Meaning & Significance of Financial Assessment - Assignment Example

? Financial Management Table of contents SL.No. Particulars Page No Financial Assessment Meaning & Significance Elements Datas included in financial assessment 3-5 5-6 6-9 2 Assess the possible purchase of a new single-head soft-serve ice cream machine - List the qualitative issues that you need to consider - Calculate the return on investment and payback period for purchasing a single-head machine Table 1 showing payback period calculations Table 2 showing return on investment calculations 9-12 12-16 14 15 References 1) Write a brief (maximum 1,500 words) analysis of the information  that you will need to include in the financial assessment, explaining  its significance. You should not include any quantitative data, but  rather describe what elements need to be considered, what data you  would include and how you would develop them, stating clearly your  assumptions. Meaning & Significance of Financial Assessment: Financial assessment plays an important role in the decision making process in an organization. It helps gain access to fast, independent and reliable financial assessment reports in order to take better decisions. It enables to achieve financial success. Financial assessment is based on past records and future projections. The company can gain much better control over their financial performance by looking at the past in order to help plan and predict the future. A sound financial plan contains a complete picture of the financial health of the business and the viability of strategic plans. It also helps to know whether the company is being run in a proper way during implementation, so that it can take preventive action before anything serious happens, for example, running out of cash. “Successful financial analysis and planning require an understanding of a company’s external and internal environments” (Analysis of Financial Statements Reviewing and Assessing Statements, 2006). Every enterprise should prepare certain statements in order to ascertain the financial condition of the business, known as financial statements. A financial statement has an important role in the decision making process. But the information in the financial statements is not effectively helpful in order to make a meaningful conclusion. Therefore, an effective and efficient analysis and interpretation of financial statements is necessary. Financial statement analysis is “the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account” (Financial Statement Analysis, 2012). Analysis means establishing a significant relationship between a number of items of two financial statements with each other, in order to draw a meaningful conclusion. By financial statements we mean three statements: i. Balance Sheet or Position Statement ii. Profit and loss Account or Income Statement iii. Cash flow statement “The term financial analysis is also known as analysis and interpretation of financial statements” (Financial Statement Analysis- An Introduction n.d). Financial statement analysis is an evaluation to assess the efficiency and performance of the firm. Thus, it is very essential to measure the financial soundness, efficiency, profitability, and future prospects of business units. Financial analysis serves the following purposes: Measuring profitability Indicating the trend of achievements Assessing the growth potential of the business Comparative position in relation to other firms Assess overall financial strength Assess solvency of the firm. Elements of financial assessment: Analysis of financial statement is an important part of the process of developing a business plan, as it also helps to monitor the success of that plan. Elements of financial analysis include:   1. Budgeting- Budgeting is an important element of financial analysis. Creating a budget means setting out planned cash inflows and outflow of the business. It facilitates indentifying liquidity of the firm by monitoring a cash flow. Budgets can also be set out for expenditure and income as well. A capital budget represents major capital spending, for example, on equipment, premises etc.  2. Profit and loss analysis - This includes the creation of a profit and loss budget setting out expected future profits or losses for the business. This is significant in assessing the return on investment of the business. Important aspects of profitability analysis are gross profit margins and operating profit margins. 3. Solvency analysis – Solvency analysis includes the calculation of net current assets of a business as shown in the balance sheet (that is, current assets - current liabilities).   4. Return on capital employed (ROCE) - It is a calculation of the return made from all of the capital employed in the business during a particular time period.   5. Useful to shareholders in order to analyze returns for each of their investment in share capital.  Financial analysis has an important role in planning because business success is measured in terms of money. Investors of the company need to feel that: Their money is safe. Their returns on investments are comparable to what they can earn from somewhere else. The planners of the company have a good intelligence of the financial implications of their actions.  The main part of the financial assessment includes the following: 1) Balance sheet: Balance sheet is a statement, which shows the financial position of a business concern. It is a statement that has different amounts of different accounts that equal each other or balance with each other in the end. The asset side should be equal to the liability side of balance sheet. Companies create balance sheet on a yearly basis at the same time of year. Assets, liabilities and equity are the important elements of any balance sheet. A balance sheet is a statement prepared at the ending of operating period affirming “all the assets and liabilities of a business arranged in the customary order to exhibit the true and correct state of affairs of the concern as on a given date” (Balance Sheet 2012).  Comparative Balance Sheet: A comparative balance sheet helps to compare assets and liabilities of the company belonging to different period of time. It contains three columns, the first two for the data of original balance sheets of two different time periods, and the next to show variation (increase or decrease) in figures. A fourth column is also there, which is used for showing percentages of increase or decrease. The following aspects are expected to be the result of the comparitive balance sheet. Profitability of the concern Current financial position and liquidity position Long-term financial position Should examine both years’ working capital in order to study the current financial position or liquidity position of the business. “Working capital is the excess of current assets over current liabilities” (Financial Statement Analysis- An Introduction n.d). The next aspect in the comparative balance sheet is to study the profitability of the concern. Comparison helps to understand whether the firm’s profitability has improved or not by studying increase or decrease in profit. An opinion can be formed about the financial position of the business organization after studying the various assets and liabilities in the balance sheet.  2) Income statement: The income statement is considered as an analysis tool as well as a planning tool. Income statements can illustrate how certain decisions of the company affect business operations. It also helps to manage expenses of the firm. “The income statement is a financial report that depicts the operating performance of a company expense over a specific period of time” (Income Statements Basics 2003). Comparative Income statement: The income statement contains the results of business operations of the concern. This statement is also known as Trading and Profit and Loss A/c. Net sales, cost of goods sold, office expenses, selling expenses etc are the important components of this statement. In comparative income statement, the values of the above components are compared with their corresponding values of previous years individually and then the differences are noted. The progress of a business over a period of time can be easily understood by looking at the comparative income statement. The changes in money value and percentage can be used to analyze the profitability of the concern. Like comparative balance sheet, income statement also contains four columns. The first two columns show the figures of various items for two years. Increase or decrease in values in absolute amount and percentages are shown in the third and fourth column. “Comparative statements are financial statements  are formatted in a manner that makes comparing line items from one period to those of a different period an easy process” (Comparative Statement Common Statement and Trend Analysis 2012). The analysis and interpretation of income statement will include the following: The changes in sales should be compared with the increase or decrease in cost of goods sold. To understand the operating profits. The changes in net profit will give a clear picture about the overall profitability of the firm. 3) Cash Flow Statement: The cash flow statement is similar to the income statement of the company. The main difference between income statement and cash flow statement is that the income statement considers some non-cash accounting items such as depreciation also. But cash flow statement shows the actual money the company has generated. Cash flow statements show the performance of the company in managing inflows and outflows of cash. It shows the company's ability to pay bills, creditors and other expenses. It finances growth better than any other financial statement. There are three activities included in the cash flow statement, which are: operating, financing and investing activities. If the owner of Cool Moose needs to take the loan from the bank, its “liquidity and level of debt will be examined” (Financial Analysis and Interpretation n.d). This can be possible if there is proper financial assessment. The bank can make knowledgeable decisions relating to the organization through financial assessment. By improving the cash flows of the firm, collecting loan documents, analyzing the portfolios of loan, assessing the financial risk, increasing the growth opportunities, diversifying market, increasing the efficiency of operations and increasing utilization of assets the firm can develop its financial assessment. 2. Assess the possible purchase of a new single-head soft-serve ice cream machine for your restaurant, using the same assumptions as on pages 3 and 4 of the Cool Moose Creamery case: - List the qualitative issues that you need to consider: Before purchasing a machine the business has to take decisions that evaluate the costs and benefits of either manufacturing a product or purchasing it from an outside supplier. This decision involves analyzing both qualitative and quantitative factors. As the owner of Cool Moose, I feel that purchasing the ice cream machine is the better option. The main considerations are focused on the qualitative issues. Qualitative factors include the product quality and the requirement for establishing and maintaining long term business relationships with the customers. Cool Moose Creamery has demonstrated homemade fudge, assorted chocolates and gelatos. They also sell ice cream treats, coolers, smoothies, gift baskets, ice cream cakes, novelty candy and Seattle’s Best Coffee. Qualitative issues of Cool Moose Creamery contain a lot of health and safety issues. When an organization purchases an asset, certain processes should be followed. “Asset purchase agreements define the assets and liabilities to be sold” (Warner, 2006). The transaction requirements are to be recorded and, depending on the asset, it may also require to be depreciated. There are various types of assets obtainable for purchase such as: machinery, insurance, land, furniture and office supplies. The Soft-serve ice cream machines created various health and safety issues. The cleanout of these Soft-serve ice cream machines was dangerous to their capacity to function accurately and the longevity of their helpful life. Moreover, if not cleaned properly, the machines were vulnerable to food-borne diseases and bacteria sickness. When a big piece of equipment or machinery is purchased, a business reports the operation by rearranging a debit to an asset account of whatever is bought, and a credit to either loans payable or cash. Every year, the equipment or machinery is depreciated by rearranging a changing entry of a credit to "Accumulated Depreciation” and a debit to "Depreciation Expense" of whichever asset is concerned. To obtain the book value of the asset, the asset account is decreased by the amount of accumulated depreciation. If Cool Moose added a soft-serve machine, every worker would require to be trained in how to clean and use the machine. Perantinos would give training for single-head machine in two hours or triple-head machine in three hours to each one of the store’s employees. A careful cleaning of the device would be required every other night and would need a worker to work afterward. A single-head machine would get an extra hour to clean and a triple-head device would take about 1.5 hours to clean. There is a need to choose and offer suitable work equipment, taking into account the working circumstances as well as the health and safety hazards in the workplace to guarantee that the new machine is operated correctly and preserved in a safe condition. Therefore decisions such as where and how it will be used, who will operate it (skilled employees, trainees etc), what it will be used for, what risks are involved etc, need to be considered. Every Cool Moose worker was paid approximately $10.25 an hour and the business also paid about $0.65 an hour per worker for Canada Pension Plan (CPP) contributions and “employment insurance (EI)” (Employment Insurance (EI) – Act and Regulations 2011). Soft-serve ice cream mix came as a liquid product that required refrigeration and, consequently, Perantinos must purchase a small refrigerator. The buying of a new asset or machine for a firm is usually a hazardous task. In addition to buying the machine, the owner needs to assess and analyze all other factors, which are involved in the setting up of the machine. As the company is going to set an ice cream server machine, they should be very alert regarding health issues, as their customers will be mostly children. Therefore, before serving the ice cream to them, the company needs to be very careful about those issues. Thus, before and after purchasing the new soft serve ice cream machine, the company needs to consider the health and safety issues of its customers in order to survive in the market for a longer period of time. -Calculate the return on investment and payback period for purchasing a single-head machine (assuming that return equals the annual cash flow resulting from the machine and that the total investment equals the machinery cost plus any incremental investments / expenditures required to install it) In order to assess the feasibility of soft serve ice cream machine, the company Cool Moose needs to clearly evaluate its areas of operations, particularly in the financial area. Therefore, to clearly obtain a better judgment regarding the setting of a new ice cream machine, the return on investment and the payback period method can be seen as better appraisal techniques. The main objective here is to determine whether the proposed project will be financially feasible in the intellect of being proficient to meet the trouble of liability and whether the proposed project will assure the expectations of return of the investors. Calculation of Return on Investment and Payback period of a single-head soft serve machine: Amortization on Straight Line Method: A single- head soft-serve ice cream machine is purchased for $15,000. The expected life of the asset is ten years. The straight line amortization method divides the cost by the life. Cost of the machine = $15000 Estimated life of machine = 10 years = Cost/Life = 15000/10 = $1500 Each year for 10 years $1500 would be expensed. Calculation of Payback Period: Payback Period is computed by dividing the cost of the project by annual earnings after tax, but before depreciation. “Payback period is the time duration required to recoup the investment committed to a project” (Madumathi n.d). A project with shortest payback period will be specified the top position. This method is more appropriate in industries where the possibility of obsolescence is high. Annual cash inflow is the money left over once all the bills and expenses are paid and depreciation is charged. Payback period = Cost of Project Annual Cash Inflows (Investment Decision- Payback Method 2010). Table 1 Payback Period calculations Method Description and Calculation Payback Period Original Cost of the Project $15000 Net sales-expense Net Income (Net sales= 2800*2.50 = $7000 Expenses= $35.14 Cost of soft-serve mix=$30, cone=$0.07, spoon=0.07, Napkin=$5) Net Income = 7000-35.14 = $ 6964.86 Annual Cash Inflow Net Income-Net expenses-Depreciation Annual Cash Inflow = 6964.86-35.14-1500 =$5429.72 Payback period =Cost of Project Annual Cash Inflows Payback period = 15000/5429.72 Payback Period =2.7 years Calculation of return on investment: Return on investment is a performance measure used to assess the effectiveness of an investment. It helps to clearly assess the financial viability of setting up of a new machine in Cool Moose Company. “ROI is defined as evaluating an initiative’s benefit compared to the cost” (Kapp, 2003). The ROI explains how much of the investment policymakers can anticipate to obtain as a benefit. If the ROI is positive, the benefits go beyond the costs and the investment should be taken into account. “ROI = Benefits-Costs” Costs (Silber, 1999). Table 2 Return On Investment Calculations Method Description and Calculation Return On Investment Annual Cash Flows (Benefits) Net Income-Net expenses-Depreciation Annual Cash Flows =$5429.72 Total Expenditure $ 15000 Return On Investment (%) =(Benefits-Costs) / Costs ROI=(5429.72 –15000) / 15000 = -9570.28/15000 =-0.638 ROI = 63.8% Assumptions: The payback period method of single-head soft serve ice cream machine is 2.7 years and the return on investment is -63.8 %. This shows that the payback period of the single head machine is suitable and appropriate. The firm will get back the original investment of $15000 within a period of two or three years. Since the return on investment of the Cool Moose is -63.8 %, it shows that it is better not to undertake the investment. The negative return on investment indicates that the costs of the machine balance the benefits. As compared to the return on investment, the payback period method is suitable as it suggests that the firm will be able to recover the original cost within a period of 2.7 years. Therefore, it is better to buy the new machine. When the used machine is considered, the original cost of a single head is $2000. It also involves a delivery cost of $150 and the repair cost (Total Investment = Machinery cost + any incremental investments / expenditures, i.e. 2000+150=$2150). The repair cost is expected to be $1000, which is half of the original cost of the machine and also the life of the machine is two to three years. It is not suitable for the firm to set a used machine as it involves more cost for repairs and also there is no suitable estimated life for it. So it is better for the firm to go for a new machine, which involves increased productivity within a shorter payback period. If the owner requires taking the bank loan of $ 25000 with an interest rate of 9%, the firm has to repay the loan amount of $518.96 for five years. It is a suitable alternative, as the firm will be able to recover the investment cost within a shorter payback period, its productivity will be expected to be high, therefore, the firm will be capable to repay the loan amount without any failure. Reference List Analysis of Financial Statements Reviewing and Assessing Statements (2006). Tech Books. [Online] Available at [Accessed on 11 June 2012]. Balance Sheet (2012). Accounting for Management. [Online] Available at < http://www.accounting4management.com/balance_sheet.htm> [Accessed on 11 June 2012]. Comparative Statement Common Statement and Trend Analysis (2012). Scribd.com. [Online] Available at [Accessed on 11 June 2012]. Employment Insurance (EI) – Act and Regulations (2011). Service Canada. [Online] Available at [Accessed on 11 June 2012]. Financial Statement Analysis (2012). 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