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Statement of Profit or Loss

Starting with ADF’s top line and we can see the news is not great for the current year with gross revenues down 6.7%. Since almost 94% of total revenues come from milk sales, ADF should really be focusing their efforts there (although calf sales are also down 8.3% for the year). Some combination of lower prices and/or smaller sales quantities are hurting ADF. While the general trend in wholesale milk prices has been downward since the start of 2014 (when prices were about H$0.27 per litre), the decline between 2015 and 2016 has actually been miniscule. Unless ADF’s milk in particular is selling for less than the market rate, it seems then that the issue is likely to be related to the quantity sold.

 

Things get a little tricky if we try to isolate a gross profit for the period as we are not explicitly told what the cost of sales (COS) figure is. The cost of sales figure also impacts some other ratios including payable days, inventory days and the cash conversion cycle. So, what are we do? I see two possibilities here:

 

1. Try to calculate a cost of sales figure. This will involve a degree of subjective judgement as you try to isolate the indirect expenses such as administrative, distribution and sales force costs. 

 

2. Take the operating expenses as the denominator for our ratios

 

For the sake of simplicity, I am using operating expenses as my denominator throughout this analysis. If we reflect on what is typically included in cost of sales: raw materials, direct labour, storage costs, factory overheads, depreciation etc, we can say that very few of the expense items in ADF's P&L would be excluded from COS. There are few pure operating expenses it seems to me in the form of administrative or marketing costs for ADF. If one looks at the profit and loss account of a real-life dairy producer such as the UK's Dairy Crest, you notice that 80% of their expenses are assigned to COS (see page 86). Moreover, while the absolute values are important when it comes to ratio analysis, what is more important is the direction of the trend when comparing one year against the other. Whether you choose option 1 or option 2, make sure to explain which you have opted for and why.

 

While revenue growth has been disappointing, at least operational expenses have been kept in check. As a whole, operating expenses have risen just H$39,739 over the year – that’s an increase of just 1.4%. This may be down to good cost control on the part of ADF or it may just be in line with the generally low rate of inflation witnessed in developed countries in recent years (the OECD rate of inflation for 2015 was just 0.6%). Honing in on some of those big-ticket expenses, and I’m drawn to the purchased concentrates, staff costs and veterinary fees. Purchased concentrates and staff costs together account for a massive 50% of total operating expenses so require special care. It’s notable that both are running ahead of inflation and ADF needs to see why that is. Vet fees have come down almost 5% which is understandable given the fact that ADF has fewer cattle. Could it also partly be down to ADF cutting corners to skimp on pricey vet visits? There is no getting away from that decline in revenues though as we see the operating profit has fallen 40% in one year. Whereas the operating profit margin (operating profit/revenues) was 19.4% in 2015 it’s now 12.4%. So, still reasonably healthy but the decline is worrying and needs to be stemmed.

 

It’s good to see the finance cost for the year come down by almost H$75,000. This is the result of ADF paying off around 22% of its long-term loan and 22% of its short-term loan. However, even though they are paying less in total interest charges, the fact that their operating profit is declining means their interest coverage (PBIT/interest expense) has fallen from 2.1 to 1.6 in a year. Any further decline in revenues and operating profit could see ADF in a situation where it does not have enough to cover its debt obligation. I would urge ADF to negotiate with their lender over their interest rate of 8%. That’s quite high for a long-term loan and as ADF has paid down over H$933,000 of that long-term debt in a year, it’s in a position to go to its lender and make its case as a responsible client who should now get some concessions. Finally, we can see that the net profit margin (net profit/revenues) has come down from a robust 7.7% in the previous year to just 3.7% in 2016.

 

Statement of Financial Position

We spoke about the falling revenues and the likelihood being that it’s related to declining sales volumes and when we analyse the non-current assets section of the balance sheet we start to understand just why ADF has suffered sales declines. You can see that assets have been shed in both the livestock section and PPE section. This is an asset-intensive industry - think of the livestock, land, milking equipment, sheds, machinery etc needed to churn out these products. We see a fall of almost H$1m in these combined illiquid assets over the year which is almost matched by the decline in long-term debt. It seems the Anderson family has been eagerly lightening its asset-base to pay off that stock of long-term debt. It’s come at a cost though it seems, as the revenue figures show.

 

Current assets are very light in comparison and again, that is typical for the dairy industry. Anything more than a minimal amount of inventory would be tragic for the company – we’re talking about milk after all! It quickly spoils and ADF can’t afford to have it sitting around which is why their inventory days ([inventory/cost of sales] x 365) stands at just 5 days in both 2015 and 2016. I’m slightly concerned by the low bank figure of just H$64,735. ADF is unlikely to be able to make any kind of significant investment with that kind of cash considering the types of capital outlay needed to run a farm. The pre-seen states as much on the introductory section of Kevin Docherty’s business plan for a more sustainable organic farm (see page 18 of the pre-seen). We are told there that the Anderson’s “…have neither the time nor the wealth to become directly involved in managing or financing his farm”. As a consequence of being so short on cash, ADF may miss out on all sorts of interesting opportunities and may get left behind by competitors. Receivable days ([receivables/revenues] x 365) has come down slightly from 24 days in 2015 to 23 days in 2016.

 

Turning to equity and non-current liabilities and what stands out of course is the big drop in that long-term loan of H$933,333. Whereas in 2015 ADF had gearing (long-term debt/equity) of 39%, that now stands at just over 30%. ADF deserves credit for reducing their financial risk by deleveraging and the fact that they pay a high interest rate probably means they are in a hurry to pay down the loan as quickly as possible.

 

Finally, we come to current liabilities. Again, we find evidence of ADF’s solid efforts in deleveraging with the short-term loan coming down by close to H$67,000 in a year. Payable days ([payables/cost of sales] x 365) remain flat at 20 days and unsurprisingly, is lower than receivable days. It's unsurprising due to the power of ADF's supermarket buyers who can delay paying an independent farm like ADF for as long as they wish. We notice that overall current liabilities exceed current assets. ADF’s quick ratio (current assets - inventories/current liabilities) stands at just 0.6 in 2016 which is below industry norms which Reuters puts at 1.1 and Biz Stats puts at 1.12. There are two reasons that ADF lacks sufficient short-term assets to cover its immediate obligations: lack of cash and high short-term debt. We spoke of the lack of cash earlier and undoubtedly the declining revenues will affect cash coming in and could exacerbate what is an already worrying cash position. While ADF is making headway with the short-term loan, why not remove that particular problem altogether? ADF could do so by rolling that short-term debt up into its long-term loan while in talks with the bank over its current interest rate. Restructuring its debt would leave its working capital (current assets-current liabilities) in a healthier state and since long-term debt tends to attract a lower interest rate too, it would work out for ADF on that front too. 

 

In conclusion, ADF needs to see sales growth and it needs it soon. I applaud ADF’s efforts to get their firm on less risky financial ground by paying down debt but they need to take care that they’re not depleting or selling off too many valuable assets. By lightening its asset base they have fewer resources with which to generate revenues. Essentially, they now need to either make more with less or move to higher value products such as organic milk that could command higher prices. That would require investment of course which leads us to the next problem: cash. The company could do with building up its cash reserves. Over the medium-term that's strongly linked to the sales they can generate but refinancing their debt (moving more costly short-term to long-term loans) and obtaining a lower interest rate would help in the short-term.

Keep an eye out for further upcoming articles on the Nov16 Strategic Case Study!

YES PLEASE!