The Popularity of Financial Ratios in Multivariate Modeling - Essay Example

 The Popularity of Financial Ratios in Multivariate Modeling Introduction In this report, we will advise NENE limited on various projects they are hoping to take up. Different appraisal methods will be used including NPV, ARR, Cash flow and Payback period methods. Ratio analysis will also be used when evaluating two companies that NENE would like to acquire. For its cost allocations, traditional and Activity based costing methods will be used to advise NENE Limited management. Question 1 Cash flows Cash flows of Alpha: Time Cash flowing in or out (£000) Project Depreciation (£000) Project Disposal (£000) Cash Flows with Depreciation (£000) Cash Flows Cumulative (£000) Investment time (100) No Deprc. (NIL) NIL (100) (100) 1st year 15 (100-10)/5 = 18 NIL 33 (67) 2nd year 18 (100-10)/5 = 18 NIL 36 (-31) 3rd year 20 (100-10)/5 = 18 NIL 38 7 4th year 32 (100-10)/5 = 18 NIL 50 57 5th year 18 (100-10)/5 = 18 10 46 103 6th year 2 No depr. (NIL) NIL 2 105 Cash flows of Beta: 　Time Cash flowing in or out (£000) Project Depreciation (£000) Cash Flows with Depreciation (£000) Cash flows Cumulative (£000) Investment time (90) NIL (90) (90) 1st year 20 (90/3) = 30 50 (40) 2nd year 25 (90/3) = 30 55 15 3rd year (50) (90/3) = 30 (20) (5) 4th year 10 (75/3) = 25 35 30 5th year 3 (75/3) = 25 28 58 6th year 0 (75/3) = 25 25 83 Payback period Payback period of Alpha =2 yrs + (0.82) = 2.82years Payback period of Beta = 3 yrs + 5/35 = 3 5/35 years Accounting Rate of Return (ARR) ARR of project Alpha: Average annual operating profit before depreciation over the six years is £34,200 (that is £ (36+33+2+46+50+38)/6). The annual depreciation charge will be £18,000.00 (that is £ (100,000.00 – 10,000.00) ÷5). Therefore, the average annual operating profit after depreciation is £16,200.00 (that is £34,200.00 - £18,000.00). Average investment = (£10,000 + £100,000) ÷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 £28,800 (that is £000 (50+55-20+35+28+25) ÷6). The annual depreciation charge will be £27,500 (that is £ (90,000 – 0 + 75,000 - 0) ÷6). Therefore, the average annual operating profit after depreciation is £1,300 (that is £28,800 - £27,500). Average investment = (£90,000 + £75,000) ÷2 = £82,500 Therefore, ARR = (£1,300÷£82,500) ×100% = 1.6%. NPV of project Alpha: Time Cash flows (£000) Discount factor (0.14) PV (£000) Investment time (100) 1 (100) 1st year 33 0.88 28.941 2nd year 36 0.77 27.684 3rd year 38 0.68 25.65 4th year 50 0.59 29.6 5th year 46 0.52 23.874 6th year 2 0.456 0.912 NPV 36.661 NPV of project Beta: Time Cash inflow/ outflows (£000) Discount Factor (0.14) PV (£000) Investment time (90) 1 (90) 1st year 50 0.877 43.85 2nd year 55 0.769 42.295 3rd year (20) 0.675 (13.5) 4th year 35 0.592 20.72 5th year 28 0.519 14.532 6th year 25 0.456 11.4 NPV 29.297 Question 1(b): Recommendation Based on the calculations made for the two projects, the directors of NENE should consider taking project Alpha. The project displays encouraging returns for the ratios and as such has a shorter payback period of two years and eight months as compared to the three (3) years and seven (1) month for project Beta[Bro06]. In six years’ time, it has a higher positive cash flow level of £105 as compared to the Beta of £83. The ARR for Alpha is higher than that for Beta at 29.4% while that of Beta is at 1.6%. This is an indication of the viability of the project to perform as expected when acquired. As such the business assets for Alpha are increasing at a higher rate than for the Beta. The rate of ARR for Alpha is an indication of the expected rates of return in the assets value for is higher[Rob122]. The NPV of Alpha is also higher than that of Beta. It indicates that project Alpha will increase the shareholder’s equity more than project Beta. For all these reasons, it is advisable that NENE should choose project Alpha. Question 1(c) Internal Rate of Return Internal Rate of Return is the method that gives the investors an easy way of estimating the quantity or rate of return that an investment is expected to offer. This is usually the discount rate in which the Net Present Value of the expected cash flows is equal to zero. The method can be calculated through a trial and error method, where the discount rate will be varied until we find where the NPV = 0[Bal1a]. Through a general rule, the IRR with an NPV which is greater than zero is usually preferred. This method also advises that all the IRRs with values higher than the opportunity cost of capital of the project should always be accepted. Advantages While using this method, one is able to estimate the return on the initial invested amount. The method is also easy to use as its calculations are not very complex. The method also provides a clear and easy way of comparing the projects to come up with the most preferred. The most important advantage of the method is that, it shows the variation of money invested in the present time and that in the future. Disadvantages IRR is known to sometimes produce a multiple of no rate of return at all. When a project with different changes in sign are evaluated in the stream of cash flows, the project may provide no IRR or even a multiple IRR that can be confusing or hard to interpret. At times, the discount rate per year varies, hence, it becomes hard to use the IRR rule of accepting all the projects with IRR value greater than the opportunity cost of capital employed[Bal01]. It is also not possible to add up the IRRs of different projects when they are to be joined together. They have to be evaluated differently. Payback Period Payback period is the method that shows the estimate time when a project is expected to yield cash flow equal to the initial amount that was invested in it. The period yielded by the method can be used to compare the period according to the company’s policy on investment. May be, according to the company’s policy, the period within which a project is supposed to yield back its investment amount is 5 years[Mel02]. If the calculated period is exceeds this period, the company rejects the project or investment. However, through a general rule, everyone would prefer an investment from which its investment amount can be repaid within the shortest time possible. Therefore, the shorter the period, the more acceptable the project will be. Advantages Payback period is the simplest method that can be referred to. The method also makes it easy for anyone to understand what decision needs to be taken as it is either long or short period. Therefore, its interpretation is very easy even for the laymen. The method is also preferred as it helps analysts to project when the project’s cost will be realized. The method is the easiest in measuring the risk and liquidity of a project [Sma10]. Disadvantages The method could not be the best for analysts as they consider it not to touch on the time value for money. In this essence, it considers that the amount of money that is invested today will be equal to that invested in the future, which is not actually true. All the cash flows that are realized beyond the payback period are usually ignored under this method[Sma10]. However, these cash flows that are nit accounted for could even be more than the cash flows that have been collected before the period. Net Present Value Net Present Value is simply summarized as the present value of the cash inflows minus the cost of the investment. This method considers that for an investment to be that which can increase the firm’s value, it must be having a NPV value of more than zero[Bal02]. In a case where the projects are many, and a decision has to be made, the one with the highest NPV will be chosen. When using this method, we need to discount all the cash flows in the business at the rate of the cost of opportunity cost. Advantages The method compares the dollar amount of money today and that which will be earned in the future through its discounted calculations. As a result, it takes into consideration the future time value of money. By using the discounted rates, the NPV method caters for the risks that would be associated with the cash flows that are expected from the investment in the future[Bal01]. Disadvantages The method is perceived as the most complex to calculate. It can also be used blindly, as it doesn’t show when the project’s NPV will begin to give a positive value that needs to be accepted. Again, those who use NPV must have an assumption that the capital of the company is unlimited. This is a disadvantage since most companies undergo capital rationing[Bal01]. The method also involves complex calculations that may lead into creations of errors during the calculation. ARR Accounting rate of return is the method that uses net income that is expected from the investment instead of the cash flows as other methods do, for project appraisal. When calculating this method, we use the expected incremental net operating income and divide it by the amount of initial investment. The resultant amount is then compared with the rate of return which is desired by the management. A general rule for using this method is that, when the ARR is higher, the project should be accepted[Wes08]. Advantages When this method is used, it shows clearly the profitability of the project. As a result, comparison is easily done on the projects with different ARR values to gauge the best one. It also considers the wholesomeness of the project’s profitability. Disadvantages This method is also such methods that do not consider that money today is not equal to money in the future. The expected cash flows from the investment are also not considered in this kind of appraisal method. Question 2 (a) Ratio Analysis i) Return on Capital Employed (ROCE) = Net Operating Profit ÷ Capital Employed ROCE for Benjamin = 10,000.00÷42,000.00 = 23.8% ROCE for Peters = 15,000.00÷44,000.00 = 34.1% ii) Gross Profit Margin = (Revenue –COGS)÷Revenue GPM for Benjamin = (80,000.00 – 60,000.00) ÷80,000.00 = 25% GPM for Peters = (120,000.00 – 96,000.00) ÷120,000.00 = 20% iii) Operating Profit Margin = Operating Income ÷ Net Sales OPM for Benjamin = 10,000.00÷ 80,000.00 = 12.5% OPM for Peters = 15,000.00÷120,000.00 = 12.5% iv) Acid Test Ratio = cash and cash equivalents ÷ current liabilities ATR for Benjamin = 45,000.00-15,000÷5,000.00 = 6 ATR for Peters = 40,000.00-17,500 ÷10,000.00 = 2.25 v) Inventory days = Ending Inventory ÷(Cost of Goods Sold ÷365.00) ID for Benjamin = 15,000.00÷ (60,000.00÷365.00) = 91.3days ID for Peters = 17,500.00÷ (96,000.00÷365.00) = 66.5 days vi) Trade Receivable Days = Average Gross Receivables ÷(Annual Net Sales÷365.00) TRD for Benjamin = 25,000.00(80,000.00÷365.00) = 114.08 TRD for Peters = 20,000.00 (120,000.00÷365.00) = 60.83 vii) Trade Payable Days = Ending Accounts Payable÷(Purchases÷365.00) TPD for Benjamin = 5,000.00÷ (60,000.00÷365.00) = 30.4 TPD for Peters = 10,000.00÷ (96,000.00÷365.00) = 38.02 Question 2(b) Profitability The gross profit margin for Benjamin limited is at 25% while that of Peters is at 20%. Gross profit margin is used as an indication of the cash that a firm has left after it has settled its Cost of Goods Sold[Rei04]. It therefore, implies that, if the value of this gross profit margin is higher, the firm will have more cash left within it. Choosing Benjamin will make NENE achieve this objective[Man10]. On the other hand, operating profit margin refers to that amount of cash left within the company after settling its variable or recurrent costs of production such as labour. It therefore means that, if the value of this ratio is high, then the firm will have more money left in its accounts after it pays its workers and other variable expenses. Both the firms have equal or high operating profit margins of 12.5%. When, chosen, both firms will enable NENE to have more cash within it after settling its variable expenses[Yak04]. Return on capital employed is another ratio that indicates the profitability of the firm. The ratio shows the efficiency with which the firm’s capital is reinvested in the business. A higher value for this ratio indicates that the firm is more efficient in employing its capital. Benjamin will be the best investment to choose in order to achieve this objective[San01]. Liquidity The management will use acid-test ratio to assess the liquidity of the two firms. Any amount lower than one shows that the firm may not be above to pay its short-term obligation using only its current assets. A higher value above one shows more efficiency of the firm[San131]. Benjamin, with a ratio of 6 will be more efficient in meeting its short-term obligations than Peters with acid-test ratio of 2.25. Benjamin, is therefore, more liquid[Van05]. Working Capital management Good working capital management depends on the availability of this capital within the firm for investment purposes. Inventory days, which measures the days taken by an inventory to be turned into cash, should be shorter for the business to be efficient in managing its capital[Bal01]. Peters has 66 days while Benjamin has 91 days of inventory days. Peters, therefore, is more efficient in capital management than Benjamin. When the trade payable days is short, it shows that the firm takes a shorter period to settle its suppliers[Bal1a]. This makes the firm to stay out of debt quickly, hence improving equity. Benjamin has a shorter trade payable days of 30 days while Peters has 38 days. Benjamin will, therefore, help NENE achieve this objective faster. On the trade receivable days, the shorter the days, the faster the firm’s customers are able to pay their credits to the firm. When customers pay their credits faster, the firm is able to have adequate capital for further investment. Trade receivable for Peters is shorter with 60 days while that of Benjamin is 114 days, therefore, Peters will help NENE achieve this objective faster[Kra10]. Question 2 (c) For large firms with different divisions in operation in different industries, it will be difficult for them to find a set of meaningful industry-average ratios[Hos05]. In cases where inflation has deeply influenced the company’s balance sheet, profits of a company are also affected hence ratio analysis of a company overtime will be interpreted with judgement. Ratio analysis is often distorted by seasonal factors; as such it is important for companies to understand these factors in order to reduce the chances of misinterpretation. There is a difficulty in determining, in general, whether a ratio is good or bad. For instance, some companies that are known for growth, historically, when they have high ratios, it might be interpreted that the company is not growing. At the same time, it might be interpreted that the company is failing[Hos05]. In certain cases, a company may have both good and bad ratios hence making it had to determine whether it is a weak or good company. The deficiencies of overlying on financial and accounting ratios are that they may often not give the accurate results of what is going on in the company[Fox01]. The investment appraisal method through the use of ratios ignores both the positive and negative cash flows that occur after the period[Hue02]. Ratios do not consider factors that are widely used in company management and decision making, and it leads to incorrect decisions on the profitability by management[Fie08]. In general terms, ratio analysis when used mechanically in an unthinking manner may be dangerous for use in decision making. Question 3(a) a) Costing i) Traditional Costing Method ii) Overhead absorption Rate (OAR) = £4,410,000/(0.5x20000+1000+10000) =£210 iii) Calculating the indirect costs for each model: 　Model A (£) B (£) C (£) Direct Labour Hrs. 0.5 1.0 1.0 Rate of Overhead absorption 210.0 210.0 210.0 Overhead absorption/ unit 105.0 210.0 210.0 iv) Full cost and per unit selling prices: 　Model A (£) B (£) C (£) Direct Material 25 62.5 105 Direct Labour 4.0 8.0 8.0 Per unit overhead absorption 105.0 210.0 210.0 Total cost 134 280.5 323 Mark-up 20% (0.2x134) =26.8 (0.2x280.5) = 56.1 (0.2x323) = 64.6 Selling Prices 160.8 336.6 387.6 v) Activity-based costing method: 　Model A (£) B (£) C (£) Machine Hours 40 15 45 Total overheads of machining 2,780,000 Overheads absorbed 1,112,000 417,000 1,251,000 Production 20000 1000 10000 Per Unit Overhead absorption 55.6 417.0 125.1 vi) 　Model A (£) B (£) C (£) Material Orders 47 6 47 Total overheads of machining 590,000 Overheads absorbed 277,300 35,400 277,300 Production 20000 1000 10000 Per unit absorption overhead 13.9 35.4 27.7 vii) 　Model A (£) B (£) C (£) Space 42% 18% 40% Total overheads of machining 1,040,000 Overheads absorbed 436,800 187,200 416,000 Production cost 20000 1000 10000 Overhead absorption per unit 21.8 187.2 41.6 viii) 　Model A (£) B (£) C (£) Direct material 25.0 62.5 105.0 Direct Labor Cost 4.0 8.0 8.0 Machining Cost 55.6 417 125.1 Logistics Cost 13.9 35.4 27.7 Establishment Cost 21.8 187.2 41.6 Per Unit full Cost 120.3 710.1 307.4 Mark-up 20% (0.2x120.3) = 24.06 (0.2x710.1) = 142.02 (0.2x307.4) = 61.48 Selling Prices 144.36 852.12 368.88 Question 3(b) ABC against Traditional Costing Method A company’s traditional cost-accounting system is necessary together with the general ledger system in supporting compliance with the financial reporting requirements. This is often necessary for cost allocation; costs are often allocated for valuation and cost reimbursement purposes[Kot011]. The traditional approach of allocating costs is made up of three steps: allocation of nonproduction departmental costs to production departments, allocation of the resultant production department costs to various products, services or consumers and accumulation of costs within production and nonproduction services. Costs obtained from the traditional allocation approach often have defects that result in distortion of costs when used in decision making[Whi03]. For instance, the costs for idle capacity are often allocated to products in the traditional approach. As such, the products cutter for cost of resources that are not accounted for in any way. In traditional costing system, costs are often allocated on the basis of single-volume measures so as to provide compliance with the financial reporting requirements. It focuses on items such as direct labour costs, machine hours, and direct labour hours. In this case, it rarely meets the desired criterion in cost allocation since it uses a single volume driver as the main cost driver[Com01]. Due to these components, it therefore provides a cheap mechanism for compliance with the financial reporting requirements. While the activity based costing system is not constraint by the requirements of financial reporting[Air00]. It has an inherent flexibility of availing reports that help decision making as concerns costs of activities. It focuses on costs through key activities unlike the traditional system that focuses on accumulation of costs through organizational activities. This method is proved to be very simple to apply and interpret. It also uses direct labour to apply costs, which is a very easy task. However, the method has been faced out due to the advancement in technology. This has come up with new ways of accomplishing tasks without necessarily using direct labour hour. The use of machines and computers is applied to accomplish this, therefore, traditional method of costing is considered to have no much work here. Activity Based Cost Activity based cost (ABC) system, therefore, provides up to standard cost allocation information particularly when costs are driven from non-volume-based cost drivers. However, the traditional cost accounting system is still used mainly to satisfy the conventional requirements of financial reporting while ABC system is regarded as a supplement to the traditional system[Bro06]. Modern management, NENE included, are encouraged to adopt the ABC systems model because of various cost determination accuracies that accrues with it[Mel02]. For companies with inaccurate cost measurements not to lose bids, they have to adopt the ABC system to facilitate the accuracy in cost measurements[Wri021]. This method has made work easy as it also improves the performance process in the manufacturing sector. It makes it possible for costs to be easily traced and allocation of costs to manufactures products to be easy. The method also uses cost drivers to allocate indirect costs. However, implementing this method becomes very expensive affair especially for small firms. The method also may result in confusing in allocation as the product margins usually vary with the method. Conclusion Capital budgeting decisions requires good financial information. This information can be obtained from the forecasted values of the projects. Ratios can also be used in appraising projects. However, ratios have their limitations, therefore, they should not be used independently. ABC method for costing is very accurate, but complicated to use. It is advisable that companies train their managers on ABC systems. Bibliography Bro06: , (Brown, et al., 2006), Rob122: , (Robb & Robinson, 2012), Bal1a: , (Balmer, 2001), Bal01: , (Balmer, 2001), Mel02: , (Melewar & Jenkins, 2002), Sma10: , (Smajlovic, 2010), Bal02: , (Balmer & Greyser, 2002), Wes08: , (Weston & Brigham, 2008), Rei04: , (Reily & Bent, 2004), Man10: , (Mankin & Jewell, 2010), Yak04: , (Yakov, 2004), San01: , (Sanusi, 2001), San131: , (Sanusi, 2013), Van05: , (Van Horne, 2005), Kra10: , (Krantz, 2010), Hos05: , (Hossari & Rahman, 2005), Fox01: , (Fox, et al., 2001), Hue02: , (Huemer, 2002), Fie08: , (Fierstein, 2008), Kot011: , (Kotier, 2001), Whi03: , (White, et al., 2003), Com01: , (Comelissen & Harris, 2001), Air00: , (Airman, 2000), Wri021: , (Wright, 2002), Read More