Evaluation of Financial Position - Excel Limited - Essay Example

Evaluation of Financial Position Excel Limited February 2009 Contents Sl No Page No Executive Summary …………………………………………………………….. 3 2. Costing System …………………………………..……………………………… 4 3. Budgetary Control Process …………………………………………………….. 8 4. Financial Viability and Performance …………………………………………… 9 5. Project Appraisal ………..……………………..………………………………… 9 6. Conclusion ………………..……………………………...………………………. 17 7. Bibliography ………….………………………………………………………….. 23 Section-I Executive Summary This report evaluates the different costing methods and inventory valuation methods, and recommends the most relevant costing model for Excel Limited. The report also studies the commonly accepted budgetary practices and recommends the optimum budget model for Excel Limited. This report also studies the historical performance of Excel Limited, its budgeted forecast, with respect to its peers in the industry. The report identifies the shortcomings of Excel Limited and advises it regarding its financial control systems. Finally, the report evaluates the cost reduction capital investment decision being considered by Excel Limited, and gives appropriate recommendation. Section-II Costing System All costs involved in the manufacture of goods needs to be captured by the costing system adopted by a company. The method of such cost capturing depends on the manufacturer’s industry, and the type(s) of products manufactured. The two major methods of costing are (a) Process Costing, and (b) Job Costing (Martin, 2009?). a) Process Costing: Process costing is the normal method of capturing the cost in most manufacturing industries especially when the products are produced in large numbers using a sequence of repetitive operations. Typically, the products are usually identical and can not be segregated. Under this method, the cost of product is known at the end of any particular manufacturing operation. The cost of each process (or department) is captured using one of the costing techniques. The direct cost attributable to the product is calculated by department, and indirect costs are allocated to the products. Industries typically include textiles, coal, cigarettes, shoes, gasoline, steel, glass, automobiles, gas, water, electricity, etc. b) Job Costing: Job costing is used for industries where manufacturing takes place against a specific order. This method is useful for tracking the costs of unique products, which are usually manufactured to a specific order. In this costing process, costs are accumulated by jobs, lots, or batches. Industries that use this costing method include shipbuilding, construction projects, large contracts, job printing, etc. The various techniques used for capturing the costs using the above methods are as under (Drury, 1996, p121-626). Absorption Costing, Variable Costing, Standard Costing, and Activity Based Costing (ABC) Absorption Costing: Absorption costing is also known as Full Costing. Under this system, all direct manufacturing costs, and all manufacturing overheads (including fixed and variable overheads) are allocated to the products. This costing concept is recommended for external reporting as per Accounting Standards Committee (SSAP 9). The limitation of this system is that the product costs can not be used for internal decision making as they would tend to throw up distorted results owing to all the fixed overhead allocation. Variable Costing: Variable costing is also frequently referred to as Marginal Costing or Direct Costing. Under this costing system, only the direct manufacturing costs and variable manufacturing overheads are considered. This technique is usually used for internal reporting when a decision to needed to be taken regarding additional production or regarding introducing a new product temporarily. In such cases, all indirect costs are not required to be allocated to this new or additional production; this is because the decision to introduce this new product line would not have an affect on the existing manufacturing overheads/ indirect costs. The management only looks at the incremental costs (and benefits) accruing owing to this additional production. However, this method does not provide proper matching because the fixed costs associated with producing the inventory are charged to expense regardless of whether or not the output is sold during the period (Martin, 2009), and can not be used for external reporting. Standard Costing: Standard Costing involves calculation of predetermined costs; they are target costs that should be incurred under efficient operating conditions (Drury, 1996). Such standard costs set the basis of variance analysis in terms of cost per product. The variance analysis can be carried out for various manufacturing centres. The variances are charged directly to the profit and loss account. This method of costing is suited to an organization whose activities consist of a series of common or repetitive operations, and is used commonly in manufacturing organizations. Activity Based Costing (ABC): Activity Based Costing was developed by Cooper and Kaplan in 1998 to address the errors resulting from incorrect allocation of overheads. This costing method is used when a manufacturing unit manufactures diverse products, which requires substantial overheads. Traditionally, such overheads are allocated to the products based on the volumes of products. However, the consumption of these overheads is often not in the same proportion of product volumes. Allocating overheads in proportion of their volumes can result in erroneous cost allocation and can thus result in incorrect decision making. Activity based costing attempts to allocate the overhead costs to the different products in proportion to their consumption by each type of product, and causes more accurate allocation of overheads to the product cost. It is suggested that Excel Limited use Process Costing method and Absorption Costing technique for its standard range of products. This is because its products are standard and fairly uniform in nature. This method should be used for external reporting purposes. However, for its large customized bin products, it is recommended that Job Costing method and Variable Costing technique be used for its internal decision making. Variable costing in the area of customized bins will enable the company to take correct pricing decisions, and ensure profitability, which seems to be affecting the company recently. Section-III Budgetary Control System The budget is an instrument for detailed operational planning and control over a short period of time, usually one year. The yearly budget is often divided intro quarterly budgets, or even monthly budgets (Chandra, 1997, p608-630). Some firms employ a rolling budget. Under this system, at the end of each quarter or each half year, the budget is extended by adding another quarter or another half year. Hence the firm always has the budget for a year ahead of it. The Master Budget covers all facets of the operations and finances of the firm. It has four major components, viz., the operating budget, the capital expenditure budget, the cash budget, and the projected financial position. The Operating Budget is the primary part of the budgeting process, and is built up using the following. Sales Budget Production Budget Materials and Purchases Budget Labour Cost Budget Manufacturing Overhead Budget Non-Manufacturing Cost Budget The operating budget for the firm may be constructed in terms of programmes (Programme Budget) or responsibility areas (Responsibility Budget). Budget may be built around products that are regarded as the principal programmes of the business, and shows the expected revenues and costs of various products. It shows the relative profitability of the different product lines, and gives an opportunity to tweak the processes to make the product lines profitable. Similarly, the budgeting process can also be built around responsibility areas, or departments, which can be broadly divided into three broad types, cost centres, profit centres, and investment centres. Excel Limited seems to follow the Responsibility Budget with departments operating as cost centres and revenue centres. The commonly used starting point for a particular year’s budget is the actual numbers for the earlier year. Using the base of the last year, the expected and planned changes in the forthcoming year are identified for the purposes pf developing the budget for that year. The focus of the budgeting process is on the increments in operations. This is the traditional budgeting approach, and is often termed as Incremental Budgeting. This type of budgeting is quite easy and often appropriate especially in budgeting for increases in salaries. However, such budgets have a significant shortcoming; they tend to perpetuate the past follies and inefficiencies. This shortcoming can be overcome using a zero-based budgeting approach. Under the zero-based budgeting system - pioneered by Texas Instruments, the departments start with a clean slate, and all activities of the organization are viewed afresh. Cost-benefit analysis is used to make decisions and prioritize fund allocation. This method requires more effort and time, and is often not done every year. This would be typically associated with business process re-engineering. This method of budgeting is also likely to be opposed by departments as they may not favor the scrutiny involved with such budgeting process. Zero-based budgeting promotes efficient allocation of resources, as it is based on needs and benefits. It also detects inflated budgets, identifies and eliminates wasteful and obsolete operations, and drives managers to find cost effective ways to improve operations. It is useful for service departments where the output is difficult to identify. The process increases communication and coordination within the organization, and increases staff motivation by providing greater initiative and responsibility in decision-making. Finally, it forces cost centers to identify their mission and their relationship to overall goals. A flexible budget (Caplan, 2009?) is a budget that adjusts for changes in the volume of activity. It is more sophisticated and is often used as a performance evaluation tool. It is usually prepared after the end of the period, and adjusts the static budget for the actual level of output. This budget helps compare apples to apples and compares the actual numbers with the budget adjusted for actual production. The flexible budget variance is the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results. If prepared before the end of period, the flexible budget is used to compare different levels of anticipated production. Excel Limited clearly uses Responsibility Budget using an incremental basis. However, Excel Limited seems to be less competitive than its competitors in the same field of operation. Some operational inefficiency especially in the areas of working capital management seems to have crept into its system over the years. Accordingly, there seems to be pressing need to have a re-look at its existing operating processes, and revamp its business process. Therefore, Excel Limited should implement zero-based budgeting for the upcoming year to ensure the inefficiencies in its system and not carried forward further. It could help find opportunities for outsourcing. Section-IV Financial Viability and Performance Excel Limited is in the business of manufacture of plastic storage bins. The financial viability and performance of Excel Limited has been evaluated in this section. The performance has been evaluated on a stand alone basis as it has been compared with that of its peers. At the outset, a set of financial ratios have been computed for the purposes of comparison and the same has been given below. Table 4-1 Comparison of Financial Ratios 2008 Budget 2007 Actual Norm Return on assets 5% 3% 8.5% Operating profit to sales 10% 8% 11.5% Gross profit to sales 20% 21% 22% Current ratio (working capital) 2.00 2.15 2.30 Quick (acid-test) ratio 0.94 1.28 1.20 Debtors collection period 68.37 52.64 30.00 Inventory holding period 120.22 88.48 30.00 Interest cover 4.33 3.40 5.70 Debt-to-equity ratio 0.38 0.33 0.65 The return on assets (ROA) is lower than its competitors’. Excel Limited has set higher targets for itself in the current year’s budget but the target numbers are far below the industry norm. It is interesting to note that Excel’s profitability ratios (profit/ sales) are not far away from its peers. However, its asset utilization is remarkably inferior. The capital investment decision making of the organization does not appear to be very strong. Another area of concern seems to be the working capital management. The collection period is very high as compared to its peers, and it is budgeting for even higher collection period, which is likely to worsen its working capital management further. However, the worst performance indicator is the Inventory Holding Period, which is grossly inferior as compared to the industry. Excel could also be using erroneous inventory valuation methods, thus overstating its operating profits and overvaluing the inventory in its stock. Whatever the reason, this area needs to be closely looked into. The lower current ratio and the high collection period also signify that the company has problems in payments to its suppliers in time, which could erode its competitiveness in time. The “soft” budget targets also seem to imply an easy incremental budgeting practice followed by the organization. The lower interest cover and the lower gearing ratio also imply inefficient use of capital. Probably the company is missing out on new expansion opportunities. Overall, the operating efficiency of the company seems to be comparable to the industry norms. Though there is some scope of improvement in this area, the companies sales and production teams seem to be doing a decent job. The company’s financial control systems do not seem to be very strong. The capital utilization is inefficient, and working capital management is abysmal. The company should consider identifying its low performing assets and disposing them off while taking a write-off on its profit and loss account. It needs to identify innovative ways of tightening up this area. Among other things, its collection period should be closely monitored and reduced. The inventory valuation method and the inventory management system need to be reviewed. The company can consider increasing its gearing ratio to optimize its capital structure. The company’s system of incremental budgeting seems to be too lax, and the company needs to implement zero-based budgeting to tighten up its yearly targets. The company seems to have targeted to grow at a rate of 26%, and seems to have developed an incremental budget accordingly without calculating the competitive cost of In spite of inferior capital management, Excel Limited is still a profitable company with a solid business model and having strengths in sales and marketing. The gearing ratio is lower its industry peers. An application for loan will not be viewed unfavourably by the banks if Excel Limited has a good investment plan. The above analysis is based on the information available information. It does not contain data pertaining to inventory evaluation method. With the available information, it is not possible to identify the reasons for the high Inventory Holding Period, viz., bad inventory management, or incorrect inventory valuation and low operating margin. This will help the management tackle the other major problems it has already identified, viz., liquidity and inventory management, and uncontrollable overheads. Section-V Project Appraisal There are various prevalent methods of evaluating capital investments. The commonly accepted methods are Net Present Value, Internal Rate of Return, Benefit Cost Ratio, and Payback Period, which are discussed below. Net Present Value (NPV) of a capital investment is equal to the sum of the present value of all the cash flows associated with it. The cash flows for the project are usually discounted at the weighted average cost of capital (WACC). The management should accept the capital investment decision when the NPV associated with a capital investment is positive. The Internal Rate of Return (IRR) of a capital investment is the discount rate which makes its NPV equal to zero. It can be deduced that the both these evaluation methods use identical principles of discounted cash flow. The investment decision is cleared if the IRR is higher than the cost of capital of the company. Benefit Cost Ratio (BCR) relates the present value of the benefits to the initial investment, and is computed as present value of cash flows divided by the investment. As in the case of NPV, the present value is of cash flows is usually discounted at the cost of capital. There is a second method of calculating Net Benefit Cost Ratio (NBCR), which involves dividing the NPV by the investment. The investment is accepted if the BCR is greater than unity or the NBCR is greater than zero. Payback period is simply the number of years required to recover the initial investment. The often criticism of this evaluation method is that this method ignores the time value of money. Accordingly, a variant of Payback period which addresses this anomaly is the Discounted Payback period. This method simply calculates the number of years required to recover the initial investment considering the discounted cash flows. Here again, the cash flows are discounted at the cost of capital. NPV was selected as the investment appraisal tool for this evaluating this investment. The tax effects and the project gearing factors were ignored. Since Excel Limited is not certain about the future cash flows, appropriate certainty factors were considered for the future years. The cash flow was discounted at Excel Limited required rate of return of 10%. The cash flow and the NPV calculation is given in the table 5-1 below. Table 5-1 Year 0 1 2 3 4 5 Investment 3,000,000           Savings   1,200,000 1,000,000 800,000 600,000 300,000 Salvage value           500,000 Cash flow (3,000,000) 1,200,000 1,000,000 800,000 600,000 800,000 Certainty Equivalent Factor 100% 100% 95% 90% 85% 80% Certainty Adjusted Cash Flow (3,000,000) 1,200,000 950,000 720,000 510,000 640,000 Net Present Value 147,915 The NPV of the investment is positive. Therefore, it is recommended that Excel Limited proceeds with this cost saving investment. The above project appraisal method assumes that the future cash flows are also reinvested at the same discounting rate, which may not be correct at all times. Apart from the above two factors ignored, the actual cash flow needs to be factored for several other factors like working capital cash flow adjustments. Section-VI Conclusion The report concludes that Excel limited should use two separate costing method for this two product ranges. It should use process costing method and absorption costing technique for its standard small plastic bin products, and also external reporting. However, for its customized large bin products, it should use job costing method and variable costing technique for internal decision making. Excel Limited should employ zero-based budgeting system for the next year to optimize its costs and to improve its operational efficiency. The financial viability of Excel Limited was conducted and capital investment discipline and working capital management were identified as its weak areas, which it needs to improve to stay competitive. Finally, the last section of this report evaluates the capital investment decision of Excel Limited, and recommends the $3 million investment in modernization equipment. Section-VII Bibliography Drury, C., 1996. Management and Cost Accounting. 4th ed. London: International Thomson Business Press Martin, J., 2009?. Management Accounting: Concepts, Techniques & Controversial Issues. [e-book] Management and Accounting Web. Available at: http://maaw.info/Chapter2.htm#Four%20Cost%20Accumulation%20methods [Accessed March 8, 2009]. Chandra, P., 1997. Financial Management: Theory and Practice, 4th ed. New Delhi: Tata McGraw-Hill Publishing Company Limited Caplan, D., 2009?. Management Accounting: Concepts & Techniques [e-book]. Available at: Oregon State University/ College of Business http://classes.bus.oregonstate.edu/spring-06/ba422/Management%20Accounting%20Chapter%205.htm [Accessed March 8, 2009]. Read More