The Financial Health of a Business Enterprise Analysis - Assignment Example

? Assignment in Accounting and Finance of the of the Q Business Report for Consideration by The Directors of Fuller,Smith & Turner Plc Based on a Two Year Comparison and Analysis of Financial Statements The financial health of a business enterprise is usually seen and interpreted through its two main financial statements, namely, the Income Statement and the Balance Sheet. While the income statement shows the sales and other revenues, cost of goods sold, the various expenses and the net profit or loss that the business has earned over the year, the balance sheet gives a picture of the assets, liabiities and owners’ equity of the business by the end of the financial year. In the case given, we see that Fuller, Smith and Turner Plc has its financial year ending on the 27th of March 2010. Further we see from the Comprehensive Income Statement that there is a seperation of amounts before exceptional items and that from exceptional items.Exceptional items are usually defined as one-off transactions that may not be repeated in the normal course of business, e.g. disposal of land, buildings or even a particular segment of the business that was not performing as desired and, therefore, put up for sale. As it says, exceptional items are defined as those items that, by virtue of their nature, size or expected frequency, warrant separate disclosure in the financial statements in order to fully understand the underlying performance of the Group. The other income exceptional item in 2010 arose from the disposal of property assets. The exceptional distribution costs and administration cost in 2009 arose mainly from the impairment of property asset values. Let us now move towards a ratio analysis of the company for the years 2009 and 2010. The current ratio for year 2009 is 0.49: 1 and for year 2010 it dropped to 0.19:1. This is quite alarming as it means that for every ?1 of its current or short term liabilities, it has only 19 pennies to meet this exigency. No wonder, it had to resort to a sale of land to get some more of the needed cash. The working capital deficiency dropped from ? 23.7 m in year 2009 to ? 101 m in year 2010. On the other hand, the total debt to total assets ratio remained fairly constant in both years, being 0.48: 1 in 2009 and 0.49: 1 in 2010 respectively. However, this means that in the case of liquidation of the company, the creditors can expect only about 50 pence to the pound at most for the clearance of their claims. This is indeed a sorry state of affairs. So both the short term and the long term solvency of the business are in question at this point (Meigs & Meigs, 1993, 943). Looking at the gross margin percentages for year 2009 and year 2010, we see that this figure remained constant at around 67 percent for the company. However, the net margin percentage has nearly doubled, from 4 percent in 2009 to 8 percent in 2010. This is a good improvement. Now we move on to an analysis of Recievables Turnover, which was 13 times in 2009 but improved slightly to 14.5 times in 2010. The asset turnover for both years 2009 and 2010 remained around 0.55 times. On the other hand, Inventory Turnover recorded a slight drop from 11 times in 2009 to 9 times in 2010. The Return on Assets, which was 2 percent in 2009, improved to 4 percent in 2010. Finally, the Return on Equity which was 4.5 percent in 2009 doubled to 9 percent in 2010. So, all in all, we can say that there remains little improvement in the company’s financial state of affairs and it would be better not to invest in this company at the present time. Sincerely, Investment Advisor Q.2. Appraisal of Different Products: Pacioli Accounting Software Systems Ltd. The finance director of any firm is most often concerned about two things: how to get surplus cash for investment and how to invest the surplus cash so as to get the best possible return. The Finance Director of Pacioli Accounting Systems is similarly trying to decide about investing in one of the three different tax accounting software packages which Pacioli will market under its own name after purchase. All the three packages have been prepared and are being sold by different firms. Evaluation of Each Project by Net Present Value Method: Net Present Value= PV of Outflows – PV of Inflows At Discount Rate of 10 Percent: Tax Wizard: (60,000) 25,000 30,000 32,000 PV of Outflows= ? 60,000 PV of Inflows= 25000(0.909) + 30000(0.826) + 32000(0.751) = 22725 + 24780 + 24032 = ? 71,537. Therefore, NPV= 71,537- 60,000 = ?11,537. Tax Easy (120,000) 50,000 70,000 40,000 PV of Outflows= ? 120,000 PV of Inflows= 50000(0.909) + 70000(0.826) + 40000(0.751) 45450 + 57820 + 30040 = ?133,310 Therefore, NPV= 133,310- 120,000 = ?13,310. Tax Angel (180,000) 95,000 80,000 58,000 PV of Outflows= ? 180,000 PV of Inflows= 95000(0.909) + 80000(0.826) + 58000(0.751) = 86355 + 66080 + 43558 = ?195,993. Therefore, NPV= 195,993- 180,000 = ?15,993. In summary, we can see that at the discount rate of 10 percent, Tax Angel with the highest positive NPV of ?15,993 would be the best investment alternative, followed by Tax Easy with a lesser positive NPV of ?13,310 and then Tax Wizard, which has the least positive NPV of ?11,537. At Discount Rate of 20 Percent: Tax Wizard: (60,000) 25,000 30,000 32,000 PV of Outflows= ? 60,000 PV of Inflows= 25000(0.833) + 30000(0.694) + 32000(0.579) = 20825 + 20820 + 18528 = ? 60,173. Therefore, NPV= 60,173- 60,000 = ?173. This means the IRR is very near 20 percent. Tax Easy (120,000) 50,000 70,000 40,000 PV of Outflows= ? 120,000. PV of Inflows= 50000(0.833) + 70000(0.694) + 40000(0.579) 41650 + 48580 + 23160 = ?113,390 Therefore, NPV= 113,390- 120,000 = ?(6,610). Negative NPV means that this investment should not be pursued. Tax Angel (180,000) 95,000 80,000 58,000 PV of Outflows= ? 180,000 PV of Inflows= 95000(0.833) + 80000(0.694) + 58000(0.579) = 79135 + 55520 + 33582 = ?168,237. Therefore, NPV= 168,237- 180,000 = ?(11,763). High negative NPV means that this investment should definitely not be pursued. So in essence, we have seen that at the discount rate of 20 percent, only Tax Wizard remains a viable investment to pursue if at all, as it gives a positive NPV of just ?173, compared to the Tax Angel and Tax Easy options, which give negative NPVs of ?(11,763) and ?(6,610) respectively. Profitablilty Index Calculation The profitability index is another measure of the profitability or otherwise of an investment project. Profitability Index= PV of Future Inflows/ Initial Investment. For each of the investment projects, and using a cost of capital of 10 percent, the Profitability Index is calculated as follows: Tax Wizard: ?71,537/ ?60,000 = 1.19 Tax Easy: ?133,310/ ?120000 = 1.11 Tax Angel: ?195,993/ ?180,000 = 1.08 We can see again that at a cost of capital of 10 percent, Tax Wizard remains the most profitable alternative to pursue, with a PI of 1.19, followed by Tax Easy with a PI of 1.11 and Tax Angel with a PI of 1.08. Calculation of the Internal Rate of Return or IRR: From the above calculations, using a rate of return of 20 percent in the worst case scenario anticipated by the Financial Director of Pacioli, we have already seen that the IRR for the Tax Wizard project is 20 percent. In the same manner, we can see that the IRR for the Tax Easy project is 18 percent and the IRR for the Tax Angel Project is 11 percent. Calculation of Payback Period: The payback period is one of the simplest methods to estimate the return on an investment. It simply measures the time taken to recover the original investment made (Brigham & Ehrhardt, 2009, 359). The formula for payback period is given by: Future Inflows compared to Initial Investment. So for the Tax Wizard project, the Payback period is 25000 + 30000 + (5000/32000)= 2 years and 2 months. For the Tax Easy Project, the Payback period will be 2 years because the initial outlay of 120,000 will be recovered as 50,000 in Year 1 and 70,000 in Year 2. For the Tax Angel Project, the Payback period will be 95000 + 80000 + (5000/58000) = 2 years and 1 month. The payback period is easy and convenient to compute, but at best is a crude formula that does not take into account the timing of cash inflows but just reduces them to today i.e. the present period. Decision if All the Projects Were Mutually Exclusive: If the three tax software programs were mutually exclusive and, therefore, an independent consideration of each other, I would recommend that the financial director invest in the Tax Angel Program because it has the highest NPV of at the current cost of capital of 10 percent. Hopefully, the financial director has locked in the cost of capital at this rate. On the other hand, if conditions deteriorate so that the cost of capital rises to as much as 20 percent, then in those conditions, the Tax Wizard alternative would be the best. Q. 3. ‘In the accounting support of an organization’s planning and control activity, especially the preparation and use of budgets, management must be aware of the implications of human behavior’. Critically discuss the above statement by elaborating on the behavioral aspects of accounting control systems and illustrate this with brief examples. Financial planning is a very important activity undertaken by modern corporations, in fact no large firm can exist without it. Planning and control of financial activities are accomplished by way of a budget. A budget is, therefore, a tool to manage and categorize estimated expenses and incomes. Be it a household, a business firm or even a Country’s Government, everybody needs a budget. A budget brings coherence and meaning to our plans by figuring out what our expenses and earnings are likely to be and then sets out to balance them. While the common man has no option but to spend from what he earns or borrow the difference, he will then have to pay interest on it. The same is the case with corporations: they can finance expansion plans with money they don’t have by borrowing from banks, venture capitalists, or stock, or bond markets. But the reputation and financial stability of the company and its management also matters, no one would like to lend to a risky business venture. What matters in the end is cash flows of the business, its sales and profitability, its cost of production and expenses as these all add up and reduce profit. The mix of debt and equity can influence how it will be seen by creditors - as a bankable venture or an unworthy risk. In the business we looked at in Question 1, there was not only an alarming situation regarding short term liquidity and solvency but even its debt to assets ratio was quite high. The firm also had to face some impairment in asset values in 2009 and sold off some land in 2010 to release needed funds. Even though some of its ratios show an improving trend, major issues remain to be solved. I do not see a wise investor putting any money into this company. The budgeting process has traditionally been an essential part of managerial control systems in organizations the world over. The budget device itself has been an effective way through which management can successfully plan, coordinate and control the future. The budgeting process usually forms part of an organization's business strategy and, thus, is a financial picture of how the business strategy and plans will be implemented in the marketplace. Usually a business has both a short term plan and a long term plan, one building into the other. Every budget has its own base of revenues and expenses depending on the nature of the industry and the planned revenues, costs and expenses that the business has envisaged for present and future. The preparation of budgets has to be done taking achievable goals into account. At best we have to plan for just a year, although some corporations have five and ten year plans as well. It is the best not to look forward too much because conditions can change and ruin the best laid plans and assumptions. Legal issues, technological advancements and other environmental factors can affect the state of things. There are fixed budgets and flexible budgets. The concept of Zero Based Budgeting was brought in by the military where typical increases over last year’s figures are no more the order of the day, rather they have to be justified and explained. This is budgeting at its best. For each element of expense there are cost drivers and the planned expenditures have to be justified along these lines. Using a zero-based budgeting system puts the burden of proof on each departmental manager. It demands that each manager must justify his all items of the budget in detail and indicate why he or she should spend the organization's money in the given manner. Thus, it requires that a decision package should be developed by each manager for every project or activity. This will include an analysis of costs and purposes, outline alternative courses of action, detail measures of performance, show the consequences of not performing the activity and the benefits of doing so. Hence, this approach is very different from the traditional budgeting techniques due to the analysis of alternatives to be presented. Departmental managers first need to identify alternative methods of performing each activity, like evaluating the costs and benefits of making a project compared to outsourcing it, or centralizing versus decentralizing the operational activities. In addition, managers are also required to identify different levels for performing each alternative method of proposed activities. This requires establishing a minimum level of spending, often 75 percent of the present operating level, and then developing separate justifications for the costs and benefits of this level of spending for that activity. These different levels allow managers to consider and evaluate a level of spending lower than the current operating level giving decision-makers the choice of eliminating the activity, as well as the ability to choose from a selection of levels of effort including tradeoffs and shifts in expenditure levels among organizational units. Another aspect that enters the budgeting scenario is cost volume profit analysis. It is seen that for some fixed expenses, like cost of storage space or electricity cost of a room, are the same, no matter one item is stored or fifty. Perhaps, the costs are fixed within a certain range of production but they increase once the production crosses that range. So this is another aspect that can be considered while preparing the cost and expense part of budgets. Using a zero-based budgeting system puts the burden of proof on each departmental manager. It demands that each manager must justify all items of the budget in detail and indicate why he or she should spend the organization's money in the manner given. Thus, it requires that a decision package be developed by each manager for every project or activity. This will include analyzing costs and purposes, outlining alternative courses of action, detailing measures of performance, showing the consequences of not performing the activity as well as the benefits of doing so. Hence this approach is very different from traditional budgeting techniques due to the analysis of alternatives to be presented. Departmental managers first need to identify alternative methods of performing each activity, like evaluating the costs and benefits of making a project compared to outsourcing it, or centralizing versus decentralizing some operational activities. In addition, these managers are also required to identify different levels for performing each alternative method of the proposed activities. This may require establishing a minimum level of spending- often taken at 75 percent of the current operating level- and then developing separate justifications for the costs and benefits of this level of spending for that activity. The different levels also allow managers to consider and evaluate a level of spending lower than the current operating level, giving decision-makers the choice of eliminating the activity, as well as the ability to choose from a selection of levels of effort involving shifts and tradeoffs in expenditure levels among the different organizational units. Once they have been evaluated, the decision packages must then be ranked in order of importance. This will give each departmental manager the chance to identify priorities, combine decision packages for old and new projects, as well as allow the top management to evaluate and compare the needs of individual units or divisions to make funding allocations. From this perspective, zero-based budgeting is quite different from traditional budgets. Normal budgets often appeal more to people who prepare budgets because they make the budget development process much easier. Managers often just add an inflation factor to the previous year's budget and then make some adjustments for major changes if any. Normal budgets also give management a fixed number with which to make year to year comparisons. However, traditional budgets can create a precedent to spend money carelessly. They can also create inefficient operations due to the fact that individual departments or units do not have to justify expenditures based on each activity but only on the last year's expenditures. In summary, the zero-based budgeting process can help managers identify redundancies and duplications among different departments, concentrating on the dollars needed for proposed programs as opposed to percentage increases or decreases from the previous year. In addition, the specific priorities of divisions and departments are identified more easily using the zero-based budgeting process. This process also allows top management and decision makers to compare the respective priorities and funding needed for projects of activities of different departments. Zero-based budgeting thus enables a performance audit to determine whether each project or activity has been performed as efficiently as planned. Given that the zero based budgeting process is not only time consuming but also work intensive, as one is forced to identify and justify every figure or alternative presented, most organizations today favor a combination of both zero-based and rolling budgets. Zero based budgeting can be of specific use in justifying a new alternative or venture, or the need to revamp or re-engineer an existing process. In all other cases, a rolling budget is generally preferred, but with the manager’s ability to justify costs nevertheless. A zero based budget can also be resorted to in the presentation of long term plans for an organization. In other cases, departmental managers are spared the responsibility of justifying each process or activity if the feasible projects are decided by top management themselves. Another aspect of human behavior that has to be considered while making and allocating budgetary funds is that most if not all departments are competing for the same pie and most of them want the largest share they can get. They will seek to do so through various means, from politics to sycophancy. This needs to be guarded against too, or the Finance Manager or Budgetary Control and Allocation Department will be in a fine mess, making enemies on all sides. It is best to be thoroughly professional, since merit will win in the end and no one will feel emotionally deprived. All requests to increase allocations beyond set or justifiable limits need to be countersigned by the top management, for which purpose some leeway will also have to be made. The overall size of the budget, its various elements and their importance in planning and implementing goals need to be known and appreciated by top management. Lastly, the top management should also at times respect the decisions of the Finance manager or owner of the budgetary process, if he or she sees that things are not as they should be and suggests some alternatives. One alternative is to proceed on the assumption that expenses and costs need to be curtailed whenever possible, rather than push for more and more funds. For instance, to reduce the cost of electricity, most extra lights should be switched off during the lunch break in slightly used areas and only emergency lighting allowed. Another way to control costs is to practice Just in Time inventory management, as it will likely reduce the ordering and storage costs. However, this requires an understanding and cohesion all down the supply chain. Another way to economize is to use the concept of Economic Order Quantity, using trigger points for storage and re-order as stocks get low and have to be replenished (Rao, 1989, 315). On the revenues side, proper allocation of excess funds to the most profitable investments keeping in mind both returns and liquidity requirements for the business is a good practice to follow. Quite clearly, there should be a responsibility both on the revenues and expenses side, so that one does not get more focus than the other. We can only give out from what we have, or else borrow it and pay a cost called interest. Regarding the types of control over the system, management may have either operational control or strategic control or both. However, a well designed accounting control system also includes good behavioral and technical elements. Budgets are made with ethical considerations - they have a balance between short and long term measures and use the best qualitative techniques. They give the managers and workers some measure of empowerment while offering them some incentives to perform through performance reward programs. Technically speaking, they should include information that is as timely and accurate as possible, and should also be consistent in their treatment of various departments while being flexible enough to meet their differing needs. . Reference List Brigham, E. & Erdhardt, M., 2009. Financial Management-Theory & Practice, 11th ed. US: South Western Publishing. Meigs, R.F. & Meigs, W.B., 1993. Accounting- The Basis for Business Decisions, 9th ed. US: McGraw Hill. Rao, R.K.S., 1989. Fundamentals of Financial Management, US:Prentice Hall College Division. Appendix Q1. Current Ratio= Total Current Assets/ Total Current Liabilities Current Ratio 2009: 23m/46.7m = 0.49: 1. Current Ratio 2010: 24.9m/125.9m = 0.19: 1. Working Capital= Total Current Assets – Total Current Liabilities Working Capital 2009: 23 m – 46.7m = ? (23.7m) Working Capital 2010: 125.9 m – 24.9 m = ? (101m) Total Debt to Total Assets Ratio: Total Debts/ Total Assets Total Debt to Total Assets 2009: 182.9m/ 379.9m = 0.48:1. Total Debt to Total Assets 2010: 205.6m/ 412.8m = 0.49:1. Gross Profit Margin= Gross Profit/ Sales x 100 Gross Profit Margin 2009: 141.7 / 210 x 100 = 67.47 percent Gross Profit Margin 2010: 154.5 / 227.7 x 100 =67.85 percent Net Profit Margin= Net Profit/ Sales x 100 Net Profit Margin 2009: 8.9m / 210m x 100 = 4.23 percent Net Profit Margin 2010: 19.2m/ 227.7m x 100 = 8.43 percent Receivables Turnover= Sales/ Accounts Receivable Receivable Turnover 2009: 210m/16m= 13 times Receivable Turnover 2010: 227.7m/15.6m= 14.5 times Assets Turnover= Sales/ Total Assets Asset Turnover 2009: 210m/ 379.9m = 0.55 Asset Turnover 2010: 227.7m/ 412.8m = 0.55 Inventory Turnover= Cost of Sales/ Inventory Inventory Turnover 2009: 68.3m/ 6.1m = 11 times Inventory Turnover 2010: 73.2m/ 7.6m = 9 times ROA= Net Income/ Total Assets x 100 ROA 2009: 8.9m/ 379.9m x 100 = 2.34 percent ROA 2010: 19.1m/ 412.8m= 4.62 percent ROE= Net Income/ Total Stockholder Equity x 100 ROE 2009: 8.9m/197m x 100= 4.51 percent ROE 2010: 19.1m/207.2m x 100 = 9.21 percent Read More