Effective Application of Financial Concepts - Essay Example

Effective Application of Financial Concepts Introduction In the wake of globalization, competition has become a critical aspect of the firms’ operation. It is worth to note that some of the indicators of good performance of the company is in its calculated financial records. This consists of different accounting concepts that emphasizes balance sheet among others. Ratio analysis is key in gauging the performance of the company and even comparing firms in different industries. Stakeholder’s interest and overall prediction of the future generally rely on such financial tools like ratio analysis. Question 1 a) i) Cash flows Cash flows of Alpha: Projected cash flows are normally arrived at by adding depreciation and disposal proceeds to profits. Cash flow= profit + depreciation + disposal proceeds 　 Cash flow Depreciation Disposal proceeds Cash Flows Cumulative cash flows Immediately -£100,000 0 0 -£100,000 -£100,000 1 year's time 15,000 18,000 0 33,000 -67,000 2 year's time 18,000 18,000 0 36,000 -31,000 3 year's time 20,000 18,000 0 38,000 7,000 4 year's time 32,000 18,000 0 50,000 57,000 5 year's time 18,000 18,000 10,000 46,000 103,000 6 year's time 2,000 0 0 2,000 105,000 Depreciation= (100000-10000)/5= £18,000 Cash flows of Beta: 　 Cash flow Depreciation Cash Flows £000 Cumulative cash flows £000 Immediately -£90,000 0 -£90,000 -£90,000 1 year's time 20,000 30,000 50,000 -40,000 2 year's time 25,000 30,000 55,000 15,000 3 year's time -50,000 30,000 -20,000 -5,000 4 year's time 10,000 25,000 35,000 30,000 5 year's time 3,000 25,000 28,000 58,000 6 year's time 0 25,000 25,000 83,000 Depreciation (years 1-3) = 90,000/3=£30,000 Depreciation (years 4-6) =75,000/3= £25,000 ii) Payback period Payback period of Alpha =2 years + [100000-(33000+36000)]/38,000) = 2 31/38 years Payback period of Beta = 3 year + (5000/35000) = 35/35 years iii) Accounting Rate of Return (ARR) ARR= (Average annual operating profit/Average investment) 100 ARR of project Alpha: Average annual operating profit before depreciation over the six years is calculated as follows Average annual operating profit= £ (33000+36000+38000+50000+46000+2000)/6) = £34,200 Annual depreciation charge, on the other hand, using straight line method will be: £ (100,000 – 10,000)/5) = £18,000 Hence, the average annual operating profit after depreciation is (£34,200 - £18,000) £16,200 Average investment = (cost of machine = disposal value)/2 = (£100,000 + £10,000)/2 = £55,000 Therefore, ARR = (£16,200/£55,000)*100% = 29.4%. ARR of project Beta: Average annual operating profit before depreciation over the six years is = (50000+55000-20000+35000+28000+25000)/6)= £28,800 Annual depreciation charge= £ (90,000 – 0 + 75,000 - 0)/6) = £27,500 Hence, the average annual operating profit after depreciation is (£28,800 - £27,500) which is £1,300 Average investment = (£90,000 + £75,000)/2 = £82,500 Therefore, ARR = (£1,300/£82,500)*100% = 1.6%. iv) NPV NPV of project Alpha: Time Cash flows Discount factor (14%) Present value Immediately -100000 1 -100,000 1 year's time 33000 0.8772 28,947.6 2 year's time 36000 0.7695 27702 3 year's time 38000 0.6750 25650 4 year's time 50000 0.5921 29,605 5 year's time 46000 0.5194 23,892.4 6 year's time 2000 0.4556 911.2 NPV £36,708.2 NPV of project Beta: Time Cash flows £000 Discount factor (14%) Present value £000 Immediately -90,000 1 -90 1 year's time 50,000 0.8772 43,860 2 year's time 55,000 0.7695 42,322.5 3 year's time -20,000 0.6750 -13,500 4 year's time 35,000 0.5921 20,723.5 5 year's time 28,000 0.5194 14,543.2 6 year's time 25,000 0.4556 11,390 NPV £29,339.2 b) Recommendation NENE should undertake project Alpha because of the following reasons. Firstly, Project Alpha has the shortest payback period. This implies that it will take the project a shorter period of time to repay its initial investment out of the net cash inflow (Kinney & Raiborn, 2009: 555). The rest of the amount will be profit. Secondly, it has a higher ARR of 29.4% compared to merely 1.6% of Beta project, making the investment more attractive. The Alpha project is, therefore, more profitable than the Beta project. Finally, Project Alpha has a higher NPV than project Beta. Project Alpha has more cash inflows than project Beta. c) The 4 main investment appraisal methods i) Payback period (PP) Payback period is the time that a project takes to recover its expenditure or the amount of time required for a project to repay its initial investment amount out of its cash inflows (Atrill & McLaney, 2011, p.364). PP provides a measure of liquidity founded on the projects expected cash flows (Weingartner 1969: 594). When using payback period, companies normally base their decisions on a maximum time limit that is predefined for projects. A project with the shortest projected time is chosen (Atrill & McLaney, 2011). This method is more realistic because it uses cash flows and not accounting profit. It is simple to calculate and is more useful in situations where there is rapid change in technology as well as improving investment conditions. Finally, the method favours quick returns by maximising liquidity, minimising risks and helping company growth. The greatest flaw of PP is that it fails to take into consideration the returns after the payback period. It ignores cash flow timings as well as overall project profitability. The method is subjective because it fails to give definite investment signal. Even though payback period gives high emphasis on liquidity, it ignores profitability. It also ignores cash flow after the payback period making it less effective in gauging a project. ii) Accounting Rate of Return (ARR) ARR is the ratio of average annual operating profit to average investment. ARR= (Annual average operating profit / Average investment) x 100%. When using ARR, companies normally base their decisions on a predefined minimum target ARR for projects. A project with the highest ARR is chosen in case there are numerous projects. In addition, a project that achieves the minimum ARR or higher is selected (Danielson & Press 2003: 498). ARR is suitable because it recognises the profitability factor of an investment and links with other accounting measures. It is also simple to calculate. However, ARR is only based on accounting income and not cash flows. It can therefore be affected by non-cash items like bad debts and depreciation when computing profits. It also fails to recognize the life of the project. Further, ARR ignores time value of money in that income in year five counts the same as year one income (Magni… 2012). It fails to consider project’s terminal value. Even though, the technique is useful in appraising projects, it can be computed in a number of ways thus leading to different outcomes which limits comparability. iii) Net Present Value (NPV) NPV is the most relevant investment technique because it takes into consideration factors like inflation. It also focuses on realistic returns that are expected out of a project (Bosch 2007: 42). The cash flows are discounted so as to bring them to the present values. The net present value is then calculated by subtracting initial investment amounts from the total present values. The decision rule is always that a project with a positive NPV be accepted and those with negative NPV be rejected. However, in case of multiple projects, a project with the highest positive NPV is chosen. NPV is an absolute measure of return because it considers the time value of money as well as the entire life of the project. It is also based on cash flows rather than profits and hence should result in maximization of shareholders’ wealth (Wetekamp 2011: 899). Even though, it appears to be the most reliable technique compares to the others, NPV fails to account for changes/uncertainty after the decision to proceed with the project has been made. The technique is also complex to calculate and difficult to explain to managers. Although NPV is the most reliable technique, it does not measure the size of the project. It also results in the multiple IRR problems because it can give conflicting answers in comparison to IRR for mutually exclusive projects in case the cash flows are negative. Although the calculation of NPV discounts future cash flows using required rate of return, it fails to reveal the actual return of the project and this limits its usability. iv) Internal Rate of Return (IRR) IRR represents the breakeven cost of capital in that it represents the discount rate at which the investment’s NPV is zero. This implies that a project that has a greater IRR than the cost of capital is often accepted because it is viable (Alesii 2006: 240). IRR considers the time value of money as well as the entire life of the project. It is also based on cash flows rather than profits and hence should result in maximization of shareholders’ wealth. However, IRR has been criticised for not being an absolute measure of profitability. It is fairly complex to calculate and the interpolation method only provides an estimate and not an accurate figure. Further, IRR fails to consider scale of development and also fails to cater for changes or fluctuations in cash flows (Atrill & McLaney, 2011, p.383). Such flaws are overcome by NPV, making it the most reliable investment appraisal technique among the four because it presents closer to real world values of a project’s returns. IRR, as an investment tool, is not suitable for rating mutually exclusive projects; it should be used in deciding if a project is worth investing in. Since IRR does not consider project’s cost of capital, it is not suitable for comparing projects that have different durations. IRR may also have multiple values in case; there are positive cash flows, then negative one and finally positive cash flows. This limits comparability of projects. Question 2 a) Ratio computation 1. Return on capital employed ROCE= [operating profit/ (Share capital + Reserves + Non-current liabilities)] 100 Benjamin Ltd: [10000/ (47000-5000)] 100=23.81% Peters Ltd: 15000/ (54000-10000)] 100 =34.09% 2. Gross profit margin Gross profit margin= (gross profit/sales revenue) 100 Benjamin Ltd: (20000/80000)100= 25% Peters Ltd: 24000/120000)100= 20% 3. Operating profit margin Operating profit margin= (operating profit/sales revenue) 100 Benjamin Ltd: (10000/80000)100= 12.5% Peters Ltd: 15000/120000)100= 12.5% 4. Acid test ratio Acid test ratio= (current assets-inventories)/current liabilities Benjamin Ltd: (45000-15000)/5000= 6:1 Peters Ltd: (40000-17500)/10000= 2.25:1 5. Inventory days Inventory days = (inventory/cost of sales) 365 Benjamin Ltd: (15000/60000)365= 91.3 days Peters Ltd: (17500/96000)365= 66.6 days 6. Trade receivable days Trade receivable days= (trade receivables/credit sales revenue) 365 Benjamin Ltd: (25000/80000)365= 114.1days Peters Ltd: (20000/120000)365= 60.9 days 7. Trade payable days Trade payable days= (trade payables/ credit purchases) 365 Benjamin Ltd: (5000/60000+15000)365= 24.4days Peters Ltd: (10000/96000+17500)365= 32.2 days b) Critical interpretation of the ratios Profitability ratios Profitability ratios measure the overall performance and efficiency of companies (Brigham and Ehrhardt, 2013: 126). In terms of ROCE, Peters Ltd has an advantage over Benjamin Ltd. It has 34.09% against 23.81% of Benjamin. This indicates that Peters is more effective in deploying funds that Benjamin. In terms of gross profit margin, Benjamin is more profitable than Peters because it has a gross profit margin of 25% to 20%. A greater proportion of Peters’ revenue goes towards cost of sales hence it is less effective in managing expenses. However, Benjamin experienced an increase in profit due to a rise in operations and not decreases in cost of sales like in the case of Peters. The two companies have the same operating profit margin implying that they had the same level of expenses relative to their sales revenue (Khan & Jain, 2007: 6.2). Even though Benjamin Limited has a higher ROCE implying efficient use of the invested capital, the ratio fails to take into consideration depreciation and amortization of the capital employed and hence NENE Benjamin LTD should acquire because it has higher gross profit margin. The higher ROCE could be as a result of depreciated assets and not actual increases in profit. Liquidity This measures the ability to pay current obligations (Dyson, 2007: 98). Benjamin Ltd is more liquid than Peters Ltd. it has an acid test ratio of 6 times to 2.25 times. It is able to meet its near term obligations with lots of ease using its most liquid assets (Kimmel et al. 2008: 290). Therefore, Benjamin has the advantage for this ratio category and NENE LTD should acquire it. Peters should not be acquired because it is less liquid. It has more current liabilities and most of its liquid assets are in the form of inventory. This indicates poor inventory management that may render it bankrupt in the near future. Even though Benjamin is more liquid, it has more money in liquid form, hence it is not using its cash maximally. Working capital management This category shows the efficiency with which the assets or resources of an organization are utilized (Kapil, 2011: 125). This category measures how effectively the firms are utilizing their assets to generate income and how well they are managing their liabilities. With an inventory days of 66.6 days, Peters is efficient in turning over its inventories than Benjamin at 91.3 days. Benjamin is faced with ineffective buying because it has high inventory levels. In addition, Peters collects cash from its receivable faster than Benjamin. It has trade receivable days of 60.9 days to 114.1days for Benjamin. This implies that less cash is tied up in trade receivables for every £1 of Peters’ sales revenue compared to Benjamin. Benjamin has bad credit policies and takes time to collect its receivables. Further, Peters has advantage for trade payable days because it is relatively higher than that of Benjamin Ltd. This is beneficial because Peters uses free finance provided by suppliers. Therefore, according to this category, Peters Ltd should be acquired because it is more efficient than Benjamin Ltd. c) Limitations of ratio analysis It is worth to note that ratio analysis like any other financial judgment tool has shortcomings. Using ratio analysis to compare the performance of two firms may be misleading if the organizations are in different industries. This is based on other extraneous factors that the firms’ experience like environmental conditions such as different business structure, regulation and other factors (Lewellen 2004: 229). Ratio analysis basically explains the correlation between historical or past information while significantly remaining ineffective in predicting the present and future information, which is of more important to the stakeholders. It therefore fails to provide adequate information for future planning and forecasting (Carlberg & Carlberg, 190). In the event that the accounting data from which the results were calculated were false, ratio analysis would yield inaccurate results. Ratios analysis emphasizes application of quantitative data while ignoring the qualitative aspect which of significant relevance (Podobnik et al. 2011: 17889). There are production concepts that ratios ignores and such include; product quality, management skills, customer service and employee morale hence ineffective comparison. Other macro-economic variables like inflation distort ratio analysis results through its influence on financial statements like balance sheet upon which ratios are computed. Any issue in the financials as a consequence of inflation is then passed on to ratios and in this way affecting their usefulness (Monea 2009: 140). The idea that accounting standards authorize use of different accounting policies like FIFO and LIFO inventory methods, comparison is significantly impaired. Question 3: a) calculation i) traditional costing ,method Total budgeted Direct Labour Hours= 0.5*20000+1*1000+1*10000= 21,000DLH Overhead Rate = Total Budgeted Overhead Dollars/Total Budgeted Direct Labor Hours OH Rate= £4,410,000/21000= £210 per DLH Cost item A B C Direct material 25 62.5 105 Direct labour 4 8 8 Manufacturing overhead 105 210 210 Total unit cost (full cost) £134 £280.5 £323 N/B: direct labour= £8*direct labour hours (8*0.5=£4) Manufacturing overhead= OH rate*direct labour hours (210*0.5= £105) Selling price = full cost * (1+0.20) A: 128*1.2= £153.6 B: 280.5*1.2= £336.6 C: 323*1.2= £387.6 b) Activity-based costing method Allocation of costs Activity A B C Machining (£2,780,000) 1112000 417000 1251000 Logistics (£590,000) 277300 35400 277300 establishment (£1,040,000 436800 187200 416000 Total manufacturing overhead £1826100 £639600 £1944300 Manufacturing overhead per unit £91.305 £639.6 £194.43 Cost item A B C Direct material 25 62.5 105 Direct labour 4 8 8 Manufacturing overhead 91.305 639.6 194.43 Total unit cost (full cost) £120.305 £710.1 £307.43 Selling price = full cost * (1+0.20) A: 120.31*1.2= £144.37 B: 710.1*1.2= £852.12 C: 307.43*1.2= £368.92 c) How activity based costing differs from the traditional costing method Traditional costing method is commonly used by manufacturing firms in assigning manufacturing overheads to the units produced (Kont & Jantson 2011: 115). Under traditional costing method, only the products are assigned the overhead cost. It therefore fails to take into consideration non-manufacturing costs such as administration expenses associated with production (Cokins 1998: 72). it is not possible to divide and allocate overhead costs like the CEO’s on a per-product usage basis. Activity-based costing, on the other hand, is a very logical method that assigns manufacturing overhead costs to products. The ABC first assigns manufacturing costs to activities well as processes that cause the overhead, then to only the products that require such activities. Businesses use ABC as supplemental costing system (Akyol et al. 2007: 581). However, it is hard to identify the activities that generally influence costs. The ABC focuses more on activities that on the structure while traditional costing method focuses more on structure than on processes (Warren et al. 2012: 1091). Also, traditional costing method assign costs using machine work hours whereas ABC assigns costs on processes and activities then to products (Thyssen et al. 2006). Traditional costing is currently obsolete particularly due to changing technological trends like business accounting software. The ABC method provides very accurate costs for products and has hence been a rising method (Reyhanoglu 2004). However, ABC is unsuitable for small manufacturing concerns because it is expensive and time consuming to set up. Under traditional costing method, most of factory overhead costs are usually allocated on the basis of only a single factor, for instance, direct labour hours or machine hours, however in reality, there are many factors, for instance, special storage, machine set ups, special handling, and so on. It is therefore, very hard to allocate all the costs in case there more diversity in customer demands. Despite ABC providing for better control over the processes of the business, it fails to conform to the GAAP. This implies that firms that use ABC need to maintain two cost systems which are very expensive. (Word Count 2473) Conclusion Effective application of financial concepts is central in forecasting the future performance of the firm and establishing its competitive edge among other firms. Ratio analysis has been in use for such estimation and predictions but despite its widespread use, it presents significant shortcomings. It is therefore worth to conclude that applying other concepts is of significant success. References Akyol, D.E., Tuncel, G. & Bayhan, G.M., 2007. A comparative analysis of activity-based costing and traditional costing. World Academy of Science, Engineering and Technology, 3, pp.580–583. Alesii, G., 2006. Payback Period and Internal Rate of Return in Real Options Analysis. The Engineering Economist, 51, pp.237–257. Atrill, P. & McLaney, E. 2011 Accounting and Finance for Non-Specialists. 7th Edition. Prentice Hall. Brigham, Eugene F, and Michael C. Ehrhardt. 2013. Financial Management: Theory and Practice. Mason, Ohio: South-Western. Bosch, 2007. NPV as a Function of the IRR : The Value Drivers of Investment Projects. Journal of Applied Finance, pp.41–46. Carlberg, C. G., & Carlberg, C. G. 2002. Business analysis with Microsoft Excel. Indianapolis, Ind, Que. Pg. 171 Cokins, G., 1998. Why is traditional accounting failing managers? Hospital materiel management quarterly, 20, pp.72–80. Danielson, M.G. & Press, E., 2003. Accounting returns revisited: Evidence of their usefulness in estimating economic returns. Review of Accounting Studies, 8, pp.493–530. Delen, D., Kuzey, C. & Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40, pp.3970–3983. Dyson, J. R., Dyson, J., Dyson, J., & Dyson, J. 2007. Accounting for non-accounting students. Harlow, Financial Times Prentice Hall. Götze, U., Northcott, D. & Schuster, P., 2008. Investment appraisal: Methods and models, Kapil, S. 2011. Financial management. Noida, India, Pearson. Pg. 120-130  Khan, M. Y., & Jain, P. K. 2007. Financial management. New Delhi, Tata McGraw-Hill. Pg. 6.2-6.27 Kinney, M. R., & Raiborn, C. A. (2009). Cost accounting: foundations and evolutions. Mason, OH, USA, Thomson/South-Western. Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. 2008. Accounting: tools for business decision making. Chichester, John Wiley. Pg. 290 Kont, K.R. & Jantson, S., 2011. Activity-based costing (ABC) and time-driven activity-based costing (TDABC): Applicable methods for university libraries? Evidence Based Library and Information Practice, 6, pp.107–119. Lewellen, J., 2004. Predicting returns with financial ratios. Journal of Financial Economics, 74, pp.209–235. Magni…, C., 2012. Economic profitability and the accounting rate of return. papers.ssrn.com. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2027607. Monea, M., 2009. Financial Ratios - Reveal how a business is doing. Annals of the University of Petrosani,, 9, pp.137–144. Podobnik, B. et al., 2011. Asymmetric Lévy flight in financial ratios. Proceedings of the National Academy of Sciences of the United States of America, 108, pp.17883–8. Available at: http://www.pnas.org/cgi/content/long/108/44/17883. Reyhanoglu, M., 2004. Activity-Based Costing System Advantages and Disadvantages. SSRN Electronic Journal. Available at: http://papers.ssrn.com/abstract=644561. Thyssen, J., Israelsen, P. & Jørgensen, B., 2006. Activity-based costing as a method for assessing the economics of modularization-A case study and beyond. International Journal of Production Economics, 103, pp.252–270. Warren, Carl S, James M. Reeve, Jonathan E. Duchac, and Carl S. Warren.2012.  Financial and Managerial Accounting. Mason, Ohio: South-Western Cengage Learning. Weingartner, H.M., 1969. Some New Views on the Payback Period and Capital Budgeting Decisions. Management Science, 15, p.B–594–B–607. Wetekamp, W., 2011. Net present value (NPV) as a tool supporting effective project management. In Proceedings of the 6th IEEE International Conference on Intelligent Data Acquisition and Advanced Computing Systems: Technology and Applications, IDAACS’2011. pp. 898–900.  Read More