"A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations". Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. (ANSWER.COM, 2010)
Two types of liquidity ratio mostly use these are blow:
"An indication of a company's ability to meet short-term debt; the higher the ratio, the more liquid the company is" Current ratio is equal to current assets divided by current liabilities. (INVESTERWORDS, 2010)
Short-term creditors prefer a high current ratio since it reduces their risk. While on the other hand, share holders may prefer a lower current ratio so that more of the firm's assets working to grow the business.
An indicator of a company's short-term liquidity. The quick ratioÂ measuresÂ a company'sÂ ability to meetÂ its short-term obligations withÂ its most liquid assets. The higher the quick ratio,Â theÂ better the position of theÂ company. (INVESTERWORDS, 2010)
The quick ratioÂ is calculated as:
Also known as the "acid-test ratio" or the "quick assetsÂ ratio.
Markfield's liquidity ratio is reasonable in 2007 but slightly down in 2008. This reduction may be due to the overdraft facility obtained by the company i.e. decreasing current assets while increasing current liabilities. Asset usage
Working capital ratio (Closing inventory holding period):
"This ratio calculates the average time that inventory is held given by the Closing inventory holding period is also referred to as Days Inventory, Inventory Holding Period and Average inventory period". (CALGARY, alberta, 2010)
It is calculated as:
Closing Inventory holding Period = (inventory x 365 days) / cost of sales.
Inventory period has decreased from 46 days to 26 days indicating more efficient stock holding. This is due to short lead times when ordering bought-in products. Company is able to save some expenses they have to incur on stock holding. For example, storage cost, supervision cost etc.
Trade receivables' collection period:
This is measure of the efficiency of a firm's credit policy and collection efforts. It is calculated as:
(Trade receivable / Credit sales revenue) x 365 days
"An increasing accounts receivable collection period is usually a bad sign as it suggests lack of credit control" (ADMIN, 2009). The trade receivable collection period looks same as compare to last year. The company needs to improve its collection period to be with sufficient cash balance for their own payments.
Trade payables' payment period:
The trade payables' payment period suggests the relationship between the use of trade credit from the creditors / suppliers and the cash flow.
(Trade payable / Credit purchases) x 365 days
The average payment period represents the number of days by the firm to pay its creditors. The creditor's days has decrease from 55 days to 45 days reflecting prompt payments to suppliers but which has increased the current ratio. Markfield plc is able to pay their creditors early as compare to last year.
An incorporated organization which exists for educational or charitable reasons, and from which its shareholders or trustees do not benefit financially by (investorwords.com)". They can be judged by its efficiency of providing services, such as, educational facilities, libraries, etc. So, there will be no question of profitability or investors ratios.
"Profitability Ratios show how successful a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is liquid and efficient it should also be Profitable." (CREDITGURU.COM, 2009)
The key profitability ratio:
Gross profit margin
Net profit ratio
Return on capital employed
Gross Profit margin:
Gross profit in relation to sales revenue. The company's gross profit margin has slightly decreased to 14% as compared to last year's figure of 17%. This could have been a result of sales team failed to assess the market or they have to reduce sales price because of competition. On the other hand company's cost of sales is much higher due to buying-in completed products for reselling.
It's also beneficial for a company to increase sales revenue from advertising campaign although bearing a burden in respect of advertising expenses.
Net profit margin:
This margin indicates profitability after all cost have been include. It is net profit as percentage of sales revenue. Net profit margin has also decreased to 5%. This reduction is mainly attributed to increased cost of sales, increase advertising campaign. Although to some extent these reduction in profits are countered by the profit on disposal of plant.
On the basis of current year performance, reduced gross and net profit margins tend to flatter the company's real underlying performance.
Return on capital employed:
"The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the investments the shareholders have made in their (companybized.co.uk)". In ROCE shareholders' investment is represented by total assets minus current liabilities.
With regard to Markfield Ltd., the ROCE has increased as compared to last year. This increase may be attributed to an increase in profit before tax because of disposal of fixes asset.
The reason for the improved profitability is due to increased efficiency in the use of company's assets, increasing from 4 to 5.9 times. Net assets show how efficiently company is able to generate income from its assets.
"Asset utilization ratios provide measures of management effectiveness. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. An example is the total asset turnover (TAT) ratio." (FINCH, Howard, 2010)
Asset turnover Ratio:
According to the beginnersinvest.about.com "asset turnover ratio calculates the total sales [revenue] for every dollar of assets a company owns". (KENNON, Joshua, 2010)
To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied.
In Mark field's case the ratio has increased as compared to the previous year which indicates that there is an efficient use of assets and the company is getting high sales revenue from each £1 of assets. Increase in ratio is also attributed the disposal of surplus plant.
A budget is a quantitative expression of a plan of action prepared in advance of the period to which it relates. Budget set out the cost and revenues that are expected to be incurred or earned in future periods. (ACCA, 2009)
Purpose of budgeting:
The main of budgeting is following.
Planning for the future
Planning for the future:
in line with the objective of the organization.
Comparing the actual and investigating results together.
Co-ordination of the different activities of the business by ensuring that manager are working toward same goal.
A target set by the organization for an individual person.
Budgets can motivate manager to encouraging them to achieve the target. Manger can provide some motivation toward their achievement.
Types of budget:
There are following types of budgeting.
Activity based budget
Zero based budget
Activity based budget:
"The allocation of resources to individual activities. Activity based budgeting involves determining which activities incur costs within an organization, establishing the relationships between them, and then deciding how much of the total budget should be allocated to each activity" (BNET.COM, 2010)
Activity based budgeting stands in contrast to traditional, cost-based budgeting practices in which a prior period's budget is simply adjusted to account for inflation or revenue growth. As such, ABB provides opportunities to align activities with objectives streamline costs and improve business practices.
Following are the advantage of the ABB costing.
Easier to understand
Consider changes in activity volume (e.g. phone calls, invoices)
Compares what you did spend with what you should have spent for given volume.
Following are the disadvantage.
Usually requires buying Activity Based Budgeting software
Requires training of all managers including budgeting department
Requires people to really understand what drives their budget
Eliminates excuse that activity volume changed because it makes visible volume changes
Requires everyone to collect or estimate activity volume
Zero based budget:
Definition ZBB " A method of budgeting that requires each cost element to specifically justifies as through the activities to which the budget relates were being undertaking for the first time .with approval the budget allowance zero". (CAT, 2009)
ZBB requires the budget for every part of the organization to be built up from 'scratch' or in more usual requires 'from base'.
ZBB has some important benefit as following
It helps to create an organizational environment, where change is accepted.
It helps to management to focus on company objective
It can assist motivation of management at level
It establishes minimum requirements from department
It can be peace male ,for example department to department
Following the disadvantage of the ZBB.
It take more management time than conventional system.
It is difficult to rank competing project present by different manger for their particular area of responsibility.
It may be difficult to developed decision packages for non production department.
Definition "a flexible budget is one which ,by recognizing cost behavior patterns, is designed
To change as volume of activity change" (CAT, 2009).
Assisting managers to make changes as the activity level changes
Allows more meaning full comparisons as it flexes to the actual volume
Inaccurate budget adjustments
Lack of motivation to influence seemingly uncontrollable events that the budget adjusts for.
There could be an element of bias where several factors affect operations
Definition "a fixed budget is one produce for a single level of activity". (CAT, 2009)
The comparison of actual with fixed budget eliminates volume variances.
More accurate figures are possible with up to date level of activity.
Fixed budgets are more expansive.
In many businesses most costs are fixed over the budget period, for example service industry.
Definition "a rolling budget is a budget continuously up date by adding a future accounting period , when the earliest accounting period has expired". (CAT, 2009)
Budget are more realistic and achievable .
The budget process is spread over the year.
Variance feedback is more meaningful.
It reduces the rigidity of the budget system.
It might help to increase management commitment to the budget.
It is difficult to plan ahead accurate once a year.
Manager will faced with a great work load.
Extra cost and time incurred.
This is a budget prepared using a previous period's budget or actual performance as a basis with incremental amounts added for the new budget period The allocation of resources is based upon allocations from the previous period. This approach is not recommended as it fails to take into account changing circumstances Moreover it encourages "spending up to the budget" to ensure a reasonable allocation in the next period. It leads to a "spend it or lose" mentality. (JIM, geoff, 2010)
Advantages of incremental budgeting:
â€¢ The budget is stable and change is gradual.
â€¢ Managers can operate their departments on a consistent basis.
â€¢ The system is relatively simple to operate and easy to understand.
â€¢ Conflicts should be avoided if departments can be seen to be treated similarly.
â€¢ Co-ordination between budgets is easier to achieve.
â€¢ The impact of change can be seen quickly.
Disadvantages of incremental budgeting:
â€¢ Assumes activities and methods of working will continue in the same way.
â€¢ No incentive for developing new ideas.
â€¢ No incentives to reduce costs.
â€¢ Encourages spending up to the budget so that the budget is maintained next year.
â€¢ The budget may become out of date and no longer relate to the level of activity or type of work being carried out.
â€¢ The priority for resources may have changed since the budgets were set originally.
There may be budgetary slack built into the budget, which is never reviewed-managers might have overestimated their requirements in the past in order to obtain a budget which is easier to work to, and which will allow them to achieve favorable results.
Which budget is better?
The large expenditure areas result in the greatest savings if personnel accounts for 75% of expenditures a 10% cut in this area will result in 75% of savings. Consider cutting or privatizing entire programs rather than hurting all programs. Look for poorly performing or expensive programs cutting cost effective programs is inefficient.
Always underestimate revenues, maintain a slight surplus for emergencies and shortfalls. Develop a miscellaneous account so that, new programs, not thought of during the planning process, can be added while maintaining agency compliance with the Cash Basic Law.
Activity based budgeting is more suitable than rolling budget, because activity based budgeting is based on an activity framework and utilizing cost driver data in the budget setting and variance feedback processes.
A variance is the difference between an actual cost and budget, expected cost.
"The difference between planned, budgeted or stander cost for the activity achieved and the actual cost incurred". (CAT, 2010) The total difference between stander and actual cost is sub analyzed into a number of different types of variance.
Following types of variance.
The difference between actual selling price per unit and the stander selling price per unit multiplied by the actual quantity sold.
Variance indicates that the actual results are better or worse than the stander. In the Markfield Ltd the sale is favorable because the performance is better than stander. It means Markfield Ltd sale is better and going towards good possession.
The difference between the stander price and the actual price for the actual quantity of martial purchased.
In Markfield Ltd the material is adverse because the actual cost is exceed than stander cost. The ingredients usage variance is found to be due to waste caused by poor quality purchased; this has been a false economy. If the quality of ingredients is poor it may affect the sales as well.
The difference between stander labor cost and the actual labor cost incurred for the production achieved.
Markfield Ltd the labor and energy cost shows a favorable variance so the change method of working has made a difference, providing these are completely variable costs. The actual cost incurred was less than the budgeted.
The difference between budgeted and actual volume of production valued at the stander overhead absorption rate per unit.
In Mark field Ltd The actual fixed overhead were greater than the budget. The detailed expenses should be consulted to identify any reason for cost differences, to judge whether the costs are controllable and what action is needed, or whether the budget should be revised.
Internal rate of return:
Is defined as the discount rate at which an investment has a zero net present value.
The internal rate of return equates to the interest rate, expressed as a percentage, which would yield the same return if the funds had been invested over the same period of time.
Therefore, if the internal rate of return for the project is less than the current bank interest rate it would be more profitable to put the money in the bank than execute the project
ADVANTAGES AND DISADVANTAGES OF IRR AND NPV:
A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.
The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.
Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.
WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS:
When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used.
The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen.
The internal rate of return (IRR) is a popular method in capital budgeting. The IRR is a discount rate that makes the present value of estimated cash flows equal to the initial investment. However, when using the IRR, you should make sure that the calculated IRR is not very different from a realistic reinvestment rate.