Financial calculation - Essay Example

ACCOUNTING AND FINANCE 2005 Accounting and Finance Introduction Planning for a new business or expansion of a business today is never again a simple task. Globalization had caused factors that are previously 'foreign' to local business, becomes more and more influencing. Local producers cannot relax and keep producing mediocre quality products as foreign competitors entering the local market. The furniture industry for example, has become an international business rather than local. Local furniture producers in a country as far as Jamaica are threatened by the presence of US competitors ('Globalization and', 2003). The global environment has made planning a more complicated task as non-financial measurements are become increasingly important toward business forecasts. Specific preferences of the industry, habits of international competitors, and other non-financial factors must be considered, to prevent bias reporting of financial forecasts. Nevertheless, financial performance is still the main indicator of corporate success or failure. This is why the financial calculation has always been incorporated within academic studies. I. Corporate Background II.1 Financial Status Financial performance of a corporation can be evaluated by observing financial ratios. Financial ratios are indicators designed to elaborate certain aspects or corporate financial performance. Different aspects are elaborated by different ratios. There are four types of financial ratios, they are: Profitability Ratios Profitability ratios display the rate of return resulted from company operation over a certain period. The amount of profit itself is not sufficient to describe corporate performance over the period. Excess of revenue over expenses are compared to total sales and corporate assets in order to obtain a ratio that describe how much money resulted from existing assets (Financial Ratios, n.d). Several profitability ratios are profit margin, return on equity and return on total assets: Ratios 2003 2004 2005 Profit margin 30.00% 18.75% 11.67% Return on asset 15.38% 17.44% 7.29% Return on equity 35.29% 31.91% 12.73% According to corporate financial statement, Fine furniture is experiencing a significant decline over the last three years. In order to properly assess corporate performance we actually ought to compare corporate ratios with industrial average. However, comparison of the three periods available has clearly displayed significant downward shift. The ratios indicated that profitability performance decline more than 50% over the past two years. Due to limited data available, we are using end of year numbers to calculate the financial ratios, instead of average numbers. Liquidity Ratios Liquidity Ratios display corporate ability to pay short-term debt. The ratios compare liabilities of the company to existing assets, to see how many assets are available to guarantee each dollar of corporate short-term loan. The most well known liquidity ratios are current ratio and acid test ratio: Ratios 2003 2004 2005 Current Ratio 1.24 1.89 1.57 Acid Test Ratio 0.86 1.19 0.79 Fine furniture displayed average liquidity performance regarding liquidity ratios. The best performance was during the year 2004. Current ratio increases during 2004, but decreases again during 2005. Similar patterns are shown by the Acid Test Ratio. Solvability Ratios Solvability ratios have similar functions to liquidity ratios. However, solvability ratios concern long term instead of short term corporate abilities to meet existing obligations. Solvability ratios include debt ratio, gearing ratio and equity ratio. Ratios 2003 2004 2005 Debt Ratio 0.97 0.95 0.94 Gearing Ratio 0.06 0.08 0.10 Equity Ratio 0.44 0.55 0.57 According to financial statements, Fine Furniture has not seemed to take full advantage of long term debt possibilities. This is revealed by the gearing ratio, which displayed that only a very small portion of the capital is financed using long term debt. However, the debt ratio described acceptable performance as every dollar of debt is secured by at least one dollar of asset. Operating/Efficiency Ratios Operating ratios are measures of effectiveness in management operations. Unlike the profitability ratios that define performance by the rate of return earned from operations, the operating ratios use more direct approach to observe the workings of management. Examples of operating ratios are account receivable turnover and inventory turnover. Ratios 2003 2004 2005 Account Receivable Turnover 1.29 1.86 2.40 Inventory Turnover 0.75 1.88 1.27 In this case, the ratios of Fine Furniture are showing different performance quality within different department. The account receivable turnover ratio indicated that credit management is improving during the period. Nevertheless, the inventory turnover ratio indicated that inventory management increased within 2004 and decreased again along 2005. Other than comparison between the years, the financial ratios also deliver other knowledge about company's performance. For instant, the number 2.40 in account receivable turnover are relatively very low numbers. The numbers indicated that most customers require more than 5 months to pay its receivables. The same condition exists with the inventory management department. The number 1.88 on the other hand, means that most products stay in the inventory warehouse for more than 6 moths before it is sold. The average cost of managing inventory must be very high compare to other industry. These two assessments indicated that efficiency is at a relatively low point. II.2 Corporate Objectives Fine furniture is another example of a small company that found success and along with it, the problem of properly manages the rapidly growing business. As indicated by the financial statement, despite having significant increase of sales in 2004, sales and profit decrease significantly during 2005. Profitability, liquidity and efficiency performance suffered from the lack of proper financial management. Even if demands are increasing, further expansion without proper financial management will only bring profitability and efficiency performances further down. Regarding to the factors mentioned above, I believe that present corporate objective is to find a good future investment that will bring in fresh cash flows and stabilize the company's financial condition. In order to broaden their minds of existing investment alternatives, management hire consultant services to analyze their company. With the presence of Thomas Heath as the new full-time financial director, hopefully, the company will found the next investment to be more profitable. II. Evaluation of Suggestions 4 III.1 Using the Payback Period and Average Rate of Return There are several ways of evaluating investment possibilities. They are divided into two, the traditional evaluation method and the discounted cash flow method. However, since we are not using the discounted cash flow method, we will evaluate the options using the payback Period and the Average Rate of Return (ARR). The Payback Period is simply the amount of time required for the cash inflow of a certain investment to match the initial cash outflow. Companies will generally choose alternative that has the shortest payback period. We need to know that this method is popular because Several reasons. First, it is simple and understandable. The method is easily calculated and provides small room for error. Second, corporations living in the 'fast lane' usually require its investment to provide cash inflows quickly, in order to provide funds for other investment activities. Third, some investors demand a quick rate of return. Thus, corporations generally choose alternatives that present quick results. Nevertheless, negative sentiments also appear toward the method because the method lacks future considerations. Corporations using only this method to consider its investment options usually overlooked investments that generate small cash flow at the beginning, but turns out to be very profitable for long term development. Therefore, the method usually used as an initial screening, and then continued with other methods ('Investment Appraisal', 2005). The Average Rate of Return on the other hand, is an investment appraisal method that presents the rate of profit resulted from the project as a percentage of the initial investment. Similar to the payback period, this traditional method is popular because of its simplicity and understandability. Nevertheless, it is often criticized because lack of providing useful guidance for managers of which alternative to choose. Like the payback period, it is usually used as preliminary evaluation method, continued with the discounted cash flow methods. Despite the abundant criticism toward the methods, the Payback Period and the Average Rate of Return are still often used investment appraisal method among growing companies ('Investment Appraisal', 2005). III.2 Equity and Debt Financing In terms of investment financing, we must realize that not all money is the same. Before we decide which alternative to choose, we must first pay attention to our debt to equity ratio. This is important to prevent the company from jeopardizing its own survival. If our company has a higher proportion of equity compare to debt, then we should consider looking for debt financing instruments. On the other hand, if the company has a high proportion of debt compare to equity, then it is better to increase ownership capital for additional funds. We must pay attention to the fact that debt and equity financing have their own advantages and disadvantages. Debt financing for instant, has a very demanding presence due to its fixed rate of return and its ability to strip companies off their assets in term of failure to meet their obligations. However as long as companies are able to pay their debts on time, creditors do not have any rights to interfere in corporate operations. Equity financing on the other hand, does not create the burden of fixed interest rates, but shareholders are given the rights to influence management decisions and corporate directions. In extreme senses, shareholders have the right to replace corporate leaders. III.3 Financial Prospects In order to elaborate more clearly on how each alternative will affect corporate financial condition, we will provide estimations on corporate financial conditions for the period ended March 31, 2006. Previously, we will display the Payback Period and Average Rate of Return calculation. Payback Period and ARR Option 1 Option 2 Option 3 Option 4 Annual cash inflow1 16 6 10 6 Initial investment 86 23 57 46 ARR 18.60% 26.09% 17.54% 13.04% Payback Period 5.4 3.8 5.7 7.7 As we can see from the calculation above, the most profitable investment according to the two traditional methods is option 2. Financial forecast for the period ended March 31, 2006, using debt financing2 Summary of Profit and Loss Account (m) Option 1 Option 2 Option 3 Option 4 Turnover 76.00 66.00 70.00 66.00 Cost of Sales 35.47 30.80 32.67 30.80 Gross Profit 40.53 35.20 37.33 35.20 Operating Expenses 22.80 19.80 21.00 19.80 Interest Expense 8.60 2.30 5.70 4.60 Profit Before Tax 9.13 13.10 10.63 10.80 Taxation 4.57 6.55 5.32 5.40 Profit after Tax 4.57 6.55 5.32 5.40 Dividends 1.30 1.87 1.52 1.54 Retained Profit for the year 3.26 4.68 3.80 3.86 Other affected Figures Option 1 Option 2 Option 3 Option 4 Share Capital 25.00 25.00 25.00 25.00 Profit and Loss Account 33.26 34.68 33.80 33.86 Total Equity 58.26 59.68 58.80 58.86 Long Term Loan 92.00 29.00 63.00 52.00 Gearing Ratio 0.61 0.33 0.52 0.47 Earning per Share 0.18 0.26 0.21 0.22 Financial forecast for the period ended March 31, 2006, using equity financing Summary of Profit and Loss Account (m) Option 1 Option 2 Option 3 Option 4 Turnover 76.00 66.00 70.00 66.00 Cost of Sales 35.47 30.80 32.67 30.80 Gross Profit 40.53 35.20 37.33 35.20 Operating Expenses 22.80 19.80 21.00 19.80 Profit Before Tax 17.73 15.40 16.33 15.40 Taxation 8.87 7.70 8.17 7.70 Profit after Tax 8.87 7.70 8.17 7.70 Dividends 2.53 2.20 2.33 2.20 Retained Profit for the year 6.33 5.50 5.83 5.50 Other affected Figures Option 1 Option 2 Option 3 Option 4 Share Capital 111.00 48.00 82.00 71.00 Profit and Loss Account 36.33 35.50 35.83 35.50 Total Equity 147.33 83.50 117.83 106.50 Long Term Loan 6.00 6.00 6.00 6.00 Gearing Ratio 0.04 0.07 0.05 0.05 Earning per Share 0.08 0.16 0.10 0.11 As stated above, debt financing will result interest expense to eat away profit and left the company with little excess. There is significant different of profit between debt and equity financing alternative. According to profitability measurement, equity financing is preferable. Nevertheless, due to increase amount of shares issued, earning will be divided with larger number resulting earning per share to decrease significantly. According to earning per share perspective, debt financing alternative is significantly better. Focusing on the four options, overall financial forecast seemed to prefer option 2 to other alternatives. Debt financing perspective stated that option 2 is financially better according to profitability or earning per share measurements. However, Equity financing alternative displays unique results. According to profitability measurement, option 1 outranked option 2, but according to earning per share measurement, option 2 is still the best option. III.4 Non-Financial Measurement Without disregarding financial measurement, managers should also pay attention to non-financial measurements in order to prevent them from making decisions based on 'wishful numbers', or numbers that strictly 'imagined' by less informed minds. Often, ignoring non-financial factors ended with serious deviation between financial forecasts and actual cash-inflow. III.4.1 Option 1 The first option is opening new stores on profitable locations using franchising agreement. Management had stated that franchising is not the right form of business to be entered by the furniture industry. Financial calculations might have presented good forecast, but social implications might have turn the financial calculation into nothing more than deceiving reports. III.4.2 Option 2 The second option is a diversification strategy, which brought the positive impression of finding new and fresh opportunities within existing business environment. This alternative is supported by the financial considerations, which all displayed that this is the best option among the four. Senior managers felt good about the idea and plan to move forward with the alternative. III.4.3 Option 3 The third option is opening 'side-businesses' related to furniture and combine it with the furniture business to widen the market share. This alternative is also approved by management and supported by financial forecasts. However, providing new product lines is a challenge. It would require experienced managers to prevent the business from becoming more complicated and time consuming for the directors. III.4.4 Option 4 The last option is expanding to international markets. As the market of United Kingdom is full with solid competition, this option is very much rational. Today, Asia is well known as the new global market. Many new corporations found their success by expanding on these 'new grounds', where the market is still open for products of good quality. Nevertheless, the project would require a considerable time of adjustments. The corporation needs to adjust to existing local environments and local consumers also need time to find these foreigners to be 'trustworthy'. Short term prospects a lot worse compare to long term. This is why financial consideration displayed that this alternative is the worst one according to the payback period perspective. III. Conclusion Overall, I conclude that the best alternative is the second option. This decision is based on both financial and non-financial consideration. Financially, this alternative require less initial investment, but able to provide the largest cash inflow compare to others. Non-financial consideration also stated that the company already has the experience and knowledge needed to run the business, but never had the thought to actually go trough with it. The closest thing to an obstacle is the fact that the alternative involves importing materials from foreign countries. This would require adequate commitment from both suppliers and producers in order to timely maintain the quality of business operations. Furthermore, I believe that the debt equity financing is still the best alternative of the period. This is due to the fact that long term debt are a very small portion of the entire equity, which indicated that existing debt facilities are not well exploited yet. However, a mixed of the two financing alternatives is very much preferable. A mixed of alternatives would reduce the rocketed interest expense resulted by the debt financing method and increase corporate performance in the perspective of earning per share. Bibliography 'Financial ratios', n.d. Retrieved October 20, 2005 from http://mercury.webster.edu/westedou/financial_ratios.htm 'Globalization and the Furniture Business'. The Jamaica Observer. 2003. Retrieved October 20, 2005 from http://www.jamaicaobserver.com/columns/html/20030208T190000-0500_39380_OBS_GLOBALISATION_AND_THE_FURNITURE_BUSINESS_.asp 'Investment Appraisal'. Timeweb. 2005 Retrieved October 20, 2005 from http://www.bized.ac.uk/timeweb/reference/using_experiments.htm Read More