Unit 2: Business Risk - Caribbean Association of Banks

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Credit Skills Academy !!!!!!

Executive Briefing

Unit 2: Business Risk

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Business Risk Managenetakeven Analysis

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Senior authors: Keith Checkley FCIB, FCIBS and Keith Dickinson FCIB

The authors have taken all reasonable measures to ensure the accuracy of the information contained in this topic and cannot accept responsibility or liability for errors or omissions from any information given or for any consequences arising.

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© Keith Checkley & Associates, November 2013

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means – electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing .

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Welcome to the Credit Skills Academy.

There have been previous financial crises but this time it is the severity and global impacts that are very different from what we have seen before. Never have banks and lending bankers received greater criticism over the quality of their lending than at the present time.

Media comment suggests that prudent lending principles have been disregarded in the quest in recent years for increased lending volumes and enhanced short term profitability. Analysts suggest that many of the prudential canons of lending have been overlooked and many lending bankers would benefit from a reconsideration and review of well tested and accredited lending principles. It is against this background that the Credit Skills Academy has been developed.

The modules in this Academy have been prepared to allow you and your colleagues instant access via e-learning and may be accessed as individual topics in which you are interested. We believe that they will also make an excellent basis for discussion with colleagues for mutual benefit.

We do hope that the extensive range will help you in your everyday job and also as someone interested in self development in the important area of Credit Skills.

Keith Checkley FCIBS and Keith Dickinson FCIB Senior authors


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Business Risk !!!!!

• The Wheel of Corporate Strategy

• Utilising SWOT analysis

• Industry Identification

• Three Principal Strategies

• Non financial Analysis framework

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THE EFFECTS OF BUSINESS RISK !

!INTRODUCTION!!A Corporate Manager in his assessment of corporate cash flow will inevitably, as part of the overall analysis need to understand the company's competitive position; it's strategy and its resultant business risk effect on cash flow needs. Every company has a strategy; be it express or implied. Express strategy will normally be well defined and be the result of a structured planning process. Implied strategy on the other hand will be the result of different business units pursuing different (and sometimes conflicting) strategies. The combined result is very often unclear and can cause severe cash flow distortions. A good starting point in the assessment of corporate risk could be to undertake a general review on how the Corporate’s strategy has been formulated. DIAGRAM-THE WHEEL OF COMPETITIVE STRATEGY

Target Markets

Marketing

Sales

Distribution

Labour

Purchasing

Research and Development

Finance and Control

Product Line

Definition of how the business is to compete

GOALS Objectives for profitability, growth, market share, social responsiveness etc.

Manufacturing

Ref: Andrews !!The Wheel of Competitive Strategy is a device for expressing the main aspects of a Corporates competitive strategy in summary format. The centre illustrates the Corporate objectives and then goes on to state how the Corporate is going to compete. The spokes of the wheel are operational factors by which the Corporate intends to achieve the "centre “objectives. Within each spoke a summarised statement of intent is required. The designer of this wheel concept states that" for the Corporate to progress effectively, not only must the policies radiate from the centre, but also each of the spokes must link smoothly together". The next step is ask what considerations are needed in formulating the centre statements for the wheel?


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7!The most frequently used model is to undertake a SWOT analysis. As discussed within Unit 3 of the Foundation level course: SWOT stands for Strengths, Weaknesses, Opportunities and Threats. In carrying out this type of assessment of strengths and weaknesses we are undertaken an internal audit of the corporate and in evaluating opportunities and threats we are then carrying out an external review of the market place in which the corporate is currently operating. Strengths/Weaknesses When looking at the strengths and weaknesses of a business, a lender will concentrate on an internal view of the performance of the business. There are a range of factors internal to any business, which will affect performance. The following illustrate the sort of topics, which can be reviewed, although this list is not exhaustive: Management What is the level of management skills?

What is the level of expertise and experience? Capital What is the liquidity, profitability and asset structure of the

business? Accounting Records How well informed is management about the financial

position? How good is the information produced? What book-keeping systems are in operation?

Marketing How many customers are there/What market share? Who are the main competitors?

Product How new is the product, what is its life cycle? What are the volumes sold and what is the value?

Premises What is the condition of the premises? How suitable are they for present/future needs? What is their location?

Plant Machinery What is the current condition of the machinery? What is the replacement policy

Labour What is the quality of labour? How good are labour relations?

Stock What are the proportions of raw materials, Work in progress and finished goods? Any obsolete stock?

Opportunities/Threats When looking at the opportunities and threats which face a business, a lender will concentrate on the range of factors external to the business which can influence performance. These can be factors over which the business has no control. However, an understanding of the extent to which these factors can affect a business can be vital in assessing accurately the quality of the business and the ultimate credit risk. The following illustrates the issues, which can be covered, but again this list is not exhaustive: Competitiveness What is the level of competition? Economic Changes What will be the impact of economic changes. Most firms are

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8!affected by pressures from business cycles, exchange rates, interest rates and inflation.

Social Changes What will be the impact of changes in demographics, lifestyle etc. Changes in the birth rate, the number of children per family and the average age of the population may affect a business’s market. Trends in social and cultural patterns can have unpredictable effects on business e.g. Food Producers reacting to trend towards health-consciousness.

Political Changes What will be the impact of changes in government legislation? Technological Changes

What new technological developments will affect the business? Some businesses may be faced with obsolescence of major assets as better processes are developed.

Ecology Ecological “friendliness” had become on of the most visible influences on business activity in recent years. e.g. firms which discharge high levels of effluent face greater fines than before and consumers are more biased towards eco-friendly products.

Labour Markets Demographic changes and workforce skills can affect the availability of suitable labour.

The use of SWOT is a good structure or non-financial analysis framework to help pinpoint not only the pros and cons of a particular lending situation, but it does help us to focus on some of the external factors, which are very important in larger business lending. These factors can significantly affect your view of the lending risk. Now we move on to some more in depth models which can be utilized where appropriate INDUSTRY IDENTIFICATION As part of this review of the company's individual strategies the Manager must analyse in depth the industry within which the company operates to identify its particular characteristics, features and peculiar risk profiles. The industry structure will have a strong influence in determining the competitive rules of the game - as well as the strategies potentially available to the corporate. Outside forces will usually affected all corporates in the industry and therefore another key issue will be the corporate's ability to deal with external factors. The intensity of competition within the industry will be determined by industry economics as well as the strategies of current competitors. A well known model for looking at industry competition is Porter's Five Forces model and this is a framework for identifying the collective strength or weaknesses of the factors driving industry competition. The intensity of the forces will then in-turn drive the rates of return on capital employed. For example, in industry such as tyres, paper and steel there is high intensity of competition and therefore economics dictate a low return on capital employed. Examples of relatively mild intensity could be oil field equipment, cosmetics and toiletries where these types of industries will generate high returns.


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9! Porters Five Forces Model

Threat of new entrants

Rivalry amongst existing competitors

Bargaining power of buyers

Bargaining power of suppliers

Threat of substitute products or services

Ref: Porter

!!!The five forces to be considered are the external aspects of the bargaining power of buyers, the bargaining power of suppliers, the threat of new entrants, the threat of substitute products or services. The internal forces consist of competitors within the industry being examined. Knowledge of Sources of Competitive Pressure This will provide the corporate with the ground work to develop a strategic action plan. Competitive pressures will highlight the critical strengths and weaknesses of the company and also pin point the company positiwithin an industry. Additionally, it will highlight areas which promise to hold the most significance in terms of opportunities and threats to the corporate. The corporate will then need to decide on what strategic changes can be possible to take advantage of the opportunities or indeed to defend against external threats. Barriers to Entry Economies of scale tend to deter entrants to the industry by forcing the entrant to come in on a very large scale or to accept a significant cost disadvantage within the industry for example, main frame computors. Product differentiation or brand identification will create a barrier by forcing potential entrants to spend heavily to overcome existing customer loyalty for example in the sports shoe industry. Another barrier to entry could be the significant capital investment requirements and advertising programmes that can be needed to carry out an entry programme and this will in-turn require large financial resources together with capital for current asset investment. The Bargaining Power of Buyers Buyers will compete within the industry by forcing down prices and trying to bargain for more services at a higher quality. This in-turn will lead to more competition within the industry. All of this at the expense of industry profitability. The power of the industry's

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10!important buying groups will depend on a number of characteristics within the market situation and also on the relative importance of purchases from the industry in the context of the overall business size. The Bargaining Power of Suppliers Suppliers can infact exert power over participants within an industry by threatening to raise prices or reduce the quality of purchased goods and services. Suppliers with great power can squeeze profitability out of an industry which is unable to recover cost increases by adding on to its own prices. An example of this could be chemical companies which have contributed to the erosion of profitability of contract aerosol packaging because the packages are facing intense competition from self-manufacture by their buyers, accordingly they have limited freedom to raise their prices. In conclusion of this five-force model; then the use of this type of structural analysis can help identify a large number of factors that can potentially have an impact on industry competition. The resulting analysis from the framework will therefore be a useful tool to the corporate manager towards his assessment of corporate risk and it,s susequent effect on cash flow issues. THREE PRINCIPAL STRATEGIES Depending on the corporates positioning with regard to their strategic advantage and also their strategic target; generic strategies tend to fall into three principal types; overall cost leadership, differentiation, and focus.!

S T R A T E G I C T A R G E T

STRATEGIC ADVANTAGE

Uniqueness perceived by the customer Low cost position

Differentation Overall cost leadership

Focus Focus

Industry Wide

Particular Segment only

Ref: Porter

!!!Overall Cost Leadership This type of strategy requires a rigorous pursuit of efficiencies in terms of costs and overheads, volume and efficient systems. Therefore it will be essential for very close managerial attention in order to achieve these efficiency aims. Achieving a low cost position will give defence against competitors and businesses will still obtain profitable returns


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11! although quite fine. It also provides a defence against buyer power trying to force down prices and generally will give a favourable position from which to defend against low cost substitute products or new entrants to the market. Examples, Black and Decker, Amstrad. Differentiation The strategy of differentiation requires the creation of differentiation in terms of the product or service offered by the business. Some examples of design or brand images would be Mercedes Cars, Porche Cars, Caterpillar Construction Equipment. By adopting a differentiation strategy this should lead in-turn to an ability to earn above average returns within an industry. Differentiation should also prove a defence against rivals provided there is customer loyalty to the brand image of the particular corporate. Focus This entire strategy is built around servicing a particular target and all functional policies are developed with this objective in mind. An effective and efficient service to the target will be necessary for success relative to competitors who are generally competing more broadly. A focussed strategy can adopt a low cost position for its strategic target as shown in the diagram or differentiation or a combination of both. IN SUMMARY The purpose of this review of the non financial factors; is to create an awareness of Business Risk and its impact on cash flow requirements. A good Corporate Manager must be able to analyse; identify and understand the company's specific strategy and the competition within the market place to determine cash flow needs and the appropriate financial structure and products to meet those needs. A useful framework for non-financial analysis is shown below.

Non-Financial Analysis

Environmental Variables

Industry Characteristics

Business Overview

SWOT Analysis

• Interest Rates • Inflation • Unemployment • Wage Controls • Population Trends • Lifestyle Changes • Political/Government Incentives • Green Issues

• Relative Attractiveness • Profitability • Competitive Pressures • Market Size • Growth Prospects

• What Business? • Growth Stage • Quality Review/ Location • Development Prospects/ Market Position • Publicity • Human Resources • Financial Resources

• Strengths • Weaknesses • Threats • Opportunities

NON-FINANCIAL ANALYSIS

!!Keep this in mind while analysing the case study. Another useful tool for business risk analysis is to be able to pinpoint at what level a business will make breakeven sales and thus the “margin of safety”. This topic follows. !

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Breakeven Analysis !!!!!!!!!!!!!!Key learning outcomes !■ Explain the effectiveness and list the limitations of breakeven analysis as a credit

risk assessment method.

■ Define fixed costs, variable costs, semi-variable costs and contribution margin.

■ Understand how to use breakeven analysis to examine the serviceability of debt in a particular business profile.


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Introduction !

Breakeven analysis is a generally neglected credit risk assessment method although it is very useful in assessing the business risk profile. Breakeven is the point at which a business makes neither a profit nor a loss, as the total costs are exactly equal to sales revenue. Breakeven is useful in exploring the serviceability of debt, by looking at the margin of safety, in a particular business profile. The concept is that certain business costs will be volume orientated, that is, that they will increase with activity. Certain other business costs will tend to remain fixed or at least almost fixed. Breakeven can be measured in sales (Ks) or sales as a number of units and can be calculated by use either of charts or formulae.

!Definitions

Fixed cost A cost which tends to be relatively unaffected by variations in volume of output.

Variable costs A cost which tends to vary in proportion to variations in output.

Semi-variable cost A cost which is partly fixed and partly variable.

Contribution margin The difference between sales and the variable costs. !!

Breakeven analysis example !!!!

Case study !Company A

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The chart below assumes an even spread of sales income over the year and in this case, the breakeven point of the particular business is Ks 30,000 in output. A good margin of safety, as the breakeven point occurs at 50% of business output, is also illustrated. There is therefore quite a comfortable fall back position.

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LOSS

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Breakeven point

Business Output: $60,000 Variable Costs: $20,000 Fixed Costs: $20,000

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Business Output !

PROFIT Total Costs

Variable Costs

10 Margin of Safety !

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Sales volume (percentage)

!Fixed Costs

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The effect of different amounts of debt could be applied on the graph by increasing the amount of fixed costs. The graph could then be redrawn to see the visible effect on the business’s breakeven point.

Credit Skills Library !

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Materials 3.50

Contract transport 0.63

Sales commission 1.20 !

Office/Admin costs 42,750

Fixed plant and machinery 14,000

Marketing 5,000 Other overheads 8,430 !

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Limitations of breakeven analysis !

Although breakeven analysis is a very useful risk assessment technique and an effective device for testing the sensitivities of business performance, the following limitations must be considered:

• all costs resolve into fixed or variable

• variable costs fluctuate in direct proportion to volume

• fixed costs remain constant over the volume range

• the selling price per unit is constant over the entire volume range

• the company sells only one product or mix of products tends to remain constant

• volumetric increase is the only factor affecting costs

• the efficiency in the use of resources will remain constant over the period. !!!Breakeven analysis example

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Case study !

Company B !

Cost per unit of production Ks !!!!!

Direct labour 4.42

Variable costs 9.75

Other costs per annum !

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70,180 !

Variable cost analysis Contract transport 7% !

Sales commission 12%

Breakeven Analysis !

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Fixed cost analysis Other 12% !

Marketing 7% !!!

Fixed P & M 20% !!!!!!!!!!

In Company B, based on a unit of sale of Ks 19.50, the variable costs totalled Ks 9.75 per unit, therefore the gross profit or contribution to overheads per unit is:

Ks 19.50 – Sale price minus Ks 9.75 – Variable cost

Ks 9.75

This represents 50% of the sale price per unit sold. These figures can be developed into a profile for the company based on different numbers of units sold.

Units sold 0 2,000 4,000 6,000 8,000 10,000

Sales Ks 0 39,000 78,000 117,000 156,000 195,00

Variable costs Ks 0 19,500 39,000 58,500 78,000 97,500

Gross profit Ks 0 19,500 39,000 58,500 78,000 97,500

Fixed costs Ks 70,000 70,000 70,000 70,000 70,000 70,000

Net profit Ks (70,000) (50,500) (31,000) (11,500) 8,000 27,500

Gross profit 0% 50% 50% 50% 50% 50%

Total costs Ks 70,000 89,500 109,000 128,500 148,000 167,500


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Company profile

Fixed costs Ks 70K – G.P. 50% – Sale price Ks 19.50 Total costs

Ks000 Sales 250

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The graph shows costs commencing at Ks 70,000 (fixed costs level) and finishing up at Ks 167,500 total costs on the basis of 10,000 units sold.

The sales line on the graph commences at zero and ends up at Ks 195,000 (10,000 units sold at Ks 19.50 per unit).

The point at which the total costs line and the sales line cross is the breakeven point and is the point where we make neither profit nor loss.

Breakeven occurs at Ks 140,000 of sales or approx 7,000 units. The sales team currently has a planned sales quota of 9,000 units to be sold and therefore the margin of safety is Ks 35,000 of sales:

Planned level of sales (per quota) Ks 175,500 (9,000 units at Ks 19.50) Less breakeven sales Ks 140,000 Net Ks 35,000 (or 20%)

!The Sales Director has suggested that the product price should be decreased from Ks 19.50 to Ks 15.25 per unit. The sales team estimate that the decrease in unit sale price will enable them to increase sales from their 9,000 unit quota to possibly 10,000 units. This suggestion will not affect any of the costs per unit, except sales commission.

The current unit cost is as follows:

Materials Ks 3.50 Contract transport Ks 0.63 Sales commission Ks 1.20 (6.2% of unit sale price) Direct labour Ks 4.42

Ks 9.75 (50% of product sale price)

Sales commission will decrease to Ks 0.95 on the new sales price of Ks 15.25. The resultant unit cost is Ks 9.50 or 62.3% of the product sale price.

Fixed costs Ks 70,000 Variable costs as % sales 62.3% Unit sale price Ks 15.25

Units sold 0 2,000 4,000 6,000 8,000 10,000

Sales Ks 0 30,500 61,000 91,500 122,000 152,500

Variable costs Ks 0 19,000 38,000 57,000 76,000 95,000

Gross profit Ks 0 11,500 23,000 34,500 46,000 57,500

Fixed costs Ks 70,000 70,000 70,000 70,000 70,000 70,000

Net profit Ks (70,000) (58,500) (47,000) (35,500) (24,000) (12,500)

Gross profit 0% 37.7% 37.7% 37.7% 37.7% 37.7%

Total costs Ks 70,000 89,000 108,000 127,000 146,000 165,000


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As evidenced by the above table, even at the new suggested sales volume of 10,000 units at a unit sales price of Ks 15.25, losses would still be incurred.


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The following graph shows that the gap between total costs and sales is narrowing, but breakeven is not reached.

!Fixed costs Ks 70K – G.P. 57.7% – Sale price Ks 15.25

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Using a breakeven formula !

A mathematical formula !

! Breakeven sales = Fixed Costs !!!then

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Breakeven sales

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G.P.% (or contribution margin) Ks 70,000

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!The required breakeven sales level is Ks 185,676. Using the proposed sales price of Ks 15.25,

a new sales volume of 12,175 units would be required to achieve breakeven.


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Breakeven Analysis !!!!!!!

Review !

The main points introduced here are:

■ Breakeven is the point at which a business makes neither a profit nor a loss, as the total costs are exactly equal to sales revenue.

■ Breakeven is useful in exploring the serviceability of debt, by looking at the margin of safety, in a particular business profile.

■ A fixed cost is one which tends to be relatively unaffected by variations in volume of output.

■ Variable costs tend to vary in proportion to variations in output.

■ A semi-variable cost is partly fixed and partly variable.

■ Contribution margin is the difference between sales and the variable costs.

■ Although breakeven analysis is a very useful risk assessment technique and an effective device for testing the sensitivities of business performance, it does have some limitations.

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Case Study: Car Developments Ltd !!!!!!!!!!!!!!Key learning outcomes !■ Assess the viability of the case study business from the information presented in

the business plan, taking into consideration the level of funding required.

■ Consider issues relevant to business start-ups and carry out a SWOT analysis of the proposed business project.


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Introduction !

You are an experienced Business Planning Manager and you receive a telephone call for assistance from one of your colleagues. He tells you that his clients, who have had many years experience in restoring vintage cars, have recently built a replica of the Avis car and there is a business plan to go into production of up to 200 vehicles per annum.

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The plan is an ambitious one and your colleague seeks your view on the viability of the business plan and level of funding required. How would you go about making the assessment using the information provided?

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Summary Business Plan !

Objective

Car Developments Ltd was formed in July 1997 with the principal aim of creating a quality replica of the Avis, the last of the traditionally styled I Type Midgets, the traditional British sports car. This two-seater convertible sports car, the immediate predecessor of the Alvor, was produced between 1953 and 1955 with a total production run of 9,600.

!Background and Concept

The original concept grew out of the continuing growth and success of the business, 15 years after its formation as the leading restoration and spares specialists in the world. The sustained expansion of these services identified the existence of a substantial market for the TI Type Avis and it became apparent that this was increasingly the most popular model in the range. The realisation that there must be a finite number of original TI Types available for restoration, combined with an insight into the spiralling costs involved in this work, led to the conviction that an even bigger potential market was waiting to be exploited for a quality replica, not a fibre glass approximate look-alike or kit car.

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The idea began to develop and a design brief was formulated, the main parameters applied to its conception being:

■ In all aspects of its outer appearance, the car should resemble the original as closely as current and known pending legislation would allow. There should be no short-cut compromises (such as the use of contemporary car doors, used very obviously by some, such as Panther) as these would detract unacceptably from the replica’s authenticity.

■ “Under the skin”, however, the car would incorporate the full benefit of the technological advancement of the intervening 30 years, including the use of current Morris power train and running gear (true to the original concept of the founder of Avis) in this case, initially, the 1.7 litre ‘0’ series engine and Ital suspension components though in a system of our own design. Similarly, the interior, due to legislation prohibiting absolute originality, would provide the modern comforts expected of any car in the ‘90’s whilst still evoking that period, for example, leather trim and a polished wooden dashboard but incorporating an interior heater, improved weather protection and even a radio/cassette player.

■ The car would be manufactured using the traditional techniques and materials, including the ash-frame bodies and steel panels, which prevailed in the era of the original IF. It would


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be hand-built, to order, with particular emphasis placed on quality and corrosion protection in order to enhance the car’s longevity and thus its retained value.

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■ To further ensure the car’s prestige and to promote its status as that of an “investment”, the car would be produced in small numbers (200 cars per annum) deliberately substantially below the known market for this type of car. It would be produced in significantly smaller numbers than either Morgan or Panther and carry a price (anticipated launch price in March 2000: $11,998) to reflect the quality applied to its engineering and assembly.

Since the Morgan is an institution in its own right and the Panther merely attempts to evoke an era, the car would create its own niche in the market for convertibles; and there is a healthy resurgence in this market; ironically, following the demise of all BL’s sports cars.

The industry forecasts show the combined sports and specialist sectors holding a steady 0.7% of the total market, represented by 12,250 units in 1999 and rising by volume in line with the growth of the total market. Hypothetically assuming no export sales (the EEC would follow within a year, the US later), 200 units in the UK alone represent a mere 1.6% of this very small sector of the market.

The aim is to create a niche, a demand, then never fully satisfy it. In this way the car would carry prestige and high retained value in much the same way as the Morgan has done for many years, and largely contributing to their success as manufacturers.

■ The car would be built, to order only, in complete form and satisfying all the requirements of EEC and National Type Approval. That is to say that it would not require a pre-registered “donor” vehicle and would not be available in kit form.

!Progress to Date and Present Position

The company has been in existence since July 1997 and has two full-time staff covering all the development work and administration. It presently operates from new, rented premises and a comprehensive set of Books of Account and tight financial and administrative controls have been maintained to enable the company’s financial position to be closely monitored. The systems introduced have been designed to capably expand with the growth of the business.

A study commissioned from an established motor industry consultant has valued, on the basis of a detailed engineering viability review, the development work carried out to date at not less than $100,000.

The first mock-up has been running since October 1997 and is now being extensively tested as the development and durability “test bed”. All aspects of the car’s design and development have been recorded in detail and technical drawings have been made of the components comprising its specification. The second car to be developed will utilise all the established engineering principles carried over from No. 1 but will be used to determine interior layout and trim and more specifically to establish the legislative requirements of National Type Approval.

As an example of the degree of credibility which the project has achieved within the motor industry, direct accounts for component supply have been secured with Unipart Limited and with many other major component suppliers, prices having been negotiated around a take-up level of 200 units per annum. Furthermore, considerable assistance has been given by the product planning and marketing departments of Austin Rover.

Several pre-production vehicles require to be built prior to a scheduled production commencement in December 1999 for launch in March 2000 with a gradual output buildup over 10 months, to the budgeted level of 200 cars per year.

A comprehensive and illustrated Business Plan has been prepared with five year projections of Profit and Loss Account, Balance Sheet and Cash Flow. The immediate priorities now are rapidly to work towards completing a second vehicle for presentation to The Department of Transport for NTA evaluation and concurrently to secure the substantial finance required to ensure the project will come to fruition.

Case Study: Car Developments Ltd !

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Finance

■ Funding of $900,000 is sought for Car Developments Limited Replica Avis Project: !

1 Equity: 19600 Ordinary Shares of $1 each to be issued fully paid !

! at $10.20 per share (representing 49% of the issued share capital) 199,920

2 Loans repayable over periods of 7 and 5 years respectively 550,000

3 Overdraft 150,000 $899,920

■ The Company’s Preliminary Business Plan, drawn up on pessimistic assumptions, assumes that:

1 the prevailing rate of UK inflation during the first five years of the project will be 10% per annum

2 interest will be payable on the Loans and Overdraft at a rate of 15% per annum, payable quarterly

3 the vehicle will be launched during March 2000 at a retail price, inclusive of Car Tax and VAT of $11,998

4 a component wastage and warranty provision of $1,000 per vehicle sold will be required

5 no interest will be received on cash on deposit at the bank.

Under these pessimistic assumptions the forecast return on the $199,920 additional equity to be issued would be at a rate of 9% per annum compound over the first five years of the project. It must be borne in mind in reviewing this rate of return that the first five years bear the brunt of the servicing and repayment of the $700,000 short term funding as is evidenced by the projected profit and loss profile:

Year ending 31st March 2000 2001 2002 2003 2004 Projected Pre-tax profit (loss) $’000 (303.5) 56.5 147.5 194 268

■ Under the following varied, and more optimistic, projection assumptions, the forecast rate of return on the additional $199,920 equity would be 25% per annum compound over the first five years:

1 The launch retail price of the vehicle to be $12,498.

2 The required component wastage provision to be $750 per vehicle sold.

3 Interest of 10% per annum to be received on cash held on deposit at the bank.

■ The $900,000 sought will be utilised as follows:

Fixed Assets Freehold Factory

$’000 $’000 200

Plant and Machinery & Fixtures and Fittings ! 204 Vehicles ! 56 ! ! 460 Development Work ! 175 Working Capital ! 424 !

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Development 58 !Capital Expenditure 92 !Training 9 159

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Car Developments Limited

Financial Forecast Assumptions

A Inflation assumptions - effected on:

1st April 2000 10.0 % 1st April 2001 10.0 % 1st April 2002 10.0 % 1st April 2003 10.0 %

B Production to commence: 1st December 1999

C Launch date: Tuesday 8th March 2000 at the Geneva Motor Show Press Day !

D Car Price Schedule $ Ex-Works ! $ Incl VAT ! ! ! ! and Car Tax ! From Launch 8th March 2000 9,484 ! 11,998 ! From 1st April 2001 10,472 ! 13,248 ! From 1st April 2002 11,461 ! 14,498

From 1st April 2003 12,646 15,998

E Personnel Plan

The Chairman and the Managing Director will receive salaries of $17,500 per annum and the Finance Director $12,500 per annum inclusive of Employers National Insurance.

The salaries of the Draughtsmen-Fitters are computed at an average of $8,000 per annum inclusive of Employers National Insurance.

All other salaried personnel have been incorporated at salaries of $9,000 per annum and wage earners at an average of $120 per week inclusive of Employers National Insurance

F Production Schedule

1st April 1999/30th November 1999 5 Additional Mock-ups 1st December 1999/31st March 2000 20 Production Models 1st April 2000/30th September 2000 80 Production Models

Thereafter production will be at the rate of 4 cars per week (200 per annum).

G The externally sourced component cost of the vehicle including the body is $4,500 per vehicle. Stocks of components ordered monthly and paid for 30 days following receipt of goods.

H A warranty and component wastage provision of $1,000 per vehicle has been provided against Sales Income. This $1,000 provision remains constant and has not been inflated during the period of the forecast.

The timber frame body will be delivered panelled from the existing restoration supplier. !

J Capital Expenditure $,000 ! 15,000 sq. ft. Freehold Factory 200 ! Management Cars 18 ! Demonstration Fleet (Component Cost) 23 ! Vans 15 ! Office Equipment, Fixtures and Fittings 10 ! Painting Booths 50 ! Tooling 64

Diagnostic Equipment 10


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Hydraulic Ramps 10

Overhead Cranes 10

Air Lines and Power Tools 20

Workshop Tools 15

Welding Equipment (portable) 5

Press and Drills 2

Sundries 3

Stores Racking 5

460* (* Includes $23,000 contingency provision)

K Accounting Policies

a) Depreciation:

Development Work and Vehicles No depreciation charged Motor Vehicles other than Development Vehicles 20% per annum on cost Freehold Factory 21/2 per annum on cost

Other Fixed Assets 10% per annum on cost

b) Rates for 15,000 sq. ft. Factory payable annually in advance: $5,000

c) No income assumed before launch date, thereafter all production cars sold cash on delivery

d) Market Research budget $20,000 expended over period of 6 months prior to production and fee paid on completion

e) Legal Fees re Building Lease and Raising of Finance $2,000

f) Audit and Accountancy: First year $12,000, thereafter $5,000 plus inflation

g) General Trade Expenses $1,000 per month at full production

h) Legislative Expenses:

Consultancy Fees 10,000 Department of Transport Test Fees 30,000 Crash Testing 4 Development Assemblies (at cost) 44,356

$84,356

i) Bank and Loan interest has been computed at the rate of 15% per annum chargeable quarterly

j) Power, light and heat $1,000 per month on full production

k) Comprehensive Insurances including product liability $12,000 per annum on full production

l) Repairs and Renewals:

i) Plant and machinery 10% of original asset cost plus inflation adjustment charged quarterly in arrears from commencement of production

ii) Building $6,000 per annum charged half-yearly in arrears as from October 2000

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m) Postage, Telephone and Stationery at a rate of $100 per Management employee per quarter

n) Motor expenses at $3,000 per vehicle per annum

o) Travelling and Entertaining at $500 per month

p) Advertising Budget $60,000 per annum commencing October 1999

q) Stocks and Work in Progress have been computed at a fixed level of 2 months anticipated production at component cost


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Training Manager’s Salary 500 ! 500 Employee Wages 5,000 ! 5,000 ! $5,500 ! $5,500 !

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L Department of Industry Grants Incorporated

a) Regional Selective Assistance Section 7 Industry Act 1972 20% grant against fixed assets $92,000 Payable 1.1.2000 $46,000

1.1.2001 $46,000

b) Support for Innovation

Product and Process Development Scheme Grant of 33 1/3% on

Cost of 5 development assemblies 50,000 (Component Cost) Wages and Salaries 50,000 (April/Oct ) Overheads 7,500 !D. of T. Test Fees 30,000 !Development Test Fuel 5,000 !Consultant’s Fees (Mr Chivers) 10,000 !Tooling, Manuals, etc. 2,000 !Market Research Project 20,000 !! $174500 !Payable 1.1.2000: $58,000

c) Department of Industry/EEC Training Grant @ 80% of New Employee

Training Costs 3 week training programme Nov ’99 Feb ’00

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Grant of $8,800 payable 1.4.2000

M In the light of the Company’s Capital Expenditure and Development Programme it has been assumed that no provision either for Corporate Tax payable or for deferred taxation will be required during the period covered by this projection.

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Summarised Projected Profit and loss Accounts

1999/00 to 2003/04

Years ending 31st March

2000 2001 2002 $’000 $’000 $’000

Sales 142 1707.5 2094.5 Purchases 67.5 880 1072 Wages 67.5 213 234 Salaries 82.5 108 120 Motor Expenses 28 56 62 Rates 4 5 6 Power, Light and Heat 2.5 13 14.5 Insurance 5 13 14.5 Repairs and Renewals 5.5 16 17 Advertising and Market Research 50 66 72 Administration 28 30 32 Loan Interest 68.5 76 60.5 Bank Interest and Commission – 13.5 5.5 Legislative and Consultant’s 84 Expenses and Fees Contingency Provision 15 180 200 Depreciation 36.5 36.5 36.5 (Grants received) (99) (55) Net Profit/(Loss) Before Tax (303.5) 56.5 147.5 Corporation Tax – – Deferred Taxation – – –

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2003 $’000

2292.5 1182

258 132

68 6.5 16 16

18.5 80 36

46.5 –

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200 39

!194

– –

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2004 $’000

2530.5 1299.5

283 144

75 7

18 17.5

21 87 39

32.5 –

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200 39

!268

– –

Net Profit/(Loss) After Tax (303.5) 56.5 147.5 194 268 Retained Earnings/(Deficit) B/f 47 (265.5) (200) (52.5) 141.5

Retained Earnings/(Deficit) (265.5) (200) (52.5) 141.5 409.5 Carried Forward


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January ! 528 550.5 391.5 209.5 February ! 605 570.5 406 220 March 11 545 523.5 358.5 166.5 April 25 594 517.5 341.5 145 May 30.5 611.5 535 354.5 153.5 June ! 615.5 485 296.5 85 July ! 632 463.5 272.5 57 August 166.5 639.5 464 298.5 44 September 191.5 635 454.5 286 28 October 427.5 637.5 455 286 25 November 500.5 596 399.5 220 !!

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Summarised Projected Balance Sheets !

!!!Fixed Assets Freehold Property

1999 $’000

2000 $’000

!195

2001 $’000 !

190

2002 $’000

!185

2003 $’000

!180

2004 $’000

!175

Plant and Machinery Tools and Tooling

! !

!170

!

!151

!

!132

!

!113

!

!94

Development work and vehicles 85 91 91 91 91 91 Fixtures and Fittings ! 13.5 12 10.5 9 7.5 Motor Vehicles ! 44.5 33.5 22.5 40 26.5 ! 85 514 477.5 441 433 394

Current Assets Bank Balance

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5

!!

–

!!

–

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96

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295.5 Stock and Work in progress – 108 158 174 192 211 Trade Debtors 4 1.5 2 2 2 2.5 ! 4 114.5 160 176 290 509

Less Current Liabilities Trade Creditors

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3

!!

115

!!

85

!!

91.5

!!

99.5

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107.5 Bank Overdraft 11 – 78.5 – – – Loan Account 8 – – – – – ! 22 115 163.5 91.5 99.5 107.5

Net Current Assets/(Liabilities) (18) (0.5) (3.5) 84.5 190.5 401.5

Total Net Assets 67 513.5 474 525.5 623.5 795.5 Share Capital/Premium 20 220 220 220 220 220 Retained Eamings (Deficit) 47 (256.5) (200) (52.5) 141.5 409.5 Shareholders’ Funds/(Deficiency) 67 (36.5) 20 167.5 361.5 629.5 Deferred Taxation ! ! ! ! ! !Long Term Funding – 550 454 358 262 166

Total Capital Employed 67 513.5 474 525.5 623.5 795.5 !!

Finance Requirements by Months (Excluding equity)

(End Month Requirement)

1999 2000 2001 2002 2003 2004 $’000 $’000 $’000 $’000 $’000 $’000

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December 576 597 394 212.5

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How to Survive in the Fast Lane They’re fun and they’re fast. All too often, though, British sports cars have proved a financial disaster for their makers. But now sales are booming again and factories are gearing up to increase production. What does the future hold for men like Peter Morgan of Morgan Motor Company and Keith Judd and the workforce at AC Cars?

JOHN HUXLEY reports

THE LONG wait for Mr. K of Hong Kong is almost over. In exactly 12 days’ time RPX 832, a golden yellow roadster with wire wheels and best black leather upholstery, will be reversed out of the finishing shop at the Morgan Motor Company’s factory in Worcestershire.

After a short test drive in the surrounding Malvern Hills and a final tune-up for its 106 mph engine, the car will be ready for delivery.

“Let me see”, says Morgan sales manager Mark Read, consulting a docket attached to the wing mirror. “This car would probably have been ordered in 1993.”

Seven years is a long time to ask anyone to wait for a car which has changed little in appearance since the 1930s and which – in the words of one current motor magazine suffers from “vague steering... bone-shaking ride... and zero design refinement”.

But customers have been queuing to buy and drive Morgan cars for almost 75 years, displaying a devotion only a bumper sticker can describe: “I love my God, my country and my Morgan – but not necessarily in that order.”

Morgan’s experience is typical – Britain’s specialist car makers are enjoying a sudden and strong upswing in sales. And after dicing with financial disaster during the recent recession, many are now recruiting craftsmen and working full throttle to meet demand. • Lotus expects to make 800 cars this year,

against only 550 in 1998. After shedding labour regularly, it is now adding to the 425 employed at its Norwich factory.

• At AC Cars of Thames Ditton, Surrey, sales manager Keith Judd says: “It’s absolutely fantastic. At the end of the year we had stocks of unsold cars, now

we’re working hard to bring delivery delays down to three months.”

• TVR of Blackpool is boosting its 100 workforce and organising a night shift to double production of its Tasmin model to eight or nine a week.

• Panther, the Korean company based in Byfleet, Surrey, sold only 27 cars last year. Marketing Manager Steve Hanlon thinks the British market alone can take 550 of the classically-shaped Kallista model this year. Employment, only 67 last August, looks set to double, he says.

“Orders were drying up, and we took a gamble and introduced a new model. Different style; glass fibre body. It wasn’t liked,” he recalls. “I used to have nightmares about going on show stands with it.”

But orders for the traditional model picked up, and ever since Morgan has been cushioned by a thick order book.

Morgan is modest about his success. Couldn’t he sell the same number of cars if he put the price up by, say, $1,000 on each model? “Probably. But it’s wrong to assume that all Morgan buyers have lots of money. I want them to be able to afford the car.” That’s what it is, the affordable dream.

Morgan offers more exhilaration per mile than most motors around. For little more than the price of a new Maestro, drivers can have distinction “wind in the hair fun” and “marvellous looks”. In a word, class.

“And I’m afraid class does not come quickly,” says Morgan.

Couldn’t he boost profits by turning out more cars (each takes 90 days to make)? Morgan is dubious. It would be difficult to increase production without having more space, machines and people, and anyway, past experience suggests it is unwise to chase sales like that.


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!Too many manufacturers he says, have

been tempted to boost output when demand suddenly rises, only to find themselves hopelessly over-stretched when the inevitable downturn comes and orders start melting away.

It’s a dangerous hairpin awaiting today’s freewheeling specialist motor manufacturers – though each claims to have checked his brakes.

Even financially embattled British Leyland can afford to dream. “Inside every Morris Marina man is a mad-cap racer waiting to climb out,” says one company employee.

Panther’s Steve Hanlon, who has worked for both Lotus and BL, believes there’s a

strong chance that the troubled car group will return to volume sports car production. “I’m sure they’d love to, given half a chance.” Industry insiders say there are already plans to use the Maestro floor-plan for a sports car.

So far, the company will say only that “anything is possible” if it can return to profitability. That is one, big ‘if’. Even then it would require a lot of convincing that there were big sales to be had in North America, a crucial market.

Nevertheless, there are straws in the wind. This month the 35,000 plus members of the MG Owners’ club are being invited to design a new MG sports car. What’s more, says club secretary Roche Bentley, the competition has the official blessing of Austin Rover.

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Extracted from The Sunday Times, 24 April 1999

CSA Member Activity 1 !■ Assess the viability of the case study business from the information presented in the

business plan, taking into consideration the level of funding required.

■ Consider issues relevant to business start-ups and carry out a SWOT analysis of the proposed business project together with a break-even calculation.

■ Would you recommend that the project goes ahead?

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Credit Skills Academy !!!!!!!!!!

This is one in a series of topics about credit, designed for easy access by banking professionals with a special interest in this field

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Documents

Unit 2: Business Risk - Caribbean Association of Banks