Financial Statements, Budget Analysis and Capital Budgeting: An Introduction to Accounting and Finance Assesment

 

Introduction

In the global arena, properly disclosed financial statements, appropriate budgeting, and accurate investment appraisal smoothen the decision-making process of the companies. In the quest for expanding and for attracting more funds from the shareholders the companies generally prepare proper strategies. In this report, a detailed analysis of the financial performance of Dexter, Philly, and Sankrust limited has been done so that the exploration of new opportunities arising in the companies could be detected easily. In this report analysis of Net present value, accounting rate of return and payback period has been analyzed theoretically so that both practical and theoretical implications of the capital budgeting tools could be understood easily.

Part A: Financial Statements

According to Gitman et al. (2015, p.50), financial statements are the tool that helps in identifying the areas that are reducing the effectiveness of the company. This identification becomes helpful in setting improvement strategies that are needed for enhancing the performance reputation of Dexter plc among its competitors. In this task as first, the transactions have been recorded in the form of journal entries then the ledgers of the main accounts have been prepared (Flower, 2018, p.25). Based on those ledgers and other accounts trial balance have been prepared. This, in turn, has paved the way for presenting the accurate balance sheet and income statement for the company (West and Bhattacharya, 2016, p.47).

Journals

Date	Particulars	Amount (£) Debit	Amount (£) Credit
1	Bank A/c                                                         Dr To Owners Equity A/c ( Being shares introduced in the business)	180,000	180,000
2	Rent A/c                                                           Dr Prepaid Rent a/c                                                 Dr To Cash A/c ( Being Rent paid in advance)	90000 22500	112500
3	Rates A/c                                                           Dr Prepaid Rates a/c                                                 Dr To Cash A/c ( Being next year’s rates also paid in advance)	2400 4500	6900
4	Delivery van A/c                                                Dr To Cash A/c ( Being delivery van purchased)	60000	60000
5	Depreciation A/C                                                Dr To Accumulated Depreciation A/c ( Being Depreciation amount adjusted) Cost of an asset- salvage value/ cost of life) (60000- 12000)/5	9600	9600
6	Wages A/c                                                         Dr To Cash a/c To Outstanding wages A/c ( Being outstanding wages recorded)	117000	114825 2175
7	Electricity Charges A/c                                         Dr To Cash A/c Outstanding Electricity bills a/c ( Being outstanding electricity Charges recorded)	7725	5700 2025
8	Raw material Inventory A/c                                  Dr To Accounts payable A/c ( Being raw materials inventory purchased in credit)	486000	486000
9	Raw material Inventory A/c                                  Dr To Cash A/c ( Being raw materials inventory purchased in cash)	39000	39000
10	Accounts Receivable A/c                                    Dr To Sales A/c ( Being sales revenue in credit recorded)	504000	504000
11	Cash  A/c                                    Dr To Sales A/c ( Being sales revenue in cash recorded)	129000	129000
12	Cash  A/c                                                                 Dr To Accounts receivable A/c ( Being cash amounts received)	438000	438000
13	Accounts payable A/c                                             Dr To cash A/c (Being cash payments done)	393000	393000
14	Van Running Expenses A/c                                    Dr To Cash A/c ( Being van running expenses paid)	33600	33600
15	Bad  debt A/c                                                           Dr To Accounts Receivable A/c ( Being bad debt entry done)	1500	1500

Figure 1: Journal Entries

(Source: Created by researcher)

Ledger Accounts

Bank A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Owners equity A/c	180000		By Bal C/d	180000
	Total	180000		Total	180000
	To bal B/d	180000

 

Cash  A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Sales A/c	129000		By Rent A/c	90000
	To Accounts receivable a/c	438000		By Prepaid rent a/c	22500
				By Rates A/c	2400
				By Prepaid Rates a/c	4500
				By Delivery Van A/c	60000
				By Wages A/c	114825
	To Bal C/d	198525		By Electricity Charges A/c	5700
				By raw material Inventory A/c	39000
				By Accounts payable A/c	393000
				By Van running expenses A/c	33600
	Total	765525		Total	765525
				By bal B/d	198525

 

Raw Materials Inventory  A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Accounts payable A/c	486000		By Bal C/d	525000
	To Cash A/c	39000
	Total	525000		Total	525000
	To Bal b/d	525000

 

Accounts receivable A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Sales A/c	504000		By Cash A/c	438000
				By Bad Debt a/c	1500
				By Bal C/d	64500
	Total	504000		Total	504000
	To Bal b/d	64500

 

Accounts Payable A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Cash A/c	393000		By Raw material inventory A/c	486000
	To Bal C/d	93000
	Total	486000		Total	486000
				By Bal b/d	93000

 

Sales  A/c
Date	Particulars	Amount Dr	Date	Particulars	Amount Cr
	To Bal C/d	633000		By Accounts Receivable A/c	504000
				By Cash A/c	129000
	Total	633000		Total	633000
				By Bal B/d	633000

Figure 2: Ledger Accounts

(Source: Created by Researcher)

In the books of Dexter Plc
Trail balance (£)
For the Year Ended 31st Dec 2018
Particulars	Amount (Dr)	Amount (Cr)
Owners Equity		180000
Rent	90000
Prepaid Rent	22500
Rates	2400
Prepaid rates	4500
Delivery Van	60000
Depreciation	9600
Accumulated Depreciation		9600
Wages	117000
Outstanding Wages		2175
Electricity Charges	7725
Outstanding Electricity Charges		2025
Van Running expenses	33600
Bad Debt	1500
Bank	180000
Cash		198525
Purchase	525000
Accounts receivable	64500
Accounts payable		93000
Sales		633000
Total	1118325	1118325

Figure 3: Trial Balance

(Source: Researcher)

Assumptions

• Rates for the period of 2017 to 2019 includes both 2018 rates as well as 2019 data so rates have been assumed to be prepaid rates and adjusted as prepaid rates in a journal entry.
• Wages totaled to be £ 117000, and it has been assumed that the amount of £ 2175 is included in that £ 117000 amount so £ 2175 has been treated as outstanding expenses

In the books of Dexter Plc
Trading and Income statement (£)
For the Year Ended 31st Dec 2018
To Purchase	525000	By Sales	633000
To Wages	117000
		By Gross Loss	9000
Total	642000	Total	633000
To Gross Loss	9000
To Rent	90000
To Rates	2400
To Electricity charges	7725
To Van running expenses	33600	By Net loss	153825
To Bad Debt	1500
To Depreciation	9600
Total	153825	Total	153825

Figure 4: Income Statement

(Source: Researcher)

In the books of Dexter Plc
Balance Sheet
For the Year ended 31St Dec 2018
Liabilities (£)			Assets (£)
Owners Equity	180000		Delivery van	60000
Less: Net loss	153825		Less: Depreciation	9600
Total		26175			50400
Current Liabilities			Current Assets
Accounts payable		93000	Accounts Receivable		64500
Outstanding wages		2175	Prepaid Rent		22500
Outstanding Electricity charges		2025	Prepaid rates		4500
Cash Credit		198525	Bank		180000
Total		321900	Total		321900

Figure 5: Balance Sheet

(Source: Researcher)

Close investigation of the income statement and balance sheet shows the accuracy in recording the purchase, wages, and sales at the first step and this has helped in determining the gross loss. The gross loss has formed the base for getting the net loss that has been found in the profit and loss or income statement (Lisowsky et al. 2017, p.745). In the context of this, it has also been seen that the balance sheet has been prepared for determining the financial position of the company. After adjustment of the prepaid expenses, outstanding expenses, equity, and other assets and liabilities the total balance is found to be £ 321900.

Part B: Budget analysis

As per the case study the company can produce up to 70000 units per year but in the current year the company has produced only 53000 units and it has been assumed that the variable cost, fixed cost and the sales amount has been estimated on 53000 units only.

a: Determination of contribution per unit

Particulars	£
Sales	689000
Less: Variable cost
Materials	278250
Labour	156350
Variable overheads	98050
Contribution	156350

Figure 6: Contribution Estimation

(Source: Created by the researcher)

For covering the total fixed costs of £ 106600 the contribution has been £ 156350 in Philly limited. Per unit, the contribution is 2.95.

b: Margin of safety and breakeven point calculation

Breakeven point	£
in Units	36135.59322
in Amount	469762.7119
Margin of safety	£
in Units	16864.40678
in amount	219237.2881

Figure 7: Margin of safety and breakeven point

(Source: Researcher)

Breakeven point of Philly limited in units and revenue, as well as margin of safety in units and revenue, has been estimated for determining the units at which the sales – variable cost equals to the fixed cost incurred by the company (Deutsch et al. 2018, p.10).

 c: Profit statement at 48000 units

Profit statement ( £)
Sales	624000
Less: variable cost
Materials	252000
Labour	141600
Variable overheads	88800
Contribution	141600
Less: Fixed cost
Production	59000
Selling	47600
Profit	35000

Figure 8: Profit Statement

(Source: Created by a researcher)

When 48000 shelves are sold and produced at £ 13 then the company could earn a profit of £ 35000.

d: Strategic evaluation process

The rise in sales Price	14.17
Rise in Units	62010
Particulars	£
Sales	878681.7
Less: variable cost
Materials	325552.5
Labour	182929.5
Variable overheads	114718.5
Contribution	255481.2
Less: Fixed cost
Production	59000
Selling	47600
Marketing and advertising	45000
Profit	103881.2

Figure 9: Profit at sales price and units rise

(Source: Created by the researcher)

Before increasing the fixed cost by incurring the advertisement expenses the company earned a profit of £ 49750. However, here the company increased the fixed cost but due to an increase in units also the profit got increased to £ 103881.20, which is indeed a good rise. Therefore, the strategy of incurring advertisement cost could turn out to be more profitable. Philly limited by taking this strategy could easily raise their profit amount and also could reach more customers by increasing the sales units.

e. Assumptions and popularity of budget model among other firms

The assumption on which the budget model is done is that the sales and the variable cost per unit remains unchanged during the financial period. Expected list of incomes and expenses remains the same and does not change at all during that financial period (Barr and McClellan, 2018, p.25). Expected list for expenses and income helps the companies in understanding the risks and weakness that could come in the coming months. This feature of the budget model makes it appropriate in other companies also. Risk forecasts that could be done by this budget model again make it effective for use in other companies also (Carlson and Hansell, 201, p.65).

Part C: Capital Budgeting

Capital budgeting technique is the guidance that aids the financial managers in deciding which investment will be profitable and which investment will not give any profit of the company (Rossi, 2015, p.43). In this Sankrust limited case study, it has been seen that the company has purchased a machine for   £ 40,000,000 and the scrap or sales value of that machine at the end of five years is £ 5,000,000. Cost of capital in this project is 7% and the cash inflow of the company is £ 17,000,000.

Assumptions

Certain assumptions in the estimation of NPV are as follows:

• The sale value at the end of five years has been taken as scrap value and has been added with the last year cash inflow as scrap value (Al-Mutairi et al. 2018, p.14). In addition to that this sale or scrap value has been deducted from the purchase cost of the machine so that depreciation amount could be deduced easily.
• The annual cash outflow of £ 6,400,000. has been assumed to be the maintenance cost that has been incurred for the last five years with the same amount only
• It has been assumed that the cash inflow that has been given is before the adjustment of depreciation so depreciation is added with cash inflow for getting cash inflow after depreciation (Andor et al. 2015, p.148).

The assumption for ARR is

The scrap value has not been deduced from cash flow for calculating accounting profit

a. Calculation of payback, ARR and NPV

Payback period

Payback
Year	Annual cash flow	Cumulative cash flow
1	17,600,000	17,600,000
2	17,600,000	35,200,000
3	17,600,000	52,800,000
4	17,600,000	70,400,000
5	22,600,000	93,000,000

Table 10: Calculation of Payback Period

(Source: Created by Researcher)

X-2/ 3-2 = 40000000-35200000/52800000-35200000

X-2/1 = 4800000/17600000

X-2= 0.2727

X= 0.2727+2

X= 2.2727 Years

In this project, by investing £ 40000000 the payback could be generated within 2.27 years so as the payback period is shorter so it can be accepted and it would also turn out to be profitable for Sankrust limited. Therefore, it can be recommended that the company could buy the machine.

Accounting Rate of Return (ARR)

Accounting rate of return ( Average Accounting Profit/ Average Investment) *100	9 %
Average Investment	40000000
Average accounting profit
Cash Inflow	17000000
Less: Maintenance cost	6,400,000
Less: Depreciation	7000000
Accounting Profit	3,600,000

Table 11: Calculation of ARR

(Source: Created by Researcher)

According to the project feasibility ranking criteria, the higher ARRs are always accepted and in this case, also it can be said that the ARR is higher (Chittenden and Derregia, 2015, p.225). The rate of 9% is higher so the project acceptance and profitability are higher in this project. Therefore, the company is recommended to buy that machine.

NPV

Cash outflow	40000000
Cash inflow	1	2	3	4	5
Annual cash inflow before depreciation	17000000	17000000	17000000	17000000	17000000
Less Maintenance cost	6,400,000	6,400,000	6,400,000	6,400,000	6,400,000
Add: Depreciation	7000000	7000000	7000000	7000000	7000000
Cash inflow after depreciation	17,600,000	17,600,000	17,600,000	17,600,000	17,600,000
Add: Scrap value					5,000,000
Cash Inflow	17,600,000	17,600,000	17,600,000	17,600,000	22,600,000

Table 12: Cash Inflow estimation

(Source: Created by Researcher)

Year	Cash inflow	Discount factor (7%)	Present value
1	17,600,000	0.935	16456000
2	17,600,000	0.873	15364800
3	17,600,000	0.816	14361600
4	17,600,000	0.763	13428800
5	22,600,000	0.713	16113800
	Total Cash Inflow		75725000
	Less: Cash Outflow		40000000
	NPV		35725000

Table 13: Calculation of NPV

(Source: Created by Researcher)

As opined by Abor (2017, p.293), positive NPV is the key to project acceptance. In this case, also like the amount of NPV is positive so the project acceptance is preferable. Amount of £ 35725000 shows that NPV is higher and the return of that amount could generate if the company invest in that project so the project could be accepted and the machine could be purchased.

b: Analyzing and explaining the limitations and merits of appraisal methods

Investment appraisal is the collection of various techniques that determines the feasibility and profits that could be generated from that project (Sari and Kahraman, 2015, p.635).

ARR

ARR is the rate of return that could be generated by the project if annual profit is divided with initial investment (Leung and Zhu, 2018, p.25). This method is based on the annual profit of the company and does not depend on the cash flow generated by the company. The merits and limitations are as follows:

Merits

• It is easier to calculate as the annual profit of the company is readily available from the income statement of the company
• Due to weight on the profit helps the company in evaluating the project performance based on profitability easily
• It is easier to operate and as the benefits are derived over the life of the project so it can be compared with a payback period

Limitations

• As the method is based on profits so non inclusion of cash flow reduces the efficiency of the method in measuring the reinvestment potential
• Mainly this does not consider the time value of the money so this method is not effective for the better capital budgeting decision-making process

Payback period

It refers to the number of years that the project will take in recovering the initial investment (Gorshkov et al. 2016, p.01). The merits and limitations of this method are as follows:

Merits

• It acts as an indicator of risks that could rise in the project so it helps in better decision making.
• Project liquidity could be measured from this project so when the issue of liquidity shortage arises then the by making the paybacks shorter this gets adjusted.

Limitations

• The cash flows generated beyond the payback are ignored so it gets biased for longer projects (Martyn et al. 2016, p.281).
• Profitability as not considered so it could not determine the total benefits that could arise in the project

NPV

It is seen as the difference between the net cash inflows over the net cash outflows generated from a project (Shu et al. 2016, p.240). The limitations and merits of the project are as follows:

Merits

• It uses the time value of money to the future income stream is considered in this method
• Total benefits accommodated with the cost of capital rate helps in determining the consistency in the financial objectives

Limitations

• The difficulty arises when the required rate of return gets discounted
• The projects having different life spans could not get better results by using NPV

c: Explaining and identifying the limitations and benefits arising when the budget is used for the strategic decision-making process

Budgeting is a plan that intends to figure out the expenditures and revenues that is seen in a project (Elhamma, 2015, p.973). Through the consultation of the external and internal factors, the future earning capability could be maintained by the company through these prices.

Merits and limitations of the budgeting process are as follows:

Merits

• Budgets motivate the company in making a timely study for risks and problems that may arise in the company. This acts as a tool for developing new strategies
• It creates a plan for spending and by controlling the expenditure and income the strategic decision-making process gets smoothened (Pattaro, 2016, p.2).
• The yardstick for performance determination and cost-effectiveness helps the company in achieving the cost reduction and profit maximization goal that serves as the base for strategic decision making

Limitations

• It is just a budgeted figure in reality what are risks and how much profit could be earned is not known (Otley, 2016, p.45).
• Active cooperation and teamwork makes the budgets successful but the absence of that can make the budget a total failure

Conclusion

In the closure statement said that can be said that different types of financial statements and capital budgeting techniques help in detecting the areas where improvement needs to be done. The statements further show the gross loss as well as the net loss that has taken place in the Dexter Plc. This further has reflected that the sales improvement and expenses reduction strategy could be adopted by the company. In the second part of the segment, it has been seen that profit, when advertisement expense is incurred, has increased, which again says that new strategies could improve the profit position of the Philly limited. Various capital budgeting techniques seen in the third segment shows that the project of machine purchase is acceptable and feasible.