The August 2017 Operational Case Study introduces us to Premium Trains, a train operating company in the fictional country of Tawland. In this article, VIVA Financial Tuition will walk you through the main financial statements given in the pre-seen materials by CIMA. We'll look at some of the most telling movements over the last year as well as analysing some key financial ratios.
Starting with the Statement of Profit or Loss and Other Comprehensive Income for 2017 and we note that while revenues have risen 3% since 2016, operating costs have advanced more rapidly. The fact that operating costs increased by just over 6% in 2017 means that net profit shows a 27% decline in the current year. The different elements that make up operating costs are detailed underneath the income statement and we can see that almost 74% of the total T$13,046,000 increase in operating costs comes from one element, the ambiguously titled "other external charges". We ascertain from the budget information for 2018 presented later on in the pre-seen, that other external charges are made up of such items as train leasing costs, train maintenance costs, insurance, marketing expenses and administrative expenses, as well as the cost of goods sold relating to the on-board cafe. It's a little frustrating that we are not presented with more detail on the individual increases for each of those individual costs but it would not be surprising to see that train maintenance costs are becoming problematic given the fact that the company's stock of own trains is over 25 years old. One would also imagine that insurance costs for an older stock of trains more prone to breaking down and presenting faults etc would be quite high. We know that management of the on-board cafe's inventory lacks rigour, with staff simply casting an eye over existing inventory and applying their own subjective judgement in re-ordering inventory when they deem it to be too low. So it's likely that COGs for this area has been rising recently.
Unsurprisingly, profitability ratios have declined between 2016 and 2017. It's difficult to calculate the gross profit margin ([gross profit/revenues] x 100%) as we cannot isolate an overall cost of goods sold figure. We can see that the operating profit margin ([operating profit/revenues] x 100%) has fallen from 10% in 2016 to 7% in 2017. Furthermore, return on capital employed ([profit before interest & tax/capital employed] x 100%) has declined from 56% in 2016 to 40% in 2017. This decline is due to the fact that obviously operating profit has declined but is also because Premium Trains has taken little effort to expand its non-current asset base in the past year. This leads us nicely to analysis of the Statement of Financial Position...
It's obvious from the first line of the Statement of Financial Position that Premium Trains has a fast-depreciating stock of trains. The overall value of property, plant and equipment has declined by just over T$5 million in 2017. We know that Premium Trains owns 15 of the 25 train units it operates and that their own trains have been in use since 1991. We also know from various articles at the end of the pre-seen that customers value modern trains and those companies that have invested in modern train units (e.g. East Trains and Northstar) have reaped the benefits of enhanced custom and market share. Current assets on the other hand, have seen an overall increase of 31% in 2017 with trade receivables and cash accounting for most of this upward movement. Given that payables have fallen by T$580,000 and we have a change in the current ratio (current assets/current liabilities) from 1.8 in 2016 to 2.5 in 2017 signalling a liquid, if financially conservative company. Premium Trains needs to take a little care with its receivables figure. We know that Tawland Rail, the government-run agency that manages Tawland's tracks and stations, often ends up settling amounts due to Premium Trains 60 days after payments have been processed whereas Premium Trains typically settles amounts due to its own suppliers 30 days after the invoices are issued. The fact that the cash position has more than doubled in the last year again points to a company that is holding back on investments.
In summary, Premium Trains is likely to struggle in generating additional revenues in the short to mid-term due to the fact that cannot expand beyond the two routes it has the franchise rights to run. Moreover, it has limited control over its pricing, with Tawland Rail approving or rejecting proposed prices. All of this means that in order to improve profits Premium Trains needs to control its costs more effectively. It would also be wise for Premium Trains to either invest in the purchase of newer trains or simply lease more of its trains (we are told in the pre-seen that its leased trains are much more modern). The company is in danger of falling into a vicious cycle where a lack of investment leads to lower revenues and profits, which in turn means there is less to invest in much-needed non-current assets.
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