Financial Management and Control: Solvent PLC, Mega PLC, and Brothers Ltd - Essay Example

? Financial Management & control Contents Part A: Solvent PLC 3 Part B: Mega PLC 6 Question1 6 Question2 8 Question 3 9 Question 4 9 Part C: BrothersLtd. 10 Question1 10 a) Payback Period 10 b) Accounting Rate of Return 10 c) Net Present Value 11 d) Internal rate of Return 11 Question 2 11 Part D 12 References 15 Part A: Solvent PLC As per the financial ratios of the company, it is observed that the company’s turnover has increased by 5% from 2010 to 2011, but it has not resulted in increase in the profitability. The reason is that the company got lesser return on its capital and equity. The capital has not been efficiently utilized resulting in the decline in return on capital employed. Since the profitability of the company (EBIT) declined, it resulted in the decline of return on capital employed. The company has not been able to earn more from the money of its shareholders. In 2011, it has earned approximately 30% lesser than 2010 from the money invested by its shareholders which resulted in a decline in return on equity. The debtors’ collection rose by 47 days over the previous year which means that in 2011, the company now required 130 days to get the money from its debtors which it did in 83 days in 2010. This not only blocks the money for the company but also makes the company lose on the interest of the money blocked with the debtors. The chance of the debtors going bad also increases if the payment cycle expands which has been proved by bad debts going up by more than 200%. The operating profit of the company has halved from 17% in 2010 to 8.5% in 2011, which implies that even when the company has sold more than the previous year, it has not been able to make profits out of the sales. This can be due to many reasons. The company might have sold at lesser price or the company might have incurred greater selling expenses. Decrease in the gross profit from 53% in 2010 to 46% in 2011, indicates that the overheads might have increased or even if the overheads did not increase, the dip in the operating profit caused the downfall of gross profit. Even when the gross profit declined 7% from previous year, the company made same amount of dividends which is unjust from the business perspective. Due to more sales, the company has been able to almost maintain its stock turnover ratio. The current ratio of the company increased from 1.5 in 2010 to 1.8 in 2011. The increase in the current ratio is a result of the increase in current assets which includes an increase in the debtors’ collection period due to which the debtors are rising, an overdraft bank balance and more than doubling of bad debts inflating the current ratio. The acid test ratio increased from 1.2 in 2010 to 1.5 in 2011. This indicates that the company now has lesser short-term assets to sell in order to cover up its immediate liabilities without selling off its inventories. The company’s ability to pay off its interest expenses has also declined and it is indicated by the fall in the interest cover ratio from 9.6 times in 2010 to 4.34 times in 2011. This is due to the shortage of funds which has been blocked by the debtors, increasing bad debts, bank overdraft balance etc. The gearing ratio describes the level of the company’s capital being funded by the owners’ money versus the money of creditors. Here, it has declined by 3% as the creditors collection period has also slightly decreased. This means that the company is paying off its creditors earlier than it used to do in the previous year. This results in lesser availability to creditors’ funds and more reliability of the business on the owners’ equity. The earnings per share of the company declined from 0.63 in 2010 to 0.29 in 2011. A decline in EPS is the result of a decline in the profitability of the company. EPS measures the allocation of company’s profit to each of its outstanding shares. Since profit has declined, the allocation to each share also declined and hence the EPS. The operating cash flow per share of the company increased from 1.2 in 2010 to 1.5 in 2011 due to increase in sales in 2011. Operating cash flow per share measures the cash generated from revenues of the company and allocated to the number of outstanding shares. Since sales increased, the revenues also increased and hence the operating cash flow per share. A working capital cycle is the time a company requires converting its current assets and current liabilities to cash. A longer working capital cycle indicates that the company is engaging its working capital for a longer period of time and not getting any return on it. Had the company engaged the working capital for a lesser period of time, it could have used the same working capital in increasing its revenue from sales and other activities. Minimizing the working capital cycle helps in maximizing the cash flow of the company. In 2010, the company paid off its suppliers in 142 days and got its money from the debtors in 83 days. Here, the company’s working capital was blocked for 83 days till the debtors paid the money. But the company took 142 days to pay off the creditors even when it had received money from debtors in 83 days. Generally, companies use borrowed capital to pay suppliers and pay interest on it. So the longer it takes to pay suppliers, the more interest is charged. In 2011, the company’s working capital was blocked up for 130 days till the debtors’ paid up. The company took lesser time now to pay off its creditors and the time was almost equivalent to the time taken by debtors to pay. This indicates that even if the company got its money late than the previous year, it paid its creditors earlier. This lowered the free cash flows available with the company but also lowered the interest the company was paying on the borrowed capital (Horngren, 1977, p.179). After assessing the financials and the ratios of the company, it has been observed that the company is more focused on increasing its top-line and not focusing on the bottom-line of the business. The company has made investments to increase the turnover but has not taken any steps to increase the profitability. An increase in turnover can result in an increase of profitability only if the whole process is properly planned right from the purchase of raw materials at lower costs, reduction in manufacturing costs and selling at a profit. If the company has a high turnover but lesser gross profit then it means that the company is working hard but not getting the desired result. Ideally, increase in turnover should result in increase of profits as the costs and fixed expenses come down with each unit of extra production. The company should also be stringent on its credit policy which is holding up much of its capital and mounting up bad debts. The company’s profitability declined in 2011 as compared to 2010 by 7% and the return on equity also declined from 60% in 2011 to 40% in 2010. In spite of this, the company declared same amount of dividends in both the years. Had the company declared lower dividends in 2011, it could have utilized that part of its profit somewhere else in the business which it required. The operating profit of the company halved either due to increase in operating expenses or reduction in operating income. Since the sale has increased operating income is expected to increase and hence the decline in operating profit can be said as a result of rise in operating expenses. Part B: Mega PLC Question1 Product A Therefore, for Product A, the number of units sold = ?100,000/?10= 10,000. The revenue per unit for A= ?10. Therefore, Cost of sale for Product A= ? (40,000+20,000+30,000) = ?90,000. Cost of sales per unit for A= ?90,000/ 10,000= ? 9 Therefore, profit per unit= Revenue per unit-cost of sales per unit= ?10-?9= ?1. Number of units manufactured for A= 98000/ 8= 11500 units. Total profit for A= ?1 * 11500= ?11500. Product B Similarly for product B, the number of units sold= ?96000/?12= ?8000 The revenue per unit of B= ?12. Therefore, Cost of sale for Product B= 38,000+18,000+27,000=83,000 Cost of sales per unit for B= 83,000/ 8,000= ? 10.375 Therefore, profit per unit= ?12-?10.375= ? 1.625. Number of units manufactured for B= 92000/ 4= 23000 units. Total profit for B= ? 1.625* 23000= ? 37375. Product C Product C, the number of units sold= 32000/8=4000 units. The revenue per unit of C=8. The cost of sales = Prime cost + Variable overhead+ Share of fixed general overhead. Therefore, Cost of sale for Product C= 13,000+11,000+10,000=34,000 Cost of sales per unit for C= 34,000/ 4,000= ? 8.5 Therefore, profit per unit= ?8-?8.5= - ? 0.5 i.e. it incurs a loss. Number of units manufactured for C= 92000/1 = 92000 units. Total profit for C= - ? 0.5* 92000= -? 46000. The profit for the company is maximized when optimum quantity of product B is manufactured. If say, 100 less units of product B are manufactured and 100 units more of product A is manufactured, the profit of the business is lowered. Say, 22000 units of B and 12500 units of A is manufactured, the profit from B becomes ? 1.625* 22000= ? 35,750. And that of A becomes ?1 * 12500= ?12500. Therefore profit is maximized only when maximum quantity of B is manufactured. Question2 A company’s profit is generally driven by its sales which boost the revenues of the company. However, for selling efficiently and running the business, certain costs are involved. These costs can be classified into fixed and variable costs. The variable costs are directly proportional to the sales and generally include freight, transportation etc. The fixed costs are generally a fixed amount that the company has to spend in order to meet its day to day expenses. If a company wants to profit, it has to try to minimize the impact of the fixed costs on its business. This can be done by increasing sales. As the sales increases, the revenues increase. Fixed costs are difficult to minimize and hence need to be subsided by doing more sales and earning more revenues so that the profitability is not hampered due to the fixed costs. For decision making, the information of variable costs is more important than fixed costs. A company might incur more variable costs to sell a unit of its product. It has to try to minimize the variable cost as the fixed costs cannot be tweaked much. After analyzing the costs, the management can take decisions related to minimizing the variable costs and minimizing the effect of fixed costs by increasing the sales revenue. So the correct information relating to the fixed costs helps the management take effective decisions in cost cutting or pricing decisions which prove to be an important step for the business (McLeavy and Narasimhan, 1999, p.61). Question 3 Break-even Sales Units = x =FC/ (p – v) Break Even sales unit for A= Fixed cost/ (price per unit-variable cost per unit) = 30,000/ (10-9) = 30,000 units. Break even sales for A= ?10*30000= ?300000 Break Even for B= 27000/ (12-10.375) = 16615 units. Break even sales for B=?12*16615= ? 199380. Break Even for C=10,000/ (8-8.5) = - 20,000 units. Break even sales for C=8*(-20000) = ? (-160,000) Margin of Safety= Budgeted Sales- Break even Sales. Margin of safety for product A= ? (100,000-300000) = -? 200,000. Margin of safety for product B= ? (96,000-199380) = -? 103380. Margin of safety for product C= ? 32,000-(-160000) = ? 192000. A negative margin of safety indicates net loss for the operations. Question 4 Break even analysis is carried out to understand the effects of fluctuations in cost and volume on the revenues and profit of the business or capital investment project. Break even analysis used to find the point from where the business starts recovering its investments and generating profits. The break even analysis of the Mega PLC indicates that the company may experience losses when optimum quantities are not produced. The margin of safety is high for the business and the company needs to revaluate its manufacturing decisions and costs incurred (Peterson and Silver, 1985, p.89). Part C: Brothers Ltd. Question1 a) Payback Period Payback period = Cost of Project / Annual Cash Inflows = ? 200,000/ ?70000 = 2.86 i.e. 2 years 7 months. The payback period of around 3 years is considered average with respect to the capital budgeting decision of undertaking the project. Though the payback period calculation ignores the time value of money, the management can make a rough estimate of the feasibility of the capital investment decisions. b) Accounting Rate of Return Accounting Rate of Return= Annual profit/ Total investment. Depreciation= (Initial Value- scrap value)/ useful life = (200,000-20% of 200,000)/ 5 =32000. Annual profit= 60,000-32000= 28,000. ARR= 28000/ 200,000= 14%. An ARR of 14% indicates strong potential and good returns from the business. c) Net Present Value Net Present Value= -200,000+ 60000/ (1.15)1 +60000/ (1.15)2 +60000/ (1.15)3+ 60,000/ (1.15)4 = -28,702. The NPV should be positive for a financially feasible investment. d) Internal rate of Return ? (-200,000+60,000+60,000+60,000+60,000)/ (1+R) 4 = 0 Therefore, IRR = 7.71%. Question 2 The investment is feasible according to the payback period and ARR calculations but is weak according to the NPV analysis. The risk of the project is low but the return expected is also not high. Since the NPV is negative, the investment will not add any value to the firm. Since the IRR is much lesser than the cost of capital, the capital investment is not at all feasible for the business. Part D a) The main sources of fund available to business are equity and debt financing. A company listed on the bourses is able to raise its finance through both equity and debt financing but an unlisted company can raise its finances only through debt financing as its main source. Since all the companies are able to raise money through debt financing, it is considered as the main source of finance to a company of any size. The debt financing method is done through a bank and it is very different from the method of financing in which an investor lends money to the business and it does not require the business to give the bank a part of its business (Forbes, 2010). Advantages: The bank or the lending institution does not interfere in the business and cannot make any decisions in the functioning of the company since they are not a part of the company. Also, the bank and the company are bound by a contract and the relationship between them ends when the company pays back the borrowed money to the bank. The bank charges interest on the loan taken by the company. This interest is deductible in tax computation which benefits the company even after paying interest. The company enjoys flexibility in choosing exactly the duration of the financing it requires. Disadvantages: The Company is bound to pay back the borrowed money in a fixed period of time. A company should not rely much on debt financing otherwise it may incur problems in cash flows which can hamper the repayment of the loans. A company using the debt financing too much is rated poorly by credit rating companies and investors and it may have problems raising funds by equity financing due to this. Many times, the company requires providing its assets as a collateral security and sometimes even personal guarantee is required which can be dangerous. b) Budgeting is one of the primary tools required for the efficient and effective functioning of a business. A budget structures the planning of the company so that it can run more smoothly. A proper budgeting makes the planning of the company structured and reliable. Budgeting also helps business identify the bigger picture of the company and take necessary steps. Budgets provide a company enhanced ability to anticipate future problems and make improvements on a continuous basis as the decisions made are on accurate financial information. It helps the management to take decisions based on accurate facts and figures (Graham and Harvey, 2001, p.187-244). For the effective and continuous growth of a company, a budget plan should be in place. A proper budgeting plan helps business managers to be confident in their present and future financial decisions and meet the business objectives, helps in assessing the business events and taking steps to mitigate the risks. A proper budget also enhances staff motivation as they feel that the company is stable and running in a planned manner. They feel safe working for the company as it has its future plans ready and hence also ready to face the future risks. A budget can help in monitoring various business activities as well. The budget review helps to analyze the areas of concern so that the company can take necessary steps before any problem becomes a potential risk. The performance of the company can be also benchmarked and the company can assess whether its working capital is being properly utilized and the sales are in line of expectation. Any company on it line of growth, requires a budget for its steady growth and proper planning. References Graham, J. and Harvey, C. 2001. “The theory and practice of Corporate Finance: Evidence from the Field”. Journal of Financial Economics. Vol. 60(1), p.187-244. Horngren, C.T. 1997. Cost Accounting, A Managerial Emphasis, Fourth Edition. New Jersey: Prentice Hall. McLeavy, D. and Narasimhan, S. 1999. Production Planning and Inventory Control. Boston: Allyn and Bacon. Peterson, R. and Silver, S. 1985. Decision System for Inventory Management and Production Planning. New York: Wiley. Forbes. 2010. The 12 Best Sources Of Business Financing. Available at http://www.forbes.com/2010/07/06/best-funding-sources-for-small-business-entrepreneurs-finance-dileep-rao.html. [Accessed on 15 December 2013]. Read More