Financial Statement Analysis and Prediction

This assignment delves into the crucial topic of financial statement analysis and its application in predicting financial distress. Students will learn various financial ratios used to assess a company's financial health and explore methods for analyzing financial statements to identify potential warning signs of distress. The assignment likely includes case studies, real-world examples, and discussions on relevant accounting principles and industry best practices.

MANAGING FINANCIAL RESOURCES
AND DECISION MAKING

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
TASK 1............................................................................................................................................1
1.1 Sources of finance available to business...............................................................................1
1.2 Implications of different sources of finance..........................................................................2
1.3 Appropriate sources of finance for business project..............................................................3
TASK 2............................................................................................................................................4
2.2 Importance of financial planning...........................................................................................5
2.3 Information needs of internal and external decision makers.................................................5
2.4 Impact of finance on financial statements.............................................................................6
TASK 3............................................................................................................................................7
3.1 Cash, sales and production budget.........................................................................................7
3.2 Calculation of unit cost..........................................................................................................8
3.3 Project evaluation methods....................................................................................................9
TASK 4..........................................................................................................................................11
4.1 Major financial statements for the business.........................................................................11
4.2 Format of financial statement..............................................................................................12
4.3 Ratio analysis of Ryanair and Easy jet................................................................................16
CONCLUSION..............................................................................................................................17
REFERENCES..............................................................................................................................18

INTRODUCTION
Finance is a significant factor for every business with having influence on its activities
and operations. In absence of adequate funds, no business can run and attain success. Present
report is going to discuss about various sources of finance and their implications on the business
enterprise. The present report will explain cash, sales and production budget with their
calculation. Furthermore, this report is going to discuss the major financial statements and ratio
analysis of Royal hotel which is a small business enterprise in UK. At the end, capital budgeting
methods will be applied to select the most viable investment project for cited venture.
TASK 1
1.1
Royal hotel is one of the new start-up firms that is opening under government schemes.
The cited venture may borrow finance from various sources. There are two types of sources that
is external and internal.
External source of finance Trade credit- This source of finance is offered by the seller to buyer as a standard trade
practice or to encourage sales. It can arise when a supplier of goods or services allow
customers to pay for goods and services on a later date (Bachelier, 2011). Apart from
this, it can be taken from bank in case of import and export of goods at specific rate of
interest. It proves to be an expensive source of finance if payment is not made within the
discount period. Venture capital- It is suitable for new or growing business under which equity or loan
capital is provided by private investors or other financial institutions. With the help of
this source, firm can raise huge amount of fund for the business. Under this option,
Venture capital firm makes investment in company’s share and get shareholding and
voting rights (Brealey and et.al, 2012). Bank Loan- All bank loans are available at specified interest rate and in the form of credit
that is often extendable for a specified period of time. Under this, rate of interest is
charged on the borrowed amount. Lease - It is a kind of contract under which one party agrees to give property on rent
which is owned by them to another party. Terms and conditions for lease are determined
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by lessor and lessee mutually (Chapra, 2011). Firm can fulfil its maximum needs by
taking assets on lease.
Internal source of finance Personal savings- Personal savings are the backbone of many small businesses. If firm
does not have any assets but still have personal finance then it can be very useful to start
any business.
 Retained earnings- It is the part of revenue which remains after paying all expenses from
earned revenue (Baker and Powell, 2009). The amount of retained earnings is used to
meet working capital needs of corporation and mainly paid to the owner.
1.2
Following are different implications of sources of finance which can affect business
operations-
Sources of
finance
Legal
implications
Financial
implications
Bankruptcy Dilution of
control
Trade credit The agreement or
deal related to
documentation
depends upon
both parties and
their mutual
understanding
(Beaver and et.al,
2011). It is not
necessary to sign
the paper of
agreement.
It have average
cost of finance
In situation of
bankruptcy, the
owner will give
the payment to
creditors at first
and then, amount
will be paid to the
venture capital
firm.
Control will not
be diluted
Venture capital In this source,
legal agreement is
necessary. Both
It includes high
cost and high risk
Same as above Control will be
diluted
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parties have to
sign the paper.
Bank loan It is necessary to
sign paper
documents of
bank.
Financial cost and
risk is low in the
mentioned source.
Same as above Control will not
be diluted
Lease Needs to sign
legal document
and contract with
lessor.
It depends upon
the contract’s
condition.
Generally, it is
average.
Same as above Control will not
be diluted
Personal savings No legal
implication
No legal
implications
Amount of
personal saving is
used to make
payment to
creditors and
suppliers.
Same as above
Retained earnings Same as above No legal
implications
(Bennouna and
et.al., 2010)
Same as above Same as above
1.3
Company selects the source of finance according to requirement of business and its
activities. There are various sources of finance which corporation can use in its operations.
Selection of finance depends on initial condition of business. For Royal hotel, option of venture
capital is not suitable because they are required to make investment in company which is having
sound business position (Bhaird, 2010). Cited company is at initial level of business so, it cannot
use this option. Organization can use following measures-
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 Trade credit is a suitable option for Royal hotel because in this source, firm is having
some relaxation period for making payment. It can borrow funds on credit basis and their
payment will be placed on decided date in future. This is an effective source of finance
because there is always scarcity of working capital for the organization. If corporation
will get some relaxation on the amount which it needs to pay then its dependency on
bank loan to meet working capital requirement will get reduced (Brigham and Ehrhardt,
2013). Furthermore, firm can use this source for improving business relations and for
giving support to the stakeholders.
 Another effective method is bank loan because it is available at low rate of interest to
company from banks. This source of finance has less risk and cost as well as interest rate
is always decided on the basis of bank norms.
 If corporation requires assets and machinery then lease is the best option as company can
meet its capital expenditure needs with the help of lease. Its cost can be decided on the
basis of mutual understanding between both parties.
2.1
With every source of finance, some costs are associated along with the benefits.
Limitations of some of the common sources are as follows- Trade credit- If goods are purchased on credit and the supplier's list is too long then the
cost of maintaining and keeping track on default of payment will be high. Moreover, it is
as a form of short term debt. If a company is unable to pay it with agreed terms and time
frame then penalties in the form of fees and interest can incur.
 Venture capital- Venture capital is having the risk of loss of equity stake. Venture
capitalists are able to render small and start up business with much needed capital
because they have easy to access against which they require a large equity stake in the
business for safeguarding their initial investment. Investors under this are generally at
high risk if business will come in loss. Moreover, as per the investment made, control of
investor in the firm may be high.
 Cost of loan- Loan to cost is a ratio it use to determine the loan percentage or amount a
lender is willing to finance based on the hard cost construction budget. This is used to
calculate the percentage of a loan.
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2.2
It is very important to develop the planning for business finance. There are various
sources of finance available but the most appropriate is one which can match with the business
conditions. Therefore, every business enterprise needs to build an appropriate planning about the
source from which it can borrow funds. Effective financial planning defines the way in which
fund will be raised and allocation of cash will be done among various business activities. Royal
hotel is at initial stage of business so, it needs fund for running its managerial activities and
functions (Lampe and Hofmann, 2013). For this purpose, cited venture needs to make investment
in an effective and balanced manner so that it can earn the highest rate of return on investments.
With the help of effective financial planning, cited venture will make 45% use of cash in core
business activities and 35% in operations. Apart from that, 20% investment is made in
investment activities that are related to mutual or equity fund. Main objective is to use the cash in
such a manner that firm can get maximum returns and make effective utilisation of available
resources. In this way, it can be said that financial planning is crucial for the business.
2.3
Information required by internal and external decision maker of firm is given as below-
Employees Employees are the most significant stakeholders of corporation. They need to
know actual financial statement of company as it influences their interest in the
firm. For example, Microsoft did not pay salary for 3 months due to heavy loss
occurred in business (Siano, Kitchen and Confetto, 2010). If firm is
continuously running with loss then personnel can resign from their job. With
the help of financial statement, personnel can evaluate firm’s financial
condition and take decision related to their career.
Suppliers They are another important stakeholders of the organization. Suppliers are
those who supply goods or raw material to company for their operations. They
have the right to know about corporation's financial condition. If enterprise
earns high profit then supplier will be more interested to supply their goods in
that firm.
Creditors Creditors are those stakeholders who provide credit to the business firm. They
require organization’s financial statements in order to evaluate its liquidity
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position and check financial condition on specific date (Abraham, Deo and
Irvine, 2008). After evaluation of company's situation, they decide whether to
give loan to corporation or not.
Shareholders They are the most important for business enterprise because they invest their
capital in the firm in order to get maximum return. They are required to know
the financial information about business because investors decide whether to
make investment in company or not. With assistance of ratio analysis,
shareholders can evaluate company's performance.
Government Government is having the right to know firm’s financial condition as it is liable
to pay tax which is charged in accordance with company’s revenue (Ball,
Jayaraman and Shivakumar, 2012).
2.4
Generally, financial statements are of three types that is balance sheet, income statement
and cash flow statement. If company raises its finance from market then it affects corporation’s
profitability as well as creates liability for business. If suppose firm borrows loan from bank then
assets side of the balance sheet will get increased by amount of cash. On the other side, liabilities
of firm are shown in balance sheet that will increase due to taking bank loan amount (Siano,
Kitchen and Confetto, 2010). In this way, both sides of the balance sheet will become equal to
each other. In addition to this, interest rate of loan will be added at the debit side of income
statement and profit amount of firm will be decreased. This profit amount will further transferred
to the liability side of balance sheet. On the other hand, if company collects money or debt from
customers or partners then it would decrease account receivable and increase the cash. It is
because; corporation collects money from its debtors. Therefore, capital in the income statement
increases which affects the financial position of enterprise. Suppose, firm raises equity then it
will receive cash in the business and amount will be recorded at assets side of the balance sheet.
Firm is always liable to pay dividend to its shareholders by which liability side of balance sheet
gets increased (Chen, 2012). Furthermore, if firm pays dividend then it will be recorded at the
debit side of income statement.
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3.1
Table 1: Cash budget for royal hotel
September October November December January February
Opening balance 0 24500 49600 76400 104600 132100
Sales 35000 37000 40000 44000 42000 36000
Total 35000 61500 89600 120400 146600 168100
Expense
Purchase 8000 9000 10000 12000 11000 9000
Creditors 800 900 1000 1200 1100 850
Logistic expenses 500 600 700 900 800 650
Employee cost 1200 1400 1500 1700 1600 1300
Total 10500 11900 13200 15800 14500 11800
Closing balance 24500 49600 76400 104600 132100 156300
Interpretation
Cash budget implies value of cash inflows and outflows. In the given table, it is
ascertained that sales of corporation is increasing from the month of September to December.
Thereafter, sales declined consistently. From the above table, it is clear that firm is having a
strong control over its purchase or expenses.
Table 2: Sales budget
July August September October November December
Sales units 3500 3700 4000 4400 4200 3600
Per unit price 10 10 10 10 10 10
Sales volume 35000 37000 40000 44000 42000 36000
Less: Discount 200 300 400 350 200 200
Sales value 34800 36700 39600 43650 41800 35800
Interpretation
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Sales budget of the cited venture is showing same trend and it can be seen that sales of firm
is increasing at a higher rate. After month of October, sales is declining. It is ascertained that
discount of the firm is increasing and after the month of October, due to decline in sale, amount
of discount also got reduced.
3.2
Table 3: Calculation of unit cost
Particular Cost in pound (£)
Fixed expenses 100000
Variable expenses 30000
Total 130000
Units produced 13000
Per unit 10
Interpretation
Per unit cost is calculated by dividing the number of units produced. In the given calculation,
fixed and variable costs are added and divided by number of units have produced. In this way,
per unit cost is computed. Fixed cost refers to the amount that remain fixed and never get
changed with variation in the level of production. By applying the following formula, per unit
cost is computed which is (£)10.
3.3
Table 4: Calculation of payback period method
Project A Project B
Initial investment -100000 -120000
1 40000 -60000 50000 -70000
2 65000 5000 55000 -15000
3 75000 80000 60000 45000
4 90000 155000 65000 110000
Interpretation
Payback period affects the time period within which firm can start making profit on
specific project. It is ascertained that project A is taking time of two years for covering the
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investment amount. On the other hand, project B takes time period of three years for recovery.
So, on the basis of this parameter, project A is more viable for the cited venture.
Table 5: Calculation of ARR
Project A Project B
Initial investment 100000 120000
1 40000 50000
2 65000 55000
3 75000 60000
4 90000 65000
4 0 0
6 0 0
Total 270000 230000
Average 67500 76667
ARR 67.50% 63.89%
Interpretation
ARR is the average rate of return which is one of the most essential methods of project
evaluation. It is ascertained from the table that ARR of project A is 67.50% and same of other
project is 63.89%. ARR of project A is higher than project B and on this basis, former project is
assumed to be viable for the firm.
Table 6: Calculation of NPV
Project PV @ 10% Present value Project B PV @ 10% Present value
Initial
investment 100000 50000
1 40000 0.909 36364 50000 0.909 45455
2 65000 0.826 53719 55000 0.826 45455
3 75000 0.751 56349 60000 0.751 45079
4 90000 0.683 61471 65000 0.683 44396
5 0 0.621 0 0 0.621 0
6 0 0.564 0 0 0.564 0
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Total 207902 180384
NPV 107902 130384
107.90% 260.77%
Interpretation
NPV of project A is higher than project B and on the basis of above calculation, project A
is more viable for the cited venture.
Table 7: Calculation of IRR
Project A Project B
Initial investment -100000 -120000
1 40000 50000
2 65000 55000
3 75000 60000
4 90000 65000
5 0 0
6 0 0
IRR 47.11% 30.51%
Interpretation
IRR reflects the internal rate of return that is earned by the project. From the above
calculation, it can be observed that IRR of project A is 47.11% and project B's IRR is 30.51%.
So, on the basis of above parameter, firm will select project A which is more viable as compared
to project B.
TASK 2
4.1
There are three major financial statements that are prepared by the firm which are as
follows- Balance sheet- This statement implies financial position of the firm which is calculated
at the end of quarter or year. It has two sides that is assets and liability. With the help of
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ratio analysis method, managers can evaluate the performance of firm and make
appropriate decisions. Income statement- It is the most important statement which implies profit that is earned
by firm. It includes revenues and expenses that incur in company (Sole Trader /
Partnership v Limited Company, 2014). This statement is used by the firm to calculate
cost as percentage of sales.
 Cash flow statement -This statement assists to know the inflow and outflow of cash from
operations as well as through investing and financial activities of business enterprise. On
the basis of this statement, firm comes to know about sources of finance from where it
can generate fund.
4.2
I
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Illustration 1: Balance sheet of partners
Here, in the financial statement, there may be more than one capital account. Profit and
loss account demonstrates profit and loss of partners as per their agreed investment ratios. Along
with this, a statement of Partner’s equity also prepares.
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Illustration 2: Income statement of partners
Sole trader
Illustration 3: Income statement of sole trader
The structure or format of main financial statement only contain owner itself information.
There is only one capital account which shows in the balance sheet. There is no income
statement from by the owner of a company.
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Company
Illustration 4: Balance sheet of company
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Illustration 5: Income statement of company
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4.3
Table 8: Ratio analysis of Sainsbury and TESCO
Sainsburry TESCO
Current assets 5742 1279
Current liability 3346 1768
Current ratio (current assets/liability) 1.72 0.72
Gross profit 2267 1882
Net sales 5654 4690
Gross profit ratio (A/B) 40.10% 40.13%
Net profit 867 523
Net sales 5654 4690
Net profit ratio 15.33% 11.15%
Debt 4088 228
Equity 4035 2249
Debt- equity ratio(A/B) 1.01 0.10
Interpretation Current ratio- Current ratio reflects the liquidity position of company. The ratio is fixed
by the firm which is 2:1. From the above calculation, it has ascertained that current ration
of Sainsbury is 1.72 and for TESCO, it is 0.72. It can be said that liquidity position of
Sainsbury is better than tesco Gross profit ratio- It refers to the ability to control its direct expenses. In the above table,
it is ascertained thatTESCO has higher net profit than Siansburry Thus, it can be said that
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former is better than latter (Current Ratio - Liquidity Ratio - Working Capital Ratio,
2014). Net profit ratio-This ratio reflects firm’s capability to control its indirect expenses. It can
be said that net profit ratio of Sainsburry is higher than TESCO. It can be said that
Sainsbury is performing better than tesco.
 Debt equity ratio- In the above table, Ryanair has 1.10 debt equity and EasyJet is 0.10.
Thus, it is ascertained that former firm is having higher equity than the latter company
(Tracy, 2012).
CONCLUSION
From the above discussion, it has been articulated that various sources of funds are
available for company. Firm must select the most suitable source with taking into consideration
the factors like scale, size and nature of business. This project has also defined that company can
select the most profitable project for business through effectual use of different capital budgeting
techniques. Furthermore, in order to identify weaknesses of firm, finance manager should use the
method of ratio analysis. By adopting all these methods, firm can sustain in the long run with
earning higher profits.
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REFERENCES
Books & 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.
Bachelier, L., 2011. Louis Bachelier's theory of speculation: the origins of modern finance.
Princeton University Press.
Baker, K. H. and Powell, G., 2009. Understanding Financial Management: A Practical Guide.
John Wiley & Sons.
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.
Beaver, H. W. and et.al., 2011. Financial Statement Analysis and the Prediction of Financial
Distress. Now Publishers Inc.
Bennouna, K. and et.al., 2010. Improved capital budgeting decision making: evidence from
Canada. Management Decision. 48(2). pp.225–247.
Bhaird, C. M. A., 2010. Resourcing Small and Medium Sized Enterprises: A Financial Growth
Life Cycle Approach. Springer.
Brealey and et.al, 2012. Principles of corporate finance. Tata McGraw-Hill Education.
Brigham, E. and Ehrhardt, M., 2013. Financial Management: Theory & Practice. 14th ed.
Cengage Learning.
Chapra, M. U., 2011. The global financial crisis: can Islamic finance help?. In Islamic
Economics and Finance. Palgrave Macmillan UK.
Chen, S. H., 2012. Genetic algorithms and genetic programming in computational finance.
Springer Science & Business Media.
Ittelson, R. T., 2009. Financial Statements: A Step-by-Step Guide to Understanding and
Creating Financial Reports. Career Press.
Keller, A., 2013. Finance & Financial Management. GRIN Verlag. Publication
Kitchen, J. P. and Confetto, G. M., 2010. Financial resources and corporate reputation: Toward
common management principles for managing corporate reputation. Corporate
Communications: An International Journal. 15(1). pp.68 – 82.
Lampe, K. and Hofmann, E., 2013. Financial statement analysis of logistics service providers:
ways of enhancing performance. International Journal of Physical Distribution &
Logistics Management. 43(4). pp.321-342.
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