Financial Ratio Analysis

Introduction

Financial statements are the documents of any company or organisation which gives the clear picture of the historic financial statements (Preve, 2011). The financial document includes all the details and the accurate assets and the liabilities such as income, expense and the cash flow. Financial statement help to communicates with the investor and give them the detail of the company where the company stands and tell them the economic history performance and the future planning and decision making that what decision they can take (Lazaridis, 2011). Financial statement is based on the three main things which are

Balance sheet

Income sheet

Cash flow sheet

These are steps which help to make the financial statement and it will in the decision making for the managers.

The source of the business finance is the investor does some investment in the company this is the source of finance to the company (Garcia-Teruel, 2011). There are two kind of finance internal and external finance. When the business is well established and there growth is good and the company capital will also increase by retaining the term of profit that the business earns. This is called internal source of finance. There are external source of finance also in which if the company go for expansion and they don’t have sufficient internal source of finance then they use external source of finance (Gill, 2013).

Task 1

Using a set of published accounts from a real business organisation, carry out ratio analysis for two years (note: usually two years figure will be given in a set of published accounts)

Financial ratio analysis is the selection, interpretation, of financial data along with other pertinent information, to assist in investment and financial decision making (Emery, 2011). It is also used internally to evaluate issues such as employees performance, the efficiency of operation and credit polices and externally to evaluate the potential investment and the credit worthiness of borrowers, among other things. The ratio analysis play very important role the organisation by using the ratio analysis the company know its position and where they stand. Making of financial statement balance sheet plays very important role in the organisation (Bougheas, 2009).

A statement prepared with a view to measure the exact financial position of a business on a certain date. All the assets and the liabilities of the company are clearly shown in the balance sheet. Balance sheet tells us clearly that what are their Capital, Current Assets, Current liabilities, Long term liabilities, short term liabilities, Fixed Assets (Deloof, 2010).

I have chosen the company Tesco for my assignment. Tesco is a giant in the UK super market and it is at the No.1 position. There is two years financial statement of Tesco 2010 and 2011.

There are six aspect of operating performance and financial condition and it can be calculate the financial ration (Bastos, 2012).

Liquidity Analysis Ratio: Liquidity ratio analyses are the short term debt which is rapidly converted into cash. Every organisation has those short term assets which will easily converted into cash and help the company. Here are some formulas to find the liquidity analyses ratio of Tesco (Berry, 2010).

Current Ratio = Current Assets/Current liabilities

= 11392/4250 = 2.68

= 11438/5862 = 1.95

Quick Ratio = Quick Assets/Current liabilities

= 8663/4250 = 2.03

= 8276/5862 = 1.41

Quick Assets = Current Assets-Inventories

= 11392-2729 = £8663M

= 11438-3162 = £8276M

Net working Capital Ratio = Net working Capital/Total Assets

= 7142/14681 = 0.48

= 5576/16623 = 0.33

Net working capital = Current Assets-Current Liabilities

= 11392-4250 = £7142M

=11438-5862 = £5576M

Interpretation of liquidity ratio: In year 2011 the current ratio of Tesco has remarkably fallen down at 1.95 as compare to previous year in 2010 it was 2.68. The main reason for decrease in current ratio is due to increase in current liabilities. If we see the figure in 2010 the current liabilities were £4250 and in 2011 current liabilities are £5862 which is 16 % more. If we breakup the current liabilities the main increase is trade and other payables which increased 10%.

If I analyse the quick ratio I will that quick ratio are decrease by 1.41 in 2011 as compared to year 2010 which was 2.03. There are two main reasons for this decrease in 2011. Quick assets decrease by 3%, the major decrease in cash and cash equivalent which is decrease by 10%. The second reason is current liabilities is increased by the 16%.

To find the net working capital ratio of Tesco in 2011 has fallen down at 0.33 as compare to the year 2010 which was 0.48. There are two effects in this ratio first is decrease in net working capital and the second is increase in total assets. The reason for decrease is increase in current liabilities for the net working capital. The second major reason for the increase in total assets in 2011 it is 19% more

Profitability Analysis Ratio: Profitability ratios also (refers to as profit margin ratio) compare content of income with sales. Profitability ratios give the new ideas to the company to increase their sales. This ratio is used for external Investors, Bankers and borrowers. Profitability ratio for the company can be calculated by these formulas.

Return of assets (ROA) = Net Income/Average Total Assets

= 2336/45408 = 0.051

= 2671/46212 = 0.057

Average of total Assets = Beginning total assets + ending total assets)/2

= 45166+45650/2 = 45408

= 45650+46775/2 = 46212

Return of Equity (REO) = Net Income/Average Stock Holder Equity

= 2336/374.5 = 6.23

= 2671/400.5 = 6.66

Average Stock Holder equity = (Beginning Stock holder equity + Ending stock holder equity)/2

= 350+399/2 = 374.5

= 399/402 = 400.5

Return On Common Equity (RECO) = Net Income/Average common stockholder equity

= 2336/374.5 = 6.23

= 2671/400.5 = 6.66

Average Common Stockholder Equity = (Beginning Common Stockholder Equity + Ending Common Stockholder Equity)/2

= 350+399/2 = 374.5

= 399/402= 400.5

Profit Margin = Net Income/Sales

= 2336/56910 = 0.041

= 2671/60931 = 0.043

Earnings Per Share (EPS) = Net Income/Number of common share outstanding

= 2336/7985 = 0.29

= 2671/8046 = 0.33

Interpretation of profitability Analyses ratio: In year 2011 return of assets was slightly increase 0.057 and in year 2010 it was 0.051. There are two main factors of increase in return of assets in 2011. There is net income which was increase to 3% in 2011. The increase of 3% of net income in 2011 there are two main factors for the increase of net income. Revenue excluding the VAT increase 40% in 2011 and the second major factor cost of sales which increase to 35% in 2011. These are the main changes which make the cause to increase in net income. The average of total assets increase in 2011 about 8%

Return of equity in 2010 is 6.23 and in 2011 there is slightly increase in 6.66. There is 0.0043% increase in return of equity. Net income has increase to 3% of the Tesco. And on the other hand the average stock holder equity has increase to 0.26% in 2011.

Tesco profit margin was 0.041 in 2010 and now it is 0.043 as compared to last year it increase slightly. Net income and sales are increase in 2011 net income was increase to 3% and on the other hand sales which has a major affect on the profit margin and the sales has a sharp rise to 40% in year 2011.

In year 2010 Tesco earns per share 0.29P and now in 2011 there prices for the share has slightly increase 0.33P per share. The number of common share outstanding has 0.61%.

Activity Analyses Ratio: Activity analyses ratio use to measure how well the assets are being used in the organisation. These activity ratio help to put more investment in work for example Equipment and machinery etc. Activity ratio has four important parts

Assets turnover Ratio = Sales/Average total assets

= 56910/45793.5 = 1.24

= 60931/46614.5 = 1.30

Average total assets = (Beginning of total Assets + ending of total assets)/2

= 45564+46023/2 = 45793.5

= 46023+47206/2 = 46614.5

Accounts receivable turnover = Sales/Average Accounts Receivable

= 56910/1843 = 30.87

= 60931/2101 = 29.00

Average accounts Receivable = (Beginning Accounts Receivable + ending Accounts Receivable)/2

= 1798+1888/2 = 1843

= 1888+2314/2 = 2101

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventories

= 52303/2699 = 19.37

= 55871/2945.5 = 18.96

Average Inventories = (Beginning Inventories + Ending Inventories)/2

= 2669+2729/2 = 2699

= 2729+3162/2 = 2945.5

Interpretation of activity analyses ratio: In year 2010 assets turnover is 1.24 and in 2011 it is increase to 1.30. There are two major factor of increase in ratio sales and average total assets.

If we will compare the sales of 2010 and 2011 there is a major rise of 40% in 2011 and it has a huge impact on the assets turnover. There is another reason average of total assets has been increase 8% and in the average of total assets there is 10% increase in noncurrent assets as compare to previous year.

Tesco accounts receivable turnover in 2010 was 30.87 and there was slightly fall on 29.00 in 2011 and the accounts receivable slightly goes down by 0.0187%. There are two main reason for the accounts receivable turnover ratio one is the cost of sales which has increase of 35.68 and the another reason is

Capital Structure Analysis Ratios:

Debt to Equity Ratio = Total Liabilities/Total Stockholders’ Equity

= 31342.0/14681 = 2.13

= 30582/16623 = 1.83

Interest Coverage Ratio = Income before interest and income tax expenses/interest Expense

= 4016/840 = 4.78

= 4399/864 = 5.09

Income before interest and income tax expenses = Income before income tax expenses + Interest Expenses

= 3176+840 = 4016

= 3535+864 = 4399

Comment on the business structure and the functional structure and explain the relative advantages of the structure of chosen organisation?

Business structure is a type of relationship with the owner of the business and business. Business structure are of many types which are sole proprietorship, general partnership, limited partnership, limited liability partnership, limited liability limited partnership, corporation, non profit corporation, limited liability company (Petersen, 2010).

Sole Proprietorship

Sole proprietorship business can be operated by the single person it is not like a limited and corporation business. In sole proprietorship there is no need to fill the documents with the state to begin the company. Sole proprietorship has some financial structure and they have some reporting system also (Lazaridis, 2011). Sole proprietorship has limited access to capital because in sole partnership there is only one partner or they are couple. There source of financing in sole proprietorship can take the small loans from banks, friends, some them have the personal investment, and the credit for suppliers. The sole proprietorship has to report their suppliers, Friends, personal loan and banks to tell where there company stands for (Preve, 2011).

General Partnership

General partnership can be formed when two or more people are willing to do a business together (Gill, 2013). In this partnership there is no local and state fillings are required to create this partnership. In general partnership businesses all the partners are equally responsible for the business they have share are his liabilities, assets and profit within partnership as a separate body (Garcia-Teruel, 2011). General Partnership has some financial structure and they have some reporting system also. General Partnership limited access to capital because in general partnership has one or two partners. There source of financing in general partnership can take the small loans from banks, friends, leasing, hire purchases, some them have the personal investment, additional investment of shareholder, and the credit for suppliers (Emery, 2011).

Limited Partnership

Limited partnership means partnership formed by two or more persons under the laws of the State under which it is formed, having one or more general partners all of which have management rights and responsibilities and one or more limited partners none of which have management rights or responsibilities (Bougheas, 2009). In the limited partnership they have limited access to capital and in this partnership they have some sources of finance which is angles investor, supplier credit, small loans, leasing, and hire purchase. These are the financial structure and the sources of finances and they need to report their financers that are happening in the company and what is current situation of the company (Deloof, 2010).

Public sector

Consisting of those industrial, commercial, trading and banking enterprises, the capital for which government provides from the public resources, the government providing the structure, content and control of the management and takes the profit or loss of the enterprises (Bastos, 2012).

Tesco PLC has some advantages as being the public sector

While I had chosen the Tesco organisation they have the different business structures.

Advice a potential investor on investing in the business compared to placing money in a deposit account. (Current deposit account interest rates should be sourced from local banks or Internet for comparison). The investor has £50 000 (or equivalent in other currency) to invest.

I will compare different option for the potential investor.

Invest in any company like John Lewis, Asda.

Invest in any banks.

As an adviser of the potential investor we need to look at the company they want to invest their money and in which way (Petersen, 2010). There is a company like john Lewis this company is very famous in the world and this is a garment industry. To invest in the John Lewis adviser need to see that where is company stand and what is its marketing value in the UK market. As an adviser I need to see that what is its annual profit per year and what are the prices of its market share. As an adviser I will suggest him to be a preferred share holder in the John Lewis. There are many types of share holder and the types are ordinary shareholder, preference shareholder, cumulative preference and redeemable (Berry, 2010).

Ordinary shareholder

Ordinary shares are just the normal shares. Ordinary share holders are the highest risk takers and they have the highest financial giants. In ordinary share if the company get into loss the ordinary share holder is the last person who will be paid (Preve, 2011).

Preference shareholder

Preference shareholder has links with the annual dividends which are distributed to share holder. Preference shareholder only receive the fix dividends which means that if the company earn more profit then normal one the preference shareholder will get his fixed divided he didn’t deal with the loss and profit of the company (Lazaridis, 2011).

Cumulative preference shareholder

Cumulative preference shareholder has a right if the other partners or dividends cant paid one year it will be carried out forward for the successive year. Dividends make sure that the growing preference share holder must be paid to increase the earning level of the business and to give the distributable profit to the business (Gill, 2013).

Redeemable shareholder

These shares come with an agreement that the company can buy them back at the future date. These shares can be a fix date or it can be taken as a choice of the business. A business cannot issue the redeemable shares (Garcia-Teruel, 2011).

As an adviser of the potential investor I will suggest him to invest his money as preference shareholder in the John Lewis if the investor invests his £50,000 money in john Lewis for 4 years. John Lewis is giving preference share holder 7.5% per year

Year                            Calculation                              Profit

1st year                        50000*7.5/100                        53750

2nd year                      53750*7.5/100                        54031.25

3rd year                       54031.25*7.5/100                   54052.34

4th year                       54052.32*7.5/100                   54053.92

Total amount in final Year                                          215887.51

After the four year period as the preference shareholder he invests £200000 in the company for the 4 years and he earns the profit £15887.51 against the original investment which is £200000. As an adviser I will suggest to potential investor to invest in the company to secure your investment. In any of the condition the company went into the loss this loss didn’t affect the preference shareholder investment (Emery, 2011).

Suppose the business requires additional finance of £500 000. Advise on a suitable source of finance giving possible alternatives, implications of each and reasons for your recommendation.

To invest in the bank for the fix deposit account it is a good choice but there are different conditions with the bank. Some of the banks will offer less percentage of money and some have a long time period condition (Deloof, 2010). As a current situation the potential investor has to look for the safe and reliable bank. As an adviser I had chosen the Lloyds TSB. This bank is deposit the money of £50,000 for 4 year with the rate 3.45%per year.

Year                            Calculation                              Profit

1st year                        50000*3.45/100                      51725

2nd year                      51725*3.45/100                      51784.5

3rd year                       51784.5*3.45/100                   51786.5

4th year                       51786.5*3.45/100                   51786.6

Total amount in final Year                                          207082.6

The potential investor does the fix deposit amount of £50000 for the 4 years in Lloyds TSB. The investor invests the £50000 for one year and he will get the profit for one year is £1725 per year and rest of the year the profit will be compounding. The potential investor invests the amount of £200000 and he will get a complete secure profit of £7082.6 for 4 years.

Recommendation as an adviser: As an adviser to a potential investor I will suggest to my potential investor that he has to go with the John Lewis Company as preference shareholder and he will get the 7.5percent per year which is better than the Lloyds TSB. In the John Lewis Company the net profit for 4 year is £215887.5 and in the Lloyds TSB the net profit for 4 years is £207082.6 while the original value for the investment is £200000. So as compare to Lloyds the best preference is John Lewis Company as preference share.

Suppose the business requires additional finance of £500 000. Advise on a suitable source of finance giving possible alternatives, implications of each and reasons for your recommendation.

The company need the additional finance for their company and there are many ways to finance the company (Bougheas, 2009). The short term loan has duration of up to one year for medium term loan its duration is 1 to 5 year period and for the long term period its duration is up to 5 to 15 years.

Short term Finance

Sale of Stock

Sale of stock is a short term loans. In sale of stock the money comes from the selling off the unsold goods. It can be done when the ploughed profit bring back to the company. It has some advantages and disadvantages (Bastos, 2012).

Advantages

It is quick way to raising the finance in the company. By selling the off season stock it reduces the cost which holding with them. By selling this block stock the covered space will be free for the other stock (Berry, 2010).

Disadvantages

It will take a long time to selling the block bulk in the market. It will give the fewer prices for the block stock (Petersen, 2010).

Working capital

Working capital in the organisation can be defined as the sum by which current assets exceed the current liabilities (Preve, 2011). The current assets and the current liabilities are shown in the balance sheet. The current assets in the balance sheet are stock held, cash in bank, debtors, and the short term investment. In current liabilities which must be paid by the company in one year and this include creditors, tax payment, and dividend to share holder and bank overdrafts. Working capital is working like a lubricant in daily transaction in company to run the business (Gill, 2013). When company is going to increase its profit the owner has to make sure that the current assets are more than the current liabilities. If the current liabilities increase over the current assets then the company is going to be in danger (Garcia-Teruel, 2011). This situation can make difficulties for the company and those are company reputation can be damage, its costs of products will be increase and it will affect the operation capacity of the company. If the current assets increase over the current liabilities its working capital will increase. Many of the business man use the delaying payment of trade debt is to increase the working capital over the short term (Lazaridis, 2011).

Bank Overdraft

Bank overdraft is widely source of finance bank overdraft supplies the money by men of over draft and loan facilities (Emery, 2011). Bank gives the big amount of loans to all the companies and loans plays very important role in the organisation. When the banks gives the loans there is a condition of the interest 2-3 percent which is calculated on the daily basses above the base rate. The bank overdraft limit set with the business condition and its credibility. Overdraft facilities are like short term and the contractors are usually grants this for one year balance to the account (Deloof, 2010).

Trade credit

Trade credit arises when a business receive goods or service from supplier without the requirement of immediate cash back payment. It is very specific source of finance which didn’t give cash on the credits but goods and services (Bastos, 2012). Trade credit compromises with the three things which are the discount available on the invoice prices, the discount period start from the day when the invoice is received and the time when the gross amount of the invoice has to be paid. Trade credit is to work when the suppliers must ensure themselves against bad debt (Berry, 2010). Insurance company take some risk against the companies but they put some kind of terms and condition the company which is relating to the amount of goods and services to be advance the customer. The suppliers rate the company based on its past credit record, its reputation and its importance as a customer to suppliers (Bougheas, 2009).

Medium Term Finance

Leasing

If the company own the free hold property or long leasehold than the capital can rise when the owner sell his property or rent his property on the market price. Leasing is one of the easiest solutions for the company to get out of any critical problem and they can still raise their money as much as possible against its property. Company can use the leasing of their land to convert their property into cash to solve out their problem and they can increase their capital and the cash flow problem can be reduces (Petersen, 2010).

Sales

If company goes in critical situation and had a tuff times that company can be closed at any time so the company can sell their fix assets for the sake of the company, by selling the fix assets can make their way easy to stable their organisation. By selling the fix assets it can rise in capital and the cash flow problem can be reducing in the company (Preve, 2011).

Bank loans

Bank loan are very helpful for organisation by using the bank loans they can survive their self in the market (Gill, 2013). Different banks have condition on the loans some of the banks give the loans for one year and some one year rolling contract and some have base rate, fix rate loan and five year commercial fixed rate loan. Loans can be given due to need of the company and loan period can be 1 to 5 years. It is more expensive than the bank overdraft limit and the loans give a lot of confidence to the company over a medium term time and it will make you more aggressive and confident to achieve your goals (Lazaridis, 2011).

Long Term Finance

Retained profit

In this source of finance the some of the profit can be taken out from the company and some of the profit retained by the business for future planning (Garcia-Teruel, 2011). It is an easy source of finance in which you don’t need to pay any interest which you have earned. At the end of the financial year of the company the profit must be paid to the government which is called corporation tax as well as to shareholder and to the dividends. In the balance sheet the retained profit shows as the reserves (Emery, 2011). For the directors of the business it is difficult for them that how much profit they should keep in their business and how much they should give to the dividends. If the directors fail to keep the sufficient amount of retained profit then the company can go for loss and they will lose their competitive edge. Now a day’s many of the companies have their corporate policy and strategy which help them that how much profit can be taken as dividends and how much is retained (Deloof, 2010).

Share issues

Share is usually required to external sources to provide additional finance.

A portion of the financial capital of a limited company which gives the holder an entitlement to a fixed return, in the case of preference shares ,or, in the case of ordinary shares, a variable dividends decided by the board of directors, ordinary share are also known as equity (Bougheas, 2009).

Ordinary shares

Ordinary shareholder is like the owner of the company and they have full right of voting and dividends right. Ordinary shareholder need clear all the dividends like debentures, loan stock, and preference shareholder and at the end he need to take out his dividend share (Bastos, 2012).

Preference shareholder

Preference shareholder has their own preferential rights and they have their fix dividends. They took their dividends (which fix by the company) form the company after clearing the debentures. Preference shareholder has no risk than the ordinary shares which is reflected to the lower rate of returns (Berry, 2010).

Debentures

A debenture is written acknowledgment of a loan. When this acknowledgement made by a company, it is a contract made under the company seal, providing for the fix rate of interest to be paid on the sum loaned to the company specifying terms of repayment of a principal at the end of period. The debentures are long term finance.

I had chosen the organisation Tesco as administration member if I need the additional finance for my organisation. There are some sources of finance which will be beneficial for the company and the sources are debts and bank loans (Petersen, 2010).

As a member of Tesco administration I will go for the banks loans. It is depend on the nature of the loans there are two types of loans secured and unsecured loans. Secured loans have the low level of risk and low interest rate but you need to leave your property as surety to return the loans. An unsecured loan has high level of risk and high level of interest rate but you don’t need to leave your property or your assets to the bank (Preve, 2011). If I am a CEO of the Tesco I need to take secured loans from the bank. Tesco has many banks who are giving finance in the organisation that Bank of England, HSBC, Lloyds TSB, and RBS. Tesco is taking a secured finance loan of £500,000 from the Bank of England for the expansion of the business. Tesco has taken the long term loan and its duration is 5-15 years. The interest rate of bank of England is 0.50% and Lloyds TSB is £3.45. The Bank of England has low interest rate against all of the banks. Tesco can utilize that money of £500,000 for the expansion, make some changes in business which will lead them to success and they can return the loan in the 15 years.

Advice on how working capital can be effectively managed within the business using figures from the accounts and your calculated ratios to illustrate your answer.

Working capital comprises the sum of assets, and it takes into consideration all the current resources of the enterprise, and their application to the current and future activities (Gill, 2013). There are different elements of current assets and the current liabilities which will make a structure of working capital. Both the current assets and the current liabilities are main parts in the working capital. Woking capital is compared as a lubricant in the daily routine life of the business. By working capital the company can meet their daily routine expenses and it will helpful for the company. Tesco two years working capital can be calculate by this formula (Lazaridis, 2011).

Working capital = Current Assets – Current Liabilities

Tesco working capital for year 2010 is calculated by this formula

Working capital = £11765M – £4250M = £7515M

Tesco working capital for year 2010 is £7515M. While Tesco working capital for year 2011 is calculated by this formula:

W.C. = £11869M – £5862M = £6007M

Tesco working capital has decrease as compare to last year 2010 £7515M and in 2011 £6007M and it is big difference of £1508M. Tesco is going to lose his sales slowly because the in year 2011 current assets are increasing and on the other side the current liabilities are also increasing as compare to previous year. Working capital is like lubricant in the Tesco. Working capital can meet the daily recruitment of the Tesco and it can work effectively by taking care of these things, better planning, monitoring capital, budgeting, sales, revenue, expenses and time period (Emery, 2011). By using these methods they can use the working capital in effective way (Garcia-Teruel, 2011).

Task 2

Budget

A statement of financial position for a definite period of time, based estimates of expenditures and proposal for financing them, budgeting generally used to forecast, control and monitor the business for the year (Bougheas, 2009). Budget is a plan which can be expressed in quantitative term. Budget can be prepared for the several reasons. By using the budget it can indicate the position of the company that what to do can monitor the progress of your business, if they see that they need money they can think to borrow money from the bank and the other financial sources (Deloof, 2010).

Cash Budget

ItemsJuly £’000August £’000September £’000October £’000November £’000December £’000
Sales Revenue114+106= 220  1181241049692  
Cost of goods sold646670595452
Salaries & Wages202020202020
Electricity668101212
Depreciation666666
Other overhead444+ 25= 2944+135= 1394
Total Expenses1001021379923194
Profit/ Loss12016-75-1352
Opening Balance909090909090
Opening Balance + Total receipts310208214194186182
Less Total Payments1001021379923194
Bank Balance at the end of Month2101067795-4588

The cash flow forecasting is very important for an organization because if the business runs out of cash and it has no resources to get finance then there are most chances of insolvent (Gill, 2013). For small enterprises cash flow is very important and the administration makes sure that the organization has enough money to survive (Petersen, 2010).

Through cash flow the organizations know that

Potential shortfalls in cash balance in advance

Make sure that business will pay the liabilities (wages, supplies, overhead, utility bills and cost of goods sold.)

Helpful in planning financial statements

Financial plans and budgeting

The most important reason of cash flow is that the stakeholders like financial institutes also came to know about the worth of business operations (Bastos, 2012).

Task 3

 Project 1 £’000Project 2 £’000
Cost (immediate outlay)200100
Expected Annual Operating Profit (loss):  
Year 15836
Year 2(2)(4)
Year 348
Estimated Residual Value of machinery712

When Cost of Capital 10%

To find out the ARR it has its own formula which will help the accountants to find out the average return of rate.

ARR?

Use straight line method to calculate the depreciation

ARR

ARR = Average income (inclusive of operational profits + cash flow) – Depreciation/ average investment on accrual basis

Depreciation

Depreciation = (total property cost – salvage value)/ life of the property.

Payback Period

Time required for the project’s expected after tax incremental cash flow to repay the entire initial investment in the project (Bastos, 2012).

Payback period can be calculated easily by using this formula:-

Payback Period= original cost of the project/Annual cash flow.

Using the payback period it has some benefits also. Payback period is very simple to understand and it is very easy to calculate. By using the short payback period method it can reduces the chances of loss (Bastos, 2011).

Net present values

Difference between the present value of a project’s expected after tax operating cash flows and the present value of its expected after tax investment expenditures. Net present value can be calculated by this formula (Preve, 2011).

NPV = present value of cash inflows – investment

Present value = CF / (1+r) n

CF = Cash inflow

R = discounting rate

N = years

NPV= CF1 / (1+r) 1 + CF2 / (1+r) 2 +………. CFN/ (1+r) n

Net present value has some advantages also. It helps the company to compare two projects requiring the same amount of cash outflow (Berry, 2010).

Discount rate

Discount rate that would make the net present value for an investment equal to zero, if the internal rate of return is more than the required rate of return than your project will be accepted as well as rejected also (Emery, 2011). If the company has one or more projects with the IRR more than the required rate of return and as compare to both projects which will the good IRR that will be selected. Internal Rate of Return can be calculated by this formula (Petersen, 2010):-

IRR= L + P1 – Q/ P1- P2 × D

L = Low discount rate

P1 = Present value of earning at lower rate

P2 = Present value of earning at higher rate

Q = Actual investment

D = Different in rate return

Payback

NPV

IRR

Year0 £0001 £0002 £0003 £0004 £000
Cash Flow(200)58(2)4 
Residual value   7 
Depreciation 64.364.364.3 
Net Cash Flow(200)122.362.375.3 
Discount Factor @ 10%10.9090.8260.751 
 (200)1115157 
Discount Factor @ 15%10.8700.7560.658 
Net Cash Flow(200)1064750 

Discount factor @ 10%

NPV= 111+51+57= -200+213

NPV= 19

Discount factor @ 15%

= 106+47+50= 200-203

NPV= (3)

Payback Period= 2.20 years

Year 1= 200-122.3= 77.7

Year 2= 77.2-62.3= 15.4

Year 3= 75.3

= 15.4/ 75.3= 0.20

So Payback period= 2+.20= 2.2 year

IRR= L% + [NPV L/Npv H + Npv L] x [H% – L%]

=14.3%

Year0 £0001 £0002 £0003 £0004 £000
 (100)36(4)8 
Residual   12 
Depreciation 29.329.329.3 
Net Cash Flow(100)65.325.349.3 
Discount factor @ 10%10.909.826.751 
Net Cash Flow(100)59.0020.637 
Discount Factor 15%10.8700.7560.658 
Net Cash Flow(100)56.819.232 

NPV when Discount factor is 10%

NPV= 17

NPV when Discount factor is 10%

NPV= (8)

IRR= 13.4%

4.        References and Bibliography

Bastos, R. (2012) “Trade credit during a financial crisis: A panel data analysis,” Journal of Business Research, 21(45), pp: 32-78

Berry, A. (2010) “Accounting in a Business Context,” Cengage Learning EMEA, 25(44), pp: 22-56

Bougheas, S. (2009) “Corporate trade credit and inventories: New evidence of a trade-off from accounts payable and receivable,” Journal of Banking and Finance, 31(45), pp: 35-75

Deloof, M. (2010) “Does Working Capital Management Affect Profitability of Belgian Firms?,” Journal of Business Finance & Accounting, 21(53), pp: 44-77

Emery, D. (2011) Corporate Financial Management, 4th ed. England: Pearson Prentice Hall

Garcia-Teruel, P. (2011) “Effects of working capital management on SME profitability,” International Journal of Managerial Finance, 33(45), pp: 12-78

Gill, A. (2013) “The Relationship between Working Capital Management and Profitability: Evidence from the United States,” Business and Economics Journal, 21(56), pp: 21-132

Lazaridis, I. (2011) “Relationship between Working Capital Management and Profitability of

Listed Companies in the Athens Stock Exchange,” Journal of Financial Management and Analysis, 23(68), pp: 34-67

Petersen, M. (2010) “Trade credit: theories and evidence,” Review of Financial Studies, 33(54), pp: 67-90

Preve, P. (2011) “Trade credit and bank credit: Evidence from recent financial crises,” Journal of Financial Economics, 42(56), pp: 56-78

Published by MALI

Writer is post-graduated in Computer science, Business Administration, Marketing and Innovation. He has 10 years of business academic research writing experience.

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