Financial Analysis and Ratio Evaluation

A financial analysis of two companies, Southwood Electricals and Westbrook Engineering, is provided. The analysis includes an examination of their profits and losses at various levels, as well as the effects of fluctuations in break-even point (BEP). The financial performance of both companies is evaluated using various accounting ratios, including liquidity ratios, activity ratios, and profitability ratios. The results indicate that Southwood Electricals needs to focus on improving its liquidity position, while Westbrook Engineering has an excellent activity level but may require improvement in profitability. Overall, the analysis highlights the importance of financial management in ensuring investment decisions are taken appropriately.

MFRD

TABLE OF CONTENTS
Introduction......................................................................................................................................1
Task 1 Finance as a resource...........................................................................................................1
Sources of Finance.......................................................................................................................1
Implications of each source.........................................................................................................3
Case Studies.................................................................................................................................4
Task 2 Understand the implications of finance as a source.............................................................5
Financial planning.......................................................................................................................5
Financial decision making...........................................................................................................5
Sample of Financial Statements...................................................................................................6
Task 3 Making Financial Decisions................................................................................................8
Analysing the sales budget and cash forecast..............................................................................8
Investment appraisal methods....................................................................................................10
Costing and pricing review........................................................................................................13
Impact on the profits..................................................................................................................16
Task 4 analysing the financial performance..................................................................................17
Accounting terminology............................................................................................................17
Evaluation of Ratios..................................................................................................................18
Conclusion.....................................................................................................................................19
References......................................................................................................................................20

LIST OF FIGURES
Figure 1: Source of Finance.............................................................................................................1
Figure 2 Positive and Negative implications of Internal Sources....................................................3
Figure 3: Positive and Negative implications of External Sources.................................................4

List of tables
Table 1 Format of Income Statement..............................................................................................7
Table 2: Format of Balance Sheet...................................................................................................7
Table 3 Sales Budget.......................................................................................................................8
Table 4: Cash Flow Forecasts..........................................................................................................9
Table 5: Calculation of ARR.........................................................................................................10
Table 6: Calculation of IRR...........................................................................................................12
Table 7 NPV calculation for project A..........................................................................................12
Table 8: NPV calculation for project B.........................................................................................13
Table 9: Impact on Break Even Point............................................................................................14
Table 10: Profit and Loss at various levels....................................................................................16
Table 11¨ Effects of fluctuations in BEP.......................................................................................16

Introduction
Managing financial resources is a difficult task as it needs effective financial planning. It
is important to do planning at every step in order to attain productive results for the business. The
purpose of this report is to evaluate how the financial is being managed within business. It will
identify the appropriate sources of finance for a business. It will also show the use of monetary
information for different stakeholders. At last the report will end in analysing the company
statements and the ratios
Task 1 Finance as a resource
Sources of Finance
Figure 1: Source of Finance
(Source: Bhowmik and Saha 2013)
Any new business whether big or small in size can avail money from two sources which
are as follows:
1

Internal Sources
 Retained profits – It is the amount of money derived after the payment of divided to the
shareholders and after the withdrawing of capital from the partners. It is also regarded as
the ploughing back of profits (Kitchen and Confetto, 2010)
 Friends & Family – Money can also be arranged from easily available options such as
from friends, family and close ones.
External Sources:
 Bank Loan – These days’ loans are available for the business from several financial
institutions. Loan are provided with the range from 1 to 25 years. It is the most
commonly available option for the entrepreneurs (Ball, Jayaraman and Shivakumar,
2012)
 Bank overdraft - All businesses are required to keep their personal accounts through
which transactions are performed. All the deposits and withdrawals are performed from
the side of the bank. The overdraft are issued to fulfil the differences between the
proceeds and its costs.
 Business angels – These people offers capital for the start-up generally in exchange for
convertible debt or ownership equity (Bonaci, Matiş and Strouhal, 2008).
 Trade credit – It is a kind of short term money which is given to the borrower in order to
pay for the goods which are received. It offers flexibility at the initial stages of the
business.
2

Implications of each source
Figure 2 Positive and Negative implications of Internal Sources
There are positive and negative implications associated with the identified sources of
finance above:
Trade credit - This source of finance is offered within a bounded time limit. The cycle for trade
credit runs for a period of 28 days (Goldman and Carrier, 2010). Company is required to return
back the credit within the stated time period. The credit is also obtained on the basis of a good
image and reputation.
Bank overdraft – Very high interest charges are associated with the bank overdraft. There is
option to exceed the prescribed limit of overdraft in case if more finance is required. Here the
power and control to operate the account remains with the bank (Joseph, 2013)
Bank Loans – Every bank has its own rate of interests. The business will required to fulfil all the
legal formalities and paper work in order to derive the loan. In case if the borrower proves to be
faulty in payments then bank has the right to cease his business operations and to declare
bankruptcy.
Retained profits – For this option to become successful, it is needed that business should earn
high amount of profits in the early stages of functioning. However there are no issues related
with ownership and control (Keller, 2013).
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Advantages
Economical
Flexibility
Low rate of risk
Serve long term purposes
Disadvantages
Fixed burden
Charge on assets
Diificulty of raising
finance
Factor of
Uncertainty

Business Angels – Under this case, as money is raised from outside investors hence they could
demand for convertible debts or ownership equity. This will have an impact on ownership and
control.
Friend and family – As discussed earlier it is the most easily available option for raising the
money (Lampe and Hofmann, 2013). However it can be adopted only when the borrower shares
a good bonding with his friend and family.
Figure 3: Positive and Negative implications of External Sources
Case Studies
Case -1 Small start-up of venture
Smith is seeking to start a new business related to the manufacturing of chairs. At the
starting, he focused on getting small contracts and orders from the clients. A sum of £ 6000 was
needed for start-up and he was the sole owner of the business (Abraham, Deo and Irvine, 2008).
Case -2 Expansion of business through partnership
After 3 years of operations, Smith decided to expand the business through involving
some partners into it. More cash was arranged through the capitals invested from the partners.
Money was also arranged by selling of an old land worth £20000. The business started taking big
orders.
4
Advantages
No obligation to repay the
money
Provide secured financing
No interest and set up fees
can facilitate faster growth
Disadvantages
time consuming process
possible loss of control
Many legal and regulatory
issues to be fulfilled
Due diligence is normally
required

Case- 3 More expansion
For further expansion they all registered themselves by a public limited corporation. In
this they manner they are able to sell their shares (Bonaci, Matiş and Strouhal, 2008). Further
growth and development was achieved through the reinvested profits.
Task 2 Understand the implications of finance as a source
Financial planning
Financial planning plays a crucial role in the functioning of the business operations. It
helps in identifying the risks and uncertainties associated with the new venture. It takes into
consideration different types of factors such as funds, location, legal aspects and resources etc
(Booker, 2006). It is also about estimating the finance needed for the business. It is helpful in
framing of financial policies related to management, procurement and investment of the money.
It is also useful in managing cash outflow and cash inflow within the company. There is a need
to maintain stability in the operations and this is not possible without doing financial planning
(Broadbent and Cullen, 2012).
It will also select the appropriate investment with right financial needs and objectives.
Planning also helps in fixing the most suitable capital structure for the business. A link can be
established between the present and future financial requirements through this function. The
income within the business can be managed in appropriate manner (Hawawini and Viallet,
2010). Company can keep it hard earned cash through tax planning, proper budgeting and
sensible spending. Through planning cash flow can be increased and increased cash flow results
in increase in capital also. Presence of adequate capital ensures the organization to think about
making other investments. The planning helps in achieving coordination between several
business activities such as production, marketing, human resource management etc. In this
manner company will be able to understand how amount of funds are required for paying the
taxes and payment for other expenses (Ittelson, 2009).
Financial decision making
The Finance department of an organization is responsible for producing variety of
information which assists in making of several decisions. The financial information produced
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from the financial statements is very useful for different types of decision makers. The types of
information can be listed as follows:
 Costing information
 Value of the total assets and total liabilities
 Figures of the net profit and gross profit
 Amount of cash flow at the end of the financial period
 Information about the sales and revenues (Siano, Kitchen and Confetto, 2010)
 Cash flow from financing, investing and operating activities
 Cash budget, sales budget, purchase budget, etc
The information need for various decision makers is as follows:
 Employees – These people require financial information in order to take decisions about
their career opportunities and growth within the company.
 Creditors – These are the ones who have lend their money to the firm. They need
information so that they can identify whether business has the potential to make timely
payments or not (Bhowmik and Saha, 2013)
 Tax authorities – The tax authorities are responsible for assuring that whether company is
making timely payment of taxes or not.
 Shareholders – These people take investment decision related to buying and selling of
shares. Shareholders always are of an expectation that company’s share will perform well
in the market as this offers them high dividends.
 Lenders – Lending bodies wants to have a check on liquidity and gearing position of the
business before rendering the loan. It is to be assured that whether borrower is capable of
paying the loan back or not (Kitchen and Confetto, 2010)
Sample of Financial Statements
Given below are the samples of income statement and balance sheet.
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Income statement
Table 1 Format of Income Statement
PARTICULARS
Revenue:
Gross Sales
Less : Sales Returns / Allowance
Net Sales
Cost of Goods Sold:
Purchases
Delivery Charges
Cost of goods sold
Gross sales profit (Loss)
Expenses:
Expenses 1
Expenses 2
Expenses 3
Total Expenses:
Net Operating Income
Other Income:
Income 1
Income 2
Income 3
Total Other Income:
Net Income (Loss): *( Format of a Financial
Statement, 2013)
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
Balance Sheet
Table 2: Format of Balance Sheet
Liabilities Amount Assets Amount
Current Liabilities
Creditors
Bills Payable
Bank Overdraft
XXXX.XX
XXXX.XX
XXXX.XX
Current Assets
Cash in bank
Accounts receivable
Inventory
Prepaid Expenses
Other Current Assets
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
7

Fixed Liabilities
Bank Loan
Secured Loan
Other long term Loan
Capital and Net Profit
XXXX.XX
XXXX.XX
XXXX.XX
Total Current Assets
Fixed Assets
Machinery & Equipment’s
Furniture & Fixtures
Leasehold Improvements
Land & Buildings
Other Fixed Assets (Less
Accumulated
depreciation)
Total Fixed Assets
Other Assets
Intangibles
Deposits
Goodwill
Other
Total assets
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
XXXX.XX
Task 3 Making Financial Decisions
Analysing the sales budget and cash forecast
Table 3 Sales Budget
Month Monthly
budget
Cumulative
Budget
Actual
Monthly
Actual
Cumulative
Variance
July 2,30,000 2,30,000 2,15,000 2,15,000 -15,000
August 2,30,000 4,60,000 2,20,000 4,35,000 -25,000
8

September 2,70,000 7,30,000 2,45,000 6,80,000 -50,000
October 2,65,000 9,95,000 2,35,000 9,15,000 -80,000
November 2,65,000 1,260,000 237,000 1,152,000 -108,000
December 300,000 1,560,000 270,000 1,422,000 -138,000
January 250,000 1,810,000
February 265,000 2,075,000
March 300,000 2,375,000
April 325,000 2,700,000
May 325,000 3,025,000
June 350,000 3,375,000
Table 4: Cash Flow Forecasts
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Brought
Forward
40,000
Sales 200,000 300,000 300,000 300,000 250,000 260,000 300,000 260,000 300,000 325,000 265,000 265,000
Total Income 240,000 300,000 300,000 300,000 250,000 260,000 300,000 260,000 300,000 325,000 265,000 265,000
Purchases 150,000 140,000 135,000 135,000 140,000 130,000 135,000 145,000 140,000 140,000 145,000 145,000
Wages 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000 55,000
Rent &
Rates
56,000 56,000 56,000 56,000
Light &
Heat
55,000 55,000 55,000 55,000
Advertising 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000
Insurances 55,000 52,000
9

Equipment 50,000 10,000 10,000 10,000
Vehicles 20,000
Directors'
Salaries
22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000 22,000
Motor
Expenses
11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000
Sundry
Expenses
11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000
Total
Expenditure
432,000 251,000 291,000 302,000 293,000 296,000 292,000 246,000 296,000 297,000 246,000 301,000
Monthly
Deficit /
Surplus
-
192,000
49,000 9,000 -2,000 -43,000 -36,000 8,000 14,000 4,000 28,000 19,000 -36,000
Accumulativ
e Deficit /
Surplus
-
192,000
-
143,000
-
134,000
-
136,000
-
179,000
-
215,000
-
207,000
-
193,000
-
189,000
-
161,000
-
142,000
-
178,000
Issues with the budgets
 Negative variance of 8-10% can be seen in the sales budget of ABC ltd
 The budgeted sales figures have not been taken into consideration while preparing the
cash flow forecasts.
 The accumulated deficit shows that extra expenses have been incurred into the business
Reason for variances
 Fickle variations in the market conditions due to which planning has not matched with
the market conditions
 Prices were estimated in inappropriate manner due to which raised sales were at different
prices from what has been planned (Statement of Cash Flows, 2000)
 Incapability of the company in fulfilling the operational functioning of the business.
Investment appraisal methods
Accounting rate of return
ARR = (Average return during the period)/(Initial Investment)
Table 5: Calculation of ARR
Project A Project B
10

ARR=810,000/450,000
ARR=1.8
ARR=180 %
ARR=680,000/450,000
ARR=1.5
ARR=150 %
Results – According to the ARR technique, the results are indicating that ABC Ltd should make
investment in proposal A as it is delivering a high rate of return.
Payback Period
Year Project A Project B
Cash flow (£) Cumulative value Cash flow (£) Cumulative
value
Initial Cost 450000 450000
1 180000 180000 60000 60000
2 230000 410000 120000 180000
3 280000 690000 250000 430000
4 120000 810000 250000 680000
Payback period = (Initial Investment) / (Cash Inflow per period)
For uneven cash flows,
Pay back period=A + B
C
A = last year value with a negative cumulative cash flow
B = absolute value of cumulative cash flow at the end of the period A
C = total cash flow while the period after A
For project A = 2+ 450000−410000
690000
= 2.05 years
11

For project B = 3+ 450000−430000
680000
= 3.02 years
According to the results of payback technique, ABC should make investment in project A
because it is recovering the initial costs in less period of time as compared to project B.
Internal Rate of Return
Table 6: Calculation of IRR
Year Cash Flow -
project A
PV
factor
@29%
PV @ 29%
- Project A
Cash Flow -
project B
PV factor
@ 15%
PV @ 15% -
Project B
1 180 0.78 139.53 60 0.87 52.17
2 230 0.60 138.21 120 0.76 90.74
3 280 0.47 130.43 250 0.66 164.38
4 120 0.36 43.33 250 0.57 142.94
Total
PV
451.51 450.23
Results – According to the IRR technique, the results are indicating that company should make
investment in project A because it is having better and higher internal rate of return.
Net present Value
Table 7 NPV calculation for project A
Year Cash flow (£) P.V. factor@ 10% Present Value (£)
1 180000 0.94 169200
2 230000 0.89 204700
3 280000 0.84 235200
4 120000 0.79 94800
Total Present value 703900
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Initial investment (450000)
Net Present value 253900
Table 8: NPV calculation for project B
Year Cash flow (£) P.V. factor@ 10% Present Value (£)
1 60000 0.94 56400
2 120000 0.89 106800
3 250000 0.84 210000
4 250000 0.79 197500
Total Present value 570700
Initial investment (450000)
Net Present value 120700
Results - As per the results of NPV technique, ABC ltd should make investment in project A
because its NPV value is higher as compared to project B.
Recommendation
After analysing the results of all the investment appraisal techniques, it is recommended
that ABC should make investment in project A because it is better in terms of revenue, profits
and returns as compared to project B. It has the potential to bring substantial savings and cost
reductions for the company
Costing and pricing review
FORMULA CALCULATION
Contribution
Margin Ratio
Contribution per Unit = (Unit
Contribution Margin) / (Unit Price)
Unit CM = Unit Price - Variable cost
per unit
v
ariable cost per unit=52.50+35.75+10.20
Variable cost per unit =£ 98.45
Unit CM =120−98.45
Unit CM =21.55
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Contribution Per Unit= 21.55
120
Contribution Per Unit=0.18=18 %
Breakeven point Break even salesunit = FixedCost
UnitPrice−Variable cost
Break even salesunit = 120,000
120−98.45
Break even salesunit ≈ 5568 units
Break even point ∈£=£ 120∗5568
Break even point ∈Sales £=668,160
Margin of safety Margin of Safety∈sales value=Budgeted sales−Break even salesMOS∈ sales value=7500−5568
MOS=1932units
MOS per unit MOS per unit = Budgeted Sales−Break even sales
Budgeted Sales MOS per unit =1932
7500
MOS per unit =26 %
Changes in the Break Even Point
Table 9: Impact on Break Even Point
CHANGES IMAPCT
At £ 5 increase in selling price Break even point= 120000
125−98.45
Break even point= 120000
26.55
Break even point ≈ 4519units
At £ 5 decrease in selling price Break even point= 120000
115−98.45
14

Break even point ≈ 7250 units
A ₤5,000 increase in fixed costs Break even point= 125000
120−98.45
Break even point= 125000
21.55
Break even point ≈ 5800 units
A ₤5,000 decrease in fixed costs Break even point= 115000
120−98.45
Break even point= 115000
21.55
Break even point ≈ 5336 units
₤5 increase in material or labour costs per
unit
Break even point= 125000
120−103.45
Break even point= 125000
16.55
Break even point=7553 units
₤5 decrease in material or labour costs per
unit
reak even point= 125000
120−93.45
Break even point= 125000
26.55
Break even point=4708units
Machine A
Contribution Per Unit 18%
Break Even Sales unit 5568 units
Break even in £ £668,160
Margin of Safety (sales value) 1932 units
15

Margin of Safety per unit 26%
Impact on the profits
Table 10: Profit and Loss at various levels
Sales
Units
Price /
Unit
Total
Revenue
Fixed
Cost
Variable
Cost / unit
Total
VC
Total
Cost
Profit/
Loss
7500 120 900000 120000 98.45 738375 858375 41625
5000 120 600000 120000 98.45 492250 612250 (12250)
8000 120 960000 120000 98.45 787600 907600 52400
10000 120 1200000 120000 98.45 984500 110450
0
95500
Table 11¨ Effects of fluctuations in BEP
Actual break even obtained breakeven Effect
£5 increase in selling price 5568 4519 Decreases
£5 decrease in selling price 5568 7250 Increases
₤5,000 increase in Fixed Cost 5568 5800 Increases
₤5,000 decrease in Fixed Cost 5568 5336 Decreases
₤5 increase in variable cost 5568 7553 Increases
₤5 decrease in variable cost 5568 4708 Decreases
South wood Electricals
Particulars Amount (in £)
Actual Sales 7500
Price per unit 120
Revenue 900000
Additional demand 500
Price per unit 102
Additional revenue 51000
Total Revenue 951000
Fixed Cost 120000
Variable cost 787600
16

Total Cost 907600
Profit/loss 43400
Westbrook Engineering
Particulars Amount
Actual Sales 7500
Price per unit 120
Revenue 900000
Additional demand 1000
Price per unit 90
Additional revenue 90000
Total Revenue 990000
Fixed Cost 120000
Variable cost 836825
Total Cost 956825
Profit/loss 33175
Task 4 analysing the financial performance
Accounting terminology
The events recorded in the journal follows three basic principles:
Real account ‘Debit’ what comes in & ‘credit’ what goes out
Nominal account ‘Debit’ all losses & expenses, ‘credit’ all incomes and gains
Personal account ‘Debit’ the receiver & ‘credit’ the giver
 Ledger - It is regarded as the book of final entry which records all the financial
transactions within individual accounts
 Trial Balance – It is a kind of measure to check the accuracy of ledger accounts.
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Evaluation of Ratios
Ratios Formula 1995 1996
Liquidity Ratios
Current Ratio Current Assets
Current Liabilities
20000
6000 = 3.33 54000
25000 =2.16
Quick Ratio Current asset−Cl . stock
Current Liabilities
20000−7000
6000 =2.17 54000−18000
25000 =1.44
Activity Ratios
Fixed assets
turnover Ratio
Net Sales
¿ Assets
120000
15000 =8 200000
12000 =16.67
Total assets
turnover Ratio
Net Sales
Total Assets
120000
35000 =3.43 200000
66000 =3.03
Profitability Ratios
Gross Profit Ratio Gross Profit
Net Sales ∗100 40000
120000∗100=33.33 % 50000
200000∗100=25 %
Net Profit Ratio Net Profit
Net Sales ∗100 30000
120000∗100=25 % 35000
200000∗100=17.5 %
Evaluation
The above calculation of ratios indicates that firm should focus on improving its liquidity
position. The short term obligations of the business are to be fulfilled in effective manner. In
terms of activity, company is doing an excellent work as both the ratios are fine ( Financial ratio
and Analysis. 2013). In terms of profitability, there is a need to focus on improving the
operational affair within the business.
Conclusion
From the above study it can be concluded that finance is the backbone of the business.
Financial management is needed to make sure that investment decisions are taken in appropriate
18

manner. Ratio analysis is an effective approach to measure financial performance despite of
having so many drawbacks.
19

References
Books and journals
Abraham, A., Deo, H. and Irvine, H., 2008. What lies beneath? Financial reporting and corporate
governance in Australian banks. Asian Review of Accounting. 16(1). pp. 4 – 20.
Ball, R., Jayaraman, S. and Shivakumar, L., 2012. Audited financial reporting and voluntary
disclosure as complements: A test of the confirmation hypothesis. Journal of Accounting
and Economics. 53(1). pp. 136-166
Bhowmik, K. S. and Saha, D., 2013. Sources of Finance. Financial Institution of the
Marginalized India Studies in Business and Economics. pp61-71.
Bonaci, G. C., Matiş, D. and Strouhal, J., 2008. Financial reporting paradigms for financial
instruments: Empirical study on the Czech and Romanian regulations. Journal of
International Trade Law and Policy. 7(2). pp. 101 – 122.
Bonaci, G. C., Matiş, D. and Strouhal, J., 2008. Financial reporting paradigms for financial
instruments: Empirical study on the Czech and Romanian regulations. Journal of
International Trade Law and Policy. 7(2). pp. 101 – 122.
Booker, J., 2006. Financial Planning Fundamentals. CCH Canadian Limited.
Broadbent, M. and Cullen, J., 2012. Managing Financial Resources. Routledge.
Goldman, C. and Carrier, J., 2010. Joint Financing in the New NHS: Thinking to the Future.
Journal of Integrated Care.18(6).pp.27 – 34.
Hawawini, G. and Viallet, C. 2010. Finance for Executives: Managing for Value Creation, South-
Western; 4th Revised edition
Ittelson, R. T., 2009. Financial Statements: A Step-by-Step Guide to Understanding and
Creating Financial Reports. Career Press.
Joseph, C., 2013. Advanced Credit Risk Analysis and Management. John Wiley & Sons.
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