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To: The Directors of Alphabet Holdings Plc

From: Maitham Rajvani – Financial Analyst at Alphabet Holdings Plc

Date: 11th January 2020

Subject: Financial Analysis of 2 Acquisition Targets: ABC Ltd &XYZ Ltd

This report demonstrates the financial analysis of both companies that could be potential investments for Alphabet Holdings Plc. Along with a critical evaluation, I have also explained my recommendation on which company to acquire and why.

Profitability

The average shareholder’s expectation as per Standard and Poor’s 500 is approximately 10% (S&P Global, 2020), therefore both companies can satisfy investors from a profitability perspective.

With a yearly profit of 21%, XYZ is likely to produce the highest return for shareholders. Due to recruiting less staff, XYZ also has a GPM of 62.7% compared to ABC’s 36.5% who recruit more to care for young children.

However, ABC’s nature of business results in them having less than half the asset base compared to XYZ who store and repair vehicles, giving them a higher ROA and ROCE.

Overall, XYZ is more profitable and their operations seem to be more in line with Alphabet’s current investments.

Liquidity

This is an organisation’s ability to pay for its current obligations (Kontus and Mihanovic 2019) and a current ratio of above 1 is deemed to be enough (Durrah. Et.al 2016).

ABC is within this range, however, XYZ has almost three times more. On the contrary, a ratio of 4.2 demonstrates inefficiency of current assets being in the bank and receiving 0.1% return (Mosquera, 2020) rather than investing in current assets to receive 41.3% return.

Ultimately, XYZ holds more than three times the amount of cash, compared to ABC resulting in XYZ being the more appropriate company to invest in, especially from a “cash is king” perspective.

Management Efficiency

This ratio assists in analysing the utilization of current assets and management of liabilities for an organisation, from an internal perspective (Borad, 2019)

ABC is running a safe operation since their client is the government who pay them obediently within 19 days. On the contrary, ABC takes 97 days to clear their payables, giving them a cash cycle of -78 days. This gives them a very good cash cycle where they receive almost five times the amount of money, before having to pay it out once.

XYZ’s nature of business means their clients are individuals who are away for long periods of time with the Heavy Goods Vehicles (HGV), resulting in their trade receivables being cleared after 83 days. Unlike ABC, XYZ clear their payables after 119 days, giving them a cash cycle of -37 days.

ABC has a better cash cycle, however XYZ is deemed to be more ethical, would be more valued and promises to be able to result in long-term relationships with their suppliers.

Gearing

The optimum gearing ratio is advised to be between 25-50% (Siyanbola, 2019).

XYZ has a ratio of 50%, keeping it within range while ABC has 0 since they have no debt. No debt may sound great, but it can be argued to be a missed opportunity. Banks grant loans with 7% interest (Barclays, 2020) and this can easily be financed by ABC who can in return, earn 18% net profit or if they invested in capital employed or assets, earn 64%. Another alternative would be to invest in cost of sales, earning 36.5% gross profit.

ABC could also use that cash to invest into buying a hotel, which would be easily affordable considering they would have a mortgage of about 3-4%, saving them the lease costs currently being paid.

XYZ’s 50% gearing may be slightly concerning at first, however their interest cover ratio demonstrates their operating profit being almost ten times more than what they pay as interest charges, classifying their gearing as ideal.

(See Appendix 1 for all Ratio Calculations)

Conclusion

ABC and XYZ are both profitable and sustainable businesses to invest in.

ABC is a safe option and has the better cash cycle considering their nature of business, however XYZ is more profitable and has the better liquidity making them the better target, while ABC is a good tenant.

Recommendation

XYZ’s line of business provides more synergy and greater potential for long-term success as well as better monetary benefits for Alphabet Holdings.

Having said that, several practices will have to be improved upon, in order to make this business more profitable. Hiring debt collectors to follow up on pending payments and investing in assets by using the cash in the bank would be my initial suggestions, which should see XYZ turning over much greater revenue and resulting in greater profit margins with less trade receivables.

The directors of Alphabet Holdings should consider entering a contractual agreement with ABC, leasing the loss-making hotel to them, resulting in creation of external income and cancelling out any losses.

1.2 Working Capital Management (WCM)

According to Ganesan (2007), WCM can be described as cash used by an organisation to maintain an efficient balance between its current assets and current liabilities. Working capital ratio is calculated as:

(Leiwy and Perks, 2013)

Below are the Working Capital Ratio’s for ABC and XYZ:

ABC Ltd

XYZ Ltd

A ratio of 1.5-2.0 is optimal, keeping the company on solid financial footing (Biedron, 2019). Therefore, with a ratio of 1.6, ABC is within range of an optimal working capital.

However, XYZ is out of range with a ratio of 4.2. A higher ratio is preferable to a lower one, but a ratio of 4.2 shows available capital as underutilized and inefficient. This means assets exist in excess that have not been re-invested to generate additional income but have rather accumulated in the bank account, generating zero return, considering the base rate on fixed deposits are approximately 0.1% (Bank of England, 2020). As a result, this will lead to a poor ROA and a missed opportunity for additional income.

Conclusively, ABC is considered to have a stronger Working Capital since it is more within ideal range rather than XYZ.

1.3 Sources of Finance

The first step is to estimate the amount of capital required in order to acquire XYZ.

As per the Price Earnings Ratio Database, the Price-Earnings Ratios (PER) is 6.4 (PERDa, 2020). Therefore, if we multiply it by the operating profit of XYZ, it gives a total of £472,000, rounding it off to £500,000. Hence, Alphabet Holdings Plc requires about £500,000 to buy XYZ.

Some of the sources of finance available to Alphabet Holdings Plc are:

Alphabet Holdings should offer £50,000 each to both XYZ directors and 22.5% shares, in order to acquire their company. It could be enough to convince them however, in case they still prove to be a tough cookie, they should be given a seat at the table to be a director of the Holding company. This source of finance is cost-free to Alphabet Holdings as the £100,000 will be from XYZ’s bank reserve. Although both directors will receive a combined 49% of shares, Alphabet Holdings will remain owners and will have acquired XYZ successfully. This source of finance is highly recommended as it proves to be a win-win for both the Holding company as well as XYZ.

2 (i) Marginal costing is an essential method that should be used to make short-term decisions with regards to profitability, since they are unlikely to change during small durations. It splits the costs into two; variable and fixed (Leiwy and Perks, 2013).

Once the costs are split, we can now calculate the contribution a single product makes by subtracting the variable cost from the sales revenue, while fixed costs remain uniform for all the products.

Below we have the marginal costing calculations for each of the products:

ii) From the findings in part (i), BOZON has the second highest contribution after AXOR, therefore ceasing the production of BOZON would result in a greater loss. Below is the marginal costing, reflecting the impact on the net operating income if BOZON’s production is ceased:

iii) CARBON results in a negative contribution, therefore ceasing its production would result positively on the Net Operating income, if AXOR and BOZON are both being produced. The table below shows the impact:

iv) The directors have been misled into thinking that fixed costs would be deducted if they were to cease the production of a specific product.

Marginal costing has proved, regardless of the number of products that are to be produced, fixed costs remain to be £3780, which is why marginal costing is very effective in evaluating product value.

v) Ceasing the production of both BOZON and CARBON will not increase profitability, but rather result in a greater loss from £240m to £900m. Below is the calculation:

My suggestion is to cease the production of CARBON; however, the organisation must continue producing AXOR and BOZON, resulting in a Net Operating Income of £180m.

I’d also suggest increasing the production of AXOR since it has the highest contribution, and it should result in profit maximisation, if fixed costs will continue to remain uniform.

3) i) Calculating the Net Present Value (NPV)

Calculating the Net Present Value:

ii) Payback Period (PBP):

The Payback period is 2 years and [(50,261/125847) * 12] = 2 Years and 4.8 Months.

Discounted Payback Period (DPBP):

The discounted payback period is 2 years and [(88,250/89,603) * 12] = 2 Years and 11.8 Months.

iii) Internal Rate of Return (IRR)

The company’s criteria were set at a 5% cushion for possible increase in inflation rates after the current cost of capital which is set at 12%, giving an accumulated total of 17%. Therefore, for this project to be accepted, the IRR must be higher than 17% at least.

In this scenario, the Internal Rate of Return is: 12.26%

iv) Recommendations

Summary of findings:

I would not recommend that this project should be undertaken because the discounted payback period cuts it close to just within the range of under 3 years, however when we look at the Internal Rate of Return, it is nowhere close to the criteria set by the company. Therefore, this project will not be able to cope with any future inflations possible and hence, I don’t recommend going forward with this specific project.

v) Limitations of project appraisal techniques

My recommendation to Alphabet Holdings Plc is to always use the above four appraisal techniques when deciding to invest into a project. The above four techniques have proven to be accurate indicators of how long an investment can take to be paid back thus a project should only be accepted when all four appraisal techniques give results that meet the conditions set by the company.