Financial Analysis of Business Based on Assumed Financial Amounts - Assignment Example

Finance and Accounting Table of Contents Table of Contents 2 Introduction 3 a) 3 Cash Budget 3 Budgeted Income ments (IS) 5 Budgeted of Financial Position (SOFP) 6 b) Disadvantages of straight line method of depreciation with respect to the case study 7 c) 8 Discounted Payback period 8 Accounting rate of return (ARR) 9 Internal rate of return 10 d) 10 Change in cost of sales 10 Changes in price 10 Conclusion 11 References List 12 Introduction The report highlights financial analysis of business of Edith based on assumed financial amounts. The business is supposed o start in January 2015 and she is confident that by the end of July she will achieve her full potential. Edith organizes parties and events for the customers; the events are organized in her venue and she charges customers fees according to their requirement (catering or organizing). The organizing fee comprises decoration of the room with the help of balloon or room enhancements or theme party. She is about to start her business with her own capital which amount to £800,000. The report elaborates the cash budget, budgeted income statement and budgeted statement of financial position based on the available data that is estimated by Edith. Thus, it helps her to recognize the benefits and deficiency of her financial plan to start the new business. The capital budgeting techniques are applied to evaluate the financial position of the business. The sensitivity analysis is also executed for examining the effect of change in cost of sales and price on cash flow. The calculations are depicted in the excel sheet however, the tables are provided in the report to discuss about the financial viability of the business. a) Cash Budget The cash budget of business of Edith is prepared after considering the following data: 1) Sales value of the business is estimated to be: January 2015: 20% February 2015: 30% March 2015: 50% April 2015: 60% May 2015: 70% June 2015: 90% The percentage is calculated on the total invested amount. 2) The calculation is shown from January to June 2015. 3) The cash outflows are leasehold venue (invested one time in January), furniture, equipment and van (bought at the beginning of the business). It also includes the labour and overhead cost. The following table is the cash budget of Edith’s business (Refer to excel sheet for detailed calculation): The table above highlights the fact that the business will encounter highly fluctuating ending cash balance during the period from January to June 2015. The fluctuation is shown in the figure provided below. Figure 1: Position of ending cash balance (Source: Author’s Creation) From the above figure it can be concluded that the business will encounter fluctuations in ending cash balance due to the variations in sales and expenditure of the business. Hence, it can be stated that the estimated sales value are not appropriate for the business. Edith needs to revise it for increasing the ending cash balance during the referred time period. Budgeted Income Statements (IS) A budgeted income statement consist all the items that are present in the income statements of a particular company (Baker and English, 2011; Balakrishnan, Sivaramakrishnan and Sprinkle, 2009). The only difference is that the income statements are prepared after considering the actual value of the business whereas the budgeted income statements is a projection of the income statement during budgeting periods in the future. A budgeted income statement is prepared for Edith’s business to highlight its profit or loss at the end of 2015. The budgeted income statement is prepared for one year staring from January 2015 to December 2015 (including both months). The following table is the budgeted income statement of the business (Refer to excel sheet for detailed calculation): The table provided above evaluates the profit of Edith’s business for the year 2015. The following details are taken into consideration while preparing the budgeted income statement of the business. The weekly and weekend sales are calculated separately after considering the number of parties that will be organized by Edith. The cost of sales also demarcates the cost for catering and organizing. The gross profit is calculated after deducting the cost of sales from total sales. The fixed expenses for the business is labor and overhead expenses that is calculated to be 20% of the total sales. Thus, it is observed that the business will encounter huge profit in its first year of operation. It can be stated that Edith will easily earn its invested amount i.e. £800,000 in the first year through sales. Budgeted State of Financial Position (SOFP) The budgeted SOFP highlights the financial position of the business with respect to assets and liabilities. The assets and liabilities mentioned in the table below are the estimated amounts of Edith. The assets and liabilities are both current and non-current. The current assets include cash and inventories. The liabilities include the payment to the creditors. The capital of the business comes from the owner itself. The budgeted SOFP is detailed below (Refer to excel sheet for detailed calculation): The table above suggests that Edith’s business will have adequate assets for supporting the payments to the creditors within a short span of time. Thus, it can be explained that the liquidity position of the business will be stable during the first year of operation. b) Disadvantages of straight line method of depreciation with respect to the case study The straight-line method of depreciation is defined as the method of reducing the purchase price or cost. This process aims at decreasing the cost of asset by equal amount every year till the useful life (Berceanu and Băndoi, n.d.’ Bierman and Smidt, 2007; Warren, Reeve, and Duchac, 2013). The main disadvantage for using straight-line method of depreciation in this case is as follows: 1) The method does not consider the expense of maintenance and repair of the assets used in the business such as van, equipment and furniture. 2) The method does not help the business to obtain funds for replacing the assets. 3) It also does not consider the use of the mentioned assets effectively (Jiambalvo, 2010). 4) The method does not reflect the difference in the usage of the assets over the period of time accurately. 5) It does not help the business to balance the cost and revenue by considering the above mentioned assets (Maher, Stickney and Weil, 2012; Pidun and Stelter, 2011). c) Discounted Payback period The discounted payback period is the period which is required by a business to recoup its initial investment and it is based on the discounted cash flows that are obtained after applying the discounting factor (Dayananda et al., 2002). In this case the discounting factor is 18%. The initial investment is £ 8, 00,000. The cash inflow for each year is considered to be sales amount of the business. The sales amount is expected to increase by 5% at the end of each year the same is reflected in the calculation below. The table highlights the discounted cash flow of the business: In the above table the cash inflow is considered to increase by 5% each year. After calculating the discounted cash flow the discounted payback period is evaluated. The formula used for evaluating it as follows: Discounted payback period= (Last period with negative cumulative cash flow) + (Absolute value of cumulative cash flow at the end of last period)/ Total cash flow The discounted payback period (DPBP) is ascertained to be 1.45 years and thus is can be stated that the investment is good. Advantage of DPBP: This method is more reliable than payback period as it considers the time value of money. In this process, the main interesting parts are that it ascertains the negative net present value of the initial investment (Joehnk, 2012). Disadvantage of DPBP: It ignores the PBP of the investment after the discounted period. Accounting rate of return (ARR) ARR is obtained after dividing the average profit by the initial investment. The ratio allows the business to compare profit potential of its investment easily and also indicates whether it will be feasible to make the investment (Warren, 2009). From the above table it can suggested that the investment in the business will be successful for Edith as it is will give her a lump sum amount in return. Advantage of ARR: It measures the profitability of the business by using the accounting tools. Disadvantage of ARR: ARR does not take in to consideration the time value of money and thus it is the main disadvantage of the method (Chandra, 2005; Weygandt, Kimmel and Kieso, 2010). Internal rate of return IRR is defined as the discount rate at which the NPV of all cash flows of a particular project becomes zero. The project with higher IRR is preferred (Needles, Powers and Crosson, 2013) The IRR for the investment of Edith business is 56% (Refer to excel sheet for calculation of IRR). Advantage of IRR: The method is widely accepted for quantifying the rate of return of a particular project after considering the discounted cash flows (Jiambalv, 2010). Disadvantage of IRR: The chosen rate or return is based on assumption and thus the process of evaluation does not give the accurate IRR (Coombs, Hobbs and Jenkins, 2005). d) Change in cost of sales When the cost of sales changes from 30% and 15% to 40% and 20% respectively, the following table elaborates the sensitivity of the changes on cash flow:   Cost of sales 30% and 15% Cost of sales 40% and 20% Cash flow 1296000 1008000 In the above table it is observed that the increase in cost of sales has decreased the cash flow of the business. Changes in price If the price is decreased by 20% then the change in cash flow is as follows: From the above table it is evident that the decision for decreasing the price will automatically decrease the profit for the year. Conclusion It can be concluded that business of Edith will be successful as it is expected to incur profit and the whole investment in the first year’s operation. However, the decision of changing the cost of sales and price is not relevant as the profit is expected to decrease to large extent. References List Baker, K. H. and English, P., 2011. Capital budgeting valuation. New Jersey: John Wiley & Sons. Balakrishnan, R., Sivaramakrishnan, K. and Sprinkle, G., 2009. Managerial accounting. New York: John Wiley & Sons Inc. Berceanu, D. and Băndoi, A., no date. Inflation influence about investment decision. [pdf] n.p. Available at: < http://www.oeconomica.uab.ro/upload/lucrari/1020081/33.pdf > [Accessed 2 July 2014]. Bierman, H. and Smidt, S., 2007. The capital budgeting decision. New York: Routledge. Chandra, P., 2005. Fundamentals of financial management. New Delhi: Tata McGraw-Hill. Coombs, H., Hobbs, D. and Jenkins, E., 2005. Management accounting: principles and applications. [pdf] SAGE. Available at: < http://196.29.172.66:8080/jspui/bitstream/123456789/1524/1/Management_Accounting.pdf > [Accessed 10 March 2014]. Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital Budgetig. Cambridge: Cambridge University Press. Jiambalvo, J., 2010. Managerial accounting. New York: John Wiley & Sons Inc. Joehnk, G., 2012. Fundamentals of investing. New Jersey: Pearson Education. Maher, M., Stickney, C. and Weil, R., 2012. Managerial accounting: An introduction to concepts, methods and uses. Connecticut: Cengage Learning. Needles, B., Powers, M. and Crosson, S., 2013. Financial and managerial accounting. Connecticut: Cengage Learning. Pidun, U. And Stelter, D., 2011. Making Your Company Inflation Ready. [pdf] The Boston Consulting Group. Available at: < http://www.bcgindia.com/documents/file72671.pdf > [Accessed 10 March 2014]. Warren, C., 2009. Managerial accounting. Connecticut: Cengage Learning. Warren, C., Reeve, T. and Duchac, J., 2013. Managerial accounting. Connecticut: Cengage Learning. Weygandt, J., Kimmel, P. and Kieso, D., 2010. Managerial accounting: Tools for business decision making. New York: John Wiley & Sons Inc. Read More