Introduction
Competition Bikes, Inc. successfully manufacturers, distributes, and sells customized bicycles for professional riders who participate in bike races, biathlons, and triathlons. Since its formation in 2001, the company has experienced substantial growth. Currently, the company operates in two locations, San Diego and Atlanta. Larry Ferguson, the company’s founder and chief executive officer, is considering opening a new location in a city in the middle of the United States for decreased distribution time. Prior to deciding to open a new location, Larry wants to ensure the company is properly controlling cost, finances, and internal controls. This report highlights Competition’s operational strengths and weaknesses, working capital, internal control, and compliance with Sarbanes-Oxley.
Operational Strengths and Weaknesses
Horizontal Analysis
A Horizontal analysis analyzes financial statement information over a certain period. Horizontal analysis assists managers with identifying year-to-year changes in a company’s financial statements. A review of Competition’s income statement reflects a 33.33% increase in sales from Year 6 to Year 7. However, sales decreased by 15% between Year 7 and Year 8. Further analysis shows that Competition’s net sales increase when advertising expenses increase. For example, Competition increased advertising spending by 37.5% between Year 6 and Year 7 and sales increased by 33.3%. When advertising expenses decreased by 16.3% between Year 7 and Year 8, the firm had its sales decreasing by 15%. Therefore, one of Competition’s strengths increasing advertisements, which in turn leads to increased sales. However, sales represent a weakness with decreased advertising spending. Therefore, from this perspective there is need for Competition Bikes, Inc. to embark on serious sales promotional services especially advertising in a bid to attracting more customers hence achieving higher sales.
Vertical Analysis
Vertical analysis assists managers with analyzing financial statement information by identifying the significance of each item using percentages of a base amount. A vertical analysis of Competition’s balance sheet shows that land represented 46.3% of the company’s assets in Year 8. It also shows that mortgage payable represented the largest portion of the company’s liabilities at 37.1%, a possible weakness if the company faces turmoil in the future. Additional analysis of the balance sheet reflects a decrease in Net Property and Equipment between Year 7 and Year 8; however, further review indicates that the decrease was not the result of a sale or loss of assets, but the result of an increase in accumulated depreciation. Since the firm experiences so much accumulated depreciation there is need to invest in fixed assets that depreciation minimally as opposed to those that depreciate faster and with large margins. In any case, Competition Bikes, Inc. has higher mortgage payable hence the need to reduce the same and apply current liabilities, which leave the firm with very little in terms of the amount it owns creditors.
A vertical analysis of the balance sheet also reveals the relationship between cash and accounts receivable. For example, in Year 6, Competition had $261,000 in cash and $271,653 in accounts receivables; each representing 6.2% and 6.5% of assets, respectively. In Year 7, cash represented 2.7% of current assets, while accounts receivable represented 16.6%. In year 8, cash represented 10.3% of current assets and accounts receivables represented 14.1%. Comparing cash and accounts receivable for the three years analyzed, shows that as cash decreases as accounts receivables increase. From this perspective, it is undeniable that the firm is giving so much of its goods on credit and not in cash.
When accounts receivable takes a greater percentage of the firm’s current assets as opposed to the cash, then there is likely to be deficit in working capital. In addition, the liquidity of the firm is at stake since there is much of the sale with debtors. With reduced liquidity of the firm as well as the working capital, the firm is unlikely to meet its daily operations and current liabilities. Moreover, higher accounts receivable as opposed to cash is likely to affect petty cash, which is vital in meeting daily and current liabilities. Going by the figures and facts of the accounts receivables and cash, there is evidence that Competition Bikes, Inc. is likely to face serious challenges in meeting its current liabilities as well as the measure of liquidity. The liquidity of Competition Bikes, Inc. is at stake with the accounts receivable taking higher percentage of current assets as opposed to cash for the three years running.
Higher cash ratio within the current assets as opposed to higher accounts receivable ratio within the current assets makes a firm stronger in respect to working capital. Working capital ensures that a firm meets its daily operations and objectives. From the above figures and facts for Year 6, 7, and 8, Competition Bikes, Inc. has a lower cash ratio in the current assets with higher accounts receivable ratio in the current assets. Consequently, Competition Bikes, Inc. strength is very low as majority of its sales are held by debtors and not in cash. The firm’s strength in terms of liquidity is also low due to higher accounts receivable as compared to available cash.
Income statement: A review of the income statement for Year 6 through Year 8 reflects the direct relationship between accounts receivables and sales. A vertical analysis exhibits the highest number of sales in Year 7. Coincidentally, Year 7 is the year Competition Bikes had the largest amount of accounts receivables during the three years analyzed. As a result, the company had increased sales in Year 7 because it sold more bikes on credit.
Trend Analysis
Managers use trend analysis to identify changes taking place in a business by calculating percentage changes for three of more years. Year 6 is the base year used to determine Competition’s net sales during the last three years. According to the analysis, net sales increased between Year 6 and Year 7, but sales dropped in between Year 7 and Year 8. Although net sales decreased, management projects sales will continue to grow through Year 11 and beyond because of word-of-mouth advertising and its bikes’ high victory rates.
Although management expects sales to continue to grow because of word-of-mouth advertising, there are weaknesses in the trend analysis. A review of the income statement shows that increased net sales did not necessarily result in increased net earnings. Overall, net earnings actually decreased by about 23.9% when comparing the Year 6 base year to Year 8. Additionally, management based forecasted sales on Competition’s performance during a three year period. Generally, companies analyze five years of performance to ensure key data is used to forecast sales and losses in future years.
Ratio Analysis
Ratio analysis identifies relationships among a company’s balance sheet and income statement items. Ratio analysis is an effective tool because it reflects Competition’s strengths and weaknesses in areas of liquidity, asset utilization, financial leverage, and profitability. The current ratio, the most common ratio used to determine liquidity, highlights the company’s strength in liquidity. In Year 8, the company had a current ratio of 5.35 times; however, Two Wheel Racing, Competition’s closest competitor, had a current ratio of 4.20 times. A current ratio of 5.35 means Competition had $5.35 in current assets for every $1 in current liabilities versus Two Wheel with $4.20 in current assets for every $1 in current liabilities.
The average collection period ratio highlights the company’s weaknesses in collecting receivables. In Year 7 and Year 8, the company had average collection period ratios of 43.8 days, which means the company collects on credit sales in 43.8 days. This poses a problem for Competition because its invoices are due in 30 days and Two Wheels generally collects on credit sales in 32.5 days; as a result Two Wheels generally has more access to working capital.
Competition’s debt ratio is another weakness revealed through ratio analysis. In Year 7 and Year 8, the company had debt ratios of 46.7% and 45.9%, respectively. This means Competition had about $.47 in debt for every $1 in assets in Year 7 and about $.46 in debt for every $1 in assets in Year 8. In Year 8 Two Wheel’s debt ratio was 38%, 7.9% less than Competition, which means Two Wheel uses less debt to finance its operations.
Competition’s most obvious weakness is the comparison to Two Wheel’s profit margin. In Year 8, Competition had a profit margin of 27%, whereas Two Wheel had a profit margin of 32.1%. This means Competition receives 27 cents in profits for every dollar in sales, whereas Two Wheels receives a little more than 32 cents. This is not a significant different; however, it does reflect that Two Wheel is more profitable.
Working Capital
Working capital represents Competition’s short-term assets and liabilities. A company has sufficient working capital when it uses working capital to ensure sufficient resources are available to run day-to-day operations. A method used to determine if Competition effectively manages working capital is to analyze activities that increase and decrease cash. Between Year 6 and Year 7, cash decreased by 54.6% because of decreases in mortgage payable, accrued salaries, and other current liabilities. Between Year 7 and Year 8, cash increased by 275.4% because of an increase in accounts and notes payable and a decrease in accounts receivable.
Based on Competition’s Balance Sheet data, it managed working more efficiently in Year 6 and Year 8. The company can improve working capital by changing its credit policies to reduce its accounts receivables collection time to less than the 43.8 days average. This may be accomplished by offering discounts for distributors who pay their invoices within a specific number of days. Another method is to use short-term financing for purchases from suppliers to ensure sufficient cash is kept on hand.
After Competition increases working capital, the excess amounts may be used to generate increased profits. One method to increase profits is to invest in more short-term or long-term investments to generate additional interest income. Competition can also use excess working capital to increase the advertising budget because the income statement reflects a relationship between increased advertising expenses and increased sales.
Internal Controls for the Purchasing System
Adequate segregation of related duties is the most effective method of internal control. A review of Competition’s operating manual reveals internal control weaknesses resulting from a lack of segregation of duties within the purchasing system. Currently, the purchasing department is in charge of selecting vendors, ordering supplies, receiving supplies, and submitting vendor invoices to the accounting department. Assigning authority to select vendors and order supplies increases the risk of a fraudulent employee in the purchasing department creating a fictitious corporation to receive the orders. This also increases the chance that vendors are selected based on their willingness to overcharge Competition and split excess amounts with the fraudulent employee. Giving the purchasing department authority to receive supplies and submit vendor invoices increases a fraudulent employee’s ability to defraud the company by confirming receipt of items and requesting payments for items not received.
Competition can reduce purchasing department internal control weaknesses by delegating some of the purchasing department’s duties to other departments or involving management. One suggestion is to assign the task of selecting vendors to an independent department like the marketing department. Another suggestion is to have a manager from the quality control department or another independent department confirms receipt of supplies by comparing the items ordered to the items received. The purchasing department can keep the responsibilities of ordering supplies and submitting invoices to the accounting department; however, a manager should sign the invoice confirming agreement with the quality control manager’s verification of the supplies received prior to submitting it to the accounting department.
Compliance with Sarbanes–Oxley
Competition is not in compliance with Sarbanes-Oxley because of its lenient policy on internal control in the purchasing department. Criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) require management to safeguard the entity’s resources, prepare reliable financial statements, and comply with laws and regulations established for public companies (“University Of Houston System Department Of Internal Auditing”, n.d.). Because the purchasing department has a significant amount of authority, Competition does not have efficient policies in place to safeguard inventory or confirm inventory expenses to ensure financial statement accuracy. If Competition implements a system segregating the purchasing department’s duties, the financial statements would be more reliable, thus, increasing the likelihood that the company is in compliance with Sarbanes-Oxley and the COSO requirements.
In order to correct various areas of weaknesses, Competition Bikes, Inc. needs to ensure that there is adequate working capital through reduction of accounts receivable while increasing the available cash for day-to-day running of operations. In achieving this, Competition Bikes, Inc. needs to promote the culture of buying goods in cash as opposed to offering credit facilities. One of the ways of attaining this is through provision of cash, quantity, and trade discounts. On a different perspective, Competition Bikes, Inc. needs to ensure that it complies with provisions of Sarbanes-Oxley because of its lenient policy on internal control in the purchasing department.
Reference
University of Houston System Department of Internal Auditing. (n.d.). 2012. Web.