Measurement of Financial Performance on the Basis of Ownership Structures - Essay Example

ADVANCE FINANCE FOR DECISION MAKERS Table of Contents Introduction 4 Financial Analysis and Business Risk Assessment 4 Importance of Financial ment Analysis in Decision Making 6 Sources of Finance 7 Internal Sources 7 Retained Earning 7 Current Assets 8 Fixed Assets 8 External Sources 8 Need for Financing 9 Classification of Sources of Funds according to time period 9 Measurement of Financial Performance on the basis of Ownership Structures 10 Ethical Issues and Corporate Governance in Financial Reporting 11 Project Evaluation 12 Net Present Value (NPV) Analysis 14 Internal rate of Return (IRR) Analysis 14 Profitability Index or Cost-Benefit Analysis 14 Break-even Analysis 15 Conclusion and Recommendation 15 References 17 Bibliography 19 Introduction The two important ingredients for successful business are planning and control of scarce resources. Financial analysis helps the organisation to formulate strong business strategies with the help of financial data. In addition, an appropriate accounting standard is also required which helps in data acquisition. The survival of business and its growth depends on correct decision making on the basis on available financial information. Proper financial management helps to identify key areas which are more profitable and areas which require attention and improvement. Advanced financial decision regarding accepting or rejecting a project is done by evaluating the expected future cash flow from investment using the discounted cash flow methods. If any firm is experiencing profits and fast growth rate then it implies that firm is investing most of its cash proceeds. In such a case the firm needs to manage its cash position by balancing profitability and liquidity otherwise it may lead to drainage of cash of firm in investments. Financial Analysis and Business Risk Assessment The financial risk of a firm is associated with the financing decision of the firm which is essentially the decision regarding the extent to which debt capital is used in capital structure of the firm. Debt capital is cheaper source of raising fund for projects than equity capital. The use of debt capital in capital structure of the firm increases the rate of return on equity to the shareholders as long as the rate of return exceeds the cost of debt capital. Using debt capital a firm can magnify the effect of earnings per share of shareholders. Inclusion of debt capital implies payment of fixed interest charges on the outstanding debt. When the firm’s earnings are good, the burden of regular interest payment is not worrisome but when earnings are uncertain, debt funding decision should be taken after analysing all scenarios and probable outcomes (Sheeba, 2011, p.249). Consider a scenario when the firm’s earnings for a given period decline due to external uncertainties like policy changes by government or insufficient supply of raw materials. In that case the fixed payments would take up significant portion of firm’s earnings. This is because even if the earnings of firm decrease or make losses during the period, the holder of debt instrument is entitled to receive regular payments of interest. This increases the business risk of the firm because if the firm is unable to service regular interest, it will have to liquidate its assets to honour debt obligations. Hence, decision regarding inclusion of debt in capital structure to finance projects should be carefully taken. Since financial risk is associated with debt capital, if there is no debt finance used in the project then there will be no financial risk. This means that projects which are completely financed by equity carry no financial risk. But it is not advisable for firms to operate projects completely by equity finance because in that case it will not be able to take advantage of cheaper debt capital. Whether a firm’s debt financing poses increased risk to equity shareholders or not depends on the stability of earnings stream of the firm. The operating risks of firm arise due to presence of fixed cost in the firm’s cost of operation. This means that if the firm uses too much fixed cost in its cost of operation, the operating risk of firm increases. Operating risk arises due to presence of fixed cost in project’s cost of operation. While the firm’s operating risk is unavoidable or can only be reduced up to a certain extent, financial risk is partly or fully avoidable. Importance of Financial Statement Analysis in Decision Making Financial statements provide financial information to the investors and creditors regarding financial performance of the company. Financial statements are also important to company’s managers as it helps them evaluate business and communicate it to outside interested parties. Analysis of financial statements helps the managers to make decisions by understanding the financial condition of the company (Wild, 2006, pp.12-15). For instance, the creditors and capital providers are generally interested in the safety and profitability of their investment. The balance sheet of the company gives them an idea about where their money was invested by providing detailed information about the assets of company. The balance sheet also lists total outstanding debt and equity of the company on a given date. The income statement of the company reports the profits or loss made by the company during the year from their operations. Income statement also includes total sales revenue and the cost of sales divided into direct and indirect cost. The company’s performances reported in the financial statements are accounting incomes and expenditures which includes cash as well as non-cash elements like bills depreciation, receivables, and provisions. To get an idea about the true cash position of the company, the cash flow statement of the company should be analysed. The cash flow statement shows the net cash flow arising from operating activities, investment activities and financing activities. The importance of cash flow statement is that it gives an idea regarding the exchange of cash between the outside world and the company during the period under observation. Shareholders’ equity shown in the balance sheet is important for making decision making because it shows the changes in various equity components including retained earnings. The amount of shareholders equity is total assets less total liabilities. The total net-worth of the company is the sum of retained earnings and shareholders’ equity. Growth in shareholders’ equity by increasing retained earnings implies accumulated investment returns (Swart, 2004, pp.300-302). Sources of Finance The dynamic environment where business exists and operates may require funds every now and then to finance projects. Project financing is concerned with the activities related to planning, controlling, raising, and administering funds required for projects. Depending on the nature and size of the project, the sources of funds can be broadly classified into long-term sources and short term sources of funds. The long term financing are also known as fixed capital that are used to purchase fixed assets. For instance, the projects that require purchase of plant and machinery, land, furniture, etc. requires fixed capital investment. On the other hand, the short term financing are more concerned with utilisation of funds for carrying out day to day operations. In order to maintain a good financial position, the firm’s would need to maintain an optimal balance between short term and long term funds (Banerjee, 2005, pp.47-99). Internal Sources Retained Earning The companies invest in scarce resources in order to supply products and services in the markets. Every product has cost which the company has to be bear. After producing goods and services, the company sells their products in the market and makes profits. These profits are retained by the company over time and can be used later to finance long term projects. Thus, retained earnings are portion of company’s profits which are not paid out to external or internal parties. Current Assets Current assets consist of cash or cash equivalents such as overdrafts, deferred payments, bank balances, stocks that are readily convertible into cash and so on. Current assets are ideal for funding short term projects. Fixed Assets Fixed assets are those that are not easily convertible in to cash or cash equivalent and includes land, plants and machinery, furniture, and so on. Since these assets require longer time frame to get converted into cash, firms generally use fixed assets as collaterals or sale them to finance long term projects. External Sources Most common way to raise external funds is through borrowings from banks or institutions. Loans vary according to time periods such as short term loans, medium term loans, and long term loans. A short term loans are issued for 2-3 years, medium term loans are issued for 3-5 years, while long term loans are issued for over 5 years. The company may take appropriate type of loan depending upon the life of project. The companies which have good credit ratings and reputation in the market and also have high networth can issue commercial papers for funding their short term projects. The long term sources are further classified in shares, debentures, and term loans. The examples of medium term sources of funds are hire purchases, leases, medium term loans. The example of short term funds includes bank overdrafts, bills payable due to deferred payments, debt factoring and so on. Both the internal and external sources of funds have individual characteristics that determine their requirements at different situations. For instance, when company wants to earn higher EPS for their share holders, they can leverage their balance sheet with debt capital to finance projects. Again consider situation when the company’s balance sheet is already highly leveraged, then the company will have limited choice to debt finance since over exposure to debt capital raises financial risk of firms. The sources of funds are classified into internal and external sources. Need for Financing Operational requirements for carrying out the project related activities Expansion or growth requirements Contingency requirements Operational costs Classification of Sources of Funds according to time period Short term Sources – Such sources are used to finance short term working capital requirements of the projects. It includes bank overdrafts, bank credits, bills receivables, issue of commercial papers, accruals, deferred incomes, inter-company deposits, trade credits, factoring, and so on. Long term Sources – Such sources includes finances raised for more than three years. It includes issue of equity shares, corporate bonds, long term loans and debentures, issue of preference shares capital, loans from commercial banks and financial institutions. Measurement of Financial Performance on the basis of Ownership Structures Financing a project by borrowed money is known as debt financing. The company must pay back the principal loan along with the interest to the lending institution. It may be in the form of bond, letter of credit, loan, or any other fixed bearing instrument. When any project is equity financed it means that money is lent foe exchange of ownership. Companies that are well established, strong fundamentals, steady revenues have easy access to debt capital at cheaper cost. Companies with high profitability but poor credit ratings often rely on equity capital to finance their projects. Since debt capital is cheaper than equity capital, in order for the firm to get access to cheaper debt, it must have good standing credit history. Projects which are expected to experience high growth in future may be equity financed. However, raising funds through equity may lead to loss of control by dilution of ownership stake in the company. On the other hand, debt increases financial risk by reducing profits on account of regular interest payments. Financial risk resulting from borrowing to finance a project and concurrent possibility of not being able to meet interest and principal repayment if business conditions deteriorate. Thus, the higher the debt and accompanying interest payment, the greater would be the financial risk. Debt finance is preferred over equity because it is cheaper and at the same time it does not involve dilution of ownership by sharing voting rights of owners. Debt also carries fixed rate of interest and tax benefits. From the above discussion it can be said that if the company is expecting steady revenues stream of cash flow from a new project and it also has strong credit ratings, then it will be able to raise debt capital to finance it projects at cheap cost of capital without having to compromise the voting rights of the owners of the company. Consider an example where interest rate on debt is 20%, tax deduction is 50% then cost of equity is only 10%. In such situation, if the company is able to earn return higher than 11% the benefits will accrue to the equity shareholders of the company. It would maximise the firm’s value by increasing the earnings per share available to owners. This process is known as capital gearing which is done by trading on equity. The managers however would have to keep in mind that higher financial gearing increases financial risk of the firm ultimately leading to liquidation of assets. Ethical Issues and Corporate Governance in Financial Reporting In financial markets the key driver for financial stability for any business is the investor confidence. The corporate governance reporting framework and its Global Reporting Initiative (GRI) guidelines promotes accountability in reporting. Accountability is considered as the cornerstone of corporate governance that aims to continuously monitor the responsibilities towards all stakeholders by implementing best practices (Fernando, 2009, pp.42-64). Fair financial reporting is related to investor confidence and misrepresenting financial position is considered as fraudulent practices. Such restatement hides the true facts of company which can keep the investor in illusion about the true risk associated with the firm (Shaw, 2010, p.184). Some constituents of ethical aspects of financial reporting are resolution of conflict of interest between company and employees, abiding with all rules and regulations; compliance with law and policies, emphasis on customer relations, proper disclosure of true financial condition of company, and encouragement of whistleblowers to reveal unethical practices (Jennings, 2011, p.97). The accounting standard no. 2, 5 of PCAOB, SOX section 404, 906, and 302 are used to address financial frauds reported according to IFRS. An effective anti fraud program should address control structure, corporate culture, and adequate procedures to detect and prevent potential fraud. Companies should comply with SOX into their corporate governance structure, internal control, financial reports and risk management, and audit activities. Financial statement fraud detection and prevention controls are addressed by SEC rules, SOX, PCAOB accounting standards. These antifraud prevention guidelines are relevant only to financial statement frauds. A high quality financial reporting system such as IFRS aims to use single robust accounting standard to reflect true financial information about the company. IFRS is more comprehensive reporting system since it presents financial and non-financial KPI (Key Performance Indicators) and footnotes. Also all listed companies in EU member countries are required to present their financial statements complying with IFRS. Worldwide regulators like Security and Exchange Commission has allowed foreign issuers to use IFRS for issuing cross-border securities. These measures are expected to facilitate comparable reports, create greater opportunity for investment and diversification, increase investor confidence, minimise investment risk, enable international audit, enhancing consistency, efficiency of global audit practices, and mitigating confusion associated with different reporting standards. Project Evaluation Decision regarding accepting or rejecting a project should be based on cost and benefit analysis of the project which depends on the expected future cash flow from investment. The cost-benefit analysis should be made on the basis of cash flows since non-cash elements such as depreciation are not considered in decision making as they do not actually result in movement of cash flow. The relevant cash flows are incremental to project of the project especially when the project is in nature of expansion or diversification. So, from the above discussion it can be said that stream of cash flows which should be used for making decisions includes only incremental cash flows such as initial investment, operational cash flows and terminal flows. Consider a case when £ 158,000 is initially invested in a project. The expected future cash flow from the project for the next five years is shown below: The decision regarding whether to accept or reject the project can be made by evaluating the project by discounted cash flow or time adjusted techniques like net present value, internal rate of return, and profitability index. To assess the riskiness of investment, the break-even analysis can be done in the project which calculates the time by which the projects expected cash flow will equal initial investment. Net Present Value (NPV) Analysis According to this concept the present value of all expected future cash flow of the project is discounted at the cost of capital. This is done since the value of money decreases with time due to influence of inflation (Brigham and Ehrhardt, 2011, p.383). Decision Criteria – Projects which yields positive NPV should be accepted while projects with negative NPV should be rejected (Gallagher and Andrew, 2007, pp.269-271). Internal rate of Return (IRR) Analysis According to this concept, the actual time adjusted return of the project can be calculated by equating the net present value of the investment to zero. It is also a discounted cash flow analysis technique. Thus, IRR is the time adjusted yield of the project at which NPV of project is zero (Megginson, Smart, and Lucey, 2008, p.267). Decision Criteria – If the IRR of a project is greater than cost of capital then such projects are accepted otherwise projects when IRR is less than cost of capital, such projects should not be accepted (Campbell, 2003, p.44). Profitability Index or Cost-Benefit Analysis Profitability Index analyses a project by the ratio of expected benefits from project to its cost of investment. It is an extension of NPV approach to evaluate profitability of investment before investing in the project (Damodaran, 2010, p.267). Decision Criteria – The higher the profitability index, the higher would be the actual return of the investment (Greer and Kolbe, 2003, pp.236-237). Break-even Analysis Break-even analysis is used to analyse the uncertainty or the risk of investment and the approach converts uncertainties into calculated risks. The break-even analysis of a project is used to determine the lowest cost of production at which the project has to operate in order to keep out of financial trouble. The payback period can be used to evaluate the project’s break-even point in years (Jackson, Sawyers, and Jenkins, 2008, p.204). Decision Criteria - The lower the break-even point, the greater is the prospects of project’s future earning and less is the chance of incurring loss (Baker and Powell, 2005, p.248). Conclusion and Recommendation The task of financial project manager includes controlling and managing projects for companies and corporations that have significant impact on company’s cash flows. Whenever any company accepts any project it has to ensure future profitability of the firm. A complete project evaluation should also take into account the broader impact of project on society along with specific interest of stakeholders. On the basis of NPV analysis, the NPV of the project is £ 30,879.95. Hence, the project should be accepted. It means that the actual difference between present value of future cash inflow and the initial cash flow of the project is positive. The profit from the project in monetary terms is £ 30,879.95. On the basis of IRR analysis, the yield of the project is 18%. Hence the project should be accepted. This means that the actual return from investment from the project after adjusting the cash inflows with the time value of money is 18%. The profitability index ratio of the project is approximately 0.22 which means that on the basis of cost-benefit analysis investment in this project is safe. On the basis of payback period analysis, the project break-evens in 3.15 years which means that project involves moderate risk as the payback period is more than half of total life time of project which is 5 years. From the above discussion it can be said that the project involves moderate risk. Also from the discounted cash flow analysis it can be said that the project’ actual time adjusted returns are positive which implies that the project should be accepted. References Campbell, H. F., 2003. Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets. United Kingdom: Cambridge University Press. Gallagher, T. J. and Andrew, J. D., 2007. Financial Management: Principles and Practice. 4. United States: Pearson Education, Inc. Baker, H. K. and Powell, G., 2009. Understanding Financial Management: A Practical Guide. United Kingdom: John Wiley & Sons, Inc. Greer, G. E. and Kolbe, P. T., 2003. Investment Analysis for Real Estate Decisions. 5. United States: Dearborn Real Estate. Damodaran, A., 2010. Applied Corporate Finance. 3. United States: John Wiley & Sons, Inc. Jackson, S. R., Sawyers, R. B., and Jenkins, G. J., 2008. Managerial Accounting: A Focus on Ethical Decision Making. 5. United States: Cengage Learning. Smart, S. B. and Megginson, W. L., 2008. Corporate Finance. United States: Cengage Learning EMEA. Brigham, E. F. and Ehrhardt, M. C., 2011. Financial Management: Theory and Practice. 13. United States: Cengage Learning. Swart, N., 2004. Personal Financial Management. 2. New Delhi: Juta and Company Ltd. Wild, J. J., 2006. Financial Statement Analysis. 9. New Delhi: Tata McGraw-Hill Publishing Company Limited. 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