2003 December

December 2003 Examiner's Solution
Case Solution 1
1. In order to assess the validity of the opinions of the Dunedin 6, compute the following ratios for Dunedin for both 2002 and
2003:
a. Current ratio
b. Quick ratio
c. Gross Profit Margin
d. Profit Margin
e. Return on Capital Employed
f. Return on Total Assets
g. Inventory Turnover
h. Average Collection Period
i. Times Interest Earned
j. Debt ratio
(20 marks)
2003 2002
Current ratio (times)
1.43 1.26
Quick ratio (times)
0.85 0.77
Gross profit margin
27.44% 33.93%
Profit margin
0.14% 5.77%
Return on capital employed
0.16% 5.55%
Return on total assets
0.1% 3.6%
Inventory turnover ratio (times)
2.24 2.41
Average collection period (days)
176 155
Times interest earned
1.4 19
Debt ratio
43.0% 35.7%
2. From the ratio analysis above, separate the ratios into:

a. those ratios which support the arguments of the Dunedin 6
b. those ratios which counter the arguments of the Dunedin 6
Provide adequate supporting explanations and comments on each of the ratios to substantiate why they have been classified
as either (a) or (b). Make reference to industry averages, where appropriate.
(10 marks)
c. Ratios which support the arguments of Dunedin 6

1. Current ratio has strengthened during 2003 from 1.26 to 1.43, but remains well below industry average of 1.85. The
improvement stems from an unhealthily high level of debtors and a major surge in inventory.
2. Quick ratio is weak at 0.85 in 2003. Whilst it has improved for the same reasons identified with respect to the Current
ratio, its level confirms the likelihood of operational cash flow problems.
3. Gross profit margin has declined dramatically from 33.9% in 2002 to 27.4% in 2003. Whilst $ weakening may contribute
to this decline, it is noticeable that other companies in this sector have not experienced the same problems – with 37.5% gross
margins being achieved.
4. The industry profit margin ratio of 7.8% confirms that this is not a highly profitable sector. However, Dunedin's
performance has fallen back badly from 5.77% to 0.14%, which suggests that falling gross margins have not been accompanied
with sufficient overhead cost control, especially in Selling & Distribution costs.
5. Dunedin's ROCE has sunk from a low 5.55% to an almost invisible 0.16%. Again, the industry average of 10.2% suggests
that other companies are able to generate better profitability with lower capital bases than Dunedin. This confirms that Dunedin's
suffering shareholders would gain a better return from investment in government bonds.
6. ROTA is very poor – half of the industry average. Coupled with ROCE above, this infers that Dunedin has too much tied up
in fixed assets, which are being insufficiently worked to generate revenue and profits.
7. Inventory turnover of 2.24 in 2003 has slowed on an already very poor 2.41 in 2002. With an industry average of 4.1
times, it would appear that Dunedin's management are exerting little control over the purchasing/manufacturing cycle. Inventory
is too high and is sitting around for too long, indicative of potential slow-moving inventory and the need for asset write-downs.
8. Dunedin's performance on debt collection is completely miserable. Against an industry average of 75 days, Dunedin is
taking an extra 100 days to collect cash from its customers. In addition to the fact that this suggests that management applies no
formal system of credit control, there must be genuine fears that such a large amount of debtors contains some potential bad
debts.
9. In 2002, the times interest earned ratio was stronger than the industry average of 15. However, in 2003, with extra
interest payable and lower profits, there is little comfort in a ratio of only 1.4 times. With profits dipping, there is a real threat to
the company's ability to service its loans and overdraft.
d. Ratios which counter the arguments of Dunedin 6
10. The only ratio that compares favourably with the rest of the industry is the debt ratio, standing at 43% in 2003, up from 35.7% in 2002. With the rest of the industry
at 55%, it would appear that Dunedin could increase its borrowings – provided that its profits can sustain the interest payments and its cash flow can generate
sufficient cash to make the loan repayments.
3. From the Accounts, your ratio analysis and extra information available, comment on the general financial performance and
status of Dunedin Products plc and outline your opinion on the merits of the dissident shareholders' point of view.
(5 marks)
It appears that the Dunedin 6 have substantial grounds for their negative view of the company's financial position:
i. The management of cash is very poor. Inventory and debtors are far too high and look to be out of control with risks to earnings from
slow moving stocks and bad debts.
ii. Gross profit margins have slumped seriously which suggests that the company has been discounting heavily to win market share at
the expense of gross margins.
iii. Selling & distribution costs have increased alarmingly over 2002 – accompanied by a sales growth that has failed to flow through to
the bottom line.
iv. If account is taken of the depreciation charge, then it is evident that the company has generated £275 000 from the sale of fixed
assets during the year. As well as this cash inflow, the overdraft has been increased by £477 000 and loans increased by £385 000.
v. The directors have increased their own remuneration by £152 000 without any justification from increased profits.
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December 2003 Examiner's Solution
Case Solution 2
1. Prepare an appropriate financial analysis of the options of:
a. replacement of the machine
Replacement of machine
Discount factors Machine costs Annual profits Savings Net cash flows Net present value
£ £ £ £ £
Year 0 1.000 −300 000 −300 000 −300 000
Year 1 0.909 −10 000 88 000 15 000 93 000 84 537
Year 2 0.826 −10 000 88 000 15 000 93 000 76 818
Year 3 0.751 −10 000 88 000 15 000 93 000 69 843
Year 4 0.683 −10 000 88 000 15 000 93 000 63 519
Year 5 0.621 −10 000 88 000 15 000 93 000 57 753
(see Note 1) 52 470
Note 1 £
Net Profit-Product X 30 000
Net Profit-Product Y 33 000
Depreciation avoided 25 000
88 000
b. outsourcing the manufacture of both products

Subcontractor
Discount factors One -off fee Royalties product X Royalties product Y Net cash flows Net present value
£ £ £ £ £
Year 0 1.000 25 000 25 000 25 000
Year 1 0.909 10 000 4 500 14 500 13 181
Year 2 0.826 10 000 4 500 14 500 11 977
Year 3 0.751 10 000 4 500 14 500 10 890
Year 4 0.683 10 000 4 500 14 500 9 904
Year 5 0.621 10 000 4 500 14 500 9 005
79 955
Product X £200 000 @ 5%
Product Y £225 000 @ 2%
2. Make a recommendation to the company based on your quantitative assessment.

3. Based on the above assessment, it would be beneficial for Norwich Engineering to use the sub-contractor option since it generates a
substantially higher Net Present Value than the machine replacement option.
4. (20 marks)
5. Identify other commercial factors that may influence the final decision.
(5 marks)
Other commercial factors that may influence the decision:
 The outsourcing proposal involves no cash outflows at any time.

 There may be strategic reasons for maintaining an in-house capability, e.g. need to maintain control and security of supply.
 If outsourcing is used, there will almost certainly be some redundancy costs which should be factored into the assessment.
 Given the nature of Norwich's customers, there would be quality/timing issues related to deliveries from the subcontractor.
 The opportunity to save £200 000 of capital expenditure and cash outflows.
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December 2003 Examiner's Solution

Current ratio (times)

Quick ratio (times)

Gross profit margin

Return on capital employed

Return on total assets

Inventory turnover ratio (times)

Average collection period (days)

Times interest earned

2. From the ratio analysis above, separate the ratios into:

c. Ratios which support the arguments of Dunedin 6

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Year 1 0.909 −10 000 88 000 15 000 93 000 84 537

Year 2 0.826 −10 000 88 000 15 000 93 000 76 818

Year 3 0.751 −10 000 88 000 15 000 93 000 69 843

Year 4 0.683 −10 000 88 000 15 000 93 000 63 519

Year 5 0.621 −10 000 88 000 15 000 93 000 57 753

(see Note 1) 52 470

Net Profit-Product X 30 000

Net Profit-Product Y 33 000

Depreciation avoided 25 000

b. outsourcing the manufacture of both products

Year 0 1.000 25 000 25 000 25 000

Year 1 0.909 10 000 4 500 14 500 13 181

Year 2 0.826 10 000 4 500 14 500 11 977

Year 3 0.751 10 000 4 500 14 500 10 890

Year 4 0.683 10 000 4 500 14 500 9 904

Year 5 0.621 10 000 4 500 14 500 9 005

Product Y £225 000 @ 2%

2. Make a recommendation to the company based on your quantitative assessment.

Other commercial factors that may influence the decision:

 The outsourcing proposal involves no cash outflows at any time.

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