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Unit 3 Entrepreneurship Level 5 CBC College

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Financial Decision Making

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INTRODUCTION

Financial decision making implies for the processwhich lays emphasis of making selection of best option out of several alternatives availableThe present report is based on the case scenario of Hi-Tech Plc which involved in the manufacturing of computer hardware and accessories.In this, report will provide deeper insight about the extent to which profitability, liquidity and solvency position of the business unit is good. Further, report also entails the manner in which capital budgeting tools help in evaluating the viability of investment options or projects. It also depicts benefits and drawbacks associated with investment appraisal techniques.Report also presentsnon-financial factors which Hi-Tech Plcneeds to consider for decision making. In this, report will exhibit funding sources which firm should consider for meeting monetary requirements.

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Part 1: Business Performance Analysis

Calculating and using ratios forthe purpose of decision making in the context of Hi-Tech plc

Ratio analysis may be served as a financial toolwhich in turn facilitates quantitative evaluation of final accounts from several perspectives such as profitability, liquidity, solvency and efficiency. By using such toolmanager of Hi-Techplc can get quick indication about financial aspects and thereby become able to take strategic decisions for future growth or success (Financial ratio analysis, 2018). In order to asses trends over the time frame ratios analysis technique has been usedby Hi-Tech Plc. Ratio analysis of Hi-Tech plc for year ended on 31st December 2016 & 2017 is as follows:

Statement of profit &loss

Particulars

Formula

2016

2017

Gross profit

 

517

541

Operating profit

 

151

225

Net profit

 

82

130

Sales revenue

 

2022

2528

Average Total assets

 

1177

1177 + 1632 / 2 = 1404.5

GP ratio

Gross profit / sales revenue * 100 (GP ratio, 2018)

517 / 2022 * 100 = 25.6%

541 / 2528 * 100 = 21.4%

OP ratio

Operating profit / sales revenue * 100

151 / 2022 * 100 =7.47%

225 / 2528 * 100 = 8.90%

NP ratio

Net profit / sales revenue * 100

82 / 2022 * 100 = 4.06%

130 / 2022 * 100 =5.14%

Return on assets

Net income / average total assets (Return on Assets, 2018)

82 / 1177 * 100 = 7%

130 / 1404.5 * 100 = 9.3%

The above depicted table shows that GP margin of Hi-Tech plc was declined from 25.6% to 21.4% significantly. By doing analysis, it has assessedthat sales revenue of such manufacturing business unit inclined from £2022 to £2528. However, decreasing GP margin presents that firm failed to exert effectual control on direct expenditure. Further, outcome of ratio analysis shows that operating profit margin inclined from 7.47% to 8.90% at the end of accounting year 2017. Along with this, increasing trend has found in NP margin over the years. In the accounting year 2017, competent strategic framework has been followed by business unit for exerting control on cost or indirect expenses.

Further, sales revenue of the company has also improvedover the time frame as a result of marketing campaign. In addition to this, return generated by Hi-Tech plc in the year of 2016 and 2017 were 7% & 9.3% respectively. This aspect shows that in the accounting period 2017 high returns were generated by Hi-Tech plcusing total assets. Hence, referring overall evaluation it can be depicted thatprofitability position of the company has increasedover the years. However, operating and net profit margin of the company was not very high. Thus, effectual measure needs to be undertaken for controlling expenses and enhancing margin. Company should focus on taking feedback from the customers which in turn helps in understanding their expectations and thereby introducing suitable products. Through this, firm would become able to enhance revenue and thereby profit margin.

Statement of financial position

By doing evaluation of balance sheet, manager and other stakeholders of Hi-techplc can assess the extent to which company is highly capable in relation to meeting its obligations. In addition to this, statement of financial position helps in ascertaining whether capital structure maintained by the company is optimal or not.Further, through evaluating balance sheet company’sefficiency in relation to making use of assets can be assessed more effectually.

Liquidity ratio analysis

Particulars

Formula

2016

2017

Current assets

 

507

668

Stock

 

120

290

Current liabilities

 

138

338

Current ratio

Current assets / current liabilities

507 / 138 = 3.67

668 / 338 = 1.98

Quick ratio

CA – (stock + prepaid expenses) / CL

507 - 120 / 138 =2.80

668 - 290 / 338 = 1.12

Tabular presentation shows declining trend in the current ratio of Hi-Techplc from 3.67 to 1.98. This in turn considered as a good indicator from the perspective of working capital management and profitability aspect.As per standard, firm should maintain 2 current assets in against to 1 current obligation. Hence, by taking into account current ratio performance or outcome it can be depicted that Hi-Tech Plcwas highly capable to meet obligations on time. Further, quick ratio measure of the company also moved from 2.80 to 1.12 in the financial year 2017. UK industry average shows thatfor meeting 1 current obligation business unit must have one asset that can easily be converted into cash. Hence, results of ratio analysis clearly present thatliquidity position of Hi-Tech plc was good in 2017.

Solvency ratio analysis

Particulars

Formula

2016

2017

       

Long-term debt

 

100

225

Shareholders’ equity

 

939

1069

Debt-equity ratio

Long term debt / shareholders equity

100 / 939 = .11

225 / 1069 = .21

From balance sheet analysis, it has identified that solvency position of Hi-Tech Plc was not good in the year of 2016 & 2017. Debt-equity position of the company was.11 and .21 in FY 2016 & 2017. On the basis of ideal ratio, firm should issue 2 equities in against to 1 debt. However, as compared to the ideal standard debt-equity position of Hi-Tech plcwas not good. Current position of the company shows that capital structure of the company was not good. Moreover, such business unit has fulfilled most of its need through equities rather than debt sources. Thus, in the near future company should make focus on considering .5:1 ideal ratio which in turn helps in developing suitable financial structure. Moreover, debt sources also offer benefits to the business entity in tax brackets. On the other side, in the case of equities,firm offers dividend when it earns enough profit margin. Thus, at the time of raising funds business unit should keep in mind ideal ratio.

Efficiency ratio analysis

Particulars

Formula

2016

2017

COGS

 

1505

1987

Average Inventory

 

120

120 + 290 / 2 = 205

Sales revenue

 

2022

2528

Average Total assets

 

1177

1177 + 1632 / 2 = 1404.5

Average Trade payables

 

138

138 + 245 / 2 = 191.5

Stock turnover ratio

Cost of goods sold / average stock

1505 / 120 = 12.54

1987 / 205 = 9.69

Total assets turnover ratio

Sales revenue / average total assets

2022 / 1177 = 1.72

2528 / 1404.5 = 1.80

Payable period

Creditors * 365 / net credit purchase

138 * 365 / 1505 = 33.47

245 * 365 / 191.5 = 35.18

  • Inventory turnover ratio:Statement of financial position presents that in the accounting period 2017, business unit failed to sell and replace its stock more frequently. In 2016 and 2017, stock turnover ratio of Hi-techplc was 12.54 & 9.69 times. Decreasing turnover ratio is not considered as a good indicator from the perspective of both revenue and profit margin. Through evaluation, it has found that usually company takes 30 days timein relation to supplying products or services to the customers.This in turn may also cause of lower stock turnover ratio in 2017. Thus, firm needs to make focus on reducing suchhigh timeframe which in turn provides assistance in improving sales and thereby stock turnover. Along with this, business unit should also focus on employing stock management tools such as economic order quantity etc. Thisstrategy will help in improving inventory turnover and reducing holding as well as ordering cost associated with stock management.
  • Total assets turnover ratio: Efficiency ratio assessment presents increasing trend in the assets turnover ratio of Hi-tech plcfrom 1.72 to 1.80 times. It indicates that as compared to 2016, in 2017 business organization hadmade effective use of assets including bothfixed and current. Thus, for enhancing such ratio Hi-TechPlcshould focus on undertaking budgeting tools and techniques. In other words, company would becomeable to make effectual use offinancial resources through undertaking modern budgeting tools such as activity basedbudgeting which in turn highly suits to the modern era. Further, emphasis needs to be placed on the maintenance of fixed assets and training of personnel. Hence, by undertaking all the above depicted measures Hi-Techplc would become able toimprove efficiency aspects.
  • Payables period:Through analysis, it has identified that payable period of Hi-Tech plc was increased from 33.47 to 35 days in 2017. It has identified from the evaluation that usually company grants credit to its customers for the period of 30 day. However, some of its customers are making payment within 30 to 90 days due to cash related issues. Considering thepresent situation it can be saidthat payable period of the company is good which in turn paces positive impact on working capital management.

Statement of cash flows

On the basis of cited case situation, in 2017, cash related issues or problems were experienced by Hi-Tech plc. Hence, due to cash shortage firm was unable to offer dividend to the shareholders in 2017. Cash flow statement of the firm present that due to high inventory, trade receivable, interest and income tax expenses it failed to generate positive inflow from operating activities. In addition to this, in 2017, significant investment was made by the company in intangible assets as well as property, plant & equipment. Further, in 2017, decreasing trend has assessed in the cash and its equivalents. Hence, all such aspects collectively caused of negative results. Thus, firm needs to frame and undertake cash control as well as monitoring strategies for making improvement in the current position.

Operating cash cycle

Particulars

Formula

2016

2017

Days sales of inventory

365 / purchase * average inventories

365 / 1505 * 120 = 29.1

365 / 1987 * 205 = 37.66

Days sales outstanding

365 / credit sales * average accounts receivable (Receivable turnover ratio, 2018)

365 / 2022 * 138 = 24.91

365 / 2528 * 191.5 = 27.65

Payable period

Creditors * 365 / net credit purchase

33.47

35.18

Operating cycle

Days sales of inventory + Days sales of inventory - Payable period (Operating Cycle, 2018)

20.53 days

30 days

The above presented table of operating cycle presents, pertaining to year2017, shows that business unit had to wait more time approximately 65 days for convertingreceivables and stock into cash. On the other side, in 2016, operating cycle was lower such as 54 days respectively. Hence, effective measure needs to be undertaken for making improvement in the cash conversion period or operating cycle.

Product line analysis

Product

Revenue 2016 (£m)

Revenue 2017 (£m)

Desktop

370

332

Laptops

1037

1052

Tablets

584

782

Accessories

31

45

Laptop

0

304

Wearable technology

0

13

It can be interpreted that firm should make marketing strategy so that desktops may be profitable for it as revenue is declined in 2017. On the other hand, business is earning adequate profits in other product lines.

PART 2: Investment appraisal

2.1 Challenging management forecast and listing advantages and disadvantages of investment appraisal techniques

Management Forecast

Forecasting is quite crucial for the company so that it may easily predict future sales and revenue in effective manner. Management forecast is challenging task for manager of the firm as every thing depends n correct estimation in order to seek the future of company. It is done by analysing past sales and demand by the customer in near future. This means that current trend of market is effectively assessed by management and as such, adequate decisions may be taken which would inject operations in the best possible manner. It can be analysed that Hi-Tech Plc has earned good profits in the past and as such, management of the company has forecasted sales for the next years. It is planning to expand its operations in Asian Markets in order to gain more revenue (Christ and Burritt, 2017).

Management forecast provides that initial investment of 500 m will be made in expansion plan in Asian Markets. The revenue forecasted in the year 2019 is 300, while in next year; it will be 560 and 740 in 2020. Moreover, 900 m in 2021 and in next financial year, forecast is to cross beyond 1120 m. This means that revenue would consistently increase in future period. Furthermore, there will be positive cash flows as well in the span of five years. It can be assessed that though management has forecasted sales and cash flows for these periods, it is not easy to attain the target in new market. This implies that management of Hi-Tech Plc has to implement well-structured strategies and provide better quality electronic goods to customers which will help company to garner desired profits in effectual manner. Thus, organization will be able to gain profits by expanding to Asian Markets.

Investment appraisal technique

Payback period

The payback period is useful capital investment technique that provides clarity when investment would return its initial outlay cost (Locatelli, Pecoraro, Meroni and Mancini, 2017). Business recognizes when initial investment will be recovered in near future. Payback period is quite effective tool for analysing how much time project will take in order to garner additional income by successfully investing in the project. It is recommended by the market experts that shorter the payback period, more beneficial for the company to invest money. Hi-Tech Plc has attained period of 4 years which clearly implies that investment in expansion to Asian Markets will get this much stated time to recover investment and as such, it is beneficial for company as investment would garner profits with much ease.

Advantages

  • It is simple to calculate and interpret the results therefrom. Furthermore, this method of capital investment is quite economical in terms of cost, time etc.
  • This method is useful for company which has fewer amounts of cash and as such, low liquidity position.
  • It emphasizes on recovery of investment amount and as such, it is suitable for Hi-Tech Plc for investing in the project (Laird and Venables, 2017).

Disadvantages

  • It is not suitable as it does not emphasize on short-term solvency of the firm. This is one of the main limitations of this method.
  • Payback period does not consider the concept of time value of money.
  • This technique is unsuitable as adequate weightage is not provided to unevenness profit rate.

Accounting Rate of Return (ARR)

ARR is the capital investment technique which provides clarity regarding rate of return that will be generated annually. This means that ARR computes the average annual yield on the net investment in the project. It is quite useful as it imparts management of Hi-Tech Plc that how much return will be produced by the company while investing in the project. This implies that company is able to seek annual rate of return in the best possible manner. It can be analysed from the computation of ARR that it is 18 % which is regarded as good for the point of view of firm. This is evident from the fact that target set by Hi-Tech Plc is 10 % of the ARR and it can be evaluated that more ARR will be gained by firm by investing in the project. Thus, organization should invest in this project and expand its operations quite effectually (Mayer, Breun and Schultmann, 2017).

Advantages

  • Main merit of ARR is that it considers profits throughout the life of project which provides clarity to business whether it should invest in it or not.
  • Net income is considered by this technique which is crucial element in investment appraisal methods.
  • Profitability aspect of the project is cleared by using ARR as accounting data is taken into account by this concept.

Disadvantages

  • The concept of time value of money is ignored by ARR while computation. Furthermore, it lays emphasis on after tax earnings and not cash inflows for effectively assessing project.
  • External factors are also not analysed which may cause changes in the profitability aspect of new project. Moreover, accounting profits are more given weightage instead of cash inflows.
  • This method is not useful when there are two mutually exclusive projects and that too having different time duration. Moreover, it does not take into account time period of the investment which lead to wrongful decisions (Wijethilake, 2017).

Net Present Value (NPV)

NPV is another useful method for analysing profitability aspect of the new project. This provides effective judgment whether investment should be made in project or not. This help management to take enhanced decision with regards to the project. NPV is taken out by subtracting cash inflows from outflows to get the present value of the investment in effectual manner. Moreover, this method is suitable as it provides clarity about investment that how much profitable it would be to invest in and garner better returns. Hi-Tech Plc has NPV of 110 which is quite good and as such, it can be interpreted that firm will have good profits and better returns will be garner by it. Moreover, higher the NPV, better for the company to invest in the project. Thus, it can be said that expansion in Asian Markets will have better growth for company.

Advantages

  • It is useful method as it takes into account time value of concept while assessing project’s profitability (Advantages And Disadvantages Of Net Present Value (NPV). 2011).
  • Entire cash inflows of the project’s life are taken into account which provides effective decision making regarding acceptance of project.
  • Cost of capital is taken into account while evaluating project and risk associated with it is analysed as well.

Disadvantages

  • It is difficult to compute cost of capital and measure it. Moreover, it gives dissatisfactory results when alternative projects involve varying outlay.
  • Discount rate is difficult to calculate as well.
  • When there are two exclusive projects having different time duration, then results are conflicting.

2.2 Sources of finance

The two sources of finance available to Hi-Tech Plc are as follows-

Bank Loan

Loan can be taken from bank on the agreed terms and conditions. Hi-Tech Plc can avail this source of finance and expand its operations in the Asian Markets. Repayment may be done in equal instalments along with interest accrued on it.

Advantages

  • It is suitable for company as interest rates can be fixed and as such, interest payments can be anticipated quite effectively (DeBoeuf, Lee, Johnson and Masharuev, 2018).
  • Only interest is paid to the bank and no share is provided.

Disadvantages

  • Collateral security is required to be given in the forms of assets by the firm.
  • There is lack of flexibility while taking bank loan.

Retained Earnings

Firm earns profits in the year and as such, part of profits is divisible to shareholders as dividends are paid to them. Remaining part can be retained for future business activities. Thus, Hi-Tech Plc can easily use retained profits from past year and expand operations by making investment.

Advantages

  • No obligation is there to repay amount.
  • It injects financial position of company in better way.

Disadvantages

  • Purpose of retained earnings should be there else shareholders will get disheartened.
  • Firm may become over-capitalized if more earnings are gathered (Batra and Verma, 2018).

2.3 Non-Financial Factors

The non-financial factors are listed below-

  1. Maintain product lines-

Investment should be made in Asian Markets by Hi-Tech Plc with regards to maintain and enhance its existing product lines so that it may be able to garner more revenue in new market by increasing manufacturing of electronic products.

  1. Manpower-

Employees are the integral part of firm as through them, efficiency can be achieved by the organization with much ease. Thus, it is required that company should hire efficient and productive workers which may attain organizational objectives (Storto, 2018).

  1. Government directions-

This is another important non-financial factor as firm is required to meet legal directions of government in Asian Markets and as such, adherence to the same, it can achieve set targets in effective manner.

CONCLUSION

By summing up this report, it has been concluded that technique of ratio analysisprovides high level of assistance in summarizing financial statements and thereby aid in decision making. It can be seen in the report thatprofitability aspect of Hi-Tech plc is good and improved over the years. Further, consideringstatement of financial positionit can be concluded that liquidity and solvency position of such manufacturing business unit was good in the concerned years. It can be summarized from cash flow statement that monetary position of the company has improved. Along with this, it has been articulated thatproposed expansion plan pertaining to Asian plan will prove to be more beneficial. Moreover, as per the selection criteria, NPV, IRR and ARRarerecognized as viable from the investment perspective.It can be depicted from evaluation thatpayback method does not consider time value of money concept which in turn recognized as its main weaknesses.For expansionary purpose, manager of Hi-Tech Plc should undertake both equity and debt sources which in turn helps in creating optimal capital structure.

REFERENCES

  • Batra, R. and Verma, S., 2018. Non-financial criteria in project appraisal methodologies: empirical evidence from Indian companies.International Journal of Accounting and Finance.8(1).pp.80-102.
  • Christ, K.L. and Burritt, R.L., 2017. Water management accounting: A framework for corporate practice.Journal of Cleaner Production.152. pp.379-386.
  • DeBoeuf, D., Lee, H., Johnson, D. and Masharuev, M., 2018.Purchasing power return, a new paradigm of capital investment appraisal.Managerial Finance.(just-accepted).pp.00-00.
  • Laird, J.J. and Venables, A.J., 2017. Transport investment and economic performance: A framework for project appraisal.Transport Policy.56. pp.1-11.
  • loStorto, C., 2018. A double-DEA framework to support decision-making in the choice of advanced manufacturing technologies.Management Decision.56(2).pp.488-507.
  • Locatelli, G., Pecoraro, M., Meroni, G. and Mancini, M., 2017.Appraisal of small modular nuclear reactors with ‘real options’ valuation.Proceedings of the Institution of Civil Engineers-Energy.170(2).pp.51-66.
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