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7497 Downloads1 I Published: 22 Jan ,2018
The operations at a business unit can be conducted efficiently through appropriate financial planning. The management and control of financial resources available is necessary to support all the business activities. It is necessary for the management to evaluate the financial requirement of various departments and satisfying them through adequate funding options. Moreover, appropriate allocation of resources to various activities is necessary for achieving operational excellence (Stolowy and Lebas, 2006). The business unit is also responsible for evaluating its performance from time-to-time through its financial statements. The report presented herewith provides an in-depth overview of various financial aspects involved in the organization. It deals with evaluation of business performance through ratio analysis. It also throws light on the manner in which profitable investment decisions can be taken by the organization. Finally, concept of break-even analysis with its application in business scenario is provided. The report henceforth provides a detailed overview of proper administration and management of finance through adoption of financial techniques.
The performance of Smithson plc, a public limited company specialized in manufacturing and distribution of office furniture, can be evaluated through ratio analysis. It is the technique to judge financial stability, profitability and liquidity of an enterprise.
Profitability ratios: The ratios are calculated to ascertain business efficiency to earn profits during the year. The gross profit ratio margin has decreased marginally and is estimated at 50.87% indicating sufficient margin of profits on revenue. However, there is significant decrease in operating and net profit margin indicating increase in operating and non-operating expenses. The net profit margin has decreased to the level of 6.53% indicating that business unit is able to save little amount of funds as a net profit (Ahrendsen and Katchova, 2012). The organization should try to deduct its expenses so as to have sufficient profits in hand at the year's end.
Liquidity ratios: In order to judge the business’s capacity to pay off its short and very short term obligations, liquidity ratios are calculated. As per the ideal ratio, current assets should be equal to current liabilities of the business unit. The current and quick ratio for Smithson plc has increased marginally on annual basis. The current and quick ratio is estimated at 0.44 and 0.41 respectively in year 2013. This indicates that business's liquidity position is in question and it may face an issue in paying off its short and very short term obligations due to outsiders. The organization henceforth should infuse more amounts of funds in liquid form. This will help in improving its liquidity and ensuring availability of sufficient funds for meeting working capital requirement.
Efficiency ratios: The ratios help in judging business's efficiency to make utilization of resources available. Asset utilization capacity of the business unit is judged by total assets turnover ratio. The ratio has reduced marginally and reached to a level of 0.88 times. This indicates that the organization is earning revenue that is 0.88 times of total assets. The organization although is managing large scale operation; it should strive to increase its revenue in comparison to sales (Vandyck, 2006). This in turn will support business activities to make optimum utilization of assets available. Inventory turnover ratio of approximately 17 times indicates that there is sufficient movement of stock within the business during the year.
Gearing/ Stability ratios: The ratios are calculated to judge long term stability position of an enterprise. As per the ideal ratio, equity should be at least double of debt employed within the business unit. The ratio of 0.48 indicates that the organization has employed sufficient equity to support debt obligations in long term. Times interest ratio has reduced significantly due to increase in debt within the business. The organization should direct its efforts to improve its profitability in comparison to interest expense to be paid. The business unit should ensure that sufficient profits are earned in comparison to interest expenses. This in turn will result in acquiring sound stability position for long term.
Working capital cycle refers to the duration for which the business unit needs to invest funds into the business (Shim and Siegel, 2008). In other words, it refers to the duration for which the organization needs to employ working capital. It is calculated with the help of following formula.
Working capital cycle indicates that availability of lack funds to manage day-to-day operations of business. The liquidity position of business is in question for both the years. However, it has improved marginally it does not resulted in availability of large amount of liquid cash as working capital.
The business unit can expand its operations by planning its investments from time-to-time. It is essential for the organization to make investment in profitable investment options. In order to judge the viability of projects into consideration, investment appraisal techniques are adopted. Henceforth, the Jones Ltd. can also judge the viability of decision to purchase new machinery through adoption of these techniques.
Payback period method: The methodology helps in calculation of number of years or duration that is required to recover initial investment (Dayananda, 2002). It recommends investment in project with lower payback period due to its capability to have fast recovery of amount invested on the part of the business unit. The payback period can be calculated with the help of following formula.
A is the last year with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A.
As per pay-back period, the company will take approximately 4 years or 3.79 years to recover its initial investment. The methodology suggests that machinery will be generating positive cash flow for next two years. Henceforth, the organization can consider the option for investment since it has capacity to generate positive cash flow.
Accounting rate of return: It is the annual rate of return generated by the organization through investment into new venture or project (Shapiro,2008). The methodology says that project with higher accounting rate of return is profitable for the organization. It is calculated with the help of formula mentioned underneath.
The accounting rate of return is estimated at 28.86% indicating that the business unit is able to generate sufficient return on annual basis. It indicates that the organization’s decision to invest in new machinery is feasible.
Net present value: It is one of the widely applicable techniques available with business unit in modern era to judge the viability of project into consideration. The methodology aims at calculation of discounted cash flow and thereby net present value of future cash flows (Sangster, 2006). It suggests that the project with positive and higher Net present value tends to be feasible and profitable in nature.
According to Net present value method, the business decision to invest into new machinery is profitable in nature. This is due to its capacity to generate sufficient cash flows in future. The investment into machinery is able to create sufficient value for the organization in today's date. Hence, as per the net present value method, the organization should consider making investment for purchase of machinery.
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Internal rate of return: It is the rate of return at which Net present value of project becomes zero. The methodology recommends that project with higher internal rate of return should be considered for investment purpose.
Internal rate of return is estimated at 17% indicating that the project is capable of generating adequate amount of return. The methodology also suggests that the investment decision is feasible in nature.
On the basis of investment appraisal analysis, the business unit should invest its money for purchase of machinery. The decision is justified on grounds of each investment appraisal technique; henceforth should be considered by Jones Ltd.
Investment appraisal techniques help in analyzing and evaluating viability of investment decisions available with the business unit. Each of the technique has its own set of advantages and disadvantages as discussed below.
Payback period method: It is one of the traditional methods that is available with the organizations. The method is acceptable by large number of organizations even in modern era due to simple approach associated with it. It does not involve many complexities and can be easily understood by layman. This in turn makes it widely applicable and simpler approach to judge financial viability of the project (Weygandt and et. al., 2009). The methodology however has certain drawbacks associated with it. These drawbacks are associated on account of its inability to take time value of money into consideration. The approach does not take into account that value of money decreases with time and there is cost associated with capital invested. This in turn results in generation of an unclear picture of viability of project.
Accounting rate of return: The method helps in calculation of percentage of return generated by the investment made. It facilitates easy comparison while investment on two alternatives. The technique although determines return in percentage terms, it does not consider time value of money and cost incurred on acquiring capital. This in turn limits its scope of applicability.
Net present value: In order to overcome the drawbacks associated with previous two methodologies; scholars devised Net present value method. This is the method that helps in deterring discounted cash flows. Henceforth, it considers the fact that with time value of money decreases. Moreover, cost of capital associated with acquisition of funds is also taken into consideration as per net present value method. The methodology takes into consideration cost of capital that is realistic in nature. The method although involves certain complexities in calculation; it is considered to be superior to all other techniques. The decision as per net present value method tends to have highest priority due to advantages associated with this methodology.
Internal rate of return: The methodology helps in determining rate of return generated by investment option after considering time value of money and cost of capital. The method helps in establishing easy comparison between two alternatives available (Peterson and Fabozzi, 2004). Moreover, it is the methodology that provides benefit of net present value with evaluation in percentage terms. Despite range of advantages it has one of the major drawbacks that is many a times it result in generation of unrealistic rate of return. Many-a-times, analysts also tends to use unrealistic cost under IRR methodology sue to hit ad trial technique. Henceforth, methodology is also incapable of satisfying all requirements of judging financial viability of project.
As per the evaluation of merits and demerits associated with each of the method, it is seen that net present value is methodology that serves all the purpose of financial analysis of project into consideration.
It is from time-to-time that every business unit needs to invest certain amount of funds for the purpose of expansion or to meet its internal needs. The organization has access to range of financing options through which it can raise funds. The list of alternatives available with the business unit to acquire funds is described underneath in detail.
Issue of shares: The business unit that is listed as a publically listed company has an option to acquire funds through issue of shares. The organization has right to float its equity capital in market up to the amount of authorized capital. The option however involves high amount of floating cost; it results in acquisition of large amount of funds for long term (Pour, 2011). It also involves dilution of ownership in hands of shareholders. It is suitable source of financing for the large scale publically listed company who requires fund for long duration.
Bank Loans: It is the form of debt capital that is raised in the form of loan facility availed from the bank. It carries a fixed rate of interest that is to be paid on regular basis with fixed obligation for repayment of principle sum. It helps in meeting all kinds of business requirement ranging from long to medium and short term. The financial units now-a-days provides variety of lending options so as to meet different kind of business requirements. The financing option helps in acquisition of funds at reasonable cost. However, it increases fixed obligation for business unit is suitable for organization with sufficient profitability.
Issue of debentures: Another external source of financing through which business unit can acquire funds is issue of debentures or corporate bonds. It is one of the costliest methods to finance the business requirement since it involves high amount of floating cost with fixed interest payment. The source of finance is suitable to acquire large amount of funds for long duration (Power, 2010). The financing option does not involve transfer of ownership but carries fixed obligation for regular payments and interest payments. The business unit should effectively judge its requirement and then raise funds through most suitable source of finance.
Retained earnings: It is one of the internal sources of finances that is available with business unit. Every organization follows practice to reserve some portion of its earnings as reserve and surplus. These in turn is available to meet financing requirement of organization in the form of retained earnings. The financing option does not involve any cost of capital and is suitable to meet all need arises at time of uncertainties (Keller, 2013). The business unit can meet its short or medium term financing requirement through this option.
Managing a business is not an easy task; there are many challenges that come with responsibility of ensuring the profitability of the business can take up most of the owner’s time in looking over financial statements and projections. These challenges are greater in the big organizations especially with the financial management (Greenwood, 2002). Besides this, owner must be knowledgeable in the concepts of the financial management and specially in analyzing 5the relation between cost, revenue and profit. He must be able to determine the acceptable revenues to cover the calculated costs in producing the products or otherwise known as break even points.
Break even analysis lets the owner to determine that what he needs to sell monthly or annually to cover the cost of his business. Small and large businesses depends their profitability analysis n the forecast that is from calculating the difference costs and revenue. This is very simple approach but still it requires the use of break even analysis as a practical and powerful tool. This approach helps the owner to attain desirable alternatives quantitatively focusing on the interrelationship between price and cost. Its basic limitation is its linear nature thus all the factors should be defined very carefully.
The break even analysis needs to be used in addition to existing financial methods in line with the business objectives to attain the optimal level of business operations. Whether it is profit or nonprofit business, it can be assured that this method has proven helpful and essential to achieve profitable success of the business. In order to be successful, business owners should establish their goals first, then develop a business plan and invest time and resources for the business to progress (Weil, 2012). The use of breakeven point is also applicable to the cash flow management as businesses with low overhead are likely to succeed especially on managing the cash flows relating to the expense.
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The profitability of the businesses lies on the careful maintenance of the balance sheets that shows that how much the business is earning or loosing during a particular accounting period (Cafferky, 2010). One of the small practices that business owners can use is the break even analysis. It works best for the single product or service but for multiservice or a product line, various modifications are required in this method.
It is important to understand that although break even analysis is tried and tested analytical tool, it is not a demand predicator. The success of the business initially lies on the careful assessment on the correct type of service or product that the entrepreneur is willing to gamble in the market. In addition to making strategic decisions to break even, a closer look on the fixed and variable costs will enable the owner to identify the areas where savings can be possible to maximize the profit (Banerjee, 2006). The use of break even analysis may seem to exclude the aspect that will affect the employees, but in long run the outcome of the management’s decisions that are based on the analysis done in addition to other analytical methods will benefit the people involved in the whole process.
The financial management and control is one of crucial aspects of the organization. It is seen throughout the report that the organization needs to evaluate various aspects while taking financing or investment decisions. It also involves the adoption of various methodologies and techniques that are developed by scholars from time-to-time. It can be said that the finance is most sensitive part of business part of part whose care can be ensured by effective planning and management.
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