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The purpose of the first part of this report is firstly to make a brief mention to the history of the selected company that has a listing on the stock exchange; Debenhams. Secondly, is to present financial performance analysis of Debenhams for financial years 2011 and 2012. The analysis is carried out by employed ratios as analytical tools to assess the company's profitability, its liquidity, the efficiency, the capital gearing of Debenhams and investment ratios performance. The calculation of these ratios from the final accounts of the company will help us to compare these two years.
The second part of this report is about the activity based costing system, ABC. In the first section compares and contrasts ABC costing and traditional absorption costing. Thence, analyses the impact of ABC costing system. Finally, concludes with the question if ABC helped companies throughout the world to refine and improve their costs systems.
As a conclusion, this paper gives a reasoned argument whether ABC should be used by Debenhams.
Company Profile: Debenhams PLC
Part I: Financial Performance Analysis of Debenhams PLC
Financial Ratios Analysis
Profitability of Debenhams
Liquidity of Debenhams
Efficiency of Debenhams
Capital Gearing of Debenhams
Investment in Debenhams
Part II: Activity Based Costing System (ABC)
Critique of the Rise of ABC
Its Comparison with Absorption Costing and its Advantages
Impact of ABC System
For Part I: Financial Performance Analysis of Debenhams PLC
For Part II: Activity Based Costing System (ABC)
Appendix A : Computation of Accounting Ratios
Appendix B : Consolidated Income Statement
Appendix C : Consolidated Balance Sheet
Appendix D : Consolidated Cash Flow
Company Profile: Debenhams PLC
Debenhams is a leading international, multi-channel British-based brand which is available in 92 countries, through stores or online, including China, India, Bangladesh, Vietnam, Romania, Turkey, Cambodia, Morocco, and Egypt etc. The Company boasts placing customers at "the heart of everything we do and are truly passionate about the products that we sell, half of which are exclusive to Debenhams". Major products offered by Debenhams are accessories, electrical, flowers, home and furniture, and gift ideas. Also, the Company offers services such as wedding services, shopping assistance, and in-store cafes and restaurants (Debenhams).
History of Debenhams dates back to 1778 when a drapers store was established by William Clark in London. Initially, the Company sold expensive fabrics, gloves, bonnets, and parasols. The Company started to expand its operations when William Debenham made investments and the name was changed to "Clark & Debenham". Further investments in the Company were made by Clement Freebody in 1851 after which it was renamed as "Debenham & Freebody". A wholesale and retail was then established selling cloth and other items to dressmakers and other large retailers. The Company made several acquisitions of retail, wholesale, and manufacturing businesses in the nineteenth century. Offices were opened in South Africa, Australia, Canada, and China. Acquisitions continued in the twentieth century and Debenhams Ltd was incorporated in 1905. Debenhams was the largest department store group in the UK in 1950, owning 84 companies and 110 stores. The business of Debenhams was repositioned in the last two decades of the twentieth century introducing exclusive merchandize. The first international franchise was opened in 1997 in Bahrain (Debenhams).
The gross transaction value of Debenhams recorded an increase of 26% in 2012. The increase was driven by "like-for-like" sales growth in stores and online in the UK and international businesses as well as new store space. Other financial indicators were also healthy during last years. For example, Debenhams' revenue increased by 2.6%, profit before tax 2.5%, and dividend per share increased by 10%, compared with the previous year. In the aftermath of an economic recession, healthy growth signs indicate the success of Debenhams' approach and strategy. For example, Debenhams continues to pursue its growth strategy and is continuously expanding through franchises (Debenhams).
Selling franchise has enabled swift expansion as capital is provided by the franchisees. Debenhams seems to be an ambitious service provider and retailer. Through acquisitions and franchises, continued growth is also expected in the future. The Company has planned a different approach for sustaining its growth in the future calling it "single view of the customer". This approach may facilitate Debenhams to have a complete perspective on the customer behaviour and shopping patterns. Another benefit of this approach will be tailored marketing customized to the need of the individual customers. Customization of the products will help the Company finds its way into different product categories. Present emphasis on growth shows the future objectives of Debenhams are driven clearly by a strategy to increase market share and ultimately the profitability. The largest sourcing hub of Debenhams is China/Hong Kong and the Company is planning to increase its presence in Far East market for example entering the prosperous market of Thailand. Besides growth strategy as a major success factor, Debenhams is also successful due to its policy emphasizing cultural diversity making efforts to satisfy needs and demands of regional markets (Debenhams).
Debenhams' confused identity
Financial Performance Analysis of Debenhams PLC
Financial information gives the ability to the users to make decisions and to plan their business. The methodology adopted for the analysis includes ratio analysis. Moreover, financial accounting statements reflect the business activities through the income statement, which is involves the profit and loss account, a cash flow statement, which considers where the money goes and comes from, and a balance sheet statement, which looks at the wealth of the business at the end of the period.
The case study for financial analysis as mentioned above is about Debenhams. This year for Debenhams wasn't profitable as is show below. As stated the Chairman of Debenhams, Nigel Northridge: "2012 was a year of celebration across the UK for many reasons; not least the Queen's Diamond Jubilee and the hosting of enormously successful Olympic and Paralympics Games. For retailers, however, it was one of the most challenging years on record."
Financial Ratios Analysis
2.2.1 Profitability of Debenhams
The profitability ratios measure the relation of profit to various financial measures, like the capital etc.
Return on year and capital employed (ROCE)
Gross profit margin
Operating profit margin
Return on year and capital employed (ROCE): This ratio shows the percentage of net profit after tax on the capital employed. As long as the rate is higher, so efficient is the capital employed.
â€º The ratio ROCE for Debenhams PLC in 2011 was 14.1% and in 2012, it had a reduction of 10%, reaching the 12.8%. By this declining in the return on capital employed, implies that the resources of the organisation are being exploited less effectively in the generation of operating profits. Non-current liabilities has been increase in the year 2012 compared to the year 2011. Operating profit has been risen by 5% and non-current liabilities have been fallen by 9%, due to payback long term loan and borrowing. In addition, equity has been increase. Also, the value of equity is higher than the non-current liabilities and that protects the company from liquidity problems.
Gross profit margin: This ratio shows the percentage of the gross profit from sales that have accomplished. As higher the percentage is, such higher is the profitability of the business from sales. The positive profit margin analysis translates into positive investment quality, such as research and development, or marketing.
â€º The gross profit margin has slightly increased in year 2012, basically the gross profit margin remained almost stagnant at 13%. This due to the increasing of sale revenue that has been increased only by 1% in 2012, and also of that at the same period the cost of sales rose only by 1% too.
Operating profit margin: This ratio shows the before interest and taxes profit of the company. As higher the percentage of this ratio is, such better is for the company.
â€º The following ratio indicates the operating profit generated from sales revenue in percentage terms. The operating profit margin for 2011 was 8.31% and it had a slight decrease of 5.86% in 2012. This slight decrease is a due of that the operating profit has a small decreasing of 5% when the sales revenue increased by 1% only. The increasing of revenue caused by the opening of two new stores in 2012, this continues to be a driver of sales growth.
The stable value of the gross profit margin and the slight decreasing of operating profit margin, do not seem very healthy for the company's profitability. This shows that the profitability ratio hasn't earned at sales, at total assets and at net worth.
2.2.2. Liquidity of Debenhams
Liquidity is the ability of a company to fulfil its obligations. The liquidity ratios indicate a firm's ability to carry out enough revenue in order to cover its obligations and continue its operations.
0.592 : 1
0.632 : 1
0.143 : 1
0.175 : 1
Current ratio or Working capital: This ratio indicates whether it can respond to the current liabilities by using current assets. As many times we can cover short-term obligations, as better for the company.
â€º Debenhams's current ratio was 0.592:1 in 2011, which increased only by 0.04:1 times to become 0.632:1 in 2012.This highlights small improvement in liquidity. The increase in current ratio could be attributed to 8.5% increase in current assets, when its current liabilities increased by 1.6% only. The increase in current assets, derived from the increase of receivables by 5% and 3.4% increase in inventories. Simultaneously increase in current liabilities was driven by 7.4% in trade and other payables.
Quick ratio: This Ratio indicates a firm's ability to meet the short-term obligations, without the need to sell stocks of merchandise. In brief, how many times can the firm to respond its current liabilities by using current assets without the final stock. As many times it can cover its obligations, as better for the company. In order a company to have a solid financial health, the quick ratio must be 1 time, which is a sign that the liquidity level of a company is high.
â€º In the present case, the quick ratio increased from the previous year by 22%, that's a good sign for the health of Debenhams. This happen because the inventories increased by 3.4%, in 2012 when its current liabilities increased by 1.6%. The calculations show that Debenhams has the ability to pay off short-term obligations without base on the sale of its inventories.
2.2.3. Efficiency of Debenhams
Another significant ratio is about the effectiveness of a company. Efficiency ratios are about the strengths and weaknesses of a company.
Net asset turnover
Trade receivables' collection period
Trade payables, Payment period.
Net asset turnover: This ratio demonstrates the efficiency and profitability with which assets of a company are exploited to generate sales.
â€º As shows the net asset turnover decreased by 4.3% in 2012. Briefly, in 2011 the net asset turnover was 1.14 times whereas in 2012 was 1.21 times. There is a decrease in the asset turnover, which implies negative aspects for sales revenue generation.
Trade receivables' collection period: This ratio looks at the number of days that trade debtors take to pay the organisation for the credit sales.
â€º The trade receivable' collection period remained the same at 12 days. It's a good movement, which the debtor collection period did not increase. The reason that is positive is because this helps the operating cash flow of the organisation.
Trade payables. Payment period. : This ratio measure the days that a company need to pay its supplier for the purchases made.
â€º Debenhams's payment period in 2011 was 93 days whereas in 2012 took approximately 99 days. The increase of the payment period is due of the increase of trade payables by 7% while the cost of sales increased a bit. That shows that Debenhams is consistent in its debt management. So, it obtains favourable purchase terms, as well as easy access to funds in future.
2.2.4. Capital Gearing of Debenhams
This ratio states the proportion of debt in a company's capital structure. The higher is the gearing ratio or financial leverage, such high is the financial risk.
Interest Cover Ratio
Gearing Ratio: The Gearing Ratio show the relation of company's long term liabilities with the equity. This shows at what level is the capital with the liabilities.
â€º Debenhams capital gearing ratio was 49.4% in 2011, which increased by 4.25% to become 51.5% in 2012. This increase is due of the faster increase long-term liabilities by 9.4% than the company's equity that increased by 0.2% only. The long term liabilities issued was employed to pay or refinance existing debt or other general corporate purposes. According the annual report of Debenhams (2012), the liabilities relates to the spreading of the charges relating to leases with fixed annual increments in rent.
Interest Cover Ratio: This ratio shows what part of dept interest is covered by the cash flow of a company. In order to don't have financial risk, the ratio must be as long higher become.
â€º Interest cover of Debenhams PLC in 2011 was 6.7 times and in 2012 has increased, and became 9.8 times. This is a result of the reduction of the operating profit by 5%, at the same time that the finance costs has increased by a higher rate. This outlines improvement in the Debenhams long-term solvency. The operating profit was decrease cause of the employment costs that decreased by 4%. In addition, the benefit of the reducing finance cost is that the bank loans and overdrafts decreased by 39% in 2012.
In brief, Debenhams is low-financially leveraged, as well as acceptably covers its interest expense positively, so brings much lower financial risk. This lower financial risk reduces its cost of capital and enhances its credit rating.
2.2.5. Investment in Debenhams
Investment ratios are employed to access the stock's performance.
Dividend Cover Ratio
Dividend Cover Ratio: This ratio shows the number of times is covered the dividend that holders of preference shares entitled to get from the net profit of the company after deducting tax. As many times covered so much better is for holders of the preference shares.
â€º The dividend cover ratio decreased to a large extent. In financial year 2011 was 9.1 times but in 2012 decreased to 3.3 times. This a due of dividends paid that increased highly from 12.9 in 2011 to 38.5 in 2012, despite the fact that the earnings was increased too by 7% only. This decline raises further concerns about the ability of the organisation to keep up its dividend policy.
Taking into consideration the ratio analysis applied to Debenhams, highlighted that the company had some alteration between the financial years 2011 and 2012. The outcome of the financial analysis of Debenhams is that most of profitability, liquidity, efficiency and investments ratios demonstrate decline. However, the gearing ratios demonstrate a rise due to the growth of the non-current liabilities. From the information and analysis that collected, is observed that Debenhams has some difficulties in their supply chain and their financial and marketing management. Even though, they have invested in a long-term development and are positive in a potential growth in the subsequent years, to achieve their aim they have to work hard. They must play in the same field as its competitors that are also department stores with product categories, like Marks & Spencer or House of Fraser etc. The financial crisis is one of the factors were conducted problems to the company. Debenhams still have a strong position in the UK and not only. For the moment is not good for the investors to invest in Debenhams, they must wait and see its performance for the next years.
Activity Based Costing System (ABC)
Activity-based costing (ABC) system gained popularity in the early 1980s as an alternative to conventional cost management systems that apparently produced inadequate results while allocating costs. Professor Robert Kaplan- a professor in the Harvard University- was an early proponent of the ABC system. ABC system links spending by an organization on resources directly to activities where support as well as indirect expenses are traced accurately by cost drivers to individual customers, products, and services. The rise of ABC has helped companies throughout the world to refine and improve their costs systems. Companies adopting ABC have successfully managed to improve cost accuracy and precision by emphasizing managers to reduce cost, to provide an effective management tool for making better decisions, and ultimately increasing profitability of companies based on a cost-effective and practical approach of ABC. Traditional costing approaches are based on calculating direct costs and subsequently adding proportionate overhead costs. These approaches, at times, lead to incorrect business decisions. Due to increased levels of overhead costs and small share of direct costs in the contemporary businesses, the cost allocations are not successful. ABC system has been devised to remove the deficiencies present in the traditional systems, ultimately allowing managers to determine the real costs related to each product or service.
Critique of the rise of ABC
Its Comparison with Absorption Costing and its Advantages
Costing systems may differ in relation to which costs are actually assigned by the companies to cost units or cost objects along with their sophistication levels. Cost systems are generally classified as: direct costing systems, traditional absorption costing systems and activity-based costing systems. Only direct costs are assigned to cost objects in direct costing system. As indirect costs are not assigned to cost units of cost objects, they report contributions directly to indirect costs. As such, direct costing system may also be categorized as 'partial costing system'. This system is suitable for decision-making in situations where the cost especially of joint venture fluctuates. A main disadvantage of direct costing system is that they do place systems to measure as well as assign indirect costs. Contrary to that, indirect costs are assigned to cost units or cost objects in both traditional absorption costing and ABC system (Durry, 2007).
Absorption costing system is related to the collection of costs by cost object, cost unit, or product. Production overhead costs, under this system, are absorbed by the products through creation of overhead absorption rates. The absorption rates often used in manufacturing companies include those which are mainly based on direct labour. The changes that have recently been witnessed in many instances now preclude the usage of direct labour as a fundamental basis specifically for overhead cost absorption, and also other methods are being developed (Major & Hooper, 2005).
There are certain disadvantages of traditional absorption costing due to which researchers have developed other costing systems. A main disadvantage of absorption costing system is encouraging production for the end stock. In absorption costing system, direct labour is often used as a basis for overhead costs despite the fact that a number of the overhead costs are either driven by direct labour or not incurred on the same basis. It is understood that other cost drivers are also there, and that several activities in the companies may lead to incurring of costs. In manufacturing such products, these costs may be driven by different issues related to production. Moreover, fixed costs, under absorption costing system, is mostly charged to products or services based on volumes as such; it is not possible to recognize the cost drivers or activities causing occurrence of such costs (Jackson & Sawyers, 2008).
During the decade of 1980, the limitations and constraints in traditional absorption costing system started to be publicized. The system was devised decades ago when many companies produced a narrow line of products. Also, materials and direct labour were the main factory costs. The share of overhead costs was considerably small while the distortions due to inadequacy of overhead allocations were insignificant. Costs of information processing were high and as such; it was difficult for the managers to justify overhead allocation methods (Cooper & Kaplan, 2007).
Companies today produce and deal with a wide range of goods and services. Direct labour costs form small proportion of total costs. Overhead costs are of significant importance. It is, therefore, difficult to justify overhead allocations by utilizing a reducing direct labour base, especially when costs of information processing are no more barriers to using refined cost systems. Furthermore, high levels of global competition during 1980s resulted in decision errors because of cost information more costly and more probable. It is against this backdrop, the rise of ABC system has been witnessed (Cooper & Kaplan, 1998).
Supporters of ABC system offer a number of arguments to justify its adoption. They argue that ABC is a fair method to charge costs to a wide variety of products. The products that use the organizational activities causing the occurrence of cost bear such costs related to these activities in a fair way. This addresses the shortcoming of absorption costing system in which general overheads of a company are spread over a range of products using methods often unrelated to the manner costs are driven or generated (Cooper & Kaplan, 1998).
Another argument signifying superiority of ABC system over absorption costing system is that the former takes into account product complexity. Different types of costs charged to a range of products are associated with the circumstances in which products are manufactured. Using ABC, complex products in particular might result in high unit costs than simple products. Therefore, this would have substantial impact in measuring profitability of the relative product than absorption costing method. Those costs that under the traditional absorption costing methods are generally considered as fixed in total may be regarded as variable especially in the long run under ABC system. Consequently, ABC supports measuring efficiency levels of managerial and administrative functions. Another advantage of ABC system is encouraging or adopting a more pragmatic approach to the policies related to stocks. ABC system does not suggest building stock of finished goods as in the case of traditional absorption costing system. The over-recoveries, in ABC system do not arise to the same level. The reason is that a greater fraction of the costs are regarded as variable instead of fixed (Horngren, 2012).
Impact of ABC System
ABC system is more appropriate than other costing systems and should be used by Debenhams. This system offers accuracy and precision but at the same time requires more resources. The justification to adopt this method relies on the advantages of improved decisions due to more accurate costs. ABC will result in more cost pools to assign overhead costs to a variety of products. Costs, using this approach, can be assigned more directly to the relevant products based on the cost drivers (Chongruksut & Brooks, 2005). Debenhams' management can exercise more control on the Company's overhead costs. Under this system, Debenhams can trace several overhead costs and assign them directly to activities. This will eventually allow identification of indirect costs. As such, Debenhams' management will be more aware of their task to control the activities leading to occurrence of costs. Another benefit that Debenhams can have is better execution of management decisions. Due to accurate costing, Debenhams can determine selling prices that will support in achieving the desired profitability levels.
A major benefit to implement ABC system is a rise in shared understanding between the accounting and sales personnel and also other employees in how effective and efficient the costing system is in relation to managing tradeoffs. This will have a significant impact on the organization change and also considerable change in company culture. Innes and Mitchell (1991) reported some factors that can help successful implementation of ABC system. These factors are; support from a company's top management; regular supply of appropriate resources; a participative way between different departments of a company in data congregating; and achievable objectives to implement ABC system (Innes & Mitchell, 1991).
Activity-based costing (ABC) system gained popularity in the early 1980s as an alternative to conventional cost management systems that apparently produced inadequate results while allocating costs. The rise of ABC has helped companies throughout the world to refine and improve their costs systems. Companies adopting ABC have successfully managed to improve cost accuracy and precision by emphasizing managers to reduce cost, to provide an effective management tool for making better decisions, and ultimately increasing profitability of organization based on a cost-effective and practical approach of ABC. As Debenhams PLC deals with several products, ABC system will be suitable as its costing system. This is because ABC system is a fair method to charge costs to a wide variety of products. Adopting ABC method will enable Debenhams to accurately measure the profitability of every product. More accurate data costs will help in setting realistic prices and also support to decide whether to buy a particular product and, in some cases, even consider eliminating a product. ABC method will help Debenhams' management exercise more control on the Company's overhead costs, trace several overhead costs, and assign them directly to activities.