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FINANCIAL
MANAGEMENT
POST GRADUATE DIPLOMA IN BUSINESS
MANAGEMENT- LEVEL 7
SUBMITTED BY: -

TABLE OF CONTENTS

Description

Page #

Part A

Part B

12

Part C

15

Part D

16

Bibliography

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Part A

Prospect Plc2
Through analysis of this case study, I shall be able to provide recommendation to
management for improvement in the business process. Ratio analysis is used in the
organizations to make analysis of the financial statements in financial terms and draw
conclusions. In such analysis, we shall takes into account the correlation of two or more
lines items which are depicted into the financial statements. Four aspects of financial
statements will be analyzed as under;

Profitability

Liquidity,

Gearing and

Asset utilization

Profitability Ratio:
Profitability ratios are used to measure the ability of a business to yield returns on the
capital invested into the venture. The fact that a company is making profit is not
sufficient to classify it as a successful business. This is because some businesses make
less profit than they would have made if the factors of production were combined
differently. Profitability ratios are not just there to tell whether a business is making profit
or not. In addition to the above; profitability ratios tell if a business is as profitable as it
ought to be. A rise in profitability ratios is a possible sign for any business.

Gross Profit Margin:

The gross profit margin can enable the management of a business to assess the ability of
the business to yield returns on investment at the gross profits level. This ratio covers
three issues which include pricing, production and inventory. This ratio can be calculated
by using the formula below:Profit Margin:

Gross Profit/Sales%

Sales prices, sales volume and sales mix

Purchas prices and related costs

Production cost, both direct and indirect

Inventory Levels and valuations.

Net Profit Margin:

The net profit margin can quickly enable a business to know how much net profit it
generates from each dollar received in sales revenue. It is an indicator that management
can use to assess whether it has well managed its operating expenses so as to ensure that
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the business generates the best possible returns on investment. This ratio also indicates
whether the organisation is making the right volume of sales that can enable it to meet up
with fixed costs while making some reasonable profits. Net profit margin can be
calculated by using the formula listed below:Net Profit Margin:

Net Profit / Total Sales %

Sales expenses in relation to sales levels

Administrative expenses, including salary levels

Distribution expenses in relation to sales level.

Return on Assets:
This ratio can be used by management to measure the level of efficiency with which the
company makes use of its assets to make profits. This ratio is used to measure a
companys level of efficiency in the use of its assets.
Return on Assets:

Sales / Total Assets less Current Liabilities %

Gross Profit
Gross Profit Ratio
Net Profit Ratio

5,870

5,850

46 %

53%

1,080
8.5%

1,900
17%

This gross profit margin is used to find out that how much should be spent on direct
operating cost and leave profit for the owner of the business. This gross profit is basically
a difference between costs of production and product revenue. When there is more gross
profit then this implies that there will be availability of revenue to absorb the operating
expenses and provide a profit to the business. When there is maintaining of track record
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of gross profit margin then this will assist the company in understanding of the
profitability trends. Here, we calculate the gross profit margin by deducting the cost of
sales from the sales revenue. Gross profit margin is better indicator of profitability. Gross
profit ratio shows the declining trend and this decline come from 53% to 46%. This is
mainly on account of increase in the manufacturing costs. The company has net profit
ratio in the year 2012 as 17% which subsequently reduce to 8.5% and this is alarming
sign and this reflect that company has not controlling the expenses. It is recommended
that company should control on costs as expenses are incurred without any limit whereas
on the other hand, there no such increase in the sales level while comparing with the
increase in the expenses level.
Liquidity:
CURRENT AND QUICK RATIO
These ratios are called liquidity ratios and these ratios are used to make analysis of short
term financial position of the company. Current ratio is used to determine the short term
financial viability of the company that whether the company is able to pay its creditors
within one year when due. In our analysis, there is improvement in the current ratio
which means that company is making good progress towards payment of current liability.
On the other hand, quick ratio is considered to be more reliable source of test of shortterm solvency as compare to current ratio and this is the fact that this ratio provides the
ability of the firm to pay its short term dues within the short time. In quick ratio, there is
exclusion of inventories and prepaid expenses from the current assets for the purpose of
calculation of quick ratio. This is well understandable that inventory took too much time
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in selling and its conversion into cash and prepaid expenses cannot be used as the
payment of current liability. It is considered good to have the quick ratio of 1:1 the same
rules apply here in the case of current ratio that this ratio also carefully interpreted. When
quick ratio is higher than 1 then this does not imply that company has the strong liquid
position but has higher debtors on its balance sheet which these debtors does not pay
quickly and accordingly company will be suffered. It is now very critical that to have
hard look on the nature of each individual asset.
Current ratio is useful test for the payment of short term debt payment of any
business. In the business community, it is considered good to have a ratio of 2:1 or higher
and it is considered satisfactory. However, one must to be careful while interpreting it. In
the simple words, computation of ratio does not truly disclosed the true liquidity position
of the company and this is the fact that current ratio does not provide a green signal. This
ratio required in-depth analysis of the characteristics of each individual current assets and
its related current liability. An organization having the high current ratio is not able to
pay its current liabilities as they are due. Due to the increase in the stock or obsolete
stock, the ratio is on the higher side but do not provide any money towards payment of
dues. This is also the real fact that some organizations having low current ratio is able to
pay its current liability as they become due and this is only that portion of current assets
consist of highly liquid assets which include the cash, bank balance and fast moving
inventories. In our companys analysis, we observed that there is no cash balance
available to the company for payment of its debts an also company has not been able to
have the marketable securities in its balance sheet. In the previous year, company has the
balance of cash in its balance sheet for payment of its current liabilities. Further analysis
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reveals that company has large portion of account receivable in its balance sheet in the
year 2013. This reflects poor account receivables management and this portion should be
converted into cash. It is also evident that company is borrowed bank overdraft for
running its operation. This is fact that company is incurred cost for not properly
managing the account receivables.
Current Ratio= Current Assets/Current Ratio

= 1.61

1.27
Quick Ratio= Liquid Assets/Current Ratio

= 1.5

1.17
GEARING RATIO
The most comprehensive form of gearing ratio is that in which there is inclusion of all
forms of debts which includes long term debts, short term debts and overdraft and
divided this figure by the shareholders fund.
Long-term debt + Short-term debt + Bank overdrafts
Shareholders' equity
Gearing Ratio for the year 2012 is =

76.7%

Gearing Ratio for the year 2012 is =

67%

The gearing ratio is calculated through the proportion of debt of the company divided by
the equity of the company. When there is high gearing ratio then this implies there is high
debt structure in the company and when there is low gearing then this means that
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company has low debts in its capital structure. There is a great deal of leverage when
there is high gearing ratio because company is bond to pay for its debts based on
continued business operations. When there is recession, company will not be able to pay
its debts and accordingly company will face difficulty in payment of its debts. The
situation will be worst when there is difficulty in managing debts. Further, when the rate
of interest is variable then company will face tough difficulty in payments of interest
when rate of interest rise.
Loan providers are very interested in the gearing ratio and this is the fact that high
gearing ratio will put their loan at risk because their money will not be repaid. The
solution of this problem found by the lenders by putting restrictions on the payment of
dividends, forced to pay excessive cash towards payment of debts, and also put restriction
on alternative use of cash. Further, creditors of the company are not in a position to
impose such terms and condition on the company. On the other hand, when there is low
gearing ratio then this implies that there is conservative financial management. In our
company analysis, in the year 2012 there is high gearing ratio and company reduced this
gearing through injection of equity.
It is appropriate at this stage to determine the interest coverage ratio which is the
measure of ability to pay the debts of the company. When there is interest coverage ratio
on the higher side then this implies that company is able to pay its debts when due and
there is no default on the company for bankrupt. In the year 2012, the company was on
the strong footing to have the interest coverage ratio of 9.5 times which is on the higher
side, whereas in the year 2013, this ratio was declined and reached to the level of 4 times.
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It is a good strategy of the company that when company payment capacity has been down
then company took decision to reduce the burden on debts from its balance sheet. When
we look in to the current ratio then we observed that company has high level of debtors in
its balance sheet and this reflect that company has credit sales and this will be a
dangerous sign for the failure sign of the company.
ASSET UTILIZATION
The focus of this ratio is to determine the efficiency of the management towards
utilization of its assets to generate sales revenue. The numerator of this ratio is to sales
revenue appeared in the profit and loss account whereas the denominator shows us total
assets which are reflected in the company balance sheet. The asset turnover ratio formula
only looks at revenues and not profits.
Net Assets in the year 2013= 11,850- 3,000= 8,850, Revenue= 12,650= 1.42 times
Net Assets in the year 2012= 8,850-2,400= 6,450, Revenue= 11,000= 1.70
Use of Asset Turnover Ratio Formula
The higher the ratio, then this reflects that companys assets producing higher sales. As a
result of this, there is preference to put weightage on the ratios which has higher value. In
the year 2012, company performance is good and this performance slightly declined in
the year 2013 which need investigation.

II) LIMITATION OF ANALYSIS

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The comparison of performance will be misleading if firm has substantial amount of

hidden assets and other firm does not possess these assets which include the substantial
land carried at historical cost.
There are some also problems exists when there are lack of uniformity. In debt to
equity ratio, we determine this ratio and compare with the industry. The problem is to
first find out the ratio formula adopted by the industry. There are also further problems
when financial statements do not reflect the elements of debts in the computation of debt
to equity ratio.
On the other hand, current ratio provides the relationships of current assets and
the size of the current liabilities and this make easy to determine the size of the current
ratio. There is a problem in calculating the current ratio due to formula of LIFO. LIFO
formula provides understatement of inventory.
III) Calculate the Working Capital Cycle in days for Prospect Plc based on the
information above, assuming 365 days, for the years 2013 and 2012 AND comment on
the companys liquidity position in 2013 compared to 2012. (round to the nearest day)
(10%)
Accounts Payable Turnover:
This ratio depicts the number of times that a business repays its creditors within an
accounting period. When the number is high, it implies that the business might have
decided to pay its creditor on a later date or it could simply have problems in paying back
its creditors.

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This ratio depict the number of days it takes the business to pay accounts payable. When
the business takes longer to pay; it might lose more money as it might not benefit from a
number of discounts associated with the prompt payment of loans. This ratio can be
calculated with the use of the formula below:Payable Payment Period 2013:
= Days x AP / Cost of Goods Sold
= 365 x 2,400/6,780
= 129 DAYS

Payable Payment Period 2012:

= Days x AP / Cost of Goods Sold
= 365 x 2,000/5,150
= 141 DAYS
Inventory Turnover:
This ratio enables financial analysts and businesses to evaluate the number of times that
their inventory is sold within a specific accounting period. Faster turnover is a positive
sign which allows a business to increase its cash flow and cash in hand. It is a positive
trend that businesses value. The ratio is achieved as depicted below:This ratio is used to analyse the average duration that each inventory lasts on the average.
When it takes fewer days to sell the inventory, it means there is more cash flow and
subsequently cash in hand. The goal of most businesses is to use fewer days to sell its
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inventory. Fewer days means more sales and profits. Days inventory formula ratio can be
achieved using the formula below:Inventory Holding Period:
= Days x Inventory/ Cost of Goods Sold
= 365 X 350/ 6,780
=18 DAY
Inventory Holding Period:
= Days x Inventory/ Cost of Goods Sold
= 365 x 250/ 5,150
= 18 DAYS

Debt Coverage Ratio:

This ratio is used to analyse the ability of a business to meet up with its debt obligations
and the capacity to manage more debt. Debt management is an important part of business
as business always involves lending and borrowing.
Net Profit + Any Non-Cash Expenses
In the year 2013, there is increase in the balance of receivables collection period from 83
days to 129 days and this shows us very poor performance of the company in managing
its account receivables. This reflects that company has changed its collection policy from
its debtors. The company has 141 days payment period for the year 2012 and
subsequently the company reduced the balance of this period to 129 days. This reflects
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that company has changed its policy towards creditors and payment is made earlier than
previous year. In the year 2012, there is negative balance of cash operating cycle which
reflect that a company can effectively manage its short-term payments to creditors when
dues. In other words, Payable Days are greater than Days in Inventory and Days in
Sales figure as a result of this; company will take more time to pay than it does to collect
from the sales of its stock. The cash operating cycle shows us the measure of liquidity
risk entailed by growth. A negative cash operating cycle indicates great cash/liquidity
management.

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Part B- BREAK EVEN ANALYSIS

An analysis to determine the point at which revenue received equals the costs associated
with receiving the revenue. Break-even analysis calculates what is known as a margin of
safety, the amount that revenues exceed the break-even point. This is the amount that
revenues can fall while still staying above the break-even point.
Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the
sales. It does not analyze how demand may be affected at different price levels.
For example, if it costs $50 to produce a widget, and there are fixed costs of $1,000, the
break-even point for selling the widgets would be:
If selling for $100: 20 Widgets (Calculated as 1000/(100-50)=20)
If selling for $200: 7 Widgets (Calculated as 1000/(200-50)=6.7)
In this example, if someone sells the product for a higher price, the break-even point will
come faster. What the analysis does not show is that it may be easier to sell 20 widgets at
$100 each than 7 widgets at $200 each. A demand-side analysis would give the seller that
information.
Fixed Cost = 4,000
Sales Price= 400 Per Unit
Variable Cost= 200+30+30+50+10= 320
Contribution Margin= 80
Cv%= 80/400*100= 20%
CV%= CM/Sales* 100
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= 20/400*100
1)

Calculate the break-even point in units for the two years 2012 and 2013 and

comment on the results (10%)

YEAR 2012
Break-Even Point= Fixed Cost/Contribution Margin
= 4,000,000/80
= 50,000 Units
Year 2013
SALE PRICE - 460
VERIABLE COST ( BALANCING FIGURE) -368
Contribution Margin- 92
Fixed Cost= 6,440,000
Break Even Point= Fixed Cost/CM
=6,440,000/92
= 70,000 Units
The company break- even point was 50,000 units in the year 2012 and in the second year (2013) the
break-even point 70,000 Units. This implies that additional cost incurred increase in the break-even
point and company is required to produce more units of products to meet the fixed cost.

Margin of Safety
The margin of safety indicates by how much sales may decrease before a loss occurs. In break-even
analysis, margin of safety is the extent by which actual or projected sales exceed the break-even sales.
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It may be calculated simply as the difference between actual or projected sales and the break-even
sales. However, it is best to calculate margin of safety in the form of a ratio. Thus we have the
following two formulas to calculate margin of safety:

MOS = Budgeted Sales Break-even Sales

MOS
=

Budgeted Sales Break-even Sales

Budgeted Sales

Margin of Safety can be expressed both in terms of sales units and currency units.
The margin of safety is a measure of risk. It represents the amount of drop in sales which a company
can tolerate. Higher the margin of safety, the more the company can withstand fluctuations in sales. A
drop in sales greater than margin of safety will cause net loss for the period.
SAFETY MARGIN= total sales- break-even sales
2012

=
=

275,000 Units -50,000 Units

225,000 Units

2013
= (275,000-70,000) Units
=205,000 Units
The performance of the company in the year 2013 is declined and company has lower level of margin of
safety available as compare to previous year.
COMMENTS ON COMPANY POLICY
The policy of the company is not in accordance with the expectations and this increase in the price of
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the product 15% as this price increase did not help the company to recover additional fixed cost.

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PART C

Ratios

Project A

Payback period (years)

Project B

Accounting Rate of Return (ARR %)

15

6
18

Net Present Value (NPV m in 15 years)

120

145

Internal Rate of Return (IRR %)

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REPORT TO DIRECTORS
The payback period of project A is 5 years and this implies that company will be able to
recover its initial investment within the period of 5 years whereas project B required 6
years to recover its initial investment. On the other hand, internal rate of return suggest
that company should prefer project a based on its higher rate of return which is 16%
whereas project B provides return of 14%.

Accounting rate of return suggest investing in the project B as this project provides
higher rate of accounting profit. Whereas Net Present Value method suggest that company
make investment in the Project value 145 million whereas project A provides 120 million,
and this suggest that project B be worth project and we recommended this project B as Net
Present Value method provides superior value.

PART D
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Committed cost is those cost which cannot be avoided and it committed to pay and hence
irrelevant for the purpose of decision making e.g. Contract signed and amount determined
and accordingly company is bond to execute the work as required. This cost is sometimes
also called future costs as this cost will be incurred in the future and this cost cannot be
changed. Committed cost is not relevant for any decision making process
II) Fixed cost is also not taken into account for the purpose of decision making. Because
fixed is not a relevant cost for the purpose of decision making. Further. Fixed cost which
change in the future course of action is considered to be a relevant cost for decision
making. Fixed cost which cannot be changed in future is not relevant cost.
BUDGETING AS TOOL FOR PLANNING AND CONTROLLING
Planning is the design of a desired future and of effective ways of bringing it about. A
distinction is normally made between short term planning and long term planning.
Stages in the Planning Process:

Establishing Objectives

Identify Potential Strategies

Evaluation of Strategic Options

Select Course of Actions

Implementation of Long term Plans

Monitor Actual Outcomes and respond to divergencies from planned outcomes.

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Multiple functions of budgets:

Planning actual operations

Coordinating the activities of the various parts of the organization and ensuring
that the parts are in harmony with each other

Communicating plans to the various responsibility centre managers

Motivating managers to strive to achieve the organizational goals

Controlling activities

Evaluating the performance of managers

Budgeting is a tool in which targets are to be achieved and these targets are fixed for
future. Further, these targets once fixed provide the yardstick and with the help of this
yardstick, company is able to determine the performance of individuals and managers and
accordingly rewarded. This is budgeting which help in the decentralization of authority
and through this initiation, there is step taken by every person which is good for the
success of the department and responsibility is shifted towards that person who takes
decisions. This process also helps the company to control mechanism and control is on
the revenue, cash and capital expenditure. This budgeting process control mechanism on
revenue, cash and capital expenditure of the firm. This is budgeting which created the
cost consciousness among the workforce.
There are various budgeting tools available which help in controlling the cost of an
organization and these includes the followings;
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1- Master Budget
2- Flexible Budgeting
3- Standard budgeting
There are various ways of budgeting and choice of budgeting method for the purpose of
controlling depends on the needs of organization. Some budgeting methods focus on the
short term period and some budgeting methods focus on the long term controlling
purposes.
Some budgets are cash focused and focusing on the inflow and outflow. All these budgets
are brought together in the Organization master budget. Master budget is most useful in
our organization wherein prepare the cash budget and forecast balance sheet and profit
and loss account. A master budget is flexible with respect to not only the particular
budget it may contain but also the many formats and layouts for the various types of
budgets. There are various components of a master budget which are as under;
1- Operating budget takes into account the operating budget which is divided into
two categories which include revenue budget and other is expense budget.
2- Cash Budget
3- Capital Budget include the decision making from short term investment to long
term investment.
4- Flexible budgeting
5- Budgeting balance sheet and budgeted profit and loss account.
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Cotrol at different organizational levels

Control is applied at different levels with in an organizations. They distinguishes between
strategic control and management control. Strategic control has an external focus. The
emphasis is on how a firm , given its strengths and weaknesses and limitations can
compete with other firms in the same industry.
The terms management accounting control systems, accounting control systems and
management control systems are often used interchangeably. Both management
accounting and accounting control systems refer to the collection of practices such as
budgeting , standard costing and periodic performance reporting that are normally
administered by the management accounting function.
Limitations and Conclusions:
Although financial ratios have been touted for their ability to enable management to
assess the financial performance to analysts and management, these ratio also have
limitations as they can some times send wrong signals about the financial health and
performance of a business. Financial ratios best explain what have happened in the past
and can help management and financial analysts to understand business trends. Even
though some trends can help to give an idea of what the future of business might look
like, these ratios cannot provide forecasts for businesses.
Ratio analysis is mostly based on accounting data. And this data is mostly drawn from
the company's financial statements. The right forecast needs to come from the economy
instead. This is a major weak point when it comes using financial ratios to make
business decision and analysis. This is especially true when it comes to predicted future
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trends in business. These ratios mostly take account of figures drawn from the balance
sheet. The balance sheet is drafted during specific periods within the financial year and
does not take into consideration some important issues. As such, these figure do not
truly reflect the off balance sheet data. These ratios may also differ from one business to
the other based on the accounting policy that the business uses. This makes it possible to
have different ratios and interpretation from the same firm based on what accounting
principles it uses.

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BIBLIOGRAPHY
1) Levy, H. and Sarnat, M. Capital Investment and Financial Decisions 5th edition,
Prentice-Hall, 2008.
2) Pike, R.H. An Empirical Study of the Adoption of Sophisticated Capital
Budgeting Practices and Decision-making Effectiveness.

Accounting and

Business Research, autumn 2007.

3) Pike, R.H. A Longitudinal Survey on Capital Budgeting Practices. Journal of
Business Finance and Accounting, spring 2008.
4) Asch, D. and Kaye, R.G.

Financial PlanningProfit Improvement through

Modelling 2nd edition, CIMA/Kogan Page, 2009.

5) Wilson, R.M.S. and McHugh, G. Financial Analysis: A Managerial Introduction
Cassell, 2009.

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