Accounting and Finance for Managers - Essay Example

Accounting and Finance for Managers Introduction This paper has discussed various accounting activities with respect to practical scenarios to enhance the knowledge of the managers. The focus of the paper has been mainly related to ratio analysis, budgeting and project evaluation with respect to capital budgeting. In addition, the project has also focussed on relevance of cash flow projection in evaluation of an investment outlay over profit projection. The paper has also highlighted the causes and consequences of financial crisis of 2008 and the impact of it on international corporate governance code. Section A a) Ratio analysis a) Interpretation of ratios and comment on financial position of Nene plc. Profitability ratio: ROSF: The return on shareholders’ fund implies effectiveness of firm in utilizing the investment of shareholders. The ROSF of Nene Plc. shows that for every £ 100, the return is £ 53.07 that has reduced to £ 44.28. The ratio of 2013 compared to 2012 shows that Nene Plc is not utilizing shareholders’ fund appropriately. To improve shareholders’ prospective, higher ratio is important, thereby maximising its earnings. Hence, the firm needs to work towards improving the ratio (Siddiqui, 2006). ROCE: Return on capital employed expresses effective utilisation of total capital that the firm has, including total assets as well as liabilities. When the firm’s profit is expected to be higher than return on capital employed, only then the firm will be considered efficient. Out of £ 698300, 34.86% is the return earned by the firm. The ratio has further improved in 2013, which indicates that the firm has utilised overall capital appropriately (Drake, n.d.). Net profit margin: The net profit margin of Nene Plc was 9.79% in 2012, which has declined to 8.96% in 2013. Apart from unusual situations, a declining net profit margin is not considered favourable. However, there are situations such as, increase in interest, fixed and variable costs, which can affect the net profit margin (Alexander, 2001). Gross profit margin: The gross profit to sales ratio has grown from 2012 to 2013 by 0.61%. This reveals the fact that Nene Plc is expanding, but its net profit reflect negative trend because of various factors such as, increase in wages and salary, office expenses and so on (Alexander, 2001). Efficiency ratio: Stock turnover period: The stock turnover period of Nene Plc has increased from 1.86 months to 1.94 months in 2013, which is approximately 2days. Since the difference is not considerably high, it is not a concern. Yet, the firm must focus on reducing its stock turnover period to improve efficiency. Average debtor and creditor settlement period: For any firm to perform efficiently, its creditor turnover period should always be higher than debtor turnover period. In 2012 and 2013, this concept has been well-adopted by Nene Plc. A reduction in debtor collection period marks adoption of efficient collection technique, reducing likelihood of bad debts. Moreover, creditor settlement period also has declined by approximately 5days, implying that creditors are being paid quickly. This enhances credit worthiness of the firm. Sales to capital employed: The ratio shows consistent improvement in sales with respect to capital employed by the firm. The possible explanation of this situation is that the firm has implemented effective marketing strategies in order to sell their product, which resulted in sales growth, exceeding the capital employed (Grier, 2007). Liquidity ratio: Current ratio: The current ratio is also known as working capital ratio as it takes into account the relationship between current asset and current liabilities of a firm. Although the stable liquidity ratio is 2:1, that of Nene Plc does not exactly represent a critical scenario in terms of firm’s liquidity. The ratios of 2012 and 2013 respectively indicate that the firm’s liquidity has declined, but the firm is still being able to meet its current obligations (Hachmeister, 2007). Quick ratio: In quick ratio or acid test ratio, stock is not considered under quick asset (current asset-stock) because it cannot be converted in cash immediately. The most stable liquid ratio is 1:1, but that of Nene Plc is quite less than the standard value. Nonetheless, this does not imply ill-liquid scenario. The firm has fast moving inventories, which provide better liquid position, despite low liquid ratio (Hachmeister, 2007). Gearing ratio: Capital gearing ratio: This ratio indicates the extent to which a firm employs fixed dividend and/or interest bearing capital (loans, debenture and preference share capital) with respect to non-fixed dividend bearing capital (equity capital, reserves and retained earnings). In 2013, the firm has considerably reduced dependency on debenture. Nene Plc can be regarded as a high-geared company (employing more equity capital) on grounds of its capital gearing ratios in 2012 and 2013. Interest coverage ratio: The interest coverage ratio is very important for creditors as it shows whether the company is in a position to pay interest from profit earned. The interest coverage ratio of Nene Plc for 2012 and 2013 is considerably high, which implies that the firm would not face difficulties in covering interest charges (Siddiqui, 2006). Investment ratio: P/E ratio: The price earning ratio of Nene Plc suggests that the firm’s earning power has improved considerably from 2012 to 2013, which is important for maintaining financial position. Dividend payout ratio: The dividend paid by the firm has improved from 2012 to 2013 and so has the dividend payout ratio, but percentage of dividend paid by the firm is quite low. This could possibly be explained as the firm has re-invested a greater share of earnings in the business (Damodaran, 2012). b) Limitations of interpreting financial performance and importance of maintaining caution while drawing conclusions and making recommendations Interpretation of financial performance, in terms of ratio analysis, is subject to certain limitations. The ratios are calculated on the basis of financial statements such as, balance sheet and profit and loss statement. These statements alone cannot accurately determine financial position of the firm. For a complete picture of a firm’s financial structure, cash flow and fund flow statements are equally important. Moreover, financial statements are greatly influenced by different accounting principles and conventions. While deriving conclusion and recommending changes with the help of ratio analysis, comparative factor must be taken in consideration. Ratio analysis is not helpful unless the data is compared and analysed, when past data is available of 4-5 years. These comparisons reflect practices of the past, but fail to provide an idea of future trends, in terms of market, demand, management policies and operations (Delen, Kuzey and Uyar, 2013). An organisation is influenced by financial as well as non-financial factors, but financial analysis ignores the non-financial factors. Decisions made on the basis of financial interpretation may often prove futile for a firm as these interpretations are mere indicators of the scenario. In addition, financial interpretation is often influenced by personal biasness. Different interpreters can portray a situation in dissimilar manner (Nissim and Penman, 2001). Section B Q 1 I. Budget statement when Labour amount is £ 20000- To determine profit in the light of labour shortage, the limiting factor analysis has been employed in the scenario. The contribution of the initial budget plan was calculated and new variable cost of labour was allocated in the order of highest contribution. Limiting factor analysis ensured that even with the constraint of labour shortage, allocation of labour was done in such a way that maximum contribution as well as profit is achieved. After applying different combination of labour cost, the best suited amount was assigned to all three services so as to maximise profit. Earlier, the amount for labour was £ 27000 which later on reduced to £ 20000 due to shortage of labour. When breakeven point was calculated it was observed that by allocating £5000, £4000 and £11000 the maximum profit can be obtained in the given scenario. As compared to profit in the given budget plan that was £ 19000, that of the current budget is £ 26000. II. What steps could the business take in an attempt to improve profitability, in light of the labour shortage? The two most important steps that help a business to achieve profitable situation with scarce resources such as, labour shortage, are limiting factor analysis and breakeven analysis. Through these analyses, business can determine the minimum labour requirement to maintain its budgeted sales amount as well as enhance profit (Levine, 2005). Breakeven analysis helps the firm to obtain a clear picture of the minimum required resources to earn minimum profit. It efficiently indicates when the firm is running losses, when at break-even point (no profit–no loss scenario) and when about to yield profit (Garrison, Noreen and Brewer, 2003). In situations where an organisation faces the problem of labour shortage, the first step towards sustainability is to reallocate available labours in such a manner that all tasks are well-managed. The firm can attempt to upgrade skills of the existing labours. Moreover, introduction of performance-based rewards also increases efficiency of existing workforce. In addition, when there is an acute labour shortage, the firm can replace manual jobs with automated machines, whenever possible (De Kok and Uhlaner, 2001). Q 2 Calculation of NPV, IRR, ARR and Payback period: Project Meeney Miney Mo (i) NPV £ 11,633.21 £ 813.66 £ 5,795.99 (ii) IRR 19.71% 11.41% 16.83% (iii) ARR 29.33% 25.33% 32.00% (iv) Payback Period 2 years 2.18 months 3 years 3.43 months 3 years 3.27 months (Refer to excel sheet for calculation) (v). Memo to the Board of Millennium Plc, for advice related to acceptance and rejection of project: TO: Board of Millennium Plc FROM: DATE: SUBJECT: project evaluation Analysis of the given three projects, Meeney, Miney and Mo, using the capital budgeting technique shows that Project Meeney has the maximum net present value of £ 11633.21 and hence, is an obvious choice for investment. Furthermore, internal rate of return method also supports the same project for highest projected rate of return for the given discounting rate of 20%. Nonetheless, accounting rate of return is highest for project Mo, but drawbacks related to ARR method such as, inconsideration of time value of money and future risk, makes it unsuitable. In addition, payback period when calculated for the three projects showed that project Meeney has the least payback period of 2 years and 2.18 months. This means that the project will return initial investment within the same period. Therefore, keeping the analysis in view, most suitable project for acceptance is Meeney. (vi) Importance of cash flow projections over profit projections to assess the viability of proposed investment projects- There are a number of disadvantages of profit projection method, which ensures that a firm is guided by cash flow projection method while accepting a project. Profit projection is usually helpful when applied on a short-term analysis, such as, for a year. Profit projection is often done department wise, which results in an ambiguous outcome. Also, profit is revenue dependent and over or under estimation of revenue may result in improper evaluation of given projects. Profit projection is of greater use when company’s profitability is concerned. For a project selection, profit projection is not assistive as it cannot anticipate profit as well as cost (Schleifer, Sullivan and Murdough, 2014). On the other hand, cash flow projection is a better option for evaluation of projects. It is more focused towards future inflows and return, rather than historical results such as, profit earned in previous years. While profit determination process is influenced by various accounting principles and assumptions, no such practice is considered in cash flow projection methods. These methods produce rational and reliable outcome. Moreover, cash flow projection is highly beneficial when a number of projects are to be considered for investment (Kruschwitz and Löffler, 2006). No profit projection method can ever determine the period span within which a firm can gain the initial investment employed in the project. On contrary, the payback period method of cash flow projection can easily calculate the same (Jennergren, 2008). While calculating and forecasting profit based on sales pattern is only a single method, cash flow projection incorporates a number of techniques, such as, NPV, IRR and Payback Period, for evaluation of projects (Jennergren, 2008). Section C a) The reasons for the global financial crisis of the 2008 and impact of it on corporate governance codes The global financial crisis of 2008 had surfaced long back. Around 2001, various banks in USA were found to be lending on a large scale to subprime borrowers with faulty credit histories as well as initiated unregulated trading of financial securities and mortgage-based securities (Ivashina and Scharfstein, 2010). By 2007, majority of these loan amounts were invested in housing properties and demand raised the property price. The debtors failed to meet the high interest rates, which grew quicker than their income. As a result, individuals started selling off their property to repay loans. The large scale selling of properties resulted in a sharp drop in price of properties and as an outcome of this house bubble burst, major banks including Lehman Brothers collapsed (Acharya and Richardson, 2009). Many banks declared bankruptcy and initiated limited and secure lending. This further added to shrinking of economy. The government, financial regulators and rating agencies are also to be blamed for this situation as they succumbed to lucrative short-term profit (Grigor′ev and Salikhov, 2009). Post financial crisis, when the macro-economic environment demanded involvement of corporate governance, several flaws were pointed out in the system. Huge discrepancies were observed in incentive system, risk management and control systems. Keeping in view severity of the weaknesses, corporate governance codes underwent a transformation (Kirkpatrick, 2008). The key regulations that were introduced are: incorporation of financial stability board, involvement of Basel committee in banking supervision, introduction of green paper by EU on corporate governance framework (European Commission, 2011); and in UK, Walker review was prepared by Institute of Chartered Secretaries and Administrators for Sir David Walker. The report comprises policies recommended for improving risk management in UK banks (ICAEW, 2014). In US, Dodd-Frank Wall street Reforms and Consumer Protection act were introduced. Overall, risk management has become the most important concern for all financial institutions worldwide, in terms of corporate governance (Acharya, et al., 2010). b) Define budgeting and explain why organisations need to budget, plan and forecast financial performance. Budgeting is the process of determining long-term and short-term financial goals of a firm. It is a method of apportioning the fund available to a firm to various expenses. Budgeting provides with a plan to allocate the cost as well as maintain sufficient funds to meet contingent affairs. Budgets can be of different types namely, cash budget, sales budget, master budget and so on. Furthermore, a number of budgeting approaches are employed by firms such as, fixed budgeting, flexible budgeting, activity based budgeting and zero base budgeting (Chaston, 2008). The planning, budgeting and forecasting (PBF) process is often considered as a time consuming process, but it lays the foundation of an effective business venture. Planning is important for directing financial objectives. Planning is the first step of any activity. Planning can be annual (1 year), long term (5-6 years) and strategic (10 years and more) in nature. Planning is necessary to guide the budgeting process (Neely, Bourne and Adams, 2003). Budgeting is to determine requirements relevant to the plan laid out. It is often done prior to real execution of the plan. This helps in scrutinizing and evaluating time, besides reducing chances of error. Since most projects involve huge investment, planning and budgeting is very important. An appropriate budget ensures that invested amount is properly allocated in all activities (Frazier, 2012). Forecasting is a method of predicting the business’s future based on previous and present data. In forecasting method, calculations are done to analyse the trend of sale, profit and cost. Forecasting is essential for product planning, determining demand and production plan as well as requirement of labour and raw material. Effective forecasting method results in reduction in cost and improvement in profit (Catahan Jr, et al., 2009). Conclusion The paper has done ratio analysis for 2012 and 2013 by taking in account the financial statements Nene Plc and has drawn inference about their financial position. Thereafter, the paper has tried to prepare a budget statement for a firm where due to labour shortage; the amount allocated for skilled labour has reduced considerable but the firm need to maximise its profit within the given constraint. In the next part, the paper has calculated NPV, IRR, ARR and payback period for 3 projects of Millennium Plc for 5years and memo has been writer to the board regarding the evaluated projects. 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