Financial analysis of Podosave Ltd.'s business operations

¶ … Sound Business Based on Sound Finances

Podosave Ltd. is a food retail organization for which I will present a financial analysis based on the information I gained and the knowledge I acquired as a result of my role within the business.

My Role

My role was to work within the business, recruiting for vacant positions and training existing employees in order that they were able to attain relevant skills for their roles. Reporting to Head Office, I would relay information that was relevant to the HR department and act on the department's behalf.

The role of financial management in business

Financial management is fundamental to the success of a business and the strength of its financial 'health'. Those who work in managing a firm's finances should be able to identify its strengths and weaknesses whilst locating opportunities for growth. A key component of this is to compare financial statements against one another to look for variations and consider what the reasons for these variances are. Looking for differences in budgetary allowances is also crucial if those who work in financial management are to plan for the future effectively and mitigate potential risk.

Financial management must incorporate the implementation and development of financial control systems and the collation of data relevant to a firm's finances. The analysis of financial reports in order to glean information relevant to strategic decision making is also a central feature of managing finances.

There are various elements of financial management. Bookkeeping and financial control entails the stringent recording of company expenditures and receipts, whilst making sure that they are in line with standard guidelines and procedures. Managing the budget so that planned expenses do not exceed the agreed funds is also a key component of financial management, as is the management of actual cash payments both received and paid, which involves the analysis of previous forecasts and projections. The collection of payments owed, the analysis of financial reports and the analysis of budgets to identify where departments have overspent or over-forecast are also significant elements of managing finances. Preparing the funds to make large purchases and of course, managing the business's profit and loss statements are both important aspects of this role.

The role of financial planning

Planning what finances a business needs to be able to afford the purchases they need to make or strategic changes they need to fund is about careful financial planning. Planning finances is about being able to analyse previous financial statements and departmental budget reports and identify what resources are available and what financial tools can be used in order to achieve a business' financial goals. Essentially, the financial aims of a business cannot be achieved without finances and tools with which to raise finances.

Looking at the financial history of a firm and looking at the current environment have a part to play in financial planning. Considering what revenue generating resources are available and what revenue saving methods can be taken advantage of is also important. Looking at the various operations that exist and developing strategies are fundamental to planning a firm's finances. Financial control is about managing the firm's existing finances as closely as possible by controlling budgets and expenditures but also by ensuring that what is charged and spent is fair. Making sure that payments that are owed are paid in full and on time is also part of this role.

Budgeting

A budget is created for every department of a business and for the business as a whole in order to control what is spent and ensure that a profit will still be made. The document can allow for future planning, to forecast what will be earned and what will be spent and can be created so that a business can assess whether they are able to progress with what they currently make and spend. The budget must take into consideration the overall revenue and the business' outgoings, what the business makes in terms of income, and what their net profit or loss may be.

There are varying styles of budgets however. Top down budgeting occurs at the highest level and feeds down into the other tiers of the operation and dictates their own budgets. For bottom up budgeting, the converse is true, as the lower tiers of the organization prepare their financial plans and pass them up to the most senior level so that an overall business plan can be created.

There are advantages and disadvantages for both and the style that is adopted will depend very much upon the type of business involved. For instance, a top down approach may demotivate lower management who feel that their budgets are tighter than is necessary, especially if they feel that other departments have been given larger budgets that provide more financial freedom. That said, this style is based on the logical assumption that every department at all levels can only have what is available from the resources that exist, based on their actual needs. A bottom up approach is based on what each department assesses as necessary for their needs, but may involve requests for money that is not actually needed in order that the department has greater financial freedom without the worry of exceeding their budgetary limitations. This style can therefore lead to money being wasted on unnecessary projects, for example.

Budgets can be prepared incrementally so that a percentage is added based on the previous budget. This allows for consistent management but could go out of date and become irrelevant. Zero-based budgeting in essence provides no budget at all at the outset of the financial period. Funding is allocated in accordance with achievements but this presents difficulties in that a task may require financing at the outset rather than on completion. It is also difficult to prioritise various projects if budgeting is done in this way. Activity-based budgeting creates budgets based on the cost of an activity and may involve target setting. This approach does allow for increased accuracy in estimating the cost of a product and a better overall conceptualisation of the overheads involved in different activities but is not time effective because of the amount of time involved in collecting the information needed to set the budget. The traditional-historic approach in budget setting is based on previous financial reports. This involves an incremental provision of funds based on when they are needed and the demonstration of potential cost benefits. Again though, this approach is rather time consuming.

Financial Statements

There are various types of financial statements that a business will use in the management of its finances. The income statement will summarise the finances a business generated over a designated period of time, as well as the costs the business incurred and the money it needed to spend. This coupled with the organization's balance sheet amounts to the financial statement that is announced by the business at the end of the accounting term. The income statement outlines what overheads the company must pay for, how much its sales cost and what profit is made. The balance sheet reflects the financial situation of a business in terms of its assets once its liabilities and equity are accounted for. It is essentially the position of the organization after all of its transactions and financial activities have been taken into consideration. The information that is gleaned from the balance sheet shows the liquidity of the organization and how much capital it has at its disposal.

The cash flow statement shows where cash payments have been made or where cash has been generated by the business over the accounting period. It will also show where cash has been spent and what has been bought with it. The statement will result in a balance of what is left once these transactions have been accounted for. The statement serves the specific aim of recording cash transactions so that payments and expenditures can be traced if necessary.

Assessing the budgetary allocation of Podosave

Various reports were collated so that an assessment could be made as to whether a shift to a method of overhead budget allocation would be beneficial. A shift such as this would be based on machine hours and mean a significant increase of the overhead budget allocated to the Luxuree product produced by Podosave, because the resources it consumes are actually much higher. The overhead budget allocated to the Layzee product has decreased 28, 5% because it uses fewer resources, and that also applies to Speedee, which consumes 20% less overhead budget.

Labor hours

Layzee

Speedee

Luxuree

Volume

30.000

25.000

5.000

Labor hours / unit

0,75

1

1,5

Labor hours required

22.500

25.000

7.500

Total

55.000

Estimated overhead budget costs

1.650.000

Estimated machine hours

55.000

Predetermined overhead budget rate $

30

Overhead budget allocated per unit

Layzee

Speedee

Luxuree

Labor hours / unit

0,75

1

1,5

Overhead budget rate per hour $

30

30

30

Overhead budget allocated to product $

22,5

30

45

1

Production scheduling

2

1,36

1,82

2,73

2

Production set-up and tooling

8

5,80

7,73

11,59

3

Supplier selection and negotiation

2

1,70

2,27

3,41

4

Delivery inspection

9

6,55

8,73

13,09

5

Production staff safety training

4

3,00

4,00

6,00

6

Machinery maintenance and depreciation

5

4,09

5,45

8,18

Overhead budget allocation to the Luxuree product is visible when using machine hours as a base, instead of labor hours. Production set-up and tooling and delivery inspection overhead budget costs are especially affected by that change.

Machine hours

Layzee

Speedee

Luxuree

Volume

30.000

25.000

5.000

Machine hours/unit

0,35

0,5

2

Machine hours required

10.500

12.500

10.000

Total

33.000

Estimated overhead budget costs

1.650.000

Estimated machine hours

33.000

Predetermined overhead budget rate $

50

Overhead budget allocated per unit

Layzee

Speedee

Luxuree

Machine hours/unit

0,35

0,5

2

Overhead budget rate per hour $

50

50

50

Overhead budget allocated to product $

17,5

25

1

Production scheduling

3

1,06

1,52

6,06

2

Production set-up and tooling

13

4,51

6,44

25,76

3

Supplier selection and negotiation

4

1,33

1,89

7,58

4

Delivery inspection

15

5,09

7,27

29,09

5

Production staff safety training

7

2,33

3,33

13,33

6

Machinery maintenance and depreciation

9

3,18

4,55

18,18

Ratio Analysis in the assessment of the investment opportunities of Podosave

It was decided that a financial assessment of whether Podosave would be carried out to identify whether a capital investment should be made into the supermarket Spendless. As such, it was important to assess the financial position of the business using various ratios. When considering whether it was advisable to make an investment in the supermarket, an appraisal of Spendless was also carried out.

Ratio Analysis -- advantages and limitations

Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. Ratios are simply one number divided by another; as such they may or not be meaningful. In finance, ratios are usually two financial statement items that may be related to one another and may provide the prudent user a good deal of information. Of the myriad of ratios that could be generated, some will be more meaningful than others. Generally ratios are divided into four areas of classification that provide different kinds of information: liquidity, turnover, profitability and debt.

Liquidity ratios indicate the firm's ability to meet it maturing short-term obligations

Turnover indicates how effectively the firm manages resources at its disposal to generate sales

Profitability indicates the efficiency with which manages resources

Debt indicates the extent to which the firm is financed by debt[footnoteRef:2] [2: Limitation of Ratio Analysis http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page26.htm]

To obtain meaning from a ratio, one must consider the way in which ratios are analyzed and used by the decision maker. A good strategy is to compare the ratios to some sort of benchmark, such as industry averages or to what a company has done in the past, or both. Once ratios are calculated, an analyst uses these benchmarks to find out where the company stands at that particular point.

Ratio Analysis as a tool possesses several important features. The data, which is provided by financial statements, is readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.

Because Ratio Analysis is based upon accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further.

Limitations of Ratios are caused by accounting information, information problems, comparison of performance over time and inter-firm comparison.

The choices of accounting policies may distort intercompany comparisons. IAS 16 allows the valuation of assets to be based on either the revalued amount or the depreciated historical cost. The business may opt not to revalue its assets because by doing so the depreciation charge is going to be high and will result in lower profit.

Businesses apply creative accounting in trying to show a financial performance or position which can be misleading to the users of financial accounting. The IAS 16 mentioned above, requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense on the income statement, but if it results in revaluation surplus the surplus should be credited to the revaluation reserve. So, in order to improve on its profitability level the company may select in its revaluation program to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost.

Ratios need to be interpreted carefully. They can provide clues to the company's performance or financial situation. But on their own, they cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the company's current financial position.

IASB Conceptual framework recommends businesses use historical cost of accounting. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision making. Ratios are based on financial statements which are summaries of the accounting records. Through the summarization some important information may be left out which could have been of relevance to those who use the accounts.

The ratios are based on the summarized year end information which may not be a true reflection of the year's overall results.[footnoteRef:3] [3: Limitation of Ratio Analysis http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page26.htm]

It is difficult to generalize about whether a particular ratio is 'good' or 'bad'. For example a high current ratio may indicate a strong liquidity position, which is good, or excessive cash which is bad. Similarly non-current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is under-capitalized and cannot afford to buy enough assets.

Inflation renders the comparison of results over time misleading as financial figures will not be within the same levels of purchasing power. Changes in results over time may show as if the enterprise has improved its performance and position when in fact after adjusting for inflationary changes it will show a different picture.

Changes in accounting policy may affect the comparison of results between different accounting years and show them to be misleading. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the business's profits are low.

Accounting standards offers standard ways of recognizing, measuring and presenting financial transactions. Any change in standards will affect the reporting of an enterprise and its comparison of results over a number of years.

As stated above, the financial statements are based on year end results which may not be a true reflection of results year round. Businesses which are affected by seasons can choose the best time to produce financial statements so as to show better results. For example, a tobacco growing company will be able to show good results if accounts are produced in the selling season. This time the business will have good inventory levels and receivables, and bank balances will be at their highest.

No two companies are the same, even when they are competitors in the same industry or market. Using ratios to compare one company with another could provide misleading information. Businesses may be within the same industry but have different financial and business problems and face different risks. One company may be able to obtain bank loans at reduced rates and may show high gearing levels while another may not be successful in obtaining cheap rates and it may show that it is operating at a low gearing level. To an uninformed analyst it may look like the second company is performing better when in fact its low gearing level is because it isn't able to secure further funding.

Companies may have different capital structures and make a comparison based on performance quite difficult. For instance, one may be equity financed whilst another is a geared company.

Selective application of government incentives to various companies may also distort intercompany comparisons. One company may be given a tax holiday while the other within the same line of business may not. Comparing the performance of these two enterprises may therefore be misleading.

Using ratio analysis to assess whether to invest capital in Spendless

Considering the information above, a ratio analysis of Spendless' financial position was carried out. The results of the analysis are outlined.

The net profit margin ratio shows the amount of net profit per $1 of turnover that a business has earned. That is, after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on. The formula is: Net Profit Margin = Net Profit / Turnover* 100 = Profit before Interest and Taxation / Turnover* 100 (Net Profit = Gross Profit -- Expenses). [footnoteRef:4] [4: Introduction to Ratio Analysis http://www.bized.ac.uk/compfact/ratios]

The net profit of Spendless Supermarkets Ltd. fell from 8.0% to 5.2%, Spendless has probably increased its turnover but this may also imply an increase in sales costs and operating expenses. It could also mean a dropout of the profit for the year.

The Return on Capital Employed ratio (ROCE) tells how much profit is earned from the investments the shareholders have made in their company. The value of the ROCE ratio should be compared with the interest rate of a savings account. If the value of the ROCE ratio is smaller, then investing in that company may have been fruitless. Keeping the money in a bank would have been more profitable and certainly safer.

The Return on Capital Employed has fallen from 20% to 15%, which could mean either a rise of equity shareholders capital or a fall of the profits for the year. Both the Net profit margin and the Return on Capital Employed ratio have fallen, which indicates a lower net profit for the financial period. However, a comprehensive analysis requires more detailed information of the company's revenue and expenses, so a profit and loss account and a balance sheet are necessary for a thorough evaluation of Spendless' financial situation.

The gearing ratio has risen by almost 15% indicating that the business prefers debt funding to equity funding. This maximizes the interest payment problems and the control problems of having a dangerously high level of long-term debt on the balance sheet.[footnoteRef:5] A shareholder of the Spendless Supermarkets Ltd. shouldn't be happy with these results. The gearing ratio was quite high in 2002 (52, 8%) and it went up. If the other ratios would have had a positive trend, maybe there wouldn't have been a problem, but in this case the shareholders should be somewhat concerned. [5: Van Horn, J Financial Management and Policy, 11th ed., Prentice Hall, New Jersey, 1998]

The current ratio is also known as the working capital ratio and is normally presented as a real ratio. That is, the working capital ratio looks like this: Current Assets: Current Liabilities = x: y (e.g. 1.75: 1). Although the current ratio is smaller in 2003 than it was in 2002, which indicates that either the Current Assets have fallen or the Current Liabilities have risen, (which is a bad thing either way, in certain conditions), without a structural analysis of the Current Assets, it is impossible to tell what caused the change and to predict the effects. For instance, Spendless may have liquidated, or sold many of its short-term investments and possibly used the cash from having sold its investments to finance its expansion. This has left Spendless in a weak working capital position as its creditors are large but its cash and short-term assets balances are small by comparison.

The Earning per share ratio is, perhaps, the fundamental investor ratio because it helps to determine the average amount of profits earned per ordinary share issued. The formula is: Earnings per share = Profit available to equity shareholders / Average number of issued equity shares. The Earning per Share ratio for Spendless has declined, although not by much: only 1.9 cents a share. This may indicate that more shares have been issued, and therefore the Net profit per share has diminished temporarily, or, more probably, the Profit for the year decreased, a fact which seems to be confirmed by the negative trend of all other ratios available for this analysis. The Earning per share ratio is the main concern of any shareholder, and its decrease couldn't be anything else but bad, especially considering that the other ratios aren't so good either. Therefore, it is advisable not to invest in Spendless Supermarkets Ltd. The data on which this conclusion is based is not sufficient, and information for more years is required, but based solely on the available data, investing in Spendless may not be advisable.