Analysis of Watch Ltd and Keep Ltd as potential investment opportunities
To: Board of Directors of ABD Plc.
Subject: Analysis of Watch Ltd and Keep Ltd as potential investment opportunities
Introduction
As part of the company’s present year’s strategic plans, a unanimous decision was made to consider the acquisition of an existing company for the following reasons:
- To diversify our current services and portfolio delivery. An acquisition of a company in a complimentary market with a wide customer base and offers unique products aside from the ones we provide as ABD will enable the firm to venture into new markets and minimize the risks associated with single markets and single product lines
- To realize synergies, the acquisition of a firm with a similar business model as ABD and operational processes will enable the sharing of best practices, reduced duplication of duties and improved efficiency. This is expected to increase revenues and save costs.
- To achieve economies of scale the combination of ABD and a firm of similar size or scale or larger, will help the ABD benefit from the advantages of economies of scale. This will increase the bargaining power of the new firm and increase market share.
Based on these objectives, we analysed two potential firms; Watch Ltd and Keep Ltd based on the financial ratios of the two companies and below are the findings of the analysis
Analysis of Watch Ltd
The current ratio of Watch limited signifies that the company’s current and quick ratio are below t the industry mark and thus the firm may experience liquidity problems. Ready Ratios (2023), gives the industry current ratio and quick ratio as 3.07 and 2.73 respectively which is higher than the ratios that watch indicates.
The accounts receivable days are fairly short, in comparison to the industry benchmark of 57 days as indicated by Ready Ratios (2023), this signifies that the firm is effective in the recovery of its debt pointing to efficient operations. This minimizes the risk of losses arising from bad debt and ensure that the firm has continuous cash flows to facilitate its operations.
The inventory turnover is relatively high gauged against the industry ratio of three times. This indicates the likelihood of a wide customer base that helps the firm to convert its inventory to sales within a relatively shorter period of time.
The accounts payable days are fairly long implying that the company is able to retain its cash flows within the firm for a longer period giving it ample time to utilize the funds to realize profits.
The firm is lowly levered based on the percentage of debt to total assets, the industry mark is approximately 44%. This symbolizes a heavy reliance on equity by the firm instead of debt. This is potentially unsustainable in the future since by principle equity is considered to be more expensive than debt. This may consequently affect the profitability of the firm in the long run affecting growth and expansion of the business.
The gross profit percentage symbolizes that the firm is left with a relatively small proportion of revenues to cover for operational expenses after paying for their cost of goods this is further proved by the industry ratio of 38.5%. This implies that watch pays for its inventory expensively which is not in line with ABD’s acquisition objectives of reducing costs. Additionally the high costs of inventory indicate that the firm may not be able to achieve the profitability it is expected to based on its scale and capacity
The operating profit percentage indicates effective management of operating expenses as the ratio for watch limited is higher than the industry ratio of 4.3%. Despite the low gross profit levels, the firm indicates a fairly high proportion of operating profit than expected.
The gearing ratio is quite low against the industry percentage of 72, firms in the industry are expected to reduce reliance on equity which is more expensive. Interest covering ratio is low against the industry mark of 4.07. Tis implies that the firm may encounter problems in repaying the interest portion of its debt from the earnings within a given period.
The dividend pay-out is high against the industry pay out of 0.24 this shows that the firm is going to great length to retain its shareholders. This is indicative of unsustainable retained earnings which shall hamper growth and expansion greatly.
Analysis of Keep Ltd
Keep limited has a high current ratio higher than the industry ratio showing that the firm is adequately able to meet its short term obligations as they fall due. In terms of the acid –test ratio, Keep limited has an equal amount of its most liquid assets as it does its current liabilities which is significantly lower than the industry ratio of 1.92. The firm may encounter slight cash falls in the payment of its short-term liabilities. However it points to the possibility that the firm holds a lot of inventory explaining the high current ratio but low acid test ratio. The high inventory could also point to a wide customer base which is in line with the targets of ABD limited.
The accounts receivables days are lower than the industry mark of 57 days which is a positive indication of effective collection of debt and ensuring continuous cash flows for operations and consequently profitability.
Inventory turnover of Keep limited is higher than the expected industry mark of 3 times. This indicates a large customer base which can be a great addition of the existing market base of ADB limited.
The debt ratio of Keep limited is above the industrial average point of 44%. This indicates minimal reliance on equity and a lower financial expenses in terms of interest rather than dividends. This reflects the objectives of ADB positively.
The gross profit ratio is below the industry average of38.5% this shows that Keep incurs relatively high costs in the purchase of its inventory.
Operating profit percentage of Keep is 5% which is higher than the industry mark of 4.3% this shows efficient management of operating expenses which is one of the goals of ABD acquisitions
The gearing ratio is higher than the industry percentage of 72 which shows that the capital mix of the firm is as expected within the industry requirements. This implies higher solvency and future sustainability of the firm.
The interest cover times is quite low I relation to the industry mark of 4.07, this may be explained by the high level o debt which translates to high proportions of interest in relation to earnings within a period.
The dividend pay-out is higher than the industry average of 0.24 which signifies high profitability sufficient enough to distribute in terms of dividends.
Comparison
In this section, we shall compare the two firms in terms of liquidity, profitability, solvency, efficiency and leverage against the acquisition objectives of ABD limited.
Liquidity
Keep ltd has a higher liquidity compared to watch limited. This ensures that the firm has sufficient funds for its operational activities minimizing the risks that occur due to cash shortages. Additionally, the quick ratio of Keep implies that the firm is well stocked minimizing the losses that may occur due to stock shortages and run-outs. This ensures continuity of the business cycle, increased customer loyalty and improves the reputation of the firm which are part of the synergies that ABD is looking for in its acquisition.
Profitability
The profitability of Watch is higher than that of keep, this implies that Keep may be experiencing higher operational costs perhaps due to its scale in relation to watch limited. In terms of the objectives of ABD acquisition, upon acquisition, with a high bargaining power the combined firms may be able to reduce their operating costs enabling the merger to achieve its desired profitability.
Solvency
According to Melville (2009), solvency reflects to the financial stability of the firm, Keep limited has a higher solvency ratio compared to watch limited. This implies that Keep has sufficient capacity to adequately repay its long term debts and to continue to exist into the foreseeable future as opposed to Watch limited. This is in line with the objectives of ABD limited to acquire a going concern that will aid the venture in navigating future unexpected risks
Efficiency
The efficiency ratios point to an equal level of efficiency except for a great parity observed in the inventory turnover times, which is higher for keep. This shows that Keep has more clients and a wide customer base which is one of the main objectives in ABD’S acquisition.
Leverage
In terms of leverage, Keep limited has a higher leverage compared to watch limited. A higher leverage according to Baker & Powell (2012), indicates that the firm’s capital is mostly funded by debt as is recommended since it’s cheaper than equity. This implies that there will be sufficient earnings for growth and expansion of the firm.
Final Decision and Conclusion
From the analysis Keep is the company to acquire since it meet s the better part of the objectives. The few parts that are not met by Keep’s performance can be met by the firm as a merger this include improving gross profit which can be achieved by the higher bargaining power which will help the merger bargain better prices for its inventory. This will in turn reduce the costs as per ABD’s objectives and improve profitability.
Recommended Additional Information
Due to the limited nature of ratios, it is imperative that the following information be gathered to shed better perspective on the acquisition:
- Operational and financial performance of the potential target firms in the electronics and parts industry. This information can be gathered through a comprehensive due diligence process that involves analysing the potential target firms’ financial statements, cash flows, revenue streams, and other relevant operational data.
- Information on customer base, brand reputation, and market share. This information will help to determine whether the acquisition will help to diversify services, achieve synergies, and realize economies of scale, which are some of the primary objectives of the acquisition.
It is critical to obtain this information as it a more accurate picture of the potential target firms’ strengths, weaknesses, and growth opportunities, allowing for a well-informed acquisition decision.
Question 2
(1532 words)
Critical Evaluation of the International Standard IAS 38: Looking At Research and Development (R&D)
Introduction
International Accounting Standard 38 (IAS 38) provides guidance on accounting for intangible assets, including research and development (R&D) expenses (IFRS Foundation , 2019). The importance of R&D in today’s business environment is inexplicable, especially in light of the COVID-19 crisis of 2020, which prompted many companies to respond to government requests for innovative solutions to produce much-needed personal protective equipment (PPE). The purpose of this report is to critically evaluate IAS 38 in relation to R&D and identify any necessary changes to make the standard more responsive and suitable to reporting R&D activities.
R&D is crucial for companies to maintain their competitive edge in the global marketplace by creating new products, improving existing products, and improving production processes. According to a recent report by the Organisation for Economic Co-operation and Development (OECD), investment in R&D has been growing steadily over the past two decades, with companies investing around 10% of their revenue in R&D activities (OECD, 2020).
However, accounting for R&D expenditures can be complex, as it involves estimating the future economic benefits that will result from R&D activities. IAS 38 provides guidance on how to account for R&D expenditures, but it has been criticized for being too restrictive and not providing enough guidance on how to account for intangible assets involved in these processes (Moir & Seamer, 2018).
Moreover, the COVID-19 crisis has highlighted the need for companies to be swift and innovative in responding to unexpected challenges. Many companies responded to government requests for PPE by investing in R&D activities to develop new production processes and equipment. However, the current rules and requirements of IAS 38 may not adequately capture the value of these R&D activities, leading to inaccurate reporting and decision-making.
Therefore, this report will evaluate IAS 38 in relation to R&D activities, identify any limitations or challenges in applying the standard, and provide recommendations for changes to make the standard more responsive to reporting R&D activities.
Current Rules and Requirements of IAS 38
IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical substance (IFRS Foundation , 2019). Examples of intangible assets include patents, trademarks, copyrights, and R&D. IAS 38 requires that intangible assets be recognized if it is probable that they will generate future economic benefits, and their cost can be reliably measured. However, IAS 38 does not provide detailed guidance on the accounting treatment of R&D costs; on whether to expense or capitalize these costs.
Challenges in Applying IAS 38 on R&D
One of the main challenges in applying IAS 38 to R&D activities is determining when to recognize R&D costs as an intangible asset. IAS 38 requires that the costs of developing an intangible asset be recognized only if certain criteria are met (Chen, et al., 2019). For example, the entity must be able to demonstrate that it has the ability to use or sell the intangible asset, and that it will generate future economic benefits. However, R&D activities often involve a significant degree of uncertainty, and it can be difficult to determine whether the criteria for recognition have been met since there is no basis for predicting commercial use.
Another challenge is determining the appropriate measurement of R&D costs like intellectual property. IAS 38 requires that the cost of an intangible asset be measured accurately. However, R&D activities can be complex and involve multiple stages, making it difficult to determine the appropriate distribution of costs to each stage (Phillips & Pugh, 2020). Its challenging to audit and value some of the Research and Development costs and for the most part will have to rely on honest disclosure by the companies.in this light, companies may choose to either expense the R&D costs or capitalize them. Capitalizing them is impressive to investors while expensing them may have an impact on the tax obligation from the earnings.
Potential Impact of Challenges in Reporting R&D
The challenges in applying IAS 38 to R&D activities can have a significant impact on financial reporting and decision-making. If R&D costs are not recognized as an intangible asset, they will be expensed in the period incurred. This can result in a significant fall in reported profits, which may not accurately reflect the true economic value of the R&D activities (Ross & Wright, 2018). Furthermore, the uncertainty and complexity of R&D activities can make it difficult for investors and other stakeholders to evaluate the potential economic benefits of R&D activities (Saeedi, et al., 2019).
Gaps in IAS 38 for Reporting R&D Activities
IAS 38 requires that R&D costs be expensed in the income statement when incurred, except when the criteria for recognition as an intangible asset are met. While this approach is consistent with the matching principle, it may not reflect the true economic value of R&D activities. According to Lueg (2021), this approach could lead to a situation where a company that invests heavily in R&D but has not yet generated revenue from the resulting intangible assets may have a lower net income than a company that has not invested in R&D but has generated revenue from existing intangible assets.
The gaps and inconsistencies in IAS 38 related to R&D activities could have a significant impact on the usefulness and reliability of financial information related to R&D activities.
For instance, if companies apply IAS 38 inconsistently, it may be difficult for stakeholders to compare R&D investments and the resulting intangible assets across companies. Similarly, if companies do not capitalize R&D costs appropriately, it may result in an understatement of intangible assets and an overstatement of expenses, leading to an inaccurate representation of a company’s financial performance (Kappes & Meyer, 2018). This could impact the ability of stakeholders to make informed decisions about a company’s future prospects.
Recommendations for Changes to IAS 38
- Recognition of Development Costs
The current IAS 38 requires only research costs to be recognized as expenses. However, businesses may not fully capitalize development costs, leading to complex criteria for asset recognition. Therefore, development costs should be recognized as expenses, unless it is probable that the asset will generate future economic benefits.
Recognizing development costs as expenses leads to more transparent and accurate financial reporting (Amat, et al., 2018).
- Enhanced Disclosure Requirements
The current IAS 38 requires limited disclosure on R&D activities, which may not provide stakeholders with a complete picture of the value created. Therefore, disclosure requirements should be enhanced to include detailed information on the nature and objectives of R&D activities, stage of completion, and estimated economic benefits.
Research has shown that enhanced disclosure requirements improve the relevance and reliability of financial information related to R&D activities (Cai, et al., 2019).
- Recognition of Internally Generated Intangible Assets
The current IAS 38 requires specific criteria to recognize internally generated intangible assets, including R&D assets. This recognition criteria should be revised to include the potential for future economic benefits, instead of demonstrating technical feasibility and marketability.
Studies have shown that the current recognition criteria for internally generated intangible assets are restrictive and result in the under-recognition of R&D value (Dražić Lutilsky & Knežević, 2020).
Benefits of Implementing the Recommended Changes
The recommended changes would enhance the usefulness and reliability of financial information related to R&D activities by providing a more accurate reflection of the value created by recognizing development costs, offering stakeholders a more complete picture of the potential for future growth with enhanced disclosure requirements, and recognizing the value created by R&D activities, even if assets are not commercially viable.
Conclusion
In conclusion, the International Standard IAS 38 provides guidance on the recognition, measurement, and disclosure of intangible assets. However, the standard poses challenges when it comes to reporting research and development (R&D) activities. The standard does not provide clear guidance on the recognition and measurement of R&D costs, which affects the usefulness and reliability of financial information related to R&D activities.
This report has evaluated IAS 38 in relation to R&D reporting, identified gaps and limitations in the standard, and recommended changes to make it more responsive. One possible solution is to provide more specific guidance on the recognition and measurement of R&D costs, which would improve the comparability of financial statements across different companies and industries. Another solution could be to develop a separate accounting standard for R&D activities, which would provide more detailed guidance and ensure consistency in reporting across different countries and industries.
Furthermore, ongoing review and evaluation of international financial reporting standards are essential to ensure that they remain responsive to changing business needs. The COVID-19 pandemic has highlighted the importance of innovation and R&D in responding to societal needs. Therefore, it is critical to ensure that financial reporting standards provide clear guidance on the recognition and measurement of R&D activities, to ensure that the information reported is relevant, reliable, and comparable.
The International Accounting Standards Board (IASB) should consider revising IAS 38 to provide more specific guidance on the recognition and measurement of R&D costs, or developing a separate accounting standard for R&D activities to enhance the quality of financial information related to R&D activities and enable stakeholders to make informed decisions.
