Case Study- Dick Smith Holdings

CASE STUDY- DICK SMITH HOLDINGS 8

Case Study- Dick Smith Holdings

Case study- Dick Smith Holdings

Introduction

Dick Smith Holdings Limited has been described as the largest consumer electronics outlet in Australia with approximately 381 outlets as at October 2014. The organization deals with a wide range of electronic products such as computers, tablets, printers, mobile phones, televisions and related accessories. Most of the sales are realized through their physical network of outlets and through a website. However, the company was in financial trouble two years after being listed with a valuation of $520. The company has applied for voluntary bankruptcy. This paper seeks to examine if there are grounds for claims against the Dick Smith Holdings directors and management as well as the company’s external auditors, Deloitte Australia.

Financial Statement Analysis

Pundits have opined that the case of Dick Smith was remarkable given that only two years after listing and carrying a valuation of $520 million, and most significantly, the firm had reported a profit of $37.9 only five months before placing itself in voluntary administration. Additionally, the firm had a sales base in excess of $ 1.3 billion while the debt stood only at $ 40 million (Dick Smith Annual Report, 2015). The company was viewed by many industry insiders as the fastest growing company within the consumer electronic industry by numbers of stores.

From the perusal of Dick Smith financial statement from the time the company was listed reveal that the enterprise started operation from a low inventory level which needed to be rebuild. However, at the same time, the company embarked on an aggressive expansion program. The expansion program would ordinarily place a lot of pressure on the inventory. After the listing of the company, it opened 75 new stores which were 25 % of the outlets (Dick Smith Annual Report, 2015). The company also launched new brands including its own private labels.

In the two years of operation, the inventory needs to support the growth or expansion grew from $ 171 million in 2012 to $ 293 million in 2015 which is an increase in excess of 70 % (Dick Smith Annual Report, 2015). However, the aggressive stocking of the stores was not matched by a significant increase in sales. The financial reports indicate that the sales grew by 10 % of the material years. It appears that the inventories were built on the organization’s private label which, by the actions that followed, shows that the bulk of the inventory was dead-stock and had to be off-loaded through a massive sales-promotion. The sales-event further depressed the organization’s financial stability and soon the company stated failing to meet its creditor’s obligations.

Financial Distress Analysis

Financial distress is arrived at when a company experiences difficulties in fulfilling its financial obligations. Although few companies go without encountering cash flow problems, cash flow difficulties are indicators of financial distress. cash flow problem are often experienced when key customers start defaulting on their payments, sales fall below projections, or creditors tighten the credit agreements (Chen, 2011). In the case of Dick Smith, the inventories were made of goods on credit and by the time the company was issuing the revisions on projections, the creditors were not only tightening the credit terms but were demanding payment on delivery.

There are several ways of working out an organization’s financial health including ratio analysis, cash flow analysis, comparative statement analysis, or credit risk analysis. Suffice to say, financial distress does not arise suddenly, thus it is possible to trace the distress by analyzing the firm’s financial statement (Chen, 2011). Nevertheless, there are several models that are used to determine the financial distress of companies although scholars and financial professionals do not agree on which is the best predicator. Dick smith Financial distress, like in many other organizations that have gone bankrupt, arose from under capitalization, poor cash flow, and poor inventory management. These factors coupled with a high debt portfolio saw the entity call for voluntary bankruptcy.

The model used is the Altman (1968) Z-score which uses a linear equation:

Z=0.32X1+0.28X2+0.11X3+0.40X4+2.55X5 (Chen, 2011)

Description

Z=overall index

X1=working capital/total Assets 147231/452105=0.32

X2=retained earnings/total assets 129420/452105=0.28

X3=Earnings before interest and taxes/total assets 51762/452105=0.11

X4=market value of equity/book value of total liabilities 130901/321204=0.40

X5=sales/total assets 1153079/452105=2.55

Discrimination

Z>2.99 which is the safe zone

Z<1.81 is the distress zone

Dick Smith Holding index stands at: Z=1.36

Working capital, which is current assets less liabilities, plays a significant role since it supports the daily operations of the organization. A negative working capital is a sign that the organization is bound to face some financial difficulties and may not satisfy its obligations. The ratio measures the organization liquidity in relation to capitalization.

The retained earnings to total assets ration indicates the degree of financing of the assets through the surplus profit. Essentially, the ratio indicates the cumulative profitability of the company and earning power. According to the analysis, the company is not doing well on this score.

According to the above analysis, Dick Smith financial distress probability is below the distress zone of Z=1.81 which means that when all factors are considered, the directors and the auditors should have noticed the distress warning through a perusal of the financial statement. It can, therefore, be concluded that, although the company was faced by serious cash flow and credit crunch, the audit did not satisfy statutory requirement and, therefore, the auditors are culpable.

An Examination And Reporting On Relevant Information Releases

According to the 2015 financial statement, the company had embarked on an aggressive expansion with the opening of more stores across the country. The expansion can be viewed as recklessness on the part of the management. The overzealous expansion plan drained the company surplus revenue which necessitated hefty borrowings and non-payment to the firm’s creditors. The scenario is worsened by the hefty inventories that were largely made of dead stocks. Suffice to say, Dick Smith purchasing decisions lead to the organization carrying stock that was overvalued and unsellable.

It is reported in various forums that In October and November of 2015, the company had made several significant announcements. The enterprise issued profit downgrade for 2016 financial year and their inability to re-affirm the profit guidance it had issued just a month before. The consequence was a massive drop in the shares values by a significant 73% in a period of two months.

Recommendation

The analysis of Dick Smith financial statement coupled with the company financial distress probability reveal a situation where the reported figures and the activities of the directors and senior managers point to a management system that was driven by the desire to open as many stores as possible without regard to their viability. The need to re-stock the stores put a tremendous pressure on the company’s financial resources which led to the firm overstretching its borrowings.

The responsibility of an auditor is rendering a professional opinion on whether the enterprise management has presented fair information on the financial statements by evaluating the financial statements objectively. It is expected that the auditor is knowledgeable on financial reporting and accounting matters. When conducting the audit, the auditor ordinarily collects evidence in order to gather reasonable assurance that the presented figures and disclosures in the financial statements are void of errors and misstatement. However, the significant element of an audit is to assess whether the audit evidence arouses doubts on the enterprise ability to continue operating as a going concern in the future irrespective of the future business uncertainty. In the case of Dick Smith audited financial statements, the auditor, Deloitte Australia, failed to notice the poor cash flow, high creditor’s debts, and the massive inventories. Consequently, the auditor recommended the passing of the financial statements as a true reflection of the enterprise financial positions. Unfortunately, shortly thereafter, the company was in serious financial problems and filled for voluntary bankruptcy.

It is, therefore, recommended that both the directors and the auditor of Dick Smith should be held responsible for the collapse of the company. The directors and management should be censured for recklessly running the company down by making poor business decisions while the auditors should be censured for failing to raise the concern on how the company was being run. This report finds that there are enough grounds for a potential claim against both the directors of Dick Smith Holdings as well as the audit firm, Deloitte Australia.

References

Chen, M. (2011). Bankruptcy prediction in firms with statistical and intelligent techniques and a comparison of evolutionary computation approaches, Computers & Mathematics with Applications, 62 (12), pp. 4514–4524.

Dick Smith 2014 Annual Report

Dick Smith 2015 Annual Report