Financial Statement Analysis

In the corporate world, there is a lot of competition. Therefore, firms are formed to achieve various goals, and they have to strive to ensure that they attain the objectives. Apart from private goals, there are statutory requirements the firms must meet. For instance, they have to prepare financial statements regularly and make them public for the shareholders and the third parties such as the government, creditors, and the community. In this essay I will analyze various aspects of that are contained in the financial statements

a)    The main goal of any corporation is to make profits. Therefore, the main question we need to ask ourselves what is profit. This is the gain a firm gets after subtracting the cost of goods produced and expenses that were in the production process of a commodity from the revenue obtained.it should be noted that there are two types of profit which include gross and net profit (Ryan, and Ryan, 2002 890). Gross profit is obtained by subtracting the cost of goods sold from net sales made during a certain trading period whereas net profit is taken to be the real profit during the year, and it is obtained by deducting overhead expenses and dividends from gross profit. For instance, assume that the company made sales of $200,000 in January, and the cost of goods was $80,000, and overhead expenses were $20,000. Then the gross profit will be $200,000-$80,000= $120,000. Also, the net profit will be gross profit less overhead expenses $120,000-$20,000= $100,000. Profit is a measure that helps the management and the third parties to evaluate if the firm is profitable or not. As a result, the net profit would boost the equity of an organization. This figure is recorded in the statement of comprehensive income, and it helps to summarize the overall performance of an enterprise in a certain trading period. 

For a business to operate effectively, it is essential to have adequate cash to help the management to carry out their daily activities effectively. Therefore, it is important to know to know what cash flow is. Thus, cash flow statement is the one in which only cash transactions are recorded which took place during the trading period.  The difference between cash flow and profit is that cash flow only records only cash transaction whereas profit entails cash and non-cash transactions. Also, the second difference lies in what the two measure. Gain measures the overall performance of the organization within a specified period whereas cash flow measures the capability to be in a position to be able to meet its current obligations as they fall due.

b)    Working capital is a tool that is used in business to measure liquidity. Therefore, working capital refers to the money that is used in the organization to carry out day to day operations. Working capital entails the following receivables, payables, and inventory. It is obvious that large organizations they sell their commodities in credit, and then the customers pay per the agreement signed, and the amount the clients owed the firm is what is called receivables. Payables are the amount of money the company owes third parties such as banks and other lending institutions. The amount is paid with interest which is an expense to the company. Lastly, it is inventory which is raw materials and other goods such as work in progress which are part of the organization’s assets.

c)     Working capital is a representation of the company’s current assets and current liabilities. The management of working capital is done on a daily basis. However, the changes of working capital are always reflected in the cash flow statement. When current assets are higher than current liabilities, it means that there is a higher cash flow and we can say that there this is positive working capital. However, when current assets are less as compared to current liabilities we have negative working capital a clear indication that there is a higher outflow of cash in the company. In situations when there is negative working capital the firm may start experiencing financial problems. Therefore, firms are supposed to manage their money correctly. 

    ii) The organization has been performing well in the past few years. However, due to poor management, there is a possibility of the company going to experience financial distress due to negative working capital. Initially, the company concrete policies on borrowing policies and the extent to which the company was to borrow from external sources. However, in the past three years due to the change of management, they have not considered these guidelines because they want to invest significantly. Therefore, through massive borrowing and poor techniques of collecting money from debtors, it comes difficult for the organization to sustain themselves. Additionally, due to bad economic times, the firm is not able to make huge sales, and this means that they have a lot of goods in stock. As a result, if the firm is not going to meet its daily obligations, it is going to be challenging to continue to operate, and this may lead to liquidation.

iii) For them to succeed and achieve its goals, it is important for the management to go back to the drawing board, and plan again. The following are the recommendations that can be used by the business to ensure that they are in a position to attain a positive working capital. The first thing the firm should do is to check their capital structure. This is important because it defines the cost of operation, and this would help to know the percentage in which they should balance between equity and debt. For instance, when choosing to use debt, they should calculate the amount of interest they will pay at the end of the period agreed and measured the consequences associated. For this firm, I would recommend they lower the number of loans they borrow so that they can reduce chances of experiencing financial difficulties. However, if they have to hire, they should go for long-term loans which they will be required when the projects have started generating income. Also, because the company requires adequate cash, they should consider revising their terms of dealing with clients. For instance, they can create a policy which acts as an incentive and motivates the customer to pay the amount they owe the within a specified period. For example, they can tell the client that if anyone pays within the first one week, he or she will enjoy a specific discount. Also, they can impose penalties on those who fail to honor their promises of paying the debt as agreed with the management (Klammer and Walker, 2004 89).

Part 2

Capital budgeting is a technique that is used by an investor to decide on the best investment option that they should undertake. Therefore, it is a method employed by firms to make choices in different projects. For instance, a company may be willing to invest in certain a project, but they have a pool in which they are supposed to choose. As a result, capital budgeting acts as would be used to help in making the best option from the alternatives available. Various steps are used by capital budgeting to ensure that the best decision is made. The following steps include:

1.    The first stage of capital budgeting is identifying the opportunities. This is accompanied by various reasons why the various proposals should be undertaken. This can be an introduction to a new product to the company or expanding the operations of the firm. Therefore, the aim of the project can be either to lower costs of production or increase output.

2.    The second step is to screen the projects proposed and evaluate them. This is the stage in which the criteria to be used in assessing the credibility of the proposals is established. This means that the goals of the project should match those of the organization. Additionally, this is the step in which factors such as time and value for money is taken into consideration. This is the point in which the costs to be incurred are calculated as well as the benefits to be ascertained from investing in the project. Also, the risk associated with taking a certain project is measured at this stage (Meier et al.,2001 45).

3.    The next stage is project selection. This step is unique depending on the nature and type of the company. This is because different companies have the unique selection they use in choosing the best project they want to undertake. After the selection exercise has been completed he management embarks on the exercise of looking for the sources that would help them get the capital required to finance the project. This is the point at which unique methods of acquiring funds are analyzed in detail, and the firm makes a choice in an option that would be appropriate to the organization, and this is termed as preparing the capital budget. After the funds have been obtained, then they work in reducing them to manageable levels to avoid wastages. In this stage a detailed report is prepared on how the activities would be carried out and how periodical reviews would be carried out (Schall et al.,2008 355).

4.    The fourth stage is implementation. It is evident that at this point the project needs to be implemented. Therefore, other issues such as projection completion time and the cost that would be required are set at this stage. It is at this point that the management assumes the responsibility of supervising the project and ensures that everything is done as agreed.

5.    Performance review is the last stage. This is the last step of capital budgeting. It entails the comparison of what has been achieved and the set standard. This means that at these stages deviations are identified and then corrected. This aims that the project works effectively without any difficult (Meier et al.,2001 123).

b) i) payback period

This is the time required to recover the amount of money invested in a certain project. It is a tool that is used to determine if the project should be undertaken or not. This would heavily depend on the period in which the investor requires the investment to be recovered in full. This means that the technique ignores time value for money. To determine the period used to recover the funds, and that is payback the following formula is used:

Payback= investment required/net cash inflow

Advantages of payback period

•    The method is simple to calculate and understand

•    The level of risk when using this technique is very low.

•    It can be used by the management when they want to make quick evaluations because it is not tedious.

•    The technique gives liquidity the priority.

Disadvantages of payback period

•    The method ignores important factors such as time value for money.

•    It does not take into account the income that would be generated after the initial capital has been recovered.

•    This technique is only effective when dealing with short-term projects.

•    This is a method that ignores profitability and puts more emphasis on liquidity.

Net present value

NPV is the difference that is obtained when comparing the present value of cash inflows and outflows with a certain period. It is calculated by the following formula:

=PV = (R ×1 − (1 + i)-n)/ I − Initial Investment

NPV =R1+R2+R3/ (1 + i)1(1 + i)2(1 + i)3

+ ...− Initial Investment

Advantages of net present value

•    This technique helps the management to know if the project would boost the value of the company.

•    It takes into account time value for money

•    It takes into consideration the cost of investment and the risks associated with investing in this project (Harris and Raviv, 1996 665).

Disadvantages of net present value

•    The use of this technique requires individuals to start guessing the cost of equity of the organization.

•    It is not possible to measure the size of the project.

The internal rate of return

This is a tool used in capital budgeting to determine the profitability of projects. IRR is a discounted rate that makes the PV cash flows equal to zero (Drake, 2006 78). IRR is calculated by the following formula 

=PV of future cash flows − Initial Investment = 0

The advantages of internal rate of return

•    Takes into account time value for money

•    The technique is simple.

•    No hurdle rate is required.

•    Easy to understand

Disadvantages of internal rate of return

•    It is a tedious technique

•    It does not take into account future costs.

•    It ignores the size of the project.

ii) Assume the company wants to invest $10,000 in 5 years in which there is no depreciation and salvage value. The cash flow would. The rate of interest is 12%

0

($10,000)

1

$2000

2

$2000

3

$2000

4

$2000

5

$2000

In payback technique the project would take five years to recover the money invested.

= ($2000*5) = $10.000

NPV= (2000/(1+12)1 +(2000/(1+12%)2+ (2000/(1+12%)3+ (2000/(1+12%)4+ (2000/(1+12%1)5

=1786.7+1,594+1,423.56+1,271.03+1,134.85

= 7,210

Present value= 7210-10000=-2,789

The project should not be undertaken because the present value is negative.

The internal rate of return

Let assume the irr is 5%

(2000/(1+3)1 +(2000/(1+%)2+ (2000/(1+3%)3+ (2000/(1+3%)4+ (2000/(1+3%1)5

=1,941+1,885+1,830+1,777+1,725

=9,158-10000=-841

With 3% the NPV is -841 reducing drastically. Therefore, the internal rate of return can be approximated at 2.5%

iii) According to the results obtained from the project should not be undertaken because the measuring techniques show negative NPV and payback shows that it would take long to recover the money invested. Also, the IRR is very low.

References

Ryan, P.A. and Ryan, G.P., 2002. Capital budgeting practices of the Fortune 1000: how have things changed?. Journal of business and management, 8(4), p.355.

Schall, L.D., Sundem, G.L. and Geijsbeek, W.R., 2008. Survey and analysis of capital budgeting methods. The journal of finance, 33(1), pp.281-287.

Harris, M. and Raviv, A., 1996. The capital budgeting process: Incentives and information. The Journal of Finance, 51(4), pp.1139-1174.

Graham, J. and Harvey, C., 2002. How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), pp.8-23.

Drake, P.P., Capital budgeting techniques. Online (datum poslední revize: 29.6. 2006): www. fau. edu/~ ppeter/fin3403/module6/capbudtech. pdf.

Arnold, G.C. and Hatzopoulos, P.D., 2000. The theory‐practice gap in capital budgeting: evidence from the United Kingdom. Journal of business finance & Accounting, 27(5‐6), pp.603-626.

Klammer, T.P. and Walker, M.C., 2004. The continuing increase in the use of sophisticated capital budgeting techniques. California management review, 27(1), pp.137-148.

Meier, H., Christofides, N. and Salkin, G., 2001. Capital budgeting under uncertainty—an integrated approach using contingent claims analysis and integer programming. Operations Research, 49(2), pp.196-206.