Reference no: EM13489175

Sassi Stores (Pty) Ltd (‘Sassi Stores') was founded 20 years ago by the current chairperson, Ms Zeta Sassoni, and the incumbent chief executive officer, Mr Roland Oliveira. The company has over 150 retail stores throughout South Africa, which all sell clothing and accessories. Sassi Stores has positioned itself to sell quality high fashion apparel at exceptional prices, which are aimed predominantly at 18-30-year-old customers. International fashion trends are closely monitored to ensure that Sassi Stores is abreast of the latest trends.

The company has grown from humble beginnings to being a leader in its retail niche in South Africa. Stores are located in large shopping centres and value centres situated close to major shopping malls.

Generally, consumer spending in South Africa has been depressed over the past two years as a result of the knock-on effect of the global financial crisis. However, Sassi Stores has managed to increase revenue despite the prevailing economic conditions. Mr Oliveira attributes this to Sassi Stores's retention of loyal customers and its ability to attract new customers who do not want to spend exorbitant amounts on quality clothing. Apparel is sourced both locally and internationally from suppliers who manufacture ‘Sassi' branded apparel.

Financial performance

Financial highlights of the 2009 and 2010 financial years and extracts from the latest forecast for the year ending 31 March 2011 are set out below:

SASSI STORES
YEARS ENDED/ENDING 31 MARCH
2009 2010 2011
Audited Audited Forecast
R million R million
R million

Revenue 1 704 1 908 2 194
Gross profit 674 736 867
Earnings before interest, tax, depreciation and
amortisation (EBITDA)
166
181
179
Profit after tax 97 106 98
Shareholders' equity 266 312 410
Cash and cash equivalents 75 80 170

The board of directors of Sassi Stores has set the following targets for the company over the next five years:

· Annual revenue growth of at least 12% per annum; and
· EBITDA/revenue margin of at least 10%.

Shareholders and distributions

The shareholders of Sassi Stores are The Sassoni Family Trust (50%), Mr Roland Oliveira (25%), Ms Gabriella Madiba (10%) (the chief financial officer of Sassi Stores), and The Sassi Stores Employee Share Trust (15%). The company consistently pays dividends on an annual
basis to its shareholders, the most recent being R60 million paid to shareholders in March 2010.

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Rolling forecasts
Ms Madiba recently attended a full-day workshop on the use of rolling forecasts as a budgeting tool. She attended the workshop in order to acquire continuing professional development points, and was impressed by the high quality of the content and the relevance of the workshop. The workshop presenters emphasised that -

· rolling forecasts are a far more effective management tool than traditional annual budgeting processes;

· rolling forecasts generally involve the preparation of quarterly forecasts for the next 18 months which are updated as frequently as required by the company, depending on the nature of its business;

· rolling forecasts alleviate the need for companies to prepare annual budgets;

· rolling forecasts encourage companies to realistically estimate what they should achieve over the next 18 months as opposed to unrealistic financial targets being forced down by top management;

· the future is impossible to predict and therefore variance analysis between actual results and budgeted results is flawed. Organisations should rather focus on improving their forecasting accuracy than spend countless hours on comparing actual results to annual budgets; and

· rolling forecasts are less detail orientated than traditional annual budgets, encouraging management to focus on the key value drivers in their business. Traditional budgets require far too much time to prepare and contain too much detail.

Utilisation of cash resources

Sassi Stores generates positive cash flows annually. The board of directors of the company has been exploring various options over time to utilise cash resources more effectively. Current deposit rates are low and Ms Sassoni is of the firm opinion that retaining cash on Sassi Stores's balance sheet destroys shareholder value. She believes that surplus cash should be paid out to shareholders and Sassi Stores should furthermore gear its balance sheet towards the enhancement of shareholder value.

Ms Madiba believes that Sassi Stores should always have a reasonable level of cash on its balance sheet as a buffer. She believes that retailers should never be in a net gearing position (in which interest-bearing debt exceeds cash resources) as retail companies generally have extended trade terms from trade creditors.

Credit division

Sassi Stores has for a number of years considered providing credit to customers. During 2010 this opportunity was investigated further and a detailed business plan has been formulated for consideration by the board of directors. It is proposed that a new division, a credit division, be established to take responsibility for the credit assessment of customers, advances, collections and monitoring of customer balances. The salient features of the business plan are as follows:

· Customers will have the opportunity of opening a Sassi Stores account from 1 April 2011. Potential account holders will be required to produce identity documentation as well as proof of permanent residency and monthly income. In addition, potential account holders will be required to submit a declaration of monthly income and expenditure, a personal statement of financial position and three credit references;

· The credit division will assess the credit-worthiness of each potential account holder based on a standardised credit scoring system. Credit limits per individual account holder will be set at 10% of their after-tax monthly income;
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· Account holders will each be charged a monthly service fee and for the 2012 financial year this will amount to R10 per month. Account holders will each receive a Sassi Stores card which will contain a five-digit pin code. They will be required to produce these cards and enter their pin code when making purchases on account at any Sassi Stores outlet;

· Account holders will be required to make minimum monthly payments of 15% of outstanding balances. Interest at 24% per annum, capitalised monthly, will be levied on
customer balances; and
· Monthly statements will not be posted to customers. Instead, customers can elect to receive statements via e-mail or notification of account balances and minimum payments due by sms on their cellular phones. Account holders will also be able to request statement printouts at any Sassi Stores outlet.

The business plan includes detailed financial forecasts for the credit division and related assumptions which are summarised below:

SASSI STORES CREDIT DIVISION
FORECASTS AND ASSUMPTIONS FOR THE YEARS ENDING 31 MARCH
Notes 2012 2013 2014 2015
Account holders
New accounts opened 1 63 000 36 000 9 600 4 800
Total number of account holders at
year end
63 000
99 000
108 600
113 400
Weighted average number of account
holders during the financial year
2
41 500
82 500
103 800
111 000
Charges to account holders
Finance charges (nominal annual,
compounded monthly)
24%
24%
24%
24%
Monthly service fees R10,00 R11,00 R11,50 R12,00
Pin card issue fee (once off) R15,00 R15,75 R16,50 R17,50
R'000 R'000 R'000 R'000
Forecast revenue and expenditure
Finance charges earned 9 159 32 050 52 352 65 101
Monthly service fees 4 980 10 890 14 324 15 984
Pin card issue fees 945 567 158 84
Total revenue 3 15 084 43 507 66 834 81 169
Pin card expenses 4 (630) (378) (106) (56)
Provision for bad debts 5 (6 986) (8 926) (5 825) (3 992)
Depreciation 6 (8 000) (8 000) (8 000) 0
Other operating costs
Variable operating costs 7 (5 188) (10 808) (14 324) (16 095)
Fixed operating costs 8 (4 500) (4 770) (5 056) (5 360)
Operating (loss)/profit (10 220) 10 625 33 523 55 666
Taxation 9 - (3 455) (10 610) (16 425)
(Loss)/profit after taxation (10 220) 7 170 22 913 39 241
Gross trade receivables 10 69 863 159 125 217 372 257 294
Provision for bad debts 5 (6 986) (15 912) (21 737) (25 729)
62 877 143 213 195 635 231 565
Information technology (IT) equipment
and system
6
16 000
8 000
-
-
Total assets 78 877 151 213 195 635 231 565
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Notes
1 The projected number of account holders has been based on detailed industry research.

2 The weighted average number of account holders during the year is based on a forecast number of new accounts opened in each month.

3 The board of directors of Sassi Stores believes that the incremental gross profit arising from credit sales should not be taken into account in evaluating the feasibility of the credit division.

4 The estimated cost of each pin card in the 2012 financial year is R10, increasing to R11,60 in 2015.

5 The provision for bad debts throughout the planning period is estimated to be 10% of gross year-end trade receivables.

6 The initial investment required in the IT equipment and system is forecast to amount to R24 million and will be incurred and paid for at the end of March 2011. This expenditure will be amortised on a straight-line basis over three years. It has been assumed that the South African Revenue Service (SARS) will permit this deduction on the same basis for income tax purposes.

7 Variable operating costs include amounts to be paid to an outsourced call centre. After investigating the cost of establishing and operating an internal call centre, it was decided that outsourcing this function would be far more cost effective. The selected external call
centre operator will be responsible for following up on overdue amounts and contacting account holders when necessary.

8 Fixed operating costs comprise mainly employee costs.

9 Income tax has been provided for on the assumption that all income will be taxable on the same basis as recorded above and that all expenditure, apart from the provision for bad debts, will be deductible for income tax purposes. It has been assumed that SARS will only permit a deduction of 25% of the accounting provision for bad debts in terms of section 11(j) of the Income Tax Act. A normal income tax rate of 28% has been assumed throughout the planning period. Taxable income has been estimated as follows:

Years ending 31 March 2012 2013 2014 2015
R'000 R'000 R'000 R'000
(Loss)/profit before taxation (10 220) 10 625 33 523 55 666
Add back: Net movement in
provision for bad debts
6 986
8 926
5 825
3 992
Section 11(j) allowance (1 747) (2 231) (1 456) (998)
Tax loss brought forward - (4 981) - -
Taxable (loss)/income (4 981) 12 339 37 892 58 660
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10 The forecast annual movement in gross trade receivables is summarised below:
Years ending 31 March 2012 2013 2014 2015
R'000 R'000 R'000 R'000
Opening balance 0 69 863 159 125 217 372
Credit sales to account holders 116 200 254 100 325 104 373 632
Monthly service fees 4 980 10 890 14 324 15 984
Pin card issue fees 945 567 158 84
122 125 335 420 498 711 607 072
Finance charges 9 159 32 050 52 352 65 101
Repayments (61 421) (208 345) (333 691) (414 879)
Closing balance 69 863 159 125 217 372 257 294
11 You may assume that the mathematical calculations in the financial forecast and the assumptions included in the business plan are correct.

Evaluation of proposed credit division

The board of directors of Sassi Stores has stated that it will evaluate the feasibility of the proposed credit division using a capital budgeting approach. The benchmark internal rate of return for the free cash flows of the credit division has been set at 20% and the division will need
to exceed this return for the project to be approved. The board has requested that the capital budget cover the years ending March 2011 to March 2015 and that the terminal value at 31 March 2015 be based on the estimated net asset value of the division at that date.

The board of directors has agreed to extend an interest-free loan to fund the establishment of the credit division and its ongoing cash flow requirements. This loan can be repaid as and when the division generates surplus cash flow.
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REQUIRED
Marks
(a) Indicate, with reasons, whether or not you agree with the workshop presenters' views on rolling forecasts.
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(b) Critically discuss Ms Sassoni's view that surplus cash should be paid out to shareholders and that Sassi Stores should introduce gearing onto its balance sheet.
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(c) Critically analyse and comment on the financial forecasts and related assumptions included in the business plan of the proposed credit division. Where appropriate, support your comments with relevant ratios and calculations.
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(d) Calculate and estimate the internal rate of return of the forecast cash flows of the credit division for the period 2011 to 2015, based on the assumptions set out in the business plan.
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(e) Identify and describe -
(i) the key business risks, including any key financial risks, to which the credit division will be exposed; and
(ii) any other key issues the board of directors should consider in evaluating whether or not to approve the establishment and operation of the credit division.
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(f) Identify and list the key internal controls that would be required in the credit division.