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Financial Decision Making

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Main Body

Part 1. Industry Review:

  • Cafes Coffee Shops or business industry involves aggregate specialise unlicenced enterprise that emphasise on selling of coffee along with cold drinks and other soft drinks.
  • The industry's success is guided by both economical and social variables, including increases in average real household earnings, choices for coffee shops over alternate social sites, and growing consumer demand in coffee varieties and sources.
  • Over past few years, the sector has grown significantly, driven by increased demands, as coffee culture has become more prominent among customers.
  • Industry sales is projected to increase at a compounded annualized rate of 4.8 percent over five years from 2019-20, plus 1.9 percent growth during current year, to around £6.6 billion.
  • The sector also faces several obstacles such as the emergence of more substitute beverages leading to a decline in the public's attachment to coffee.
  • The biggest advantage for this sector is to grow their businesses into different markets like China, India, where there is huge population (Lee and Lee, 2015).
  • Companies with the maximum market share throughout United Kingdom in this industry are Caffe Nero Group, Costa Limited, Pret-A-Manger and many other.
  • Changes in Minimum wage might have a major effect on business operators' profitability level. Cafes and coffee business usually employ a fairly large range of low-paid employees, and labour costs constitute a substantial share of operators aggregate sales.
  • Household spending on foods and non-alcoholic drinks includes items purchased from stores, cafes and shops. While some of such spendings supports sectors that overlap with the sector of cafes-coffee shops, higher total household spending on such products usually indicates improved prospects for industry enterprises.

Part 2. Business Performance Analysis:

2.1 Analysis of profit and loss account statement:

The P&L statement analysis includes analysing the numerous line elements in a statement, and also tracking trends for specific line items across several periods. This method is used to consider a company's cost structures and its capacity to make profits. It help to determine company's probability level during a specific period. This analysis help to define corporation's future performance and frame a budget with more reliable and accurate projections (Muradoglu and Harvey, 2012).

In this context analysis of income-statement of Roast Ltd shows that company's turnover has been increased from £2022000 to £2534000 (25.32 percent growth) during 2017 to 2018 while company's cost of sales has been changed from £1505000 to £1990000 (32.23 percent growth) from 2017 to 2018 respectively. Company's operating income in year 2018 was 60000. Whereas operating expenses raised to £477000 in year 2018 from £466000 year 2017. Roast Ltd has reported operating profit of 127000 and 51000 during year 2018 and 2017 respectively indicating a upward trend. Overall net profit of company was 81000 and 36000 in year 2018 and  2017 respectively which shows that company's overall profitability level has been increased.

For further effective analysis of company's P&L account, application of different ratio would be helpful. Ratio help to interpret company's performance while analysing key relationship among different reported items in income statements of one or more period. Following are some ratios related to analysis of income-statement of Roast Ltd, as follows:

Gross margin:

It exhibits specific percentage of sales which company has earned after subtracting cost of sales form overall turnover. Here below table shows the computation of gross margin of Roast Ltd as per reported figures of sales and gross profit, as follows:   

(£'000)

Year - 2017

Year - 2018

Gross profit

517

544

Net sales

2022

2534

Gross profit Margin = Gross profit/ Net sales x 100

25.57%

21.47%

Through analysis of gross margin(%) of company it has been analysed that gross margin company has earned in year 2018 is 21.47% which was 25.57% in year 2017 indicating declining trend. It means that company's efficiency to provide gross profits before deducting any operating or non-operating expense has been declined.

Operating Profit Ratio: 

This ratio includes operating profit company earned after providing its all operating expenses but before interests costs and taxes. Which help to interpret company's operational effectiveness. Below table shows company Roast Ltd's operating profit ratio of two years, as follows:   

(£'000)

Year - 2017

Year - 2018

Operating profit

51

127

Net sales

2022

2534

Operating profit ratio= Operating profit/ Net sales x 100

2.52%

5.01%

Company's operating ratio are 5.01% and 2.52% in year 2018 and 2017 pointing out towards increasing trend. Such trend shows that company's capabilities to generate profits by its operating activities has been increased. It simply also implies that company's operating expenses has optimised and operating income is also increased.  

Net-Profit Margin ratio:

This most vital ratio which help to determine a company's overall net probability level or status (Richard, Kirby and Chadwick, 2013). This ratio shows relationship among net-profits and net-turnover of company. Presented table shows Roast Ltd's net-margin ratio, as follows: 

(£'000)

Year - 2017

Year - 2018

Net profit

36

81

Net sales

2022

2534

Net profit ratio = Net Profit / Net Sales

1.78%

3.20%

As per above table company's net-margin ratios are 3.2% and 1.78% in year 2018 and 2017. Which clearly states that company's net profitability level has been improved. Company's net-margin generation capacity has been enhanced over the period and for acquisition purpose would be beneficial in probability terms.

2.2 Statement of financial position:

Analysis of financial position of corporation is assistive for share brokers, investment bankers, investors, company and financial institutions or banks for effective evaluation of profitability status of investment made in particular company or take decision like acquisition or merger. Analysis of balance sheet could be described as just an evaluation of a corporation's assets, obligations and capital. Such analysis is typically performed at specified time intervals, such as yearly or quarterly. The balance sheet evaluation process is being used to extract real figures on the company's income, assets and obligations. Another most critical factors to be taken in analysis of financial statements is whether or not corporation could pay obligations in order to stay in effective operation. Current ratio, Liquid or quick ratio and working-capital can help to measure short-term and long-term financial strength corporation in quick manner (Epstein, Buhovac and Yuthas, 2015).

In this regard, as per analysis of line items stated in Statement of Financial Position of Roast Ltd it has been seen that company has made capital expenditure towards purchase of Property, Plant and Equipment(PPE) because company's PPE value has been increased from £670000 to £996000 during 2017 to 2018 respectively. Another notable thing here is that company's cash and cash-equivalents which was £134000 in year 2017 has been reported as nil in year 2018 which shows that company has utilised its all cash funds in year 2018. While overall current assets level has been reached to £447000 which was £347000 in year 2017. Company has not issued any shares during 2018 as in both year company's share capital is £200000. With addition of net profit and other reserves company's retained earning has been reported at £660000 in year 2018 which was £579000 in year 2017. Therefore aggregate equity funds increase form £779000 to £860000.

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There is significant change in company's Long-term borrowings, since company's long term debts has been reached to £275000 in 2018 which was £100000 in 2017. Also company has acquired a bank overdraft facility of £73000 in year 2018. While company's trade creditors has been changed from 138000 to 235000 during period 2017-2018. Aggregate liabilities are increased by £345000 (From £238000 to £583000) during year 2017 to 2018.

Moreover, for improved analysis of financial position of respective company, several key ratios are interpreted in study while considering major line items of balance sheet. Analysis through ratios provides more clear view about company's real time or actual fiscal position. In this regard following are crucial ratios of company, as follows:

Current ratio: 

this is short-term liquidity measure ratio which shows whether company is capable to pay-out its all current debts and liabilities by using all its current-assets. This is significant ratio to identify that whether company is financially stable or not. Current ratio of 2 or above 2 is generally recognised as favourable level which simply implies that company's current assets should be two times or more than two times of company's current liabilities (Finke and Huston, 2014). Here below table exhibits Roast Ltd's current-ratio for year 2017 and 2018, as follows:

(£'000)

Year - 2017

Year - 2018

Current assets

347

447

Current liabilities

138

308

Current ratio = Current assets / Current liabilities

2.51 times

1.45 times

Above data contained in table regarding current ratio of company shows that  in year 2017 company's current ratio is greater than 2 i.e. 2.51 times while in year 2018 it has been dropped to 1.45 times. Such drop in current ratio signifies that company's efficiency of paying current obligations using current-assets has been decreased.

Debt to Equity Ratio: The debt-equity ratio implies to total debt amount, or overall debt, divided by overall equity worth. Such measurements are extracted from balance sheet. Remember that debt-equity ratio doesn't quite inform us how much a stock is bad or good because no market factors like market value or stock price are here used. Reduced debt-to-equity ratio figures imply less risk, which is beneficial. increased debt-to-equity ratio is undesirable as it means businesses rely more on outside creditors and are therefore at heightened risk, notably at increased interest rates. An rising trend amount in debt-to-equity ratio is troubling fact, as it implies rising the proportion of a company ' assets funded by debts. This ratio is indicator of company's long-term financial liquidity position.

(£'000)

Year - 2017

Year - 2018

Debts

238

583

Equity

779

860

Debt to Equity Ratio = Debs / Equity

0.3055

0.6779

As figures shows company's debt-equity ratio has been increased from 0.3055 to 0.6779 during 2017 to 2018 which shows that company's long term financial performance has been decreased. It is not a favourable sign for company as it shows financial liquidity is not sound.    

Return on capital employed: Return on capital employed (ROCE) is a fiscal ratio which compares profitability of a business and efficiency in which it utilizes its resources. The ratio calculates, how well a corporation produces income from its capital-invested. The ROCE metric is recognized as significant profitability ratio also and is often applied by stakeholders to assess the viability of investment (Huston, Finke and Smith, 2012). Capital employed is simple differences of total-assets and total-liabilities. Here following is ROCE of Roast ltd of year 2018 and 2017, as follows:

(£'000)

Year - 2017

Year - 2018

Operating profit

51

127

Capital employed

879

1135

ROCE = Operating Profit / Capital Employed

5.80%

11.19%

As table exhibited company's ROCE percentage has been increased from 5.80% to 11.19%. Which indicates that Roast Ltd's efficiency to provide return on aggregate employed capital as been increased. It also reflects that for investment purpose company is suitable and financially sound.

2.3 Statement of cash flows:

A cash flow is significant report in statement form which covers all the changes in cash either in or out to assess the actual free cash-flow of company. Analysis of it starts with a beginning amount and produces a finishing balance after all cash earnings and expenditures accrued during period are accounted for. The analysis of cash flow is mostly used for reasons of financial reporting. At any point in time, the cash flow of a corporation is the variation between its available cash at start of an accounting period and at the end. The money involves bond proceeds capital gains, and asset sales, which heads out to paying for operating costs, personal expenditures, key debt service, including asset purchases such as machinery (Porter and Norton, 2012).

This can be found in the sense of Roast Limited Company that the cash-flows from operating activities in year-2018 was negative £24000. This means there are more operations that become trigger of cash outflows. Main cause of outflow though operational activities is purchase of inventories amounting £179000 and increase in trade receivables by £55000. While due to heavy capital investment towards purchase of Property, Plant and Equipments company's cash-flows from investing activities is negative £358000. Increasing long term debts resulted in cash flows from financing activities of £175000. Through considering cash-flows from different operations, company's Cash and cash equivalents at the end of year is negative £73000. Which shows that company's liquidity position is not good as company is not capable to generate cash flows from business.

Operating cash cycle:

 It is a from of activity ratio which measure or computes an average time period needed for converting corporation’s inventories/stocks into liquid funds or cash. This ratio presents actual flow of cash within business and indicates how efficiently company converts its all stocks in cash monies. Consideration of this cycle is significant to improve overall cash funds requirements in business, This cycle is divided into three major parts which are inventories outstanding period, payable outstanding period and sales outstanding period (Saxonberg and Sirovátka, 2014). Here below is formula of operating cash-cycle, as follows:   

Operating cash cycle =  Days inventory outstanding + days sales outstanding - days payable outstanding.

The OC provides insight into operational performance of an organization. A narrower cycle is mostly preferred, indicating a company which is more effective and productive. A smaller period shows that a business can rapidly recover its stock cost and has enough money to fulfil its obligations. If the OC of a corporation is large, it can cause problems with cash flow. Following are the calculations for operating cash-cycle of company Roast Ltd, as follows:s

For year 2017:

Days inventory outstanding= > 365/inventory turn over

         = > 365/12.54

         = > 29 days

Days sale outstanding=> 365/ receivable turn over

= >    365/21.74

= >     17 days

Days payable outstanding=> 365/ payable turn over

     = > 365/ 10.90

      => 33 days

So operating cash cycle =>  (29+17-33) days

=> 13 days

Working Note:

Inventory turn over= cost of sales/ average inventory

=> £1505/£120

=> 12.54

Receivable turn over =>  net sales/account receivable

 =>  £2022/£93

=> 21.74

Payable turn over => cost of sales/ account payable

= £1505/£138

= 10.90

For year 2018:

Days inventory outstanding= 365/ inventory turn over

         =  365/ 6.65

         =  55 day

Days sale outstanding=      365/ receivable turn over

=      365/ 17.12

=     21 days

Days payable outstanding= 365/ payable turn over

     =  365/ 8.47

                 =  44 days

So operating cash cycle=  (55+21-44) days

= 32 days

Working Note:

Inventory turn over= Cost of sales/ average inventory

        = 1990/ 299

       = 6.65

Receivable turn over=  Net sales/ account receivable

= 2534/148

= 17.12

Payable turn over = Cost of sales/ account payable

     = 1990/235

     = 8.47

From above computations of operating cash-cycle of company Roast Ltd it has been analysed that company's overall operating cash-cycle is 13 days. Lower operating cycle shows that company is more efficient in conversion of inventories into cash. As in respective company's OCC is 13 days which is adequate but as per cafe industry's scenario this ratio should be optimised more but existing OCC is also acceptable. Company's assessed inventories-days outsailing are 29 days and Days-sale outstanding period is 13 days. While days-payable outstanding are 33 days. Overall analysis shows that company is operating effectively as the OCC is at acceptable level.

Dividend policy: It is policy which corporation applies to manage its dividend-payout percentage to shares or securities holders. Several analyst recommends that a dividend policy could be irrelevant in theoretical way, since investors may sell his part of shares or securities in case they requires funds. In respective company's it has been analysed that company is following no divided policy as company's dividend payout is zero. In year 2018 Roast Ltd has not paid any dividend amount to its shareholders.

Part 3. Investment Appraisals:

3.1 a Management forecast:

Managing division of company Roast limited is attempting to make capital investment of around £500 million. With a forecast made about of cash-flows during five years period from year-2017 to year-2021. As per their forecast company's cash-inflow or contribution during stated period would be £60, £112, £148, £180 and £224 million respectively. But during 2017 and 2018 this estimation has gone wrong.  Further decline in gross margin and negative cash flow shows that company will not achieve such forecasts of management. So it is advisable to readjust such forecast as per company's current performance.

3.1 b  Investment appraisal technique:

These are considered as specific tools and measures which are used to define viability of any financial decision and investment made by company. Main investment-appraisal techniques are profitability index, net-present value, internal rate-of-return, payback period, and accounting rate-of-return. They are mainly applied to evaluate performance of any new project like acquisition or merger decision. In this context following is discussion upon different major investment appraisal-techniques, as follows:

Payback period:

it simply indicates the time-period needed to retrieve aggregate initial costs involved in investment or project. Simply it defines no. of years company can take to reimburse initial investment in project. As stated in exhibit:3 company's payback period is 4 years. Which clearly states that company would recover cash outflow of £ 500 million within 4 year which is so such investment is viable as payback period is less then entire project period i.e. 5 year.

Benefits: 

This it most simplex and casual approach no complex calculation or assumptions are required under this method.

Drawback:

 Inflation and time-value of money concept is totally ignored in this technique which reduced its significance and relevancy (Montford and Goldsmith, 2016).

Accounting rate of return:

This is another crucial method which shows how much percentage return company will get from any investment. As per figures stated in Exhibit:3 ARR of investment is 18%. Which is a positive figure of return and also below the forecasted ARR i.e. 10 percent so investment is viable as it is efficient to get return form investment.

Benefits: 

This technique is advantageous for company as it clearly describes profitability level of any investment or project.

Drawback: 

This technique also ignores the key factors like time value of money as here in this method cash-flows are not discounted.

Net-Preset Value or NPV: Outcomes of this technique exhibits net viability of any investment. It is most preferred and widely applied method which help assess whether investment would be profit making step or not. According to the figures shows in exhibit:3, company's project NPV is £ 110 million at discounting rate of 5%. A positive NPV is indicator of financial viability of any project/investment.

Benefits:

 This more accurate method of investment appraisal as this technique discounts cash flows at a specific rate with aim to consider time value of money factor.

Drawback:

 Major drawback of this method is that here no specific percentage has been prescribed to discount cash flows so sometime it may lead to inaccuracy in results. 

3.2 Source of finance:

Source of finance which a company select, directly impacts its financial performance, capital structure and liquidity position. So while taking any decision about source of finance, company should evaluate the long-term and short-term effect of such sources. In this context  Roast Ltd is considering a further investment, into Italy of £400k from year-2019. Thus following is a discussion on different sources of finance, as follows:

Equity finance: 

This is most cost effective and crucial source though which company can arrange funding of £400k without any additional costs. Under this source company can issue its share  in public. It is a secure method by which company can arrange such a huge investment money.

Benefit: 

The core benefit of an equity finance is no obligations or liabilities regarding repayment of money generated through this means.

Drawback:

Here main drawback of equity finance is loss of control and ownership share. Ownership may be lost due to excessive issuance of shares in public. Also distributed ownership lead to loss of substantial control over company (Arnold, 2012).

Debt Finance:

When a corporation acquire money through borrowing which is to be paid-back by company in future periods in addition with interest it is termed as debt finance. It may be secured or unsecured. This is quick source which can be used by Roast Ltd to acquire funds.

Benefit: 

The capacity to pay back heavy-cost debt is a significant benefit in debt financing, increasing monthly contributions by hundreds or thousands of dollars. Increasing capital cost increases cash-flow of corporation.

Drawback:

A debt financing downside is that corporations are obliged to pay-back loan principal amount along with interest. Companies with cash-flow issues can find it hard to repay loans and borrowings.

References

  • Arnold, G., 2012. Corporate financial management. Pearson Education.
  • Dinçer, H. and Yüksel, S., 2018. Financial sector-based analysis of the G20 economies using the integrated decision-making approach with DEMATEL and TOPSIS. In Emerging trends in banking and finance (pp. 210-223). Springer, Cham.
  • Epstein, M. J., Buhovac, A. R. and Yuthas, K., 2015. Managing social, environmental and financial performance simultaneously. Long range planning. 48(1).  pp.35-45.
  • Finke, M. S. and Huston, S. J., 2014. Financial literacy and education. Investor behavior: The psychology of financial planning and investing.  pp.63-82.
  • Huston, S .J., Finke, M. S. and Smith, H., 2012. A financial sophistication proxy for the Survey of Consumer Finances. Applied Economics Letters. 19(13).  pp.1275-1278.
  • Lee, S. W. and Lee, K.H ., 2015. Decision Making Model for Selecting Financial Company Server Privilege Account Operations. Journal of the Korea Institute of Information Security and Cryptology. 25(6).  pp.1607-1620.
  • Montford, W. and Goldsmith, R. E., 2016. How gender and financial self‐efficacy influence investment risk taking. International Journal of Consumer Studies. 40(1).  pp.101-106.
  • Muradoglu, G. and Harvey, N., 2012. Behavioural finance: the role of psychological factors in financial decisions. Review of Behavioural Finance. 4(2).  pp.68-80.

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