Financial statement analysis

Business Decision Making for the Hospitality Industry

Question 1
The statement of the profit and loss account is one significant financial statement for a
specific period of time that provides a summary of all the revenues, expenses and the costs.
The said financial statement of any entity highlights the ability of the entity in the generation
of the revenues and profits out of the core business operations. The yet another financial
statement that is of utmost importance is the statement of financial position. The statement of
the financial position of the entity presents the financial position of the entity at a given point
of time. Thus the varied risks such as the liquidity risk, credit risk, financial risk and overall
business risk can be analysed from the study of the above mentioned financial statements
(Delen, Kuzey and Uyar, 2013). There are various ratios that are calculated and used for the
analysis of the financial statements. Some of the ratios and their significance is stated as
follows.
a) Gross, operating and earnings margins: The analysis of the gross, operating and the
earning margins fall in the category of the profitability ratios. The aim behind the
computation and analysis of the above ratios is to determine the ability of the entity to
generate the earnings at different levels. The above stated margins are calculated against
the revenues and expressed in the percentage form to determine the percentages, the
profits form out of the total profits (Fridson and Alvarez, 2011). While the gross profit
margin highlights the efficiency of the core business operations, the operating margin
highlights the profits with the inclusion of the operating expenses. The net profit margin
is further calculated to review the impact of the indirect expenses of the entity, such as the
administrative and the marketing expenses. The comparison of the stated ratios is
conducted in relation to the industry benchmarks as well as the past year performances to
study the impact of the expenses on the earnings of an organisation.
b) Return on capital employed and return to equity: The operational efficiency of the
company is analysed through the computation of the above mentioned ratio, and thus the
future potential of growth is reviewed. The return on capital employed is calculated to
analyse the efficiency of the company in the generation of the earning against the amount
invested in the form of capital (Edmonds, 2013). Thus, the shareholders equity as well as
the long term liabilities are considered to gauge the efficiency of the company. In contrast
to this, the return on equity is focussed only on the money invested by the shareholders of
the company.

c) Acid Test: The acid test ratio or the quick ratio is the expression of the analysis of the
short term liquidity position of an organisation. The liquidity position must be
significantly analysed by the management as well as the stakeholders to get the useful
insights about the working capital or the management of the day to day business
operations. A sound liquidity situation of an enterprise highlights the positive fact that the
organisation is comprised of sufficient short-term assets such as the cash to cover the
payment of the current liabilities in the form of creditors and other short-term obligations.
The quick ratio is devoid of the inventories, which are further complex to liquidate as
compared to cash and the other short term investments that are readily convertible into
cash (Williams and Dobelman, 2017). Thus, the ratio aids in the presentation of a reliable
picture of the cash position of the company.
d) Financial gearing and interest cover: These ratios are the part of the analysis of the
capital structure and the involvement of the risk therein. These ratios are of the utmost
interest of the prime stakeholder groups of the investors and the regulators that are
concerned of the financial risk involved before the extension of the financial assistance
and determination of the vitality of the business operations and the type of financing
(Robinson, et. al, 2015). The financial gearing ratio or the debt to equity ratio highlights
the levels of the outside borrowings in the financial structure of the company. The interest
cover ratio is indicative of the levels of the profits available for the servicing of the cost
of the debts of the entity. Thus, both these ratios highlight the various aspects of debt
financing within the entity.
Question 2
The holding cost refers to the cost incurred by an entity for the storage of the inventory that
remains unsold with the entity. Thus, the holding costs of the inventory together with the
shortage costs and the ordering costs form the total inventory costs. The holding costs of the
inventory is inclusive of the components like price of the spoiled or the damaged goods, rent
cost for the storage space, cost of the insurance, taxation, transportation, depreciation and the
labour charges. Thus, all the business expenses that are related and are necessary for the
carrying of the inventory are included here.
The Economic order quantity (EOQ) represents an ideal order quantity that should be
purchased by a company in order to minimize inventory costs that is further comprised of
shortage costs, holding costs, and order costs. The economic order quantity can be
determined by the use of the following formula.

EOQ = √ 2 DS
H ,
Where
S=Order cost (per purchase order)
D=Demand in units (generally in annual terms)
H=Holding costs (per unit, per year)
The EOQ for the given data is computed as follows.
Annual
Demand = 40000 units
Order cost = € 178 per order
Holding costs = € 1.25
EOQ = SQRT((2*40000*178)/1.25)
EOQ = 3375.203698
Thus, the optimal number of the products to be ordered as per the given data has been
determined as computed above, using the stated formula.
Question 3
There are various methods of the investment or the project appraisal to assess whether it is
worth or not to invest in a project. Thus, the various methods prescribe various methods to
review the cash inflows and outflows, and the overall utility of the project is adjudged.
Net Present Value (NPV)
The Net Present Value method is regarded as the most useful technique of the project
appraisal and is regarded as advantageous over the other techniques of the project evaluation,
because of its consideration of the time value of money (Baker and English, 2011). In light of
the business environment of an entity a suitable cost of capital rate is determined, and an
estimation is made of the cash flows over the project life. These cash flows are then
discounted to arrive at the Net Present Value. The formula for the Net Present Value formula
is expressed below:
NPV=∑
i=1
n CFi
(1+ d)i

= CF0 + CF 1
(1+k )1 + CF 2
(1+k )2 + …. + CF 3
(1+k )3
where:
CFi = net cash flow from year i,
CF0 = initial investment,
k = discount rate, and
n = number of years.
When a single project is in consideration, the positive NPV would lead to acceptance of the
project and the negative NPV would lead to the rejection of the project (Gray, Larson and
Desai, 2011). Additionaly to state the mutually exclusive projects can be analysed and
compared and the project that has the highest NPV is accepted by the organisation subject to
other factors (Brigham and Houston, 2012). The NPV for the data in the case study is
computed as follows.
Amount in
€
Initial cash
flows
Initial outlay 260000.00
Total 260000.00
Years 1 2 3 4 5
Annual cash
flows 55500.00 65780.00 75900.00 88630.00 95450.00
Net present
value PVF@8.00
%Year
0 -260000.00 1.00 -260000.00
1 55500.00 0.93 51388.89
2 65780.00 0.86 56395.75
3 75900.00 0.79 60251.87
4 88630.00 0.74 65145.70
5 95450.00 0.68 64961.67
NPV 38143.87
Since the NPV of the project is positive, the project can be accepted by the entity.

Payback period
The computation of the Payback period is one of the basic and the fundmental project
evaluation tool apart from the NPV. The tool is descriptive of the time in which the annual
cash flows would be equal to the initial invested amount, and thus recover the same. Th cash
flows after tax are used for the evaluation of the project proposal. The formual is expressed
below.
Pay back period = Cost of the project/ Annual cash inflows
In context of the evaluation of the various projects and for a single selection available, the
project whose payback period is the lowest among all is accepted (Prakken, 2012). The
lowest payback period highlights the fact that the initial cost of the projects would be
recovered at earliest.
The payback period calculation for the project with the given data is stated as follows.
PAYBACK PERIOD
Project Qatar
Year
Particula
rs
Cash
Flows
Cumulative Cash
flows
0
Purchase
Cost -260000.00 -260000.00
1
Annual
cash
flows 55500.00 -204500.00
2 65780.00 -138720.00
3 75900.00 -62820.00
4 88630.00 25810.00
5 95450.00 121260.00
Payback
period 3.71
Thus, the project initial cost would be recovered in 3.71 years approximately. The decision
on the basis of the payback period would depend on the benchmark set by a company and the
other objectives.
Internal Rate of Return
The Internal Rate of Return also known as the IRR method or Discounted Cash Flow Return
is also used for the examination of the project proposal. The technique is also known as the

Economic Rate of Return. The rate computed by the said technique represents the interest
earned in the context of a proposal, on different point of times during its life (Gὂtze,
Northcott and Schuster, 2015). A trial and error method is put in use to estimate the said rate.
The formula for the IRR is expressed below.
IRR= 𝑑l + NPV at Dl
NPV at Dl−NPV at Dh❑
× difference∈discount rates,
Where dl = lower discount rate anddh = higher discount rate.
In Excel, the IRR is computed using the formula IRR, accordingly the IRR for the given data
is computed to be 5 %.
Apart from the quantitative data, there is various qualitative data that is also considered for
the evaluation of the project. Some of the other non-financial factors to be considered for the
evaluation of the projects are elaborated as follows. These qualitative factors belong to the
areas of political and social environment, Technology, Legal factors and the Environmental
factors. It is essential to consider these factors too. In context of the business scenario of
today, the events like US China Trade tensions and the Brexit are of the prime interest in
terms of the political factors. These factors have the potential to vitally impact the cash flows
of the projects, financial sector volatility and the fluctuations in the exchange rates. In
addition the external factors in the form of the control of the regional governments, extent of
the foreign direct investments and the legal compliances to be adhered by a company. The
economic factors are also inclusive of the taxation rates (Moran, 2015). The environmental
and the social factors refer to the demand of products, lifestyle, the levels of income and
consumer preferences. Thus, the conduct of the external analysis is vital for the selection of a
project apart from the qualitative data regarding the levels and the kinds of the cash flows.
Question 4
The break event point calculation highlights that level of production within an organisation
where the total cost of producing the goods or providing the services which means the total
fixed and variable cost is equivalent to the total revenues. Thus, it is a no profit no loss
situation. The significance of the calculation lies in the fact that it aids in the determination of
the number of units to be sold and the margin of safety. Thus, the calculation aids in the
preparation of the various budgets and setting the targets, optimum pricing strategy, apart

from the monitoring and cost control. There are various advantages associated with the
breakeven point and the same are expressed below:
1) Breakeven point aids in the gauging the efficiency by the determination of
the profit and losses at different levels of sales and production within an
entity.
2) It is useful for the management to study the relationship between fixed and
variable costs.
Margin of safety is descriptive of the difference between the actual sales of an enterprise and
the break-even sales, and thus the measure of the downside risk is assessed. The level of
margin of safety highlights the fact to which level, the sales of an entity can be reduced such
that the company or a project does remains profitable. The breakeven point and the margin of
safety for the given data is computed as follows.
Computation of BEP in units
Description (Amount in €) (Amount in €)
Revenue (a) 1680000
Less: Variable costs (b):
Description Amount
Material 700000
Labour 280000 980000
Contribution (a) - (b) 700000
Contribution per unit 5
Contribution percentage 42%
Fixed overheads 250000
Breakeven point = (250000/5)
Breakeven number of units 50000
Margin of safety = (140000-50000)/140000
Margin of safety = 64%
Question 5
The role of the budgeting is empirical in the management and the financial accounting. The
budgets are prepared by each and every organisation, no matter the size of the operations and
the type of the industry or the levels of the disintegration. The usefulness of the budget
preparation is often linked to the performance evaluation and the analysis of the variances

among the planned and the actual performances of an enterprise over a period (Hilton and
Platt, 2013). The usefulness of the budget can be categorised in the following four heads,
namely the tool for motivation, financial control, risk assessment, coordination and the cost
control.
Following is the description of the role of the budget preparation exercise and the tool for the
performance evaluation in an enterprise. As a financial year or a financial period commences,
the top management engages in the formulation of the budgets and the base is the past
performances and the aims of the future such as expansion and others (Hilton & Platt, 2013).
The comparison is conducted of the actual performances with the budgeted performances to
review the variances and the areas of concern that are not performing up to the mark. The
inefficiencies are thereby highlighted and the corrective measures devised to address such
variances. Thus, the controlling objectives of an entity are fulfilled. In addition, the
management is able to make efficient decisions in context of the performances of various
units (Isaac, Lawal and Okoli, 2015). The preparation of the budget is also linked to the
improvement of the motivation of the employees of an organisation because the bottom up
approach is often used in the preparation of the budgets and thus the employees feel
committed towards the attainment of the professional goals apart from providing the
necessary information for the preparation of the budget to the senior management. The scare
resources are efficiently allocated in various departments. Thus, the central unit of an
enterprise is able to exercise the central control on the activities of the branches and the
benchmarks are set for the review of the performances. The budget for the given data is
provided as follows.
Calculation for 27000 units
Calculation of the variable
costs Amount
Total production cost 20000
Total rate 10000
Total variable cost 2
Hence, total fixed cost is 15000
As (10000*1.5)= (20000*0.75)
Budget
Particulars Units Rate Total
Sales revenue 27000 32.5 € 8,77,500.00
Direct Materials 5 € 1,35,000.00
Direct labour 3 € 81,000.00

Production overhead 2 € 54,000.00
Fixed costs 0.56 € 15,000.00
Administration overhead 2.96 € 80,000.00
Profit
18.9814
8 € 5,12,500.00
Adjustement of the fixed costs in given data first
Budget
Particulars Units Rate Total
Sales revenue 10000 32.5 € 3,25,000.00
Direct Materials 5 € 50,000.00
Direct labour 3 € 30,000.00
Production overhead 2 € 35,000.00
Fixed overhead 1.5 € 15,000.00
Administration overhead 8 € 80,000.00
Profit 11.5 € 1,15,000.00
Budget
Particulars Units Rate Total
Sales revenue 20000 32.5 € 6,50,000.00
Direct Materials 5 € 1,00,000.00
Direct labour 3 € 60,000.00
Production overhead 2 € 40,000.00
Fixed overhead 0.75 € 15,000.00
Administration overhead 4 € 80,000.00
Profit
€
17.75 € 3,55,000.00

References
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