Using Ratios to analyse a companies profitability - Free Essay Example

# 1. Analyse the performance and financial position of the company and comment on any features you consider significant by calculating the ratios that will help in assessing the profitability, liquidity, efficiency and investment ratios of Haflan Ltd.? Definition Profitability Ratio : Measures  that indicate how well a  firm  is performing in terms  of its  ability  to generate  profit. 1. Gross Profit on Net Sales = Net Sales Cost of Goods Sales Net Sales = 3900 2430 3900 = 1470 - 3900 Gross Profit on Net Sales Ratio = 0.37 2. Net Operating Profit Ratio = Earning after Tax Net Sales = 337.50 3900 = 0.08 Definition Liquidity Ratio : A class of financial metrics  that  is used  to determine a companys ability to pay off its  short-terms debts obligations.  Generally, the higher the value of the ratio, the  larger the margin of safety  that  the company possesses to cover short-term debts.  Ãƒâ€šÃ‚  Ãƒâ€š Current Ratio = Current Assets - Current Liabilities = 2130 1717.50 = 1.24 Inventory Turnover Ratio = Cost of Goods Sales Average Inventory = 2430 - 900 = 2.7 Definition Efficiency and investment ratios : Measure of relationship between income and overhead expenses. Efficiency Ratio = Non Interest Expenses Revenue = 990 - 3900 = 25.38 Investment Ratio = Net Profit Before Tax Share Holders Equity = 480 1050 = .45 Question # 2. Relying on your findings and interpretation of information in (1) above, present an evaluation or make recommendations on the strategic portfolio of the organisation. Answer Recommendations on the strategic portfolio of Haflan Ltd. To improve the financial assets of Haflan Ltd. there should be a focus on attracting more clients and giving them them satisfaction they desire. An organization like Haflan Ltd. needs to have a positive portfolio so that it will achieve its financial and business goals. An organization needs to make sure that it will only use strategies to attract clients and make them purchase the firms products and services. It is expected that Haflan Ltd. will continue its upward trend wherein it will acquire more market shares. Since the movement from May to Jun is an upward movement then it is expected that it will continue unless the environment forces a downward or unchanging movement. The firm would make use of strategies that made it successful like low prices and well used advertising strategies.   Hafl an Ltd. should make sure that most of its finances would be used for advertising to attract clients and would be used to help the investment project succeed in competitive environment. To improve the financial assets of Haflan Ltd. there should be a focus on attracting more clients and giving them the satisfaction they desire. An organization like Haflan Ltd. needs to have a positive portfolio so that it will achieve its financial and business goals. Question # 3. Identify (and name) a known organisation of your choice then carry out a performance audit of the organisation referring to internal and external factors. You need not present any calculation. Answer Performance audit of Tesco using internal and external factors Tesco has been successful and has reached a wide market due to the assistance of the internal and external environment. The internal factors for its success could be the use of positive strategies like low pricing and the use of advertisements to reach more clients. The external factors for its success could be the peoples need to purchase products that have lower prices, the need for a store that can easily be located and the need for a store that doesnt have much shoppers. Financial managers may have harped on capital efficiency, but no financial performance measurement told managers that they hurt shareholders by bringing on-line excess factory capacity, building expensive inventory, or allowing overgenerous payment terms. Of course, financial measures can improve decision making by means other than just taking into account the cost of shareholder capital. Other factors excluded by conventional accounting include inflation, valuing many intangible assets, and accounting for externalities. Executives who believe that these factors distort decision making should factor them into their measures through inflation adjustments, intangibles accounting, and full-cost environmental accounting (Carlsson 2001).If, for example, executives want to highlight the return on investments in such intangible assets as RD, brands, and employee training, they should capitalize those costs and calculate the return on the investment in them.  Most executives today figure they already go overboard in demonstrating their companys financial performance. The required report card may not reveal the most compelling measures of company value. Instead, that reporting may flummox stakeholders understanding of financial value (Milgate 2004). Companies that rely solely on traditional accounts risk driving away investors and thus driving up the cost of capital. Investors are wary of the alternative truths produced by ac counting discretions. After all, they know that GAAP reporting allows accountants to apply varying principles to everything from cash, receivables, securities, and inventories to plant, equipment, intangible assets, long-term liabilities, revenues, and cost of goods sold. Two identical companies, with identical results, can report opposite results, one growing income, the other shrinking. The first task of executives should be to comply with the existing standards use the mandated reporting framework to more fully explain their performance but if they want to win loyal stakeholders through financial accountability, they have to go much further. They need not necessarily publish a lot more information, which CFOs endlessly complain about. But they need to voluntarily disclose the few key metrics and explanatory detail that show if the company is working to create value (Comiskey Mulford 2000). Question # 4. Yudio Ltd. is considering a capital investment project costing  £5 0,000. The project is expected to have a life of 4years with a residual value of  £5000. Estimated future profits before taxation on the project are as follows: Year Profit Before tax  £20,000  £22,000  £23,000  £24,000 The companys cost of capital is 15% and it uses straight line depreciation. You are required to calculate: ARR of the project Payback period of the project NPV, IRR and PI of the project and justify whether or not the project is worthwhile. Ignore taxation. Answer Depreciation = 50000 5000 - 4 = 11250 Pay Back Depreciation after Tax. It will be calculated later as PATBD. Pay Back Period P.B.T Tax + Dep = PATBD 1) 20000 _ () + 11250 = 31250 2) 22000 () + 11250 = 33250 3) 23000 _ () + 11250 = 34250 4) 24000 _ () + 11250 = 35250 ______ _______ ________ 89000 45000 134000 Pay Back Period 31250 18750 * 12 = .564 - 33250 Euro 50000 will be covered in approx. 1 yr. and 5 months. 2) ARR It will be calculated as PATAD- Profit after tax and depreciation But we have to ignore Taxes. Therefore we will calculate as tax = nil and depreciation have been calculated by given PB tax. 20000 22000 23000 24000 - 89000 ARR = Total Profit * 100 Net investment * No. of yrs. of profit = 89000 * 100 50000 * 4 ARR = 44.5% PATED [email  protected]/* */% NPV of cash inflow 31250 .869 27156 33250 .756 25137 34250 .657 22502 35250 .571 20127 5000 .571 2855 - 139000 97777 3) NPV of cash outflow 50000 NPV of inflow 97777 NPV of outflow 50000 - Surplus NPV 47777 So the viability of this project is positive. 4) P. Index G.P.I = 97777 = 1.9555 - 50000 5) IRR 1 = .666 1+ 50 Discounted @ 50% 1) 31250 .666 20812 2) 33250 .444 14763 3) 34250 .296 10138 4) 35250 .197 6944 5) 5000 .197 985 Discounted @ 55% 1) 31250 .645 20156 2) 33250 .416 13832 3) 34250 .268 9179 4) 35250 .173 6098 5) 5000 .173 865 50130 Discounted 1) 31250 .641 20031 2) 33250 .411 13665 3) 34250 .263 9008 4) 35250 .169 5957 5) 5000 .169 845 49506 55% + 130 * (56% 55% ) 130 + 494 55% + .208 * 1% IRR = 55.208% Question # 5. Financing projects within an organisation is paramount for many obvious reasons. Identify and discuss the ways through which the company raise fund for its project. Propose and justify the ways to source fund for a specific project of your choice. Answer The sources of financing will, generically, comprise some combination of  debt  and  equity  financing. Financing a project through debt results in a  liability  or obligation that must be serviced, thus entailing cash flow implications independent of the projects degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a  dilution  of ownership, control and earnings. The  equity is also typically higher than the  cost of debt  (see  CAPM  and  WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk. Sources of funds available to Tesco Given the positive market trend for Tesco the probable source of funds would be the income from sales, the income from deals with suppliers and other receivables. The income from sales would give the finances to support the move into the market. The income from sales will be utilized so that it can grow further and multiply.   A source of funds would be the payment received from suppliers in other branches. Suppliers who lets the company sell some of its product have to pay a certain fee for the promotion and marketing of their products. The funds from the payment of suppliers would give more funds to the company as they initiate a new markets.   The investors and stockholders would also serve as a source of income. The investors and stockholders would be business people who would like to try out Tescos market. They are the ones that have the finances to invest in a new company or a thriving one. The funds from local investors and stockholders would serve as a good so urce of finances for Tesco.  Question # 6. From your knowledge of financial appraisal techniques select appropriate and relevant financial information for use in the process of making strategic decisions on investment. Justify you position. Answer The most commonly used method for conducting a financial appraisal of small projects requiring less financial investments is the payback method. For larger projects, the average rate of return is commonly used as the principal criterion and the payback period is used as a supplementary criterion. Discounted cash flow (DCF) techniques are now being increasingly used to evaluate large investments.  Many other criterias are used for evaluating investments: profit per dollar invested (calculates the actual profit earned in terms of each dollar invested); cost saving per unit of product (calculates the amount of savings on the cost of production per unit); and investment required to replace a worker (calculates the additional amount required to replace an existing worker). From the above discussion we could chalk out the following financial information for use in the process of making strategic decisions on investment. The appraisal criteria for evaluating projects should b e standardized. The use of many methods makes comparison between projects difficult. The approach followed for evaluating projects must be clearly defined. Vague qualitative phrases should be substituted by quantitative measures wherever possible. This is necessary to promote understanding and avoid confusion. Discounted cash flow techniques should receive greater emphasis. They are theoretically superior and practically feasible. To sum up, the evaluation must be carried out in explicit, well-defined, preferably standardized terms and should be based on sound economic principles. Investment decision-making must be based on a careful and sound evaluation of the available data. Question # 7. On the basis of a post-audit appraisal make recommendations on the appropriateness of selected investment project decisions? Recommendations on the appropriateness of selected investment project decisions  Tesco should use the post audit appraisal to determine if the selected investment project decisions would be helpful to the firms growth and would be helpful for the success of the firm in the industry. Tesco can use the post audit appraisal to analyze the financial standing of the firm. It can use such appraisal to understand how the firm improved after the investment project was initiated. Moreover Tesco should make use of the post audit appraisal to know the trends in the finances and how it will affect the firm.   The future trends will help in forecasting the next steps that the firm must take. Tesco should make sure that most of its finances that it would be used for advertising to attract Indian clients and would be used to help the investment project succeed in India. Question # 8. What do you understand by Financial Viability? In analysing financial statements discuss relevant information necessary to assess the financial viability of an Organisation? Definiti on : The ability of an entity to continue to achieve its operating objectives and fulfill its mission over the long term. The use of financial statements to analyze financial viability Based from Tescos balance sheet in 2009 the company has higher total assets for 2009 than 2007 and 2006. In 2006 the company had $198,924, in 2007 the company had $253,185 and in 2008 the company acquired 238,908. This shows that the firm acquired more things in 2008 than the previous years.   Tesco had lower total liabilities for 2008 since it had $141,203 compared to $171,765 in 2007. It was a bit higher than the total liabilities in 2006 which is 132,727.   Tesco had financial viability in 2008 since it was able to acquire more than have additional liabilities. Tesco achieved more financial success in 2008 than the other years. The mark of the financially accountable organization has changed. Once upon a time, standard accounting measures like earnings per share were the gold standards of performance measurement. Traditional measures today, if used in isolation, raise a red flag. They signal to investors that managers may be reporting their performance reflexively as slaves to tradition, rather than as leaders of a well-wrought financial and business strategy. Every company has to follow GAAP accounting for mandated financial reporting, but none has to restrict itself to GAAP conventions in choosing measures to gauge and boost performance. Executives must choose yardsticks, traditional or new, that drive value at every point along the accountability cycle. The board of directors, employees, shareholders, and other stakeholders deserve and expect no less (Case, Kremer Rizzuto 2000). Businesses measure financial performance not just with traditional numbers. It bets its business on measures that gauge its contribution to long-term shareholder value: economic profit and cash flow return on investment. Executives should expect a list of financial measures to naturally focus on shareholder interests, the stakeholder most sensitive to financial performance. However, the financials should also take into account the performance delivered to other st akeholders involved in generating value (Birched Epstein 2000). In practice, the measures appropriate for shareholders may also be appropriate for others because of stakeholders intersecting interests. As managers create new financial measures, they must use them to deliver greater value at every point in the accountability cycle. Financial measures are among the most powerful of all measures. People simply watch dollars more carefully than other units of measure, especially if their pay depends on it. Executives number-one job in driving financial accountability is to choose or devise the financial measures that provide appropriate decision-making information internally, at every step in the management planning and control process. They have to renounce complete reliance on measures that have led to value-destroying decisions in the past. They have to open their minds to fresh thinking. Most managers outside the executive suite didnt even know their companies were taking value-des troying actions or actions that stunted the growth of cash flows, discounted at the cost of capital, that ultimately enlarge a shareholders investment (Milgate 2004).  Question # 9.Explain the statement that correlation does not necessarily imply causation. (b) In the following set of data, y represents ten finance companies total operating costs (in millions of  £) for a particular year and x represents the companies assets (in of  £) for the same year. Y 5 3 2 5 2 3 4 3 2 6 X 310 250 100 450 150 200 320 230 140 400 (i) Sketch the scatter diagram and comment on the relationship between x and y. (ii) Find the equation of the least-squares regression line, assuming that operating costs depend on assets. (iii) Calculate the correlation coefficient and comment on the result. (iv) Use your results in (ii) above to predict the operating costs for a firm with assets of  £500 million. Comment on the likely accuracy of your prediction. Answer Correlation does not imply causation is a phrase used in  science  and  statistics  to emphasize that  correlation  between two variables does not automatically imply that one  causes  the other. Weak type of positive correlation is shown in the scatter diagram of above Figure, which is said to exhibit just a  possible positive correlation.  Ãƒâ€šÃ‚  This scatter diagram still shows a perceivable diagonal line going in the upper right direction, but the points are more spread apart than in a scatter diagram with strong positive correlation. Equation of the least-squares regression line.   In a cause and effect relationship, the  independent variable  is the cause, and the  dependent variable  is the effect.  Least squares linear regression  is a method for predicting the value of a dependent variable  Y, based on the value of an independent variable  X. The Least Squares Regression Line Linear regression finds the straight line, called the  least squares regression line  or LSRL, that best represents observations in a  bivariate  data set. Suppose  Y  is a dependent variable, and  X  is an independent variable. The population regression line is: Y = ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢0  + ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢1X where ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢0  is a constant, ÃÆ'Ã… ½Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢1  is the regression coefficient, X is the value of the independent variable, and Y is the value of the dependent variable. Given a random sample of observations, the population regression line is estimated by: ÃÆ'†¦Ãƒâ€šÃ‚ · = b0  + b1x where b0  is a constant, b1  is the regression coefficient, x is the value of the independent variable, and ÃÆ'†¦Ãƒâ€šÃ‚ · is the  predicted  value of the dependent variable. We can solve for b0  and b1  by using the following equations. b1  = ÃÆ'Ã… ½Ãƒâ€šÃ‚ £ [ (xi  -  x)(yi  -  y) ] / ÃÆ'Ã… ½Ãƒâ€šÃ‚ £ [ (xi  -  x)2] b1  = r * (sy  / sx) b0  =  y   b1  *  x where b0  is the constant in the regression equation, b1  is the regression coefficient, r is the correlation between x and y, xi  is the  X  value of observation  i, yi  is the  Y  value of observation  i,  x  is the mean of  X,  y  is the mean of  Y, sx  is the standard deviation of  X, and sy  is the standard deviation of  Y Properties of the Regression Line When the regression parameters (b0  and b1) are defined as described above, the regression line has the following properties. The line minimizes the sum of squared differences between observed values (the  y  values) and predicted values (the ÃÆ'†¦Ãƒâ€šÃ‚ · values computed from the regression equation). The regression line passes through the mean of the  X  values (x) and the mean of the  Y  values (y). The regression constant (b0) is equal to the  y intercept  of the regression line. The regression coefficient (b1) is the average change in the dependent variable (Y) for a 1-unit change in the independent variable (X). It is the  slope  of the regression line. The least squares regression line is the only straight line that has all of these properties. The Coefficient of Determination The  coefficient of determination  (denoted by R2) is a key output of regression analysis. It is interpreted as the proportion of the variance in the dependent variable that is predictable from the independent variable. The coefficient of determination ranges from 0 to 1. An R2  of 0 means that the dependent variable cannot be predicted from the independent variable. An R2  of 1 means the dependent variable can be predicted without error from the independent variable. An R2  between 0 and 1 indicates the extent to which the dependent variable is predictable. An R2  of 0.10 means that 10 percent of the variance in  Y  is predictable from  X; an R2  of 0.20 means that 20 percent is predictable; and so on. The formula for computing the coefficient of determination for a linear regression model with one independent variable is given below. Coefficient of determination.  The coefficient of det ermination (R2) for a linear regression model with one independent variable is: R2  = { ( 1 / N ) * ÃÆ'Ã… ½Ãƒâ€šÃ‚ £ [ (xi  -  x) * (yi  -  y) ] / (ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢x  * ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢y  ) }2 where N is the number of observations used to fit the model, ÃÆ'Ã… ½Ãƒâ€šÃ‚ £ is the summation symbol, xi  is the x value for observation i,  x  is the mean x value, yi  is the y value for observation i,  y  is the mean y value, ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢x  is the standard deviation of x, and ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢yis the standard deviation of y.   Ãƒâ€šÃ‚  Ãƒâ€š Standard Error The  standard error  about the regression line (often denoted by SE) is a measure of the average amount that the regression equation over- or under-predicts. The higher the coefficient of determination, the lower the standard error; and the more accurate predictions are likely to be. The predicted operating cost for the firm will be  £ 49 million . The coefficient of determination measures the proportion of variation in the dependent variable that is predictable from the independent variable. The coefficient of determination is equal to R2; in this case, (0.70)2  or 0.49. Therefore,  £ 49 million is predicted operating cost.