The November 2017 Management Case Study introduces us to ZedEx (ZX for short), an office furniture manufacturer based in the northern European fictional country of Kordia. ZX is a privately-owned manufacturing company operating in what seems like a high-cost location where stringent government regulations make conducting business profitably more difficult, especially compared to lower-cost, overseas rivals. VIVA Financial Tuition has been examining the financial statements presented in the pre-seen document, and below we outline the main findings.
The statement of profit or loss indicates that in spite of positive revenue growth of 5%, ZX's financial performance has not been great in 2016 with net profit declining by almost 19%. This drop in profitability is caused by costs rising at a faster rate than revenues, more specifically, cost of sales. Cost of sales is by far the largest cost category for the company and it grew by 10% in 2016. Either the cost of material inputs, labour and production overheads have risen quite drastically thus causing cost of sales to rise by so much, or the company is selling more units of its furniture goods than in 2015, but at lower prices. It may well be a combination of both effects, but there is reason to believe that downward pressure on prices is playing a bigger role in flattening profitability. We are told in the pre-seen that in the office furniture segment of the market in Kordia there has been price pressure in recent times due to overcapacity and a large number of furniture manufacturers. There is also the fact that cheaper, overseas manufacturers have been making headway in recent times. Added to all this is the fact that ZX and their rivals in the office furniture segment are dealing with large corporate clients with significant buyer power, and you can see why maintaining high prices in such an environment might be challenging. This is problematic for ZX due to the fact that they have high costs built into their offering given the highly skilled workers they employ and customised service they offer to their clients.
When we turn to the statement of financial position, we note that the company seems to be investing for the future with capital employed (equity + non-current liabilities) rising by 40% in the last year. This investment has not been matched by higher returns however, with return on capital employed ([PBIT/capital employed] x 100%) falling from 70% in 2015 to 45% in 2016. ZX takes a fiscally conservative approach with absolutely no debt present on the balance sheet. This means there is plenty of room for the company to take on debt funding should they need to make any big investments in the future. This financial prudence is also demonstrated by the fact that they opt to keep liquidity high. The current ratio (current assets/current liabilities) rose from 1.9 to 2.4 in the last year. Cash rose by 10% and trade receivables rose reasonably modestly when compared to total revenues. However, there are indications that inventory may be becoming a problem, as they rose 72% in 2016 with inventory days ([inventories/cost of sales] x 365) going from 20 days in 2015 to 31 days in 2016. In fact, the management accounting information we come across later in the pre-seen shows the trend continue into 2017, with inventory days rising again, to 38 days. We are told in the pre-seen that the company keeps plenty of inventory on hand to fulfill client orders promptly by starting production as soon as orders are sent to the manufacturing department. ZX would do well to investigate whether they can operate under a just-in-time system with supplies being sent to the production facility only when needed. It may well be the case that current local suppliers are not able to fulfill this need, however, in which case they may need to start looking elsewhere for supplies.
Interestingly, we are also presented with the statement of profit or loss for ZX's main rival in Kordia, RiPlan. It's clear that RiPlan has performed very poorly in 2016 with revenues falling almost 5% and a net loss being made by the company. They are surely losing market share and it may well be that aggressive rivals like ARM are stealing custom from RiPlan, given that company's ambitious projections of 20-25% growth in the coming year. It's also noticeable that RiPlan seems to be carrying a lot of debt due to the high interest expense figure on its statement of profit or loss. RiPlan's interest coverage (operating profit/interest expense) has declined from a comfortable 9.0 to just 1.2 in the past year. RiPlan is now barely able to service its debt obligation.
In conclusion, there are indications of a challenging market environment with many competitors fighting it out for clients with high buyer power. Add to this the fact that cheaper overseas manufacturers are growing in prominence and ZX has reason to worry. The company does have room to grow if they plan to make big investments as they can take on long-term loans easily. They would do well to get on top of their growing problem with inventory by looking to work with suppliers who can help implement a JIT system. Other than that, ZX could look to substitute in cheaper materials and they could also look to source more materials from lower-cost, overseas suppliers if it doesn't affect their inventory figure. Other than that, the company should continue to emphasise high quality and customer service in an attempt to justify higher prices...
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