ACCT3302-2/10-H02

School of Economics and Commerce

ACCT3302 FINANCIAL STATEMENT ANALYSIS

Accounting and Finance

Lecture Handout

Phil’s Pharmacy Case

Phil and David started a pharmacy business in a large shopping centre about 3-4 years ago. The
pharmacy is aligned with a major buying co-operative. The centre is located in a relatively new
suburban area. Phil previously ran a smaller pharmacy, which he sold to go into business with David.
David previously worked in a pharmacy attached to a hospital in the U.K. Both men work an average
of 60 hours a week in the business spending about 20% of their time on administration. They employ
three assistants who work full-time on the shop floor and are extremely busy most of the time. Phil
and David’s nearest competitor is situated adjacent to a medical centre about one kilometre from the
shopping centre. Phil and David closely monitor their competitor’s prices. Phil and David are
concerned about the potential impact on sales if their prices are much above those of their nearest
competitor. Although Phil’s pharmacy spends only a modest amount on direct advertising, the
business is required to contribute to the cost of promoting the shopping centre and to advertising
campaigns run by the buying co-operative.

Phil and David have come to you for advice because they believe that after a number of years of
establishing the business and working long hours they should be doing better. Phil and David would
like you to conduct an analysis of their business in terms of how it compares to other similar
businesses and what areas they might look at to try and improve the pharmacy’s profitability. Phil and
David are also considering selling the business. For this reason, they would like you to also conduct a
business valuation for the pharmacy. This will help them determine a fair asking price should they
decide to put the business on the market.

To aid you in your assessment, Phil and David have provided you with their statement of financial
performance (Exhibit 1) for the last financial year and some other data that they could readily access.
Using the information provided by Phil and David, you have been able to obtain (from an electronic
benchmarking service for small businesses) a report (see Exhibit 2) that shows a number of key ratios
for Phil’s Pharmacy compared with twenty-two other pharmacies. This report allows you to assess
Phil’s Pharmacy’s relative standing on each ratio.

Except for stock on hand, Phil’s Pharmacy does not have any major assets of note. The premises
together with all computers, cash registers and shop fittings are leased.

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Required
1. What are the major business strategies adopted by Phil and David?

2. List and discuss the major strengths and weaknesses of Phil’s Pharmacy based on the information
contained in Exhibits 1 and 2. (An explanation of the ratios contained in Exhibit 2 is provided in
Appendix 1)

3. Provide Phil and David with some suggestions as to how they might improve the operating
performance of Phil’s Pharmacy (that is, how should their business strategy be altered, if at all).

4. Determine two values for Phil’s Pharmacy. The first should be based on the pharmacy’s current
operating performance. The second valuation should incorporate the likely impact of your
suggestions in 2 above. (Refer to Appendix 2 for guidance on the valuation of a small business)

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 EXHIBIT 1
Phil’s Pharmacy: Statement of Financial Performance

Sales $1,850,650
Cost of Sales
Opening Stock $160,980
Purchases 1,344,568
1,505,548
Closing Stock 181,892 1,323,656
Gross Profit 526,994
Wages – employees 105,232
Advertising 38,916
Communication 4,064
Equipment 11,536
Occupancy 118,270
Other 136,014 414,032
Net Profit $ 112,962

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 EXHIBIT 2
Comparative Ratios Report

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 APPENDIX 1
Information Relating to the Comparative Ratios Report (Exhibit 2)

Tables 1 and 2 contain an explanation of the content and the definitions of key terms in Exhibit 2.
When considering the ratios, you will notice that the ratios net income for every $100 of sales, cost of
sales for every $100 of sales, wages for every $100 of sales, and overheads for every $100 of sales will
sum to 100 for an individual business. However this precise relationship will not hold in the case of
the group figures because the median and quartile results are calculated independently for each ratio.
This means, for example, the median result may be that of a different business for each ratio.

Table 1
Explanation of Content in Exhibit 2
Result Throughout the report, the result for the median is used as the group
standard for each ratio.
Rank A ranking of ‘1’ indicates the highest value for a particular ratio.
However, for many ratios the ranking order is arbitrary and does not
mean that a low ranking is necessarily better or worse than a high
ranking.
Median The use of median results is a much fairer indicator of performance, than
say the simple average, since it is not distorted by extreme results.
Upper and lower quartiles The upper and lower quartiles are indicators of the spread of results
achieved by the participants.
Average of best three The best three businesses are selected on the basis of the ratio net
income per full-time equivalent proprietor. The average results for these
same three businesses are then shown for each ratio.

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 Table 2
Definition of Key Terms in Exhibit 2
Advertising/promotion expenses Includes any payments for this purpose contained in a lease
agreement (provided the amount can be separately identified).
Average debtors Is the monthly average, or best estimate of the average, of all
debtors outstanding during the year.
Average stock Is the average of opening and closing stock for the year.
Communication expenses Includes postage, telephone, fax and courier charges.
Cost of sales Is calculated as opening stock plus purchases less closing
stock. Purchases include all payments made for goods
intended for resale.
Equipment expenses Are all expenses of leasing or hiring any office equipment,
partitioning and fittings; including maintenance contracts and
insurance. Where equipment is owned, depreciation, repairs
and insurance are included.
Full-time equivalent (FTE) Shows the average number of equivalent full-time proprietors
proprietors for the year. Where a person was a proprietor for only part of
a year or where they only worked part-time in the business a
proportion (e.g., .5) is used.
Full-time equivalent (FTE) staff Shows the average number of equivalent full-time staff for the
year. Where a person only works part-time in the business a
proportion (e.g., .5) is used. Note that for the ratio Sales per
FTE Staff, FTE staff includes proprietors.
Net income Is sales less cost of sales, wages and overhead expenses
(excluding income tax, interest expense and proprietors’
remuneration). It is an assessed profit not necessarily related
to the official accounting profit or to taxable income. Refer to
comments under occupancy costs, wages and other overhead
expenses.
Occupancy costs Includes rent, insurance, cleaning and electricity. Where a
property is owned by a business, a notional rent is included,
and property ownership costs (repairs, rates, etc) are excluded.
Other overhead expenses Are those business expenses that would be included in a
statement of financial performance and are not shown
separately in the other expense categories. Salary payments to
principals, income tax and all interest expenses are excluded
so that the operating efficiency of the business can be more
accurately compared.
Sales Includes all business revenues. Revenue of a private or non-
business nature is excluded.
Wages Includes labour on-costs such as long service leave provision,
workers compensation and superannuation payments but
excludes proprietors’ remuneration and superannuation.

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 Appendix 2
Notes on Valuing a Small Business

There are many different approaches to valuing a business. Three commonly used approaches are: net
asset backing; future maintainable earnings; and discounted cash flows. The net asset backing method
identifies and lists the reported book values of assets and liabilities. The future maintainable earnings
approach involves estimating future profits and discounting them at an appropriate rate. Finally, the
discounted cash flow approach involves estimating the future cash flows of a business and discounting
them back to today’s dollars. Which of the three methods should be used when conducting a particular
business valuation depends on the purpose of the valuation and the information available. If a business
has a finite life with known cash flows, then the discounted cash flow approach is likely to be the most
appropriate. However, if the business is profitable and is to be valued as a going concern, then the
future maintainable earnings approach would normally be the preferred method. Finally, if the
business is not profitable, it might be advisable to use the net asset backing method.
In the case of Phil’s Pharmacy, we know that the business has no assets of note, and as such the net
asset backing method would not be an appropriate valuation technique. Additionally, the case provides
no information regarding the timing or amount of future cash flows and, further, there is no reason to
believe that the business has a limited life. Consequently, the discounted cash flow approach would
also be inappropriate. Finally, we know that the business has a history of past profits and it seems
reasonable to assume that these will continue into the future. Therefore, the most appropriate valuation
method to use in this case would be the future maintainable earnings approach.
When using the future maintainable earnings approach there are two important estimations that have to
be made: the future maintainable earnings; and the discount rate to be applied to those earnings. In
determining future maintainable earnings, a valuer would have to decide whether to use an average of
past profits, the latest year’s profit, or budgeted future profits. This decision will depend on
expectations of the future and how representative past profits are of future expectations. Even if past
profits are used, it is likely that adjustments will have to be made to these figures so that they reflect
expected future conditions (for example, any planned changes for the business). In valuing Phil’s
Pharmacy, only the most recent statement of financial performance is available and, therefore, this will
have to be used as the basis for estimating future maintainable earnings.
In addition to the normal issues associated with estimating future maintainable earnings for large
companies, the estimation of future maintainable earnings for a small business provides some further
complexities. For example, owners of small businesses often organise their accounts to suit their own
particular circumstances (for example, some expenses or revenues that are of a private nature may be
included in the accounts of the business). This means that in conducting a small business valuation,
care has to be taken to remove the effects of any non-business expenses or revenues. This will not
always be an easy task as some expenses (for example, vehicle expenses) may partly relate to business
activities and partly to private activities. In these cases, valuers will have to exercise their judgment in
terms of what proportion of the expense to eliminate.
When it comes to estimating an appropriate discount rate a good starting point is to obtain an industry
P/E ratio based on companies listed on the Australian Stock Exchange. Once a base rate has been
obtained, adjustments must be made for business specific risks (for example, liquidity issues associated
with private companies or adjustments for size of business). Phil’s Pharmacy is a small business,
which inherently makes it riskier than a larger business.
It must be emphasised that the process of business valuation is a subjective process and there is no
inherently correct value for any business. Any adjustments made in arriving at future maintainable
profits, or the discount rate to be applied, are necessarily subjective and will be affected by any
assumptions made by the valuer. It is important, therefore, that all assumptions are clearly disclosed in
any valuation report.