Financial Statement Analysis & Forecasting

This assignment focuses on the analysis of financial statements and forecasting future cash flows. It draws upon concepts from corporate finance, investment appraisal, and financial management. Students are expected to demonstrate their understanding by applying relevant theories and techniques to analyze provided financial data and forecast future trends.

MFRD

TABLE OF CONTENTS
Introduction......................................................................................................................................3
Task 1...............................................................................................................................................3
Internal and external sources of finance......................................................................................3
Implications of different financial sources..................................................................................4
Evaluation of suitable source of finance for the business project................................................4
Analysis of cost of different sources of finance..........................................................................5
Importance of financial planning.................................................................................................5
Information requirements of different decision makers..............................................................5
Impact of finance on different financial statements.....................................................................6
Task 2...............................................................................................................................................7
Analysis of budgets in order to make viable decisions for business...........................................7
Explanation of computation of unit cost and making pricing decision using relevant
information...................................................................................................................................8
Assessment of viability of project by making use of investment appraisal techniques...............8
Comparison of suitable format of financial statements for different types of business
organization...............................................................................................................................11
Financial statement of company................................................................................................12
Interpretation of financial statement by making use of ratio analysis ......................................12
Conclusion.....................................................................................................................................14
References......................................................................................................................................15
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INDEX OF TABLES
Table 1: Cash budget (in £'000).......................................................................................................8
Table 2: Calculation of Mark up on cost price (in £'000)................................................................9
Table 3: Calculation of Price by considering return on capital employed (in £'000)......................9
Table 4: Information of available projects.....................................................................................10
Table 5: NPV of project A ............................................................................................................10
Table 6: NPV of project B.............................................................................................................10
Table 7: ARR of option 1...............................................................................................................11
Table 8: Statement showing cumulative inflow of project A........................................................12
Table 9: Statement showing cumulative inflow of Project B........................................................12
Table 10: Computation of financial ratios of Volkswagen Plc......................................................13
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INTRODUCTION
Financial sources are crucial for business entity thus organizations are required to make
optimum utilization of available resources. For this aspect, they are required make suitable
business decisions by making use of appropriable financial tools. Present project report is
focused on evaluation of financial tools that can be used by management of business in order to
make effective financial decisions (Stendardi and O’Reilly, 2006). Present study will include
description of sources of finance along with its impact and financial cost. Further description will
be provided regarding financial techniques such as unit pricing, budgeting, investment appraisal
techniques and ratio analysis in order to make better decisions. For understanding of practical
approach Volkswagen has been considered.
TASK 1
Internal and external sources of finance
Management of Volkswagen is planning for expansion for the launch of new car in the
market. For this aspect, company can generate funds from following sources:
External sources of finance Equity issue: Company can issue part of their authorized capital to generate funds for
their business project. For this financial source company will be required to pay dividend
that is part of the profit to the shareholders (Nickels, McHugh and McHugh, 2011). In
addition to this, shareholders will also have right to participate in decision making of
business. Debt finance: Management of Volkswagen can also take loan from the banking and
financial institutions. For this financial source, they will be required to pay interest
charges in regular time interval (McKinney, 2015). Further, as per their contractual deed
they will be liable for the repayment of principal amount. Bank overdraft- For the fulfilment of capital requirements company can use service of
bank overdraft. In accordance with this financial source company can make payment to
the trade payable in excess to the available balance. For this service, bank will charge
interest rate from the customer.
Internal sources of finance
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 Retained earnings- In order to generate funds for the business project, company can make
use of their previous profits. Retained earning can be defined as accumulated profits
which are not used by the company (Galloway and Deakins, 2012). However, this
financial source is available up to limited extend.
 Sale of assets- Company can also sell their assets which are not providing economic
benefit to them. This financial source will also make reduction in cost of maintenance
and repairs of non-economical machines (Rao, 2003). Instead of sales, company has also
option for the lease of equipment.
Implications of different financial sources
Implication of external source of finance
External financial sources can be availed by the payment of financial cost. These sources
make reduction in profitability of business. It is because; in debt financial source company has to
pay interest which reduces net profit while in equity net profit is distributed which makes
reduction in availability of retained earnings. For debt finance, company has to provide security
of assets and in addition to this their obligations is also increased (Helfert, 2004). In equity
sources, company is not obliged for the capital payment but this sources make alteration in
controlling power of the business. It is because; equity shareholders have right to participate in
decision making of business.
Implication of internal source of finance
Internal financial sources are generally comprises of opportunity cost instead of financial
cost. Further, these source also affect liquidity position of the business as it makes increase in
current obligations. These sources are available up to limited extend thus it can only satisfy short
term requirements of business (Jury, 2012). Use of retained earnings will make reduction in
reserve and surplus due to which risk will be increased in the future contingencies. For bank
overdraft, company will be required to bank charges. It is kind of interest for short term loan
however rate of interest of this source is generally higher than other loans.
Evaluation of suitable source of finance for the business project
In accordance with the description of financial sources, it will be suitable for company to
select equity finance and facility of bank overdraft. Equity financial source is suitable for
company because it does not impose obligation of payment of principal amount. It is because;
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equity shareholders are paid at the time of wind up of company (Nofsinger and Varma, 2005).
Further, financial cost of this source is fluctuated as per the availability of profits with the
business. With the facility of bank overdraft, management of Volkswagen can satisfy their
working capital requirements in proper manner.
Analysis of cost of different sources of finance
Cost of external financial sources
For debt finance company is obliged to make payment of interest in regular time period.
Interest is charged at the fixed percentage depending on the terms and conditions of the loan.
Further, company will also be liable to make repayment of the principal amount for the discharge
of obligation. In equity source, company is required to pay dividend i.e. portion of profit to the
shareholders (Newberry and Pallot, 2005). This financial cost is not fixed in nature as it
fluctuates with the availability of profit. There is not obligation for the repayment of principal
amount. For bank overdraft company will be required to pay bank charges.
Cost of internal financial sources
Retained earnings and sales of assets do not include financial cost. However, for the
utilization of this source, company has to sacrifice the opportunity of best second alternative.
Further, profit expected from second best alternative is considered as opportunity cost of that
option.
Importance of financial planning
Financial planning can be defined as strategies developed by business organization in
order to achieve their aims and objectives in an effective manner. In the success of business,
financial planning plays vital role. By appropriable financial planning, organization can make
use of business resources in an optimum manner in order to enhance their profitability
(Broadbent and Cullen, 2012). Further, they can manage inflow and outflow of cash to maintain
proper liquidity. In addition to this, they can satisfy their working capital requirements in a
proper manner to avail business opportunities.
Information requirements of different decision makers
Information of business is required by various parties in order to make viable decisions
for the business. Description of needs of these parties is enumerated below:
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 Management- Management requires information of business in order to make future
strategies in order to attain aims and objectives in an effective manner. Decision
regarding future operational activities are taken on the basis of past commercial activities. Shareholders- For the decision of reinvestment or divestment, shareholders require
information of business (Dyson, 2003). By considering information of business they
compare desired and actual return and make decision regarding future investment
strategies. Employees- Human resources of the business requires information to assess the potential
opportunities for growth to them. For this aspect, they consider growth, profitability and
future activities of business. Financial institutions- For the assessment of liquidity and solvency of business financial
institutions requires financial statements. By considering this information, they determine
capability of business in repayment of loan.
 Government- Government requires business information in order to assure that tax
obligation is accomplished by management in proper manner (Cox and Fardon, 2003).
Further, by this information they also assess that operational activities are conducted in
an ethical manner.
Impact of finance on different financial statements
Impact of finance on different financial statements is enumerated below:
Income statement
Financial sources attracts financial cost which is recorded to the debit side of the income
statement. Due to this aspect, profitability of business is reduced as expenses side is increased.
Debt finance and bank overdraft attracts interest cost while equity finance attracts cost of
dividend.
Position statement
Both asset and liability side of the position statement is affected by the generation of
funds from the financial sources. It is because, debt increases non current obligations and equity
make increase in shareholders funds (Hopwood, Unerman and Fries, 2010). Further,
simultaneous effect is provided to the cash and cash equivalents.
Cash flow statement
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Cash generated from financial sources is shown in financing activities of cash flow
statement. This aspect makes increase in overall cash inflow of business. Further, cost of finance
is also deducted from this part of the statement.
TASK 2
Analysis of budgets in order to make viable decisions for business
Budget can be defined as forecasted statement prepared for the prediction of future
operational activities (Götze, Northcott and Schuster, 2008). Preparation of budget is done by
considering previous financial facts and market trend. Operational budget of Volkswagen for six
months is as follows:
Table 1: Cash budget (in £'000)
Particulars January February March April May June
Income From Sales 150 250 360 350 310 350
Payment Received From
Debtors
200 225 240 350 225 300
Other income 100 200 150 145 280 250
Total Revenue Received 450 625 750 895 815 880
Paid To The Creditors 40 30 50 60 70 75
Purchases Made In Cash 60 55 85 150 125 150
Operating And Production
Expenditure
110 130 140 200 150 200
Sales And Distribution
Expenditure
40 50 75 175 140 175
Total Expenditure paid 250 265 350 585 485 600
Profit during the period 200 410 400 260 330 300
In accordance with the operational budget of the company it can be said that there are
high fluctuation in profit earning capacity of business. For the stability in profitability figures,
company is recommended to balance their fixed and variable expenses. In addition to this, sales
and distribution strategy of organization is not effective because these expenses are continuously
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increasing but same effect cannot be noticed in the value of sales. Further, this strategy is
required to be modified to earn high profits.
Explanation of computation of unit cost and making pricing decision using relevant information
Unit costing is suitable for the organization engaged in production in uniform units
during the accounting year. By considering unit cost, management of company can make
decision regarding their pricing strategy (Serguieva and Hunter, 2004). Volkswagen can set their
price of the auto mobile product on the basis of following two strategies
Calculation of unit price
Table 2: Calculation of Mark up on cost price (in £'000)
Particulars Price
Direct cost 200
Fixed cost 100
Total cost 300
Units 500
Cost per unit 0.6
33.33 % mark-up on cost price 0.2
Selling price 0.8
Table 3: Calculation of Price by considering return on capital employed (in £'000)
Particulars Price
Direct cost 200
Fixed Cost 200
Total Cost 100
300
500
20 % return on capital employed
(1,00,00,000) £2,000.00
Per unit return 0.4
Selling price 0.64
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In accordance with the both techniques, it can be said that pricing from method of return
capital employed is more beneficial. It is because; it satisfies profitability requirements of
business by providing product at lower price to the customer. Due to this aspect, it is win-win
approach for both customers and the organization.
Assessment of viability of project by making use of investment appraisal techniques
Investment appraisal techniques are used for the evaluation of available investment
proposals in an effective manner (Mason, 2007). These proposals require heavy investments, due
to which companies are required to make proper comparison of risk and return in order to select
viable project for the investment. Volkswagen is having two options for the investment.
Information of these projects is as follows:
Table 4: Information of available projects
Year Project A Project B
Investment £40,000.00 £40,000.00
1 Cash Inflow £18,000.00 £25,000.00
2 Cash Inflow £15,000.00 £25,000.00
3 Cash Inflow £25,000.00 £25,000.00
4 Cash Inflow £18,000.00 £25,000.00
Cost of capital will be 10% 10.00% 10.00%
Evaluation of these projects by the applicability of investment appraisal techniques is as follows:
Net present value
This is the most viable technique for the investment appraisal because it considers all the
factors of proposals such as inflow, outflow, present value of money and profitability. Company
is recommended to make investment in the project with the positive and high NPV (Edward and
de Renzio, 2010). Computation of net present value of both the projects is as follows:
Table 5: NPV of project A
Year Inflow PV Factor
Inflow by considering
PV factor
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1 £18,000.00 0.909 £16,362.00
2 £15,000.00 0.826 £12,390.00
3 £25,000.00 0.751 £18,775.00
4 £18,000.00 0.683 £12,294.00
Total inflow £59,821.00
Less: Initial investment £40,000.00
Net present value £19,821.00
Table 6: NPV of project B
Year Inflow PV Factor
Inflow by considering
PV factor
1 £25,000.00 0.909 £22,725.00
2 £25,000.00 0.826 £20,650.00
3 £25,000.00 0.751 £18,775.00
4 £25,000.00 0.683 £17,075.00
Total inflow £79,225.00
Less: Initial investment £40,000.00
Net present value £39,225.00
Average rate of return
In this method of investment appraisal computation of average profit is done by
considering amount of average investment and inflow (Le Fur, Dallochio, and Salvi, 2011).
Company is recommended to make investment if project is able to provide return in accordance
with their expectations. Computation of ARR of both the projects is as follows:
Table 7: ARR of option 1
Year Inflow of project A Inflow of project B
1 £18,000.00 £25,000.00
2 £15,000.00 £25,000.00
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3 £25,000.00 £25,000.00
4 £18,000.00 £25,000.00
Total inflow £76,000.00 £100,000.00
Average inflow £19,000.00 £25,000.00
average investment £40,000.00 £40,000.00
Average rate of return= (Average inflow/average investment*100)
ARR 47.50% 62.50%
Payback period
In accordance with this method of investment appraisal time period is determined in
which project will return the initial amount invested by the business (Sherman, 2012). A project
is said to be profitable if provides initial investment prior to the completion of the life of the
project. Formula of pay back is as follows:
Payback period = A+ (B/C)
Whereas:
A Completed year of last negative inflow
B Amount of last negative inflow
C Inflow in next year
Table 8: Statement showing cumulative inflow of project A
Year Inflow Cumulative inflow
0 -£40,000.00 -£40,000.00
1 £18,000.00 -£22,000.00
2 £15,000.00 -£7,000.00
3 £25,000.00 £18,000.00
4 £18,000.00 £36,000.00
=2+ (7000/25000)
=2.28 years
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Table 9: Statement showing cumulative inflow of Project B
Year Inflow Cumulative inflow
0 -£40,000.00 -£40,000.00
1 £25,000.00 -£15,000.00
2 £25,000.00 £10,000.00
3 £25,000.00 £35,000.00
4 £25,000.00 £60,000.00
=1+ (15000/25000)
=1.6 years
In accordance with the above evaluation it can be said that Project B is more beneficial in
comparison to Project A. It is because; it is providing high NPV and ARR. Along with this, it is
also providing early recovery of initial investment.
Comparison of suitable format of financial statements for different types of business organization
Description of financial statements prepared by different types of business organizations is
enumerated below: Sole proprietorship- Organization operating in this structure do not required to comply
accounting norms for the preparation of financial statements. Generally, these entities
prefer single entry system for accounting (Mason, 2007). Partnership- These business entities records transactions of partners along with the
operations of business. Due to this aspect, they prepare profit and loss appropriation
account and partners capital account.
 Company- These organizations are required to prepare financial statement in accordance
with the provisions of IFRS and IASB (Cox and Fardon, 2003). They are required to
prepare all major financial statements i.e. income statement, position statement and cash
flow statement.
Financial statement of company
Income statement
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This statement is prepared to determine profit or loss earned by business during the
accounting year. It is prepared on the basis of accrual concept. Computation of profit and loss is
done by deducting expenses from the earned revenue (Format of a Financial Statement, 2013).
Position statement
This statement shows assets, liabilities and equity of the business on particular
accounting done. It is prepared on the principle of accounting equation i.e. all assets are equal to
the amount of liabilities and capital (Dyson, 2003).
Cash flow statement
This statement shows inflow and outflow of cash during the accounting year. For better
presentation information is recorded in three parts i.e. operating activities, investing activities
and financing activities.
Interpretation of financial statement by making use of ratio analysis
Table 10: Computation of financial ratios of Volkswagen Plc
Ratios Formula 2014 2013 2012
Activity Ratios
Net Sales 202458 197007 192676
Total Assets 351208 324333 309518
Total Assets Turnover Ratio Net Sales/ Total Assets 0.58 0.61 0.62
Cost of goods sold 165934 161407 157518
Inventory 31466 28653 28674
Inventory Turnover ratio COGS/Inventory 5.27 5.63 5.49
Liquidity ratios
Current Assets 131102 122192 113061
Current Liabilities 130706 118625 105526
Closing Stock 31466 28653 28674
Current Ratio
Current Assets / current
Liabilities 1.00 1.03 1.07
Quick Ratio
(Cu. Assets - Cl.
Stock)/Cu. Liabilities 0.76 0.79 0.80
Solvency ratios
Debt 76608 68349 70675
Equity 90189 90037 81995
Debt Equity Ratio Debt/ Equity 0.85 0.76 0.86
Net income 11068 9145 21881
Annual Interest Expense 84 52 169
Times Interest Ratio
Net Income/ Interest
expense 131.76 175.87 129.47
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Profitability ratios
Gross profit 36524 35600 35154
Operating profit 12697 11671 11948
Net profit 11068 9145 21881
Net Sales 202458 197007 192676
Gross Profit Ratio
(Gross Profit/ Net Sales)
*100 18.04% 18.07% 18.25%
Operating Profit Ratio
(Operating Profit/ Net
Sales) *100 6.27% 5.92% 6.20%
Net Profit Ratio
(Net Profit/ Net Sales)
*100 5.47% 4.64% 11.36%
 Efficiency ratios- Activity ratios of the company shows fluctuating trend. This aspect
shows that company is not able to make effective utilization of available resources.
Company is required to make improvement in production process for increase in
efficiency. Liquidity ratios – Liquidity ratio of the company shows efficiency of business in payment
of current obligation. Current ratio of company is less than ideal while quick ratio is near
to the ideal (Jury, 2012). Company should attempt to enhance their current assets to attain
better liquidity position. Gearing ratios – Gearing ratio of the company shows that proportion of debt and equity
in business is not optimum. It is because, equity is comparatively high due to which
entire profit is distributed to the shareholders (Annual report of Volkswagen, 2014).
Company is recommended to generate funds from the debt finance in order to make
reduction in their cost of capital.
 Profitability ratios- In accordance with the profitability ratios of Volkswagen plc, it can
be noticed that there is fluctuating trend. This aspect shows there is risk in investment for
the shareholders of company.
CONCLUSION
In accordance with the present study, it can be concluded that management of companies
are required to make decisions after making proper evaluation of the financial information. In
this manner, they will be able to make reduction in their risk and can enhance profitability
thereto. For the evaluation of financial performance of business, ratio analysis can be used. By
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considering the interpretation of these ratios, management can make modification in their
business strategies to achieve their aims and objectives in an effective manner.
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REFERENCES
Books and journals
Broadbent, M. and Cullen, J., 2012. Managing financial resources. Routledge.
Cox, D. and Fardon, M., 2003. Management of Finance. Osborne Books.
Dyson, J. R., 2003. Accounting for Non-Accounting Learners. Pitman.
Galloway, L. and Deakins, D., 2012. Evolution, financial management and learning in the small
firm. Journal of Small Business and Enterprise Development. 9(1). pp.7 – 16.
Götze, U., Northcott, D. and Schuster, P., 2008. Investment appraisal. Methods and Models,
Berlin, Heidelberg.
Helfert, A. E., 2004. Techniques of Financial Analysis. Tata McGraw-Hill Education.
Hopwood, A. G., Unerman, J. and Fries, J., 2010. Accounting for sustainability: Practical
insights. Earthscan.
Jury, T., 2012. Cash Flow Analysis and Forecasting. John Wiley & Sons.
Le Fur, Y., Dallochio, M. and Salvi, A. , 2011. Corporate finance: theory and practice. John
Wiley & Sons.
Mason, C. M., 2007. Informal sources of venture finance. In The life cycle of entrepreneurial
ventures. Springer US.
McKinney, J. B., 2015. Effective financial management in public and nonprofit agencies. ABC-
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Online
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