Analyis of financial objectives. financials projecttions and investment decisions - Essay Example

?AZTEC CATERING ANALYIS OF FINANCIAL OBJECTIVES; FINANCIALS PROJECTTIONS AND INVESTMENT DECISIONS INTRODUCTION It has been 40 years since Aztec Catering has been serving the catering needs of businesses, schools, colleges, retirement homes and hospitals. The company offers its services throughout the United Kingdom however the main focus has been in the Midlands and South regions of United Kingdom. Although, Aztec has been serving the needs of its clients for the last 40 years however it faces competition in increasing its sales and profitability. The main competitor of Aztec Catering is Compass Group which is not only operating in United Kingdom but it has expanded its operations internationally. Therefore, being an international brand Compass Group is a major threat for Aztec Catering. Being employed in the finance department at Aztec Catering, this report analyses the tasks that Ms. Field, the Chief Financial Officer at Aztec Catering, has given and this report is aimed to review the three current objectives of the company, prepare and analyse the three year financial plan of Aztec Catering as well as evaluate the capital investment decision that the company can take and how this decision can add the value to the company. The report has been divided into three sections and each section aims to accomplish the three tasks that have been provided. The first section of the report critically evaluates the suitability of the current objectives of Aztec Catering. Moreover, this section analyses and compares the objective of the competing firm, Compass with the Aztec’s objectives. The second part of the report analyses and predicts whether the company would face any financing problem in the next three years. Moreover, this section also justifies the solution that the company can implement in order to help itself from such problems. The third section of the report analyses and evaluates the capital investment decision that the company can take. This section analyses how this investment decision can be helpful in increasing the wealth of the shareholders of the firm and different investment appraisal techniques have been used in order to analyse whether investment should be made or not. Some of the techniques that have been used in order to analyse the investment decisions are: Net Present Value (NPV), Internal Rate of Return (IRR), Accounting Rate of Return (ARR), and Economic Value Analysis (SVA). Section 1: Critical Analysis of the objectives of Aztec Catering and Compass Group The first section of the report cortically analyses the objectives of Aztec Catering and its competitor Compass Group. It is important to know that Compass Group is an international brand and it is not only operating and serving the clients of United Kingdom but it has presence in different parts of the world. Therefore the objectives of Compass Group should be considered as the benchmark and the company should and can use the objectives of Compass Group to achieve more success in United Kingdom and even then expand its offerings to other parts of the world. The current objectives of Aztec Catering that have been decided at the end of 2012 board meeting are as follows: a. To maintain a profit margin of around 24% b. To ensure the current strong financial position is maintained c. To satisfy the shareholders by maintaining a dividend payout ratio of 50% It can be found that all the three objectives of Aztec Catering have been focusing and emphasizing on profitability and financial position of the company. The first objective of the company focuses on maintaining a minimum profit margin (Tucker, and Lean, 2003). Profit margin of the company is the ratio of net profit after to sales. Or it is the ratio that the company earns after deducting all the expenses and paying of interest expense as well as taxes to the revenue (Cravens, and Piercy, 2008).. Therefore, the first objective encourages the management to focus on achieving higher profitability regardless of how it has to be done. In order to meet the first objective, there is no clear idea of how to achieve such a profit margin. With increasing competition in the industry, it has become difficult for Aztec. There can be different ways to increase the profit margin, such as reduction in cost, offer inferior or low quality products that would reduce the cost and increase the profit margin (Cravens, and Piercy, 2008). However such ways are short term solution and can lead to a disastrous situation at the end of the day. On the other hand, if the company focuses on satisfying its customers then it will increase its sales and profitability. The other objective of the company has reviewed and discussed in the annual meeting is to make sure strong financial position of the company is maintained. The focus of this objective is to make sure that the balance sheet of the company looks good and the company has a strong financial position despite of its market share, despite of how it is serving its customers, despite of customer loyalty and customer satisfaction and other important factors that can help the company in increasing its sales and financial position. So, if the company starts focusing on other aspects well regardless of their objectives then it can perform better. The third objective of the company is to give half of the net profit to the shareholders and retain half of the amount. Different organizations have different policies and they tend to first analyse the situation properly and then decide the amount of dividend they should give to their shareholders. One of the major reasons that organizations do not set a specific dividend payout ratio is that they may change the amount of dividends accordingly (Johnson, Scholes, and Whittington, 2008). For instance, if the organizations see different investment opportunities then they may retain amount more in order to raise capital to make investment in that particular investment opportunity. Therefore by declaring a payout ratio, the organization is limiting itself from capitalizing the advantages that may emerge later on (Jensen, 2001). So it is important for the organization to remain flexible in their approach and should have capital to make investment as the opportunity arises. It is important to analyse and review the objective of Compass Group as well because Compass Group is one of the main competitors of Aztec Catering. Moreover, the company has been successful and operating in different parts of the world; therefore the reason behind the success should be known and should be considered as the standard. The main objective of Compass Group is “to provide the best possible service to our customers.” This means that the company has only one objective which is to offer the best services to the customers. This objective also highlights the importance of customer satisfaction as if the company is able to offer the best possible services to its customers then customers will be satisfied with the services or even delighted. Moreover, when the focus of the organization is on customers then it will be help the company in increasing their sales and thus the revenue generated will increase. With more revenues, the company will be able to earn more profits and therefore this will help the company in increasing its profit margin. As the profit margin of the company will be increased, the company will have a strong financial position with more amounts earned and more earnings retained. So, this shows that Aztec Catering can also achieve its three objectives by satisfying customers in the best possible manner however they initially need to overlook short term earnings and focus on long term investment. Compass Group has been highly successful because of focusing on the customers rather than the profits and therefore Aztec Catering also need to review their objectives and right now they need to focus on the customers rather than earnings. Section II: Analyse whether Aztec Catering would Face any Financing Problem Section II of the report analyses the future financial position of the company and this part of the report will also analyse whether the company will face any financing problems in the next three years or not. The report with some predictions and some data available, forecasts the financial statements of Aztec Catering for the years 2013, 2014 and 2015. By forecasting these financial statements, the report then analyses the financial position and whether the company needs additional funds or not. The first financial statement that has been prepared is the income statement of Aztec Catering. The income statement for the years 2012 to 2015 of Aztec Catering is as follows: Aztec Catering INCOME STATEMENT     2012 2013 2014 2015 SALES   100 120 150 190 OPERATING PROFIT (EBIT) 24 28.8 36 45.6 INTEREST @ 10% 4 4.8 6 7.6 PROFIT BEFORE TAX 20 24 30 38 TAX @ 30% 6 7.2 9 11.4 NET PROFIT 14 16.8 21 26.6 DIVIDEND PAID 7 8.4 10.5 13.3 RETAINED EARNINGS 7 8.4 10.5 13.3 In order to prepare this income statement, an assumption regarding the calculation of interest expense has been made. The interest expense for the year 2012 is already known however to calculate the interest payment for 2013 and future years, an assumption has been made that the ratio of interest expense to the sales will remain the same throughout the time period. The ratio of interest expense to sales is 4% and it has been increased from 2013 to 2015 with the same ratio. The other financial statement that has been prepared is the balance sheet. Some accounts of balance sheet have been first identified and calculated and they are presented below. There are also some assumptions made in order to prepare the balance sheet of Aztec Catering. As the capital employed ratio to sales has been equal to 1 and therefore in predicting the future financial statements of the company, this ratio has been kept accordingly. So, the capital employed by the company from 2012 to 2015 will be: 2012 2013 2014 2015 CAPITAL EMPLOYED 100 120 150 190 As the capital employed is equal to total Assets minus Current liabilities. Therefore, the capital employed of Aztec Catering includes long term debt and shareholders’ equity. It has been assumed that the share of shareholders’ equity in total assets will remain the same throughout from 2012 to 2015. The contribution of equity in the capital structure of Aztec Catering is 37.5% and the same ratio has been maintained. Moreover, the shareholders’ equity section includes the retained earnings that have been calculated above in the income statement. The difference between the capital and retained earnings has been used to calculate the share capital. So, the shareholders’ equity of the company for 2012 to 2015 is as follows: CAPITAL 2012 2013 2014 2015 SHARE CAPITAL 10 13.6 21.1 31.8 RETAINED EARNINGS 50 58.4 68.9 82.2 TOTAL CAPITAL 60 72 90 114 Now the debt of the company needs to be analysed. LIABILITIES 2012 2013 2014 2015 CURRENT LIABILITIES 60 72 90 114 LONG TERM LIABILITIES 40 48 60 76 TOTAL LIABILITIES 100 120 150 190 As the interest expense has already been calculated and therefore the long term liabilities has been calculated by taking the same amount of interest percent and interest expenses and then using these two values, the debt has been calculated. Long term debt has been calculated using the ratio of interest expense and total debt in 2012 would increase in future. Moreover, one of the major assumptions is that things would remain the same or the company will need additional funds. Moreover, by focusing more on the debt to equity ratio of Compass Group it has been identified that the company has a ratio of 37.5% which is not what the management would require. The balance sheet of the company is as follows: BALANCE SHEET   2012 2013 2014 2015     CASH 30 39.6 54 73.2 OTHER CURRENT ASSETS 70 92.4 126 170.8 TOTAL CURRENT ASSETS 100 132 180 244           NON CURRENT ASSETS 60 60 60 60           TOTAL ASSETS   160 192 240 304     LIABILITIES   CURRENT LIABILITIES 60 72 90 114             LONG TERM LIABILITIES 40 48 60 76 TOTAL LIABILITIES 100 120 150 190 CAPITAL   SHARE CAPITAL 10 13.6 21.1 31.8 RETAINED EARNING 50 58.4 68.9 82.2           TOTAL CAPITAL   60 72 90 114     TOTAL EQUITIES and Liabilities 160 192 240 304 As the balance sheet shows that the proportion of debt is high in the capital structure than the expected and therefore the company needs to either increase the equity or reduce the debt (Bevan, and Danbolt, 2002). One of the easiest ways by which the management can reduce this ratio is by giving less cash in the form of dividends to the shareholders (Harris, and Raviv, 1991). Retained earnings is considered as one of the main sources of raising capital and Aztec Catering can also raise funds through retained earnings rather than debt. If the company raises capital from its retained earnings then it gives a positive signal to others (McLaney, 2009). Section III: Investment Appraisal The third section of the report assesses the investment opportunities that the company has and how this investment will help in increasing the wealth of the shareholders. Different investment appraisal techniques have been used to analyse and evaluate the investment opportunities on hand. Moreover, this section also calculates the cost of capital of the company. One of the first techniques that have been used to analyse the investment is the accounting rate of return (ARR) which is the average return the company has earned over the period of time. The following table calculates the ARR for Aztec Catering: 2012 2013 2014 2015 Average Return 14 16.8 21 26.6 19.6 Addition to Investment 100 20 30 40 Average Return 10.32% This shows that the average return that the company would be able to earn from 2012 to 2015 is 10.32%. As the result is not very profitable plus considering the fact that this amount is not discounted therefore such an investment should not be accepted. The other technique that has been used to assess the project is the Net Present Value (NPV). However, before calculating the NPV, it is important to calculate the cost of capital of the company. Cost of capital is the weighted average cost of capital which is also termed as ‘WACC’. WACC for Aztec Catering has been calculated and it is shown in the table below: WACC 2012 2013 2014 2015 Cost of equity 11.7% 11.7% 11.7% 11.7% Cost of debt 10% 10% 10% 10% tax 30% 30% 30% 30% weight of equity 37.50% 37.50% 37.50% 37.50% weight of debt 62.50% 62.50% 62.50% 62.50% WACC 6.25% 6.25% 6.25% 6.25% Net Present value shows the discounted values of the future expected cash flows (McLaney, 2009). NPV of the future cash flows of Aztec Catering is - $55.54. So, as the NPV of the project is negative therefore such a project should not be accepted as the discounted returns of the project will increase the loss in real values. Internal Rate of Return is the other technique that has been used and this technique presents the interest rate where the future cash flows after being discounted will have a value of 0 (Gitman, 2003). IRR of the project is -23%. The weighted average cost of capital is 6 percent and as IRR is less than the cost of capital, therefore this project should not be accepted. Economic Value Analysis (EVA) is the third technique used in this report. This technique has also been used by different businesses around the world. EVA can be defined as the capital employed minus financing cost and cost of capital of the firm. EVA for Aztec Catering has been shown in the table below:   2012 2013 2014 2015 EVA ? 7.75 ? 9.30 ? 11.63 ? 14.73 Conclusion and recommendation This report has presented some of the important facts that Aztec Catering needs to consider in order to be successful in the years to come. One of the problems with Aztec Catering is that it is focusing on profitable objectives rather than focusing on their customers which have not been the focus of competitors like Compass Group. Compass Group has been successful and they have expanded their services to different parts of the world and the main success reason is that they serve each client one by one as well as these companies focus on what the customers have to say. Therefore it is important for Aztec Catering to analyse and review their objectives. The report moreover has analysed whether the company will face problems in future or not. The report suggests that the company would be able to do well in future and as the time will progress the company will be able to increase their sales as well as revenues. However, it has been recommended that the company should take the actions appropriately. The report has also analysed whether investment should be made or not in the project. Different investment appraisal techniques have been used and some of the techniques that have used by the company. The management of the company needs to get reunited and analyse whether themselves whether they are operating only profit. References Jensen, M. C. (2001). ‘Value Maximization, Stakeholder Theory, And The Corporate Objective Function’. Journal of Applied Corporate Finance, vol. 14, pp. 8–21. Tucker, J. and Lean, J. (2003). ‘Small firm finance and public policy’. Journal of Small Business and Enterprise Development, vol. 10, no. 1, pp. 50-61. McLaney, E. (2009). Business Finance: Theory and Practice, Pearson Education: New Jersey. Harris, M. and Raviv, A. (1991). ‘The theory of capital structure’. Journal of Financial Economics, vol. 41, pp. 297-355. Gitman, L. (2003). Principles of Managerial Finance. Addison-Wesley Publishing: Boston. Bevan, A.A. and Danbolt, J. (2002). ‘Capital structure and its determinants in the United Kingdom – A de-compositional analysis.’ Applied Financial Economics, vol. 12, no. 3, pp. 159-170. Johnson, G., Scholes, K. and Whittington, R. (2008). 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