Financial Management

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Table of Contents

Part A – Elmwood Plc. 2

1.    Profitability ratio. 2

2.    Liquidity ratio. 3

3.    Gearing ratio. 3

4.    Asset utilization. 4

5.    Working capital cycle. 4

Part B: Kellogg Ltd. 5

1.    Investment appraisal calculation. 5

2.    Critical assessment of project appraisal methods. 7

Part C: Break-even model and source of finance. 9

1.    Break-even model 9

2.    Internal and external finance seeking by company to purchase new machine. 10

Conclusion. 11

References. 12 

Part A – Elmwood PLC

Ratio basically is the comparisons between 2 things that are in similar quantities. It is calculated by divided one thing to one thing. Ratio analysis is the financial statement analysis. Based on the available data from financial statement, Elmwood can calculate the ratio to support for internal comparisons and external comparisons base on the income statement of 2013 and 2014.

On the behalf of financial statement analysis, Elmwood PLC will know their strength and weakness from that many strategy and ideas will be formed. Ratios also give the company the trend line that tell company about whether the performance of the company improved or not and that areas they need to improve. Especially, based on the ratio analysis, Elmwood can make the right decision and can improve better.

1.      Profitability ratio

A profitability ratio is a measure of profitability, which is a way to measure a company’s performance. Profitability is simply the capacity to make a profit, and a profit is what is left over from income earned after you have deducted all costs and expenses related to earning the income. This section includes three ratios including net profit, gross margin and operating margin.

Net profit: For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax.  All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. Formula:

 

2014

2013

 

We can see that the net profit of Elmwood has decreased from 23.31% in 2013 to 13.23% in 2014. Although the sales volume has increased, the net profit ratio still decreases. The core reason of this drop comes from the increase of manufacturing cost and selling and distribution expenses.

 
Gross margin: Gross margin ratio may be indicated to what extent the selling prices of goods per unit may be reduced without incurring losses on operations. It reflects efficiency with which a firm produces its products. Formula:

 

2014

2013

 

The calculation shows that the gross margin had a significant decrease from 2013 to 2014 which is 23.31% and 13,23% respectively. The increase of sales volume in 2014 does not fit with the increase of net profit. The low gross margin may cause lack of money to pay operating expenses like salaries, utilities, and rent which indicates the weak efficiency of business.

Operating margin: It  takes into account the costs of producing the product or services that are unrelated to the direct production of the product or services, such as overhead and administrative expenses. Formula:

Operating Margin =

Operating Income [3]

Revenue

 

2014

2013

 

The operating margin has a slightly decrease in 2014 compared to 2013 which is 29.52% and 34.17% respectively. Low ratio means  that less proportion of revenue is converted to operating income. A fall in operating margin ratio overtime means that the profitability is decreasing. In general, Elmwood has the weak efficient is controlling its overall costs which  have a lower operating margin ratio.

 

2.      Liquidity ratio

Current ratio is balance-sheet financial performance measure of company liquidity. Current ratio indicates a company’s ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Formula:

 

2014

2013

 

The current ratio of Elmwood has decrease from 0.43 in 2013 to 0.21 in 2014. The low ratio shows the weak ability to pay off its short-terms debts obligations. The company will find hard to raise cash or convert assets into cash. Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term.

 

Quick ratio is a measure of a company’s ability to meet its short-term obligations using its most liquid assets (near cash or quick assets). Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Quick ratio is viewed as a sign of a company’s financial strength or weakness; it gives information about a company’s short term liquidity. The ratio tells creditors how much of the company’s short term debt can be met by selling all the company’s liquid assets at very short notice. Formula:

 

2014

2013

The quick ratio of 2014 is lower than 2013 which is 0.14 and 0.17 respectively.  The decreasing of quick ratios generally suggests that Elmwood is over-leveraged, struggling to maintain or grow sales, paying bills too quickly or collecting receivables too slowly.

 

 

3.      Gearing ratio

The gearing ratio measures the proportion of a company’s borrowed funds to its equity. The ratio indicates the financial risk to which a business is subjected, since excessive debt can lead to financial difficulties. A high gearing ratio represents a high proportion of debt to equity, and a low gearing ratio represents a low proportion of debt to equity. This ratio is similar to the debt to equity ratio, except that there are a number of variations on the gearing ratio formula that can yield slightly different results. The most comprehensive form of gearing ratio is one where all forms of debt – long term, short term, and even overdrafts – are divided by shareholders’ equity. Another form of gearing ratio is the times interest earned ratio, which is calculated as shown below, and is intended to provide some indication of whether a company can generate enough profits to pay for its ongoing interest payments.

Formula:

Earnings before interest and taxes[5]
Interest payable

2014

2013

 

The gearing ratio of 2014 is lower than 2013 which is 2.64 compared to 4.22. This low gearing ratio may be indicative of conservative financial management of Elmwood, but may also mean that a company is located in a highly cyclical industry, and so cannot afford to become overextended in the face of an inevitable downturn in sales and profits.

4.      Asset utilization

The asset utilization ratio calculates the total revenue earned for every dollar of assets a company owns. For example, with an asset utilization ratio of 52%, a company earned $.52 for each dollar of assets held by the company. An increasing asset utilization means the company is being more efficient with each dollar of assets it has.

Return on Assets (ROA): It measures how effectively the company produces income from its assets.

Formula:

 

 

2014

2013

 

The return on asset of Elmwood in 2014 in significant lower than 2013. The company has low efficiency to turn earn a return on its investment in assets. In other words, ROA shows how efficiently a company can covert the money used to purchase assets into net income or profits.

 

Debt to asset ratio: It indicates the proportion of a company’s assets that are being financed with debt, rather than equity. The ratio is used to determine the financial risk of a business. A ratio greater than 1 shows that a considerable proportion of assets are being funded with debt, while a low ratio indicates that the bulk of asset funding is coming from equity. Formula:

 

 

2014

2013

 

The debt to asset ratio has a slightly drop in 2014 which is 1.3 and 1.3 respectively. A ratio greater than 1 also indicates that Elmwood may be putting itself at risk of not being able to pay back its debts, which is a particular problem when a business is located in a highly cyclical industry where cash flows can suddenly decline. A company may also be at risk of nonpayment if its debt is subject to sudden increases in interest rates, as is the case with variable-rate debt.

5.      Working capital cycle

Working capital denotes the aggregate value of the current assets of a company, which can be continuously circulated to support the current operations. The working capital further helps us in understanding the liquidity position of an organization, i.e. how fast can the assets be converted into cash.

Working capital 2013 = current asset – current liability = £4,130 – £3,310 = £820

2014 = £3,790 – £2,555 = £1,235

We can see that the working capital of 2014 is higher than working capital of 2013 which is £1,235 and £820 respectively.

Conclusion

This part has calculate several important financial ratio when assessing the business performance of Elmwood LTD. The result shows that all performance of company has been decreasing in volume and margin. Although the net sales increase in 2014, but it is not enough to cover the other ratios because an increase of selling and administrative expenses, and other cost. Therefore, Elmwood falls into a hard business position.

 

Part B: Kellogg Ltd

1.      Investment appraisal calculation

Summarized table:

Year

Cash inflow

Cash outflow

Depreciation

Net cashflow

0

-

-950000

-

-

1

280000

-57500

142500

80000

2

280000

-57500

142500

80000

3

280000

-57500

142500

80000

4

280000

-57500

142500

80000

5

280000

-57500

142500

80000

6

280000

-57500

142500

80000

 

The initial cost of new machine is £950,000. The annual cash inflow of sales is £280,000 and outflow is £57,500 for every year. The cash outflow does not include depreciation of 6 years under straight line method. So

Depreciation of each year = (£950,000 – £950,000 @ 10% ) / 6 = £142,500

Therefore, the net cash flow equal to inflow minus outflow and depreciation.

  1. a.      Payback period method

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven.

Year

Net cash flow

Cummulative cash flow

0

-950000

-950000

1

80000

-870000

2

80000

-790000

3

80000

-710000

4

80000

-630000

5

80000

-550000

6

80000

-470000

7

80000

-390000

8

80000

-310000

9

80000

-230000

10

80000

-150000

11

80000

-70000

12

80000

10000

 

Payback period = 11 years + [70,000 / 80,000] = 11.875 years equals to 11 years, 10 months and 15 days,

We can see that it requires nearly 12 years to cover the cost of investment. However, this method has some problems. Firstly,. it ignores any benefits that occur after the payback period and, therefore, does not measure profitability. Secondly, it ignores the time value of money.

 

  1. b.      Accounting rate of return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.

ARR =

Average Accounting Profit

Average Investment

Annual depreciation = £142,500

Average accounting income = £80,000

Accounting rate of return = £80,000 / £950,000 = 8.42%

  1. c.       Net present value (NPV)

This is one of the most popularly used in investment decision which based on the cash flow and time value of money. We have the formula:

- Initial cost

Where “i” is rate of return per period and “R” is net cash flow per period

Year

Cash inflow

Cash outflow

Depreciation

Net cash flow

Discount factor 7%

Present value

0

-

-950000

-

-

1

-950000

1

280000

-57500

142500

80000

0,935

74766

2

280000

-57500

142500

80000

0,873

69875

3

280000

-57500

142500

80000

0,816

65304

4

280000

-57500

142500

80000

0,763

61032

5

280000

-57500

142500

80000

0,713

57039

6

280000

-57500

142500

80000

0,666

53307

NPV

-568,677

 

We can see that the NPV of project is -£568,677. A negative NPV means that the present value of the costs exceeds the present value of the revenues at the assumed discount rate.

  1. d.      Internal rate of return

IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return (ROR).

We have formula: IRR = A+ , where:

A is discount rate that provides positive NPV

a is amount of positive NPV

B is discount rate that provides negative NPV

b is amount of negative NPV

We will try “r” until it gives the value between positive and negative NPV. Then, apply in the formula. However, with the help of Excel, we have the IRR of Kellogg project is -17%. A negative rate of return means that Kellogg lost money on the account. The value of their account decreased by that rate.

2.      Critical assessment of project appraisal methods

In this part, we will critically analyze the pros and cons of two techniques including payback period and net present value.

  1. a.      Payback period method (PBP)

One of the most concerns from the investors is how long their project can cover the initial cost. Pay-back period method is an explicit answer which offers simple and quick project selection. In academic word, PBP is the period of time taken for the future net cash inflows to match the initial cash outlay (Pike and Neale, 2009, p. 94).

The most outstanding merit of PBP is simple to understand and calculate. Watson and Head (2010, p. 161) also point out that risk and liquidity are considered. The shorter the payback period, the greater is the liquidity because the project generates cash inflows more quickly to recover the initial investment. However, PBP also has numerous deficiencies. Firstly, PBP concentrates on a project net cash flow, but ignores the overall profitability (Merrett and Sykes, 1973). Additionally, it ignores the cash flows after the payback period except that this method offers a simple rule of thumb, which allows managers to make swift decisions on minor projects (Hillier, Grinblatt & Titman, 2008). Finally, the change in value of money is not mentioned, e.g., inflation (Lefley, 1996).

Despite the shortcomings, PBP is most commonly used by companies and treated as selection aid. Anderson and Prakash (1990) argued that payback period could be envisioned as project duration. A study of Boardman et al (1982) also supported the use of PBP when facing with downturn in liquidity. Giving statistical evidence, Graham et al (1992) found that 56.7% of US firms used the payback period method and it is more popular for smaller firms than it was for bigger firms. Brounen et al., (2004) also demonstrated that 69.2% in the UK, 64.7% in Netherlands, 50% in Germany and 50.9% in France choose the payback period method as their favorite capital budgeting tool.

In short, pay-back period is the simplest way to aid selection and communicate the desirability of project when the unity required among project members. However, PBP has no link with shareholder wealth and the next method may give a solution to fill this gap.

  1. b.      Net present value (NPV)

Unlike pay-back period method, the NPV takes into account the size of the cash inflows, but also makes adjustment for the timing of the money. According to Baker and Powell (2005, p. 230), NPV is “the amount of cash flow in present value terms that the project generates after repaying the invested capital and paying the required rate of return on that capital”. The required rate of return is the minimum percentage return acceptable to compensate for a project’s cost of capital and risk.

There are some advantages of NPV method. Firstly, NPV gives a good criterion for making decision that maximizes the shareholder wealth. Secondly, NPV recognizes the time value of money and consider total benefits arising out of the proposals. Last but not least, NPV provides best method for selection of mutually exclusive project. In contrast, there are also demerits of NPV technique. It is difficult to understand the calculation and estimate the value of inflow and outflow throughout the project’s life. Additionally, Watson and Head (2010, p. 169) point out the difficulty in estimating the cost of capital of company and selecting discount rate is not straightforward and fixed during project life. Finally, the assumption of NPV is available in perfect market competition.

It is no doubt that NPV method is popularly chosen by companies. Brounen et al (2004) replicated Graham and Harvey’s (2001) study for four European countries – the United Kingdom, Netherlands, Germany and France. Regarding NPV method, the results showed that the usage rates were 47% for the UK, 70% for the Netherlands, 47.6% for Germany and 35.1% for France. However, since Irving Fisher’s assumption in wealth maximization of NPV method over 100 years ago (Volkman, 1997), there have been many controversies about the link between NPV and shareholder wealth maximization. Crundwell (2008, p. 191-193) said that “the NPV is the method that is preferred in all cases which measures the contribution of the project to shareholder value”. In contrast, some studies point out that NPV just “affects the company value” instead of shareholder wealth (Baker and Powell, 2005, p. 255). To support this, Laux (2011, p. 30) indicates that a zero NPV would maintain the value of the firm; positive NPV projects would increase firm value.

Part C: Break-even model and source of finance

1.      Break-even model

One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs. At this point, no profit is made and no losses are incurred. The break-even point can be expressed in terms of unit sales or dollar sales. That is, the break-even units indicate the level of sales that are required to cover costs. Sales above that number result in profit and sales below that number result in a loss. The break-even sales indicates the dollars of gross sales required to break-even.

Nowadays, although the context of business environment is unpredictable, break-even model is still useful for business. It is difficult to overstate the importance of break-even model to sound business management and decision making. Benoliel (2002) said that any company that ignores the break-even point runs risk of an early death and at the very least will encounter a lot of unnecessary headaches later on.

In any business, the manager of it has to make irrespective of what they produce they have to ensure that the products they produce maximize owners equity. That is the products and services they offer can make a profit and to identify loss making products and introduce new products if they have a profitable market. In addition, they must have a cost control system which cam minimize overheads and direct cost of producing goods and services. Break-even analysis according to Bukisa.com (2008) is one of the simplest method for a business to make the above mentioned decisions. In effect break even analysis enable business managers to make effective decisions based on sound rational basis and based on cost information and other limiting factors. As well, it gives the manager how he can improve profitability of the business as a whole in a dynamic and uncertain market place by monitoring cost and improving the efficiency of the organization on a continuous basis.

Despite its useful applications, break-even model according to Tsorakidis et al (2009), is subject to some restrictions. This is like any other concept has its limitation. In every single estimation of the break-even level, he uses a certain value to the variable “selling price”. Therefore, if they want to find out the level that produce profits under different selling prices, many calculations and diagrams are required. A second drawback has to do with the variable total cost, since in practice these cost are difficult to calculate due to the fact there are many things that can go wrong and mistakes, that can occur in the production.

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