Managing Financial Resources - Assignment Example

 Managing Financial Resources Finance as a resource: Finance is considered as one of the precious resources from the organizations’ point of view. But the procurement of funds and effective utilization of funds are the major functions of finance department. The term cost refers to monetary values of all sacrifice made to achieve an objective. Types or techniques of costing means the manner of ascertaining costs. Opportunity cost refers to the value of an advantage relinquished in accordance with another option. It is the cost of the best alternative foregone. It is the value of benefits foregone when one decision alternative is selected over another. But usually the concept of opportunity cost is not recorded in the books of accounts. Then also it is a significant factor in the decision making process also. Decision making is the fundamental nature of the management of an entity. It is necessary to collect, analyze and present the accounting information in an appropriate manner to meet the requirements of various interested groups. Stake holders of the company means those groups of persons who are interested in the organizational functions and affairs. The stake holders of the company means the share holders, lenders, employees, suppliers, customers, competitors, Government as well as the public as a whole. More over, the balance sheet of a company is giving focus on the changes that have taken place in the accounting year. The ultimate object of financial statements is that of evaluate the financial strength and weaknesses of the firm. Financial Decisions: Capital budgeting means the planning for capital assets. The decision about capital budgeting means a decision as to whether or not the money should be invested in long term projects. The term budget is a device which helps the management in planning and control of business activities. It is statement relating to the future plans. Budget is essential for business, because it provide management with a plan of operation to be followed during a specified future period. Not only this, but also it is possible to plan and control the income and expenses. A business might have cash budget, sales budget, purchase budget, etc. The concept of variance analysis is an important concept in standard costing. Variance means the difference between actual cost and standard cost. Variance point out to the management that whether the costs are under their control or beyond? It may be either favourable or not. If the actual cost is less than the standard, the difference indicates that there is a positive variance, but reverse on the other hand. Variance analysis is the procedure of evaluating variances by sub dividing the total variances in such a way that the management can assign responsibility for poor performance. Generally the variances may be of cost variance and sales variance. Among them, the cost variance is significant and which may be of three types, material variance, labour variance, and over head variance. For example, a product requires 50 units of material @ of £3 per unit. The actual consumption of material for manufacturing the same product came to 60units @of £2.80 per unit- Therefore, material cost variance= Standard cost_ Actual cost. Standard cost= Standard quantity* Standard price per unit. I.e. 50*3= £150. Actual cost= Actual quantity* Actual price per unit 60*2.80= £168. Material cost variance= £150_£168= £18(unfavourable) Material price variance= Actual quantity*(Standard price Actual price) 60*(3_2.80) = £12(favourable) Material usage variance= Standard price* Standard Quantity Actual quantity) 3*(50_60) = £30 (unfavourable) Costing and Pricing Decisions Unit costing is a method which is used by the company when it produces only one product, and when the units are identical. The main object of unit costing is to find out the cost per unit of output. More over, the concept of costing and pricing decisions are related to each other to a great extend. The major discussion about the cost classification, treatment of wages, etc. Sensitivity Analysis: It is one of the important concepts used in undertaking or managing financial resources of an entity. One important aspect of sensitivity analysis is the margin of safety which is the excess of budgeted sales revenue over the break even sales revenue. “Sensitivity analysis quickly reveals that the crucial parameter is the pure rate of time preference. This is the extent to which we choose to discount future costs and benefits” (Jquiggin 2006). Investment Appraisal: Investment appraisal technique is an important concept adopted in Financial management, because it is a crucial factor to decide that whether the money should be invested in long term projects. For the purpose of taking the better decision, the fundamental project evaluation techniques like Pay back period, ARR (Accounting or Average Rate of Return), NPV (Net Present Value), or IRR (Internal Rate of Return) is applicable. Pay Back period: It is one of the simplest methods to calculate the period within which the entire cost of a project will be completely recovered. Here cash flow means profit after tax but before depreciation. Cost of Machine A- £12.000 and Machine B- £10.000. Net Cash flows for each machine for the four years are- Year Machine A (£) Machine B(£) 1 2 3 4 Total 6.500 5.500 3.500 1.500 4.500 3.500 3.500 2.500 17.000 14.000 Here for computing the pay back period of both machines, For Machine A, amount of £12.000 will be recoverable within 2years (I.e. 6.500+5.500); on the other hand, Machine B costing £10.000 will be recoverable within 2½ Years. (I.e. 4.500+3.500=8.000; requires 2.000more for the cost of printing machine.) So, the balance amount will be recoverable as- 2.000/3.500*12 (months) = 6.85 months. So, Machine B requires 2years and around 7months. Machine A has a pay back period of 2years and it has a much higher return than Machine B, and therefore Machine A should be preferred. Accounting Rate of Return (ARR): It refers to average annual yield on the project. Here, the profit after tax and depreciation as percentage of total investment is considered. ARR= Total Profit after tax and depreciation*100/Net Investment in the project*number of Years of Profits. OR ARR= Average income/Average investment*100. Machine A- Average earnings= £17.000/4= 4.250 Average investment= cost at the beginning+cost at the end/2= £12.000+0/2= 6.000 ARR= 4.250/6.000*100= 70.83%. Machine B- Average earnings= £14.000/4=3.500 Average investment=£10.000+0/2= 5.000 ARR= 3.500/5.000*100= 70%. On the basis of ARR Project, Machine A will be selected as its ARR is higher than that of Machine B. Discounted Cash Flow (DCF) Even though pay back method and ARR method is good indeed, but ignoring the time value of money. The value of money received in future is not equivalent to the value of money invested now. The principle of DCF is that money has a time value. The major DCF methods are discounted pay back method, NPV (Net Present Value), IRR (Internal Rate of Return) etc. NPV- One of the major methods for the evaluation of investment proposal, which is giving stress for the time value of money. NPV= Total Present value of future cash inflows_ Total Cash outflows. Machine A Year Net cash inflows (£) Discount Factor@10% Present value(£) 1 6.500 0.909 5908.5 2 5.500 0.826 4543 3 3.500 0.751 2628.5 4 1.500 0.683 1024.5 Total 14104.5 Machine B Year Net cash inflows (£) Discount Factor@10% Present value(£) 1 4.500 0.909 4090.5 2 3.500 0.826 2891 3 3.500 0.751 2628.5 4 2.500 0.683 1707.5 Total 11317.5 NPV of Machine A= 14104.5_ 12.000= 2104.5 Machine B= 11317.5_ 10.000= 1317.5 Machine A is more profitable investment. Because cash flow in the earlier years are higher than that in the case of Machine B. IRR- is the rate at which the sum total of cash inflows after discounting equals to the discounted cash out flows. IRR= r+ PVCFAT_ PVCO/▲PV*▲r Here, PVCO= present Value of cash outlay. PVCFAT=Present value of cash inflows. r = Interest rates. ▲r = Difference in interest rates. ▲PV= Difference in present values of inflows. While undertaking the capital investment decision, a comparison of IRR with the required rate of return known as cut off rate. If IRR is greater than the cut off rate, project should be accepted; if it is less than the cut off rate it should be rejected. IRRis giving stress for the concept of time value of money. Bibliography JQUIGGIN. (2006). Sensitivity Analysis. [online]. John Quiggin. Last accessed 02 February 2008 at: http://johnquiggin.com/index.php/archives/2006/12/27/sensitivity-analysis/ Read More