Improve profitability in the future

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Reference no: EM13489242

Arete Office Automation (Pty) Ltd ('Arete') supplies digital office automation equipment. Each device can perform a multitude of functions and customers no longer have to purchase separate printers, copiers, scanners and fax machines. Arete was started in 2003 by Lionel and Susan DeMille, who each own 50% of the issued share capital of the company. Susan used to be the sales and marketing director of a major international office automation group before venturing into her own business. Lionel had been an audit partner in a medium-sized firm in Johannesburg prior to starting the new venture with his sister.
Susan is the chief executive officer of Arete and is also responsible for the sales and marketing function. Lionel, who used to be the financial director, said two years ago that he gradually wanted to become less involved in the company. Arete accordingly appointed a financial manager who has taken over Lionel's responsibilities. Last year Lionel decided to pursue interests in the property development industry but he does still attend management meetings and spends one day a week in Arete's offices. Susan and Lionel are the only directors of Arete.
The company sources office automation equipment from two equipment manufacturers, one based in Korea and the other in Taiwan. Their products are competitively priced and both supply brands that are well known in the international and local markets for their high quality. Arete does not have an exclusive relationship with the manufacturers, and local competitors also import these machines and market them in South Africa.
Arete rents office automation equipment to customers on either a three- or a five-year basis. Customers do not have the contractual option of purchasing equipment when a rental period expires. The rental amount covers maintenance and servicing of machines as well as the use of the equipment based on a fixed number of copies per month. If customers exceed this number they must pay extra for the additional copies at a set rate per copy. Customers are also charged for consumable items such as paper, toner and ink.
Arete has grown rapidly over the past three years with a compound growth of 45% per annum in terms of volume and value of rental contracts. It is anticipated that this growth will slow to 25% per annum as it is becoming increasingly difficult to take market share away from competitors.
Arete discounts all customer rental agreements with commercial banks, and receives lump sums from the banks based on the future rental payments receivable from customers. Discounting is with recourse. The company collects the rentals from its customers and pays these amounts over to the banks on a monthly basis.
Arete recognises the amounts received on discounting of rental agreements as revenue and expenses the cost of the equipment to cost of sales.
Extracts from the detailed management accounts of Arete for the financial year ended 30 September 2007 and the budget for the year ending 30 September 2008 are set out below:
1
ARETE OFFICE AUTOMATION (PTY) LTD
ABRIDGED INCOME STATEMENTS FOR THE YEAR ENDED 30 SEPTEMBER
Notes
2007
2008
Actual
results
Budgeted results
R'000
R'000
Revenue
223 471
278 389
Proceeds from discounting of
rental contracts
191 798
239 748
Consumables
1
31 673
38 641
Cost of sales
(144 041)
(173 817)
Cost of new equipment
(109 325)
(134 259)
Settlements
2
(30 688)
(34 763)
Sales commission
3
(4 028)
(4 795)
Direct costs
4
(30 357)
(36 112)
Cost of consumables supplied
(22 298)
(27 435)
Labour
(6 003)
(6 393)
Travelling costs
(2 056)
(2 284)
Gross profit
49 073
68 460
Overheads
(48 370)
(49 303)
Advertising
5
(3 406)
(3 065)
Bad debts
6
(3 050)
(800)
Communication costs
(3 637)
(4 073)
Entertainment
(2 092)
(2 259)
Rental of premises
(1 719)
(1 882)
Salaries and wages
7
(29 370)
(31 720)
Other expenses
(5 096)
(5 504)
Sundry income
Profit on sale of used equipment
8
1 500
3 500
EBITDA
2 203
22 657
Depreciation
(2 219)
(1 956)
EBIT
(16)
20 701
Interest income
56
0
Finance charges
9
(1 220)
(920)
(Loss)/Profit before tax
(1 180)
19 781
2
Notes
1 Consumables revenue represents the sale of ink, toner, paper and other consumables to customers. It also includes revenue from 'additional' copies.
2 In cases where potential customers have existing, unexpired rental contracts with competitors of Arete, Arete may offer to settle outstanding rental obligations in return for entering into contracts with Arete for new equipment. These costs are accounted for as settlement costs.
3 Sales personnel receive monthly basic salaries as well as commission on new rental contracts. The standard commission is 2% of revenue.
4 Direct costs consist of the expenditure incurred in maintaining and servicing customer equipment in terms of rental contracts, and the cost of consumables supplied.
5 Arete embarked on an extensive advertising campaign in 2006/2007 which included radio spots and billboards. While the company is not convinced that this expenditure has resulted in a significant increase in revenue, the media exposure has enhanced Arete's profile in the market. The company plans to cut back on advertising expenditure in the 2008 financial year.
6 The bad debt expense in 2007 is largely attributable to the liquidation of a single customer which resulted in Arete having to pay the outstanding rental liability to the commercial bank itself. Because of the size of the bad debt, the company regards this write-off as an exceptional event.
7 A recent survey by an independent human resources consultancy firm revealed that Arete's staff receives significantly higher salaries and wages than industry norms. For example, Susan's salary of R2,5 million per annum is 45% higher than her peers at companies of a similar size, while Lionel receives compensation of R1,5 million per annum despite the fact that he is not a full-time employee. According to the consultancy firm the basic salaries of sales personnel are approximately 25% higher than industry norms. The whole matter is of great concern to Susan.
8 The sundry income originates from the sale of used equipment returned at the end of rental periods. Arete expects these profits to increase in future years.
9 Finance charges relate to the interest paid on the company's bank overdraft. The major reason for the increase in the bank overdraft was that Arete advanced a R4,5 million non-interest bearing loan to its shareholders to enable them to invest in a property development venture. The bank overdraft is fully secured by the company's assets.
Poor profitability in the 2007 financial year, and planned turnaround
The shareholders of Arete are concerned about the company's performance in the 2007 financial year. Arete has never previously made an operating loss.
Susan DeMille has instructed her managerial staff to devote special attention to the following issues in order to return to profitability and achieve the budgeted profit before tax in the 2008 financial year:
• Reduce operating expenses by cutting back on advertising, limiting salary increases and generally being more cost conscious;
3
• Only selectively agree to 'settlements' as part of selling new rental contracts;
• Negotiate better equipment deals with equipment manufacturers;
• Deliver at least a 25% increase in rental revenue; and
• Improve the profitability of the Consumables division.
Consumables division
Lionel DeMille prepared a rough profitability analysis per division for the year ended 30 September 2007 and the results of this are summarised below. He allocated overheads and depreciation to divisions on the basis of each division's revenue as a percentage of company revenue.
ARETE OFFICE AUTOMATION (PTY) LTD
ABRIDGED DIVISIONAL INCOME STATEMENTS
FOR THE YEAR ENDED 30 SEPTEMBER 2007
Consumables division
Sales division
R'000
R'000
Revenue
31 673
191 798
Proceeds from discounting of
rental contracts
0
191 798
Consumables
Additional copies
2 686
0
Sale of ink, toner, paper, etc.
28 987
0
Cost of sales
0
(144 041)
Direct costs
(30 357)
0
Gross profit
1 316
47 757
Allocation of overheads
(6 856)
(41 514)
Profit on sale of used equipment
0
1 500
EBITDA
(5 540)
7 743
Depreciation
(314)
(1 905)
EBIT
(5 854)
5 838
John Schmid, the head of the Consumables division, is most unhappy that his division is perceived to be less profitable than the Sales division and is accordingly responsible for the company's operating loss in the 2007 financial year. His views on the matter are as follows:
• Part of the proceeds on discounting of rental agreements should be allocated to his division as these relate to future expenditure that will be incurred by Arete in servicing rental machines.
• The company should estimate servicing costs over the full rental contract period, mark up such expenditure and include this amount in the rental contract. At present these costs are ignored for the purposes of pricing rental contracts because sales personnel are eager to close transactions.
4
• Arete should provide for these future servicing expenses on entering into rental contracts and release the appropriate amount to the income statement as expenditure is actually incurred.
• Sales personnel should receive commission on gross profit (after consideration of bad debts) per rental contract.
• Overheads which are not under its control or which have no bearing on its activities (for example advertising expenses) should not be allocated to the Consumables division.
Black economic empowerment
The company is facing increasing pressure from its customers to introduce a black economic empowerment (BEE) shareholder in the business. Lionel suggested that he and Susan sell 25,1% of their shares to an employee share trust established for the benefit of historically disadvantaged individuals. He recommended that the sale of shares be based on a valuation of R215,3 million, which represents a price-earnings (PE) multiple of 15 times the 2008 forecast profits. He noted that ZX Office Solutions Ltd ('ZX'), a business very similar in nature and size to Arete, recently listed on the Alternative Exchange of the JSE Ltd at a PE multiple of 10 based on their forecast profit after tax to 30 June 2008. The share price of ZX has appreciated significantly since listing and the company's shares are currently trading on a 15 PE multiple of its 2008 forecast profits. Lionel used their PE multiple to value the shares in Arete.
Lionel suggested that the purchase consideration arising from the sale of the 25,1% shareholding to the proposed employee share trust remain owing on loan account to himself and Susan. The loan will bear interest at the prime overdraft lending rate and be repayable on or before 30 September 2013. In the event that the loan is not fully repaid, Lionel and Susan DeMille will be entitled to repurchase the 25,1% shareholding in Arete at par value. Lionel is adamant that the employee share trust should not be allowed to appoint any directors to the board of Arete until such time as they have fully repaid the loan amount as well as any accrued interest.
5
REQUIRED
Marks
(a)
Critically analyse the abridged income statement of Arete Office Automation (Pty) Ltd for the year ended 30 September 2007 and the related information provided, and comment on the company's trading and financial performance in 2007, as presented. Calculate relevant ratios and show all your workings.
22
(b)
Discuss, with reasons, whether you agree with John Schmid's views regarding the profitability of the Consumables division and his recommendations for rectifying this perception and improving company profitability.
10
(c)
Discuss Susan DeMille's instructions to managerial staff to improve company profitability and indicate whether you believe these will achieve a turnaround in the profitability of Arete Office Automation (Pty) Ltd for the 2008 financial year.
12
(d)
Identify and explain what actions the company could take to improve profitability in the future, apart from those already identified by Susan DeMille.
5
(e)
Discuss Lionel DeMille's valuation of Arete Office Automation (Pty) Ltd for the purpose of the proposed BEE transaction and indicate any reservations that you would have about this valuation of the business.
10
(f)
Advise the beneficiaries of the proposed employee share trust of Arete Office Automation (Pty) Ltd on whether the proposed acquisition of a 25,1% shareholding in Arete Office Automation (Pty) Ltd represents an attractive investment opportunity. Provide your detailed reasoning.
12
(g)
Identify seven key business risks facing Arete Office Automation (Pty) Ltd and explain how these may negatively affect the business in future. In addition, indicate how the company could mitigate the risks that you have identified.
21
(h)
Outline any concerns you may have about the actions of the shareholders and directors of Arete Office Automation (Pty) Ltd from an ethical point of view.

Reference no: EM13489242

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