Critical Analysis of Financial Statements

This document provides a critical analysis of financial statements, including an industry review of the cafe and coffee shop industry. It analyzes the business performance of the company, including the statement of profit or loss, statements of financial position, and cash flows. The document also discusses the challenges and opportunities in the industry and provides insights into the company's profitability, liquidity, and gearing.

CRITICAL ANALYSIS OF
FINANCIAL STATEMENTS

TABLE OF CONTENTS
EXECUTIVE SUMMARY.............................................................................................................1
PART 1 : Industry Review...............................................................................................................1
PART 2 : Business Performance Analysis ......................................................................................2
2.1 Analysis of Statement of Profit or Loss.................................................................................2
2.2 Analysis of Statements of Financial position.........................................................................4
2.3 Analysis of Cash Flows of company.....................................................................................6
PART 3 : Investment Appraisal.......................................................................................................8
3.1. a Management Forecast........................................................................................................8
3.1.b Investment Appraisal Techniques benefits and limitations ...............................................8
3.2 Sources of Finance.................................................................................................................9
REFERENCES..............................................................................................................................11
APPENDIX....................................................................................................................................12

EXECUTIVE SUMMARY
The finding from the study reflects that as the profitability ratio of Roast Ltd attained as
5.2% which indicates that company is generating profits so referring to this Starbucks must
acquire Roast Ltd in order to increase its workforce and in attaining a competitive edge against
their rivalry that is Costa. Moreover, this acquisition will be beneficial for Starbucks in order to
gain a leading position in the market through achieving economies of scale within the operations
so that higher profitability could be gained. Though the cash flows of Roast Ltd. Resulted as
negative but the it has sufficient assets through which the company could recover its debt
obligation in an effective and efficient way. During the case study all the figures showed a
considerable profits in year 2018. All the activities were enhanced by companies using
appropriate strategies so that the performance of companies could be better from last year.
Company achieved the profits in company year and increase were considerable from previous
year. Though company has showed increased profitability but it has negative cash flows the year
that is a area of concern and company has to focus over turning the cash flows to positive. If the
cash flows are not made positive it can affect the business sometimes to even shut down.
PART 1 : Industry Review
Cafe and coffee shop industry includes every specialists unlicensed establishments which
have focus over sale of coffees, adding to cold and hot drinks and light snacks. Industry
performance is driven both by economic as well as social factors. It includes growth of
disposable income of real household, preferences of people have driven from social venues and
increased consumers interests in coffee blend and origins. Over the recent years industry is
performing strongly well because of increased demands. Coffee culture is becoming very
popular in between the consumers (Lang and Stice-Lawrence, 2015). Over five years by 2018-19
revenues of the industry is expected to raise at compounded annual rate of 4.8 percent, inclusive
current years growth of 1.9% for reaching £ 6.6 billion. Companies holding the greatest market
share in Cafe and Coffee shops in UK are Pret A Manger, Costa Ltd, Starbucks Coffee Company
Limited and Caffe Nero Group Holdings Ltd. They are the major players of the industry but Cost
is ranked highest with 2121 number of outlets in nation that is followed by Starbucks with 898
outlets and Caffe Nero with the 650 stores.
Challenges and Opportunities
1

 Minimum wage change can have significant influences over profit margins. Minimal
wage is expected to raise in 2018/19 that can threat profit margins of the industry.
 Depreciation of pound will make the purchases through imports more expensive for the
industry weighing over the profits of company.
 Household expenditures over beverages and food are also including cafe and restaurant
products. Few of these expenditures will be supporting industries for competing with
coffee and cafe shop industry.
 Spendings over non alcoholic beverages are tend to rise in the years that will present new
opportunity for the industry operators.
PART 2 : Business Performance Analysis
2.1 Analysis of Statement of Profit or Loss
Key observations drawn from Profit or loss statements for the year ending 31 December 2018 are
discussed below.
Sales and gross Profit
Company has performed exceptionally well during the current year. The opening of new
outlets has helped the company to increase its revenues. Costa has raised the revenues by 25.32
% from past year. Increases are seen due to the new opening stores in the country with new
products and services with completely new and unique Italian taste. The growth of the company
in revenues in present year is very significant with the new strategies adopted by the company
for attracting the customers. Company is having large customer base that is increasing every year
due to the raising trend towards the cafe culture and increase in in household income of the
consumers.
The gross profit margin of the company has decreased by 16.04%. Margin of the
company during year 2018 is 21.47% which was 25.57 % in year 2017. The decline if in gross
profit margin is seen as the import cost have made the purchases costlier. This has increased the
costs of the product but the company has not transferred the costs to the consumers yet therefore
despite of increase in revenues, the gross profit margin of the company has gone down.
Another factor that may have lead the margins to be lows may be the heavy discounting
for the promoting the sales in new areas and outlets with new product ranges. It is to be
considered that whether the promotional strategies of the company has worked as against its
2

revenues. Net profit margin of company for the present year is 5.01% where it was only 2.52%
in year 2017.
The profit margin of company has increased by 98.7% company has been able to have growth in
the net profits even after the decrease in gross profits.
2018 2017
Operating Expenses £'000 £'000 Change
Employee expenses 227.7 269.9 -15.64%
Directors remuneration 35.1 51.8 -32.24%
Bad Debt charges 7.9 5.3 49.06%
Utility costs 22.8 26.2 -12.98%
Legal and Professional
fees 3.6 28.7 -87.46%
Depreciation charges 31.7 20.9 51.67%
Store maintenance 72.2 27.6 161.59%
Distribution costs 29.2 8.9 228.09%
The revenues of the company has increased from last years that has left enough amount wit the
company to carry out its operating costs. Revenues of the company has increased where the
operating expenses of the company from previous years have decreased comparatively. The
employee expenses of company have reduced by 15.64% in 2018. A Human Resource and
Marketing director of the company has resigned from the company and the role has been
combined with Chief executive director of the company Paola King. This reduced the cost of
company as the chief was given role without any additions because of which the director
remuneration of the company reduced by 32.24%. Company for increasing the revenues granted
many of its product on credit, that helped the company in grabbing new markets and customers
but the credit sales increased the bad debts by 49.06% from last years that is £ 79000 in year
2018. Utility cost of company has reduced from last year.
Last year company filed a law suit against Caffe Tostato for stealing and copying various
brand designs of Roast Ltd. The results were in favour of the company and Tostato would be
paying £25 million for legal costs and the £45 million for damages. Therefore this year the legal
cost of the company has reduced by 87.46%. Company during the years purchased new plant and
equipments as company has opened new outlet in number of regions of the country. Therefore
the depreciation cost of the company has increased by 51.67% from previous year. The new
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outlets ans increased inflations of the company has increased the store maintenance and
distribution cost of the company. For maintaining the stores company has hired new employees
and purchased and renewed the existing warehouses of company. Products to be available in
easy reach of the company it has collaborated with new distribution channels now the customers
can buy their products over the online platforms. Now the products of the company are available
at the doorstep of the consumers because of these distribution channels.
Other major reasons behind the increased profits were decreased heat and power charges.
Company has outsourced many of its business support areas inclusive of human resources,
payrolls, finance and customer support teams. These all the above factors have contributed to
raise the profit margin of the company.
Return over capital employed of company for the year 2018 is 8.80% which was 5.01%
in year 2017. It showed a increase of 75.50% due to other operating income of 60 in current year.
Company has generated return higher than previous year that will enable the company in
attracting new investor towards the outlet. It is essential for company to earn adequate return
over its capital employed for having growth in the business. If company is no able to earn
enough return over the capital employed that represent the inefficiency of company to make
effective utilisation of its resources. Company can further increase its return by disposing off the
surplus assets and inefficient that are not generating much revenues for the company. Company
shall adopt for new promotional and marketing strategies current year being initial for the new
outlets therefore the low pricing helped company in grounding its roots. But gradually company
should increased its prices for getting high returns over its capital employed.
Return on equity of the company has increased by 103.81% to 9.42%. Company has seen
increases as its profits after tax are increased where the equity capital of the company have
remained constant during the year. The increased return will create new base for company ion
the market. Company will be able to raise more funds through financial leverage and equity
capital for the expansion plans.
2.2 Analysis of Statements of Financial position
Reviewing the financial position of the company following analysis has been made.
Gearing and liquidity
2018 2017
4

Current Ratio 1.45 2.51
Quick Ratio 0.48 1.64
Debt /Equity 31.98% 12.84%
Gearing 24.38% 11.38%
Interest coverage 4.88 8.5
Company is growing with an enormous speed and is showing considerable growth fro the
past year company has struggled through various issues in the past year. Liquidity position of the
company could be measured using the liquidity ratio of the company. Current ratio of the
company present the ability of company to meet its short term obligations with the current assets.
Current liquidity ratio of company is 1.45 where it was 2.51 last year in 2017. The liquidity
position of company should be strong as company is a service industry it company should have
strong liquidity position. The standard current ratio is 2:1 where ratio of company is below the
standard level. Company had strong liquidity position last year. This year the decline is seen as
company is running negative in cash. Trade payables of the company have increased this year
and also the negative cash has raised the bank overdraft that is current liability of the company.
Current assets of the company have not raised as that of its current liabilities. Weak liquidity
position could be very dangerous for the company.
Quick ratio of the company measures the liquidity position of company excluding the
inventories of the company. Inventory by many investors is not considered to be current asset as
does not have the ability of generating quick cash for the company when required. The inventory
of the company could not be sold in market instantly therefore it is not a liquid asset. The
inventory of the company for the year is £299 that is high amongst the current asset. Quick ratio
of company is 0.48 that is very low in comparison to previous year. Last year inventory of the
company was only 120 as number of stores were less and also the cash balance had sufficient
funds for the company. The liquidity position of the company has gone down this year and
company as against these are required to take considerable steps for making strong liquidity
position of company. The trade payables of company has raised very high company should lay
policies for ensuring that the payments are made on time.
Debt-equity ratio of the company this year has raised to 31.98% with an increase by
149.10%. company has increased the debt from previous year £175 which were raised for
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implementing the expansion plan and purchasing new equipments for the outlets. The trends are
within the industry average that are high as 40-50%. Company do not raise funds from the
market every year and the loans will be repaid within few years. This does not affects the
position of company. Gearing ration of the company is 24.38% it will be reduced when the debts
of company will be repaid. Company can face significant problems in repayment of the loans as
it is already running negative in cash and that is a great matter of concern.
2.3 Analysis of Cash Flows of company
Cash flows of the company
Company had a opening cash balance of £134 that has gone negative in the current year
to £73. These variations are seen mainly due to working capital and the substantial capital
expenditures. The cash expenses of the company have increased as this year increased borrowing
has increased the interest expenses of the company from previous year. Due to increased
revenues also the company had to pay income tax of £ 20 for current year. Major expenses of the
company has occurred due to purchases of plant property and equipments for the new outlets of
company. All theses expenditures of £ 358 were paid in the current year. Where the company
has not disposed any asset for the year. This dis balanced the cash position of the company.
During the year it raised long term loans of £175 for carrying out the expenses. There are cases
where company is showing an increase in profits and is having negative cash flows. This can
have negative impact over the market position of the company. Suppliers may stop supplies on
credit and the investors may start withdrawing their investment for being on the safer side. This
could significantly affect the company and its future operations. Though it is seen the cash will
be turned positive as it may not purchase PPE for next year. It is essential for company to give
proper disclosures for going negative in cash balances.
Working Capital management
The net working capital of the company that are defined as inventory + receivables –
trade payables (299+148-235) that is £212 in 2018. It shows that company is showing increased
working capital tied up. This could be explained more clearly by cash operating cycle of
company.
2018 2017 Change
6

Inventory days 55 29 26
Receivable days 21 17 5
Payables days 43 33 10
Operating Cycle 33 12 21
The cash operating cycle of the company has increased from 12 days to 33 days. Reason
for decline in cash balance is including the faster payments to the supplier of raw coffee (Cristea,
2017). Payments has been fastened by the company as it imports for foreign countries and delay
in payments results in interest changes that costs high because of the exchange rate differences.
Company has increased the payable period from the last year by 10 days but requires to be
extended further maintaining the conversion during its expansion plan. Receivable periods of the
company have also been increased by 5 days but this essential for creating the base in market.
For having the bargaining capacity company is required to make quick payments. Seeing the
liquidity position of the company it would be challenging tasks to get increased supplies for new
outlets. Concerns are serious as against the inventory period as it has increased from 29 days to
55 days. For delivering higher efficiency over its assets base company is required to have higher
sales volume by discounting policies or lower margins. Inventory is required to have faster
movements for having high margins with low volumes.
Dividend policy
Last year the dividend of company was £30 when the profits were £36 and this profits
are £81 than also company has not paid any dividend this year. Dividend coverage is around 1.2
last year. The dividends are essential as investor make investments for earning returns. This year
company did not paid the dividend. The decision of not paying dividend was right and accurate.
Company is going through an expansion that requires funds and if the funds are distributed in the
form of dividends company would be required to borrow more funds from the outside sources.
Also the company is running out of cash this year. Payment of dividend would have required
more cash funds and that would have caused the cash balance to go even more down. Therefore
the decision of company of not paying the dividend is viable as per current situation and
circumstances.
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PART 3 : Investment Appraisal
3.1. a Management Forecast
Roast ltd is planning to expand it business to new region of the nations for which it
requires loans of £500 million. The company is planning to purchase new coffee machines from
the Italian Supplier. The Italian technology will in coffee machines will give an immense
experience to its customers. It would be more beneficial for the company if it starts with phase
two of its strategies. The management should not go with the first phase as the sales starts in
January. Till then company can make its business stable by the new machines it is planning to
adopt. Management will be requiring the initial investment of around £ 500 million. For raising
the funds company can raise funds through banks as it has shown high growth in year. The banks
provide loans on the profitability and liquidity of business. Profitability is seen but company has
gone negative in cash balances. Therefore it would be a difficult task for the company to raise
loan through financial institutions.
Management forecasts that Net present value of the investment will be £ 110 million if
discounted taking 5% as the base rate. NPV of the project is positive but the discounting rate of
the company is too low that shows high profitability. This not may be the case in actual
situations. The average rate of return in company do not consider the time value of money
therefore it could not be relied blindly by the company. The average rate of return is 18% where
the target is 10%. The returns are considerably high as it does not considers time value.
Management also forecasts the pay back period of 4 years. Pay back period of company is very
high where benefits are derived only if pay back period is low. Company will not earn sufficient
returns if the pay back period is less.
3.1.b Investment Appraisal Techniques benefits and limitations
Net Present Value
Advantages
 It represents whether company will exceed the initial investment of cash or not at present. It takes into account time value of money and factors risks.
Disadvantages
 There are not set guidelines for determining required rate of return.
 It cannot be used to compare projects with different sizes (Crowther, 2018).
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ARR
Advantages
 It is easy to calculate and for understanding and considers total profits over the entire
period of economic life cycle. Method considers accounting concept of profits for calculation of accounting rate of
return.
Disadvantages
 Time factor is not considered in this method.
 The method do not considers the external factors affecting the profitability of the
company.
Pay Back Period
Advantages
 It is simple and easy to understand method. The method is most beneficial in case of uncertainty.
Disadvantages
 This method also ignores time value of money(Williams and Dobelman, 2017).
 The method do not covers all the cash flows and ignores profitability.
3.2 Sources of Finance
Equity finance
Equity financing refers to process of raising capital by selling shares of company in the market.
Advantage
 The equity finance is committed to the business and is intended for the projects it is
planning to expand.
 Company is not required to pay back the finances as shareholders are given ownership in
the company. Company can get capital from the market more easily as compared with other sources
(Nielsen, Roslender and Schaper, 2016).
Disadvantages
9

 It involves high cost to the company to raise funds from market.
 Shared ownership lays more pressure on the business that can intervene the operation of
company.
Bank Borrowings
Bank borrowings are raised by company for financing the projects as well as for meeting short
term business requirements. Banks provide different kinds of loans for working capital, fixed
assets and for investment appraisals.
Advantages
 Company are payable at fixed periods at fixed instalments. They are not required to be
paid on demand.
 Loan can be availed by the company as they are available on charge over assets. Fixed interests rates allow the company to make budgets in previous so that they are not
required to make disturbance in their present cash flows in between (Robinson and et.al.,
2015).
Disadvantages
 Banks charge high interests for the long term loans and have to be paid at fixed time
intervals otherwise companies are required pay high interests.
 The assets of company have charge, that could be sold by banking case of failure to repay
the bank loan
Recommendations
Roast ltd based on its current financial position should go for equity financing as it will
provide funds to the company for its expansion plan without any interests payments and extra
costs. Loan will be a difficult option for the company as company has a negative liquidity
position of company.
10

REFERENCES
Books and Journals
Williams, E.E. and Dobelman, J.A., 2017. Financial statement analysis. World Scientific Book
Chapters. pp.109-169.
Robinson, T.R. and et.al., 2015. International financial statement analysis. John Wiley & Sons.
Crowther, D., 2018. A Social Critique of Corporate Reporting: A Semiotic Analysis of Corporate
Financial and Environmental Reporting: A Semiotic Analysis of Corporate Financial and
Environmental Reporting. Routledge.
Cristea, A.M., 2017. The Content and Quality of the Information Contained in the Financial
Statements. Hyperion Economic Journal.5(4). pp.17-20.
Lang, M. and Stice-Lawrence, L., 2015. Textual analysis and international financial reporting:
Large sample evidence. Journal of Accounting and Economics. 60(2-3). pp.110-135.
Nielsen, C., Roslender, R. and Schaper, S., 2016, March. Continuities in the use of the
intellectual capital statement approach: Elements of an institutional theory analysis.
In Accounting Forum (Vol. 40, No. 1, pp. 16-28). Taylor & Francis.
Grant, R.M., 2016. Contemporary strategy analysis: Text and cases edition. John Wiley & Sons.
11

APPENDIX
Statement of Profit or Loss for Harridges Ltd for the year ended 31 December
Particulars 2018 2017 2018 2018 2017
£'000 £'000 Evol'n % of Sales % of Sales
Revenue 2534 2022 25.32%
Cost of Sales 1990 1505 32.23% 78.53% 59.39%
Gross Profit 544 517 5.22% 21.47% 20.40%
Other operating
income 60 0 2.37% 0.00%
Operating Expenses: 477 466 2.36% 18.82% 18.39%
Operating
Profit/(Loss) 127 51 149.02% 5.01% 2.01%
Finance costs 26 6 333.33% 1.03% 0.24%
Profit/(Loss) before
Tax 101 45 124.44% 3.99% 1.78%
Income Tax expense 20 9 122.22% 0.79% 0.36%
Profit/(Loss) for the
period 81 36 125.00% 3.20% 1.42%
2018 2017
Operating Expenses £'000 £'000 Change
Employee expenses 227.7 269.9 -15.64%
Directors remuneration 35.1 51.8 -32.24%
Bad Debt charges 7.9 5.3 49.06%
Utility costs 22.8 26.2 -12.98%
Legal and Professional
fees 3.6 28.7 -87.46%
Depreciation charges 31.7 20.9 51.67%
Store maintenance 72.2 27.6 161.59%
Distribution costs 29.2 8.9 228.09%
Ratio Analysis
Profitability
2018 2017 Change
12

ROCE PBIT 127 51
Equity plus
Liabilities 1443 1017 8.80% 5.01% 75.50%
ROE PAT 81 36
Equity 860 779 9.42% 4.62% 103.81%
Gross
Margin Gross Profit 544 517
Revenue 2534 2022 21.47% 25.57% -16.04%
Net
Margin PBIT 127 51
Revenue 2534 2022 5.01% 2.52% 98.70%
Efficiency
2018 2017 Change
Net Asset
Turnover Revenue 2534 2022
TALCL 1135 879 2.23 2.30 -2.94%
Inventory
Days Inventories 299 120
Cost of Sales 1990 1505 54.84 29.10 88.44%
Receivabl
e Days Receivables 148 93
Revenue 2534 2022 21.32 16.79 26.99%
Payables
payment
period Trade payables 235 138
Cost of Sales* 1990 1505 43.10 33.47 28.79%
Liquidity
2018 2017 Change
Current
Ratio Current Assets 447 347
Current
Liabilities 308 138 1.45 2.51 -42.28%
13

Quick
Ratio
CA -
Inventories 148 227
Current
Liabilities 308 138 0.48 1.64 -70.79%
Operating cash Cycle
2018 2017 Change
Inventory days 55 29 26
Receivable days 21 17 5
Payables days 43 33 10
Operating Cycle 33 12 21
PPE addition
Opening
balance 670000
Depreciatio
n 31700
Less:
closing
balance 996000
So additions
= 357700
Solvency
2018 2017 Change
Debt
/Equity
Interest bearing
debt 275 100
Equity 860 779 31.98% 12.84% 149.10%
Debt
/Equity
Interest bearing
net debt
Equity
* nets off cash
Gearing
Interest bearing
debt 275 100
IBD + Equity 1135 879 24.23% 11.38% 112.97%
Interest Operating Profit 127 51
14

cover /(loss)
Finance costs 26 6 4.88 8.5 -42.53%
Dividend
cover PAT 81 36 0 1.2
Dividend 0 30
Dividend
per share Dividend 0 30
No. of ordinary
shares 200 0.15
15