Financial analysis of Zest Spa - Essay Example

Executive summary Zest Spa is planning to provide express services at one or more of three chosen international airports in India. The process comprises significant amount of fixed and variable investment on the part of the company and therefore it was considered necessary to evaluate the project from financial as well as non-financial aspect. The financial analysis of Zest Spa comprises profit projection for the current year for the three alternative choices along with analysis of net cash inflow using techniques such as net present value, internal rate of return, payback period and accounting rate of return. It was observed during the analysis that project at airport A will be only successful in earning profit while that in airport B and C will be earning loss. Additionally, NPV, IRR and ARR of project at airport A are positive and highest among the three and the payback period of the same project is lowest. The sensitivity analysis also revealed in this regard that project at airport A is relatively less sensitive. The paper also assess the external factors of the projects using PEST analysis and the composite outcome of the overall analysis was that the firm should go ahead with its express services only at airport A and under no situation should consider project C as it is the most unfavourable project among all. From investment appraisal perspective, project B could be considered but it was gather that the project generates negative profit when compared with respect to all costs. Hence, the recommendations are presented in favour of project A. Financial analysis and interpretation In a business plan or a new venture, financial analysis and projection are considered as an essential aspect thereof. The success and controlling of the business significantly depends on financial projections of a firm as quantitative control is equally important for a firm besides qualitative control. Financial analysis primarily consists of important aspects such as budgeting, investment appraisal, profit and growth projection and ratio analysis. The other measures that are also considered as useful are determination of weighted average cost of capital and comparing the same with return on investment and internal returns and sensitivity analysis. Annual profit before taxation Profit and loss analysis is essential in a business so that for an accounting period (commonly a year), the profit or loss incurred by a company is determined. The Profit and loss statement is one of the essential financial statements that present profitability of a firm. Determination of profit or loss is necessary so that an estimate of costs and earnings can be determined. The statement is also useful in calculation of various margins. The total cost including investment cost, variable cost, fixed cost and financial cost has been deducted from estimated revenue for each airport for calculation of net profit before tax for Zest Spa at each airport (Alexander, 2001). Table 1 (Source: Author’s creation) It was determined in the calculation that only spa at airport A will be making profit at the end of the operational year while spa at airport C will be making maximum loss between both the airports. Annual cash flows and net cash inflows Cash flow primarily denotes operating activities within a firm in monetary respect. The key aspects of cash flow are inflow and outflow. Inflow of cash denotes cash received or earnings of a firm while cash outflow reflects all the costs or expenditures that are paid-off by the firm. Cash flow can be classified in three main activities financial, investment and operating activities. The cash flow of Zest Spa has been calculated in table 2 and while calculation all the above mentioned components have been added in a composite manner. The revenue has been considered as inflow and fixed and other variable costs have been considered as outflow. The net inflow was calculated by deducting outflows from inflow (Bamber and Parry, 2014). Table 2 (Source: Author’s creation) “Simple” payback period The “simple” payback period is also identified as non-discounted payback period in financial accounting. Payback is an important capital budgeting techniques which is deployed to determine the time span within which the investment outlay is recovered through the net inflows. Payback period is used as a supportive technique and deployed with methods such as net present value determination. For instance, if two projects have almost similar NPVs then a firm can accept the project that has lesser payback period (Collier, 2012). The projected payback period for each of the projects are given as follows: Table 3 (Source: Author’s creation) The life time of each of the three projects is 3 years and it was observed that the project at airport C takes time beyond the project’s shelf life. Correspondingly, the company will be incurring heavy loss if the same is undertaken. Project at airport A and B are in relatively better positions. Since, airport A consumes minimum time for recovering project cost, the same should be accepted by the company. NPV Calculation Net present value method is a very convenient discounting cash flow evaluation method that is generally deployed by managers for comparing multiple mutually exclusive projects like the scenario that has been presented in the paper. NPV is generally deployed in project or investment assessment because it emphasizes on time value of the fund. The inflows are usually discounted by using discounting factor (generally cost of capital) so that actually value of the firm is considered while evaluating the project. In context of Zest Spa, cost of capital is determined by using cost of equity and cost of debt along with proportion of debt and equity that has been invested by the firm (Drury, 2013; Dyson, 2010). Table 4 (Source: Author’s creation) One of the prime criteria of NPV method is that the value should be more that 1 as negative NPV reflects potential loss. Another criterion that is very useful in this regard is a project with highest NPV is selected among multiple projects. Spa facilities at airport C was observed to generate negative NPV while spa at airport A was determined to generate highest NPV. Hence, among the three projects, project at airport A should be selected by firm on the basis of NPV. Supplementary capital investment appraisal Besides NPV and payback period, the other methods that are used for conducting investment appraisal are internal rate of return and accounting rate of return. The calculated values are discussed as follows: Table 5 (Source: Author’s creation) Internal rate of return is also a discounted measure which is calculated at the point when NPV of a project is zero. The primary criterion of IRR method is that a project will be accepted if the same is higher than firm’s cost of capital. In comparative analysis, a project with maximum IRR is accepted as greater return indicates maximum maximisation of shareholders’ wealth (Drury, 2013; Dyson, 2010). Conversely, accounting rate of return is a non-discounted technique of determining return on overall investment. ARR method is considered more effective with respect to payback period. It can be observed in table 5 that IRR of spa project at airport C is negative and relatively less than the cost of capital whereas the ARR is also less than firm’s cost of capital. In this regard, the projects at airport A and B are in better position and can be selected (Drury, 2013; Dyson, 2010). Sensitivity analysis In financial management, sensitivity analysis is also referred as what-if analysis and is a useful method of determine sensitiveness of profitability of a firm or project with respect to other factors such as cost, sales and others. The sensitiveness of the spa project with respect to the three airports has been assessed with respect to certain assumptions such as drop in sale, increase in variable cost and decline in price and increase in sales (Alexander, 2001). Table 6 (Source: Author’s creation) It can be gathered from the above table that if the total sales is dropped by 10percent then the services at airport C will be affect most significant as it was gathered from the breakeven analysis that airport C will have lowest margin of safety as a result of sales drop. The same was witnessed for other conditions as well. In this regard, services at airport A and B exhibit moderate level of margin of safety with respect to breakeven sales and are less sensitive to such externalities. NPV sensitivity NPV sensitivity method is another important measure adopted by managers in investment appraisal. In this method, sensitiveness of the NPV was calculated with respect to changes in inflow. In table 7, NPV has been calculated for each projects with respect to 5% increase in inflow and 5% decline in inflow. It was determine that NPV of the projects are more sensitive to increase in value of inflow by 5%. It can be observed that the decline in cash inflow value affected NPV but the impact was relatively higher with respect to positive growth. Additionally, sensitiveness was determined to be highest for spa project at airport C while the same was least for project A (Sangster, 1993). Table 7 (Source: Author’s creation) Potential impact of internal and external business factors Internal Competitors: The concept of delivering spa facilities at airports is a relative new concept and it can be ascertained that the level of competition will be comparatively less. However, the firm should adopting strategic marketing in this regard so that they are able to distinguish themselves from potential competitors (Stacey, 2007). Cost: The company has scope of cost reduction to a great extent and the costs should be adjusted in accordance with its revenue. Redundant cost may cause poor profitability. The company need to re-assess its variable cost so that, scope of cost reduction is recognised and implemented (Stacey, 2007). Employee management: Employees play an important role in success of any venture as they are the first set of contact individuals with respect to consumers. Employee management can be undertaken by means of participative leadership and employee management. Supportive and motivated employees contribute significantly towards profitability and growth of business (Stacey, 2007). External: PEST Political: The political environment of India is relatively stable as the country is not susceptible political disturbance. The government encourages foreign as well domestic investment in indigenous area of economic activities. The country is of strategic importance to a number of developing and developed countries and as a result attracts a large number of business and leisure travellers. This factor will act favourable to Zest Spa’s business (Yahoo Finance, 2014; The Economic Times, 2014). Economic: India is one of the prominent emerging economic with high growth rate. The country is undergoing major economic transformation and more that 69% GDP of the country is earned from its service sector. The spa is expected to grow in the country as the taxes are moderate and there is limited entry and exit barriers in this regard (Yahoo Finance, 2014; The Economic Times, 2014). Social: The socio-cultural environment of the country is largely dependent of its population and economic development. The country has highly diversified population which enrich its cultural and social environment. Another important fact in this regard is that the country has majority of urban population who avail various kind of services and welcome new changes. Therefore, the scope of the spa is very positive in this regard (Lakshmana, 2013). Technology: Technologies are no more limited to manufacturing industry. Instead, the spa and wellness industry is also welcoming technological development in spa facilities worldwide. Since the project is associated with delivering spa services at international airport, the company must accommodate global standard technologies in its spa activities (Global Spa Summit, 2008). Recommendation It was ascertained from the analysis that the express service of the company will be successful only at airport A as the project’s NPV at other airports is lower than that of airport A and also only project at airport A was successful in earning profit. Since this project can earn profit after meeting all costs and has high return rates, therefore, is recommended for the company among all the three alternatives. Appendix Critical evaluation of the investment appraisal techniques I. Net present Value method Strengths: The most important strength of NPV method is that its ability to accommodate time value of an investment. Time value consideration is essential in a project because it reflects that present value of money is never equivalent to the future value of the same. Another advantage of NPV method is its ability to evaluate different kinds of projects irrespective of its nature (independent or mutually exclusive). Weaknesses: The key weakness that was determined in this method is the discounting factor. Determination of discounting factor or the cost of capital can be ambiguous because the same can be calculated by deploying different methods (Bamber and Parry, 2014). Calculation formula Where T is the total number of years and t = 1, 2, 3…, Tth; r= discounting factor; C0= initial investment and Ct= yearly net inflow. II. Internal rate of return Strengths: IRR is another discounting capital budgeting technique that is generally employed with NPV method. IRR reflects the total internal return that a project generates throughout its entire life. IRR is preferred for another reason over various non-discounted cash flow techniques, which is its ability to pay equal weight to each of the cash flows. A number of analysts and managers calculate IRR to estimate budget and expenditure and savings associated with a project. Another benefit of IRR is that calculation process is hassle free unlike NPV. Weaknesses: IRR method is not devoid of quantitative flaws and its primary flawed assumption suggest that the method supposes that cash flows worth reinvesting will be done so at the same rate as that of the internal return. IRR method can often be misleading by generating multiple values. Additionally, the method appraises only projected cash flows and neglect external costs and factors that may impact firm’s profitability (Drury, 2013). Calculation formula The rate of return (r) is calculated by assuming that the value of the formula is zero because at IRR, NPV is always zero. III. Accounting rate of return Strengths: ARR method is one of the major non-discounted techniques that are used for calculating overall return from total investment. Accounting rate of return can be considered equivalent to return on investment with respect to potential outlay. This technique is also preferred because of its holistic approach as it not only considers the cash flows but also determine overall profitability. Weaknesses: The primary flaw that was recognised in the ARR method is that the process measures short term profit and thereby ignores risk associated with the project in long run. Furthermore, the profitability method also depends on numerous accounting policies and does not emphasise on the cost of capital. The effectiveness of the method is declined by the factor that it does not take in consideration time value of money (Dyson, 2010). Calculation formula In the formula, incremental income is calculated by deducting annual depreciation from net inflow. IV. Payback period Strengths: Payback is also a non-discounted technique but is used by managers for determining effectiveness of a project in terms of project return years. Payback period presents an estimate regarding how quickly a project can recover the net initial outlay. The payback period method is considered as a useful tool by managers for short term project evaluation. Weaknesses: Payback period alone is not sufficient for project evaluation because it neglects time value of money invested in a project and it does not emphasize on inflows that occur after the payback time span (Sangster, 1993; Collier, 2012). Calculation formula V. Sensitivity analysis Sensitivity analysis has been performed on the basis of breakeven analysis and the formulas are discussed as follows: Contribution = (Selling price - Variable cost) per unit Breakeven sales volume = Fixed cost/ contribution per unit Breakeven sales = breakeven units × selling price Margin of safety = Net sales – breakeven sales Reference list Alexander, C., 2001. Market models: a guide to financial data analysis. New Jersey: John Wiley & Sons. Bamber, M. and Parry, S., 2014. Accounting and Finance for Managers: A Decision-Making Approach. Great Britain: Kogan Page Limited. Collier, P., 2012. Accounting for Managers: Interpreting Accounting Information for Decision-Making 4th Edition. New Jersey: Wiley. Drury, C., 2013. Management Accounting for Business. 5th Edition. Connecticut: Cengage Learning EMEA. Dyson, J., 2010. Accounting for Non-Accounting Students. 8th Edition. New York: FT Prentice Hall. Global Spa Summit, 2008. 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