(a) Archway Co’s restated figures

On the assumption that Landing Co purchases Archway Co, the following adjustments relate to the effects of notes (i) to (iii)
in the question and the property revaluation:
$’000

Revenue (94,000 x 95%) 89,300

Cost of sales (see below) 76,000
Loan interest (10,000 x 8%) 800
Equity (10,000 + 2,300 RE + 3,000 revaluation) 15,300
Non-current liabilities: 8% loan notes 10,000
The cost of sales should be first adjusted for the annual licence fee of $1m, reducing this to $72m. Half of these, $36m,
are net of a discount of 10% which equates to $4m (36,000/90% – 36,000). Adjusted cost of sales is $76m (73,000
– 1,000 + 4,000).

(b) These figures would give the following ratios:

Annual sales per square metre of floor space (89,300/12,000) $7,442
ROCE (13,300 – 10,000)/(15,300 + 10,000) x 100) 13.0%
Net asset turnover (89,300/(15,300 + 10,000)) 3·5 times
Gross profit margin ((89,300 – 76,000)/89,300 x 100) 15.0%
Operating profit margin ((13,300 – 10,000)/89,300 x 100) 3·7%
Gearing (debt/equity) (10,000/15,300) 65·4%

(c) Performance
Archway Co Archway Co Sector
as reported as adjusted Average
Annual sales per square metre of floor space $7,833 $7,442 $8,000
ROCE 58·5% 13% 18·0%
Net asset turnover 5·0 times 3·5 times 2·7 times
Gross profit margin 22·3% 15% 22·0%
Operating profit margin 11·7% 3·7% 6·7%
Gearing nil 65·4% 30·0%

A comparison of Archway Co’s ratios based upon the reported results compares very favourably to the sector
average ratios in almost every instance. ROCE is particularly impressive at 58·5% compared to a sector average of
18%; this represents a return of more than three times the sector average. The superior secondary ratios of profit
margin and asset utilisation (net asset turnover) appear to confirm Archway Co’s above average performance. It is
only sales per square metre of floor space which is below the sector average. The unadjusted figure is very close to
the sector average, as too is the gross profit margin, implying a comparable sales volume performance. However, the
reduction in selling prices caused by the removal of the brand premium causes sales per square metre to fall
marginally.
As indicated in the question, should Archway Co be acquired by Landing Co, many figures particularly related to the
statement of profit or loss would be unfavourably impacted as shown above in the workings for Archway Co’s
adjusted ratios. When these effects are taken into account and the ratios are recalculated, a very different picture
emerges. All the performance ratios, with the exception of net asset turnover, are significantly reduced due to the
assumed cessation of the favourable trading arrangements. The most dramatic effect is on the ROCE, which, having
been more than three times the sector average, would be 27·8% (18·0 – 13·0)/18·0 x 100) below the sector
average (at 13% compared to 18·0%). Analysing the component parts of the ROCE (net asset turnover and profit
margins), both aspects are lower when the reported figures are adjusted.
The net asset turnover (although adjusted to a lower multiple) is still considerably higher than the sector average. The
fall in this ratio is due to a combination of lower revenues (caused by the loss of the branding) and the increase in
capital employed (equal to net assets) due to classifying the loan notes as debt (non-current). Gross margin
deteriorates from 22·3% to only 15·0% caused by a combination of lower revenues (referred to above) and the
loss of the discount on purchases. The distribution costs and administrative expenses for Archway Co are less than
those of its retail sector in terms of the percentage of sales revenue (at 11·3% compared to 15·3%), which mitigates
(slightly) the dramatic reduction in the profit before interest and tax. The reduction in sales per square metre of floor
space is caused only by the reduced (5%) volume from the removal of the branded sales.
Gearing
The gearing ratio of nil based on the unadjusted figures is not meaningful due to previous debt being classified as a
current liability because of its imminent redemption. When this debt is replaced by the 8% loan notes and
(more realistically) classified as a non-current liability, Archway Co’s gearing is much higher than the sector
average. There is no information as to how the increased interest payable at 8% (double the previous 4%) compares
to the sector’s average finance cost. If such a figure were available, it may give an indication of Archway Co’s credit
status although the doubling of the rate does imply degree of risk in Archway Co seen by the lender.
Summary and advice
Based upon Archway Co’s reported figures, its purchase by Landing Co would appear to be a good investment.
However, when Archway Co’s performance is assessed based on the results and financial position which might
be expected under Landing Co’s ownership, the recalculated ratios are generally inferior to Archway Co’s retail
sector averages. In an investment decision such as this, an important projected ratio would be the return on the
investment (ROI) which Landing Co might expect. The expected net profit after tax can be calculated as $2m
((3,300 before interest and tax – 800 interest) x 80% post-tax), however, there is no information in the question as
to what the purchase consideration of Archway Co would be.
That said, at a (probable) minimum purchase price based on Archway Co’s net asset value (with no goodwill
premium), the ROI would only be 7·9% (2,000/25,300 x 100) which is very modest and should be compared to
Landing Co’s existing ROI. A purchase price exceeding $25·3m would obviously result in an even lower expected
ROI. It is possible that under Landing Co’s management, Archway Co’s profit margins could be improved,
perhaps coming to a similar arrangement regarding access to branded sales (or franchising) as currently exists
with Cardol Co, but with a different company. If so, the purchase of Archway Co may still be a reasonable
acquisition.

Marking Guide: Marks

(a)
1
Revenue /2
Cost of Sales 2
1
Loan interest /2
Equity 11/2
1
Non-current liabilities /2
5
(b) 1 mark per ratio 6
(c) 1 mark per relevant comment up to 9
Total Marks 20