Financial Analysis and Break-Even Analysis - Example

FINANCIAL ANALYSIS AND BREAK EVEN ANALYSIS Table of Contents Introduction 4 Task 4 i) Financing of Chosen Company 4 ii) Ratio Analysis 6 iii) Recommendations 9 Task 2 9 a) 9 b) 10 c) 10 d) 11 e) 12 f) 13 References 15 Appendix 16 Table 1: Ratio Analysis 16 Table 2: Task 2(a) 16 Table 2: Task 2(b) 16 Table 2: Task 2(c) 17 Table 2: Task 2(d) 17 Table 2: Task 2(e) 17 Introduction As the accountant of Greensleeves Ltd, a small manufacturing company in leisure sector, there are two tasks that needs to be conducted for the owners of the company. The first task requires choosing a UK based company from FTSE 250 (preferably in retailers sector of Travel and Leisure) and then provide recommendation to client regarding whether an investor should invest in the respective company or not. Task one will analyse the financing details of the company and conduct a historical ratio analysis revealing profitability, liquidity and efficiency of the company. The company chosen for task one is Thomas Cook Group Plc (Ticker: TCG.L). Task two requires evaluation of planned manufacturing assembly for Greensleeves Ltd through which it plans to sell products online nationally. This task produces a report containing necessary recommendations for the Board of Directors of Greensleeves Ltd on the basis of break-even analysis and margin of safety. Task 1 i) Financing of Chosen Company Financing refers to the capital structure chosen by the firm that will ultimately maximise the returns of the shareholders. Primarily, financing can be broadly classified into debt financing and equity financing. The former is more cheaper source of finance and requires periodical payment of interest on outstanding debt principal till maturity. Equity capital on the other hand does not involve any regular commitments to the shareholders and but excess dilution of authorised capital could dilute majority shareholding of the promoters. The choice of financing determines the overall cost of capital of the company. Since, debt capital is cheaper, tax-deductible and increase leverage it is often used as a popular source of financing. At the same time it must also be kept in mind that excess leverage results in increase of financial risk. Hence, many times companies prefer financing through multiple sources so as to minimise risk and maximise profits (by reducing cost of capital). The balance sheet of TCG shows the total assets, total liabilities, and stockholders’ equity of the company on a given date. The difference between total assets and total liabilities is also known as stockholders’ equity. When financial statements of the company was analysed from 2010 to 2013, it was found that the total liabilities of the company increased at 3.45 percent compounded annual growth rate. During the same period, the long-term liabilities or debt financing of the company experienced 5.23 percent increase. In comparison, the total stockholders’ equity declined by 31.69 percent. This implies that the company is presently leveraged at significantly high values. The debt-to-equity ratio of the company reveals its leverage and during 2010 to 2013, the company’s debt-to-equity ratio increased at compounded annual growth rate of 51.44 percent. Hence, in the year 2010, 75 percent of chosen firm’s financing was via debt and the remaining was via equity. This percentage of debt-to-equity increased to 91 percent in 2013. As discussed the firm will have to consider the fact that if it is unable to generate significant profits from operations then it will not be able to cover its interest liabilities. This often leads to solvency or financial risk that could force the company to liquidate assets to service debt. ii) Ratio Analysis Profitability Analysis - These ratios measure the company’s ability to generate earnings relative to assets, sales or equity and thus highlight how effectively the company is being managed. It is a key indicator of the company’s performance in its industry of operation and also helps to measure the company’s financial position. These ratios are mainly derived from the income statement of the company (Thukaram, 2007, p.99). Some example of profitability ratios are Gross profit Margin, Net profit Margin, Operating Margin, Return on capital employed, etc. The gross profit margin of the company was 0.24 in 2010 or the gross profit of the company was 24 percent of total sales for that year. The operating margin of the firm was 3 percent of total sales for the year 2010. In 2013, the values of gross margin and operating margin declined to 0.21 and 0.02 respectively. In other words, the profitability of the company in terms of gross margin declined at compounded annual growth rate of 4.51 percent while the operating margin of the company remained marginally stable. Liquidity Analysis - These ratios help to evaluate the ability of the firm to honour its short-term liabilities or current obligations. Hence, it is sometimes also considered as an indicator for the measure of working capital management. The firms’ short term obligations include carrying out day to day operations, payments to creditors for purchase of raw materials, payment of daily wages of labourers, outstanding expenses and bills payables, etc. These are financed by short-term loans, accounts payables, etc. Generally, the higher the ratios are, the higher would be the liquid of the firm ( Mittal, 2011, p.53). the most common tools used for measuring liquidity are liquid ratio and current ratio. The ratio of current assets to current liabilities is called the liquid ratio where as if the inventory is removed from current assets of liquid ratio, then the formula changes to quick ratio. This is because inventory or stock is the least liquid ‘current’ asset. In 2010, the current ratio and quick ratio of the company were 0.43 and 0.42 respectively. These ratios remained quiet stable till 2012 but then increased to 0.54 and 0.53 respectively in 2013. Overall, there was found to be increase in liquidity of firm’s assets. The liquidity ratios namely, current ratio and quick ratio increased at compounded annual growth rate of 7.72% and 8.01% respectively from 2010 to 2013. Efficiency Analysis - These ratios are also known as activity ratios and they helps to analyse how efficiently a company utilises its assets and liabilities. These ratios are very useful when the performance of a particular company is compared to its competitors. The significance of efficiency ratio is in the fact that when the ratios improve over time it implies that the company’s profitability is also improving (Sinha, 2009, p.133). The efficiency ratios in-terms of ‘Inventory Turnover’, ‘debtor collection period’ and ‘creditor payment period’ was optimum in 2010. From 2010 to 2013, the average period of trade payables and receivables were 54 and 24 respectively. This means that the company had enjoyed and utilised an average of 30 days trade cycle during 2010 to 2013. However, the trade cycle declined from 2010 to 2011 and then slowly started to increase thereon till 2013. iii) Recommendations Based on the results of ratio analysis and financing pattern of the company it can be said that the operating profitability of the company increased improved marginally during 2010 to 2013 with liquidity remaining stable as well from 2010 to 2012. The company has been found to efficiently manage their working capital as during 2010 to 2013, there was average 30 interval between creditor payment period and debtor receivables period. The liquidity of assets of the company increased from 0.42 in 2012 to 0.53 in 2013. The earnings-per-share of the company increased due to increased leverage in financing. In short, the stocks of TCG.L appears attractive for the potential investors and hence they are advised to invest in the company. Task 2 a) the variable costs comprises of all direct costs which varies with the volume of production. Such cost may include but not limited to direct labour, direct materials, and direct overheads. It is given that Greensleeves Ltd employs labour at £10.5 per hours for 7 hours. This means that total cost of direct labour is £73.50 direct material. Also, cost of direct materials and other related costs are £71 and £15.50 respectively. Therefore total variable cost of the company is, TVC = (£73.50+£71+£15.50) = £160 It is given that company plans to sell 750 units of greenhouse per month; this means that variable cost per unit is £160/750 or £0.21only. b) The break-even point (or BEP) represents amount of sales (in terms of units or amount) that will cover the total cost of production of the company. At this point, the company will be in no-profit/no-loss zone. The company will start making profit for every unit sold beyond BEP and needless to say that unless sales cross BEP the company will incur net losses. The formula to calculate break-even sales is, BEP = Fixed Cost/ (per unit sales price – per unit variable cost); in case of Greensleeves, the company has total fixed cost of £80,000 per month. The unit sales price is, £320/750 (that is, sales price per unit planned sales) or £0.43. earlier it was calculated that the variable cost per unit of the company is £0.21. Hence, BEP = 80,000/ (0.43-0.21) = 375,000 units. c) The margin of safety (MOS) refers to the extent by which the actual/planned/forecasted sales of Greensleeves Ltd exceeds the break-even sales of the company. The variable is widely used tool for measuring operational risk. the basic formula to calculate MOS is, MOS = Planned Sales – Break-even Sales; & MOS (%) = [(Planned Sales – Break-even Sales)/ Planned Sales] x 100 It is given that the company plans to sell 750 units of greenhouse per month with selling price of £320. This means that the total sales amount of the company is £240,000. The break-even point in amount turns out to be £160,000. Therefore, the MOS of Greensleeves Ltd turns out to be £80,000 (or 33.33%). After analysing this margin, the company could determine the acceptable drop in sales which the company can absorb without incurring significant losses. This means that the company must sell 33.33% of budgeted sales every month if it wishes to remain profitable. Sales below £80,000 will lead to losses as the company’s fixed cost is equal to this amount. Alternatively, this implies that higher MOS will ensure that company will be able to with stand higher fluctuations in sales and vice-versa. In short, a drop in sales greater than the calculated MOS will cause net loss for the period (Heitger, Mowen and Hansen, 2007, p.120). d) From the given information it can be deduced that if the target sell price of Greensleeves Ltd greenhouse gas be £320 and that the company plans to sell minimum 750 units per month then the revenue generated per month would be £240,000 [that is, 750x320]. The total variable cost of the company was earlier found out to be £160 and the total fixed cost of the company is £80,000 per month. This means that the total cost of the company turns out to be, Forecasted Sales £ 240,000 Total Variable Cost £ 160.00 £ 120,000 Total Fixed Cost £ 80,000 Total Cost £ 200,000 Forecasted Profit £ 40,000 From the above calculations it is clear that if taxes are ignored and the company is able to sell 750 units of greenhouse per month, then it will be able to make profit of £40,000 only. According to the given scenario, Greensleeves Ltd targets to earn a profit of £60,000 per month and thus it requires determination of the number of greenhouses that needs to be sold to earn the same. Target Profit £ 60,000     Planned Sales (Units) 875 Unit Sell Price £ 320 Unit Total Variable Cost £ 160     Total Revenues £ 280,000 Total Variable Cost £ 51,200 Total Fixed Cost £ 80,000 Forecasted Profits £ 60,000 The above calculation shows that if Greensleeves Ltd produces and sells 875 units of greenhouses per month then it will be able to earn profit of £60,000 each month. e) It is given that the company is considering an option to improve the design and quality of greenhouse. This initiative would require buying specialist materials and increasing direct labour time by minimum 2 hours. Also, the company expects direct materials per green house to increase from current £71 to £80. The company expects to sell the improved greenhouse at £370 per unit from present £320 per unit. Under these conditions, the expected changes in break-even point and margin of safety is shown as follows: Direct labour £ 10.50 9 £ 94.50 Direct materials     £ 80.00 Other Variable Costs     £ 15.50 Total £ 190.00 Variable cost/unit £ 0.25 Fixed Cost (Monthly) £ 80,000 Selling Price £ 370 Planned Sales (units) 750 Unit Price £ 0.49 (Units) Amount New Break-even Point 333333 £ 164,444 New Budgeted Sales 750 £ 277,500 New Margin of Safety  N.A £ 113,056 MOS (%)  N.A 40.74% The above calculation shows that the most probable implication of improving design and quality of greenhouse on BEP and MOS would lead to reduction in break-even point by 41,667 units to 333,333 units. This means that the margin of safety should also increase which is true in this case. The new MOS will increase from 33.33% to 40.74%. As discussed earlier, higher MOS will ensure increased potential of the company to withstand higher fluctuations in sales. Conversely, earlier the company could withstand up to 33.33% of target sales but now the company will be able to withstand 40.74% of budgeted sales per month. A significant drop in sales, say below 40% of budgeted sales, would result in net losses for Greensleeves. Based on the above discussion, the managers are advised to take up the option of improving quality and design of greenhouse. f) The break-even analysis is a tool that is popularly used by companies to determine how and when the company will be able to recover all expenses and thereby start making profits. The main variables that are related to core operations of any business are sales, variable costs and fixed costs. Not only does the technique uses all these variable, it also analyses the current pricing strategy of the company in terms of number of units sold (or planned) as well as per unit sell price. This technique considers fixed cost of the company which although is not influenced by volume of sales but definitely affect the net profit of the company during the period. The break-even analysis helps to answer the following: i. Will the product make money? ii. Is the fixed cost of the company too high with respect to sell price of product? iii. Is the variable cost per unit less than sell price per unit of the product? Certain assumptions that underpin the use of BEP analysis includes the following: i. Variable cost varies directly with changes in output ii. Variable cost per unit remains constant iii. Fixed cost remains constant irrespective changes in volume iv. Fixed cost per unit varies with the output The above discussion suggests that BEP-analysis can help the management of Greensleeves Ltd formulate appropriate pricing strategy and set realistic sales target. A target sales lower than break-even point will result in losses and hence it is a very important analysis for the purpose of planning. References Heitger, D., Mowen, M., and Hansen, D., 2007. Fundamental Cornerstones of Managerial Accounting. United States: Cengage Learning. Mittal, R., 2011. Management Accounting and Financial Management. New Delhi: Vaibhav Printers. Sinha., 2009. Financial Statement Analysis. New Delhi: PHI Learning Pvt. Ltd. Thukaram, R., 2007. Management Accounting. New Delhi: New Age International. Yahoo Finance, 2014. Thomas Cook Group PLC (TCG.L): Balance Sheet. [Online]. Available at: https://uk.finance.yahoo.com/q/bs?s=TCG.L&annual. [Accessed on May 14, 2014]. Appendix Table 1: Ratio Analysis Table 2: Task 2(a) Table 2: Task 2(b) Table 2: Task 2(c) Table 2: Task 2(d) Table 2: Task 2(e) Read More