Prompt 1: Applying stakeholder theory, explain the factors that affected inventory management at DSG over the period 2013 to 2016. What impact did inventory management have on profitability?
The process of inventory management illustrates the effective approach to ensuring an entity has an appropriate amount of stock on hand to be sold, and to ensure that this stock is not held for such a time that it becomes obsolete.
From the information provided, Dick Smith Group (DSG) executed a new and ill-fated strategy, whereby they erratically purchased a significant amount of stock between 2013-2016 in line with their expansion hopes. This is further emulated in that DSG had to put on massive sales in order to move some of this excess stock and communicating this to customers that they had multiple quantities of items such as mouses and batteries etc.
Due to their poor inventory management, much of this stock did become obsolete or had to be put on sale which meant profit margins were even lower. Dick Smith were receiving rebates from the large quantities of stock that they ordered, however, we note that in proper accounting treatment, rebates are not recognised as income but as a mere offset of an expense. In this case, unfortunately, the benefit of a rebate was not enough to compensate for the costly exercise of over-ordering stock. This in turn affected the profitability of the company, raising extremely high levels of debt with the bank and suppliers and losses on written-down stock.
Stakeholder theory outlines the interconnected relationships between those with a vested interest in a company. Stakeholders range from the company executives, employees, suppliers, customers, competitors, government bodies and more.
In relation to the poor inventory management decisions made by DSG, this in turn affected a number of stakeholders. Two key stakeholders identified in the case study are: the shareholders (Pauline) and suppliers.
Pauline is greatly impacted by the affect of the inventory disaster as it was communicated in 2015 that DSG would be doing an inventory write-down. Given that they are retailers, and their main function is to sell goods, having steady inventory write-downs is not a promising sign. The outcome of this write-down was that it caused DSG share price to drop dramatically and left shareholders disgruntled and no longer trusting DSG and their capability to run a business and pay dividends. Having shareholders that are dissatisfied with the company’s performance means that they will struggle in the future to garner more shareholders, as dropping market prices suggest serious problems, and unhappy shareholders will result in a poor reputation.
Suppliers are also affected by DSG’s poor inventory management in that due to the large amounts of stock that were being ordered, this meant a significant amount would have been put on credit and repayment times were extended due to the sheer volume of supplies. Initially, this would have been welcomed by the suppliers, in that they were selling huge amounts of stock to a trusted partner. However, given the poor inventory management which eventually lead to the demise of DSG, this meant that suppliers were left in the lurch and not being paid. Given the unmodified audit opinion provided by Deloitte in 2015, this may well have lulled the suppliers into a false sense of security as they were continuing as a going concern and were expected to pay their debts when they were due. DSG requested extended credit terms from suppliers until they went into voluntary administration and then into receivership leaving significant liabilities to their suppliers being unpaid.
Prompt 2: Identify at least three (3) factors that caused the collapse of DSG and for each factor identified explain how short-term decisions resulted in shareholders losing their investment;
There were a myriad of poor decisions that lead to the demise of DSG and in turn shareholders losing their investment, however, we identify the three main aspects as being: inventory management, cash flow issues and poor choice of business strategy.
Inventory management proved to be a major contributing factor in the collapse of DSG in that the mounting expenses were not being overrun by revenue, in fact, the stock that DSG had purchased was costing them even more than expected as they had to write it down. DSG wrote down approximately $60,000,000 worth of inventory in 2015, which accounted for 20%. The product mix at DSG was described as ‘bizarre’ and they were not understanding their customers properly by stocking the products that they really wanted. The short-term decision to purchase excessive amounts of inventory before considering the costs vs. benefits meant that a company struggling financially incurred even further costs, heavily contributing to it’s demise.
Cash flow issues were another major contributing factor to DSG going into voluntary administration and then receivership. In 2015 cash flows were negative, and the rapid expansion and opening of new stores would mean further pressures on cash flows. In addition to this, given the cash flow pressures, it meant that DSG was at a point where they were breaching their debt covenants with the bank and this was almost unfixable. The cash flow issues were not dealt with in a timely manner, and due to this not being rectified when the cash flows were already negative and spending being significantly reduced, this meant that DSG were unable to pay their shareholders, the bank, and many other stakeholders involved, and ultimately, no cash resources meant they could no longer meet their current or future commitments including paying shareholders their dividends.
The third aspect that contributed to the disintegration of DSG was the business strategy it adopted. Given the rapidly changing and competitive market that is within the retail landscape, especially the innovative section that encompasses technology goods, this meant that DSG, along with other competitors were trying new and erratic business strategies to react to these changes. The changes to the business strategy meant that there were plans for rapid expansion and purchasing an unnecessarily high level of inventory (given their cash-flow position) to obtain rebates. The opening of the new stores could have been interpreted to be a mechanism to offload excess stock. Given the changes to remain competitive and profitable within the industry, this lead to impulsive decisions being without the necessary resources. Again, these desperate attempts to stay afloat meant that the company suffered drastically and shareholders lost their investment through the company’s demise.
Prompt 3: The Cash Flow Statement provides users with information relating to Operating activities, investing activities and financing activities. Explain the cash flow position of DSG and the issues that can arise from this position;
The statement of cash flows is a financial report that details the amount of cash and cash equivalents that are moving in and out of a company for the period.
The cash flow statement is made up of three different types of cash flows, these are: operating cash flows, financing cash flows and investing cash flows. Whilst these are all money entering and exiting the business, they are all classified differently and represent different information.
Operating cash flows are the day-to-day activities of the business, for DSG these include receipts from transactions, salary expenses, payments made to suppliers etc.
Investing cash flows relate to the sale or acquisition of non-current assets, and activities to do with loans from the bank.
Finally, financing activities detail the cash-related activities of the shareholders, which for DSG would be the money collected from issuing new shares or the money expensed in the form of dividends.
As detailed, in 2015 the cash flow position of DSG was ominous. Their operating and investing cash flows were negative for a third year in a row, which would be determined as being extremely concerning as this raised a significant amount of debt. The financing cash-flows were positive, meaning that the cash inflows from equity raising activities (issuing shares) were greater than the outflows (dividend payments). Whilst this is noted as a positive, given the situation, this was due to the stock price plummeting and therefore dividends being a lower payout and shareholders were keen to buy more stock at the low price as they were oblivious to what was transpiring behind closed doors.
Given the other two cash flows were showing as negative, this tells us that DSG’s expenses were continuing to exceed their revenue and that they are no longer operating in a way that is sustainable and conducive to a successful business. Although DSG reported a positive net profit for the year, this still does not discount the importance of the statement of cash flows as it does not necessarily represent free cash. The cash flow issues that DSG were facing were a key indicator of the uncertainty surrounding their future and how their drastic business strategy was not rewarding them with a positive net cash flow. Given the obligations to their shareholders, employees, banks and suppliers, a lack of cash and therefore limited liquidity would put the going concern of DSG in serious doubt.
Prompt 4: The DSG auditors provided an unmodified opinion on the DSG accounts. Identify and explain areas of risk that auditors may need to consider when auditing retailers
An unmodified audit opinion is where the auditor expresses an opinion that financial statements are presented, in all material respects, in accordance with applicable financial reporting framework. DSG was given an unmodified audit opinion for the year 2015, which signifies that Deloitte believed there were no material misstatements made in the reports prepared for their review. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
Prior to an engagement the auditor must plan the audit to reduce audit risk to an acceptably low level. During the risk assessment phase of the engagement the auditor will undertake various risk assessment procedures to ensure that appropriate attention is paid to the accounts and transactions most at risk of material misstatement. This pertains to the different environments within which the entity exists in, for DSG it is the company itself, the retail industry and the Australian economic landscape.
Given the heavy amounts of negative media attention gained by the DSG collapse, it would be recommended that auditors are aware of these risks within the retail industry going forward. There are two main risks that are relevant to the retail industry in that of inventory and cash flows.
Given DSG wrote down $60,000,000 worth of inventory in 2015 and had to resort to rapid sales to try and recover some of this inventory and avoid writing down further amounts. Unfortunately, the clearance sales generated an insufficient margin on sales to alleviate the financial pressure the business was facing. Therefore, it is strongly recommended that auditors recognise the risk of inventory write-downs and how damaging they can be to a business whose livelihood and sole function is to deliver goods.
Another major risk that needs to be appropriately accounted for is the cash flow position of retailers. Reporting negative cash flows for day-to-day operating activities and for investing activities would automatically be a red flag. Given the contextual contingencies of DSG and that this was the third year in a row some aspect of the cash flow statement were negative, this garners attention and further substantive testing. Cash flows and liquidity are imperative for businesses like DSG and other retailers, in that if they are not generating enough revenue to cover their expenses, they need to re-evaluate their business structure or engage in other restructuring activities. Ensuring that the company is liquid means that if needed, they will be able to pay their debts as and when they fall due, and remain profitable, which are the two pillars of assessment for being a going concern.