The Lord College

Financial Management
Submitted By: ATHE No. :

Executive Summary This assignment describes the importance of financial management for a business professional; it is divided in three tasks. In task one the importance of financial statements is been highlighted describing various types of statements produced by the organisation and their users. Second task suggest is on analysis of financial health of the company with help of financial statements using the ratio analysis techniques, the limitation of the techniques are also been highlighted. In final section different investment appraisal techniques have been discussed with their advantages and disadvantages.

Task - 1 Financial statements are important reports. They show how a business is doing and are very useful internally for a company's stockholders and to its board of directors, its managers and some employees, including labour unions. Externally, they are important to prospective investors, to government agencies responsible for taxing and regulating, to lenders such as banks and credit rating agencies, and to investment analysts and stockbrokers.

All public companies are required to prepare documents showing the company's financial performance at regular periodic intervals. Most companies prepare annual statements; others prepare them semi-annually, quarterly or as often as monthly. These show the financial wealth of a company (how much it owes and owns) but can be manipulated. It is often required that statements for external consumption be audited by independent accounting firms.

Parts of Financial Statements and their Importance The two basic parts of financial statements are; Income statement and Balance sheet,

The purpose of the income statement is to report the success or failure of the company's operations for a period of time. The income statement lists the company's revenues followed by it expenses. A key point to recall when preparing an income statement is that amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. Therefore they are not reported on the income statement. Retained earnings statement shows the amounts and causes of changes in retained earnings during the period. The time period is equivalent to the time covered on the income statement. Financial statement users can evaluate dividend payment practices by monitoring the retained earnings statement. Some investors seek companies that have a history of paying high dividends, while others seek companies that reinvest earnings to increase the company's growth.

The purpose of the statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. Users are interested in the statement of cash flows because they want to get a better understanding of what is

happening to a company's most important resource. The statements of cash flows answer these following questions; 1. Where did cash come from during the period? 2. How was the cash used during the period? 3. What was the change in the cash balance during the period?

The statement of cash flows also organizes and reports the cash generated used in the following activities: financing, investing, and operating. All businesses are involved with these three types of activities.

The balance sheet is based on this equation: Assets = Liabilities + Stockholders Equity. This equation is referred to as the basis accounting equation. The balance sheet reports the company's assets, liabilities and owners equity. It is a financial window to the company at a specific point in time. Claims are divided into two categories: claims of creditors, which are called liabilities and claims of owners, which are called stockholders equity. On the balance sheet it lists the company's financial position as of a specific date in this order: assets first, then liabilities and stockholder's equity. A note to self about stockholders equity is that it is composed of common stock and retained earnings. Among other things, analysis of balance sheets can tell whether the company owes too much or is lending too much or has too much in inventory; its detailed attachments detail who is owed and who owes the company and what properties it owns, if any. Analysis of income statements can tell whether prices or volumes sold are not high enough to give sufficient profits and what the big and small costs of the business are. Analysis of cash flows can tell whether most needs are met through internally generated funds or whether some come from borrowings.

The users of financial statements are people who use financial documents for a large variety of business purposes and their ability to make decisions using these statements helps them to succeed in the business world. These can be classified in to two groups; Internal Users External users

The internal users of accounting information are the managers who organize, operate and plan daily business routine. They are directly affiliated with the company and use managerial

accounting, which includes in-depth reports used to determine financial strengths and weaknesses. For example, internal users would include management, finance, marketing, and human resources. An example of a human resource manager would be that he or she has to ensure the rights of their employees by using wage information along with other data. Important questions arise with internal users. A question for a marketing manager would include, "What price for an Apple I Pad will maximize the company's net income?"

External users are groups of individuals that are outside organizations, and they use accounting to make financial decisions. An example of an external user would include a creditor, who uses accounting to evaluate the risks of granting credit. Taxing authorities, investors, and customers are also external users. External users would receive limited financial information from a company such as financial statements. These statements are the backbone of financial accounting and they give the external users enough information to inform them of the company's economic position. Assets, liabilities, revenues, and expenses are of great importance to users of accounting information. For business purposes, it is customary to arrange this information in the format of four different financial statements; balance sheet, income statement, retained earnings statement, and statement of cash flows. Task 2 Financial ratio analysis is a tool used by individuals to do quantitative analysis of information of a company's financial statements. Financial Ratio Analysis is independent of either firm as well as industry; these ratios do not depend on the size of company. Different financial ratios are easy to compare than the raw numbers. A financial ratio is a simple relationship of two values present in the financial statement. These are basically mathematical expressions which are calculated to draw conclusions from given financial information about the organization under study. For the purpose of study these ratio may be expressed in different forms like proportion, percentage or as number of times. There are a number of different ratios which can be calculated from given source of information but choice of ratio varies according to the objective and the purpose of the study (www.spandane.com, 2009).

Ratio are useful in intra firm comparison, inter firm comparison as well as industry comparison. The main advantage of ratio analysis is that it makes the study of financial position of an organization very easy. On one hand ratio analysis offer great help in studying

the financial strength of a company on other hand there are some limitations associated with the use of ratio analysis. Some of these limitations are listed here as under; The information provided by ratios can deliberately be manipulated. Different firms follow different accounting policies thus while comparing two firms utmost care should be taken. Comparison of the organization operating under different conditions may give misleading results. Ratio analysis is mainly focusing on measuring companys profitability, liquidity, and efficiency and gearing level. In given case profitability and liquidity ratios are calculated from the financial statement of given corporation for the period of 2008 and 2009 to gauge the financial health of the company on the basis of that. Profitability ratios: Profitability ratios are also known as profit margin ratios. It measures the degree to which the business is profitable. Different profitability ratio calculated for the company is given in the table

Ratio Gross profit margin Net Profit margin Return on equity

2008 38% 2% 21.05%

2009 35.75% 3.79% 25.85%

The company is successful in earning more for the investor as the return on equity increase in year 2009. But the gross profit margin of the company is dipped slightly in 2009 compare to 2008 that may be attributed to the growth in sales revenue. Liquidity Ratio: In business liquidity measure how quickly a company can convert its assets into cash. It is a good tool for measuring companys ability to pay its short term debt. Greater the liquidity ratio the more sound is the company. Current ratio is used to measure the liquidity that a firm has to meet its short term debt. In mathematical form it is represented as follows (McConnon, 2002).

Ratio Current Ratio Quick Ratio

2008 2009 1.5 0.87 1.3 0.7

The current ratio as well as quick ratio suggests that company is passing through the tough time as far as the liquidity is concern. Compare to year 2008 the liquidity of the company in 2009 is gone down. To look in to the detail overall industry and market situation should be studied. The accepted values of current and quick ratios are 2:1 and 1:1 respectively. Task 3 Investment is a key part of building business. New assets such as machinery can boost productivity, cut costs and give business a competitive edge. Investments in product development, research and development, expertise and new markets can open up exciting growth opportunities. At the same time, managers need to avoid overstretching limited financial resources or restricting the ability of the business to pursue other options. Deciding where to focus the investment is an essential part of making the most of available resources. Even a project that is not designed to generate a profit should be subjected to investment appraisal to identify the best way to achieve its aims. There are different tools available to a manager in order to carry out investment appraisal these ranges from payback period to internal rate of return (IRR).

Payback Period: Payback is the number of years required to recover the original cash flow outlay investment in a project. The payback is one of the most popular and widely recognized traditional methods of evaluating investment proposals.

Many firms use the payback period as an investment evaluation criterion and method of ranking projects. They compare the projects payback with a predetermined, standard payback. The project would be accepted if its payback period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period. Thus, if the firm has to choose between two mutually exclusive projects, the project with shorter payback period will be selected. There are certain advantages as well as disadvantage associated with this method of appraisal these are listed as follows.

Advantages 1. The most significant merit of payback is that it is simple to understand and easy to calculate. 2. Payback method costs less than most of the sophisticated techniques that require a lot of the analysts' time and the use of computers. 3. The emphasis in payback is on the early recovery of the investment. Thus, it gives an insight into the liquidity of the project. The funds so released can be put to other uses. 4. An investor can have more favourable short term effects on earnings per share by setting up a shorter standard payback period. 5. The risk of the project can be talked by having a shorter standard payback period as it may ensure guarantee against loss.

Disadvantages In spirit of being simple and other virtues, the payback method suffers from a number of serious limitations; 1. Payback fails to take account of the cash inflows earned after the payback period. 2. It does not consider all cash inflows yielded by the project, thus fails to predict the profitability of the project. 3. Share values do not depend on payback periods of investment projects. 4. A firm may face difficulties in determining the maximum acceptable payback period.

Let us re-emphasize that the payback is not a valid method for evaluating the acceptability of the investment projects. It can, however, be used along with other tools of investment appraisal as a first step in roughly screening the projects. In practice, the use of discounted cash flow techniques has been increasing but payback continues to remain a popular and primary method of investment evaluation.

Accounting Rate of Return (ARR) The accounting rate of return (ARR) is a way of comparing the profits generated by a project with respect to the amount invested. The ARR is normally calculated as the average annual profit expected over the life of an investment project, compared with the average amount of capital invested. For example, if a project requires an average investment of 100,000 and is expected to produce an average annual profit of 15,000, the ARR would be 15 per cent.

The higher the ARR, the more attractive the investment is. The ARR is widely used to provide a rough guide to how attractive an investment is. The main advantage is that it is easy to understand.

Disadvantages Unlike other methods of investment appraisal, the ARR is based on profits rather than cash flow. So it is affected by subjective, non-cash items such as the rate of depreciation used to calculate profits. The ARR also fails to take into account the timing of profits. In calculating ARR, a 100,000 profit five years away is given just as much weight as a 100,000 profit next year. In reality, investor would prefer to get the profit sooner rather than later (Businesslink.gov.uk, 2011).

Net Present Value (NPV) The NPV calculates the present value of all cash flow associated with an investment: the initial investment outflow and the future cash flow returns. The higher the NPV the better is the project (Moneyterms.co.uk, 2011). 1. If the value of NPV is greater than 0, then the project is a go! In other words, it's profitable and worth the risk. 2. If the value of NPV is less than 0, then the project isn't worth the risk and is a no-go. In other words, you'll pass on it.

So NPV takes risk and reward into consideration, which is why we use it in the world of corporate finance and capital budgeting. The key advantage of NPV is that it takes into account the time value of money the fact that money you expect sooner is worth more to you than money you expect further in the future (Businesslink.gov.uk, 2011). Discounted cash flow techniques are widely used techniques for investment appraisal because they consider both the cash flow as well as profitability of the project.

Disadvantages The NPV calculation is very sensitive to the discount rate; a small change in the discount rates causes a large change in the NPV. As the estimate of the appropriate discount rate is uncertain, this makes NPV numbers very uncertain.

References:
Alexander, D. (2007). Financial Accounting, 3rd edition. London : Prentice Hall. Businesslink.gov.uk. (2011, August). Investment Appraisal Techniques. Retrieved August 20, 2011, from http://www.businesslink.gov.uk: http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1081822890&r.i=1081822742&r.l1=10 73858790&r.l2=1073858944&r.l3=1081822141&r.s=m&r.t=RESOURCES&type=RESOURCES McConnon, J. (2002). Keeping Your Business on the Treck Part III. Retrieved April 17, 2010, from www.umext.maine.edu: http://www.umext.maine.edu/onlinepubs/PDFpubs/3002.pdf Monea, M. (2009). Financial Ratios Reveal How a Business is Doing? Annals of the University of Petroani, Economics , 9 (2), 137-144. Moneyterms.co.uk. (2011). NPV (net present value). Retrieved August 20, 2011, from http://moneyterms.co.uk/npv/: http://moneyterms.co.uk/npv/ Tonysurridge.co.uk. (2011). Analysing Financial Statement. Retrieved Janury 03, 2011, from http://www.tonysurridge.co.uk/: http://www.tonysurridge.co.uk/ Umext.maine.edu. (2010). Ratio Analysis. Retrieved Janury 03, 2011, from http://www.umext.maine.edu/onlinepubs/PDFpubs/3002.pdf: http://www.umext.maine.edu/onlinepubs/PDFpubs/3002.pdf www.spandane.com. (2009). Ratio analysis. Retrieved March 12, 2010, from www.spandane.com/: http://www.spandane.com/books/Training%20Notes%20for%20Bank%20Staff/Concepts/11RatioAnalysis.pdf

Appendix-1 Financial statement