Analysis of Managing Financial Resources - Research Paper Example

Managing Financial Resources 1 WHAT IS ACCOUNTING? Accounting is a method of keeping financial records of business transactions and for the preparation of statements concerning the business’ assets, liabilities, and operating results. Accounting consists of several aspects; one of which is bookkeeping. A bookkeeper keeps tracks of all the company’s transactions and keeps the ledgers of the company balanced. Other aspects include auditing by external firms, which ensures that accounting fraud is prevented by examining the ledgers of a company with other records to ensure that the ledgers provide a true and fair view of the company’s financial dealings. Accounting is used for drawing up the financial records of a company in order to make important decisions, such as whether or not to make a major investment. Proper accounting supports company officials while they make these decisions, showing them whether or not an investment will be practical, and if the company can afford it. Ethical and professional accounting forms a clear financial image of a business, and allows managers to make informed decisions, keeps investors abreast of developments in the business, and keeps the business profitable. 2 FINDINGS 2.1 Accounting Ratio The business performance of a company can be monitored and analysed with the use of accounting ratios. The ratios are used to interpret financial information about the company. The results can be compared with past results or with industry standards to gauge the company’s overall performance. The quantitative results for this segment can be found in the Appendices section of this report. Current Ratio This measures the ability of a company to meet its short-term financial liabilities as they fall due. It is of particular interest if a company wishes to extend its short-term credit facilities. Current Ratio = Current Assets / Current Liabilities. Company A’s Current Ratio is 1.17, while Company B has 1.03 and Company C resulted in 2.5. This means that all three companies are still able to generate enough cash to settle its short-term liabilities. As a guide, a current ratio of 2 is ideal. For Company C, its result is higher than the ideal guideline and this suggests that Company C may have resources lying idle, for instance, the untimely collection of its receivables. A better ratio to consider when looking at the liquidity of the companies would be the Liquidity Ratio. This ratio does not take into account the companies’ stocks, which can be difficult to value and which can be obsolete. Debt-Equity Ratio This assesses the financial risk of a company. A high gearing ratio poses risks if a company is unable to meet its financial obligations as this can very well lead to bankruptcy. Therefore, it is important that this is constantly monitored. Debt-Equity Ratio = Total Long Term Debt / Total Equity The Gearing Ratios for all Companies A, B and C are quite low at 9.2%, 8.1% and 15.4% respectively and the results should not cause an alarm. However, it is good to note that the companies should have a balanced mix of equity and debt to finance its operations. Return on Asset There are several ratios available that can measure the ability of a company to generate profits from its sales. These include Gross Profit Margin, Return on Assets and Return on Equity. A good profit margin is essential in any form of business to ensure there is always enough cash to run its operations. Thus, it is also important that receivables are collected on a timely basis. Return on Asset is a type of profitability ratio and measures the level of profit compared to the value of net assets invested in your business. Return on Assets = Net Income / Total Assets The profitability of all three companies is sound. The Return on Assets are 1.7%, 1.3% and 3.3% for Companies A, B and C respectively. It can be seen that Company C generates the highest return on its assets, whereas Companies A and B are almost on par. However, as this ratio includes the measure of profit, which is historical based, it can be said that this is not a very reliable method of gauging the performance of the companies. This is because; many factors can distort the profit of the companies, for instance, accounting method of depreciation. Return on Equity This ratio looks at whether a company is an asset creator or a cash consumer. As additional cash investments increase on the asset side of the balance sheet, the ROE number shows whether additional dollars invested are dollars of return from previous investments. Return on Equity = Net Income / Shareholders’ Equity The results for Companies A, B and C are 2.3%, 1.8% and 4.6%. Again, Company C has the most attractive results. Shareholders’ of companies with high returns will be pleased to know that their investments are turning into cash. On the other hand, as mentioned above, this ratio also has limitations because it uses profit in its calculations. Earnings per Share This ratio determines the corporate value and can be calculated by subtracting the dividends on preferred stock from net income, and dividing the result by the (weighted average of the) combination of all outstanding common shares and all common stock equivalents. EPS = (Net Income – Dividend on Preferred Stock) / Average Outstanding Shares The Earnings per Share of Companies A, B and C are 31.4%, 27.2% and 52.6%. All three have generated positive returns. On the contrary, this ratio is also not very ideal because of the use of profit values in its calculations. However, it is still a good ratio for comparisons of companies within the same industry. 2.2 USING ITEM A INFORMATION Direct Labour Hours 120,000 108,000 132,000 144,000 Variable Costs 100% 90% 110% 100% Power 36,000 32,400 39,600 43,200 Consumables 6,000 5,400 6,600 7,200 Direct Labour 420,000 419,999 462,000 504,000 Fixed Costs 100% 90% 110% 100% Depreciation 22,000 22,000 22,000 22,000 Staff Salaries 43,000 43,000 43,000 43,000 Insurances 9,000 9,000 9,000 9,000 Rent & Rates 12,000 12,000 12,000 12,000 Flexible budgets are budgets that change in response to different output levels or changes in other relevant factors. Flexible budgets can complement the use of fixed budgets, they have a part to play and can apply in more than one context. In the planning process it is quite usual to produce a range of estimates for different planning scenarios of sales, costs, market prices, etc. It is necessary to compare these to the actual results to measure the differences and to inform managers of the company’s actual position based on its targets. The start of an annual budget cycle will prompt the managers of any organisation to formalise their views and identify the most likely outcomes and targets in order to set the budget. A set of feasible and desirable end results will have be established, which will then be incorporated into the master budget statement. This is also a form of fixed budget. The budgetary process has a wider planning and control framework in organisations and involves strategic planning, management control and operational or task control. Strategic planning is the process of deciding the goals of the organisation and the formulation of the broad strategies to be used in attaining these goals. Management control assures that the organisation carries out its strategies. Operational or task control assures that specific tasks are being carried out effectively and efficiently. Budgets are a management tool that support planning, control, co-ordination, communication, performance evaluation and motivation. Planning the budget ensures that managers have thought ahead about how they will utilise resources to achieve company policy in their area. Control is set once a budget is formulated. A regular reporting system that tracks the progress of the plans can be established and some form of management by exception can be made. On the other hand, coordination ensures that every department is aware and is working together to meet the plans. Communication is created with the creation of the budget, which can be a powerful tool in defining or clarifying the lines of communication within the enterprise. Performance evaluation can be based on budgets. Budgets are useful tools for evaluating how the manager or department is performing. If sales targets are met or satisfactory service provided within reasonable spending limits then bonus or promotion prospects are enhanced. However, the management must ensure that appraisals cannot be solely based on this. Flexible budgets are a useful part of planning. It is also appropriate to use the flexible budget for the purpose of control. When preparing performance reports it is important to take account of the variability of some costs with different levels of output. When actual output levels have varied from those planned in the fixed budget the cost targets being used for all variable and semi-variable costs should be adjusted. 2.4 USING ITEM B INFORMATION Breakeven Point (units) = Fixed Costs / (Selling Price per unit – Variable Cost per unit) = 42,500 / (80* - 46) = 1,250 units * Selling Price per unit = Sales / No. of Units Sold = 134,400 / 1,680 = 80 The Breakeven Point based on the company’s cost structure for the period is 1,250 units. Target Profit/(Loss) = [BEP (units) * Contribution Margin per unit] – Fixed Cost = [1,100 * 34] – 42,500 = ($5,100) For selling 1,100 units, the company can expect to generate a loss of $5,100 for the period. Breakeven Point (units) = (Fixed Cost + Target Profit) / Contribution Margin per unit = (42,500 + 27,200) / 34 = 2,050 units In order to generate a target profit of $27,200, the company is expected to sell a minimum of 2,050 units. 2.5 USING ITEM C INFORMATION The quantitative calculations for this segment can be found at the Appendices section of this report. Payback Period The payback period calculation looks at the shortest number of years to recover the cost of the project. Although the calculation is easy to understand and simple, it still has its limitations. It ignores the benefits that occur after the payback period and more importantly, the method ignores the time value of money. However, choosing projects based on this method, Project C seems the most attractive because the cost of the project can be recovered in the shortest time, i.e. approximately 2 years. Net Present Value The Net Present Value is an indicator of how much value an investment or project adds to the firm. The Net Present Value is a more reliable method of calculating the returns expected from investments as the method considers the time value of money. The Net Present Value compares the value of a dollar today to the value of that same dollar in the future, taking both inflation and returns into account. A positive Net Present Value generated from a prospective project is a good sign and should be accepted On the contrary, a negative Net Present Value resulting from projects should be rejected because the cash flows will also be negative. Based on the above results, Project C should be chosen because it has the highest NPV, i.e. $26,618. However, if the company has larger capital expenditure budget, the company may consider choosing Project A as well, because it has a positive NPV, i.e. 16,992. On the other hand, Project B should be ignored, as the return on investment is negative, i.e. -$10,345. 2.6 OTHER FACTORS TO CONSIDER Other than financial factors, companies should consider the current economic conditions and the supply versus demand. It is vital that projects also consider its customers and must be able to add value to the end users. One pressing issue recently is the social and environmental responsibilities that are expected of organisations in running their businesses. Thus, companies must ensure that projects undertaken will not have an adverse effect on the environment and that it is able to comply with local and international legal conditions. 3 CONCLUSION Although there are limitations in the analysis of accounting ratios, this tool is still highly used by investors and management in assessing the overall performance of its business. As such, companies should perform such analysis on a regular basis, taking into account external factors such as the current economic situation. Relying solely on this historical analysis would not benefit the business in its future growth. In addition, budget planning is essential in ensuring the companies meet and improve its target performances. *** End *** APPENDICES Accounting Ratios Ratios Company A ($’000) Company B Company C Working Result Working Result Working Result Current Ratio 252 / 215 1.17 271 / 264 1.03 200 / 80 2.5 Return on Assets 14 / 815 1.7% 14 / 1,056 1.3% 15 / 455 3.3% Return on Equity 14 / 600 2.3% 14 / 792 1.8% 15 / 325 4.6% Debt to Equity 55 / 600 9.2% 64 / 792 8.1% 50 / 325 15.4% EPS 55 / 0.5*350 31.4% 64 / 0.5*470 27.2% 50 / 0.5*190 52.6% Payback Period Project A Project B Project C Initial Cost 200,000 230,000 180,000 Less: Scrap Value 10,000 15,000 8,000 Total Cost 190,000 215,000 172,000 Cash Inflows 330,000 320,000 315,000 Expected Life 5 5 4 Payback Period 2.9 Years 3.4 Years 2.2 Years Net Present Value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Project A -200,000 80,000 70,000 65,000 60,000 65,000 18% Disc Factor 1.000 0.8475 0.7182 0.6086 0.5158 0.4371 Disc Cash Flow -200,000 67,800 50,274 39,559 30,948 28,411 NPV 16,992 Project B -230,000 100,000 70,000 50,000 50,000 65,000 18% Disc Factor 1.000 0.8475 0.7182 0.6086 0.5158 0.4371 Disc Cash Flow -230,000 84,750 50,274 30,430 25,790 28,411 NPV -10,345 Project C -180,000 55,000 65,000 95,000 108,000 - 18% Disc Factor 1.000 0.8475 0.7182 0.6086 0.5158 - Disc Cash Flow -180,000 46,612 46,683 57,817 55,706 - NPV 26,618 REFERENCE 1. Belverd E. Needles. Financial Accouting. Paperback, 2006. 2. Frank Wood and Alan Sangster. Business Accounting 2 (v. 2). Paperback, 2005. 3. Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso. Financial Accounting, Study Guide: Tools for Business Decision Making. Paperback, 2009. 4. Philip Ramsden. The Essentials of Management Ratios. 1998. 5. Mike Tayles. Budgetary Control - The Organisational Aspects. ACCA Student Newsletter1998. Read More