Financial Analysis As The Stability Of The Business - Essay Example

Financial Analysis As The Stability Of The Business. Table of Contents Introduction 2 Section A 3 a)Ratio Analysis for Nene PLC 3 b)Limitations of interpreting financial performance and importance of maintaining caution while drawing conclusions and making recommendations 6 Section B 8 Question 1 8 a)Limiting Factor Analysis 8 a)Steps for Profitability Improvement in Labour Shortage 9 Question 2 10 i)Payback Period 10 ii) Accounting Rate of Return 11 iii) Net Present Value 12 iv) Internal Rate of Return 12 v) Memo to Management for Suggested Project 12 vi) Cash Flow Projections vs. Profit Projections 13 Section C 14 a)Causes for Global Financial Crisis 14 b)Budgeting 15 Conclusion 16 Reference List 17 Bibliography 20 Introduction Financial analysis is a test of viability, success, stability and profit making ability of a business. It comprises of various tools and techniques that include ratio analysis, project finance, cash flow analysis, capital budgeting and such other measures. These tools prove to be helpful in the financial determination of the success or failure of a particular project or company. The following paper is divided into three sections where Section A is devoted to a comprehensive Ratio Analysis of Nene PLC. The section calculated ratios to arrive at an assessment of the financial position of the concern. Section B uses tools of corporate finance to analyze situations where the shortage of resources can be appropriately adjusted to get the maximum amount of profits for the concern. In a second part of the section, project finance tools have been used to suggest the best project among the three available options. Section 3 is a discussion of the causes of the global financial crisis and budgeting. Section A a) Ratio Analysis for Nene PLC ROSF: The ROSF or the return on shareholder's fund's ration represents the amount that shall be available to the shareholders in return for per unit of their investment (Albrecht, 2011). The ROSF figure for NENE PLC has been calculated to be 32% per GBP1 for the year 2012 and it fell to 26% per £1 in 2013. The fall in ROSF cannot be interpreted to be a negative sign owing to a fall in company profit because the decline in the ratio comes from a rise in the shareholder’s funds despite a decent rise in profits. This decrease has come about with the company’s plan for further investments where the profits have not been able to generate the same amount of sales per shareholding as before. ROSE: The ROCE figure, on the other hand, does not reflect much change. This is because the asset changes have not yet been impacted with the additional business funds brought in through equity funding. The total capital employed by the business has remained quite identical and so have the profits before interests and taxes. Hence the ROCE figure does not see much change. Gross Profit Margin and Net Profit Margin: These two ratios have to be taken together in order to bring a more comprehensive and clear view abuts company profitability. The GP ratio does not bring in a much change in 2013 over 2012 and remains stable at about 22.5% approximately. However, this might indicate that the company is not growing as expected. Yet, when one looks at the net profit margin figures, there is quite some difference between 2012 over 2013. The net profit margin has fallen from 7.1% in 2012 to about 6.1% in 2013. This fall has not come from the rise in interest expenditure but from the rise in the corporate tax rates which leaves little profits in the hands of the company. Stock Turnover Period: While analyzing company efficiency, it was observed that the inventory turnover days had increased from 56 in 2012 to 59 in 2013. This is not a healthy sign for the company. The increase in inventory implies the increase in storage costs and hence operational expenses of the company which in turn put pressure on the cash flow needs. It is therefore desired that the Nene PLC works towards reducing the same. Average Settlement Period and Creditor Settlement Period: For any company, it is always desired that the creditor’s turnover period is higher than the debtor’s turnover period so that the funds received can be utilized for paying off company’s debts and there is no additional pressure on short term liquidity. For Nene PLC, the situation is well handled as we see that there is a fall in the debtor’s turnover period as well as creditor’s turnover period showing improvement is short term fund management. Sales to Capital Employed: The sales to capital employed ratio is a representation of a number of sales, the company is able to generate per unit of equity outlay employed. There is a slight appreciation in the ratio which remains close to about 3 times. This rise has come about owing to rise in shareholders’ funds through fresh issue of shares but is not so significant. It further implies that sales have also gone up commensurate with the rise in equity funding. An analysis of the liquidity ratios shows that Nene PLC has sufficient liquidity in the system where the company is having healthy cash balance to pay for its operational needs. However, the year 2013 has observed a slight fall in both the current ratio as well as the quick ratio raising slight concerns over the operational cash management situation of the company. Gearing Ratio: This ratio measures a number of debt funds employed by the company as opposed to its equity funds. It is observed that Nene PLC has brought down a significant amount of such debt funds thereby reducing its gearing ratio. Hence Nene PLC can be said to be a low gearing company. The interest cover ratio shows the firm's ability to pay for its interests out of company profits. Nene PLC has shown a high rise in this ratio over 2012 in 2013 (Neely, Bourne, and Adams, 2003). Investment Ratio: Nene PLC has observed a 50% rise in stock price due to positive investor sentiments. This has also brought up the price/earnings ratio. The Dividend per share has also risen which is an indicator of the sound financial position of the company. However, the dividend payout ratio is significantly low despite the sound financial position. This shows that the company has plowed back a large amount as retained earnings for its future expansion plans. b) Limitations of interpreting financial performance and importance of maintaining caution while drawing conclusions and making recommendations The ratio analysis based interpretation is one of the most popular methods used for analyzing the financial statements of a company. However, it is not free from its limitations. Financial ratios are calculated based on the firm's financial data available and are supported by the historical data. Hence calculation of such is not capable of producing results that have the ability to predict the future course of actions of the company (Delen, Kuzey, and Uyar, 2013). The differences might also arise in terms of the difference in the accounting standards followed by companies. In this context, one company might be following the US GAAP in one year and might have moved on to IFRS standards in the following year. The difference in accounting policies calculated through different standards impact the results and hence the ration. This also has an effect on their interpretations (Levine, 2005). The financial ratios represent simply the factual data. This also needs to be supported by other facts like investment plans or ways in which funds shall be utilized to give a clearer picture of the firm's financial position and industry standing (Nissim and Penman, 2001). The financial ratio also needs to be supported by other formats of the financial data like the balance sheet and the profit and loss statement to give a comprehensive picture of the actual financial position of the company. Along with this, one has to also consider market news and investor sentiments before going about the interpretation of causes behind profit or loss-making or slump in share prices (Siddiqui, 2006). Section B Question 1 a) Limiting Factor Analysis When Labour amount is £ 20000 At least 50% of the budgeted sales revenues are required to achieve for each service. Therefore, at least 50% of labor costs of each service is needed. Service Labour costs £ 000 50% of labor costs £ 000 Alpha 9 4.5 Beta 6 3 Gamma 12 6 Total 27 13.5 Therefore, the labour left is £20,000 – £13,500 = £6,500. 　 Alpha Beta Gamma 　 £ 000 £ 000 £ 000 Variable Cost 　 　 　 Material 6 4 5 Skilled labour 9 6 12 Expenses 3 2 2 　 18 12 19 Allocated fixed cost 6 15 12 Total Cost 24 27 31 Profit 15 2 2 Sales revenue 39 29 33 Contribution 21 17 14 Contribution Margin of labor 2.33 2.83 1.17 Ranking 2 1 3 Optimal Production Plan Ranking Material available for production (£) 　 6,500 　 　 　 　 Total Material Left 1 Beta 3,000 3,500 2 Alpha 3,500 0 3 Gamma 0 0 Therefore, the profit is £9,640 and the calculation is shown as follow: Service Alpha Beta Gamma Total 50% of labor costs £ 000 4.5 3 6 13.5 Allocation 3.5 3 0 6.5 Total labor cost £ 000 8.00 6.00 6.00 20 Contribution margin of labor 2.33 2.83 1.17 　 Contribution of service 18.64 16.98 7.02 42.64 Less fixed costs 6 15 12 33 Profits 12.64 1.98 -4.98 9.64 a) Steps for Profitability Improvement in Labour Shortage In the event of resource scarcity, a company can undertake two possible approaches towards the improvement of their profit position and ensure a better management of resources to attain the best possible results. One of these approaches is the sensitivity analysis while the other is break-even analysis. The aim of each one this analysis is to provide for the best possible allocation of available resources so as to maximise profits in the event of resource shortage (Jennings, 2006). The break even analysis is representations of the best situation in which the company can earn the profit or maintain a no profit no loss situation as a best case scenario. However, in the case of sensitivity analysis, each of the resources is arranged and rearranged unless the best combination that yields maximum profit scenario is ascertained (Porter, 2011). After this, the firms can increase the productivity of existing resource like labor through their skill development or machinery by increasing runtime (Schleifer, Sullivan and Murdough, 2014). Hence enhancements can add to the further profitability of the concern. Question 2 i) Payback Period In the above figures we see that the Payback period for the three project choices for Millennium PLC has been calculated (Garrison, Noreen, and Brewer, 2003). For the first year, Meeney recovers £20,000 of the total outlay of £60,000 which leaves £40,000 still unrecovered. After 2 years £6,000 remains unrecovered. It is only from the third year that operating profit before depreciation reaches a positive figure to £27,000. Hence it would take £6,000 of operating profit in the third year to bring the cumulative cash flow figure to zero. Hence the payback period is 2 years + (6/27) = 22/9 years. For the first year, Miney recovers £17,000 of the total outlay of £30,000 which leaves £13,000 still unrecovered. After 3 years £2,000 remains unrecovered. It is only from the fourth year that operating profit before depreciation reaches a positive figure to £5,000. Hence, it would take £2,000 of operating profit in the third year to bring the cumulative cash flow figure to zero. Hence the payback period is 3 years + (2/5) = 32/5 years. For the first year, Mo recovers £8,000 of the total outlay of £30,000 which leaves £22,000 still unrecovered. After 3 years £3,000 remains unrecovered. It is only from the fourth year that operating profit before depreciation reaches a positive figure to £8,000. Hence it would take £3,000 of operating profit in the third year to bring the cumulative cash flow figure to zero. Hence the payback period is 3 years + (3/8) = 33/8 years. ii) Accounting Rate of Return Accounting Rate of Return (ARR) = Average Accounting Profit/Average Investment Meeney = 12000/17500 = 1.45% Miney = 6000/7600 = 1.27% Mo = 6000/9600 = 1.6% iii) Net Present Value The NVP for Meeney is £11323>0 The NVP for Miney is £814>0 The NVP for Mo is £5796>0 iv) Internal Rate of Return Meaney: IRR = £71642.88 Miney: IRR = £29660.16 Mo: IRR = £58108.8 v) Memo to Management for Suggested Project To: Management of Millennium PLC From: Date: Subject: Evaluation of Suggested Projects Based on the above calculations, the management of Millennium PLC is suggested to go with a company that provides them with the highest possible NPV and IRR and the lowest possible Payback Period. In this scenario Project, Meeney is chosen among the three because it has the highest IRR of £71642.88. The project also has the lowest Payback Period of 22/9 years which implies that the project shall be earning positive profits rendering cumulative cash flow to be zero after 22/9 years. The project also suggests the highest NPV of £11323. vi) Cash Flow Projections vs. Profit Projections Cash flow projections in the analysis of projects help to have a combined look at the cash inflows as well as the cash outflows in a concerned project. This process makes interpretations based on the way in which cash inflows are realized and the manner in which such cash inflow pay's off for the initial investments to generate positive profit inflows (Hoofman, 2009). It does not make estimations of profits in the process. Estimation of cash inflow and outflow also does not get impacted by the accounting standards in terms of the way in which such inflow shall be calculated. In the selection of projects, cash flow projections help to determine the levels of business activity and hence are more reliable in making estimations and decisions (Elmaleh, 2005). Using the profit estimation method for selection of projects is based on sales figures and hence estimated profit figures. This method is impacted by numerous accounting principles and standards while making an estimation of profit and hence is rendered to be somewhat ambiguous in nature. Additionally, this method requires estimations of cost figures as well. Hence, the method is not very reliable when several aspects of estimations are involved (Kruschwitz and Löffler, 2006). Section C a) Causes for Global Financial Crisis The global financial crisis of 2008 had a massive influence on the economy of the world. The crisis began in July 2007 in the US. A credit crunch had begun in the US when investors began losing confidence in the value of subprime mortgages which triggered a liquidity crisis. The US federal banks in response to the situation injected a significantly large amount of capital into the financial markets. By September 2008, stock markets around the world began to crash and started becoming extremely volatile to the economic crisis. The economic crisis originated from the housing market of the US (Henry and Piekarski, 2005). The sudden fall in the price of house property had induced many investors to buy houses by taking subprime mortgage loans from different financial institutions. A significantly large portion of such loan takers became insolvent. Therefore banks had to face a situation where the repossessed land and house had lower value in the market in comparison with the value of the loan that it had originally given out (Grant, 2001). The banks, therefore, began to face a liquidity crisis. The US economy thus began to collapse which began having a recurring effect upon other economies (Grigor′ev and Salikhov, 2009). The global financial crisis made the regulatory authorities realize that an immediate change in the corporate governance system was required. It was realized that an effective risk analysis system was to be brought into action which could correctly interpret the liquidity aspect more accurately (Warren, 2009). The financial turmoil was caused as a result of inadequate management of risks by the regulatory authorities. Banks should be more responsible towards analyzing the repaying capacity of the creditors in order to prevent default (Acharya et. al., 2010). b) Budgeting Budgeting is an important aspect of managing finances in an organization. Budgeting helps a company to set standards of performance. By preparing a budget a company can effectively analyze the amount of revenue and expenditure pertaining to a specific period. This helps the organization to make plans for the coming budgeted period (Ingram, 2007). It also facilitates the comparative analysis between the actual performances of the firm in respect of its budgeted performance. Budgets are also considered as a suitable tool for maintaining a control over expenses incurred by a firm. The main reasons behind the necessity of budgeting in an organization are discussed as follows (Banerjee, 2010). One of the primary roles played by budgeting is that it helps in maintaining adequate control over the expenditures incurred by the firm. Budgets suitable provide a plan for the organization in respect of future expenses (Hachmeister, 2007). Budgets help to set standards of performance. The actual performance of a firm can be measured against the budgeted performance. This helps the organization to easily realize its deviation from the set goals and accordingly take steps for correcting the same (Grier, 2007). Budgeting is done on the basis of forecasting future transactions. This helps an organization to forecast future scenario and anticipate events that may affect the firm's operations (Harrison, 2008). In most organizations, budgets play an important role in decision-making and planning for the coming financial period. On the basis of the forecasted budgets, management is required to decide upon strategies relating to achieving the set targets, reducing costs and maximizing profits. Conclusion In Section A, ratio analysis of Nene PLC presented that the company was a sound and profit making concern that had to focus more on improving its operational efficiency in order to gain higher profits. In Section B, Project Meeney was ascertained to be the most viable project because it provided Millennium PLC with highest NPV and IRR and with the lowest Payback Period. Section C found that the global financial crisis was caused by a mix of financial and governmental failures. 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