Finance - GUD Holdings Limited - Case Study - Assessment Answer

Finance Assignment

Assignment Task

Scenario

The Chief Investment Officer (CIO) of Ramstein Holdings, one of Germany’s largest hedge funds, Mr Till Lindeman has contracted your company, Accept Consulting to investigate Breville Group Ltd and GUD Holdings Ltd. Both these companies are leaders in the small appliance market in Australia and Mr Lindemann believes that his clients would benefit from diversification these companies would bring to an international share portfolio. With this in mind, Ramstein is considering investing substantial amounts in either company but is being cautious given the current state of the Australian economy. Lindemann is interested to understand what the Cashflow Degree of Operating Leverage (DOL) is for these companies for 2014 & 2015. A copy of these reports has been provided in the attachment.

They have requested that you prepare a report for them that detail the following information.

The Cashflow DOL for 2014 & 2015 for Breville and GUD using information contained in their 2015 Annual reports ( Any calculations and assumptions must be detailed in an appendix and not appear in the body of the report) 2. Where there significant differences in DOL between the companies the reason for this

should be explained 3. Where there are significant differences between years for either company the reason for the

difference should be explained. 4. A short summary of the reasons that analysis of the accounting and cash flow DOL is useful for a prospective investor. This should be supported by appropriate academic research.

Instructions:

This is a research assignment and requires the use of independent research using company reports and academic papers.

You will be assessed on the following criteria:

1. Accuracy of calculations presented
2. Explanation/analysis of relevant changes in DOL
3. Analysis of reasons why analysis of accounting and cashflow DOL may be useful for aprospective investor
4. Depth & Quality of research undertaken to support your answers.
5. The report should be no more than 1,00 words (excludes calculations & appendix)

Discussion

2 At the onset; the purpose of the DOL was to depict the sensitivity of pre-tax operating cash flows to changes in revenue. It thus indicates the certainty of forecasts by depicting the degree to which operating cash flows may vary with changes in revenue.

For Gud holdings, a DOL of 2.69 compared to Breville DOL of 1.91 implies that for a 1 % change in revenue the pre-tax operating cash flows of Gud will change by 2.69% while for Breville they will change by merely 1.91 % in the year 2015. In 2014, For Gud holdings a DOL of 3.86 compared to Breville DOL of 1.89 implies that for a 1 % change in revenue the pre-tax operating cash flows of Gud will change by 3.86% while for Breville they will change by 1.89 %. (Refer Appendicle) The significant differences in DOL between the two companies is attributable to the fact that cash flow DOL drops down as revenue increases. This drop is also attributable to the fact that EBITDA responds quickly to changes in revenue while the fixed costs remain static to the revenue change. To be noted that DOL is not same for all levels of revenue and varies thereby depending on the behaviour of the fixed costs (Parrino and Kidwell, 2009)

3 In 2015, the Gud company fixed costs were lower implying increase in profit on each additional sale. The company need not endeavour to increase sales volume to provide for fixed costs and may not be able to earn higher profits after less fixed costs. The EBITDA increase and fixed cost decrease contributed to the lower DOL in 2015 for Gud. In 2014, with higher fixed costs which the company incurred even in the absence of incremental sales implying lower profits on sale. The company endeavour was to increase sales volume to provide for fixed costs so as to be able to earn higher profits after providing for fixed costs. Another reason for the difference is because the EBITDA and Fixed costs of Breville do not change much whereas the change is much more profound for Gud. In Breville case, the difference is not significant. (Refer Appendicle)

4 Analysis of the Accounting and Cash flow DOL is useful for a prospective investor owing to the ability of these two measures to predict the sensitivity of the operating cash flows and profits to changes in revenue. Where the cash flow degree of operating leverage is unreasonably high ; it is an indication of an increased level of forecasting risk. This is so because even a minor error in sales could be magnified largely in the cash flow projections.

Analysis of the Accounting and Cash flow degree of Operating leverage would also help the investor form an idea of the breakeven point for sales of the company which in turn would affect the future revenues and profits of the company. For example, in the case analysed above in Part 1, Gud with higher cash flow operating leverage and consequent Accounting leverage may be able to earn more revenue than Breville. However, the revenue is more at risk due to poor management decisions or market conditions.

The analysis also helps the investors to compare DOL among companies in the same industry, especially relevant for high fixed costs industries. Due to the nature of the fixed costs been incurred in spite of the increase or decreases in the sales volume, where the company earns a substantial profit on sales, fixed cost will be recovered. Even where two companies earn the same revenue and operating profit for the past two years, the degree of change in operating income will depend on the operating leverage. Where fixed costs are high, profits will decline with sales.

The investor will accordingly interpret this information such that the profits of the company with higher DOL are expected to fluctuate more compared to the company with the lower DOL with changes in revenue. This in turn is a sign of a riskier operating cash flow due to the volatility of the revenue and profit. The company with the lower DOL will similarly imply a less risky investment proposition. (Smallbusiness.chron.com, 2016) Investors normally compare and rank potential investments on the basis of the degree of risk to their investment. Conservative investors prefer companies with lower DOL, while aggressive investors prefer companies with higher DOL as the investment promises larger returns with increased revenues. (Nitin D Sharma, 2015)

Conclusion

The significant differences in DOL between the two companies is attributable to the fact that Cash flow DOL drops down as revenue increases. The significant differences between years in the Cash flow DOL calculation for Gud is attributable to the fact that DOL is not same for all levels of revenue and varies depending on the behaviour of the fixed costs.

The investor will accordingly interpret this information such that the profits of the company with higher DOL are expected to fluctuate more compared to the company with the lower DOL with changes in revenue. This in turn is a sign of a riskier operating cash flow due to the volatility of the revenue and profit. Investors normally compare and rank potential investments on the basis of the degree of risk to their investment. Conservative investors prefer companies with lower DOL, while aggressive investors prefer companies with higher DOL as the investment promises larger returns with increased revenues.

• All other expenses are assumed to be variable for both the companies.
• Only the portion of research and development costs directly charged to the income statement is being treated as a fixed cost for Breville. The Amortized portion of this expense being in the nature of non-cash expense is not considered as a part of the fixed cost for the DOL calculation.