financial management & control

7/28/2019 Financial Management & Control

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FINANCIAL MANAGEMENT AND CONTROL

(Authors name)

(Institutional Affiliation)


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Introduction

All organizations operate on the premise of making profit eventually. The organizations

must ensure that they are thorough on the financial records they keep because this is what

determines how well the business performs. In every financial year, organizations need to review

their financial records and balance their books in preparation for the next financial year. Using

ratios and other business finance concepts, the organization is able to determine its financial

position. This information will also help the organization when creating their budget. Several

methods exist that can be used to determine an organizations financial position and future

forecasts. Some of these methods and tools have been discussed in this paper.

PART A

1.Payback period

This refers to the number of years that it takes to recover the initial cost of the project from the

cashflows generated by the project.

Depreciation = (Initial costSalvage value) Number of years

Depreciation = (200,000 - 40000) 4

= 40000 per year

Earnings before interest and tax 80,000

Depreciation ( 40000)

Earnings before tax 40000

Tax -----

Add: Depreciation 40000

Annual cashflow 80000


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Payback period = Initial cash outlay annual cashflow

Payback period = 200000 80000

2. 5 years

This means that it will take two and a half years to successfully recover the initial cost

of the machine from the cashflows.

The payback period method is preferred because of its simplicity in application and

comprehension. Furthermore, it uses cashflows rather than profitability of the project

(Gitman & Mcdaniel, 2009).

Disadvantages of payback period method

1.It ignores the time value of money

2.Ignores the cashflows after the payback period

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

of the cashflows.

2. Accounting Rate of Return

This method uses the accounting profits from Financial statements to assess the

viability of the investment by dividing the average income affter tax by the

averageinvestment.

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

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


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Average investment = ( 200000 + 40000) 2

Average investment = 120000

Accounting rate of return = 80000 120000

= 0.66 = 66.67 %

In this case, the management will set the minimum accepted Accounting rate of return

which will depend on the ARR that the firm is currently enjoying on its existing projects.

If the Accounting Rate of Return is compared to the companys cost of capital, the

investment will be considered feasible since the rate of return is higher than the expected cost

of capital.

Advantages

1.Simple to understand and use

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

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

Disadvantages

1.Ignores the time value of money

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

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


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3. Net Present Value

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

present value of the cash outflows.

Annual revenue 80000

Less: Operating costs 15000

Earnings before interest and tax 65,000

Depreciation ( 40000)

Earnings before tax 25000

Tax -----

Add: Depreciation 40000

Annual cashflow 65000

Year Cashflow Discounting factor (10 %) NPV

0 (200,000 ) 1 (200,000)

1 65000 0.9091 59090.90

2 65000 0.8264 53719

3 65000 0.7513 48835.46

4 65000 0.6830 44395.87

6041.23

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

the project will yield positive returns.


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Advantages

1.It takes into account the time value of money

2.Uses the cashflows and not the profitability

3.It is consistent with the shareholder wealth maximization objectives

Disadvantages

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

2.Uses the firms cost of capital to discount the cashflows thus assuming that the

firms source of capital is readily available (Gitman & mcdaniel, 2009).

4. Profitability Yield

Profitability Yield = Discounted present value of the annual cashflows Discounted

value of the initial cost

Discounted present value of the annual cashflows = 59090.90 + 53719 +

48835.46 + 44395.87

= 206041.23

Profitability Yield = 206041.23 200,000

= 1.03

Since the Profitability Yield is greater than one, the project is considered

economically feasible.


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PART B

(a).

Break Even Point (Units) = Fixed costs Contribution

Contribution = Selling PriceTotal Variable Cost

Total variable costs = 8 + 4 = 12

Contribution = 20 - 12 = 8

Therefore;

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

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

= 40000 units 20

=800000

The Value of Safety Margin is calculated as;

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

Actual Sales

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

= 46.67 %


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(b).

Last Years Contribution Margin Ratio = (Selling Price Contribution) Selling Price

100

Last Years Contribution Margin Ratio = (20- 8) 20 100

= 60%

New contribution = 105% 8 = 8.4

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

60% = (s.p - 8.4) s.p 100

Let Selling price be; X

0.6 = (X-8.4) X

0.6X = X -8.4

0.6XX = -8.4

-0.4X = -8.4

X = 21

Therefore, the New Selling price should be 21


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(c).

Effect of increasing the Unit variable costs by 0.4

Old Break even point (Units)

Old Break even point (Units) = Fixed costs Contribution


Total variable costs = 8 + 4 = 12

Contribution = 20 - 12 = 8

Therefore;

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


= 40000 units 20

= 800000

New Break Even Point (Units)

New Break Even Point (Units) = Fixed costs Contribution


Total variable costs = 8 + 4+ 0.4 = 12.4


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Contribution = 20 - 12.4 = 7.6

Therefore;

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


= 42105 units 20

= 842105

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

and Value.

Units = 4210540000 =2105 units

Value = 2105 units 20 = 842105

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

= 75000 units

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

i.e New sales units = 1.1 75000

=82500 units


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El-Domyati Co

Expected Income Statement

Sales (82500 units 20) 1650000

Less : Expenses

Unit Variable costs

(12.4 82500 units) 1023000

Fixed Costs

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

Profit 289

The Assumptions and Criticisms of Break Even Point analysis

1. Break Even Point analysis assumes that Selling price, Units Demanded,and Variable costs are easy to estimate and are fixed over the entire period (Gitman &

mcdaniel, 2009). However, this is misleading since in the Business world, Selling

price is not fixed. It depends on the client, discounts and other factors.

2. This analysis can only be conducted in the short-run.3. It assumes that there is only a single product or a constant production mix.4. It assumes that Variable costs remain constant within the relevant range.


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5. There is an assumption that all costs can either be divided into Fixed costsor Variable costs. However, some costs such as labour are known to exhibit

characteristics of both Fixed and variable costs.

PART C

1. Liquidity Ratios(a). Current Ratio : This shows the number of times that the firm can pay its current

liabilities from the current assets (Gitman & Mcdaniel, 2009).

i.e Current ratio = Current assets Current liabilities

The current ratio for the firm has been gradually declining over the years from 2.00 in

2010, 1.8 in 2011 and 1.65 in 2012. This indicates that the current liabilities of the firm are

increasing or the current assets are decreasing.

(b). Acid Test Ratio : This is a more refined ratio that measures the ability of the firm to

pay its current liabilities from the liquid/ quick assets.

Quick assets = Current assetsstock

Acid test ratio = Quick assets Current liabilites

The decline in the Acid test ratio further affirms our earlier inference that current

liabilities of the firm are increasing of the current assets are declining.


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2. Asset Utilisation Ratios(a). Account receivables ratio = Credit sales Average debtors

The declining Debtors turnover ratio from 9.72 in 2010, 8.57 in 2011 and 7.13 in 2012

indicates the firms increasing investment in debtors. This shows that the opportunity cost of

capital is rising, and will reduce the firms profitabitlity significantly.

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

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

2009).

In 2010, the inventory turnover ratio was 5.25 times. This means that the annual cost of

sales was 5.25 times bigger than the average stock. This ratio has been declining from 4.8 in

2011 to 3.8 in 2012. This shows that either the cost of sales has decresed against an increasing

average stock held by the firm.

(c). Account payable days / Average payment period = (365 average creditors)

credit purchases

This shows the average period extended to the firm by its creditors to pay back their

debts. An increasing Average payment period indicates improving relations between the firm and

its creditors. This is beneficial to the firm as it can improve its profitability by making use of the

extended credit period. Credit purchases are considered a dource of external financing to the

firm.


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

This ratio compares the firms total sales to its fixed assets. It shows the proportion of

sales generated from fixed assets. This ratio has been increasing from 1.75 in 2010, 1.88 in 2011

to 1.99 in 2012. This shows that the total sales generated from fixed assets have been increasing.

This essentially infers an increase in efficiency in the use of fixed assets.

(e). Sales as a Percentage of 2009 sales

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

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

The 100 % in 2010 shows that the sales in 2009 and 2010 were equal. In 2011, the sales

and increased by 3 % to 103 % and in 2012 they increased by 6 % in comparison to the base year

2009.

3. Profitability Ratios(a). Gross profit margin = (Gross profit sales) 100

This ratio indicates the ability of the firm to control the cost of goods sold expense. It

shows the gross profit as a percentage of the total sales. In 2010, the gross profit margin was 40

%, it declined to 33.6 % in 2011 and finally settled at 30 % in 2012. The decreasing gross profit

margin is a direct reflection of the decreasing profitability of the firm.

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

100


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This ratio shows the ability of the firm to control its operating expenses. The operating

expenses comprise of goods sold, selling and distribution expenses, general and administration

expenses. The operating profit margin was constant at 7.8 % in 2010 and 2011 then shot up to 8

% in 2012. This indicates improved management of operating expenses in 2012.

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

100

This ratio, also referred to as the Primary ratio, measures the effieciency with which the

company utilises the capital invested in it to earn profits.

Capital employed = net fixed assets + working capital

Prospects return on capital employed has been steadily decreasing over the three years

from 8.5 % in 2010, then 8 % in 2011 and 7 % in 2012. This negative trend indicates a drop in

the profitability of the firm and decreased effeiciency in using the firms capital employed.

4. Gearing ratios

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

The fixed charge capital refers to the borrowed funds that have a fixed rate of return.e.g

preference shares, debentures etc.This ratio indicates the proportion of fixed charge capital to

total capital. It is the most popular indicator of financial risk in the company. The rising gearing

ratio of Prospect Ltd. From 40 % to 52 % indicates increasing riskiness in the financial structure

of the company.


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

This ratio indicates the number of times that the company can pay interest charges out of

operating profits. The decreasing interest coverage ratio from 15 times to 8 times in 2012 is a

negative indicator to long term lenders who thus consider the company risky.

5. Investor Ratios(a). Earnings per share = Earnings attributable to Ordinary shareholders number of ord.

shareholders

It indicates the earning power of the firm. It is a measure of how much earning or profit

will be received by each ordinary shareholder per share. The EPS has decreased from 1.30 in

2010, to 1.00 in 2011 then further down to 0.80 in 2012. This trend is unfavorable to investors

who will perceive Prospect Ltd as a failing company in terms of the return per share of capital

invested(Longenecker, 2012).

PART D

a) The main sources of finance available to business and the advantages anddisadvantages of such finance

Financing a business requires a lot of capital, which in most cases is not readily

available in the business. Therefore, potential business people have to look for other sources of

finances for their business. The most commonly used sources of funding include; personal

savings, government assistance, business partners, venture capital, convectional debt financing

and going public. Sources of funding can be categorized as either internal or external sources.

(Gitman & mcdaniel, 2009)


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External sources of finance

Bank loans and bank overdraftsBanks and credit facilities offer individuals bank loans to help finance businesses. This

is a long term finance that the business can repay in instalments over a given period of time (Longenecker, 2012). Bank overdrafts are short terms source of finance that resembles a loan

facility. They help businesses to finance the seasonal fluctuations of the business finances

(Dlabay & Burrow, 2007).

Advantages of a bank loan

i. Bank loans are convenient and easily accessible from banks.ii. Banks offer their customers multiple loan option where the individual can

pick the most suitable option for the business.

iii. Bank loans offer tax benefits where business taking loans from banks aregiven a little relief from tax

iv. Unlike other lending agencies, bank loans offer lower rates to theircustomers.

Disadvantages of bank loans

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

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


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iii. Banks seldom give the business the full amount applied for making itdifficult for the entrepreneur o proceed as planned because they have to look for the extra

money(Longenecker, 2012).iv. Banks have a long list of conditions and sometimes it is difficult to meet

all of them. This discourages potential applicants

Share capital from friends and familyShare capital refers to outside investors who commit their funds to the

business. These could be either friends or family of the owner(s) of the

company (Dlabay & Burrow, 2007).

Advantages

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

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

Internal sources of finance

Retained profits


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This refers to cash that is generated in the business. This is retained

profit gotten from the business (Dlabay & Burrow, 2007).

Advantages of using retained profits

Interest is saved Self dependence where the company does not need to owe any

institution or individual money.

Maintaining the company secrets where the company does nothave to divulge business information to outsiders.

Disadvantages of using retained earnings

The company tends to lose its liquidity since its reserve isexploited.

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

Profit deprivation where shareholders are denied the opportunity toenjoy their profits.

Personal savings

This is money from the founders savings.

Advantages of using personal savings


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When personal savings are used, the individual still maintainshis/her control over the business. This is unlike in the case where a loan is

applied and the back or financial institution has a right over the business

(Dlabay & Burrow, 2007).

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

Disadvantages of personal savings as a source of finance

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

b) The use of budgets as a means of planning and controlling the variousbusiness activities

A budgeting is a process where resources, amount of capital, goals and milestones of a

company are analyzed. Budgeting helps people to plan and control their finances. It is a

formalized system that helps individuals to plan, forecast, monitor and control the operations of

an organization. A budget is a plan that is used to mainly control finances (Gitman & Mcdaniel,

2009). A budget should cover the projected cash flows as well as the current cash flows to make

it easier for financial planner to do their job. Planning is a future oriented process that involves

making assumptions and forecasts regarding the organizations environment, especially the

uncontrollable factors (Dlabay & Burrow, 2007). Controlling on the other hand involves the

monitoring of business activities aimed at ensuring that the implementation of the plan is


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effective. Budgets are financial statement indicating the plans the organization has put in place.

This links them to the control system of the organization. Once the budget is set, managers can

now effectively monitor the financial performance of the organization. This process is

continuous especially because the external environment of a business is spontaneous and can

change at any time. Performance is measured against the budget and any deviations noted are

rectified with immediate effect. Therefore, it can be stated that the budget acts as the road map

for the organization.

Conclusion

Based on the data provided above, organizations must take time to calculate all their

finances. This information determines how well the organization thrives in the market. For

example, in the first part, the data acquired will help the organization to effectively decide on the

feasibility of the choices they make. Financial decisions in any organization form the backbone

of the organization because without finances, the organization cannot thrive. This means, all

financial calculations must be precise and accurate lest they mislead the organizations

management in their decision making process.


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References

Dlabay, L. R., & Burrow, J.,2007.Business finance. Mason, Ohio, South Western.

Gitman, L. J., & Mcdaniel, C. D., 2009. The future of business: the essentials. Mason, OH:

South-Western Cenage Learning.

Longenecker, J. G., 2012. Small business management: launching and growing entrepreneurial

ventures. Mason, OH: South-Western Cengage Learning.


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