Financial Decision Making Process within the Organisation - Essay Example

Financial Decision Making Process within the Organisation “Financial management is the process of planning decisions in order to maximise the owners’ wealth” (Shim & Siegel, 2000). Financial managers are responsible to manage the cash, acquire the funds, raise and allocate financial capital for their respective firms. However the above mentioned decisions must be arrived after considering the risk- return trade off. The importance of the financial management lies in the decisions taken and the outcome of the same. An appropriate financial management helps to obtain adequate funds for the firms at a minimum possible cost and ensures effective utilisation of the acquired funds to maximise the shareholders’ profits. Apart from generating profits from the shareholders, financial management also aims to maximise the profitability of the company to ensure a sustainable growth in future. Ensuring the sustainability of the organisation through proper reserve creation and re-investment of the profit amount is one of the crucial tasks in the realm of financial management. Financial Statement analysis and making investment decisions are two most crucial responsibilities of the financial managers. Financial Statement analysis includes the analysis of various ratios and financial statements like balance sheet and profit and loss account. A balance sheet discloses the financial condition of an organisation in a specific period of time. It mainly shows “what is owned by a business, what is owed, and the owner’s share (or net worth) of the business” (Langemeier & Klinefelter, n.d.). A profit and loss statement of any company discloses the organisation’s revenue and expenses for a specific period of time. Ratio Analysis Financial ratios assist in the evaluation the financial reports like balance sheet and profit and loss statement (Brigham, Ehrhardt, 2008). There are four types of ratios. These are liquidity ratios, solvency ratios, efficiency ratios and profitability ratios. Liquidity ratios are those ratios which measure the liquidity state of the organisation by evaluating the company’s liquid assets against its current liabilities. Financial leverage has certain important implications on the performance of the organisation. This mainly takes into account the long term liabilities against the total capital employed. This is also known as the ‘gearing ratio’ (Financial Times, 2009). A certain level of financial leverage can result in huge profitability; however, the company must be aware of the risk attached to it. Interest coverage ratio measure the ability of any firm to pay its interest by assessing its operating profit against the interest payable (Fund A Business, 2010). Efficiency ratios evaluate the efficiency with which the management uses its assets and capital (Bizwiz, n.d.). These include Debt collection Period, Creditor’s turnover ratio and Stock Turnover ratio. Finally profitability is the result obtained after executing the policies and decision in various sphere of financial management (Brigham & Houston, 2007). The above mentioned ratios provide significant clues to the financial and operational effectiveness of the firm. However the profitability ratios show the combined effects of liquidity, asset and debt management on the operating results (Brigham, Ehrhardt, 2008). Investment Appraisal Methods Investment decisions are crucial for maintaining a safe and sustainable growth of any organisation. Before zeroing down on any project, it is very much essential to evaluate the project using different Investment Appraisal Methods. These methods include Net Present Value, Internal Rate of Return (IRR), Pay Back Period and Profitability Index (Williamson, 2003). Net Present Value (NPV) considers the time value of money. The NPV method is useful to compare the similar projects with equal amount of cost while the IRR method enables the comparison of projects having different values (Bized, 2007). Profitability index of any project provides an assessment of its net present value against the initial capital outflow. The most simple investment appraisal method is the Pay Back Period, which is quite useful while comparing projects with shorter durations (British Computer Society, n.d.). The method considers the duration taken to repay the initial cost of a project. One of the limitations of this method is that the payback period does not take the time value of money into consideration. Certain conflicts can arise while evaluating any project using these methodologies. Financial managers must zero down on the project through a cautious evaluation of the same. Answer to the question no 1 a) The above table shows a number of ratios, calculated for both the company, Bronte Limited and the industry it is operating in. The image, provided below, discloses information about three ratios, Gross profit Margin, Net Profit Margin and Return on Capital Employed. Bronte Ltd has noticed almost parallel, slightly upward shift in the straight lines in the year 2009 from 2008. This means that the changes in gross profit, Profit before Tax (PBT) and Net Profit were almost consistent. Looking at the ratios of the industry and the company, it is quite apparent that the gross profit margin of industry has been quite low compared to that of Bronte in that year. Despite it, the industry has been able to generate more net profit compared to that of the organisation. The reason behind this seems to be the comparatively higher tax deduction the company faced in that year. In addition to it the low debt ratio of the company, compared to that of the industry it operates in could be another major cause. Even the return on capital investment is quite good for the industry, indicating the fact that the administrative expenses might be quite high for the company. Hence, despite of having a high gross profit margin, the company failed to make higher profit before tax against total capital employed. The above image is the graphical representation of the current ratio and acid test ratio for the company as well as for the industry. There has been a decline in the company ratios from 2008 to 2009 is quite noticeable. Despite the increase in the inventory and receivables value, the current assets have seen a drastic decline. The rationale behind it is that the company has drastically reduced most of their liquid assets as bank balance and enhanced their noncurrent assets. Such a circumstance led to a sharp decline in, the liquidity position of the company, which in turn will increase the probability of default for the organisation. Even when compared to the industry, the liquidity position of the organisation is quite low, which can be an agonizing sign for the company. Looking at the trends the company is showing in the case of Inventory turnover ratio, it is apparent that the higher inventory turnover ratio in 2009 is because of the higher inventory level it held in that particular year compared to that of 2008. That is the reason that despite of an increase in the cost of sales the ratio did not see a decline in 2009. The increase in the receivables collection period can also be attributed to the high receivable amount the company had in the year 2009. In 2009, the company had paid off some of its obligations. Hence the company has seen a low payables payment in 2009. The 2009 figures for the company has shown the same trend with the industry figures, as it had earlier shown in 2008 . The changes in the first two ratios can be attributed to the higher receivables and inventory level. Payable payment ratio has seen a difference because of the reduced obligations of the company or higher cost of sales in that particular year. The graph, presented above, provides an assessment of its debt amount against the capital employed. The Industry has higher gearing ratio when compared to the company. The reason is that the industry holds a higher amount of debt as a percentage of the total capital employed. In 2009, Bronte, although, had slightly increased its debt percentage, still the company possesses a very low debt amount. It seems that the company carries low financial leverage and prefers to finance the organisation with higher amount of owners’ equity. This may be advantageous for the company from the point of view that this would reduce distress risk for the company. However, having more equity on its portfolio, the company is losing on its tax shield amount; hence it has to face higher tax deductions which in turn would reduce the profitability of the company. The company’s strength lies in its profitability, low debt amount resulting in reduced financial distress risk. However the company has its weakness mostly in the lower current and acid test ratios. This can increase the probability of default for the company. b) As stated above, the company is holding much low liquid assets, which means that in distress the company will not be able to lay its hands on its liquid assets. The situation can be threatening for the company. The company should enhance its liquidity position and add more cash and cash like assets in its portfolio. Apart from this, the company has increased its inventory level, which would incur a higher inventory holding cost for the company. This may be the reason that the company has incurred higher cost of sales in 2009. The company should keep an optimal level of inventory which would allow them to meet the customer demands at a minimal inventory cost. The company also has higher receivables collection period, which means that the company management has been failed to manage its receivables in the appropriate way. Piling up more receivables means that the working capital, which the company could have used in other necessary operational activities, of the company is stuck in the receivable cycle and hence the company is losing out on its profit margin. The company needs to enhance its receivable management and its working capital management system. The organisation can add some debt amount on its portfolio, so that it can fetch the advantage of tax shield, resulting in lower amount of tax deductions. In such a course, the profitability can see an improvement in near future. c) There are certain limitations of the ratio analysis. Many large organisations operate in different industries. For them, it is quite tough to calculate the industry average values. That means that the analysis of financial ratios is quite useful in case of small organisations (Brigham, Ehrhardt, 2008). Seasonal factors can misrepresent a ratio analysis. In such a case, through the year it becomes difficult to generalise the performance of any company based on its ratio analysis. Answer to the question no 2 a) The below mentioned tables show the assessment for both the machines, using different Investment appraisal methods. b) The Net Present Value of machine A is £ 818.56, while the NPV for the machine B is £ 1013.32. Here both the machines have positive NPVs. As Machine B has higher NPV than that of machine A, the suggestion would be to choose machine B, based on the calculation of NPV. Internal rate of return is the rate of return, at which the NPV would be zero. This is same for both the machines. On the basis of IRR, both the machines are equally attractive. Profitability index is also higher for the second machine. Having glance over the payback period, machine A looks much more attractive as the machine has slightly lower pay back period. That means that machine A would be able to cover its initial cost in a lesser period, compared to machine B. However, the difference in the payback period is quite small. Looking at the assessment of both the machines using the four investment appraisals, it is quite evitable that the company, Planning Limited, should go for the machine B. The machine has shown noticeably high positive NPV value, while the difference in the payback period was quite low. The machine B has shown a superior performance in most of the various assessment procedures. c) There was a conflict of choice as both the machines show the same internal rate of return, which means any one can be indifferent between these two machines. In the assessment through payback period, machine A is showing its superiority over machine B. NPV and Profitability Index, both have indicated the better performance of machine B over machine A. Here the question arises, which one method should be considered while deciding on the machine. In such case the NPV and profitability index of machine B has quite high compared to machine A, which has been the influential factor behind zeroing down machine B. d) All the investment appraisals consider the initial cost and the benefits of the machines to assess the projects. So it is quite crucial to identify the proper initial cash outflow and the periodical cash inflows. While carrying on the assessment part, the cash inflow and outflow, cost of capital are estimated for each of the projects. To take the appropriate decisions on the projects, the estimation part is of much significance and should be carried out vigilantly. Reference Bized. 2007. Investment Appraisal. [Online]. Available at: http:// www.bized.co.uk/ [Accessed on March 26, 2010]. Bizwiz. No Date. Efficiency Ratios Calculation Formulas and Explanations. [Online]. Available at: http://www.bizwiz.ca/efficiency_ratio_calculation_formulas/efficiency_ratios.html [Accessed on March 26, 2010]. Brigham, F., E. & Ehrhardt, C., M. Financial management: theory and practice. USA: Cenage Learning, 2008. Brigham, E. & Houston, J. Fundamentals of financial management. USA: Cengage Learning, 2007. British Computer Society. No Date. Investment Appraisal. [Pdf]. Available at: http://www.bcs.org/upload/pdf/profissuessamplechapter.pdf [Accessed on March 26, 2010]. Financial Times. 2009. Gearing. [Online]. Available at: http://lexicon.ft.com/term.asp?t=gearing [Accessed on March 25, 2010]. Fund a Business. 2010. Interest Coverage Ratio. [Online]. Available at: http://www.fundabusiness.org/index.php?option=com_content&view=article&id=58:interest-coverage&catid=67:investment&Itemid=11 [Accessed on March 25, 2010]. Langemeier, N., L. & Klinefelter, D. Balance Sheet — A Financial Management Tool. US: Texas Agriculture Extension Service. Shim, K., J. & Siegel, G., J. Financial Management. New York: Barron’s Educational Series, 2000. Williamson, D. May 8, 2003. Capital Budgeting: the key numerical techniques. [Online]. Available at: http://www.duncanwil.co.uk/invapp.html [Accessed on March 26, 2010]. Bibliography Arnold, G. Corporate Financial Management (2008) (4th Edition) FT. Prentice Hall. Brealey, R., Myers, S. & Allen, F. Principles of Corporate Finance. New York: McGraw Hill, 2007. Burrough, B. and Helyar, J. Barbarians at the Gate. London: Random House, 2004. Chew, D. 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