on that new industrial estate.’

‘That’s right, Frankie. It took a long time to complete and absorbed loads of cash,’
explained Bradley.

‘And a lot of management time as well, I’m sure. No wonder their growth seems to have
stalled.’ Tina was critical of the management of MSS for its lack of progress in the last
couple of years. Nonetheless, she thought that the business had potential.

‘No wonder MSS had to go to the market for a capital injection,’ added Frankie. ‘It must
be in dire straits.’

‘Maybe not as bad as you think,’ retorted Bradley. ‘Its share price still looks good and I
hope it stays that way – I’ve still got quite a few shares in it’ (see Appendix 2). ‘OK, Tina.
Maybe it’s the right time to get on with your financial review of MSS. The Trade
Association statistics should be useful for your analysis’ (see Appendix 3). ‘I’ll do what I
can to explain any gaps you have. Let’s agree to meet this time tomorrow to discuss your
findings, Tina.’

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APPENDIX 1

Miami Software Solutions Inc. 2020 2019

Profit and Loss Accounts (Summary) $’000 $’000

Sales 4,740 3,985
Cost of Sales 1,415 1,352
Gross Profit 3,325 2,633
Other Expenses 1,865 1,815
Profit before taxation 1,460 818
Taxation 245 156
Profit after taxation 1,215 662
Dividends payable 190 100
Retained profit for the year 1,025 562

Balance Sheets $’000 $’000

Non-Current Assets
Property 300 300
Plant & Equipment 825 389
Motor Vehicles 217 25
1,342 714

Current Assets
Inventory 585 625
Debtors 1,086 592
Cash at Bank 30 306
1,701 1,523

Current Liabilities
Creditors 392 995

Net Current Assets 1,309 528

Total Assets less Current Liabilities 2,651 1,242

Creditors > One Year

Long-term Loan 550 466
Net Assets 2,101 776

Capital and Reserves

Ordinary Share Capital 400 200
Share Premium 100 -
Retained Profits 1,601 576
2,101 776

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APPENDIX 2

Note: Ordinary Share Capital comprises Ordinary shares with a nominal/par value of 25
cents each ($1 comprises 4 × 25 cents shares).

The market price of one Ordinary share of 25 cents was:

2020 2019
105 cents 92 cents

APPENDIX 3

The following information has been obtained from the US Software Trade Association,
which collates accounting data from all its member companies. The numbers given
comprise the industry averages for each of the ratios over the last three years.

2020 2019 2018

Quick ratio (times) 2.5 2.4 1.8
Gross Profit margin 55% 63% 61%
Profit margin ratio 16% 18% 24%
Return on total assets 31% 38% 41%
Return on capital employed 28% 29% 32%
Inventory turnover ratio 1.8 2.0 1.9
Average collection period (days) 44 42 43
Debt ratio 66% 53% 52%
Dividend cover 4.1 4.4 4.8
Dividend yield ratio 12% 12% 11%

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Required:

1. Define and compute the following ratios for both 2019 and 2020.

(i) Quick ratio

(ii) Gross Profit margin
(iii) Profit margin ratio
(iv) Return on total assets
(v) Return on capital employed
(vi) Inventory turnover ratio
(vii) Average collection period
(viii) Debt ratio
(ix) Dividend cover
(x) Dividend yield ratio
(20 marks)

2. Using the Trade Association statistics as a standard, compare and contrast MSS’s
performance over the two years, identifying its financial strengths and weaknesses.

(15 marks)

Total 35 marks

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Case Study 2

‘I don’t think that will be possible in June,’ stressed Marie. Marie LeChapeau was the
Chief Financial Officer of Chicago Answers Inc., a recruitment company that specialised
in hiring business development executives and providing temporary CEOs for its clients.
Marie had been in her current position for the last three years and considered that she
had a clear understanding of the company’s cash flow position.

‘It has to be – there’s no option.’ Al Caponetti was always firm in his demands, behaving
in exactly the same manner since his appointment as CEO three months ago.

‘We have to move office in June. Otherwise, we will pay significantly more in monthly
rent – we have to pay the full year’s rent in advance in June to get the 30% discount.’

‘Al, you know how cyclical our business is. The summer months are always our worst for
sales,’ countered Marie. ‘It’s a bad time for us to commit. Can’t we delay it into the
autumn?’

‘No – it’s essential that we move in June. No more discussions, just make it happen,
organise the cash to suit it. Just get on with it,’ instructed Al, slamming the door shut as
he exited Marie’s office.

Marie sat back in her chair, muttering angrily to herself and starting to assess her current
data on the company’s cash position.

Somewhat reluctantly, she began to prepare a cash forecast that would provide the
answer (or not) to Al’s demands. See Appendix A for further information.

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APPENDIX A

The following information is available to assist the preparation of the Cash Budget for
each of the three months to 31 July:

1. The opening cash balance is $298,645 as at 1 May.

2. Advance rental for the new offices is estimated to cost $150,000 and would be
payable in June.

3. The HR Director advises that monthly Administration salaries will normally run at
$70,000 per month, rising to $80,000 in June due to the overtime necessary to
move to the new offices.

4. Monthly salaries for Business Development staff are $25,500 per month. Other
Marketing costs are expected to be $10,250 per month, except in June, when an
extra $15,200 will be spent on an annual trade exhibition.

5. Non-current assets are depreciated on a straight-line basis with a fixed monthly

charge of $30,250.

6. The company’s annual profit-sharing bonus scheme for all staff is due to be paid
out in July as well – a total cost of $102,000.

7. Other monthly overheads (excluding salaries and depreciation) are expected to be

$36,000 per month.

8. The company is also due to pay $45,000 of corporation tax in May.

9. Trade creditors at 30 April amount to $122,000, all relating to April purchases

(payable in May).

10. Projected purchases from suppliers for the three months are:

May $120,000
June $65,000
July $85,000

The company has a policy of paying its suppliers in the month following the
month of purchase.

11. Trade debtors at 30 April are $590,000 with the following age profile:

Unpaid from March Sales $285,000

Unpaid from April Sales $305,000
$590,000

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12. Projected sales for the next three months are:

May $295,000
June $247,000
July $155,000

From reviewing the payment performance of customers, it is evident that

customers settle their debts in the second month after the month of sale. For
example, the company receives payment in May for sales in March.

13. The company’s current overdraft limit is $200,000.

Required:

1. Prepare the Cash Budget for each of the three months to 31 July.
(22 marks)

2. In view of the funding requirements highlighted by the Cash Budget, outline the
actions that Marie may take to ensure that she meets Al’s demands and also that
the company does not break its overdraft limit.
(3 marks)

Total 25 marks

END OF PAPER