Magoosh GRE

Finance and Accounting Assignment

| August 17, 2016

Part A:

Grey Plc is a distributor of professional equipment and supplies and has shown varying performance over the past three years. This report will aim to analyze the trends in financial performance of the company through the aid of liquidity ratios, profitability ratios, asset utilization ratios, gearing ratios, and investors’ ratios. The report will begin with an analysis of the company’s liquidity position, followed by its profitability, asset utilization, gearing ratios, and investors’ ratios.

Liquidity Analysis:

The firm’s liquidity position can first be measured through its current ratio which shows a firm’s ability to meet its current liabilities through its current assets. In the case of Grey Plc, the firm’s current ratio is increasing from 2009 to 2011 as it began from 2.00 in 2009, increased to 2.13 in 2010, and then further increased to 2.18 in 2011 which means that the firm has approximately double the current assets to pay off its current liabilities. One of these current assets is cash as the company’s cash balance has increased from £100,000 in 2009 to £150,000 in 2010 and then to £250,000 in 2011. This shows that the company is in a highly liquid position as it is increasing its cash balance. However, this may also mean that the firm is not properly investing its free cash to earn a return. The company’s acid test ratio got lower from 2009 to 2010 but then increased in 2011 to 1.40 showing that in previous years inventory may have been a larger part of the firm’s current assets than it was in 2011.

Profitability Analysis:

The profitability ratios show how well the company is generating profit. The company’s sales have increased from 2009 to 2011, which shows a positive trend as sales were 5% more in 2010 than they were in 2009 and were 10% more in 2011 than they were in 2009. However, the company’s gross profit percentage has decreased from 2009 to 2010 from 40% to 33.6% which means that there may have been an increase in the company’s cost of goods sold. However, the company’s operating profit percentage has decreased from 2009 till 2011 from 7.8% in 2009 to 7% in 2011. This means that while the company’s sales have increased, either the company’s cost of goods sold have increased or the company’s operating expenses may have increased, which caused a reduction in the company’s operating profit margin. Moreover, the company’s bad debts have also increased by 10% per annum which is an additional expense to the company. The expansion programme in 2009 may have been a cause to the company’s decreasing operating profit margin as well. 

Asset Utilization Ratio Analysis:

A problem that can be seen within the company is the company’s accounts receivable turnover ratio which is decreasing through the years. This shows that the company is not able to quickly recover its accounts receivable which is not seen as a positive sign as the company’s bad debts balance is also increasing. The firm’s inventory turnover ratio is increasing which means that the firm is quickly able to turn its inventory into sales which is seen as a positive sign and can also be attributed to the fact that the company’s sales volume has increased. This suggests that the company is not holding large amounts of inventory stagnant. The company’s accounts payable days have also increased from 2009 to 2011 from 60 days in 2009 to double amounting to 120 days in 2011 which means that the company keeps cash in circulation for a longer period of time which can be seen as a positive aspect. Thus, while the company’s accounts receivable turnover is decreasing, the company is performing positively in inventory turnover and accounts payable days.

Gearing Ratio Analysis:

The company has decreased its level of gearing from the year 2009 to 2011 as gearing was at 40% in 2009, decreased to 35% in 2010, and further decreased to 30% in 2011. This means that the company is relying less on external finance and loans and is thus less financially geared which is also a positive performance indicator. The company’s interest cover ratio is decreasing from 2009 to 2011 which means that the company is less able to cover its level of interest with its outstanding debts. However, while the ratio is decreasing, it is still high at 7 times in 2011 which shows that the company is sufficiently capable of catering to its outstanding debt.

Investors Ratio Analysis:

The company has announced dividends of £750,000 every year which is seen as a positive performance indicator. Moreover, the company’s earnings per share have increased significantly from 0.55 to 1.20 from 2009 to 2011 respectively which also shows a high growth level.  The company’s operating cash flow per share has also increased over the years. Consequently, Grey Plc’s return on capital employed has also shown a positive trend from 8.5% in 2009 to 8.7% in 2011. The company’s return on equity has also increased from 15% to 20% respectively which shows that the company is substantiating adequate returns from its investment. 

Conclusion of Analysis:

Grey Plc has shown commendable performance over the years and has been able to gain adequate returns in each of the respective areas defined above. To calculate the company’s Working Capital Cycle in days, we need to consider that the company’s accounts payable in days is increasing and the company’s inventory turnover is increasing, yet the company’s accounts receivable turnover is decreasing which means that the company’s working capital cycle is becoming longer. This is not a positive trend as it is eroding the performance of the company and in order to increase its working capital cycle in days, it is essential for the company to decrease its level of bad debts and increase its accounts receivable turnover.

Then the company will also be able to increase its net profit and will thus help the company improve its overall performance.

Part B:

(A)The theory of constraints is a management paradigm which describes operational or management processes as not being highly restrained by a large number of constraints but limited to a small number of constraints. The theory of constraints determines that there is usually one constraint in the managerial process which acts as the “weakest link” between the other parts of the process. The theory believes in removing this weakest link in order to improve the whole process and focuses upon finding the weakest part of the process in order to restructure the whole process around it (Bierman & Schmidt, 2012).

The theory of constraints emphasizes that in order to optimize short-term decision making, a firm’s managers should find bottlenecks or problems in the managerial or operation process and attempt to remove them in order to increase efficiency (Bierman & Schmidt, 2012).

(B) (i) A bottleneck resource is an asset which slows down the production process and causes other processes to slow down as well. It is also the machine which is using the most capacity (Mason, 2007). The bottleneck resource in the situation described in this case may be machine 1 as it requires the most machine hours per unit and also spends the most machine hours on product C. Product C has the least demand yet machine 1 spends the most time on producing it which may be a cause for it to be termed as a bottleneck resource.

(ii) Each machine has a limited capacity of 12,000 hours out of which it must produce products A, B, and C. Machine 1 requires 0.15 hours to produce product A, 0.20 hours to produce product B, and 0.20 hours to produce product C. With a 12,000 hours capacity, the machine can produce 12,000/0.55=21,818 products. Machine 2 requires 0.10 hours for product A, 0.18 hours for product B, and 0.15 hours for product C. Accordingly, the machine can produce 12,000/0.43= 27, 906 products.  Machine 3 requires 0.10 hours for Product A, 0.15 hours for Product B, and 0.10 hours for Product C. Accordingly, the machine can produce 12,000/0.35=34,285 products.

So all three machines combined can produce 84,009 units. Thus, the company should produce 34,000 units of product A, 25,009 units of product B, and 25,000 units of product C. This will ensure that the company meets the demand for these products and uses all the capacity of the machines.

(C) The percentage of demand that Product A occupies is 25,000/70,000=0.35%. The percentage of demand that Product B occupies is 24,000/70,000=0.34% and the percentage of demand that Product C occupies is 21,000/70,000=0.30 %.

The breakeven point for product A: (x) (25) = (15) +70,000

25x=85,000

X=3,400

The margin of safety is 34,000-3,400=30,600 units

The breakeven point for Product B: (x) (28) =15+68,000

28x=83,000

X= 2,964

The margin of safety is 25,009-2,964= 22,045 units

The breakeven point for Product C: x32= 15+60,000

32x=75,000

X=2,344 units

The margin of safety is 25,000-2,344=22,656 units

Thus, the optimal mix for each of the products is well above the breakeven point which means that using all three machines will enable the firm to produce efficiently and effectively.

Part C:

There are various investment appraisal methods which allow a firm to assess whether an investment is optimal and will produce the required returns or not. One of the popular investment appraisal methods includes the Net Present Value Method. According to the Net Present Value Method, the cash flows expected from an investment are discounted back to assess their present value. Usually, the investment with the higher Net Present Value is selected as the most worthy or optimal investment (Isaac, Leary, & Daley, 2010).

According to the Net Present Value Method, Project B is most appropriate for Blue Plc as it has a higher Net Present Value than Project A which amounts to £36 million. There are advantages and disadvantages involved in using the Net Present Value Method which include the fact that the Net Present Value method accounts for the time value of money and measures the effects of inflation and other similar factors which may affect the value of the cash flows that the business is likely to generate in the future.  Another advantage is that the cash flow before the beginning of the project and after the end of the project is considered in calculating the value of the Net Present Value. Measures such as the profitability of the projects and the risk involved in the project are both given high priority in the calculation of Net Present Value. Moreover, using this measure helps maximize a firm’s value (Isaac, Leary, & Daley, 2010).

There are also certain disadvantages of using the Net Present Value method, which include the fact that it is difficult to use and that the net present value cannot give an accurate assessment of which project would be a better investment if the projects are mutually exclusive or if they are not of equal value. Moreover, calculating the appropriate discount rate is rather difficult and may not be accurate. The discount rate is usually estimated which may mean that it may vary in actual terms. The Net Present Value may not give an accurate decision if the projects are of unequal duration and can thus not be used in all situations (Reilly & Brown, 2011).

However, in the case of Blue Plc, both projects A & B are of equal duration measuring four years and both require an initial investment of £20 million. Thus, in this case using the Net Present Value Method may be appropriate as both projects are of the same duration and require equal investment and the same cost of capital.

The other investment appraisal method that can be used to assess the feasibility of investments is the payback period. As Project A and Project B are both of the same duration and both require four years for execution, the payback period for Project A is 4.5 years, which is longer than its execution. Comparatively, the payback period for Project B is 3.6 years, which is less than that required for the execution of the project and is less than that required in Project A.  Therefore, according to the payback period method, Project B is the optimal investment as it has a lower payback period.

The advantage of using the payback period method is that it is simple to use and understand. This method enables a company to identify the project with the quickest return on investment, especially in the case when the company has limited cash and can only invest in a project which allows it to regain its money back as fast as possible. This is the case with Blue Plc as the company can only invest in one project and would require its money back as fast as possible (Bierman & Schmidt, 2012).

However, one of the problems with the use of the payback period method is that it completely ignores the time value of money and does not consider or evaluate the fact that cash flows may not be regular and may occur later on in the process of the project. There may also be some projects which have an acceptable rate of return but still do not meet the requirements for the payback period. This method also does not consider any cash flows that a project would generate after the initial investment has been recovered. Thus, it does not accurately give an assessment of the profitability of a project but only evaluates how long it will take to recover the initial investment of a project. Using this method may mean a company overlook many attractive projects only because the company is focusing upon short-term profitability alone (Bierman & Schmidt, 2012).

According to Blue Plc’s case, the payback period is lower which means that it is a feasible project with a higher rate of return. However, we must ideally combine this analysis with the analysis of other factors such as the Net Present Value to determine whether this project is the most optimum investment or not.

Accordingly, the better investment appraisal method is using the Net Present Value method as it accounts for the time value of money and also measures subsequent cash flows that a project generates after the initial amount has been recovered. The payback period is simple but does not provide a fully accurate picture. Moreover, in the case of Blue Plc when the cost of capital, duration of the project, and the initial investment required in the project are the same for both projects, the Net Present Value is the most appropriate investment appraisal method to use in evaluating the feasibility of both projects (Kim, Shim, & Reinschmidt, 2013).

However, using either method has generated the same result as Project B seems to be the optimal choice regardless of whether the payback period is used as the investment appraisal method or whether the payback period is used as the investment appraisal method. 

Part D:

(A)There are various sources of finance that can be used by a business in order to finance its operations. However, the use of these sources of finance also involves various advantages and disadvantages. A privately owned business can use the owner’s savings and personal assets to finance business expansion or to finance the start of a business (Beck & Demirgue-Kunt,2006). The advantages of using this source of finance are that the owner does not have to pay any interest or share any of the profits with investors or others as he/she is using their own money in the business venture. There are also no acquisition costs and no major hassle in raising or using this source of finance. However, there is also risk involved for the owner in using his/her own personal savings which includes the fact that he/she may lose all of this money if the business goes into a loss (Berger & Udell, 1998).

Another source of finance for a business is allowing investors to invest in the business. In the case of a sole trader or a private limited company, the owners can allow partners to join in the investment or can turn the company into a public limited company.In the case of a public limited company, the owners can sell shares on the stock exchange in order to gain more finance. However, this will also mean that the owners of the company will lose a substantial amount of control in the company once investors are allowed to invest in the company.  They will also be required to keep their investors happy and this can be a tiresome and pressurizing ordeal also resulting in conflicts. Profits will also have to be divided with the investors, meaning that the owners cannot keep all of the profits to themselves. On the other hand, the owners of the business will also be able to share the risk with other investors and will not be solely liable for all of the business losses (Mason, 2007).

Another major source of business finance is bank loans. They can provide a quick and reliable source of funding which also enables businesses to keep their persona operating cash to themselves for emergency situations. A business may also be exempted from paying back their loan in full if they file for bankruptcy and provided that they do not have the required amount. However, in order to obtain a bank loan, a business may have to provide collateral which may be a hassle or it may be difficult for a firm to obtain a loan if they do not have the required collateral. Interest payments will also have to be made on the loan which will mean that the business has to return more than they actually borrowed. Payments on the loan will also be due at specific times regardless of whether the business is doing well or whether it is not doing well (Beck & Demirgue-Kunt, 2006).

Another source of finance for businesses is government grants and loans. Some governments provide start-up and expansion programs to facilitate their business sector and these can prove to be a highly valuable opportunity for businesses to receive free finance. The interest rates on these loans are also much lower than the rates on other loans and are usually provided without collateral. However, the problem with obtaining government loans and grants is that there is usually a lot of red tape that has to be surpassed before the loan can be granted and thus it is not available to all businesses. The loan or grant is still a loan or grant and eventually has to be repaid (Berger & Udell, 1998).

(B)  Break-even analysis uses a firm’s selling price of products against a firm’s fixed and variable costs in order to determine the quantity of products that a firm needs to sell in order to recover the costs it has incurred to produce those products. There are certain assumptions that the break-even analysis makes in order to calculate this quantity. First of all, the break-even analysis assumes that all costs can be categorized as either fixed costs or variable costs. However, on a practical basis, it is nearly impossible to accurately classify costs into these categories because some costs have both a variable and fixed proportion. Another assumption is that fixed costs remain constant at any level of activity, even when there is no production. However, this may also not pose a highly accurate picture and may not be able to accurately depict the true nature of fixed costs as some fixed costs may begin to vary with differing levels of output (Al-Habeeb, 2012).

The break-even analysis also assumes that the unit selling price will remain constant. However, in the contemporary business environment, this is not practical as the unit selling price may vary with differing consumer tastes and purchasing habits. As competition increases, firms may be constantly changing their unit selling price which then makes the break-even analysis void and inaccurate. The breakeven analysis also keeps inventory levels, the design of the product, efficiency and productivity levels, and variable costs constant (Tsorokidis et al, 2011).

The contemporary business environment involves high rates of competition, innovation, and varying productivity and efficiency levels. Moreover, other business problems and issues may also affect the rate of sales and the level of costs at various times in the production and selling process. Thus, in such cases, the break-even analysis is a highly limited model in assessing the number of units needed for sales to break-even (Berger & Black, 2011).

On the other hand, the break-even analysis is a simplistic model which can at least give a business a rough idea regarding how many units it needs to sell in order to recover its costs. It can be used in cases where selling prices and costs remain constant and perhaps in businesses where it is easy to categorize these costs into the separate categories of fixed and variable costs. Businesses should not completely rely upon the break-even analysis and may have to use other more thorough accounting methods in order to determine the optimum quantity to sell which would enable them to achieve a profit (Berger & Black, 2011).

Accounting and forecasting models are usually based upon assumptions and none of them exist without disadvantages. Thus, it is essential for a business to use all of these models with caution and only use them as a guideline in order to calculate various results for their business. 

References

Alhabeeb, M. J. (2012). “Break‐Even Analysis.” Mathematical Finance. pp.247-273.

Beck, T., & Demirguc-Kunt, A. (2006). “Small and medium-size enterprises: Access to finance as a growth constraint.” Journal of Banking & Finance, Vol.30(11) pp.2931-2943.

Berger, A. N., & Black, L. K. (2011). “Bank size, lending technologies, and small business finance.” Journal of Banking & Finance. Vol.35(3) pp.724-735.

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

Isaac, D., O’Leary, J., & Daley, M. (2010). Property development: appraisal and finance. Palgrave Macmillan.

Kim, B. C., Shim, E., & Reinschmidt, K. F. (2013). Probability Distribution of the Project Payback Period Using the Equivalent Cash Flow Decomposition. The Engineering Economist. Vol.58(2), 112-136.

Liesen, A., Figge, F., & Hahn, T. (2013). “Net Present Sustainable Value: A New Approach to Sustainable Investment Appraisal.” Strategic Change. Vol.22 (3‐4) pp.175-189.

Mason, C. M. (2007). “Informal sources of venture finance.”  The life cycle of entrepreneurial ventures .pp. 259-299. Springer US.

Berger, N. & Udell, G. (1998). “The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle.” Journal of Banking & Finance. Vol.22 (6), pp.613-673.

Reilly, F. K., & Brown, K. C. (2011). Investment analysis and portfolio management. CengageBrain. com.

Tsorakidis, N., Papadoulos, S., Zerres, M., & Zerres, C. (2011). Break-Even Analysis. Bookboon.

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