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Accounting and Financial Management Ratios

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Introduction

Accounting and financial management is the process of preparing financial reports for an organisation and managing organisation's financial performance. It is the main responsibility of accountants and managers of the company to appropriately maintain and keep financial and accounting information in the form of financial reports so that internal and external stakeholders can analyse accurate data of the business (Ward, 2012). Actual performance can be determined with the help of various accounting techniques including ratio analysis, capital budgeting and cost of capital. Main aim of this project report is to develop an understanding about the accounting and financial management in the context of an business organisation. Two different companies have been discussed in this report.

First organisation which is provided is Bitmap PLC which is a furniture manufacturing company and executing its business operations in London, UK. Another business entity which is provided for analysing accounting and financial management is Toyland Ltd. This company is based in London and currently manufacturing toys for children. In this project report calculation of accounting ratios, working capital cycle and capital budgeting of two different companies are performed according to the different case scenarios.

Part- A

Introduction

Bitmap Plc is a furniture manufacturing company which is currently operating its business activities in London successfully. Board of directors of organisation have analysed significant changes in the financial statements of Bitmap Plc. Directors of this business entity have asked the management accountant to prepare a report on the financial performance of the organisation (Banerjee, 2012). Various financial ratios have been calculated in this report.

1. Calculation of relevant ratios to analyse organisation's performance

Ratio analysis: 

It can be defined as a qualitative analysis of organisation's performance with the help of various information which is recorded in financial statements of the company. All the internal and external stakeholders use ratios to determine that organisation is performing well or not in the market. In the case of Bitmap Plc, ratio analysis have been conducted for the directors so that they can analyse the cause of changes in financial statements (Blankespoor and et.al., 2013). Various types of ratios are calculated as a management accountant from the financial statements of two years of this organisation below:

Profitability ratios: 

Such type of ratios are calculated by the accountants of the companies in order to analyse the actual profit making ability of the organisation. Following are the ratios that are calculated by management accountant of Bitmap Plc:

  • Net profit ratio:

Formula:

 Net profit after tax / total revenues * 100

Particular

2016

2017

Net profit after tax

3220

4060

Revenues

18000

23000

Net profit ratio

17.89%

17.65%

From the above calculation it has been observed that Bitmap Plc's net profit ratio has been decreased to 17.65% in year 2017 from  17.89% which is for year 2016 (Khan, 2015).

  • Gross profit ratio:

Formula:

Gross profit / total revenues * 100

Particular

2016

2017

Gross profit

9100

12200

Revenues

18000

23000

Gross profit ratio

50.56%

53.04%

While calculating the ratio the management accountant of Bitmap Plc have identified that gross profits of the company have increased in year 2017 which has resulted in increased ratio. 50.56% and 53.04% are the gross profit for year 2016 and 2017 respectively.

Liquidity ratios:

The ratios are calculated to ascertain actual liquid strength of a company (Krakhmal, 2012). Main purpose behind the calculating this ratio is to make future planning for investment and purchasing of business assets. If is it weak than management accountant suggests directors to take appropriate actions. In Bitmap Plc following liquidity ratios are calculated:

  • Current ratio:

Formula: 

Current assets / Current liabilities

Particular

2016

2017

Current assets

4150

5160

Current liabilities

1500

1100

Current ratio

2.77

4.69

From the above calculation it has been analysed that organisation's liquid strength is very good as in year 2016 current ratio was 2.77 and in year 2017 it has increased up to 4.69.

  • Quick ratio:

Formula:

Quick assets / current liabilities

Particular

2016

2017

Quick assets

2350

2800

Current liabilities

1500

1100

Quick ratio

1.57

2.55

From the above calculation it has been analysed that organisation have good liquidity because the ratio of Bitmap Plc in year 2016 and 2017 are more than ideal ratio which is 1:1.

Gearing ratios: 

These ratios are related to organisation's capital structure in which relationship of internal and external liabilities are analysed with each element of organisation. Main purpose of gearing ratios is to determine company's financial stability (Taipaleenmäki and Ikäheimo, 2013).

Management accountant of Bitmap Plc have calculated following ratios for the purpose of analysing company's stability in monetary terms:

  • Debt equity ratio:

Formula: Total debts / total equities

Particular

2016

2017

Total debts

3500

4600

Total equities

12000

15760

Debt equity ratio

0.29

0.29

From the above computation it is assessed that debt equity ratio in year 2017 and 2016 is same which shows that debts and equities has no contribution against the changes  observed by board of directors. In both years that is in 2016 and 2017 debt equity ratio is 0.29.

  • Total asset to debt ratio:

Formula: 

Total assets / total debts

Particular

2016

2017

Total assets

15500

16760

Total debts

3500

4600

Total asset to debt ratio

4.43

3.64

From the above calculation it has been observed that organisation's total asset to debt ratio is decreased in year 2017 when compared to 2016. For both the years this ratio is computed as 4.43 and 3.64 respectively.

Asset utilisation ratios: Such type of ratios are calculated to analyse the value of organisation's assets compared to revenues (Brigham and Houston, 2012). Following ratios are calculated by management accountant of Bitmap Plc in order to analyse overall utility of assets of the company:

  • Fixed asset turnover ratio:

Formula: 

Total revenues / Fixed assets

Particular

2016

2017

Revenues

18000

23000

Fixed assets

11350

15200

Fixed asset turnover ratio

1.59

1.51

From the above calculation it has been analysed that fixed assets turnover ratio of Bitmap Plc has been decreased up to 1.51 in year 2017 from 1.59 which is for 2016.

  • Total asset turnover ratio:

Formula:

 Total revenues / total assets

Particular

2016

2017

Revenues

18000

23000

Total asset

15500

16760

Total asset turnover ratio

1.16

1.37

While calculating total asset turnover ratio, management accountant of Bitmap Plc have analysed that the ratio of the company has been increased in year 2017 as compare to previous year. For the years 2016 and 2017 this ratio is calculated as 1.16 and 1.37 respectively which shows enhancement of business operations of this company.

Investors potential ratios: 

All such type of ratios are mainly used to analyse performance of organisation's shares. Management accountant of Bitmap Plc has used following ratios to provide appropriate information to all its investors:

  • Return on equity ratio:

Formula:

 Net profit after tax/total equity * 100

Particular

2016

2017

Net profit after tax

3220

4060

Total equity

12000

15760

Return on equity ratio

26.83%

25.76%

From the above table it has been observed that in year 2016 return on equity was 26.83% which has decreased in year 2017 up to 25.76% which shows that investors are receiving low returns against their contributed capital.

  • Dividend coverage ratio:

Formula:

Profit after tax/Dividend

Particular

2016

2017

Profit after tax

3220

4060

Dividend

200

300

Dividend coverage ratio

16.10

13.53

From the above calculation it has been analysed that dividend coverage ratio of the organisation has been decreased to 13.53 in year 2017 from 16.10 in 2016 which shows that investors are reverencing comparatively low dividend against their contributed capital

2. Calculation of working capital cycle for Bitmap Plc

In this Part, calculation of  working capital cycle is required, for this, firstly calculate the various ratios which is mandatory for calculation of working capital cycle which are-

For Year 2016

Inventory collection period = Inventory/Annual sales*365

                                             = 1800/18000*365

                                             = 36.50 Days

 

Trade Receivables period = Trade receivables/Annual sales*365

                                          = 1600/18000*365

                                          = 32.44 Days

 

Cash and marketable securities period = Cash/Annual sales*365

                                                                = 750/18000*365

                                                                = 15.21 Days

 

Trade payables period = Trade payable/Annual sales*365

                                      = 1500/18000*365

                                      = 30.42 Days

 

Working Capital Cycle in Days:-

         Inventory collection period                                                  

36.50

Add: Trade receivables period                                                   

32.44

Add: Cash and marketable securities period                               

15.21

Less: Trade payables period                                                      

30.42

         Working Capital Cycle in days:-                                             

53.73

 

For Year 2017

Inventory collection period = Inventory/Annual sales*365

                                             = 2,360/23000*365

                                             = 37.45 Days

 

Trade Receivables period = Trade receivables/Annual sales*365

                                           = (2300/23000*365)

                                           = 36.50 Days

 

Cash and marketable securities period = Cash/Annual sales*365

                                                                = (500/23000*365)

                                                                = 79.35 Days

 

Trade payables period = Trade payable/Annual sales*365

                                      = 1100/23000*365

                                      = 17.46 Days

 

Working Capital Cycle in Days:-

         Inventory collection period                                                

37.45

Add: Trade receivables period                                                    

36.50

Add: Cash and marketable securities period                               

79.35

Less: Trade payables period                                                       

17.46

         Working Capital Cycle in Days                                       

135.84

From the above calculation it has been observed that working capital cycle in days is 135.84 days for the organisation.

Conclusion

From the above report it has been concluded that organisation is performing well in the market. Profitability and liquidity of the company is also very good. Ratios analysis is conducted for the purpose of analysing the actual performance and status in market. The difference in financial statements have been occurred due to the changes in revenues, assets, liabilities and profits.

PART B

1. Various investment appraisal techniques

Toyland Ltd. is a toy manufacturing company which is currently established in London. Directors of the organisation are willing to purchase a new machine so that profits can be maximised. There are two options available in the market of this machinery which has same cost. They have asked the finance manager of the organisation to produce a report so that it can help to make appropriate decision (Ramanna, 2013). The report is based on investment appraisal techniques that are as follows:

The information which is common for both the machines:

Cost of acquisition

£ 500000

Useful Life

6 Years

Salvage Value at end of 6th Year

£ 50000

Method of Depreciation

Straight Line Method

Depreciation per annum

£ 75000

  1. The payback period:

Payback Period= Years before full recovery of cost+Unrecoverable cost  at the start  of the years/Cash inflows of the year of full recovery of cost

Machine A: Outflow =500000

Years

Cash Inflows (in £)

Cumulative cash Inflows (in £)

1

300000

300000

2

250000

550000

3

200000

750000

4

150000

900000

5

50000

950000

6

70000

1020000

Total

1020000

 

Payback Period of Machine A

=1+(500000-300000) / 250000

=1.8

Machine B: Outflow =500000

Years

Cash Inflows (in £)

Cumulative cash Inflows (in £)

1

20000

20000

2

50000

70000

3

150000

220000

4

200000

420000

5

250000

670000

6

350000

1020000

Total

1020000

 

Payback Period of Machine B

=4+(500000-420000)/250000

=4.32

  1. The discounted payback period:

Discounted Payback Period = Years before full recovery of cost as per discounted cash inflows+unrecoverable cost  at the start of the years/Discounted Cash inflows of the year of full recovery of cost

Machine A: Outflow= 500000

Years

Cash Inflows (in £)

Present Value Factor @10%

Present Value

Cumulative Present Value of cash Inflows (in £)

1

300000

0.909

272700

272700

2

250000

0.826

206500

479200

3

200000

0.751

150200

629400

4

150000

0.683

102450

731850

5

50000

0.621

31050

762900

6

70000

0.564

39480

802380

Total

1020000

 

802380

 

Discounted Payback Period of Machine A

=2+(500000-479200) / 150200

=2.14

Machine B: Outflow= 500000

Years

Cash Inflows (in £)

Present Value Factor @10%

Present Value

Cumulative Present Value of cash Inflows (in £)

1

20000

0.909

18180

18180

2

50000

0.826

41300

59480

3

150000

0.751

112650

172130

4

200000

0.683

136600

308730

5

250000

0.621

155250

463980

6

350000

0.564

197400

661380

Total

1020000

 

661380

 

Discounted Payback Period of Machine B

=5+(500000-463980)/197400

=5.18

  1. The accounting rate of return:

Accounting Rate of Return= Average Net Profit / Average Investment

Machine A: Outflow= 500000

Salvage Value at end of 6th Year (in £)= 50000

Years

Cash Inflows (in £)

Depreciation

Net Profit

1

300000

75000

225000

2

250000

75000

175000

3

200000

75000

125000

4

150000

75000

75000

5

50000

75000

-25000

6

70000

75000

-5000

Total

1020000

 

570000

Average Net Profit= 570000/6 =95000

Average Investment

= (Initial investment + Salvage Value)/2

=(500000+50000)/2

=275000

Accounting Rate of Return(%)

  =95000/275000*100

=34.55%

Machine B: Outflow= 500000

Salvage Value at end of 6th Year (in £) =50000

Years

Inflows (in £)

Depreciation

Net Profit

1

20000

75000

-55000

2

50000

75000

-25000

3

150000

75000

75000

4

200000

75000

125000

5

250000

75000

175000

6

350000

75000

275000

Total

1020000

 

570000

Average Net Profit

=570000/6

=95000

Average Investment

=(Initial investment + Salvage Value)/2

=(500000+50000)/2

=275000

Accounting Rate of Return(%)

=95000/275000*100

=34.55%

  1. The net present value:

Net Present Value= Present value of cash inflows – cash outflow

Machine A: Outflow= 500000

Years

Cash Inflows (in £)

Present Value Factor @10%

Present Value

1

300000

0.909

272700

2

250000

0.826

206500

3

200000

0.751

150200

4

150000

0.683

102450

5

50000

0.621

31050

6

70000

0.564

39480

Total

1020000

 

802380

Net Present Value  (in £)

=802380-500000

=302380

Machine B: Outflow=500000

Years

Cash Inflows (in £)

Present Value Factor @10%

Present Value

1

20000

0.909

18180

2

50000

0.826

41300

3

150000

0.751

112650

4

200000

0.683

136600

5

250000

0.621

155250

6

350000

0.564

197400

Total

1020000

 

661380

Net Present Value  (in £)

=661380-500000

=161380

 

  1. The internal rate of return: Percentages for calculation of IRR are chosen with the help of trial and error method.

IRR= LDR (Residue of LDR- Initial investment/ Residue of LDR- Residue of HDR) (HDR- LDR)

Rate of Return= (Total cash Inflow-Cash Outflow) / Cash Outflow*100*1 / No. of Years

Machine A: Outflow= 500000

Total Cash inflow= 1020000

No. of Years = 6 Years

Rate of return(%)

=(1020000-500000)/500000*100*1/6

=17.33

Firstly the rate which is assumed is 36% and 37%

Years

Cash Inflows (in £)

Present Value Factor @36%

Present Value

1

300000

0.735

220500

2

250000

0.541

135250

3

200000

0.398

79600

4

150000

0.292

43800

5

50000

0.215

10750

6

70000

0.158

11060

Total

1020000

 

500960

 

Years

Cash Inflows (in £)

Present Value Factor @37%

Present Value

1

300000

0.730

219000

2

250000

0.533

133250

3

200000

0.389

77800

4

150000

0.284

42600

5

50000

0.207

10350

6

70000

0.151

10570

Total

1020000

 

493570

Internal rate of return

=36+(500960-500000)/(500960-493570)*(37-36)

=36.13%

Machine B: Outflow= 500000

Total Cash inflow= 1020000

No. of Years = 6 Years

Rate of return(%)

=(1020000-500000)/500000*100*1/6

=17.33

Firstly the assumed rates are 17% and 18%

Years

Cash Inflows (in £)

Present Value Factor @17%

Present Value

1

20000

0.855

17100

2

50000

0.731

36550

3

150000

0.624

93600

4

200000

0.534

106800

5

250000

0.456

114000

6

350000

0.390

136500

Total

1020000

 

504550

 

Years

Cash Inflows (in £)

Present Value Factor @18%

Present Value

1

20000

0.847

16940

2

50000

0.718

35900

3

150000

0.609

91350

4

200000

0.516

103200

5

250000

0.437

109250

6

350000

0.370

129500

Total

1020000

 

486140

Internal rate of return

= 17+(504550-500000)/(504550-486140)*(18-17)

= 17.25%

Recommendation: Machine A should be selected by Toyland Ltd. because it is better than Machine B in all the above method of evaluating economic feasibility.

2. Key benefit and limitations in investment appraisal method

Investment appraisal means the collection of various techniques which are used to identify the importance of various investment proposal. The main motive of these methods is to measure the validity of a portfolio management (Renz, 2016). There are various factors which makes an investment appraisal important. These factors are financial, legal, environmental, social, operational, risk etc. There are various techniques of investment appraisal with a number of limitations and advantages.

Pay back period method:

It is very simple method to assess the viability of a project. It defines the period which is required to cover the cost of investment project (Payback Period Method, 2018). This method is considered as effective for calculating the both financial and non financial background of the project.

Advantages:

It is very simple method to calculate the project viability and it is understandable for both financial and non financial background persons.

Limitations:

The simplicity of that method become a risk for the short term projects and it ignores the aspects after payback point.

Accounting rate of return(ARR):

It is a financial ratio which is used to prepare the capital budgeting format. It is the ratio of average annual profit of the proposed  project and the capital invested. This method helps in measuring the capital needed for acquire a project and expected accounting profit (Lambert and Sponem, 2012).

Advantage:

It shows the relationship between the capital required and expected profit to be generated by project and consider the accounting profit rather than cash inflow. It clearly define the attractiveness of project. This method can be applied in real life. For instance, if the Toyland Ltd. Can sue this method to ascertain their relationship between annual profit and capital.

Limitations:

t does not consider the time value of money and exclude the depreciation as well. Accounting rate of return method is difficult to understand as it does not include any non financial information.

NPV(net present value):

It is calculated by the discounted cash flow to find the present value of project. The discount rate usually calculated on the basis of weighted average cost of capital. It would be negative or positive both. Positive NPV shows the decision in favour of project and a negative signify the rejection of proposed project (Sharma and Panigrahi, 2013).   

Advantage:

It consider all the cash flows of business and clearly signify the results for acceptance and rejection (Baxter, R. and et.al., 2013). This method is considered as the best technique and should be used in practical scenario by Toyland.

Limitations:

Discounted rate is not clearly mention for this method and include all the cash flows not profits. Negative NPV results for rejection which would not always a right decision for the proposed project.

Internal Rate of Return(IRR): 

It is calculated by using the discounting cash flows and these are discounted twice. After calculating IRR, it can be compared with the weighted average cost of capital for assessing the viability of project. If IRR is less than the WACC then project will be rejected and if opposed to it so it shows acceptance.

Method of calculation:

IRR= a+{(b-a)*Na/Na-Nb}

a= lower discount rate chosen

b=higher discount rate chosen

Na=NPV at lower rate

Nb= NPV at higher rate  

Advantage:

It clearly define the acceptance and rejection level and include all the cash flows.

Limitations

It depend on the WACC for the decision of acceptance and rejection. Sometime it generate the several results which mislead the decisions.

NPV is the strongest of the four techniques which are described above. In real life business context NPV is the bester method for adoption regarding to investment appraisal.

3. Suitable sources of finance for investment

Sources of funds:

Funding refers to the credit which is acquired by the organisations from internal and external sources so that all the planned strategies can be implemented. As Toyland is willing to buy a new machine. For this purpose funds can be raised form following resources:

Bank loan: 

It can be defined as the credit which is taken by organisations from banks. The loan is provided to such companies who provide a collateral security to the bank so that if the borrower fails to make repayment to bank then the security or the asset can be seized or sold by the lender. Toyland Ltd. can contact to the bank so that a higher amount can be received to buy the machine in order to maximise sales and profits of the organisation (Edwards, 2013).

Venture funding: 

It can be defined as the investment which is made by individuals in an organisation in a specific project for the purpose of getting higher returns. Such investments are mainly concerned with higher risk and provide high return. Toyland Ltd can invite such type of funding for the organisation by sharing the appropriate information of the project so that their interest can be raised (Budding, Grossi and Tagesson, 2014).

Both the above mentioned sources of funds can be used by directors of Toyland Ltd. for the purpose of making investment.

PART C

1. Budget and its relation with strategic objective and plans

Budget:

 It can be defined as the financial estimation of a upcoming period. It helps the organisations to keep sufficient funds for such activities that are going to be performed in future. Main purpose behind the formulation of a budget is to operate business in limited monetary resources. Managers of business entities allot appropriate funds to the each functional departments so that they can execute all their operations effectively.

Budgets, strategic objectives and plan are related to each other because objectives and plan are formulated according to budget. For example, as Toyland Ltd in above question is willing to buy a new machine so that it can enhance its profits. For this purpose the organisation have to make strategic plans and form a budget. As objective of the company is to maximise profits which is possible when demand increases. To attain all the objectives it is required to form strategic plans and implement them.

From above analysis it can be analysed that strategic objectives and plan are related to budget because it is not possible to implement plan and achieve objectives without proper budget.

2. Budgeting process and and interlinking of budgets used in an organisation

Budgeting process: 

It can be defined as the procedure in which budgets are formulated by the managers of the organisation. It helps to allot appropriate amount to different departments according to their requirements. Process of budget formulation is described below:

Step 1: In this step managers of the company set financial goals so that profits can be enhanced.

Step 2: When the goals are set than managers are required to analyse all the different sources of income in order to evaluate overall income of company.

Step 3: In this step total expenses that may take place in future are assessed and than a proper budget will be formulated according to incomes and expenses.

Step 4: After formulation budget will be presented in front of top executives for their approval. They analyse the budget and than mark their approval, if they find any error they ask for modifications.

Step 5: In this step approved budget is implemented within the organisation to operate business appropriately.

Step 6: This is the last step in budgetary process in which implemented budgets are monitored and controlled by employees and other concerned persons of the organisation. It will help to determine that budget is beneficial or not.

Various budgets are used by an organisation that helps to execute business appropriately. All the budgets are as follows:

Expenditures budget:

 All the expenses of a business are recorded in expenditures budget. It includes all direct and indirect expenses that are recorded in income statements of the company.

Operating budget: 

It includes all operating expenses that are recorded in profit and loss account of an organisation. It guides managers while they are willing to analyse all the operating expenses of business.

Both the above described budgets are interrelated with each other. If managers found any mistake in operating budget than they can resolve it by checking it is expenditure budget. As expenditure budget is vast hence it can help the accountants to formulate operating budget accurately.

Conclusion

From the above project report it has been concluded that for all the business entities it is very important to effectively manage and maintain financial information so that organisation's performance can be measured. Various investment appraisal techniques like pay back period, internal rate of return, accounting rate of return and net present value can be used to compare two different investment options for the business. While analysing actual performance of an organisation ratio analysis is the best tool that can help to evaluate that a company is performing well or not.

References

  • Renz, D. O., 2016. The Jossey-Bass handbook of nonprofit leadership and management. John Wiley & Sons.
  • Brigham, E. F. and Houston, J. F., 2012. Fundamentals of financial management. Cengage Learning.
  • Taipaleenmäki, J. and Ikäheimo, S., 2013. On the convergence of management accounting and financial accounting–the role of information technology in accounting change. International Journal of Accounting Information Systems. 14(4). pp.321-348.
  • Krakhmal, V., 2012. Customer profitability accounhngin. Accounting and financial management, p.188.
  • Ward, K., 2012. Strategic management accounting. Routledge.
  • Banerjee, B., 2012. Financial policy and management accounting. PHI Learning Pvt. Ltd..
  • Blankespoor, E. and et.al., 2013. Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk?. The Accounting Review. 88(4). pp.1143-1177.

 

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