assignment mfrd a2 will
TRANSCRIPT
Table of Contents
Introduction:................................................................................................................................................2
3.1. Analyse budgets and make appropriate decisions.................................................................................2
3.2. Costing and pricing decisions...............................................................................................................4
3.3. Investment decision..............................................................................................................................6
4.1. Discuss main financial statements of Holyrood Products Ltd:............................................................10
4.2. Appropriate formats of financial statements for different types of business.......................................16
4.3. Interpret financial statements using appropriate ratios and comparisons............................................19
Reference:.................................................................................................................................................29
1
Introduction:
This paper is a business report about Managing Financial Resources and Decisions. This report
presents how to make financial decisions based on financial information. Sources of data used in
the report are from the internet and references. This paper will explain how to analyse budgets
and make suitable decisions. Moreover, it will explain the calculation of unit costs. Finally, it
will show how business uses investment appraisal techniques.
3.1. Analyse budgets and make appropriate decisions
Sale price of each product of Holyrood Products Ltd in year 4:
Assuming that Holyrood’s number of sale is equal to the number of products they produce.
According to case study, sale price of DVD Recorders for year 3 is:
375000/30000 = 12.5$
In year 4, there are several reasons for Holyrood to change their sale price. Firstly, they set the
objective of achieving 25% profit on total cost. Therefore, in order to reach that much profit, sale
price is required to change. Secondly, change in price results from change in cost. In the market,
material cost, labor cost and overhead cost change over the time. To balance cost and profit, the
business need to adjust sale price.
DVD recorders Calculators Watches
Variable costs
Direct materials 158000 15000 10000
Direct labor 96000 (**) 10000 25000
Works and 32000 2500 15000
2
administration
overhead
Selling overhead 15000 4500 2250
Fixed costs
Works and
administration
overhead
18000 8000 13500
Selling overhead 8000 2250 6750
Total cost for each
product
327000 42250 72500
Total cost for 3
products
441750
Profit 441750 x 25% =
110,437.5 (*)
Proportion for cost
of each product out
of total cost
74.02% 9.56% 16.41%
Profit for each
product
81745.8 10557.8 18122.8
Sales revenue for
each product
408745.8 52807.8 90622.8
3
Number of each
product
30000 5000 10000
Sale price 13.6 10.6 9.1
(*): According to case study, the objective of Holyrood Products Ltd is achieving 25%
profit on total cost.
(**): According to case study, other variable costs will be held at the level attained in the
year ended 30 June Year 3.
3.2. Costing and pricing decisions
Question (a):
Apportioned Investment 300000
Return on investment 20%
Profit after tax (PAT) 20% x 300000 = 60000
Profit before tax (PBT) (*) 100000
Expense/Apportioned investment 300000
Revenue (**) 400000
Annual production 40000
Sale price (Unit price) (***) 10
(*): PAT = PBT – Tax expense = PBT – PBT x 40% = PBT x (1 – 40%) = PBT x 60%
60000 = PBT x 60%
=> PBT = 100000
(40% : Tax rate – according to case study)
(**): Revenue = Expense + PBT = 300000 + 100000 = 400000
4
(***): Sale price = Revenue / Number of units produced (Annual production) =
400000/40000 = 10
Question (b):
Profit after tax (PAT) = 6% x Sale revenue
Assuming that (a) is unit price. Therefore:
Sale revenue = 40000a
Profit before tax (PBT) = Sale revenue – Expense (Apportioned Investment) – Trade
discount (*)
= 40000a - 300000 – 40% x 40000a
= 24000a - 300000
(*): Trade discount = Discount rate x Sale revenue = 40% x 40000a
Profit after tax (PAT) = PBT – Tax expense (**) = 24000a – 300000 – (9600a – 120000)
= 14400a – 180000
6% x 40000a = 14400a -180000
(a) =15$
(**): Tax expense = Tax rate x PBT = 40% x (24000a – 300000) = 9600a – 120000
In conclusion, the unit price is 15
3.3. Investment decision
Accounting Rate of Return - ARR
5
Cost 50000
Estimated Scrap value 10000
Estimated life 5 years
Estimated future cash flows
Year 1 10000
Year 2 15000
Year 3 20000
Year 4 25000
Year 5 25000
cash inflows 95000
6
Total Cash flows 95000
Total depreciation 40000
Total profit after depreciation 55000
Average profit (5 years) (*) 11000
Value of investment initially 50000
Eventual residual value / Scrap value 10000
60000
Average value of investment 30000
Estimated average profits = Average annual cash flows
=
= = 11000
Estimated average investment = = = 30000
7
ARR for the project = = = 36.67%
Payback period:
Project
Cost $50,000
Estimated future cash flows
Year 1 $10,000
Year 2 $15,000
Year 3 $20,000
Year 4 $25,000
Year 5 25000
According to non-discounted payback period method, the time that Holyrood could
payback for the investment is in the first few months of year 4.
8
Net Present Value (NPV)
The decision rule is as follow:
NPV > 0 Present value of benefits is greater than
present value of costs – return generated is
higher than cost of capital project should
be accepted.
NPV < 0 Present value of benefits is smaller than
present value of costs – return generated is
lower than cost of capital project should be
rejected.
Year Cash flow Present value factor Present value
$ 10% $
0 (50000) 1.000 (50000)
1 10000 0.909 9090
2 15000 0.826 12390
3 20000 0.751 15020
4 25000 0.683 17075
9
5 25000 0.621 15525
NPV 19100
NPV > 0: Accept the project.
4.1. Discuss main financial statements of Holyrood Products
Ltd:
Balance sheet:
A basic structure of balance sheet could be illustrated as follow:
Company’s name Balance Sheet as on Day/Month/Year
(£)
Assets
Current assets
Stocks
Cash
…
Total current assets
10
Non-current assets
Tangible assets
…
Total non-current assets
Total assets
Liabilities
Current liabilities
short term loans
…
Total current liabilities
Non-current liabilities
long term loans
…
Total non-current liabilities
Total liabilities
11
Owners’ equity (Balance)
Holyrood Products Ltd Balance sheet as on 31 July 2013
12
2013 2012
Fixed Assets £000 £000
Tangible assets 773,823 745,041
773,823 745,041
Current Assets
Stocks 9,601 8,594
Debtors due after more than one year 8,448 7,682
Debtors due after less than one year 9,017 8,237
Investments 301 203
Cash 15,160 13,609
42,527 38,325
Creditors due within one year (135,361) (122,919
)
Net current liabilities (92,834) (84,594)
Total assets less current liabilities 680,989 660,447
Creditors due after one year (299,942) (292,915
)
Provisions for liabilities and charges (62,419) (57,399)
318,628 310,133
13
Capital and Reserves
Called-up share capital 4,149 4,292
Share premium account 126,739 124,819
Capital redemption reserve 165 -
Revaluation reserve 22,439 23,386
profit and loss account 165,136 157,636
Equity shareholders’ funds 318,628 310,133
Investors of Holyrood via the balance sheet know about the business’s fundamental
information. For example, Holyrood’s long term debt was 8448 in 2013 and 7682 in 2012;
Holyrood’s short term debt was 9017 in 2013 and 8237 in 2012. Investors might be interested in
cash business has, cash Holyrood possessed in 2013 was 15160 and in 2012 was 13609.
This section will discuss about the purposes of balance sheets. For different parties, the purposes of
balance sheet are different as well
For Purpose
Decision makers Evaluate business’s
situation and make change
when necessary
Creditors Consider to make decision
on loan to the business
Figure 6: Purposes of balance sheet for different parties (boundless 2014).
Income statement (The profit and loss account):
Its basic structure is as follow:
14
The first part - Revenue from selling goods
- Cost of production of goods
sold
The second part - Cost not linked with trading:
indirect costs or overheads.
- Non-trading income.
Figure 7: Structure of trading, profit and loss account (Biery, M 2014)
Holyrood Products Ltd profit and loss account for the year ended 31 July 2013
2013 2012
£000 £000
Turnover from continuing operations 730,913 601,295
Cost of sales (621,894) (503,699
)
Gross profit 109,019 97,596
Administrative expenses (34,036) (27,511)
Operating profit 74,983 70,085
Net interest payable (18,844) (16,517)
Profit on ordinary activities before tax 56,139 53,568
Tax on profit on ordinary activities (19,744) (18,152)
Profit on ordinary activities after tax 36,395 35,416
Dividends (7,434) (6,902)
Retained profit for the year 28,961 28,514
15
In general, at the ended 31 July 2013, Holyrood was profitable. Business’s revenue increased by
129618. However, the cost of sales also increased significantly by 118195 from 2012 to 2013.
This is the main the reason for the slight increase in profit.
There are five main purposes of income statement. First of all, managers use income statement to
evaluate how well the business spend its money. Next, income statement shows revenue and
expenses for a specific period. Moreover, income statement helps managers to understand
financial position and make change when necessary. In addition, thanks to income statement,
managers could evaluate whether business is profitable. Lastly, information from income
statement is the basis for decision making (Odland, S 2014).
4.2. Appropriate formats of financial statements for different
types of business
Income statement:
This section will discuss about the difference in profit-loss account for different types of
business. The most obvious difference is that non-incorporated businesses are more flexible in
the way they present their profit-loss account compared with incorporated businesses
(Nikolakopulos, A 2014).
Balance sheet:
For all types of business, it is similar to present the first half of balance sheet – net assets. Non-
incorporated businesses are more flexible in the way of presentation of balance sheet compared
to companies (Adkins, W 2014). For companies, they have to comply the Company Act in wordings
and layouts. According to the UK Company Act for balance sheet format, method adopted in
determining the form of balance sheet is presented below.
Presentation Balanced format Sum of all liabilities and
equity are added together
illustration for Asset =
Liability + Equity
16
Report form Top-bottom or Vertical
form
Classification Current and non-current Current and non-current
asset/liability method.
Grouped into line items Similar assets or liabilities
are grouped into line items.
Figure 10: Form of balance sheet according to the UK Company Act (legislation 2014)
According to the UK Company Act for balance sheet format, there is a number of items need to be
indicated in balance sheet.
No. Item
1 Share capital
2 Reserves and Surplus
3 Share application money
4 Long term borrowings
5 Long term provisions
6 Short term borrowings
7 Trade payables
8 Other current liabilities
9 Short term provisions
10 Tangible assets
11 Intangible assets
12 Non-current investments
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13 Long term loans and advances
14 Other non-current assets
15 Current investments
16 Inventories
17 Trade receivables
18 Cash and cash equivalents
19 Short term loans and advances
20 Other current assets
21 Contingencies and commitments
22 Dividends
Figure 11: Balance sheet format according to the UK Company Act (legislation 2014)
The next section will discuss about the bottom half of balance sheet. It represents the owners’ stake in
the business.
Company
(owners are
shareholders)
Initial stake Share capital
Subsequent
profits earned
Balance on
income
statement
Partnership Partners’
individual stakes
Capital
accounts which
are used for long
18
term investment
Current
accounts
Which are
used to record
profit shares,
salaries, interest
on capital
accounts, etc.
Sole trader Profits or
losses
Capital
account the
bottom of
balance sheet
have one line for
capital.
Alternative way of presentation of
profit earned and loss suffered in
current year is as below:
Figure 12: Difference in the bottom half of balance sheet for company, partnership and sole
trader (Carter, C 2014).
4.3. Interpret financial statements using appropriate ratios and
comparisons
There are some rules managers should remember when they interpret financial statements.
Firstly, financial statements need to be put in business’s context. Secondly, eradicating unusual
items to make the process of interpretation more effective. Thirdly, manager’s analysis should
base on the result of more than one fact. Fourthly, using more than one accounting period to have
a better view of business’s situation (Richards, D 2014).
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One of the most effective methods for analyzing accounting ratios is comparison. Managers could
compare accounting ratios as follow:
Comparison
External Competitors
Industry average
Internal Previous periods
Budgets
Figure 13: Comparison of accounting ratios (Richards, D 2014)
Profit measures:
Profit before interest and tax (PBIT) is measurement of profitability and cash flow. It shows
business’s ability to repay debts. This ratio is usually used by investors and lenders in order to
evaluate business’s status. Lenders focus on the business’s ability to repay (Wright, T 2014).
2013 2012
£ £
Net interest payable 18844 16,517
Profit on ordinary activities
before tax
56139 53,568
PBIT 74983 70085
(PBIT: Profit before interest and tax)
PBIT = = 7%
Return on capital employed (ROCE):
20
Profit need to be taken into account with capital employed, this will show how profitable
investment is. Therefore, ROCE is one of the most important profitability ratio.
Formula for ROCE: ROCE =
Capital employed = Total assets less current liabilities
ROCE ratio shows businesses how much profit generated by capital invested. Higher ratio
means more profit generated by capital employed. Investors look into this ratio to evaluate how
efficient business employs its capital. One thing businesses should keep in mind is capital return
rate should always be higher than interest rate of loan to help businesses to avoid losing money
(readyratios 2014).
Related to Holyrood:
2013 2012
PBIT 74983 70085
Total assets less current
liabilities
680,989 660,447
ROCE 11% 10.6%
ROCE could be compared with ROCE from the previous periods, ROCE of other businesses or
current market borrowing rate. As can be seen, there has been a slight increase – 0.4% in ROCE
of Holyrood from its 2012 level. Case study does not provide information about ROCE from
competitors or current market borrowing rate; however, borrowing rate from banks is around
10%, then Holyrood’s ROCE of 11% in 2013 and 10.6% in 2012 seem almost equal. It means
that Holyrood has used its available resources not really efficiently.
Profit margin and asset turnover:
21
Profit margin shows how profitable sales generate. Asset turnover shows how well assets are
being used to generate sales (Johnson, R 2014). Formula for profit margin and asset turnover are
as below:
Profit margin =
Asset turnover =
This results in: Profit margin x Asset turnover = = ROCE
2013 2012
Sales / Turnover from
continuing operations
730,913 601,295
Profit
margin
Asset turnover ROCE
2013 74983/730,9
13
X 730,913/680,9
89
= 74983/680,9
89
10.26% X 1.07 times = 11%
2012 70085/601,2
95
X 601,295/660,4
47
= 70085/660,4
47
11.66% X 0.91 times = 10.6%
22
From 2012 to 2013, ROCE increase by 0.4%, asset turnover increase by 0.16 times and profit
margin decrease by 1.4%. Clearly, profit margin decreased a little; however, higher asset
turnover has compensated for this.
Liabilities ratio:
Liabilities ratio indicates business’s financial leverage. Thanks to liabilities ratio, managers
know how many percentages of total business’s assets are financed by liabilities. Investors and
lenders are also interested in this ratio. Investors do not want to invest in businesses with high
liability ratio because these business suffer more risk. These businesses also have lower ability to
repay; thus, lenders will be not interested in these firms (accountingcoach 2014).
Liabilities ratio =
In general, 50% of liabilities ratio is a safe limit. Due to the context and nature of each business, they
have different safe limits for liabilities ratio.
2013 2012
Creditors due within one
year
135,361 122,919
Creditors due after one year 299,942 292,915
Total liabilities 435303 415834
Fixed assets 773,823 745,041
Current assets 42,527 38,325
Total assets 816350 783366
Liabilities ratio 53.3% 53.1%
23
As can be seen, liabilities ratio of Holyrood in both 2012 and 2013 is quite high, exceed 50% -
safe limit in general.
Gearing ratio and Debt/equity ratio:
Capital gearing take into account business’s long term capital structure (Vitez, O 2014).
Formula for gearing ratio is as follow:
Capital gearing ratio =
Prior charge capital comprise preference shares and debentures.
Total capital = Ordinary shares and reserves + Prior charge capital + Long term
liabilities/Provisions
= Total assets less current liabilities.
In general, 50% could be a safe limit for gearing ratio, there is no absolute limit. High gearing ratio
affects negatively to borrowing power unless the business could rise its shareholders’ capital, retained
profits or by new share issue.
2013 2012
Total assets less current
liabilities
680,989 660,447
Creditors due after one year 299,942 292,915
Gearing ratio 299942/680989=44.05% 292915/660447=44.35%
There is almost no change in gearing ratio between 2013 and 2012, 44.05 in 2013 compared
with 44.35% in 2012. Assuming that 50% of gearing ratio is a safe limit, as can be seen, gearing
ratios of Holyrood for both 2012 and 2013 did not exceed the safe limit. In case Holyrood’s
gearing ratio is too high (>50%), this causes the business some negative effects. Firstly,
liabilitites or preference shares (if available) of Holyrood will be larger than its equity capital. As
can be seen, liabilities result in an increase in interest payment such as interest for a bank loan;
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preference shares results in preference dividends. Consequently, a large amount of PBIT is paid
in interest or preference dividends instead of being distributed to equity holders.
Debt/equity ratio, which is similar to gearing ratio, provides the same sort of information that
gearing ratio provides. Formula of debt/equity ratio is as follow:
Debt/equity ratio =
2013 2012
Creditors due after one year 299,942 292,915
Equity shareholders’ funds 318,628 310,133
Debt/equity ratio 299,942/318,628=94.14% 292,915/310,133=94.45%
Higher debt/equity ratio means higher risk because in that case, business is relying more on
external lenders. As can be seen, almost a half of the assets of Holyrood are financed by long
term debts and a half of the assets of the business are financed by shareholders’ equity. It means
that Holyrood does not rely too much on long term debts. 94.14% and 94.45% debt/equity ratios
are acceptable for Holyrood.
Current ratio and Quick ratio:
Current ratio shows managers the degree of liquidity of business. In other words, Current Ratio
indicates business’s financial strength. It show how good business’s solvency is. The formula is
as follow:
Current ratio =
25
2013 2012
Current assets 42,527 38,325
Creditors due within one
year
135,361 122,919
Current ratio 42,527/135,361=31.42% 38,325/122,919=31.18%
Figure 14: Current ratio of Holyrood in 2013 and 2012
In theory, an acceptable current ratio is 1.5. The implication behind current ratio is that it
would be better when current assets of business are able to cover business’s current liabilities.
Higher current ratio indicates larger opportunity for businesses to pay short term obligations by
short term assets. If business uses non-current assets to pay off its current liabilities, this results
in a shortage in budget for non-current liabilities, which could lead to bankruptcy (Kokemuller,
N 2014).
Another ratio used to check the standard of liquidity of business is Quick ratio. Quick ratio is a
tool used to measure business’s liquidity. Different from current ratio, quick ratio takes into
account business’s most liquid assets (cash, bonds, account receivables) only (Kokemuller, N
2014). The formula is as below:
Quick ratio =
Quick ratio is applicable for those businesses which are not able to convert current assets into
cash quickly. When business cannot convert current assets into cash quickly, cash cycle will be
long. There are two main reasons for this: Finished goods inventories are warehoused for long or
they are sold on long credit. Quick ratios of Holyrood in 2012 and 2013 are as below:
26
2013 2012
Current assets 42,527 38,325
Stocks 9,601 8,594
Creditors due within one
year
135,361 122,919
Quick ratio (42,527-9,601)/
135361=24.32%
(38,325-8,594)/
122,919=24.19%
Figure 15: Quick ratio of Holyrood in 2013 and 2012
In general, a quick ratio between 0.5 and 1 is acceptable. In case of Holyrood, quick ratios in
2013 and in 2012 are almost the same – about 24% and it is not in safe limit. It means that, with
most liquid assets, Holyrood might find it difficult to pay short term liabilities for the two years.
Debtor days ratio:
Debtor days ratio is average debtors’ payment period, formula is as follow:
Debtor days ratio =
2013 2012
Trade debtors 9,017 8,237
Sales 730,913 601,295
Debtors days ratio 4.5 days 5 days
From 2012 to 2013, there was a decrease by 0.5 day in Holyrood’s debtors days. This indicates
an improvement of debtors management of the business.
Stock turnover period:
27
This ratio shows the average number of days which stocks are hold. Stock turnover period is
reliable for comparison of changes from year to year, formula is as follow:
Stock turnover =
Holyrood’s stock turnover period in 2012 and 2013 are as below:
2013 2012
Stocks 9,601 8,594
Cost of sales 621,894 503,699
Stock turnover 5.6 days 6.2 days
The stocks day of Holyrood decreased from 6.2 days to 5.6 days between two years. This
implies a speed-up in trading.
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Reference:
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