Mineral, a public limited company, has prepared its financial statements for the year ended 31 October 20X3. The following information relates to those financial statements.
20X3 20X2
$m $m
Group revenue 250 201
Gross profit 45 35
Profit before interest and tax 10 9
Profit before tax 12 8
Profit for the year 5 4
Non-current assets 42 36
Current assets 55 43
Current liabilities 25 24
Non-current liabilities – long-term loans 13 9
Equity 59 46
The company expects to achieve growth in retained earnings of about 20% in the year to 31 October 20X4. Thereafter retained earnings are expected to accelerate to produce growth of between 20% and 25%. The growth will be generated by the introduction of new products and business efficiencies in manufacturing and in the company's infrastructure.
Mineral manufactures products from aluminium and other metals and is one of the largest producers in the world. Production for 20X3 increased by 18% through the acquisition of a competitor company, increased production at three of its plants and through the regeneration of old plants. There has been a recent growth in the consumption of its products because of the substitution of aluminium for heavier metals in motor vehicle manufacture. Cost reductions continued as a business focus in 20X3 and Mineral has implemented a cost reduction programme to be achieved by 20X6. Targets for each operation have been set.
Mineral's directors feel that its pricing strategy will help it compensate for increased competition in the sector. The company recently reduced the price of its products to the motor vehicle industry. This strategy is expected to increase demand and the usage of aluminium in the industry. However, in spite of the environmental benefits, certain car manufacturers have formed a cartel to prevent the increased usage of aluminium in car production.
In the period 20X3 to 20X5, Mineral expects to spend around $40 million on research and development and investment in non-current assets. The focus of the investments will be on enlarging the production capabilities. An important research and development project will be the joint project with a global car manufacturer to develop a new aluminium alloy car body.
In January 20X3, Mineral commenced a programme of acquisition of its own ordinary shares for
cancellation. At 31 October 20X3, Mineral had purchased and cancelled five million ordinary shares of $1. In addition, a subsidiary of Mineral had $4 million of convertible redeemable loan notes outstanding. The loan notes mature on 15 June 20X6 and are convertible into ordinary shares at the option of the holder. The competitive environment requires Mineral to provide medium and long term financing to its customers in connection with the sale of its products. Generally the financing is placed with third party lenders but due to the higher risks associated with such financing, the amount of the financing expected to be provided by Mineral itself is likely to increase.
The directors of Mineral have attempted to minimise the financial risk to which the group is exposed. The company operates in the global market place with the inherent financial risk that this entails. The
management have performed a sensitivity analysis assuming a 10% adverse movement in foreign
exchange rates and interest rates applied to hedging contracts and other exposures. The analysis indicated that such market movement would not have a material effect on the company's financial position.
Mineral has a reputation for responsible corporate behaviour and sees the work force as the key factor in the profitable growth of the business. During the year the company made progress towards the aim of linking environmental performance with financial performance by reporting the relationship between the eco-productivity index for basic production, and water and energy costs used in basic production. A
feature of this index is that it can be segregated at site and divisional level and can be used in the internal management decision-making process.
The directors of Mineral are increasingly seeing their shareholder base widen with the result that investors are more demanding and sophisticated. As a result, the directors are uncertain as to the nature of the information which would provide clear and credible explanations of corporate activity. They wish their annual report to meet market expectations. They have heard that many companies deal with three key elements of corporate activity, namely reporting business performance, the analysis of the financial position, and the nature of corporate citizenship, and have asked your firm's advice in drawing up the annual report.
Required
Draft a report to the directors of Mineral setting out the nature of information which could be disclosed in annual reports in order that there might be better assessment of the performance of the company. Candidates should use the information in the question and produce their report under the headings: (a) Reporting business performance
(b) Analysis of financial position (c) The nature of corporate citizenship
Note. Use your knowledge of ratios from your F7 studies, but build on it.
Answer
REPORT
To: The Directors, Mineral
From: Accountant Date: 12 November 20X1
Information to improve assessment of corporate performance
In addition to the main financial statements, annual reports need to contain information about key elements of corporate activity. This report focuses on three main areas:
Reporting business performance Analysis of the financial position Nature of corporate citizenship (a) Reporting business performance
A report on business performance may include a ratio analysis, with a year on year comparison. The ratios commonly selected are those concerned with profitability and liquidity:
Profitability
20X1 20X0
Return on capital employed
13 59 10 = 13.9% 46 9 9 = 16.4% Sales profit Gross 250 45 = 18% 201 35 = 17.4% Sales PBIT 250 10 100% = 4% 201 9 100% = 4.5% 20X1 20X0
Long- and short-term liquidity
s liabilitie Current assets Current 25 55 = 2.2 24 43 = 1.8 Equity s liabilitie term – Long 59 13 100% = 22% 46 9 100% = 19.6%
These ratios raise a number of questions.
Use of ratios
(i) Gross profit margin has risen, while operating profit margin and return on capital employed have fallen. Possible problems with control of overheads?
(ii) Short-term liquidity has improved, but gearing has deteriorated. Is the company using
long-term loans to finance expansion? The company has expanded, both in revenue and
non-current assets.
(iii) Standard ratios are a useful tool, but must be discussed in relation to the specific circumstances of the company.
(1) The impact of the increase in production through the acquisition of the competitor company and the regeneration of old plants needs to be taken into account when
considering revenue and non-current asset ratios and other comments in the report. (2) When considering profit ratios, the effectiveness of the cost control programme
might be assessed.
(iv) As well as year on year comparison, a report on business performance might usefully compare actual performance against targets. To enhance the usefulness of the
information, the targets should be industry specific, measurable and realistic.
(1) The targets set for growth in retained earnings are 20% for 20X2 and between 20% to 25% thereafter. Reporting on actual performance would be informative.
(2) An objective is to generate the growth by the introduction of new products and improved efficiency. The actual performance in these areas might also be worthy of comment.
(v) The discussion of business performance also takes into consideration the risks that the
business faces. In the context of Mineral, such a discussion would cover:
(1) The proposed $40m expenditure on research and development and investment in non-current assets. Are the directors justified in assuming the predicted growth in retained earnings that this large expenditure is meant to bring about?
(2) The joint project to develop a new aluminium car body will be very lucrative if
successful, but is the risk v return decision appropriate?
(3) The company's pricing strategy and projected increase in demand should be discussed.
(vi) Knowledge management is also an important issue where new processes and products are
being developed.
(vii) As modern investors become more sophisticated, they are also likely to want to learn about the company's strategic objectives including the maintenance and development of income and profit streams, future projects and capital expenditure projects.
(b) Analysis of the financial position
(i) Annual reports should contain a review of the company's financing arrangements and financial position as well as a review of its operating activities.
(ii) In the case of Mineral plc, such a review is likely to note that:
(1) Gearing has increased, but it is still low, so the expenditure on research and
development could be financed by borrowing, if not by retained earnings. (2) Of the long-term loans of $13m, debentures of $4m could be converted into shares or
(3) Should the debentures be converted, the existing shareholders' interest will be diluted, and they should be made aware of this.
(4) Current assets are comfortably in excess of current liabilities (by $30m), so the company should have little problem in redeeming the debentures.
(iii) The report will need to disclose information about the treasury management policies of the
company. This would cover such issues as the potential adverse movement in foreign exchange risk and details of the use of financial instruments for hedging.
(iv) Currency risk and interest rate risk need to be managed and minimised, and the report
needs to disclose the company's approach for dealing with this.
(v) Credit risk is also an important issue, particularly as the company operates in the global market place.
(vi) A statement of cash flows will be provided as part of the financial statements, but the
annual report should also indicate the maturity profile of borrowings.
(vii) Finally, the financial analysis might benefit from the use of techniques such as SWOT analysis, covering potential liquidity problems and market growth. Reference would be
made to the cartel of car manufacturers aiming to prevent the increased use of aluminium
in the car industry. (c) Nature of corporate citizenship
(i) Increasingly businesses are expected to be socially responsible as well as profitable.
(ii) Strategic decisions by businesses, particularly global businesses nearly always have wider social consequences. It could be argued, as Henry Mintzberg does, that a company
produces two outputs: (1) Goods and services
(2) The social consequences of its activities, such as pollution
(iii) One major development in the area of corporate citizenship is the environmental report.
(1) This is not a legal requirement, but a large number of UK FTSE 100 companies produce them.
(2) Worldwide there are around 20 award schemes for environmental reporting, notably the ACCA's.
(iv) Mineral shows that it is responsible with regard to the environment by disclosing the following information.
(1) The use of the eco-productivity index in the financial performance of sites and
divisions. This links environmental and financial performance
(2) The regeneration of old plants
(3) The development of eco-friendly cars. Particularly impressive, if successful, is the
project to develop a new aluminium alloy car body. Aluminium is rust-free, and it is also lighter, which would reduce fuel consumption.
(v) Another environmental issue which the company could consider is emission levels from
factories. Many companies now include details of this in their environmental report.
(vi) The other main aspect of corporate citizenship where Mineral plc scores highly is in its
treatment of its workforce. The company sees the workforce as the key factor in the growth
of its business. The car industry had a reputation in the past for restrictive practices, and
the annual report could usefully discuss the extent to which these have been eliminated. (vii) Employees of a businesses are stakeholders in that business, along with shareholders and
concerned with employee welfare. Accordingly, the annual report might usefully contain
information on details of working hours, industrial accidents and sickness of employees.
(viii) In conclusion, it can be seen that the annual report can, and should go far beyond the financial statements and traditional ratio analysis.