05: ZARA CO.
Zara Co is a listed company which has traditionally manufactured children’s clothing and toys with long lives. Five years ago, it began manufacturing electronic toys and has since made significant investment in development and production facilities. The first electronic toys which Zara Co introduced into the market were received very well, partly as it was seen to be ahead of its competitors in making the most of the technology available.
The country where Zara Co is listed has seen a significant general increase in share prices over the last three years, with companies in the electronic goods sector showing particularly rapid increases.
Statement by Zara Co’s chief executive
Assume it is now September 20X3. Zara Co’s annual report for the year ended 31 March 20X3 has just been published. Its chief executive commented when announcing the company’s results:
‘I am very pleased to report that revenue and gross profits have shown bigger increases than in 20X2, resulting in higher post-tax earnings and our company being able to maintain increases in dividends. The sustained increase in our share price clearly demonstrates how happy investors are with us. Our cutting-edge electronic toys continue to perform well and justify our sustained investment in them. Our results have also benefited from improvements in operational efficiencies for our older ranges and better working capital management. We are considering the development of further ranges of electronic toys for children, or developing other electronic products for adults. If necessary, we may consider scaling down or selling off our operations for some of our older products.’
Sally Turner represents an institutional investor who holds shares in Zara Co. Sally is doubtful whether its share price will continue to increase, because she thinks that Zara Co’s situation may not be as good as its chief executive suggests and because she believes that current share price levels generally may not be sustainable.
Financial information
Extracts from Zara Co’s financial statements for the last three years and other information about it are given below.
Zara Co statement of profit or loss in years ending 31 March
(All amounts in $m)
|
20X1 |
20X2 |
20X3 |
Sales revenue |
1,385 |
1,636 |
1,914 |
Gross profit |
381
_____ |
451
______ |
528
_____ |
Operating profit |
205 |
252 |
300 |
Finance costs |
(46)
_______ |
(50)
_______ |
(66)
_______ |
Profit before tax |
159 |
202 |
234 |
Taxation |
(40)
______ |
(51)
______ |
(65)
______ |
Profit after tax |
119 |
151 |
169 |
Dividends |
(60) |
(72) |
(84) |
Zara Co statement of financial position in years ending 31 March
(All amounts in $m)
|
20X1 |
20X2 |
20X3 |
Non-current assets |
2,070 |
2,235 |
2,449 |
Cash and cash equivalents |
10 |
15 |
15 |
Other current assets |
150
______ |
130
________ |
125
_______ |
Total non-current and current assets |
2,230
______ |
2,380
_______ |
2,589
______ |
Equity
Ordinary shares ($0·50) |
400 |
400 |
400 |
Reserves |
805
______ |
884
_______ |
969
_______ |
Total equity |
1,205
______ |
1,284
_______ |
1,369
_______ |
Non-current liabilities |
920 |
970 |
1,000 |
Current liabilities |
105
_______ |
126
_______ |
220
______ |
Total equity and liabilities |
2,230
______ |
2,380
_______ |
2,589
_______ |
Other information |
Market price per $0·50 share ($2·50 at 31 March 20X0, $5·06 in Sept 20X3) |
$2.76 |
$3·49 |
$4·44 |
Earnings per share ($) |
0·15 |
0·19 |
0·21 |
Dividend per share ($) |
0·075 |
0·09 |
0·105 |
Analysis of revenue |
Non-electronic toys
Electronic toys
Clothing |
302
249
834
______ |
350
319
967
_____ |
404
390
1,120
______ |
|
1,385
______ |
1,636
_____ |
1,914
______ |
Analysis of gross profit |
Electronic toys
Non-electronic toys
Clothing |
100
72
209
_____ |
112
88
251
_____ |
113
105
310
_____ |
|
381
_____ |
451
_____ |
528
_____ |
Note. None of Zara Co’s loan finance in 20X3 is repayable within one year.
Â
Required
a. Evaluate Zara Co’s performance and business prospects in the light of the chief executive’s comments and Sally Turner’s concerns. Provide relevant calculations for ratios and trends to support your evaluation.
a. Profitability
Zara Co’s chief executive is correct in saying that the absolute increase in revenue and gross profits on all products was greater in 20X3 than 20X2, but the % increase in revenue was smaller on all products, and the % increase in gross profit on toys was also lower. The % increase on the electronic toys shows the biggest fall, possibly indicating greater competition.
The improvements in operations mentioned by the chief executive seem to have maintained gross and operating profit margins and resulted in the absolute overall increases in gross and operating profits. However, this aspect of performance is almost all attributable to Zara Co’s older products. The gross profit on electronic toys has hardly increased and the gross profit margin has fallen over the last two years. Although the margin remains higher than on the other products, even the 20X3 margin may not be sustainable. If competitors are starting to catch up with Zara Co, then the profit margin on the current range of electronic toys may continue to fall in future years, as prices fall to maintain market share.
Despite the emphasis on developing the products, the revenue generated by electronic toys is still below the revenue generated by non-electronic toys.
Asset turnover and return on capital employed have risen significantly over the last two years. However, part of the reason for the 20X3 increases was the significant increase in current liabilities. The further amount of investment which the chief executive appears to be contemplating suggests that asset turnover and return on capital employed may fall in future years, particularly if profit margins on electronic toys cannot be sustained.
Liquidity
The figures for other current assets seem to support the chief executive’s contention that working capital is being managed better, as other current assets are falling as revenue and gross profits are rising.
However, the fall of the current ratio from 1·52 to 0·64 is significant, and the biggest reason for the fall in 20X3 was the large increase in current liabilities. Cash balances have remained at a low level, despite higher revenues and profit. Possibly there is now a bank overdraft, which could have contributed to the significant increase in finance costs between 20X2 and 20X3. It would seem that cash reserves have been exhausted by the combination of investment in non-current assets and the payments to finance providers (both interest and dividends), and Zara Co is more dependent on short-term liability finance. Slowdown in any product area, particularly electronic toys, may result in significant liquidity problems.
Solvency
Gearing has fallen over the last two years, but this is due to share price increases which may not be sustainable. If book values rather than market values are used to calculate gearing, the fall in gearing is much smaller. More information is needed about an additional $30 million in long-term loans. Although costs on these may be higher than on its current loans, this would not account for all the increase in finance costs. As discussed above, Zara Co may be making use of overdraft finance. The fact that current liabilities have increased much more than non-current liabilities could be an indication that Zara Co is having problems raising all the longer term loan finance which it requires.
The figures suggest that Zara Co’s board needs to review future financing carefully if the company wants to make further investment in electronic products. At some stage, the board will have to consider raising further finance, either through an issue of shares or through selling off parts of its operations.
Investor ratios
Both earnings and dividends per share have risen since 20X1, which could help explain the significant increase in share price. Dividend cover has remained around 2·0 despite an increase in earnings. Although dividends have increased, dividend yield has fallen since 20X1. The increase in total shareholder return is due solely to the increases in share price, which have also resulted in the price-earnings ratio increasing in 20X3. The current rate of share price increase does not appear to be warranted by the most recent results and may be partly due to generous dividend levels, which may not be sustainable if more cash is required for investment.
Conclusion
Despite the chief executive’s optimistic message in the annual report, the benefits from the electronic toys’ development may be short-lived. There appears to be a mismatch between investment, dividend and financing policies. As discussed, margins on current products may fall further and there is no guarantee that margins on new electronic toys or other products will be higher if competition generally is increasing.
Further significant investment in electronic toys or other goods may be difficult to finance. Increased reliance on short-term finance is clearly not sustainable, but obtaining more debt may be problematic, particularly if gearing levels rise as share prices fall. Zara Co seems reluctant to take advantage of high share price levels to issue equity capital. This, plus the increase in dividends, may indicate Zara Co’s board is unwilling to risk upsetting shareholders, despite the large increases in share price. The chief executive may be right in saying that funds may have to be obtained by selling off one of the other parts of the business, but revenue and profits from the older products may be more sustainable. An increased concentration on electronic products may be a high-risk strategy. Possibly, if investors become less positive towards the electronic goods sector, they may realise this, resulting in an increase in cost of capital and a fall in share price.
Note. Credit will be given for relevant, alternative approaches to the calculations and discussion.
(Max 10 marks)
Appendix
 |
20X1 |
20X2 |
20X3 |
Profitability |
% Increase in revenue |
 |
18.1 |
17.0 |
Gross profit % |
27.5 |
27.6 |
27.6 |
% Increase in gross profit |
 |
18.4 |
17.1 |
Operating profit % |
14.8 |
15.4 |
15.7 |
% Increase in operating profit |
 |
22.9 |
19.0 |
Asset turnover (revenue/ (total assets – current liabilities)) |
0.65 |
0.73 |
0.81 |
Return on capital employed % (operating profit % x asset turnover) |
9·6 |
11·2 |
12.7 |
Liquidity |
Current ratio |
1.52 |
1.15 |
0.64 |
Solvency |
Gearing % (non-current liabilities/ (non-current liabilities + market value of share capital)) |
29.4 |
25.8 |
22.0 |
Gearing % (non-current liabilities/ (non-current liabilities + book value of share capital + reserves)) |
43.3 |
43.0 |
42.2 |
Interest cover |
4·5 |
5.0 |
4.5 |
Investors |
Earnings per share ($) |
0.15 |
0.19 |
0.21 |
Dividend per share ($) |
0·075 |
0·09 |
0.105 |
Dividend cover |
1.98 |
2.10 |
2.01 |
Market price per $0·50 share |
2.76 |
3.49 |
4.44 |
Price/earnings ratio |
18.4 |
18.4 |
21.1 |
Dividend yield % (dividend per share/share price) |
2.72 |
2.58 |
2.36 |
Share price gain/(loss) % |
10.40 |
26.45 |
27.22 |
Total shareholder return % |
13.12 |
29.03 |
29.58 |
Types of products: |
Electronic toys   |
|
|
|
% Increase in revenue |
|
28.1 |
22.3 |
Gross profit % |
40.2 |
35.1 |
29.0 |
% Increase in gross profit |
|
12.0 |
1.0 |
Other toys |
% Increase in revenue |
|
15.9 |
15.4 |
Gross profit % |
23·8 |
25.1 |
26.0 |
% Increase in gross profit |
|
22.2 |
19.3 |
Clothing |
% Increase in revenue |
|
15.9 |
15.8 |
Gross profit % |
25.1 |
26.0 |
27.7 |
% Increase in gross profit |
|
20.1 |
23.5 |
(Note. Credit will be given for alternative, relevant, calculations and discussion. Candidates will not be expected to complete all the calculations above to obtain 10 marks.)
(Max 10 marks)