Finance Assignment: Financial Decision Making For Roast Ltd

Question

Task:
Case Study - ROAST LTD
Your role
You work in the finance department of Starbucks UK. Your Chief Financial Officer (CFO) has asked you to review the financial statements and other material sourced for you below, of Roast Ltd, an independent UK chain of coffee houses. The objective is to assist her in evaluating the attractiveness of the company as a target for acquisition by Starbucks.

Finance Assignment Task
Prepare a 3,500 word business report for your CFO providing analysis and business advice to address the requirements below.

Format: business report with headings, sub-headings and paragraphs

Executive summary – key highlights/findings drawn from each task below to answer the central question: should Starbucks acquire Roast Ltd or not?

Note: no introduction or conclusion is required except where stated as part of the requirements. No marks will be awarded for an introduction or conclusion.

Part 1: Industry Review
Using your own independent research, provide a top-line review (in bullet point format) of the current UK coffee house industry. This should include a summary of who the key players are, how well it is performing, and any challenges or opportunities that you find.

Part 2: Business Performance Analysis
You will need to calculate and use appropriate ratios in your analysis for the sections required below:

2.1 Statement of Profit or Loss
Analyse and comment on the financial performance of Roast Ltd using all relevant information from exhibits 1 and 2. Your analysis should critically evaluate the lines of the Statement of Profit or Loss. 2.2 Statement of Financial Position

Analyse and comment on the financial position of Roast Ltd using all relevant information from exhibits 1 and 2. Your analysis should critically evaluate the lines of the Statement of Financial Position.

2.3 Statement of Cash Flows
Use the Statement of Cash Flows (exhibit 1) and identify what has happened to the cash position of Roast Ltd during 2018.

Calculate and explain Roast Ltd’s Operating Cash Cycle (OCC) for 2018 and 2017.

Critically evaluate the company’s 2018 dividend policy and explain whether you think Roast Ltd was right not to make a dividend payment in 2018.

Part 3: Investment Appraisal
Critically evaluate the investment appraisal information (exhibit 3).

Your evaluation should challenge the management forecast in the first part of your answer. Then, in the context of Roast Ltd, critically evaluate the following investment appraisal techniques considering the benefits and limitations of each technique. You need to give a clear assessment as to whether the company was right to proceed based on the results of each appraisal technique and what we now know.

Use the following sub-headings to structure your answer:
3.1.a Management Forecast
3.1.b Investment Appraisal Techniques

• Payback period
• Accounting Rate Of Return
• Net Present Value

3.2. Sources of Finance
Given that Roast Ltd is considering a further investment, this time into Italy of £400,000 from 2019, assess the benefits and drawbacks of two alternative sources of finance for this further investment, including an assessment of their appropriateness in this case. Give a clear conclusion as to what course of action you recommend.

The word limit is 3,500 words excluding numerical tables, bibliography and appendices. The executive summary is included in the word count.

To assist you with this task you have been supplied with the following information:

• Exhibit 1: Extracts from Roast Ltd’s Financial Statements for 2018, including the Statement of Profit or Loss, Statement of Financial Position, Statement of Cash flows and Statement of Changes in Equity.
• Exhibit 2: Notes from a meeting between the Loan Officer at Finance Bank and Roast Ltd’s Chief Financial Officer, Dan Shaw.
• Exhibit 3: Investment Appraisal – Romania expansion figures drawn up in 2016 for 2017 onwards.

CASE STUDY – ROAST LTD
Roast Ltd is an independent coffee house chain that was established in the UK in 2008. It has become a well-established part of the popular café culture that has developed alongside the emergence of the digital age, with workers taking their mobile devices to their local café to benefit from wifi, a caffeine boost and possibly something to eat, as an alternative location to their desk.

To face off competition, Roast Ltd has built its brand strength on the fact that it is independent. Paola King, the chair of the company since their inception, and formidable driving force behind their success to date, cites their USP as follows: “We offer an alternative to the big brands: we are all about employing local people, and giving something back to the high street; our coffee shops are not cookie-cutter duplications of each other, they all have a certain character depending on their location, and that’s important to us in this increasingly globalised and corporate world. This is a family business, proud of its Italian heritage and inspiration: my parents were from Rome, and we use only the best Italian technology in our coffee machines and follow Italian brewing processes to ensure that every cup of Roast coffee is on a par with what you’d get in a top Italian caffè.”

It may be smaller in size than its big brand competitors, but that hasn’t limited Roast’s ambitions, as it is currently in the middle of a two-phase expansion strategy:

• Phase one – which commenced at the start of 2017 was the opening of a chain of coffee shops in Romania. This has been slow to get going: the launch was initially anticipated for midway through 2017, but ultimately sales only started in January 2018.
• Phase two – In 2019 Roast Ltd is seeking to use its strong supplier contacts in Italy to acquire a share in a coffee machine manufacturer for which it needs to secure finance of a further £400,000.

Answer

Executive Summary
The coffee house industry has lots of opportunities and growth options. In case of the Roast Ltd concerned herein finance assignment, the profit margins are good but current financial position is dicey. The company is able to covers the cost of sales but due to finance expenses facing deficit situation. The cash flows are negative and company has invested a large sum in the Romania returns from which is required to be forecasted properly. The company is facing cash crunch and only way for survival is the return from the new investments in the Romania. In the forecasted data the financial appraisal techniques shows the positive result. The techniques will be useful only when the data is correct.

Thus, the main deciding factor to invest in the Roast Ltd by Starbucks will depend upon the further estimate of the Romania project. The business is prosperous and profitable. The only fault is the delay in investing activity. Thus, the company should not invest in Roast Ltd due to investment in Romania may hamper the liquidity position of the company.

Part 1: Industry Review of UK Coffee House Industry
The coffee industry of the UK has an orthodox trade structure. The coffee trade in the UK is conducted by linking suppliers from countries that produce coffee to UK based roasters by various importers. The coffee produced is then sold via mediums like hotels, restaurants, department stores, supermarket stores, retail outlets, dedicated coffee houses, fast food outlets, bookstores, motorway services, vending machines, and fuel stations.

Coffee can be grown only in certain areas. Areas that have a proximity to the equator are the zones where coffee can be successfully grown. The national value chain of the UK coffee industry usually begins with sales agents and importers. In the UK, the coffee products imported from other countries reach the final customers via various channels. The customers of imported coffee range from retail stores, in-house or personal consumers, and out-of-house buyers like coffee shops, pubs, restaurants, coffee houses, and bars (CEBR 2018). Green coffee is one of the most single selling coffee categories that are imported into the UK. The UK’s arrangement in the supply chain signifies that the imported coffee products (soluble coffee and primarily roasted coffee) from the European Union hold a much greater value as compared to other countries.

A larger portion of retail coffee products are sold via supermarkets and hypermarkets and this accounts for 37% and 35% of retail coffee selling respectively. The buyers in the UK are more into consuming instant coffee. In the year 2017, the overall sales turnover of instant coffee amounted to £810 million (CEBR 2018). This turnover is itself equal to 54% of the total sales turnover which amounts to £1.5 billion yielded by the sale of all types of coffee products in the retail industry. Even though the instant coffee market is generating an excellent turnover, yet there is a downward trend in the same due to the introduction of products like roasted coffee, filtered coffee, grounded coffee, and coffee pods (CEBR 2018).

In 2017, freshly grounded coffee pods yielded a sales turnover amounting to £305 million while standard freshly grounded coffee generated a sales turnover amounting to £214 million. The sudden demand for grounded coffee is large as a result of the reforming coffee house culture in the country which has encouraged the buyers to make coffee that tastes like the ones served at “Barista” at their homes.

Around 33% of the sales volume of all types of coffee items is represented by the out-of-home segment. The overall standard turnover yielded from coffee items in the food sector amounted to £3.2 billion in the year 2017. This signifies a 9% increase from £2.9 billion to £3.2 billion in a single year itself.

Macroeconomic contributions and impacts of the coffee industry
Direct impacts
The activities associated with the production of coffee in the UK have a direct impact on the coffee industry of the country. In the year 2017, the estimated overall GVA contribution to the country’s GDP of £3.7 billion was equal to 1/9th of the GVA of the overall foodservice industry. It is estimated that around 76% of the value of an average cup of coffee is produced in the afore-mentioned country. The foodservice sector is denoted as the largest segment of the UK’s coffee house industry in terms of higher profit margins earned in the out-of-the-home market.

In 2017, the turnover of £7.2 billion was estimated for the UK coffee house industry. This signifies that from 2012 to 2017, there is an average growth of 7% every year. Labour compensation of £2.5 billion was estimated for the year 2017 and this accounts for 68% of the overall GVA estimated for the same year. When it comes to full-time equivalent labors

The key players in the UK coffee house industry are Costa Limited, Starbuck Coffee Company Limited, Pret A Manger Limited, and Caffe Nero Group Holdings Limited.

Part 2 Business Performance Analysis
2.1 Statement of Profit or Loss
The income statement or the statement of Profit or Loss is the summary of all the incomes and expenses incurred during the year. The profit is the main driving force of the company. It is the profit through which the return to the shareholders and other stakeholders are given (Carlon 2019). In the given case the Roast Ltd the income statement is showing increased revenue as compared to the last year.

The gross profit ratio has decreased from 26% to 21%. That means that the company is earning less from its operating activities that are its cost of production or sales have increased and the profit margin on sales has reduced. On the other hand, the net profit of the company has increased from 2% from 2017 to 3% in 2018. Thus, the loss of revenue from the operating activities is recovered from the non-operating activities. The gross profit after considering the ‘other operating income’ is coming as 24% which also lower than the gross profit of the previous year without any other operating income. There is no other operating income in the last year. Thus, the company has generated a new source of revenue in the current year which may grow in the coming years and benefit the company (Carlon 2019). The operating profit ratio has increased from 3% in the previous year to 5% in the current year. The reason being the cost of sales has increased proportionately but proportionate increase in the operating expenses is lesser.

The finance cost has increased from 6000 to 26000 in the current year this shows that the company has become more leveraged and the use of external funds in the company has increased. The company has taken debt has both good and negative points. The positive thing is that the company is expanding and the company is able to cover its interest expenses and when it falls due. This is possible only when the cost of debt is less than the return of the company. The drawback of debt is that it is a fixed charge on profit and even in case of the adverse situation the liability continues (Ferris, Noronha & Unlu 2010). The shareholders gain from the prudent use of debt as it will reduce the cost of capital and thus return to shareholders will increase.

In the operating expense schedule, there is a reduction in the employee expenses, director’s remuneration, and legal and professional fees. This is also a very vital point as reducing the number of employees or reducing the remuneration of the directors is generally done is a difficult situation when the financial position is not good and thus a question on the going concern also arises (Gerhard 2017). The more focus of the company was in store maintenance and distribution and marketing. Since the volume of inventory has increased so the increase in in-store cost is justified to some extent but it has increased more than double as compared to last year. The distribution and advertising expenses have also increased more than double the last year but the increase in sales is around 25% only. Thus, more benefits from the marketing expenses incurred in the current year will be seen in the coming years. The major increase is seen in the distribution cost which may indicate some improved method for better and timely delivery of the goods (Kim 2013). The bad debts have also increased which should be monitored.

The increase in various cost patterns is also due to the company entering a new market of Romania which has to lead to additional cost at the initial stage of settlement and will generate the desired return for the coming from the hereafter. The company gross margin has reduced as the increased cost of ingredients is not passed to the customers. The outsourcing of the employees is also a strategic decision and if implemented properly will benefit the company in the long run (Laux 2014). The credit limit as required by the customers from 30 days to 90 days should be taken very cautiously as the cash flow problem of the many corporate is actually in deficit and future viability should be analyzed rather than trusting the past trends of the customers.

2.2. Statement of Financial Position
The financial position of Roast Ltd as of 31st December 2018 shows the increase in the Plant, Property, and Equipment which is mainly attributed to the investment for setting up in the new country of Romania. The indication can be seen from increased depreciation cost in the income statement and even after the depreciation net investment has led to an increase in the total value of fixed assets in the balance sheet. There has been a significant increase in the inventory levels and also the receivables have increased. The inventory level has increased 2.5 times the inventory level in the previous year. This all is the result of the investment and entering a new market and geographical area.

The main reason for concern is the nil balance of the cash and cash equivalents. The company is having increased debt funds and thus higher interest amount payable in the coming years. The company is not having much cash equivalents and total dependence is upon the current revenue generation. The company has already taken a bank overdraft of 73000. If due to any circumstances the expected revenue is not generated the company will not be able to meet its liabilities on time and default its payments (Atril 2014). This is hampering the goodwill of the company and also affects its future business deals as the stakeholders will lose confidence in the company. The payables have also increased from 138000 to 235000. Thus, there has been a significant increase in the liabilities and the corresponding increase in assets has not resulted in any short-term cash equivalents.

The interest coverage ratio has increased from 12% to 20% which shows the positive sign in the balance sheet but when we come to see the Current Ratio it has reduced from 2.51 times to 1.45 times in the current year. This shows that most of the amount of the funds is used for fixed assets and current assets have reduced. This indicates the long-term investment in the operations of the company. The dividend has been paid in the last year but as the funds are less in the current year the no dividends have been proposed which is a good decision as the funds required for the investment is borrowed from outside and use of borrowed funds for dividend purpose is not justified (Sherman 2015).

2.3. Statements of Cash Flow
The cash flow is showing the negative cash flow from an operation which is a critical issue. The cash from the operation is positive and has become negative due to the financial expense that is interest paid (Atril 2014). Thus, this point should be evaluated that the company soon is able to recover the interest cost from the operating activities and generate positive cash flow from operation. There has been huge investment in the Property, Plant, and Equipment. The whole future of the company depends upon the return from such investment in the assets of the company. The proceeds from the long-term borrowing are 17500 which is very less as compared to the investment done in the assets. Thus, this shows that the initial cash and equivalents balance was very good that is the reason such a huge investment is managed with such a small amount of borrowings (Beaver, Correia & McNichols 2012).

The operating cash cycle of the roast ltd is coming as 22 days. The operating cycle of the company means that the investment in the inventory is finally realized in cash through the collection from debtors. The cash invested in the business for 22 days. The company has decided not to give any dividend for the year 2018. The company has given a dividend of 30000. This system of irregular dividend hampers the shareholder's confidence. Keeping in view the current position of the company we would prefer the decision taken by the management. The cash and cash equivalent of the company is Nil and the company has borrowed funds from the market. This is the year when the huge investment is done in the asset of the company for expansion and growth. Thus, the company is already in need of the funds. In order to reduce the burden of the debt and finance charge, the internal source of the funds is the best. The ability uses its reserves for expansion purposes is the most secure source (Chen & Gong 2019). Thus, in the decision of the management not make dividend payments in the year 2018 is correct and shareholders will gain through higher wealth and returns in the coming year.

Part 3 Investment Appraisal
3.1.a Management Forecast
The management has forecasted in the year 2016 for revenue from 2017 onwards. The expected revenue for the year 2018 was expected to be 560,000 and the actual sales in the Romania country are 350,000. Thus, the actual sale is less than the expected sale for 2018. The sale was expected to start for the mid of 2017 but delayed due to some unavoidable reason the actual started from January 2018 onwards. The sale which is expected to grow at the rate of 87% in the initial years has been slowed down and only around 60% was recorded in the second year. In the initial half-year, there was no sale recorded for the same. This gives the indication that the management should change its forecast as per the current situation and plan accordingly. The delay in the realization of the sales will hamper the liquidity position of the company as the finance and other charges will continue to be incurred (Davydov 2016). The management has also estimated that the variable cost will be fixed at 80% of the revenue which is also not a good assumption. Inflation has been ignored. The proportion of inflation between the income and expense may not be the same and the rate of increase in the income may be lower than the rate of increase in the expenses.

The management needs to re-forecast the expected revenue in the project and invest and take further actions accordingly.

3.1.b Investment Appraisal Techniques

• Payback period
  In context of Roast Ltd which is considering expansion of its Coffee division in Romania by investing £500 million. From the review of Exhibit 3 in the Case study it is seen that the Payback Period of the project is 4 Years. Thus, it is beneficial to invest in the project as the Total Investment amount would be realised within 4 Years and result extra cash flows from the 5th Year onwards.

  Coming to the advantages of payback it can be observed that an early focus on the payback leads to higher liquidity for the company followed by the assessment of investment risk for the company. It is a more reliable tool because short term prediction can be done through this mechanism (Pucheta-Martiinez & Garcia-Meca 2019). It enjoys the advantages of easy computation and hence is preferable over other appraisal methods. However, it suffers from few frailties that is the ignorance of cash flow timing and thereby it becomes difficult to ascertain the cash flow produced at the end and the total return of the project (Rakow 2019). Another major shortfall of the mechanism is that it influences heavy investment.

• Accounting Rate of Return
  In context of Roast Ltd which is considering expansion of its Coffee division in Romania by investing £500 million. From the review of Exhibit 3 in the Case study it is seen that the Accounting Rate of Return (ARR) is 18% which is greater than the target ARR of 10% of Roast Ltd. Thus, it is beneficial to invest in the project as ARR is greater than the target ARR of Roast Ltd.

  The benefits that can be derived from ARR is the computation is simple and focus solely on the net operating income to assess the management performance (Renneboog, Szilagyi & Vansteenkiste 2017).

  However, there are few shortfalls with this mechanism and the major being the discard of the time value of money. In this method, a dollar in hand is the same as dollar received in the future. Further, there is no consideration of the cash flow and stress is given on the net operating income. In real terms the cash flow is of major importance because it helps the company to invest in other projects (Yang & Gabrielsson 2017). Lastly, a project might look desirable in one stage while in another it might become undesirable.

• Net Present Value
  In context of Roast Ltd which is considering expansion of its Coffee division in Romania by investing £500 million. From the review of Exhibit 3 in the Case study it is seen that the Net Present Value (NPV) is £ 110 million at a cost of capital of 5%. Thus, it is beneficial to invest in the project as NPV is positive.

  From the study it is imperative that the NPV considers the time value of money and aids in the decision-making process of the company (Teece 2018). The most useful part of the NPV mechanism is that it considers the discounted cash flow of the investment to ascertain the viability. However, the mechanism is subjected to disadvantage that the method is not suitable for the comparison of projects with different sizes. NPV is an absolute figure but not percentage hence NPV of larger projects will be more than the smaller size project.

3.2. Sources of Finance
As per the scenario, Roast Ltd is vouching for an investment into Italy amounting to £400,000. Hence, two alternative sources that can be selected here are the bank loans and retained earnings. The advantages and disadvantages of both the sources are as follows:

• Bank Loan
  A bank loan contains the advantage of not taking the ownership position in the business and obligation ends once the loan has been repaid. The presence of fixed rate loans where the interest rate does not change during the tenure of the loan is the main advantage (Tosun 2019).

  However, there are chances that the personal assets will be seized on non-payment of loans. The higher interest rate can often be a barrier when it comes to the business requirements.

• Retained Earnings
  Retained earnings carries the advantage of self dependence and hence no requirement of external borrowings. Moreover, this method helps in interest savings. There is no document requirement to maintain the financial position documents that is needed to be required to be furnishing to the lender (Tosun 2019).

  However, money can be misused by the management of the company and can lead to over-capitalization. In context of Roast Ltd it is appropriate for Roast Ltd to use Retained Earnings to fund the expansion project in Italy. Retained earnings are the best source of finance with no cost to the company whatsoever.

  The overall discussion clearly interprets that bank loan will provide a major boost to the company’s functioning. Since it has a substantial track record and it can service the loans from the returns of the coffee business, the bank loan would be best recommended.

References
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Appendix