A Financial Analysis of ABC Company - Example

A Financial Analysis of ABC Company and Number Introduction This paper analyses the financial aspectsof ABC Company. A cash flow statement is used to analyze the operating, financing and investing activities of the company. The cost implications of taking up a new project are also analyzed in detail as well as the decision of whether or not to purchase equipment that will be used in the production of a new product line. The risks that the company is exposed to when undertaking the project are also evaluated. Section I ABC Company operates in the manufacturing industry. This industry is very capital intensive since the cost of producing a product and taking it to market is relatively very high as compared to the cost incurred in the service industry for example. Therefore, the ultimate challenge that would face the company is obtaining adequate finance to continue operations as well as implementing its growth strategy by taking up new projects. Obtaining finance has become rather challenging over recent years due to the economic hardships experienced. ABC Ltd might be forced to give up a considerable security in order to secure the financing needed, plus show the potential of the project is high. Financial institutions have become rather strict while financing companies’ project due to the increasing level of liquidation and bankruptcy that most companies have been forced into. Section II a) ABC Company Cash flow statement for the year ended 31 Dec 19X2 Operating Activities Cash receipts from customers (18,000 – 12,000) 6,000 Cash paid to suppliers and employees (25,000 – 21,000) 4,000 Cash generated from operations X Income taxes paid (3,000) Net cash flow from operating activities 7,000 Investing activities Purchase of property plant and equipment (10,000) Net cash flow from investing activities (10,000) Financing activities Dividends paid (10,000) Net cash flow from financing activities (10,000) Net change in cash and cash equivalents (13,000) Cash and cash equivalents b/f 7,000 Cash and cash equivalents c/f 5,000 b) i) The company’s financing and investing activities are currently yielding negative cash flows. This is not a good sign on the going concern aspect of the business because if the company cannot adequately invest and find sources of funds to finance its activities then it will face the risk of closure in the long term. ii) To improve the cash flow of the business, the management of ABC Ltd has to make better investment decisions through proper asset management while purchasing and disposing its assets. The company also has to implement an aggressive approach while finding sources of funds to finance its activities. It can choose to issue its share capital, borrow through loans or debentures or use lease agreements when in need of new assets. (Horngren, Foster & Datar, 2001) iii) This project cannot be financed with the current cash flow. This is because the company intends to increase its revenue to $3 million in the next three years, which is no mere task. Therefore, proper investment into the project is required and the finances of the company cannot presently hold the needed investment into the project. iv) There are many advantages and disadvantages of using both equity and debt as a source of finance. However, I am of the view that debt is far much better than using equity due to the fundamental reason that ownership of the business is not given up in the process while using debt. Although the gearing level of the company increases while using debt, debt would be a better source of finance. (Drury, 1998) Section III a) Product cost for the expansion product Direct materials ($5.60 * 5,000) 28,000 Direct Labor ($4.00 * 5,000) 20,000 Variable factory overheads ($1.00 * 5,000) 5,000 Variable selling expense ($0.20 * 5,000) 1,000 Fixed factory overheads (5,000/45,000 * 198,000) 22,000 Fixed selling expenses (5,000/85,000 * 191,250) 11,250 Total product cost $87,250 b) Reduction in cost of existing product Cost of existing product without the expansion product: Direct materials ($1.30 * 80,000) 104,000 Direct Labor ($2.80 * 80,000) 224,000 Variable factory overheads ($1.00 * 40,000) 40,000 Variable selling expense ($0.20 * 80,000) 16,000 Fixed factory overheads 198,000 Fixed selling expenses 191,250 Total product cost $773,250 Cost of existing product when expansion product is added: Direct materials ($1.30 * 80,000) 104,000 Direct Labor ($2.80 * 80,000) 224,000 Variable factory overheads ($1.00 * 40,000) 40,000 Variable selling expense ($0.20 * 80,000) 16,000 Fixed factory overheads (40,000/45,000 * 198,000) 176,000 Fixed selling expenses (80,000/85,000 * 191,250) 180,000 Total product cost $740,000 Cost of existing product saved due to the expansion = $773,250 - $740,000 = $33,250 c) Selling price for the new product Cost of production of the product: Direct materials ($5.60 * 5,000) 28,000 Direct Labor ($4.00 * 5,000) 20,000 Variable factory overheads ($1.00 * 5,000) 5,000 Fixed factory overheads (5,000/45,000 * 198,000) 22,000 Cost of production $75,000 Gross margin = Gross Profit = 40% Sales Therefore, Cost of Production = 100% - 40% = 60% Sales Sales = $75,000 = $125,000 60% Selling Price per Unit = $125,000 = $25 per unit 5,000 d) Contribution margins and break-even points per product i) Existing product Contribution margin: Sales ($12 * 80,000 ) 960,000 Direct materials ($1.30 * 80,000) (104,000) Direct Labor ($2.80 * 80,000) (224,000) Variable factory overheads ($1.00 * 40,000) (40,000) Variable selling expense ($0.20 * 80,000) (16,000) Contribution margin 576,000 Break-even point = Fixed Cost = $176,000 + $180,000 = 49,444 units Contribution per unit ($576,000/80,000) ii) New Product Sales ($25 * 5,000) 125,000 Direct materials ($5.60 * 5,000) (28,000) Direct Labor ($4.00 * 5,000) (20,000) Variable factory overheads ($1.00 * 5,000) (5,000) Variable selling expense ($0.20 * 5,000) (1,000) Contribution margin $71,000 Break-even point = Fixed Costs = $22,000 + $11,250 = 2,342 units Contribution per unit ($71,000/5,000) Section IV a) Net Present Value (NPV) without taxes and depreciation Year Cash flow PVIF 12%, n Present Value 0 (42,000) 1 (42,000) 1 15,000 0.893 13,395 2 13,000 0.797 10,361 3 10,000 0.712 7,120 4 10,000 0.636 6,360 5 6,000 0.567 3,402 NPV (1,362) b) In case of a 5-year straight line depreciation, Depreciation = 42,000 = $ 8,400 per year 5 Depreciation will be $8,400 for each of the five years, thereby increasing the fixed costs of the company by $8,400 for each of the five years until the equipment has no useful life. However, depreciation does not involve any cash movements therefore it is not a cash outflow hence it will have no significant difference in the eventual cash flow of the company if there are no income taxes to deduct. If there is income tax imposed on the profits of the company, then depreciation will be deducted before computation of income tax. Once income tax is computed and deducted from the profits of the company, depreciation is added back to the cash flow since it is not a cash item. c) Given the cash flow implications of the equipment and the Net Present Value, it is not advisable to purchase the equipment. This is because the equipment has a negative NPV, this means that the present value of the cash inflows attributed to the equipment are not enough compared to the present value of the cost of the equipment. Therefore, the equipment would cost too much in relation to the amount it would bring into the company hence making it a bad investment to make. Conclusion Section V a) Risks in the Project Any new project that is undertaken by any company has the definite financial risk it is faced with. ABC Ltd has to take into account the fact that the finances needed to implement the project have to be sourced and adequate consideration given to the financial institution that the project will be successful. Sourcing finances for the project is also an added challenge to it all since various financiers will have various reasons as to why they should or should not finance the project. Therefore, the success of the project must be carefully assessed before venturing into it. The fact that this new product line would require additional raw materials and more time than the cedar shingles is also a major risk to the project. This is because the new product generally requires more resources than the existing product hence the cost of failure of the new product will have severe implications to the company. The new product will force a reduction in the production of the existing product given the existing productive capacity of the company. Therefore, the revenue from the existing product will be greatly reduced in order to accommodate the new product which is yet to be proven. Despite the additional revenue expected from the new product, the additional costs involved represent a high risk to the company. (Horngren, Foster & Datar, 2001) Another risk that the project might face is the opportunity cost that it will be forced to incur by taking up the project. The next best alternative that the company had before it decided to undertake the project might be carefully evaluated. This is because the opportunity cost might be greater than the value obtained from undertaking the project. b) Responsibility as the Controller and Management Accountant As the controller and management accountant of ABC Ltd, my role is to ensure the proper recording and preparation of the company’s financial statements according to the outlined rules and regulations. The provision of well prepared and analysed financial and operational information would be my principal duty. This would be essential in the management decision process since the company’s financial operations will be made available in adequately broken down portions. (Lucey, 1993) Therefore, it is my duty to equip the managers of the company with the proper information that would enable them to make informed business decisions hence allowing them to be appropriately equipped while performing their management and control functions in the company. It would also be my responsibility to administer tax policies and procedures that are important to the company as well as supervise the preparation of any reports that should be made to any Government agencies. As a management accountant it would be my duty to the performance of the company with the operating plan and make a report of the results of operations to the appropriate management levels. (Kaplan & Atkinson, 2004) c) Actions of the CEO The CEO should not reduce the output levels of the existing product drastically in order to maintain its revenue stream before the new product peaks in the market. The revenue from the existing product should not be compromised until the new product is tested and proven in the market to be successful. This will offer a buffer of funds from the revenue that will help meet the costs of implementing the new project hence avoiding severe financial constraints that the company would face if the project is unsuccessful. The CEO should also not approve the purchase of the new equipment given the negative NPV that results. The equipment would offer lower financial benefits as compared to its purchase cost hence it would not bring value to the company. The company’s CEO should adequately evaluate the benefit of the project and source the funds needed putting in mind the cost of the finance. The cost of financing the project should not put the company in financial challenges over the coming years. It should come at a relatively manageable interest. References Drur.y, C., (1998). Costing an Introduction, 4th Edition. Thomson Learning. Drury, C., (2008). Management and Cost Accounting, 7th Edition. Chapman and Hall Horngren, C. T., Foster, G. & Datar S. M., (2001) Cost Accounting: A Managerial Emphasis, 10th Edition. Prentice Hall of India; New Delhi. Lucey, T., (1993) Costing 4th Edition. DP Publications, London. Lucey, T. (1993) Management Accounting, 5th Edition. Continuum, London. Robert Kaplan & A A Atkinson (2004). Advanced Management Accounting, 2nd Edition. Prentice-Hall. Read More