Financial Analysis for Managers - Case Study Example

Running Header: Accounting Accounting Author’s Name Instructor’s Name Course Number Date of Submission a) Horizontal Balance Sheet Horizontal analysis Assets 2016 2015.00 2014 SAR 000 SAR 000 SAR 000 Current Assets Cash and Cash Equivalents -8% 156% 0% Receivables and prepayments 4% -5% 0% Inventories 14% 2% 0% Derivatives Financial Instruments 267% 170% 0% Total Current Assets 8% 25% 0% Non-Current Assets Investments -39% -39% 0% Property, Plant and Equipment 31% 16% 0% Biological assets 21% 15% 0% Intangible Assets-Goodwill -32% -26% 0% Derivative Financial Instruments 499% 548% 0% Prepayments 16% -37% 0% Deferred Tax Asset 21580% 1706% 0% Total Non-Current Assets 25% 11% 0% Total Assets 21% 14% 0% Liabilities and Equity Liabilities Current Liabilities Bank Overdraft 16% 52% 0% Short Term Loans 27% 33% 0% Current Portion of Long-term Loans -25% 7% 0% Payables and Accruals 52% 30% 0% Derivative Financial Instruments -11% -67% 0% Total current Liabilities 19% 19% 0% Non-Current Liabilities Long Term Loans 31% 21% 0% End of service Benefits 32% 16% 0% Deferred Tax Liabilities -33% -20% 0% Derivative Financial Instruments -10% 39% 0% Total Non-Current Liabilities 30% 20% 0% Total Liabilities 26% 20% 0% Equity Share Capital 33% 0% 0% Statutory Reserve 32% 16% 0% Other Reserves 52% -16% 0% Treasury Shares 93% 68% 0% Retained Earnings 9% 43% 0% Equity attributable to Share Holders 23% 13% 0% Perpetual Sukuk 0% 0% 0% Equity Attributable to Equity Holders 20% 11% 0% Non-Controlling Interest -43% -25% 0% Total Equity 16% 8% 0% Total Liabilities and Equity 21% 14% 0% Vertical Balance Sheet Vertical analysis Assets 201600% 201500% 201400% SAR 000 SAR 000 SAR 000 Current Assets Cash and Cash Equivalents 3% 7% 3% Receivables and prepayments 5% 5% 6% Inventories 11% 10% 12% Derivatives Financial Instruments 0% 0% 0% Total Current Assets 18% 22% 21% Non-Current Assets Investments 1% 1% 1% Property, Plant and Equipment 73% 68% 68% Biological assets 4% 4% 4% Intangible Assets-Goodwill 3% 4% 6% Derivative Financial Instruments 0% 0% 0% Prepayments 0% 0% 0% Deferred Tax Asset 0% 0% 0% Total Non-Current Assets 82% 78% 79% Total Assets 100% 100% 100% Liabilities and Equity Liabilities Current Liabilities Bank Overdraft 1% 1% 1% Short Term Loans 1% 1% 0% Current Portion of Long-term Loans 4% 6% 7% Payables and Accruals 11% 10% 9% Derivative Financial Instruments 0% 0% 0% Total current Liabilities 17% 18% 17% Non-Current Liabilities Long Term Loans 35% 34% 32% End of service Benefits 2% 2% 2% Deferred Tax Liabilities 0% 0% 0% Derivative Financial Instruments 0% 0% 0% Total Non-Current Liabilities 37% 36% 35% Total Liabilities 54% 54% 51% Equity Share Capital 28% 22% 25% Statutory Reserve 6% 5% 5% Other Reserves -2% -1% -2% Treasury Shares -1% -1% -1% Retained Earnings 10% 13% 11% Equity attributable to Share Holders 39% 38% 38% Perpetual Sukuk 6% 6% 7% Equity Attributable to Equity Holders 45% 44% 45% Non-Controlling Interest 1% 2% 3% Total Equity 46% 46% 49% Total Liabilities and Equity 100% 100% 100% Horizontal Income statement Horizontal analysis 2016 2013 2014 SAR 000 SAR 000 SAR 000 Sales 17% 9% 0% Cost of sales 11% 6% 0% Gross profit 27% 15% 0% Selling and Distribution expenses 27% -88% 0% General and administration expenses 25% 17% 0% Operating income 27% 13% 0% Share of results of associates and joint ventures -263% 357% 0% Other expenses 243% 391% 0% Finance cost 48% 10% 0% Income before Zakat and foreign income tax 23% 6% 0% Zakat and foreign income tax 5% -6% 0% Income before non-controlling interest 24% 7% 0% Non-controlling interest -76% -1323% 0% Net income for the year 24% 14% 0% Vertical Income Statement Vertical analysis 2016 2013 2014 SAR 000 SAR 000 SAR 000 Sales 100% 100% 100% Cost of sales -60% -62% -64% Gross profit 40% 38% 36% Selling and Distribution expenses -19% -2% -18% General and administration expenses -3% -3% -3% Operating income 17% 16% 16% Share of results of associates and joint ventures 0% 0% 0% Other expenses -1% -1% 0% Finance cost -2% -2% -2% Income before Zakat and foreign income tax 15% 14% 14% Zakat and foreign income tax -1% 0% -1% Income before non-controlling interest 14% 13% 13% Non-controlling interest 0% 1% 0% Net income for the year 14% 14% 13% b) Literature review In making financial decisions, one needs to analyses the company’s profitability as well as financial position. However, Szramiak (2017) states that it would be difficult to interpret the amounts contained in the financial statements in a meaningful way in deciding which investment option is more riskier than the other. As such, various tools are used for this purpose including horizontal and vertical analysis. The analysis help the decision makers compare a company’s result for different years using different basis. This is also important as it helps investors who would want to compare investment options of differing sizes. The two approaches are similar as they convert the amounts of money reported to percentages although they make use of different basis in their computation (Bruce, 2011). Horizontal analysis has its focus on trends and changes in financial statements items over time which helps the decision maker see relative changes over time while identifying positive and troubling trends. On the other hand, vertical or common size analysis compares all the amounts presented in the financial statements relative to a key financial component. This is also useful in identifying trends (Accounting-financial-tax.com, 2009). It is worth noting that these tools are not only useful to investors but also to other decision makers such as the management in deciding what they need to improve concerning the company’s operations. Horizontal analysis Balance Sheet i) Total assets trend The company’s total assets have gradually increased by 21% between the year 2014 and 2016. However, the greatest increase has been noted in non-current assets which improved by 25% over the same period with the greatest increases being noted in property, plant and equipment, deferred tax assets and derivative financial instruments. As far as current assets are concerned, inventories recorded a notable increase. However, the company’s cash recorded a mixed trend initially increasing by 156% in 2015 before declining by 8% in 2016. The assets increases is a reflection of the developments the company has undertaken as well as the company’s debt management strategy. Liabilities trend The company’s liabilities increased by 26% between 2014 and 2016 with the greatest increases being noted in non-current liabilities which increased by 30% over the period. The greatest increase resulted from long-term loans which increased by 31% and long service benefits which increased by 32%. This is in comparison to current assets which increased by 19% with the accounts payables increasing by the greatest margin of 52%. The trend noted in the liabilities is in line with the company’s debt management policy since the company’s debt seems to be under control. Equity trend The company’s equity increased by 16% during the period. This was caused by new share issuance as well as increases in the company’s reserves. However, it the company needs to adopt measures to better manage liabilities since they had the largest increase which outnumbered the increase in assets. Income statement Sales revenue trend Despite the increasingly difficult operating environment, the company’s revenue increased by 17% between 2014 and 2017. This is an indication of strong performance thanks to the company’s sales and marketing efforts as well as the strong brand. Cost of sales trend The company’s cost of sales increased by 11% between 2014 and 2016 which is desirable as it is lower than the increase in revenues resulting in improved gross margins which recorded a 27% increase over the period. Profit trend The company recorded a 24% increase in net profits between 2014 and 2016. This is an indication of good performance thanks to the efficient cost cutting measures implemented by the company. Vertical analysis Financial position (Balance Sheet) Assets analysis The greatest portion of the company’s assets between 2014 and 2016 has been the long-term assets with property, plant and equipment computing the greatest portion. The PPE also recorded the greatest increase from 68% in 2014 to 73% in 2016. On the other hand, company’s current assets as a proportion of the total assets recorded a decline with the only increase recorded in inventories. Liabilities analysis The company’s non-current liabilities formed the greatest portion of the company’s liabilities and also recorded a slight increase from 35% in 2014 to 37% in 2016. However, there was a significant increase in the company’s long-term loans from 32% to 34% as a proportion of total assets. This shows that the company’s debts are well managed and this proportion is in line with the company’s strategy of managing interest obligations given that the proportion of long-term loans that is current liability significantly declined from 7% to 4% over the period. However, the company needs to better manage its payables since they significantly increased. Equity analysis The company’s total equity as a proportion of total assets declined from 49% in 2014 to 46% in 2016 despite the significant increase in contributed equity. This shows the need to better manage the company’s debts to ensure that investors’ funds in the company do not get diluted by increased debts hence depressing the returns. Income statement Gross profit analysis The company’s gross profit has gradually improved from 36% in 2014 to 40% in 2016. This shows that the company has relatively low production cost which has declined over the same period. This is good for the company given that the market conditions have been tough over the period. Net profit analysis The company’s net income has also improved from 13% in 2014 to 14% in 2016 which an indication of growth and declining operating costs despite the environmental conditions being tough. Conclusion From the analysis above, it is clear that the company’s profitability has improved over the three years with the financial position improving over the same period. However, there is need for increased efficiency to ensure increased net earnings given the high gross profit margin. In addition, there is need to ensure that the company’s debts are well managed to prevent the proportion of equity from falling further. c) Comparison of vertical analysis and horizontal analysis Both the tools are financial analysis tools used in helping users understand the company’s past, present and possible future performance by converting the figure amounts presented in the financial statements into percentages. Vertical analysis shows each account on the company’s financial statements in monetary figures as a percentage of another item. For the balance sheet, each account is expresses as a percentage of the total assets while each item on the income statement is expressed as a percentage of sales (Accounting-financial-tax.com, 2009). Vertical (common size) analysis is used in showing annual changes in a company and in comparing data from two companies or industry averages by comparing the percentages and hence discovering how one company is performing when compared to other companies or the industry. On the other hand, Horizontal analysis is a year over year comparison of ratios or line items financial statements. This is achieved by comparing each item in the previous year and is expressed as a percentage and hence helps identify trends of how the company has been performing over the years. 2. Project analysis a) Net Present Value Method The project’s required rate of return is 10% Where:- -Co = Initial cash flow C = Cash flow r= Discount rate and T = Time Details Option 1: New Store at Barka Net Present Value Option 2: Take-over existing store at Ibra Net Present value Initial cost 200,000 -200,000 200,000 -200,000 Cash Flows Year 1 60,000 54,545.45 20,000 18,181.82 Year 2 80,000 66,115.70 60,000 49,586.78 Year 3 100,000 75,131.48 80,000 60,105.18 Year 4 60,000 40980.81 120,000 81,961.61 Year 5 40,000 24,836.85 80,000 49,673.71 NPV 61,610.30 59,509.10 IRR 21.98% 19.01% b) Net present value (NPV) is a capital budgeting technique which is the difference between the amount invested and the present value of future cash flows (Lunkes, 2015). The method calculates the expected monetary gain or loss from a project through discounting all expected future Cashflows and outflows back to the present point in time using the required rate of return (Hasan, 2013). It is considered the most straight forward technique for determining whether the project has yielded a return over the alternative equal risk investment in a project (Shapiro, 2005). It is the present value of the net cash inflows less its initial investment outlay. The decision criteria under NPV is that if the NPV is positive, the project is adopted holding other factors constant and if negative, the project is rejected. On the other hand, IRR is a capital budgeting technique that also uses time value of money though being expressed in percentage form. IRR means the discount rate that leads to the NPV being zero where the present value of the cash inflows is equal to cash outflows (Peterson, 2004). It calculates the discount rate at which a project’s present value of all expected cash inflows would be equal to the present value of its expected cash outflows. The decision rule is that if it is greater than the required rate of return, then the project is accepted all other factors being held constant. Otherwise the project is rejected (Hasan, 2013). Based on the above literature and the calculations above, I would recommend project A since it has a higher NPV of 61,610.30 and an IRR of 21.98% which is higher than the required rate of return of 10% compared to project B which has an NPV of 59,509.10 and an IRR of 19.01% It is worth noting that in making the investment decision, other non-financial factors also have to be considered. We need to ensure that the project ought to meet the requirements of current and future legislation (Peterson, 2004). The project also ought to match industry standards and good practice and need to improve the business reputation. It is also important that the company has the capacity and capability to run the project. We also need to have enough markets for the project (Hasan, 2013). If we only consider financial factors, then the project may be constrained by the non-financial factors and hence the company will end up wasting money. Thus, apart from making financial considerations, we should also consider the factors mentioned above among others (Lunkes, 2015). Based on the above literature, the non-financial factors we should consider includes the supply availability. If we have no supply, the project may fail if the one we want to initiate fails. Consumer trends also have to be considered. It would be prudent to invest in a market that is growing as opposed to the one that is stagnated. It is also good to consider the population growth since a growing market means the market will keep on growing bigger. In addition, we should consider competition. If the competition is moderate, we may end up having a bigger market soon but if the competition is big, we may end up losing the market. Based on this therefore, I would recommend project A since it promises the greatest returns and on establishing the supply, the market has the potential to grow and hence the project has potential for growth. 3. Break-even point a) BEP = Total fixed expenses / (Revenues –Variable costs) BEP = Total fixed expenses /Contribution ratio Contribution margin ratio = contribution margin/Sales Product A = (300,000-240,000) = 60,000/300,000 = 0.2 Product B = (300,000-20,000) = 100,000/300,000 = 0.33 BEP for product A = RO30, 000/0.2 = 150,000 B = RO70, 000/ 0.33 = $210,000 b) The sales volume to maintain the desired profit Contribution margin ratio = contribution margin/Sales Product A = (300,000-240,000) = 60,000/300,000 = 0.2 Product B = (300,000-20,000) = 100,000/300,000 = 0.33 Sales = Fixed costs+ Target profit/contribution margin ratio Product A = 30,000 + 10,000/0.2 = 40,000/0.2 = 200,000 Product B = 70,000+10,000/0.3 = 80,000/0.33 = 240,000 c) Margin of safety = Budgeted Sales – Break even sales or (Budgeted sales –Break even sales)/Budgeted Sales Product A = 300,000- 150,000 = 150,000 or (300, 000- 150,000)/300,000 = 50% Product B = 300,000 – 210,000 = 90,000 or (300,000-210,000)/300,000 = 30% d) If the business goes through ups and downs in the demand. When the demand is low, product A is likely to fetch higher profits given the fact that it has low fixed costs. This means that it will have less expenses and hence be able to earn more profits even when sales are low. However, product B will fetch higher profits when the demand is high since it has low variable cost although it has higher fixed costs. This means that when the demand is high, its expenses will be low owing to the lower variable costs which depends on the number of units sold thus fetching higher profit for the company. e) Importance of CVP in decision making CVP is important in figuring out how changes in costs and volume affect their operating expenses and net income thus enabling the company make important cost decisions (Ray, 2012). CVP enables comparison of different relationships including the cost of operations and cost of production, amount of sales as well as the profits that arise from sales. By so doing, the company gains a strong insight into the productivity of its products or services (Wilkinson, 2016). CVP is useful in making informed decisions about the company’s products or services. This is good in helping managers make smart cost effective moves. This, way, the company can improve profitability by cutting costs or even discontinuing production lines that are not profitable (Robert, 2017). References: Bruce, T2011, Using horizontal with vertical analysis to provide a larger financial picture, Retrieved on 27th April 2017, from; http://www.brighthub.com/office/finance/articles/118967.aspx Accounting-financial-tax.com, 2009, Horizontal vs vertical analysis of financial statements, Retrieved on 27th April 2017, from; http://accounting-financial-tax.com/2009/10/horizontal-vs-vertical-analysis-of-financial- statements/ Szramiak, J2017, 2 ways to analyze an income statement, Retrieved on 27th April 2017, from; http://www.businessinsider.com/horizontal-and-vertical-analysis-of-income-statements- 2017-3?IR=T Shapiro, C2005, Capital budgeting and investment analysis, New York, John Willey & Sons. Peterson, P2004, Capital budgeting: Theory and practice, London, Rutledge. Lunkes, J2015, Capital budgeting practices: A comparative study between a port company in Brazil and in Spain, Journal of public administration and policy research, vol. 7, no. 3, pp. 39- 49. Hasan, M2013, Capital budgeting techniques used by small manufacturing companies, Journal of Service Science and Management, vol. 6, pp. 38-45. Ray, P2012, Managerial accounting: Decision making and performance improvement, London, Rutledge. Wilkinson, A2016, Management and cost accounting: An introduction, New York, John Willey & Sons. Robert, K2017, Management Accounting, Oxford, Oxford University Press. Read More