Managerial Accounting - Margin of Safety - Assignment Example

Managerial Accounting Student’s Name Institution’s Name Date Managerial Accounting Margin of Safety The margin of safety refers to the quantity of sale dollars or the number of units by which actual sale can decline below the budgeted or anticipated sales before a loss is registered. It is the rate reduction which can take place before a business breakeven is attained. The concept of margin of safety is useful when an important sales proportion is at risk of elimination or decline, as it might be the case when a contract of sales is coming to an end. A small margin of safety may trigger action to lower expenses. The opposite condition might occur when the safety margin is considerably high that a business is highly safeguarded from variations of sales. In dollars, margin of safety computation involves the subtraction of break-even sales from actual or total budgeted sales. It can also be computed in percentage where the obtain margin of safety in dollars is divided by actual or total budgeted sales in dollars. There are two forms of margin of safety. They include budget based and unit based margin of safety. Budget based margin of safety involve using the budgeted level of sales in place of current sales in the margin of safety computation. Unit based margin of safety on the other hand involves employing number of unit sold in place of current sales level in the formula (N.a., n.d.). The term margin of safety was made popular by Benjamin Graham who is regarded as the founder of value investment, together with his followers. Graham highly employed this concept in the stock market. Margin of safety in stock market is regarded as investment principle where an investor only buys securities when the market price is considerably below the intrinsic value. When market price is considerably below the investors’ intrinsic value estimation, the margin of safety is the difference and this difference permits making of investment with low downside risk. Although margin of safety does not warranty a successful investment, it gives a room for error in the judgment of analyst. According to Chew (2015), the determination of intrinsic value of a company or its true worth is very subjective. This is because every investor contains a varying way of computing the intrinsic value that might or might not be accurate. Moreover, it is highly complex to predict earnings of a company. In this regard, margin of safety offers a cushion over calculation errors. The actual concept behind margin of safety in the stock market can be explained based on Graham’s principle. Graham founded his principle on simple truths. He clearly understood that the price of stock would vary in the future compared to the current value; it could be more or less than the current value in the future. He also understood that the current dollar valuation could be off and this, subjecting investors to avoidable risk. In this regard, Graham established that an investor can substantially reduce his or her risk by purchasing stock at a discount to its true value. Although there is never an assurance that the price of stock would augment, the discount offers the margin of safety required for an investor to guarantee that losses would be reduced. According to Klarman (1991), margin of safety is highly preferred by value investors who permit room for imprecision, analytical error, and bad luck so as to evade sizable losses with time. A margin of safety in Klarman (1991) is essential since valuation is a vague art, which is based on unpredictable future, and done by human who can easily make mistake. Investors employ all possible tactics to maximize on their returns and to reduce on losses. However, the volatile state of the market makes it hard to maximize on better returns. Value investors thus consider investing with margin of safety as a way of protecting themselves from great losses in the market, particularly in the declining markets. In this case, value investing refers to the principle of purchasing security as significant discount from the actual underlying value and putting them on hold until they gain more value. In value investors’ language, this involves purchasing a dollar for 50 cent. Value investing integrates the conservative evaluation of fundamental value, with the requisite patience and discipline to purchase when enough value discounts is accessible. Clarification of the Employed Key Words Intrinsic value: refers to the company’s actual value or an asset founded on an underlying view of its actual value that include all business aspects, with regard to both intangible and tangible factors. This value might or might not be the same as present market value. Intrinsic value is also basically employed in pricing of options to show the monetary value of an option. Downside risk: refers to an approximation of potential of security to suffer value decline if the conditions in the market change. It refers to the level of loss which could be experienced due to decline in the value. Based on the employed measures, downside risks describes a worst investment scenario, or the amount an investor can lose Margin: Refers to the variation between selling price of a service or product, and its cost of production, or the company’s expenses versus company’s revenue ratio. Market price: refers to the current price that a service or asset can be sold or bought. Based on economic theory, market price converges at a section where the forces of demand and supply meet. It can highly be re-evaluated if there is a shock in either demand or supply side. Actual cost/price: it is the present true prices of security in the market. Budgeted Cost: Is the anticipated prices or cost of security Stock Market: Refers to the market in which shares of public companies are traded and issued either via over-the-counter markets or exchanges markets. Stock market is among the most essential aspects of free-market economy, since it gives firms with capital, access in exchange for providing investors a share of ownership in the firm. Price: a value which will purchase a finite weight, quantity, or other measures of services or goods. Breakeven analysis: It is an evaluation employed to establish when a business will manage to cover all its costs and start making a profit. It involves noting the cost of production, and the market prices to establish the point in which the cost matches the prices in the market. Output: the amount of services or good produced by a company for a particular time period. Breakeven point: The point where total revenue is equal to total cost of production. It can be expressed as sales or units dollars. Breakeven point in unit can be computed by dividing fixed cost with the contribution margin for every unit. In sales dollars, breakeven point is computed by multiplying break-even amount units by the sales in every unit. Margin of Safety in the Accounting Standards In managerial accounting, margin of safety is an accounting tool which assists financial managers to understand the level in which sales can decrease before a firm reaches its breakeven. Margin of safety is an accounting tool that is highly guided by the available accounting standards. Various accounting standards restrict the provision of margin of safety, by focusing more on income statement. According to Fabozzi (2001), the income statement demonstrates the income, expenses, and revenues of a corporation over a time period. Based on the accounting standards, a company have to develop income statements for the interim and fiscal year periods. In this preparation, companies are required to provide comprehensive analysis of the common stock, preferred stock, and bonds. Based on the accounting standard requirements, the fixed income security holders of margin of safety need to be provided by the cash flow and earnings of a corporation. The business value of a company shows the amount that can be gained on the invested capital and the company generated cash flow. In this regard, the analyst has to establish a factual earnings base of recurrent earnings from which, volatility and growth of earnings and dividends might be projected. Everything a common stockholder can attain from investment are capital appreciation or/and dividends. The two are both reliant on future earnings, and investors’ expectations of dividends and future earnings. Beside this, the available accounting standards provide that the company provide clear financial ratio analysis to assist investors evaluate their investment risks. Some of the ratios that guide investors in determining margin of safety are the company’s debt ratio and the leverage ratio. Leverage ratio refers to long-term debt as a total capitalization. The higher the debt level, the higher the operating income percentage which has to be employed to handle fixed duties. Analysts are required to evaluate the margin of safety for a company with high leveraged. The long-term debts are documented in the balance sheet and thus, the income statement and the balance sheet have to be done as per the required accounting standards to enhance analyst ability to evaluate the margin of safety of a company, to be able to guide investors accordingly (Fabozzi, 2001). Numerical Value Example to Demonstrate Margin of Safety The numeric value example is based on Arkan Building Materials Co. which is UAE company founded on 15th of January 2006. The corporation was established for the purpose of developing and owning businesses and companies engaged in the construction-associated sector (Adx.ae, 2015). Breakeven point Breakeven point is computed as fixed cost divided by gross profit margin, or fixed costs divided by the contribution margin. In this case, the contribution margin is computed by subtracting variable costs from sales price. The computation will be based on the company’s 2015 financial statements. Based on this statement, the company’s revenue or sales was 876926, and cost of business operation was 662,630. In this case, the gross profit margin of the company for the year was (Adx.ae, 2015): Gross profit margin = Revenue - cost / revenue = 876926-662630 / 876926 = 214926 / 876926= 0.245 and in percentage this is equivalent to 24.5%. The computation outcome is used to compute the breakeven point which is given by: The Company’s fixed cost is equivalent to 107187 = fixed cost / gross profit margin = 107187 / 24.5% = 437497.95 Margin of Safety Margin of safety is computed as sales revenue – breakeven point/ sales revenue x 100% =876926 – 437500/ 876926 = 439426/ 876926 x 100% = 0.501 x 100% = 50.11% Interpretation of the Results The analysis result demonstrates that Arkan Building Materials Co. has a positive margin of safety of 50.11%. This implies that the company can manage to reduce its current level of sales by 50% without incurring any losses. The company is about 50% above the breakeven point which simply demonstrates that that the company is making a considerable amount of profit from its current sales. This shows that the actual company’s earnings are far beyond the breakeven point in which the cost of sales is equivalent to the company earnings. The company expenses are highly manageable and can be catered by the amount of revenue the company is acquiring from its sales, and on top of that, the company will manage to make 50% gains from the sales. In this regard, this company can be considered safe to invest in, since it has a high ability to enhance returns in any investment. It is considerably hard for this company to fall to a level that it cannot earn profit. Margin of safety is an important managerial tool that can be used to measure the business trend and the level in which the company can still operate safely without registering losses. In addition, this demonstrates that the company does not have a lot of debts that it is paying which could increase its level of expenses and reduce its profitability. Thus, investors can easily gain from its level of profitability and be protected from any financial risk that would be brought about by depending highly on debts. References Adx.ae. (2015). Arkan Building Materials Company (ARKAN) PJSC: Financial statements. Retrieved from < https://www.adx.ae/English/News/Pages/20160413133200428-ARKAN-EN.PDF> Chew, J. (2015). Chapter 20: “Margin of Safety” as the central concept of investment by Benjamin Graham. Retrieved from < http://www.valuewalk.com/wp-content/uploads/2015/09/Chapter-20_Margin-of-Safety-Concept.pdf> Fabozzi, F. J. (2001). Bond credit analysis: Framework and case studies. John Wiley & Sons. Klarman, S. A. (1991). Margin of safety: Risk-averse value investing strategies for the thoughtful investor (1st ed). HarperrBusiness N.a. (n.d.). Chapter 3: analysis of cost, volume and pricing to increase profitability. Retrieved from < https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwjKtrjZ4bnOAhXlCMAKHYYLAHcQFggiMAE&url=http%3A%2F%2Fhighered.mheducation.com%2Fsites%2Fdl%2Ffree%2F0070900493%2F76580%2FSample_chapter.pdf&usg=AFQjCNGa7u6ZH4VBGxri9ESndeGNqzQpHQ&sig2=HprgNIJL4hxepDkinDwnxA&bvm=bv.129422649,d.d2s> Read More