Financial Statements, Budget Analysis and Capital Budgeting

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

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.

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