1. Executive Summary
This report presents an analysis of The Body Shop PLC’s pro forma financials from 2002-2004 and insights into financial requirements for the company as it moves forward with their new strategies for achieving operational efficiencies and reclaim its brand image as a top manufacturer-retailer in the beauty and personal care industry.
We have constructed pro forma financial statements based on the sales-driven estimates and interest and tax fixed burdens. The key determining factors to the accuracy of these projections are the assumptions made about revenue growth and the sales-driven accounts like cost of goods sold, current assets (viz., inventory). Also, assumptions about the company’s capital budgeting structure and dividend policy have been made which can have a significant impact on the outcome of the projects and the management actions associated with it.
The company is currently facing a situation where it cannot drive its sales growth without adversely affecting the bottom line. The reduction in bottom line for the year is acceptable if it is a result of investments in fixed assets which support additional capacity or to implement a strategic marketing plan for higher future sales.
Based on the analyses of the pro forma statements and sensitivity analysis of key relationships explored, we have come to a conclusion that the company can sustain operations without any need for external financing if they limit their sales growth and cogs/sales ratio at 15% and 0. 35 respectively. That would require the management to further take some cost reduction initiatives necessary to meet that objective. Also discussed in the results section is the effect of the company’s dividend policy and inventory management on their need for external funding.
2. Introduction / Background
The Body Shop International PLC was one of the fastest growing manufacturer-retailers in the world; however in the late 1990s it lost market share. The firm had an annual revenue growth rate of 20% in the early to middle 1990s, but by the end of the decade, revenue growth slowed to around 8%. New retailers of naturally based skin- and hair-care products began to flood the market, which caused prices to decrease along with The Body Shop’s competitive advantage. The Body Shop shifted from its core values as well, becoming more of a mass-market line as it expanded into “ almost every mall in America, as well as virtually every corner on Britain’s shopping streets.” This was in contrast to its brand image of being a unique boutique shop for skincare.
The founder of The Body Shop, Anita Roddick, stepped down as CEO in 1998 after many failed attempts to renew the company’s image. She was replaced by Patrick Gournay, an executive from the French food giant Danone SA. However, problems continued to plaque the company despite this management change. Revenue grew 13% in 2001; however pretax profit declined 21%.
Even though pretax profit declined, Gournay was convinced that implementing a new strategy would produce successful results. Gournay’s strategy consisted of three primary objectives: “ To enhance The Body Shop Brand through a focused product strategy and increased investment in store; to achieve operational efficiencies in our supply chain by reducing product and inventory costs; and to reinforce our stakeholder culture.” The purpose of this case is to estimate The Body Shops future earnings and financial needs. Anita Roddick and Patrick Gournay would like projections of the next three years of financial statements to determine what type of financing will be required to attain success.
3. Methodology / Description of Model
We began this case by creating a pro forma, which is a projected income statement and balance sheet, for The Body Shop. For this particular case, a percentage-of-sales forecasting method was assumed when determining our most of our projected figures. Therefore, it was required that we at least had the company’s current Income Statement and Balance Sheet. Once we completed the pro forma, we were able to determine The Body Shop’s External Financing Needed, or EFN, amount. With that information we conducted a sensitivity analysis and ratio analysis of different scenarios the company may face to demonstrate their affect on the company’s financials. Each step is further explained, along with flow charts and diagrams, to better understand our methodology.
For our pro forma, we first began with the income statement. To determine Sales, we assumed an increase at a consistent rate each year. COGS and operating expenses were estimated as a percentage of Sales. Exceptional Costs and Restructuring Costs were not considered since pro forma statements exclude unusual and nonrecurring transactions. With these figures, we were able to determine our Profit Before Tax (PBT). For our tax expense, we assumed a constant tax rate. By subtracting the Tax Expense from our PBT we determined the Profit/(loss) After Tax. Lastly, we subtracted dividends, which remained unchanged each year, from the Profit/(loss) After Tax to find the company’s Retained Earnings. Below is a diagram illustrating these steps:
Balance Sheet For our balance sheet, we began by adding together all of The Body Shop’s assets. This included Cash, Accounts Receivable, Inventories, Other Current Assets, Other Assets and Net Fixed Assets. All Current and Fixed Assets were calculated with percentage-of-sales forecasting. For Liabilities and Shareholders’ Equity, Current Liabilities were calculated with percentage-of-sales forecasting. Long-Term Liabilities were assumed to be the same for the first year, growing by the EFN figure for each consecutive year. Retained Earnings from our Income Statement were added to the previous year’s Shareholders’ Equity to determine the current Shareholder’s Equity. To determine the EFN, we subtracted the value of the Total Assets from the sum of Liabilities and Shareholders’ Equity. This is shown in the diagram below: How to Calculate EFN
If EFN is greater than zero, the company is in a shortage of cash and therefore needs to borrow additional funds. A firm can raise funds either through increasing their debt or equity. Increasing the debt of the firm comes at a cost and that cost is reflected through and increase in the firms Interest Expense. If the EFN plug is less than zero, the company has Excess Cash that can be added to their Current Assets. With the firm having more cash than necessary for its operations, it can earn interest on this cash. In the case we assumed the firm could receive the same rate as the cost of debt. The following diagrams summarize the relationship between EFN and the firm’s cash:
Circularity Problem: A circularity problem exists by the way in which the pro forma Income Statement and Balance Sheet are interrelated. The Income Statement provides a key figure for Retained Earnings which is carried over to the BS. Concurrently, without the pro forma Balance Sheet, we cannot calculate the interest expense associated with the amount of EFN, a figure needed to prepare the pro forma Income Statement. By the time we calculate EFN, debt would change, changing the interest expense.
Statement of Cash flows The Income sheet, Balance Sheet and the Statement of cash flows are the three part of company’s financial report. The statement of Cash flows allows investors to understand the company’s financial structure and the how company’s operation are supported by the incoming and outgoing cash flows. The cash flow is determined by Operations, investing and financing activities of the company.
The cash flow from operating activities includes Net income and changes in the Noncash expenses and Revenues included in the Net income. In the body shop case, there is an increase in increased Depreciation Expense, Accounts Payable, Accruals and Taxes payable and decrease in increase of Account receivable and inventories. The summation of Net income and Non cash expenses and revenues contributes towards the cash flow from the operating activities. As per the body shop case, they are not buying any equipment from any other source. So, the statement of cash flow from the investing activity should be “ 0”. The changes in debt, loans, common stocks or dividends are accounted for in cash from financing activities. There is no loan has been taken by the firm and no common stock has been issued by the firm. In the body shop case, the changes in cash from financing are the dividends paid out to the stockholders of the firm.
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