Financial Fluency for Management Decision Making - Example

Financial Fluency for Management Decision Making

Income Statement

The term is one of the key elements applied by business entrepreneurs and accountants regarding financial statements. However, in most cases, the term is used to refer to the profit and loss statements (P&L) or sometimes to mean a statement of income (Barker, 2010, p.153). The income statement is a significant accounting component as it indicates the profitability of the firm during a given time interval within the specified duration in the heading.

Statement of Financial Position

The term refers to the financial position of a firm at a specific date. It is the Balance Sheet, comprising of three key elements such as assets, liabilities and equity (Deaconu, 2012, p.50).Statement of financial position of a business or entity is always classified.

Statement of CashFlows

A summary of the expected incoming and outgoing cash in an entity over a specified period of accounting, a month or a year. It is one of the key statements of financial accounting of business (Öztürk, 2015, p.399). Statement of cash flow indicates the sources as well as uses of cash by financing, operating and investment activities for a stated period. One of the important purposes of using this accounting aspect is to prevent and monitor the level of the company’s debt.

Statement of Changes in Equity

Often used to refer to the changes in equity for a corporation features such as a sole proprietorship, company or partnership entity. The chief objective of this accounting statement is to summarize the activities contained in the equity accounts for a specified duration. The accounting report indicates the firm’s equity movement in addition to accumulated wealth and losses to allow the company’s shareholders to describe on outlet equity and sources (Kiley, 2014, p.1058).

Q1b.

The revenue statement for the year ending 31st December 2015 indicates that the firm acquired higher sales revenue compared to the previous year (Arbidane & Volkova, 2012, p.9). The high sales revenue (470,000 pounds) witnessed higher gross profit (249,100 pounds) with a total expenditure (119500 pounds) and an operating profit of (130,100 pounds). For the year 2014, the sales revenue was 460,000 pounds that witnessed gross profit (239,200 pounds) with a total expenditure (116450 pounds) and an operating profit of (123,200 pounds). Comparing the two fiscal years using current ratio indicates the year 2015 to be advantageous (Cagle et al. 2013, p. 45).

Current Ratio = Current Asset/Current Liabilities

Current Assets = Sales Revenue (470,000 pounds)

Current Liabilities= Total expenditures + corporation tax (142828 pounds)

Current Ratio = 470000/142828

=3.291

For the year 2014,

Current ratio = 460,000/144683

=3.179

Cash refers to the physical form of currency such as coins as well as banknotes used in a country. In accounting and finance, the term relates to the current assets encompassing money. Current assets refer to currency equivalents that may be accessed immediately (Bostwick et al. 2016, p.341). Profit refers to the financial gain, majorly the difference between the amount acquired and the amount used up in operating, buying or producing item.A company success and the survival depends on both the profitability and growth (Fonda, 2016, p.52). Profitability is, therefore, essential to the company’s long-term survival in the business world. A firm’s net profit is the return after all the expenses associated with manufacturing, production and the product sales deduction (Collins, 2016, p.41).

Concept of Working Capital Cycle

Working capital cycle (WCC) refers to the sum of time it will take for a given firm to transform the net current liabilities and current assets into cash. A longer WCC means the company has a long tying up capital in its working capital without getting a revenue on it (Szpulak 2015, p.405). A positive working capital cycle balances outgoing and incoming costs to reduce net working capital and increase free cash flow (Haron & Nomran, 2016, p. 462).

Net Working Capital Ratio = Net working capital/Total Assets

Net working capital = Current Assets- Current Liabilities

NWC = 470000-142828

= 327172 pounds

Total Assets =106272 pounds

NWC ratio =470000/106272

= 4.423

Marginal Costing

In using marginal costing, only manufacturing costs are allocated to the item produced. The costing will include material cost, labor cost as well as the overheads. Fixed overhead are the cost not incorporated in the cost of product whereas the fixed are always considered as period costs (Correa et al. 2014, p.143).

Item

Quantity

Total (pounds)

Grade XY Faux leather

2

20.0

Zip

1

2.0

Labor

½ hour

4.0

Totals (pounds)

26.0

Absorption Costing

The term refers to a costing system that treats all costs of production of a firm as items cost regardless of whether they are fixed or variable costs. Under absorption costing method, the calculations involve direct material costs, direct labor as well as variable and fixed overhead costs (Gupta et al. 2010, p.890). The concept permits the allocation of a portion of the fixed manufacturing overhead cost to a unit of production, in addition to the variable manufacturing cost.

Items

Costs (pounds)

Premises Costs

20,000

Production Supervisor

18,000

Production Sundries

300

Marginal costing

26.0

Total (Pounds)

38,326

Alternative total cost

The term refers to the total expenditure incurred in reaching a particular level of output in case such total cost is divided by the quantity produced on average.The assessment is determined by:

(Average fixed cost + Average variable cost) x Number of units (3000)=Total cost

Fixed Cost = 200 pounds

Variable Cost = 600 pounds

(800)(3000)= 240,000 pounds

Item

Cost (pounds)

Fixed

200

Variable

600

Total cost

240,000

Advantages of Using Marginal Costing and Absorption Costing

One of the benefits of using absorption costing is that it is GAAP-compliant and needed for recording to the Internal Revenue Services (IRS).

Absorption costing puts into account all the costs involved in the production of an item. The costing includes a company’s fixed costs of operating such as salaries, utility bills, and facility rental.

Marginal costing is a straightforward and easy to understand to any firm that is intending to use the technique in book-keeping.

Disadvantages of Using Marginal Costing and Absorption Costing

One of the disadvantages of marginal costing is that total costs is not indeed isolated into fixed costs and variable costs.

Furthermore, for marginal costing the fixed costs keep on constant and variable costs are consistently varying depending on the output level.

Absorption costing can make a company’s level of profit to seem better than it is during an accounting period.

Absorption costing also fails to give a better analysis of cost and volume as variable costing provides during book-keeping.

Q3 Variance Analysis

Q3a. The Original Budget

Items

Quantity

Total Cost(pounds)

Sales

50 units

1000

Direct labor hours

25 hours

200

Grade MQ faux

50 units

140

Total

1340

Flexed budget April

Original (pounds)

Flexed (pounds)

Actual (pounds)

Sales

1000

190

810

Direct labor hours

200

56

144

Grade MQ faux

140

-163.75

303.75

Total (pounds)

1340

-82.25

1257.75

Variance in Sales Volume and Variance in the Average Selling Price

Sales volume variation is the measure of change in profit because of the difference between actual budget and the estimated sales quantity.The variance quantifies the effect of alteration in the level of sales on the profit as well as the average selling price. The nature of the sales volume variance (SVV) helps in establishing a meaningful investigation of other variances in preparing the operating accounting statement.The variation in the selling price caused the profits of the firm to change resulting in higher revenues.

Variance in the Labor Efficiency and Variance in Labor Rate

Labor efficiency variance is an accounting term that measures the difference between the number of direct labor hours you budgeted for and the number of actual time (hours) the employees work. The variance helps indicate how good a small business manages its direct labor costs during a period regarding gaining profits.Variance in labor rate for this case increases the profits for the firm since the number of days needed to complete the task is reduced therefore reducing the overhead costs.

Variance in Material Quantity Used and Variation in Material Price

Cutting the material supply from 50 units to 45 units affected the revenue attained by the firm, therefore, implicating on the profits achieved during the sales. Variation in the price of material reduces the profits although this can increase the sales but with the reduced material quantity lowers the profits.

Flexed budget May

Original (pounds)

Flexed (pounds)

Actual (pounds)

Sales

1000

190

810

Direct labor hours

200

11

189

Grade MQ faux

140

265

405.0

Total (pounds)

1340

341

999

The best measure to take is to use versed labor since it will be economical and improve the profit of the company. Since increasing of either work rate or working hours does not necessarily enhance the benefit of the firm. Labor efficiency variance is the primary driver of profits for this Myla’s business.

Q4a. NOTE: for all calculations, the currency is in pounds

• Payback period

= 200000/60000

=3.33years

• Accounting Rate of Return

ARR = Average Accounting profit/ Average investment

Annual depreciation= (initial investment- scrap value of the item)/ useful life in years

AD= (200000-20000)/5

= 36,000

Average accounting income = 60,000-36,000

=24,000

Accounting Rate of Return = (24,000/200,000) x100

ARR=12%

• Net Present Value

NPV = (-200000) + 60000/ (1+0.5)1 + 60000/ (1+0.5)2 +60000/ (1+0.5)3 +60000/ (1+0.5)4 +60000/ (1+0.5)5

NPV = 259,768.6-200,000

=59,768.6

• Internal Rate of Return
• NPV @ 10%

60,000/ (1+0.1)1+ 60,000/ (1+0.1)2 +60,000/ (1+0.1)3 +60,000/ (1+0.1)4 +60,000/ (1+0.1)5= 227,447.21

= 227,447.21-200,000

=27,447.21

IRR = ra + NPVa (rb-ra)/ (NPVa- NPVb)

IRR = 0.05 + 59768.6(0.10- 0.05)/ (59,768-27,477.21)

IRR= 0.143

• NPV @ 20%

NPV = 60,000/(1+0.20)1 + 60,000/(1+0.20)2 + 60,000/(1+0.20)3 +60,000/(1+0.20)4 + 60,000/(1+0.20)5 - 200,000

NPV = 179,436.73-200,000

= -20,563.27

IRR = 0.05 + 59768.6(.20-0.05)/ (59,768.6- (-20,563.27))

= 0.162

Payback period refers to the span of time needed for an investment to recover its initial cost regarding profits (Kim et al. 2013, p.115).

Accounting rate of return refers to total profits a firm can anticipate based on the amount of capital invested. It is also known as the simple return rate.

Net Present Value is a famous measure of the profitability used in a business budgeting to assess a particular project’s possible return on the investments made (Merlo, 2016, p.40).

Internal Rate of Return refers to the interest rate at which the net present value (NPV) of all cash flows from a project. The IRR of a project is to evaluate the attractiveness of that project regarding investments.Consequently, if the IRR of designed project exceeds the firm’s required rate of return, therefore, the project will be considered desirable.

Advantages of Payback

The method is commonly used by a business analyst for various reasons because it is simple to use by finance and accounting personnel.

The concept is easy to understand by accounting staffs for either large or small businesses.

Disadvantages of Payback

The method often overlooks the time value of money at the duration prepared

The model/concept does not consider cash flows from the project that might occur immediately after the recovery of initial investment.

Advantages of Accounting Rate of Return

ARR provides an accounting information needed for bookkeeping. Consequently, other individual reports are not needed for determining ARR.

The method is straightforward and easy to evaluate and understand

ARR technique is an accounting profit reflection, therefore, measures the profitability of project investment.

Disadvantages of ARR

ARR method overlooks the time value of monetary

The method also overlooks the cash flows from investment

Advantages of NPV

The method considers the basic concepts that a future dollar is less worth than a dollar at present

The technique also indicates to whether an investment will generate value for the firm and by how much regarding dollars.

NPV method ponders the cost of investment as well as the risk inherent in creating projections about the future.

Disadvantages of NPV

The greatest disadvantages of the technique are that it requires some guesswork concerning the firm’s capital cost.

Furthermore, the NPV method is not suitable for comparing two projects of different size.

Advantages of IRR

The IRR technique considers the time value of money in assessing a project

The method is simple to use, understand and interpret after the assessments.

Disadvantages of IRR

The technique ignores the economies of scale

Q5.

Sales & Gross Profit

Sales505,000

Cost of Sales277,750

Gross Profits (pounds)227,250

Gross Profit (%)45

Sales 176,000

Cost of sales96,800

Gross Profit 79,200

Gross profit (%) 55%

Sales 40,500

Cost of sales32, 400

Gross Profit 8,100

Gross Profit (%) 20%

Total Sales 721,500

Total Cost of sales 374,550

Total Gross Profit346,950

Total Gross Profit (%) 48.09%

Expenditure

Salaries60,000

Rent12,000

Business Rates3,000

Gas & Electricity3,600

Insurance2,400

Other expenses4,800

Depreciation1,200

Total 87,000

Profit

Operating 259,950

FinanceNIL

Profit before Tax259,950

Causes of Changing Gross Profit Margin

The gross profit margin for a business is the percentage of the firm’s returns after the deduction of the cost of items. Decreasing the gross profit margin in the long-run may be of significance. A firm may decide to reduce the profit margin by pulling down the cost of the goods the company sells. Increasing the operating profit margin is often beneficial to the operation of a business entity. Though, if a firm momentarily reduces its gross profit margin, it might create directed efforts to raise its operating profit margin to compensate for the loss.

Cash Inflows

Sales Receipts (30-day term sales) 22,000

Sales Receipts (60-dayterm sales) 44,000

Sales Receipts (cash sales) 721,500

Other Cash Inflows 5,000

TOTAL CASH INFLOW 792,500