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Financial Decision Making for Managers

Financial Decision Making for Managers

Introduction

Financial statements are the lens on a business and spell outperformance of the company. Investors, management, employees, customers, suppliers and the government use financial statements to make crucial valid decisions. As a part of assessing published financial statements, we have chosen Next Plc.,a fashion and retailing firm for men, women and children in the UK. Financing and investing decisions tell us where funds will be collected and where those funds will be invested. In this report, we will analyse both of these decisions. We will determine the short-term and long-term financial needs cost of each source and choose the best one for our respective business. Finally, we will evaluate each of the investment proposals using the most popular techniques.

 

Task - 01
1.1  Financial Statement and Ratio Analysis 

The financial statement is the formal record of all the activities of a business firm over a specific period. Financial statements are the lens of a business (Penman, 2014). They provide necessary information about the performance of the company that is badly needed to make a crucial decision by the investors, management, employees, customers, suppliers and government. The structure of the financial statements varies based on the different ownership structure of the business. There are four main parts of financial statements, excluding footnotes. Generally, a Limited Liability Company prepares all these four parts, whereas a sole proprietorship does not prepare all these items. It does not need to prepare a profit and loss distribution account. Without any corporate tax exposure, sometimes it prepares only profit and loss accounts only for the owner’s use. Though partnership businesses make profit and loss distribution accounts, their structures are quite different from a limited liability company. In April 1989, IFRS and IASB took the initiative to introduce a framework for preparing and presenting financial statements. Finally, in September 1989, IFRS and IASB approved the conceptual framework of reporting the financial statements. Financial statements must be prepared in compliance with the international financial reporting standards along with the generally accepted accounting principles. Faithfulness, relevance and materiality are the fundamental characteristics of financial statements. Comparability, verifiability, timeliness and consistency are some of the enhancing qualitative features of the financial statements (IFRS, 2014).  So, due to different types of ownership structure, their format of financial statements and reporting requirements are other.

1.2  Structure, Format and requirements of Published Accounts

Stakeholders read a business and draw crucial decisions based on financial statements. There is a chance to manipulate this information or provide vogue and false information. This is the obfuscation of the stakeholders where they are confused about the financial statement information. There is asymmetric information in an efficient market, but investors can’t make a reasonable decision due to data manipulation. On the other hand, sometimes stakeholders cannot understand the information of the published financial statement and this situation is referred to as a lack of insight (Pandey, 2011). So a credible person is needed to solve this manipulation, and he is an auditor. In accounting, an auditor is a person who makes an independent report to the concerned stakeholders whether its financial statements are prepared following relevant laws and regulations providing trustworthiness and Fairview. He also examines all the records, systems, and control points of the business and reports its weaknesses that help the firm strengthen its operations. Published financial statements are somewhat different from the internal financial system. The internal financial system uses the volume of sales, whereas published financial information includes turnover. Internal financial information includes details of all the items, such as revenues and expenses. In contrast, a published financial statement does not provide details of everything, but it must be formal and disclose all the relevant procedures and policies. Internal financial information is prepared for the management to take strategic management.

1.3  Ratio Analysis

Ratio analysis is an essential tool among various tools of financial statement analysis (Barone et al., 2011). It provides clear identification of the financial condition of a business firm and helps to ascertain whether the business is gaining or suffering losses. There are five categories of ratios such as liquidity, activity, profitability, leverage and coverage ratios. Now we are going to analyse the financial statements of Next Plc. A company using those ratios.

  • Liquidity Ratios

Liquidity ratios represent the ability of the firm to repay its short term obligations (Shajahan, 2011). We have found the current ratio and quick ratio for 2013 and 2012 of Next Plc. The current ratio for 2013 is 1.48 and 1.07 in 2012. The quick ratio is 2.5 for 2013 and 2.0 for 2012. The Benchmark of the current and short ratio is 2 and 1, respectively, but the company has an excess quick liquid asset that may create profitability problems.

Current Ratio for 2013 of Next Plc.

                                          = 1207.8/816

                                          =1.48

Current Ratio for 2012 of Next Plc.

= 875.2/816

= 1.07

Quick Ratio for 2013 of Next Plc.

= 1854.2/742.4

= 2.50

Quick Ratio for 2012 of Next Plc.

= 1482.5/742.4

= 2.0

  • Activity Ratios

Activity ratios measure the efficiency of the firm by generating revenues by converting production into cash. Inventory turnover represents the ability to sell its products once it gets ready to sell. Here inventory turnover is 56.69 for 2013 and 56.65 for 2012. Total asset turnover is 1.88 for 2013 and 1.86 for 2012.   

Inventory Turnover for 2013 of Next Plc.

= {(331.8 + 387.9)/2}/243*100

= 52.69 Times

Inventory Turnover for 2012 of Next Plc. 

= 371.9/2395.8*365

= 56.65 Times

Asset Turnover for 2013 of Next Plc.

= 3565.8/1893.6

= 1.88

Asset Turnover for 2012 of Next Plc.

= 3441.1/1854.2

= 1.86

  • Profitability Ratios

Profitability ratios measure the efficiency of the management to earn profit using all the resources of the business. They also measure the long term sustainability of the business firm. Here we have got a gross margin of 31.59% for 2013 and 30.37% for 2012. Return on capital is 61.85% in 2013 and 53.74% in 2,012, which implies the satisfactory level of efficiency of the management.   

Gross Profit Margin for 2013 of Next Plc.

= (1125.8/3562.8)*100

= 31.59%

Gross Profit Margin for 2012 of Next Plc.

= (1045.3/3441.1)*100

= 30.37%

Return on Capital for 2013 of Next Plc.

= (666.5/1893.6-816)*100

= 61.85%

Return on Capital for 2012 of Next Plc.

= (579.5/1854-742.4)*100

= 53.74%

  • Leverage Ratios

Leverage ratios measure the ability of the firm to pay the long term debt. This ratio is very crucial to potential investors because they make decisions mainly based on these ratios. Here we have used two leverage ratios, debt to equity and debt to total assets ratio, and found that external liability is very high for this alarming company.  

Debt to Equity Ratio for 2013 of Next Plc.

= 1608/285.6*100

= 563%

Debt to Equity Ratio for 2012 of Next Plc.

=1631.5/222.7*100

= 732%

Debt to Assets Ratio for 2013 of Next Plc.

= 1608/1893.6

= 85%

Debt to Assets Ratio for 2012 of Next Plc.

=1631.5/1854.2

= 88%

  • Coverage Ratios

Coverage ratios measure the degree of ability of the firm to meet up its financial obligations. The higher the coverage ratio, the better the ability to pay its debt (Scherr, 2003). We have used the dividend coverage ratio and interest coverage ratio, and we have found that the company has enough capacity to pay its interest.    

Dividend Coverage Ratio for 2013 of Next Plc.

= 508.8/147.7

= 3.44

Dividend Coverage Ratio for 2012 of Next Plc.

= 474.8/135.1

= 3.51

Interest Coverage Ratio for 2013 of Next Plc.

                          = 695.1/29

= 23.96

Interest Coverage Ratio for 2012 of Next Plc.

= 601.8/28.9

= 20.82

 Source: Financial statement of Next Plc.

1.4  Ownership and Financial Structure

There are different sorts of business organisations based on ownership structure such as sole proprietorship, partnership, limited liability company, public sector organisations, co-operatives and international business structure. A sole proprietorship is a single owner business initiated, funded, operated and managed by a single individual. This is the oldest form of business and easy to f; moreover get more flexibility to manage and control. Partnership business comprises 2 to 20 eligible persons who provide funds and skills to the business and share profits and losses. Still, each partner is mutually liable for the business and their liability is unlimited. The limited company includes private and public limited companies based on a memorandum of article and operated by a memorandum of association. Private limited companies are 2 to 7 and cannot raise fund issuing shares to the general public. In contrast, public limited companies with unlimited members can issue prospectuses to the general public and collect funds selling securities to those public(Gitman, 2011). In the case of public sector organisations, the government is the owner and regulator of those businesses. A cooperative company is formed and operated by the contributed subscription of the members. International business structures such as joint venture, business alliance, licensing and franchise are formed through merger and acquisition financial or capital structure. The controlling system of the businesses, as mentioned earlier, is different due to different ownership structures. For the public limited company the optimal capital structure could be 50% common stock, 10% preferred stock and 40% debt financing.

1.5  Relative Ownership Advantage of chosen Business Firm

 There are four types of published financial statements such as balance sheet, income statement, cash flow statement and equity statement. The balance sheet provides the financial position of a firm at a point of time. The income statement reveals the efficiency of the management to earn profit using all of its resources (Fridson and Parvalez, 2011). Cash flow statement includes all the cash inflows and outflows and optimal cash balance. Finally, the equity statement reveals the net increase or decrease of shareholders balance.  To evaluate and interpret the published financial statement we have chosen NEXT Plc. a leading company in the United Kingdom in retailing fashions and accessories for men, women and children (nextplc.co.uk, 2014). It is a public limited company, having much-experienced personnel and large size it has some ownership structure advantages. Next plc. Belongs in the garments industry and this market is very un-concentrated that means highly competitive.  

1.6  Comparison of Two years Financial Statements and Evaluation

Performance of our chosen Next Plc. Company is very well in 2013 based on the above ten financial ratios. We know, if a firm becomes reputed, growing and earns an above-average return, it can issue debentures or obtain loans at a lower cost. As our firm needs only 500000 pounds, it would be better if it borrows from banks or other financial institutions or makes a credit agreement with a bank. The Finance manager of Next plc should consider both liquidity and profitability. However, the market is too competitive. Next Plc. Is earning an above-average return, and investors should invest here cause it is somewhat less risky.  Fixed and permanent current assets should be financed by long term financing, whereas existing temporary assets should be funded by short term financing.   

1.7  Advice to Potential Investors

Investors want to invest their money in a profitable business firm. Simply a higher level of risk bears a higher level of return. Investors can invest in the Next Plc. Without any hesitation, because their financial performance is outstanding, which is better than the industry. Our respective business needs only 500000-pound money, and they can raise it from individual lenders or banks. So it is my suggestion that investors can invest in this company as their profit margin and ROCE is at a satisfactory level.

1.8  Sources and Cost of Finance

There are two primary sources of financing: internal and external sources in two forms: short term and long term financing. Short term financing includes bank loans, bank overdraft, commercial papers, banker’s acceptance and so forth. In contrast, long-term internal sources include promoter capital, retained earnings and general reserves, and long-term external sources may be share capital, bonds or debentures, borrowings from banks and financial institutions. Raising funds by selling shares has some problems, such as the firm has to give up partial ownership and incurs some issuing cost. Here one advantage is that shareholders take more risk than debt holders. Debt financing provides an interest tax-shield gift for the company, but they must be paid fixed interest on time (Ross. el, 2009).  

Capital structure is a choice of that combination of debt and equity that maximises the firm’s value. The optimal capital structure of a business firm may be composed of 50% common stock, 10% preferred stock and 40% debt financing (Gitman, 2011). The cost of capital is the minimum rate of return that a firm must earn to compensate investors for deferred consumption and taking a risk. Practically, firms obtain money for investment in the form of equity or debt or both. They usually maintain a target debt-equity level, and thus, firms’ cost of capital refers to the weighted average cost of debt and equity. Debt capital provides a tax shield advantage for the business firm, and it is better for firms with higher tax exposure. In contrast, raising money by selling new shares requires additional floatation cost, but stockholders take many risk and residual claimants. Raising funds from reserve and retained earnings are less costly than the issuance of new shares. This argumentative question: which source is better, debt or capital? It depends on some crucial factors such as tax structure, capital structure and so forth. But existing shareholders want to raise funds from debt financing, which increases their return and increases the risk of the business. These different sources and cost of funding affect the financial statement significantly. If they take huge loans, they have to reveal the loans’  sources and instalments, which negatively impact the potential investors. 

1.9  How Working Capital can be efficiently managed

Working capital meets up the daily transactional funding. Working capital management means managing all the items of current assets and current liabilities. The finance manager should match profitability and liquidity problems. He should be interested in both of them. Fixed assets and permanent current assets should be financed from long term financing, and existing temporary assets should be funded through short term financing. He should follow a matching policy to hedge both of the risks. Thus he can manage working capital efficiently. 

 

Task - 02
2.1  Budgets and Cash Flow
  • Green Limited

Cash flow Forecast

Items

July

‘000

August

‘000

September

‘000

October

‘000

November

‘000

December

‘000

Cash receipts from customers (Proceeds of credit sales)

106

114

118

124

104

96

Cash payments to suppliers (prices for credit purchase)

-64

-64

-66

-70

-59

-54

Salaries and wages paid

-20

-20

-20

-20

-20

-20

Electricity bill paid

  

-20

  

-34

Other overheads paid

-4

-4

-4

-4

-4

-4

Payments for a delivery truck

  

-25

   

Payments of bank loans

    

-135

 

Surplus or deficit balance

-18

18

-17

30

-114

-16

Beginning balance

90

72

90

73

103

-11

Ending  balance

72

90

73

103

-11

-27

 

A Cash flow budget is an essential tool to plan for and control cash inflows and outflows. This summarises all the future expected cash inflows and outflows over a specific period (Terry and John,2003). Here July to October of the cash budget of Green limited. Cash inflows are more than outflows, whereas this scenario is quite different in November and December, and cash flow is negative. But in November Company has paid a 135-pound bank loan which is a positive sign. 

2.2  Recommendation for Managing Cash Flows

To manage cash balance efficiently, optimal cash balance should be determined. Three sorts of cash collection float such as mail float, process float and clearing should be reduced as far as possible, and surplus cash balance should be properly invested. Financing and investment decision is very much crucial to a finance manager. The fund required purchasing non-current assets such as building, plant, equipment, machinery and furniture known as long-term or fixed capital. Generally, the size and nature of the business determine the long term capital needed (Business.gov.in, 2014). For a manufacturing company, more long term capital is needed compared to trading and service company because they have to invest too much in plant, machinery and warehouses. In contrast, money invested in current assets is known as working capital. Working capital management means managing all the items of existing assets and current liabilities. Excess of existing investments may create a profitability problem, and a shortage of existing assets may make a liquidity problem. Working capital meets daily operational expenses such as material cost, labour cost, overheads, and administrative costs. Without these operating costs, the production of products of a business is not possible. Without an optimal production level, the company will not generate enough revenues, resulting in profit and shareholder wealth maximisation. So working capital is the lifeblood of a business firm.

 

Task - 03
3.1  Investment Appraisal Techniques
  • Accounting Rate of Return

Project 1(‘000):

Annual depreciation = Initial Investmentscrap valueUseful Life in years

        = (200-7)/3

= 64.33

Average profit or loss calculation:

Year

1

2

3

Cash flow

58

-2

4

Scrap value

  

7

Depreciation

-64.33

-64.33

-64.33

Accounting income

-6.33

-66.33

-53.33

Average accounting loss

-42

Accounting Rate of Return = Average LossAverage Investment

= -42/200

= 21%

Project 2(‘000):

Annual depreciation = Initial investmentscrap vavue Economic Life

   = (100-12)/3

  = 29.33

Average profit or loss calculation:

Year

1

2

3

Cash flow

36

-4

8

Scrap value

  

12

Depreciation

-29.33

-29.33

-29.33

Accounting income

6.67

-33.33

-9.33

Average accounting loss

-12

Accounting Rate of Return = Average lossAverage investment

    = -12/100

    = -12%

 

  • Payback Period

Project 1(‘000):

Payback period = Initial investmentAnnual cash inflow

= 200/ (58-2+4)

= 3+ years

Project 2(‘000):

Payback period = Initial investmentAnnual cash inflow

= 100/ (36-4+8)

= 3+ years.

 

  • Internal Rate of Return

Project 1(‘000):

0 = (Investment) + CF1/ (1+IRR) 1 +CF2/ (1+IRR) 2 +CF3/ (1+IRR) 3

0 = (200) + 58/ (1+IRR) 1 + (-2)/(1+IRR)2 + 4/(1+IRR)3

IRR1 = -60.63%

Project 2(‘000):

0 = (Investment) + CF1/ (1+IRR) 1 +CF2/ (1+IRR) 2 +CF3/ (1+IRR) 3

0 = (200) + 58/ (1+IRR) 1 + (-2)/ (1+IRR) 2 + 4/ (1+IRR) 3

IRR2 = -44.9%

         [N.B: Both projects is calculated with the help of a financial calculator]

 

  • Net Present Value

Project 1(‘000):

NPV = Present value of expected cash inflows in three years – Cash out flow for the project

           = 59.34 – 200

           = (140.65)

Project 2(‘000):

NPV = Present value of expected cash inflows in three years – Cash out flow for the project

= 44.45-100

= (55.55)

 

3.2  Recommendations

ARR, Payback period, IRR and NPV are some of the popular investment proposal evaluation techniques. We are given two mutually exclusive investment proposals, but we cannot take any of these projects because we have negative IRR, ARR and NPV. Moreover, both of the projects require more than three years to recover their initial investment. So considering the above techniques, we can say without any hesitation that both the projects should be rejected.

 

Conclusion

At the very end of the report, I have found, using my underpinnings, that the performance of our chosen business is very well based on the ten most important financial ratios. It may be a profitable firm for the investors if they invest their excess or idle money. The company is in the growth stage because its earnings are above the average of the industry. Among many financing sources, the company should raise funds from banks or financial intuitions without losing any partial ownership. Our respective company got two investment project proposals, but any one of the projects would not be able to add extra value to the firm, and that’s why they should be rejected.

 

 

 

 

 

 

 

 

References

Barone, E. Anthill, P. Kothari, J and McLaney.2011. Introduction Accounting and Financial Management, 1st ed. Harlow: Pearson Education.

Fridson, M. S, And Alvarez, F, 2011. Financial Statement Analysis –A Practitioner guide,4th ed.

Gitman, L. J., 2012.Principles of managerial Finance, 12th ed. USA: Pearson Education Inc.

Nextplc.co.uk, (2014) Next Plc. Available from: http://www.nextplc.co.uk/ [Accessed 27 April 2014].

Barth, M, 2006. Fair Values and Financial statement Volatility. London: IASB 

Business.gov.in, (2014) Business Portal of India: Starting a Business: Financing a StartupBusiness: Types of Financial Needs. Available from: http://business.gov.in/starting_business/types_financialneeds.php [Accessed 27 April 2014].

Pandey, I. M., 1981. Capital Structure and Cost of Capital, 1stEd. New Delhi: Vikas.

Penman, H.S., 2014. Financial statement Analysis and Security Valuation, 3rded. New Delhi: Mc Grew Hill.

Rose, S.A. Wasterfield, R. W. And Jaff, J. 2010. Corporate Finance, 11th ed. New York: McGraw Hill Inc.

IFRS, [Online] available at: <http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/EDMay08/Pages/Frequently-Asked-Questions.aspx> (Accessed on 27 April, 2014)

Levy, H. & Sarnat, M. (1978) Capital investment and financial decisions. 1st edition. Englewood Cliffs, N.J.: Prentice/Hall International.

Wilkes, S. 1977. Capital Budgeting Techniques,1st ed. London: Wiley

Madura, J. (2003) International financial management. 1st edition. Mason, Ohio: Thomson/South-Western.

Shajahan M. M., 2009. Fundamentals of Finance, 2nd ed. Dhaka: S.N Publication

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