The History Of Financial Management And Control

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02 Nov 2017

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Introduction

All organizations operate on the premise of making profit eventually. The organizations must ensure that they are thorough on the financial records they keep because this is what determines how well the business performs. In every financial year, organizations need to review their financial records and balance their books in preparation for the next financial year. Using ratios and other business finance concepts, the organization is able to determine its financial position. This information will also help the organization when creating their budget. Several methods exist that can be used to determine an organization’s financial position and future forecasts. Some of these methods and tools have been discussed in this paper.

PART A

1.Payback period

This refers to the number of years that it takes to recover the initial cost of the project from the cashflows generated by the project.

Year Revenue Cost Depreciation EBT TAX CFAT

1 80000 15000 40000 25000 - 65000

2 80000 15000 40000 25000 - 65000

3 80000 15000 40000 25000 - 65000

4 80000 15000 40000 25000 - 65000

Payback = initial cost ÷ cashflow

£200000 ÷ £65000

3.07 years

This means that it will take 3.07 years to successfully recover the initial cost of the machine from the cashflows.

The payback period method is preferred because of its simplicity in application and comprehension. Furthermore, it uses cashflows rather than profitability of the project (Gitman & Mcdaniel, 2009).

Disadvantages of payback period method

1.It ignores the time value of money

2.Ignores the cashflows after the payback period

3.It is difficult to obtain a maximum payback period because of the unpredictability of the cashflows.

2. Accounting Rate of Return

This method uses the accounting profits from Financial statements to assess the viability of the investment by dividing the average income affter tax by the averageinvestment.

Accounting rate of return = Average income (after tax) ÷ Average investment

Average investment = (Initial capital outlay + Salvage value) ÷ 2

Average investment = (£ 200000 + £ 40000) ÷ 2

Average investment = £ 120000

Accounting rate of return = £ 80000 ÷£ 120000

= 0.66 = 66.67 %

In this case, the management will set the minimum accepted Accounting rate of return which will depend on the ARR that the firm is currently enjoying on its existing projects.

If the Accounting Rate of Return is compared to the company’s cost of capital, the investment will be considered feasible since the rate of return is higher than the expected cost of capital.

Advantages

1.Simple to understand and use

2.Readily computed from the accounting data and therefore easy to ascertain

3.It uses the cashflows generated from the entire period.

Disadvantages

1.Ignores the time value of money

2.Uses accounting profits rather than cashflows, some of which may be unrealizeable.

3.Ignores the fact that profits could be re-invested

3. Net Present Value

Net present valus is the difference between the present value of cash inflows and the present value of the cash outflows.

Year Cashflow Discounting factor (10 %) NPV

1 £ 65000 0.9091 £ 59090.90

2 £ 65000 0.8264 £ 53719

3 £ 65000 0.7513 £ 48835.46

4 £ 65000 0.6830 £ 44395.87

4 £40000 0.6830 £ 27320

Total £233361.23

Less: outflow £200000

£33361.23

The Net present Value of the project is positive. This means that implementation of the project will yield positive returns.

Advantages

1.It takes into account the time value of money

2.Uses the cashflows and not the profitability

3.It is consistent with the shareholder wealth maximization objectives

Disadvantages

1.It is more difficult to compute as compared to the non-discounted methods.

2.Uses the firm’s cost of capital to discount the cashflows thus assuming that the firm’s source of capital is readily available (Gitman & mcdaniel, 2009).

4. Internal Rate of Return (IRR):

Calculating the negative NPV at 20%

Year

Cash Outflow

Cash Inflow

Net Cash flow

Discount factor (20%)

Present value

0

(200,000)

-(200,000)

1.00

(200,000)

1

65000

65000

0.83

54145

2

65000

65000

0.69

53950

3

65000

65000

0.58

37700

4

105000

105000

0.48

31200

(23005)

IRR= R1+NPV1 * R2-R1

NPV1-NPV2

= 10+33305 *20-10

33305+23005

= 10+ 33305 *10

56310

= 15.91%

PART B

(a).

Break Even Point (Units) = Fixed costs ÷ Contribution

Contribution = Selling Price – Total Variable Cost

Total variable costs = £8 + £4 = £12

Contribution = £20 - £12 = £8

Therefore;

Break Even Point (Units) = £320,000 ÷ (£8) = 40000 units

Break Even Point (Value) = Break Even point units × Selling price

= 40000 units ×£20

=£800000

The Value of Safety Margin is calculated as;

Value of Safety Margin (V.o.S) = Actual Sales – Break Even Point Sales× 100

Actual Sales

Value of Safety Margin (V.o.S) = (£1,500,000 - £800000) ÷ £1,500,000 ×100

= 46.67 %

(b).

Last Year’s Contribution Margin Ratio = (Selling Price – Contribution) ÷ Selling Price ×100

Last Year’s Contribution Margin Ratio = (£20- £8) ÷£20 × 100

= 60%

New contribution = 105% ×£8 = £8.4

Therefore, to maintain the Contribution Margin Ratio at 60%, the Selling price should be;

60% = (s.p - £8.4) ÷ s.p × 100

Let Selling price be; X

0.6 = (X-8.4) ÷ X

0.6X = X -8.4

0.6X – X = -8.4

-0.4X = -8.4

X = 21

Therefore, the New Selling price should be £ 21

(c).

Effect of increasing the Unit variable costs by £0.4

Old Break even point (Units)

Old Break even point (Units) = Fixed costs ÷ Contribution

Contribution = Selling Price – Total Variable Cost

Total variable costs = £8 + £4 = £12

Contribution = £20 - £12 = £8

Therefore;

Break Even Point (Units) = £320,000 ÷ (£8) = 40000 units

Break Even Point (Value) = Break Even point units × Selling price

= 40000 units ×£ 20

=£ 800000

New Break Even Point (Units)

New Break Even Point (Units) = Fixed costs ÷ Contribution

Contribution = Selling Price – Total Variable Cost

Total variable costs = £ 8 + £ 4+ £ 0.4 = £ 12.4

Contribution = £ 20 - £ 12.4 = £ 7.6

Therefore;

Break Even Point (Units) = £ 320,000 ÷ (£ 7.6) = 42105 units

Break Even Point (Value) = Break Even point units × Selling price

= 42105 units ×£ 20

=£ 842105

This shows that an increase in the Unit variable Cost raises the Break Even Point Units and Value.

Units = 42105 – 40000 =2105 units

Value = 2105 units ×£ 20 =£ 842105

Actual sales (units) = £1,500,000 ÷£ 20

= 75000 units

Both actions are expected to raise the units of sale by 10%

i.e New sales units = 1.1 × 75000

=82500 units

El-Domyati Co

Expected Income Statement

Sales (82500 units ×£ 20) £ 1650000

Less : Expenses

Unit Variable costs

(£12.4 × 82500 units) £ 1023000

Fixed Costs

(£1500 × 12) + £320,000 £338000 (£1361000)

Profit £289

The Assumptions and Criticisms of Break Even Point analysis

Break Even Point analysis assumes that Selling price, Units Demanded, and Variable costs are easy to estimate and are fixed over the entire period (Gitman & mcdaniel, 2009). However, this is misleading since in the Business world, Selling price is not fixed. It depends on the client, discounts and other factors.

This analysis can only be conducted in the short-run.

It assumes that there is only a single product or a constant production mix.

It assumes that Variable costs remain constant within the relevant range.

There is an assumption that all costs can either be divided into Fixed costs or Variable costs. However, some costs such as labour are known to exhibit characteristics of both Fixed and variable costs.

PART C

Liquidity Ratios

(a). Current Ratio : This shows the number of times that the firm can pay its current liabilities from the current assets(Gitman & Mcdaniel, 2009).

i.e Current ratio = Current assets ÷ Current liabilities

The current ratio for the firm has been gradually declining over the years from 2.00 in 2010, 1.8 in 2011 and 1.65 in 2012. This indicates that the current liabilities of the firm are increasing or the current assets are decreasing.

(b). Acid Test Ratio : This is a more refined ratio that measures the ability of the firm to pay its current liabilities from the liquid/ quick assets.

Quick assets = Current assets – stock

Acid test ratio = Quick assets ÷ Current liabilites

The decline in the Acid test ratio further affirms our earlier inference that current liabilities of the firm are increasing of the current assets are declining.

Asset Utilisation Ratios

(a). Account receivables ratio = Credit sales ÷ Average debtors

The declining Debtor’s turnover ratio from 9.72 in 2010, 8.57 in 2011 and 7.13 in 2012 indicates the firm’s increasing investment in debtors. This shows that the opportunity cost of capital is rising, and will reduce the firm’s profitabitlity significantly.

(b). Inventory Turnover ratio = Cost of Sales ÷ Average Stock

This ratio shows the efficiency of the firm in managing its stock(Gitman & Mcdaniel, 2009).

In 2010, the inventory turnover ratio was 5.25 times. This means that the annual cost of sales was 5.25 times bigger than the average stock. This ratio has been declining from 4.8 in 2011 to 3.8 in 2012. This shows that either the cost of sales has decresed against an increasing average stock held by the firm.

(c). Account payable days / Average payment period = (365 × average creditors) ÷ credit purchases

This shows the average period extended to the firm by its creditor’s to pay back their debts. An increasing Average payment period indicates improving relations between the firm and its creditors. This is beneficial to the firm as it can improve its profitability by making use of the extended credit period. Credit purchases are considered a dource of external financing to the firm.

(d). Sales to fixed assets / Total asset turnover

This ratio compares the firm’s total sales to its fixed assets. It shows the proportion of sales generated from fixed assets. This ratio has been increasing from 1.75 in 2010, 1.88 in 2011 to 1.99 in 2012. This shows that the total sales generated from fixed assets have been increasing. This essentially infers an increase in efficiency in the use of fixed assets.

(e). Sales as a Percentage of 2009 sales

This is a comparison of sales using 2009 sales as the base year.

i.e (sales in year X × 100) ÷sales in 2009

The 100 % in 2010 shows that the sales in 2009 and 2010 were equal. In 2011, the sales and increased by 3 % to 103 % and in 2012 they increased by 6 % in comparison to the base year 2009.

Profitability Ratios

(a). Gross profit margin = (Gross profit ÷ sales) × 100

This ratio indicates the ability of the firm to control the cost of goods sold expense. It shows the gross profit as a percentage of the total sales. In 2010, the gross profit margin was 40 %, it declined to 33.6 % in 2011 and finally settled at 30 % in 2012. The decreasing gross profit margin is a direct reflection of the decreasing profitability of the firm.

(b). Operating profit margin = (operating profits before Interest and tax ÷ sales revenue) × 100

This ratio shows the ability of the firm to control its operating expenses. The operating expenses comprise of goods sold, selling and distribution expenses, general and administration expenses. The operating profit margin was constant at 7.8 % in 2010 and 2011 then shot up to 8 % in 2012. This indicates improved management of operating expenses in 2012.

(c). Return on capital employed = (Earnings after Interest and tax ÷ Capital employed) * 100

This ratio, also referred to as the Primary ratio, measures the effieciency with which the company utilises the capital invested in it to earn profits.

Capital employed = net fixed assets + working capital

Prospect’s return on capital employed has been steadily decreasing over the three years from 8.5 % in 2010, then 8 % in 2011 and 7 % in 2012. This negative trend indicates a drop in the profitability of the firm and decreased effeiciency in using the firm’s capital employed.

Gearing ratios

(a). Gearing ratio = (Total fixed charge capital ÷ total capital) * 100

The fixed charge capital refers to the borrowed funds that have a fixed rate of return.e.g preference shares, debentures etc.This ratio indicates the proportion of fixed charge capital to total capital. It is the most popular indicator of financial risk in the company. The rising gearing ratio of Prospect Ltd. From 40 % to 52 % indicates increasing riskiness in the financial structure of the company.

(b). Interest coverage ratio = Earnings before Interest and Tax ÷ Interest charges

This ratio indicates the number of times that the company can pay interest charges out of operating profits. The decreasing interest coverage ratio from 15 times to 8 times in 2012 is a negative indicator to long term lenders who thus consider the company risky.

Investor Ratios

(a). Earnings per share = Earnings attributable to Ordinary shareholders ÷ number of ord. shareholders

It indicates the earning power of the firm. It is a measure of how much earning or profit will be received by each ordinary shareholder per share. The EPS has decreased from 1.30 in 2010, to 1.00 in 2011 then further down to 0.80 in 2012. This trend is unfavorable to investors who will perceive Prospect Ltd as a failing company in terms of the return per share of capital invested(Longenecker, 2012).

PART D

The main sources of finance available to business and the advantages and disadvantages of such finance

Financing a business requires a lot of capital, which in most cases is not readily available in the business. Therefore, potential business people have to look for other sources of finances for their business. The most commonly used sources of funding include; personal savings, government assistance, business partners, venture capital, convectional debt financing and going public. Sources of funding can be categorized as either internal or external sources. (Gitman & mcdaniel, 2009)

External sources of finance

Bank loans and bank overdrafts

Banks and credit facilities offer individuals bank loans to help finance businesses. This is a long term finance that the business can repay in instalments over a given period of time(Longenecker, 2012). Bank overdrafts areshort terms source of finance that resembles a loan facility. They help businesses to finance the seasonal fluctuations of the business finances (Dlabay & Burrow, 2007).

Advantages of a bank loan

Bank loans are convenient and easily accessible from banks.

Banks offer their customers multiple loan option where the individual can pick the most suitable option for the business.

Bank loans offer tax benefits where business taking loans from banks are given a little relief from tax

Unlike other lending agencies, bank loans offer lower rates to their customers.

Disadvantages of bank loans

The application process is lengthy because banks need to verify all credentials offered before they sanction the loan.

The risk of losing collateral especially where the business defaults in payment. This is because, bank loans are usually sanctioned using the collateral offered.

Banks seldom give the business the full amount applied for making it difficult for the entrepreneur o proceed as planned because they have to look for the extra money(Longenecker, 2012).

Banks have a long list of conditions and sometimes it is difficult to meet all of them. This discourages potential applicants

Share capital from friends and family

Share capital refers to outside investors who commit their funds to the business. These could be either friends or family of the owner(s) of the company (Dlabay & Burrow, 2007).

Advantages

In most cases, you do not have to pay back the money with interest

Disdavantages

Family and friends tend to get too involved in the business especially since they feel they own a share of the company

Internal sources of finance

Retained profits

This refers to cash that is generated in the business. This is retained profit gotten from the business (Dlabay & Burrow, 2007).

Advantages of using retained profits

Interest is saved

Self dependence where the company does not need to owe any institution or individual money.

Maintaining the company secrets where the company does not have to divulge business information to outsiders.

Disadvantages of using retained earnings

The company tends to lose its liquidity since its reserve is exploited.

Possibility of overcapitalization where the profit is retained in the business for too long

Profit deprivation where shareholders are denied the opportunity to enjoy their profits.

Personal savings

This is money from the founders’ savings.

Advantages of using personal savings

When personal savings are used, the individual still maintains his/her control over the business. This is unlike in the case where a loan is applied and the back or financial institution has a right over the business (Dlabay & Burrow, 2007).

Personal savings have no interest charges and the owner is solely responsible for how he chooses to use the money.

Disadvantages of personal savings as a source of finance

Personal savings are rarely enough and have to be supplemented with other sources of financing for example bank loans.

The use of budgets as a means of planning and controlling the various business activities

A budgeting is a process where resources, amount of capital, goals and milestones of a company are analyzed. Budgeting helps people to plan and control their finances. It is a formalized system that helps individuals to plan, forecast, monitor and control the operations of an organization. A budget is a plan that is used to mainly control finances (Gitman & Mcdaniel, 2009). A budget should cover the projected cash flows as well as the current cash flows to make it easier for financial planner to do their job. Planning is a future oriented process that involves making assumptions and forecasts regarding the organizations environment, especially the uncontrollable factors (Dlabay & Burrow, 2007). Controlling on the other hand involves the monitoring of business activities aimed at ensuring that the implementation of the plan is effective. Budgets are financial statement indicating the plans the organization has put in place. This links them to the control system of the organization. Once the budget is set, managers can now effectively monitor the financial performance of the organization. This process is continuous especially because the external environment of a business is spontaneous and can change at any time. Performance is measured against the budget and any deviations noted are rectified with immediate effect. Therefore, it can be stated that the budget acts as the road map for the organization.

Conclusion

Based on the data provided above, organizations must take time to calculate all their finances. This information determines how well the organization thrives in the market. For example, in the first part, the data acquired will help the organization to effectively decide on the feasibility of the choices they make. Financial decisions in any organization form the backbone of the organization because without finances, the organization cannot thrive. This means, all financial calculations must be precise and accurate lest they mislead the organization’s management in their decision making process.



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