Assignment Brief
- Company X is considering a new manufacturing plant as part of its aggressive expansion plan. Currently the management has identified two different plants that allows the company to fulfil its requirement. However, due to constraints in the budget, the company can invest only in one plant.
Plant 1:
It is forecasted that this plant will require a cash investment of $700,000 at time 0 and $1,000,000 in year 1. After-tax cash inflows of $250,000 are expected in year 2, $300,000 in year 3, $350,000 in year 4 and $600,000 each year thereafter through year 10. Though the plant might be viable after year 10, the company prefers to be conservative and end all calculations at that time.
Plant 2:
This new plant will require a one-time investment of $1,750,000 at time 0. The plant is expected to generate after-tax cash inflows of $500,000 in the first 2 years and $725,000 each in the next 3 years. The company prefers to end all calculations for this plant in 5 years.
- If the required rate of return is 15%, what is the NPV of the two projects? Are these two projects acceptable?
- Calculate the IRR for both projects.
- What is the payback period for the two projects?
- Based on your calculations above, which plant would you recommend to the management of Company X to invest in? Justify your answer.
(20 marks)
- ABC is an entity that operates in the soft toy manufacturing industry. ABC has applied to the bank where you are employed, for a long-term loan of $150 million. Your manager has asked you to carry out an analysis and prepare the supporting documentation for the next management meeting to discuss this application for a loan. Extracts from the financial statements of ABC are provided below:
| Statement of financial position as at 30 June | 2018 | 2019 | |
| $m | $m | ||
| Non-current assets | |||
| Property, plant and equipment | 548 | 465 | |
| 548 | 465 | ||
| Current assets | |||
| Inventories | 146 | 120 | |
| Receivables | 115 | 125 | |
| Cash and cash equivalents | – | 41 | |
| 261 | 286 | ||
| Total assets | 809 | 751 | |
|
EQUITY AND LIABILITIES |
|||
| Equity attributable to owners of the parent | |||
| Share capital ($1 shares) | 120 | 120 | |
| Retained earnings | 353 | 279 | |
| Total equity | 473 | 399 | |
|
Non-current liabilities |
|||
| Long term loans | 90 | 180 | |
| Current liabilities | |||
| Payables | 196 | 172 | |
| Bank overdraft | 50 | – | |
| 246 | 172 | ||
| Total liabilities | 352 | ||
| Total equity and liabilities | 809 | 751 | |
| Statement of comprehensive income for the year ended 30 June | 2018 | 2019 |
| $m | $m | |
| Revenue | 1,200 | 1,400 |
| Cost of sales | (840) | (930) |
| Gross profit | 360 | 470 |
| Distribution costs | (40) | (45) |
| Administrative expenses | (130) | (120) |
| Profit before interest and tax | 190 | 305 |
| Finance costs | (11) | (15) |
| Profit before tax | 179 | 290 |
| Income tax expense | (50) | (85) |
| PROFIT FOR THE YEAR | 129 | 205 |
Analyze the financial performance and financial position of ABC and recommend whether or not ABC’s application for borrowing should be considered further (Marks are available for the calculation and presentation of relevant ratios)
(25 marks)
- Barbara is the managerial accountant in charge of a large furniture factory. She needs to identify whether the current year’s couch models are going to turn a profit and wants to measure the number of units they will have to produce and sell in order to cover their expenses. Her budgeted sales volume is 3000 units for the next year. Here are the production stats.
Total fixed costs: $500,000
Variable costs per unit: $300
Sale price per unit: $500
You are required to calculate the following.
- The breakeven point in sales units
- The budgeted profit if she sells 3000 units next year
- The margin of safety
- The sales required to achieve a profit of £200,000
(10 marks)
- The following information is available for periods 1–6 for the ABC Company:
($)
Unit selling price 10
Unit variable cost 6
Fixed costs per each period 300 000
The company produces only one product. Budgeted activity is expected to average 150,000 units per period, and production and sales for each period are as follows:
| P1 | P2 | P3 | P4 | P5 | P6 | |
| Units Sold (000s) | 150 | 120 | 180 | 150 | 140 | 160 |
| Units Manufactured (000s) | 150 | 150 | 150 | 150 | 170 | 140 |
There were no opening inventories at the start of period 1, and the actual manufacturing fixed overhead incurred was $300,000 per period. We shall also assume that non-manufacturing overheads are $100,000 per period. Calculate the net profit at the end of each period using Marginal Costing and Absorption Costing.
(15 marks)
- A small manufacturing firm is to commence operations on 1 July. The following estimates have been prepared:
July August September
Sales (units) 10 36 60
Production (units) 40 50 50
Opening inventory (units) NIL
It is planned to have raw material inventories of $10,000 at the end of July, and to maintain inventories at that level thereafter.
Selling prices, costs and other information:
Per unit ($)
Selling price 900
Material cost 280
Labour cost 160
Variable overheads 40
Fixed overheads are expected to be $5,000 per month.
Settlement terms on sales: 10 per cent cash, the balance payable the month following sale. Labour is paid in the month incurred, and all other expenditures the following month.
Calculate the following for the 3 months.
- The budgeted cash receipts from sales
- The Production budget together with budgeted cash payments for raw materials
- The total of the budgeted cash payments for labour and overhead
- The budgeted net cash flow of the firm.
- Explain if the management should have any concerns regarding the cash flow of the firm. If so, what would you recommend them to do in such situations?
(15 marks)
- Smith Company manufactures two products, Alpha and Beta, using the same equipment and similar processes. An extract of the production data for these products in one period is shown below.
Alpha Beta
Quantity produced (units) 10,000 14,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 30
Orders handled in the period 15 30
$
Overhead costs
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000
Required
- Calculate the production overheads to be absorbed by one unit of each of the products using an Activity Based Costing approach, using suitable cost drivers to trace overheads to products.
- Discuss the merits and drawbacks of using an ABC system and justify whether it is worthwhile to implement an ABC system to a modern mobile phone assembly plant.
(15 marks)
Budgeting – Example Questions
- Example:
Preparing a materials purchases budget ABC Manufactures two products, Seeta and Teeta, which use the same raw materials, D and E. One unit of Seeta uses 3 litres of D and 4 kilograms of E. One unit of Teeta uses 5 litres of D and 2 kilograms of E.
- A litre of D is expected to cost $. 3 and a kilogram of E $. 7.
- Budgeted sales for 20X2 are 8,000 units of Seeta and 6,000 units of Teeta; finished goods in inventory at 1 January 20X2 are 1,500 units of Seeta and 300 units of Teeta, and the company plans to hold inventories of 600 units of each product at 31 December 20X2.
- Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
- The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of items held in store, as follows.
Product Seeta: loss of 50 units Material D: loss of 500 litres Product Teeta: loss of 100 units Material E: loss of 200 kilograms
Required to Prepare a material purchases budget for the year 20X2
2.Example
XYZ company produces three products X, Y and Z. For the coming accounting period budgets are to be prepared based on the following information.
Budgeted sales
Product X 2,000 at Rs. 10,000 each
Product Y 4,000 at Rs. 13,000 each
Product Z 3,000 at Rs. 15,000 each
Budgeted usage of raw material
RM11 RM22 RM33
Product X 5 2 –
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material Rs. 500 Rs. 300 Rs. 400
Finished inventories budget Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Product X Product Y Product Z
Expected hours per unit 4 6 8
Expected hourly rate (labour) Rs. 900 Rs. 900 Rs. 900
Required to Prepare a material purchases budget for the year 20X2
Ratio Analysis
Financial ratios can be used to examine various aspects of the financial position and performance of a business and are widely used for planning and control purposes.
They can be used to evaluate the financial health of a business and can be utilised by management in a wide variety of decisions involving such areas as profit planning, pricing, working-capital management, financial structure and dividend policy.
Ratio analysis provides a fairly simplistic method of examining the financial condition of a business.
A ratio expresses the relation of one figure appearing in the financial statements to some other figure appearing there.
Ratios enable comparison between businesses.
Differences may exist between businesses in the scale of operations making comparison via the profits generated unreliable.
Ratios can eliminate this uncertainty.
Other than comparison with other businesses, it is also a valuable tool in analysing the performance of one business over time.
However useful ratios are not without their problems.
Figures calculated through ratio analysis can highlight the financial strengths and weaknesses of a business but they cannot, by themselves, explain why certain strengths or weaknesses exist or why certain changes have occurred.
Only detailed investigation will reveal these underlying reasons. Ratios must, therefore, be seen as a ‘starting point’.
Financial ratio classification
The following ratios are considered the more important for decision-making purposes:
Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position.
The following broad categories provide a useful basis for explaining the nature of the financial ratios to be dealt with.
Profitability. Businesses come into being with the primary purpose of creating wealth for the owners. Profitability ratios provide an insight to the degree of success in achieving this purpose. They express the profits made in relation to other key figures in the financial statements or to some business resource.
Efficiency. Ratios may be used to measure the efficiency with which certain resource have been utilised within the business. These ratios are also referred to as active ratios.
Liquidity. It is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations. Certain ratios may be calculated that examines the relationship between liquid resources held and creditors due for payment in the near future.
Gearing. This is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business. Gearing is then something that managers must consider when making financing decisions.
Investment. Certain ratios are concerned with assessing the returns and performance of shares held in a particular business.
Profitability ratios
- Return on ordinary shareholders’ funds (ROSF)
The return on ordinary shareholders’ funds compares the amount of profit for the period available to the ordinary shareholders with the ordinary shareholders’ stake in the business.
Net profit after taxation and preference dividend (if any) X 100
Ordinary share capital plus reserves
The net profit after taxation and any preference dividend is used in calculating the ratio, because this figure represents the amount of profit available to the ordinary shareholders.
- Return on capital employed (ROCE)
The return on capital employed is a fundamental measure of business performance. This ratio expresses the relationship between the net profit generated by the business and the long-term capital invested in the business. Expressed as a percentage.
Net profit before interest and taxation x 100
Share capital + reserves + long-term loans
Note, in this case, the profit figure used in the ratio is the net profit before interest and taxation. This figure is used because the ratio attempts to measure the returns to all suppliers of long-term finance before any deductions for interest payable to lenders or payments of dividends to shareholders are made.
ROCE is considered by many to be a primary measure of profitability. It compares inputs (capital invested) with outputs (profit). This comparison is of vital importance in assessing the effectiveness with which funds have been deployed.
3. Net profit margin
The net profit margin ratio relates the net profit for a period to the sales during that period.
Net profit before interest and taxation x 100
Sales
The net profit before interest and taxation is used in this ratio as it represents the profit from trading operations before any costs of servicing long-term finance are taken into account.
This ratio compares one output of the business (profit) with another output (sales).
The ratio can vary considerably between types of business.
For example, a supermarket will often operate on low prices and, therefore, low profit margins in order to stimulate sales and thereby increase the total amount of profit generated.
A jeweller, on the other hand, may have a high net profit margin but have a much lower level of sales volume.
Factors such as the degree of competition, the type of customer, the economic climate and industry characteristics (such as the level of risk) will influence the net profit margin of a business.
4. Gross profit margin
The gross profit margin ratio relates the gross profit of the business to the sales generated for the same period.
Gross profit represents the difference between sales value and the cost of sales.
The ratio is therefore a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account.
As cost of sales represents a major expense for retailing, wholesaling and manufacturing businesses, a change in this ratio can have a significant effect on the bottom line (that is, the net profit for the year).
Gross profit x 100
Sales
Efficiency ratios
Ratios used to examine the efficiency with which various resource of the business are managed include the following:
1. Average stock turnover period
Stocks often represent a significant investment for a business.
For some types of business (for example, manufacturing), stocks may account for a substantial proportion of the total assets held.
The average stock turnover period measures the average number of days for which stocks are being held.
Average stock held x 365
Cost of sales
The average stock for the period can be calculated as a simple average of the opening and closing stock levels for the year.
A business will normally prefer a low stock turnover period to a high period as funds tied up in stocks cannot be used for other profitable purposes.
2. Average settlement period
A business will usually be concerned with how long it takes for customers to pay the amount owing.
Trade debtors x 365
Credit sales
A business will normally prefer a shorter settlement period.
- Average settlement period for creditors
The average settlement period for creditors tells us how long, on average, the business takes to pay its trade creditors.
Trade creditors x 365
Credit purchases
Referred to as ‘free’ source of finance for the business, not surprising that some businesses attempt to increase their average settlement period for trade creditors.
4. Sales to capital employed
The sales to capital employed ratio examines how effective the long-term capital employed of the business has been in generating sales revenue.
Sales
Share capital + reserves + long-term loans
Generally a higher ratio for sales to capital employed is preferred to a lower one. A higher ratio will normally suggest that the capital (as represented by total assets minus current liabilities) is being used more productively in the generation of revenue. However, a very high ratio may suggest that the business is undercapitalised – that is, it has insufficient long-term capital to support the level of sales achieved.
Liquidity ratios
1.Current ratio
The current ratio compares the ‘liquid’ assets (cash and those assets held that will soon be turned into cash) of a business with the current liabilities (creditors due within one year).
Current assets
Current liabilities
The ideal is often expressed as 2: 1 meaning that the business can meet its short-term liabilities twice over.
2. Acid test ratio
The acid test ratio represents a more stringent test of liquidity. It can be argued that, for many businesses, the stock in hand cannot be converted into cash quickly. As a result, it may be better to exclude this particular asset from any measure of liquidity.
Current assets (excluding stock)
Current liabilities
Gearing ratio
Financial gearing occurs when a business is financed, at least in part, by contributions from outside parties. An important factor in assessing risk. Where a business borrows heavily, it takes on a commitment to pay interest charges and make capital repayments. This can be a significant financial burden and can increase the risk of a business becoming insolvent.
One particular effect of gearing is that returns to ordinary shareholders become more sensitive to changes in profits. For a highly geared company, a change in profits can lead to a proportionately greater change in the returns to ordinary shareholders.
The gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a business
Long-term liabilities x 100
Share capital + reserves + long-term loans
Interest cover ratio
The interest cover ratio measures the amount of profit available to cover the interest payable.
Profit before interest and taxation
Interest payable
The lower the level of profit coverage, the greater the risk to lenders that interest payments will not be met.
Investment ratios
1. Dividend per share
The dividend per share ratio relates the dividends announced during a period to the number of shares in issue during that period.
Dividends announced during the period
Number of shares in issue
Factors that influence the amount that a company is willing or able to issue in the form of dividends include:
- The profit available for distribution to investors
- The future expenditure commitments of the company
- The expectations of shareholders concerning the level of dividend payment.
- The cash available for dividend distribution
- Dividend payout ratio
The dividend payout ratio measures the proportion of earnings that a company pays out to shareholders in the form of dividends.
Dividends announced during the period x 100
Earnings for the year available for dividends
The earnings available for dividends, in the case of ordinary shareholders, would normally be net profit after interest and taxation and after any preference dividends announced during the year.
- Earnings per share (EPS)
The earnings per share (EPS) relates the earnings generated by the company during the period and available to shareholders to the number of shares in issue. For ordinary shareholders, the amount available will be represented by the net profit after tax (less any preference dividend where applicable).
Earnings available to ordinary shareholders
Number of ordinary shares in issue
Many investment analysts regard the EPS as a fundamental measure of share performance. The trend in earnings per share over time is used to help assess the investment potential of a company’s shares.
- Price/earnings (P/E) ratio
This ratio relates the market value of a share to the earnings per share.
Market value per share
Earnings per share
The ratio is, in essence, a measure of market confidence in the future of a company. The higher the P/E ratio, the greater the confidence in the future earning power of the company and, consequently, the more that investors are prepared to pay in relation to the earnings stream of the company
Price/earnings ratios provide a useful guide to market confidence concerning the future.
Limitations of ratio analysis
Although a useful tool ratios do have limitations.
Quality of financial statements.
Ratios are based on financial statements and the results of ratio analysis are dependent on the quality of those statements.
One important issue when making comparisons between businesses is the degree of conservatism that each business adopts in the reporting of profit.
Therefore any review of the financial statements should include an examination of the accounting policies that are being adopted.
There are some businesses that may adopt particular accounting policies or structure particular transactions in such a way that portrays a picture of financial health that is in line with what those who prepared the financial statements would like to see rather than what is a true and fair view of financial performance and position.
This practice is referred to as creative accounting and has been a major problem for accounting rule-makers.
Inflation
A persistent problem in most Western countries is that the financial results of a business are distorted as a result of inflation.
One effect of inflation is that the values of assets held for any length of time may bear little relation to current values.
Generally the value of assets will be understated in current terms during a period of inflation as they are usually recorded at their original cost (less any amounts written off for depreciation).
The basis of comparison
Ratios require a basis of comparison in order to be useful. Moreover, it is important that the analyst compares like with like.
When comparing businesses, however, no two businesses will be identical, and the greater the differences between the businesses being compared, the greater the limitations of ratio analysis.
Balance sheet ratios
Because the balance sheet is only a ‘snapshot’ of the business at a particular moment in time, any ratios based on balance sheet figures such as the liquidity ratios, may not be representative of the financial position of the business for the year as a whole.
APA
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