Report To The Board Of Directors

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02 Nov 2017

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Trinity Saint David London

Financial Management – SBMA7100

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Word Count: 4137

Table of Contents

Introduction

The main aim of this assignment report is to talk two major areas coming under financial management namely, ratio analysis and investment appraisal. For any financial manager working in any company regardless of the size, maturity and of the industry they are involved in, they should have a thorough knowledge on these two areas. Ratio analysis is considered to be one of the major analytical tools used by internal and external stake holders to evaluate the financial performance of the company. Hence, in order to identify and improve the performance, every company should carry out a detailed ratio analysis. In order to apply the theoretical knowledge in to practical world, the published financial statements of British Airways were analysed and a detailed ratio analysis was carried on for past three years.

In the second part, it discusses about investment appraisal technique. In order to grow in the industry every company should involved in capital investments. When doing so, they should always appraise that investment or the project to assess whether that will yield a profit or a loss to the company.

Part 1

Calculation of ratios

According to Lasher (2010: p.85) ratio analysis is considered to be the general technique used by majority of users of financial statements in order to read and analyse financial information of a company. Ratio analysis involves taking sets of numbers out of the financial statements and formatting ratios with them. Hence, ratio analysis is considered to be the main analytical tool used by investors and other related partied to analyse and evaluate the performance of a company for a given period of time.

According to Besley et al (2008: p.67) there are three main groups who uses ratio analysis as,

Managers, who employ ratios to help analyse, control and thus improve the firm`s operations

Credit analysts, such as bank loan officers or bond rating analysts, who analyse ratios to help ascertain a company`s ability to pay its debts.

Security analysts (or investors), including stock analysts, who are interested in a company`s efficiency and growth prospects, and bond analysts who are concerned with a company`s ability to pay interest on its bonds and the liquidation value of the firm`s assets in the event that the company fails.

According to Kumar (2003: p.102) ratio analysis is very significant and useful in many respects. They are,

It is a technique for diagnosing the financial health of a business.

It is easy to understand the financial position of a business enterprise in respect of short term solvency, long-term solvency, capital structure position etc. With the help of ratios.

Ratio analysis would pinpoint the deficiency of various departments or branches of a business unit even though the overall performance is satisfactory.

Accounting ratios calculated and tabulated for a number of years enable the users of financial information to determine the future results on the basis of past trends.

Ratios analysis helps in communicating financial strength and weaknesses of a firm in amore easy and understandable manner. It enhances the value of the financial statements.

Although ratio analysis posses advantages as such it also inherits some disadvantages. According to Siegel et al (2006: p.261) the users of ratio analysis must be aware of many limitations including,

It is often to identify the industry group to which a company belongs. This makes industry comparison a problem.

Diversity among companies in applying GAAP may result in a distorted ratios and comparisons.

Published industry norms are only approximations.

The historical cost of an asset may differ from its current value.

A ratio does not reveal its components.

A company may window dress making its financial picture look better than it really is.

Under the appendix list the ratio analysis for the choose company is carried out.

According to that, the results for the past three focus years have been changed drastically. In both 2009 and 2010, their net profit took a negative value; making most of their ratios a lower or even negative value. But, during the year 2011, the company performance has been excellent and they have been able not only to recover the losses for past two years but also to record a satisfactory net profit.

Evaluation of ratios

Profitability ratios

According to the appendix, there are two main types of profitability ratios as company profitability ratios and company profitability ratios. According to Nikolai et al (2010: p.280) company profitability ratios are used to evaluate how effectively company has been in meeting its overall profit (return) objectives, particularly in relation to the resources invested. Under this, there are three sub ratios as profit margin, return on assets and return on equity.

According to Gitman et al (2009: p.393) the ratio of net profit to net sales is the profit margin which is also known as return on sales. This measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted. Hence, a higher profit margin is always better than a lower one. The net profit margin of the company (British Airways) for the year 2011 has been increased up to 6.72% from being negative values for the previous two years. The net profit margin is used to measure the earning power of the company. Thus, the company has not performed well in both 2009 and 2010 regarding to their operating efficiency. But, in the year 2011, the company performance has been excellent that they have been able to recover from their negative losses and to remain competitive in the industry by increasing its earning power.

According to Moles et al (2011: p. 133) the return on assets calculation divides a measure of earnings available to shareholders (net income) by total assets (debt plus equity) which is a measure of the investment in the firm by both share holders and creditors. The information that this ratio provides about the efficiency of asset utilisation is obscured by the financial decisions the firm has made and the taxes it pays. When focusing on the British Airways, following the net loss they incurred in both 2009 and 2010, their return on assets ratio has also taken a negative value. But in 2011, the value of the ratio has increased up to 7.17% which indicates that the company has utilized its assets up to 7.17% in the revenue generation process.

According to Brigham et al (2009: p.110) the single most important ratio over which the management has control is the return on equity ratio. Most of other ratios have an impact on the return on equity ratio. This tries to capture the return earned on the common stock holders` investment in the firm. For a firm that only uses common stock to finance its operations, the ROE and the ROA figures are identical. But according to the appendix, the ROA and ROE figures of British Airways differ in a great degree and hence it is assumable that the company use both debt and equity to finance its operations.

On the other hand, stockholder profitability ratios are used to evaluate how effective a company has been in meeting the profit objectives of its owners. According to Bhattacharyya (2011: p. 74) earnings per share is an indicator of the amount of revenue profit of the concern that goes to each equity share. I.e. it indicates the quantum of earnings of the company that is receivable by each equity share. In line with the profitability ratios, the EPS of the company for 2009 and 2010 has been negative whereas the value has increased up to $0.29 in the year 2011.

Liquidity ratios

According to Coutney et al (2004: p.164) liquidity ratios provide an indication of the organisation`s ability to meet its financial obligations. In other words, these ratios examine the firm`s ability to have sufficient cash or assets that can be converted to cash in order to enable it to trade and pay its accounts when they due fall. Current ratio is considered to be indicative if an organisation`s ability to pay short – term debts. Over the past three years the current ratio of British Airways has gradually increased which is a positive sign about the liquidity level of the company. ON the other hand, quick ratio excludes inventory as the liquidity of that is lower than other current assets. Hence, this is a more accurate indicator of the liquidity. In British Airways, there is a very little difference between the current ratio and the quick ratio which says that the inventory level of the company is at a lower level.

Efficiency ratios

According to Koen et al (1999: p. 27) efficiency ratios for a given year is used to determine whether an enterprise has generated enough cash in relation to other years and in relation to other institutions. A more general definition for efficiency ratio can be how efficiently a firm is operating for a given period of time.

According to Burns et al (2011: p.203) the inventory turnover ratio measures how many times the inventory of a company is sold and replaced over a specific period. Although this ratio depends upon the industry a firm is involved in, the higher the inventory turnover, the better it is. According to the financial statements of British Airways, the ratio has faced a slight decrease in the year 2011 from 88 times to 84 times.

According to McLean (2003: p.71) total asset turnover ratio indicates the extent to which assets produce revenue. According to the appendix, the total asset turnover ratio has decreased from 94% to 90% over the period of 2010 to 2011. This indicates that the asset utilisation of the company has been reduced by 4%

Report to the Board of Directors

To: The Board of Directors

From: Financial Analyst

Date: 06/05/2013

Subject: Ratio analysis for 2009, 2010 and 2011

According to Siddiqui (2006: p.623) ratio analysis is one of the methods used to analyse financial statements. Financial statements in their original form are a collection of monotonous figures. The statements are very detailed and do not present the required information at a glance. Hence, ratio analysis is an attempt to present the information of the financial statements in a simplified, systematic and summarised form. These ratios provide accurate and fair indications about the performance and growth of the company and hence, by analyzing them the company can get a detailed understanding as to how they should attempt to improve their financial performance and financial management.

According to Flynn et al (2007: p.5-20) it is useful to combine the individual ratios in order to obtain an overall picture of the company. This type of analysis is often referred to as structured analysis. The Du Pont model is a frequently used structured analysis. As the objective of financial management is the maximisation of wealth, a structured analysis should aim towards measuring how effectively this objective is achieved. The du Pont model uses the return on equity as the overall indicator of success. While profit maximisation would not be a primary objective, a satisfactory return on shareholders’ funds would be required to maximize wealth.

According to Besley et al (2011: p.229) the idea of Du Pont analysis is to attain greater detail by dissecting a single ratio into two or more related ratios. Thus, the company can use this approach to integrate the ratios and thereby get an overall detailed picture of the company.

According to Brigham et al (2011: p.110) a sound financial analysis involves more than just calculating and comparing ratios. Other related qualitative factors must also be considered such as,

To what extend are the company`s revenues tied to one key customer or to one key product. To what extend does the company rely on a single supplier. Reliance on single customers, products, or suppliers increases risk.

What percentage of the company`s business is generated overseas. Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.

What are the probable actions of current competitors and the likelihood of additional new competitors?

Do the company`s future prospects depend critically on the success of products currently in the pipeline or on existing products

How does the legal and regulatory environment affect the company

The company should always use a mixture of both qualitative and quantitative analytical tools in order to improve the quality of their financial performance and financial management.

Part 2

2.1 Appraisal of the investment projects

2.1.1 Payback period method

Project 1

Year

Cash flows

Cumulative cash flow

0

-1100

-1100

1

-110

-1210

2

200

-1010

3

400

-610

4

500

-110

5

670

Payback period = 4 + ((110/520) * 12)

= 4 years and 2.5 months

Project 2

Year

Cash flows

Cumulative cash flow

0

-800

-800

1

-20

-820

2

140

-680

3

250

-430

4

300

-130

5

460

Payback period = 4 + ((130/380) * 12)

= 4 years and 4.1 months

The first project will cover its capital cost in 4years and 2.5 months whereas the project 2 will take 4 years and 4.1 months. Thus, project 1 should be selected according to the pay back period method.

2.1.2 Net present value method

Project 1

Year

Cash flows

Discounting factor

Present value

0

-1100

1

-1100

1

-110

0.909090909

-100

2

200

0.826446281

165.2892562

3

400

0.751314801

300.5259204

4

500

0.683013455

341.5067277

5

670

0.620921323

416.0172864

NPV

23.33919069

Project 2

Year

Cash flows

Discounting factor

Present value

0

-800

1

-800

1

-20

0.909090909

-18.18181818

2

140

0.826446281

115.7024793

3

250

0.751314801

187.8287002

4

300

0.683013455

204.9040366

5

460

0.620921323

285.6238086

NPV

-24.1227934

As the net present value of project 1 is greater than the net present value of project 2, according to the net present value technique, project 1 should be selected.

2.1.3 Internal rate of return method

Calculating IRR for project 1 (£`000)

NPV under a cost of capital of 20%

Year

cash flows

Discounting factor

Present value

0

-1100

1

-1100

1

-110

0.833333333

-91.66666667

2

200

0.694444444

138.8888889

3

400

0.578703704

231.4814815

4

500

0.482253086

241.1265432

5

670

0.401877572

269.2579733

NPV

-310.9117798

IRR for project 1 = 0.1+ (0.2-0.1) * (23.33919069/ (23.33919069 – (310.9117798)))

= 10.69825349%

Calculating IRR for project 2 (£`000)

NPV under a cost of capital of 20%

Year

Cash flows

Discounting factor

Present value

0

-800

1

-800

1

-20

0.833333333

-16.66666667

2

140

0.694444444

97.22222222

3

250

0.578703704

144.6759259

4

300

0.482253086

144.6759259

5

460

0.401877572

184.8636831

NPV

-245.2289095

IRR for project 2 = 0.1+ (0.2-0.1) * (-24.1227934/ (-24.1227934- (245.2289095)))

= 8.908994746%

As the discounting rate at which the decision will be revise (i.e. internal rate of return where the net present value of the project will be zero) is greater in project 1 than in project 2, project 1 should be selected under this method.

2.2 Relevant considerations and financial information useful in decision making

According to Blocher (2006: p.841) before undertaking a capital investment firms must define clearly the objectives of the capital investment project and set unambiguous boundaries for the project. The management must not know not only what the project will do but also what it will not do. Lack of clear definition of a proposed investment project will increase the difficulty in estimating revenues, costs and cash flows. Too often a project without clear boundaries grows into a huge undertaking that exceeds the firm`s available resources. Furthermore, the company should focus on the legal requirements and relevant restrictions towards the proposed project. If the project impacts the environment in a negative manner, then the company will have to face negative reactions from their customers which will ultimately lead to lower the demand and thereby the profitability of the firm. Thus, a company should focus on all these things before undertaking a capital investment.

2.3 Evaluating Investment appraisal methods

2.3.1 Payback period

According to Floyd (2004: p.91) this method of investment appraisal calculates how long it takes a project to repay its original investment. Hence, this method concentrates on cash flows, highlighting projects that recover quickly their initial investment. As this project mainly focus on cash flows, all the non cash items such as depreciation are excluded.

According to Wiggins (2010: p.67) this method is quick to calculate and easy to understand. Furthermore, the relevant data for calculations are readily available and this is more appropriate for simple projects. This method concentrates on earlier cash flows which are easier to forecast. This is also a measure of liquidity since it is based on cash flows. But the main disadvantage of using this method to appraise investment projects is that this does not account for time value of money over time in which the project is operational. Furthermore, the potential profitability of the project is ignored. As a result a manager using this method of appraisal may reject investment opportunities that are more profitable than the project finally selected. This may be a big issue for a company whose main focus is on maximizing the profitability of the company. Cash flows which occur after the payback period are ignored. Hence, this is not suitable for complex projects which will be continued for a long period of time.

2.3.2 Accounting rate of return

According to Drury (2006: p.244) the accounting rate of return (also known as the return on investment and return on capital employed) is calculated by dividing the average annual profits from a project into the average investment cost. This method differs from other methods because profits are used rather than of cash flows. The use of accounting rate of return can be attributed to the wide use of the return on investment measure in financial statement analysis.

According to Needles et al (2011: p.1167) the accounting rate of return method has been widely used because it is easy to understand and apply, but it does have several disadvantages. First, because net income is averaged over the life of the investment, it is not a reliable figure. Actual net income may vary considerably from the estimates. Second, the method is unreliable if estimated annual net incomes differ from year to year. Third, it ignores cash flows. Furthermore, it does not consider the time value of money.

2.3.3 Net present value

According to Brigham et al (2009: p.338) the net present value indicates how much a project contributes to share holder wealth. The larger the net present value, the more value the project adds and this will lead to a higher stock price. Thus, net present value is a method of ranking investment proposals using the net present value, which is equal to the present value of future net cash flows, discounted at the cost of capital.

According to Siddiqui (2006: p.321) there are several steps involved in determining the net present value of an investment project as,

Determination of an appropriate rate of interest to discount cash flows (generally know as the cost of capital).

Computation of the present value of total investment outlay (i.e. cash outflows) at the determined discounting rate. If the total investment is made in the first year itself, then the present value will be the same as the cost of the project.

Computation of the present value of total cash inflows (profit before depreciation and after tax) at the above determined discount rate.

Subtracting the present value of total cash outflows (cost of the investment) from the present value of cash inflows to arrive at the net present value of cash inflows.

In case the net present value is positive, the project proposal will be accepted.

In case there is more than one project then the company should choose the project with the maximum positive net present value.

Same as every investment appraisal technique, net present value also have its own advantages and disadvantages.

According to Sheeba (2005, p.390) the advantages of this method includes, it considers all cash flows. It reveals the true profit potential of any investment. Furthermore, it considers the time value of money. The riskiness of the future cash flows are incorporated in estimation of the cost of capital which is the discount rate used in the NPV calculations. But on the other hand, the discount rate or the cost of capital has to be calculated before calculating the net present value. The cost of capital does not remain constant and hence, any changes in the discount rate affect the value of the investment. Furthermore, this method requires calculation of the future cash flows of the investment proposal. The cash flow estimations are used to calculate the NPV of the investment. Any changes or errors in these result in the NPV calculation going wrong. Cash flow calculation and forecasting is a difficult task to achieve.

2.3.4 Internal rate of return

According to Rohrich (2007: p.79) the internal rate of return is the discount rate which sets the net present value of an investment to zero. This rate is also known as the critical discount rate of the investment, because a higher discount rate would lead to a net present value of the investment below zero. The internal rate of return represents a break even rate of return of the investment opportunity. A single investment is profitable, if its internal rate of return exceeds some predetermined cut off rate of return. This hurdle rate is usually the market rate of interest which reflects the opportunity cost of the capital employed. To be selected, the investment project must generate a return at least equal to the return available elsewhere on the capital market.

According to Moyer et al (2012: p.364) the internal rate of return method is used widely by business firms because this technique takes into account both magnitude and the timing of cash flows over the entire life of a project in measuring the economic desirability of the project. owever, some potential problems are involved in using the internal rate of return technique. The possible existence of multiple internal rates is one such problem. This will occur if the cash flows of the project are not in a conventional method. (I.e. there are cash outflows excluding the initial outlay over the life time of the project.) If there is more than one internal rate of return, there will be a problem in selecting a single rate.

2.4 Report to the Chief Financial Officer

To: The Chief Financial Officer

From: Financial Analyst

Date: 06/05/2013

Subject: Investment Appraisal Techniques

For any company who wish to grow in the industry and ensure the sustainability, they should continuously involve in capital investments. As capital investment decision requires a large pool of funds, subject to uncertainty of future and the irreversible nature of those decisions, before investing the company should always evaluate the project.

According to Rohrich (2007: p.3) with regard to the nature of the asset, a company can distinguish between three main investments as physical investments (e.g. real property or machinery), financial investment (e.g. stocks or shares in other companies) or intangible investment (e.g. investment in employee education, research and development). Regardless of the type or the size of the investment project, they should be evaluated in terms of liquidity, profitability and risk. There are commonly used techniques to do this including,

Payback period

Accounting rate of return

Net present value

Internal rate of return

For the given two projects which have the same life time, the payback period had a slight difference. Since, lower the payback period, the better it is, project 1 should be selected which has a lower payback period than project 1. The net present value of the project 1 is also greater than the project 2 which records a negative net present value. The rate at which the net present value will become zero (i.e. internal rate of return) is higher for project 1 than for project 2.

Hence, project 1 must be selected.

Conclusion

The above report was done with the intention to give a complete and clear understanding about two major subject areas coming under financial management namely ratio analysis and investment appraisal. In the first part of the report, it includes a detailed ratio analysis which was carried out for British Airways comparing the data for 2009, 2010 and 2011. This analysis helps the company to identify their weak points and the points where they could work on in order to improve the performance of the company.

In the latter part of the report, it has a detailed analysis about the techniques a company can use to evaluate their capital investment projects. Here, the company should not rely on a single technique. Rather they should use a mixture of techniques to evaluate the profitability, liquidity and the risk of the project.

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