Test of Professional Competence in Management Accounting: Has Domusco Come a Bridge Too Far? Adrian Sims Analyses the Pre-Seen Material for November's Case Study and Finds That the Company's Foundations Are Shaky
Sims, Adrian, Financial Management (UK)
The Domusco case study may look extremely complex and open-ended, but don't despair. It bears all the hallmarks of one particular case writer who likes to ensure that a financial issue forms the backbone of their cases.
Candidates must be prepared to root their answers in an understanding of the financial position of Domusco, a hitherto successful construction firm that seems to have overstretched itself as a consequence of poor corporate governance. You must ensure that the recipient of your advice appreciates this. Advising them what to do is likely to be the crux of the exam requirement. The unseen material on the exam day is likely to throw up further issues for you to handle, of course.
Domusco has been doing well Its 2004 profit is 16 per cent up on 2003's figure. Its turnover has increased only slightly from 10.2 per cent in 2003 to 11 per cent, which means that margins are improving. Its cash position looks healthy: Z$501m in December 2004 compared with only Z$98.2m the year before. Earnings per share have also risen: from Z$1.34 to Z$1.55. Domusco has a ten-year plan which shows that the company's EPS has risen by 86 per cent over the first five years of its existence owing to the growth of its businesses, particularly house building. On top of this, it has just unexpectedly won a contract to build a sports stadium that will boost its EPS by a further four per cent over the next 18 months.
All in all, the outlook for Domusco seems favourable. But it isn't. The financial accounts give the first signs of trouble. In 2003 the firm carried Z$1,020m of debt and Z$3,018m of equity and its capital gearing stood at 25 per cent. By the end of 2004, its debt was Z$1,920m and gearing stood at 36 per cent. In 2005 the company intends to carry a debt of Z$2,420m, which would still give a capital gearing of 38 per cent, before both debt and gearing fall after 2006. This doesn't include the capital needed to build the sports stadium.
But the revenue figures are speculative. The pre-seen material stresses how hard it is to plan in this industry. It the revenues don't materialise, there will be trouble. Some of the omens are bad. The profits from the motorway in Wye would have been due in 2005 and 2006, accounting for about six per cent of the firm's total profits in each year. Because the road's foundations have washed away, the project is actually going to lose Z$35m, so total profits will be down by more than eight per cent for each year.
Domusco is now engaged in speculative projects. It builds homes and offices and holds them as inventory (Z$5.4bn at December 31, 2004--up from Z$4.5bn a year earlier) until they are bought. It has already sold one office block at a loss. This is the sort of business that spawned southern European holiday villa complexes, sold to tourists using high-pressure tactics. It's the industry that builds commerce parks on the edge of towns and prestige buildings in city centres, covered in estate agents' boards or let on low rents to "anchor tenants" in the hope that they will draw in other clients at full rent. It's all very speculative and characterised by sharp business practices that quite often cross the ethical line.
Zee's economic outlook is apparently healthy, so we could assume that the demand for buildings will remain buoyant here. But more than hall of Domusco's houses are outside Zee, as are an unspecified number of office blocks. If the economies of these other countries falter, the firm may not achieve the profits it has anticipated. This is particularly likely to affect house building, which is already the largest part of Domusco's activity and is forecast to provide nearly half of its sales and profits by 2009.
The Hadsi project looks to be falling apart. Domusco has agreed to pay Z$830m, of which the second half falls clue for payment in December 2005 and will be funded from the sales of houses and offices there. We don't know whether these sales are on target, but we are told that other builders have failed to buy some of the parcels of land that Domusco had expected to sell. …