Financial Management and Control of Prospect Plc - Assignment Example

Financial Management and Control Table of Contents Part A 3 A report to the Board of Prospect Plc 3 a)Profitability ratios: 3 b)Liquidity ratios 4 c)Gearing ratio: 6 d)Asset utilization ratio: 6 2.Ratio analysis 6 3.Working capital cycle days: 7 Part B 7 1.Break-even point 7 2.Margin of safety 8 3.Company policy 8 Part C 9 Payback period 9 Accounting Rate of Return 9 Net Present Value 10 Internal Rate of Return 11 Part D 11 Reference 12 Part A 1. A report to the Board of Prospect Plc To the board of Prospect Plc., this report is aimed to evaluate the performance of the Prospect under different areas such as profitability, liquidity, gearing and asset utilization. To be able to evaluate the performance of this company well under the above mentioned areas, the Board will first have to appreciate analysis of different ratios that contribute to profitability, liquidity, gearing and asset utilization. With the ratios, it will be very easy to evaluate the performance of the company by the Board and advice the board on the way forward about the company. The following are the analyses of certain ratios under their respective headings; a) Profitability ratios: Profitability ratios are those ratios that measure a company’s ability to generate earnings relative to sales, assets and equity. The ratios normally assess the ability of a company to generate earnings, profit and cash flow relative to certain form of measure, normally the amount of money invested. They then analyze and highlight how effectively the company is profitable and how this profitability is being managed. There are several ratios known as profitability ratios, including, return on sales, return on investment, return on equity, return on capital employed, gross profit margin and net profit margin. We will only analyze Gross Profit Margin and Net Profit Margin with regard to the performance of Prospects Plc. i) Gross profit Margin; = (Net sales – Cost of Sales) / Sales Revenue Using information from the financial statements of Prospect Plc.: Gross profit margin for 2012 (all values are in pounds); = (11,000,000p – 5,150,000) / 11,000,000 = 0.53 or 53% For 2013; Gross profit margin = (12,650,000 – 6,780,000) / 12,650,000 = 0.46 or 46% This information is very critical to the Prospect Plc as it shows the company the its gross profit margin. In other words, we realize that in 2012 the gross profit margin was 53% while in 2013 it is only 46%. It means that; in 2012, from one dollar that the company makes from its sales, 0.53 of it remains in the company at the end of the day as the profit. This figure is slightly above average so we can say the company makes more remains with more than it spends. This is a sign of profitability of the company. However, in 2013, this value reduced to only 0.46 of a dollar remaining in the company for every dollar the company makes from its sales. This shows that the company spends more than half a dollar on costs of sales and remains with less than half as profit. Therefore, the company’s profitability here is reduced. ii) Net Profit Margin; = Net (after tax) profit / total revenue For 2012; Net Profit Margin = 1,900,000 / 11,000,000 = 0.17 0r 17% For 2013; Net Profit Margin= 1,080,000 / 12, 650,000 = 0.085 0r 8.5% Net profit margin is normally very important to shareholders as it shows them how much a company is able to convert its revenues into profits. The higher this ratio is, the more profitable the company also is. As can be seen from the calculations above, the company had a higher net profit margin in 2012 than in 2013. This reduction in the net profit margin can be explained to have been contributed to due to poor management of expenses since there was an increase in net sales, yet this increase was not directly translated to an equivalent increase in profits. Therefore, the company was more effective in converting revenues into profits in 2012 than in 2013. b) Liquidity ratios These are ratios of a company that shows its ability to meet its short-term obligations. In other words, they are ratios that measure the ability of a company to pay off its liabilities when they fall due. Generally, when the liquidity ratios are greater than 1, it means that the company is having a good financial health and is less likely to fall into financial difficulties. A number of ratios are involved including, current ratio, quick ratio, cash ratio and working capital ratio. However, for Prospect Plc, we will only analyze current ratio and the quick ratio. i) Current ratio: Current ratio = current assets /current liabilities For 2012; = 3,050,000 / 2,400,000 = 1.27 For 2013; = 4,850,000 / 3,000,000 = 1.62 From the general rule of liquidity ratios, both figures show clearly that the company has a good financial health (Jim, How is the Current Ratio Calculated and Interpreted, 2011). These values are greater than 1 in both years, showing that the company will be able to meet its obligations when they fall due. A higher value of the ratio means that the company is more capable in paying its obligations. Hence, in 2013, the company was more capable of paying its obligations than in 2012. This shows a good trend taken by the company as far as meeting its obligations is concerned. ii) Quick ratio (Acid–test ratio): = current asset –inventories) / current liabilities For 2012; = (3,050,000 – 250,000) / 2,400,000 = 1.17 For 2013; = (4,850,000 – 350,000) / 3000,000 = 1.5 According to the general rule of liquidity ratios, these figures are both above 1 and show that the company has a good financial health (James, 2013). With a quick ratio of 1.17 in 2012, this means that the company has $1.17 of liquid assets available to cover each $1 of its current liabilities. Likewise, in 2013, the company has $1.5 of liquid assets available to cover each $1 of its current liabilities. The higher the quick ratio is, the better the company’s liquidity position. Therefore, the company was in a better liquidity position in 2013 than in 2012. This is a good trend for the company as it is able to meet its most current obligations with its most liquid assets. c) Gearing ratio: = (long-term liabilities / capital employed) x 100 For 2012; = 2,800,000 / 2,800,000 +3,650,000 = 2,800,000 / 6,450,000 = 0.43 x 100 = 43% For 2013; = 3,500,000 / 3,500,000 + 5,350,000 = 0.395 x 100 = 39.5% This ratio shows the proportion of assets invested in the business that are financed by borrowed funds and especially by the long-term liability (Jim, 2012). For instance, for this company, 43% of the total assets invested here are financed by the long-term assets while the remaining 57% are financed by the owner’s equity. And in 2013, 39.5% of the total investment is financed by the long-term liabilities while 59.5% are financed by the owner’s equity. This shows that most of the investment is done by the owner’s equity. In general, the higher the gearing ratio, the more risky the business is since it is not optional to repay loan and interests just as it is for dividends. In this company, the gearing ratio is manageable since it is below average of the total percentage of the investment. Therefore, the business is somehow safe. d) Asset utilization ratio: = revenue / average total assets For 2012; = 11,000,000 / 8,850,000 = 1.24 For 2013; = 12,650,000 / 11,850 = 1.07 This value always explains that, the company earned $1.24 for every $1 of assets owned by the company in 2012 and $1.07 for every dollar of assets owned in 2013. The higher this value of asset utilization is, the more efficient the company is being with each dollar of assets it has. 2. Ratio analysis In a company, for one to infer its performance and determine whether it is financially healthy or not; one or two numbers are not just enough. Nevertheless, in practice, a number of different ratios are normally determined and used to compare the company’s performance over time or to compare its performance with the performance of other companies in the same industry (Pamela, 2013). A critical evaluation of most of these ratios normally helps the management to know the companies that will eventually fall and those that will continue to survive. The ratios are also helpful in that, when the management realizes five years before the company fails, that the company s not doing well by use of these ratios, there is a good opportunity to improve on the performance of the company to make it regain its good performance. However, on the limitations of the ratios, it is one thing to calculate and know the ratios, and to interpret and utilize the ratios is another thing. This shows that interpretation of ratios requires certain skills and knowledge and implementation on the meaning is necessary to make the ratios have meanings. 3. Working capital cycle days: = average working capital x 365 / annual sales revenue For 2012; = 6,450,000 x 365 / 11,000,000 = 214.02 = 214 days For 2013; = 8,850,000 x 365 / 12, 650,000 = 256 days This describes how many days it will take a company to convert its working capital into revenue. The shorter this value is, the better is for the company. For 2012, the company will take 214 days to convert its working capital into revenues while in 2013 it will take the company 256 days to do the same. This shows that the company was more efficient in 2012 than it was in 2013. The company therefore is more liquid in 2012 where it was able to convert its working capital faster into revenues, than in 2013. Part B 1. Break-even point = fixed cost / (price per unit – variable cost per unit) For 2012; BEP = 4,000,000 / (400 - 90) = 12,903.20 units For 2013; BEP = 6,440,000 / (460 - 90) = 17,405.4units The break-even point results show that the company will have to sell more units of air conditioners in 2013 in order to break-even or to realize all the expenditures used in the production and sales. The difference will be because in 2013, there was much fixed cost that was added which actually made the break-even point to go higher. This shows that, the lower the fixed cost a company applies in its productions, the lower the break-even point is hence the company can make profits faster. On the other hand, when the fixed costs are increased, a company takes longer to break-even as far as the units it is required to sell to meet this value is concerned. 2. Margin of safety = (Budgeted Sales Units – Break-even Point) / Budgeted Sales Units In 2012; = (275,000 – 12,904) / 275,000 = 0.95 or 95% In 2013; = (275,000 – 17,406) / 275,000 = 0.94 or 94% The margin of safety is used to measure risk. It is actually used to represent the amount of drop in sales which the company can tolerate (Irfanulla, 2012). The higher the margin of safety, the more the company can withstand the fluctuation is sales. Therefore, in 2012, the company was able to withstand the fluctuation in sales more efficiently than in 2013. However, in general, this company is generally best suited to withstand fluctuations in sales as it has higher margins of safety n both years. 3. Company policy The company’s policy to increase the price by 15% is a very noble decision. This is because the company’s fixed costs were increased highly in the second year. For the company to compensate for this huge cost, it is only wise to increase its price by 15% so that the break-even point and the margin of safety cannot be so much apart from each other in both the two years. However, if the amount of units produced in 2013 is the same as the amount that was produced the previous year, it does not make a good management of costs. At least, the fixed cost could be increasing as the volume of sales also increases. In this way, the company would not need to increase the price in order to maintain its contribution margin, but it will even lower its break-even point and make profits faster. Part C Managers are normally faced with tough decisions to make when they want to choose on which project to take up. This is because several factors are considered when such kind of decisions are made, without which, a bad project that will bring losses to the company can be chosen, or that which will take a long time to pay back the investment amount. It is therefore very critical that managers make good use of certain ratios such as payback period, IRR, ARR and the Net Present Value to help them know which project has the best option of being taken up for investment. With the data given about the two options of supermarkets A and B that Nere would like advice on, we will evaluate the ratios one by one to enable Nere to arrive at the best option that will suit his investment plan. Payback period The payback period of a project refers to the number of year that a project will have to take to pay back the initial investment amount used to initiate the project (Rosemary, 2012). Generally, the faster the payback period is, the better is the project and it is advisable to accept a project with a shorter payback period. This means that such a project will take a shorter period of time to pay back the initial investment and give profits for the rest of the years. Considering the data given for Nere and the two projects, project A will has a payback period of 5 years while project B has a payback period of 6years. This simply means that it will take 5 years for project A to pay back the 20 million pounds that will be used as the initial investment capital unlike project B which will take 6 years. It therefore means that, Nere should choose project A since it takes a shorter time to pay back the initial capital and begin giving back profits. If project A is chosen, Nere will break-even in 5 years and will begin enjoying the profits 1 year earlier than if project B would be taken. Accounting Rate of Return This is a technique which uses the accounting information as revealed in the financial statement s such as, in the balance sheets and profit and loss accounts, in order to measure the profitability of an investment (Penman, 2013). The general criterion for ARR normally is arrived at by comparing the value of ARR with the value of the rate of return. This criteria hold that, a project whose accounting rate of return is higher than its required rate of return should be accepted while that whose accounting rate of return is lower than its required rate of return should be rejected. According to the information given about the two projects, A and B, the ARR and the IRR for project A are 15% and 16% respectively; while the ARR and the IRR for project B are 18% and 14% respectively. As we can see these figures very critically, project B should be accepted since its ARR is higher than its required rate of return. This means that this project will have higher affinity to bringing back returns to the project as compared to the project B. Moreover, the project with a higher ARR should always be ranked higher than that with a lower ARR. Hence, project B is accepted since it has a higher ARR than project A. In as much as project A will pay back the investment amount faster it earns returns at a lower rate than project B. Net Present Value This is normally the difference between the present value of cash inflows and the present value of cash outflows. These project cash flows are normally discounted by an appropriate rate of return required by the investor. The appropriate cash flows are the after tax cash flows and the net cash flows should be estimated on the after tax basis. The general criterion for the Net Present Value is that; a project with a positive net present value should be accepted while that which has a negative net present value should be rejected. This is because; a positive net present value increases the shareholder’s wealth while a negative net present value decreases the shareholder’s wealth. However, if both the net present values of the projects are positive, then the one with a higher net present value should be taken up. This is because the one with a higher net present value will obviously increase the shareholder’s wealth even more. When the data about Nere and the two projects are considered, the net present value for project AA is 120 million pounds while the net present value for project B is 145 pounds. Both the two NPVs are positive showing that all of them will increase the shareholder’s wealth, hence both should be accepted. However, if Nere is not able to undertake all the projects at ago and can only settle on one, then it I obvious that the best choice will be project B. project B has a higher net present value, hence it will increase the shareholder’s wealth even more than project A by 25 million pounds after 15 years. Internal Rate of Return This is the rate of return which equates the present values of cash inflows with the present values of cash outflows. In other words, it is the discounting factor at which the net present value is equal to zero. The general criterion on the choice of the best project using the Internal Rate of Return normally follows a comparison of the IRR with the cost of capital. This means, if the IRR is compared to the firm’s cost of capital and it is found that the IRR is greater than the cost of capital in this case the project will be taken up. However, for a project whose IRR is less than the cost of capital, it is normally rejected. If both the IRRs of the projects being evaluated are higher than the cost of capital of that firm, then priority is normally given to the project with the highest IRR. Bringing the given data about Nere and his two projects A and B into the picture, the IRR of these projects are given as 16% and 14% for the projects A and B respectively. However, the cost of capital of this firm is not give. If we assume that the cost of capital of the firm is 15%, and then it will be very obvious that project A will be accepted as it has an internal rate of return which is higher than the firm’s cost of capital. But, even without the firm’s cost of capital, it still stands that the project with a higher internal rate of return is always given a priority as compared to that project of a lower internal rate of return. Project A has a higher rate of return than project B, hence it is advisable to take up project A. In general, while looking at the evaluation above, we find out that two ratios are in support of Nere taking up project A two ratios are also in support of Nere taking up project B. however, it is only a wise idea to advice Nere to undertake project B since the difference in the two accounting rates of return is larger with project B having the higher rate. Accompanied with a higher net present value, project B will give much more return than project A given time. Part D a) Committed fixed cost is a very important factor that any investor needs to look at when deciding on the units of products to produce in order to maximize the company’s profits. This follows the fact that is a company already has a committed fixed cost or assets, it would be cheaper for the firm to manufacture products in the long run having not to necessarily realize this cost time and again when production is being made. It also encourages specialization and makes a company grab the opportunities for outsourcing if sorted for. This is different from a situation where a company does not have a committed fixed cost and would like to produce for the first time, it might be forced to outsource services of another company with already existing fixed cost in order to reduce on cost. b) Budgets are normally used in production in order to help the management to know the exact material, labor and overhead costs required. It also helps the management in deciding how much to produce for what periods of time. This normally helps in managing resources such as the direct materials, labor resources or the overhead resources. It therefore helps to avoid wastage and proper planning for every requirement for production. It is easy to know the units produced, price per unit and even cost of producing each unit. There are also variances that normally occur during production, with a budget, it is very easy to know, monitor and control such variances in order to make correct management and production decisions. Reference Irfanulla, J. (2012). Margin of Safety. Accounting Explained Journal , 1-2. James, J. (2013). Financial Ratios Explanation. University of Notre Dame , 1-3. Jim, R. (2012). Gearing Ratio. Tutor2u Journals , 1-2. Jim, R. (2011). How is the Current Ratio Calculated and Interpreted. Tutor2u Journals , 1-2. Pamela, P. D. (2013). Financial Rtios Analysis. A Journal of James Madison Uiversity , 1-3. Penman, S. (2013). Book Rate of Return. A Journal of Tel Aviv University , 1-2. Rosemary, P. (2012). Payback Period: A Capital Budgeting Decision Method. Bizfinance Journals , 1-2. Read More