Sources Of Financial Data, Ratio Analysis, Budgeting Models, And Capital Investment Evaluation

Main Sources of Financial Data and Validity Assessment

AC 1.1 Ways of obtaining financial data and assessment of its validity:

For this section, Sainsbury Plc is chosen as the organisation, which is one of the leading retailers holding 16.9% of the market share in the retail industry of UK (About.sainsburys.co.uk 2018). Financial data provide raw materials for driving conclusion of the financial position of the business. Primarily, an organisation could obtain financial data from internal resources as well as external resources (Bekaert and Hodrick 2017). The internal resources denote the records generated by the business, while the external resources imply the sources available from the third parties.

The internal financial data could be obtained from the accounting system of the organisation, control function reports like sales department reports, other departmental managerial reports and reports prepared by the suppliers, customers and staffs. These reports provide details of the financial aspects of the departmental operations and thus, the accounts and finance division of Sainsbury could be provided with information regarding revenue details and necessary expenditure generated over a year (Cornwall, Vang and Hartman 2016). By combining these reports, the financial department could accumulate and interpret data for developing information to infer about its financial position. The other sources from which Sainsbury Plc could obtain financial data include company house, company website, financial information database and research reports, which are external data sources.

Validity implies the reasonableness and accuracy of financial data producing suitable quality information for ascertaining financial condition of a specific organisation. Thus, it is necessary for Sainsbury to evaluate the data collected based on regular sampling for validity to be conducted by internal as well as external auditors. The validity of financial data could be evaluated by reviewing and questioning financial data, which is presented in the below section.

AC 1.4 Review and question of financial data:

The internal auditors are the employees of the organisation and they assess business operations and accounting for bringing disciplined and systematic approach to analyse and enhance risk management effectiveness along with processes of governance and control. However, due to lack of independence, they are sometimes limited to report any error or fraud to the top management due to perceived threats of their employment (Dyckman, Magee and Pfeiffer 2014). These auditors are not normal staffs and they are hired by the organisation, who are responsible to report to the top management.

The external auditors give reasonable assurance that the financial reports do not contain material misstatements, errors or frauds for providing unqualified audit opinion. In this context it is noteworthy to mention that the external auditors are not and need not be expected to provide complete assurance about validity and reliability of the financial statements. However, they audit only published accounts by ensuring that certain rules are followed and they do not assure that the company information is published in a comparable format.

AC 1.2 Application of different types of analytical tools and techniques to a range of financial documents:

Ratio Analysis for Financial Performance

Ratio analysis is considered as the most powerful tool of analysing the financial statements, as it ascertains the levels of financial performance along with formulating conclusions aiding in the decision-making process planning, forecasting and controlling (Beatty and Liao 2014). For Sainsbury Plc, the following six ratios are considered by taking into consideration the financial statements of the years 2017 and 2018:

From the above table, it is evident that the first ratio taken into consideration is net profit as a percentage of sales. In case of Sainsbury, the ratio has declined from 1.44% in 2017 to 1.09% in 2018 due to increase in cost of sales over the year, since the sales revenue of the organisation has increased as well (About.sainsburys.co.uk 2018). On the other hand, a higher return on capital employed indicates better business performance denoting effect utilisation of assets. For Sainsbury Plc, decline could be observed from 5.73% in 2017 to 4.43% in 2018, as it fails to generate adequate profit from its long-term funding. Thus, in terms of profitability, Sainsbury Plc is not placed in a favourable position in the UK retail market (Elliott 2017).

For Sainsbury Plc, gearing ratio is observed to decline from 63.15% in 2017 to 57.86% in 2018, as it has focused on raising additional funds through equity by minimising its long-term liabilities. Thus, the organisation has managed to minimise its exposure to financial risk over the years (Finkler et al. 2016).  

Acid test ratio helps in evaluating the liquidity position of an organisation by not including few current assets like inventories and prepaid expenses, as they could not be converted into cash within shorter timeframe. Even though Sainsbury Plc has managed to increase its acid test ratio from 0.53 in 2017 to 0.59 in 2018, it is below the industrial standard of 1. This is because it has been collecting amounts from the debtors lately due to which the cash balance has not increased over the years.

In terms of average age of debtors in days, it could be observed that Sainsbury Plc has increased its debtor terms from 7.99 days in 2017 to 9.54 days in 2018, as it is facing difficulties in collecting from its customers. However, a decline in average age of stock in days is observed from 26.35 days in 2017 to 24.86 days in 2018, as it has aligned its inventory base in accordance with the market demand. Thus, in terms of efficiency, Sainsbury Plc is placed in a slightly favourable position in the UK retail market.

Budgeting Models and Cash Flow Analysis

Based on the above evaluation, the major strengths of Sainsbury Plc could be listed down as follows:

• A slight improvement in liquidity could be observed due to minimised time of inventory turnover in days.
• The capital structure of the organisation is effectively balanced, as it has concentrated on raising funds through equity, instead of relying too much on debt funding.

However, there are certain weaknesses evident from the above analysis for Sainsbury Plc, which could be listed down as follows:

• The organisation is struggling in terms of profitability due to its minimised earnings from the banking subsidiary and as a result, it has failed to generate adequate returns from investments made.
• The organisation is following a lenient policy in collecting amounts from the debtors due to which the working capital availability has fallen over the years.

In order to overcome these challenges, the following recommendations would be extremely beneficial for Sainsbury Plc to improve its financial performance:

• It needs to appoint a specialised market research firm in order to assess the changes in the tastes and preferences of the customers towards the retail products. Accordingly, new product lines could be added and they need to be marketed effectively, which would help in increasing the overall revenues.
• It needs to formulate stringent policy for its debtors in collecting amounts from them within a shorter timeframe by providing discounts for timely payments, which would help in increasing the availability of working capital.

However, it is to be borne in mind that the ratios are subject to certain limitations, which are demonstrated briefly as follows:

• Ratios are derived from past results and the same results are not expected to remain the same in future.
• Due to the difference in accounting policies concerning inventory valuation and depreciation, the accounting data as well as ratios of the two organisations could not be compared.
• No particular standards are laid down for ideal ratios. For instance, current ratio is considered to be ideal, if current assets are greater than current liabilities. However, this standard might not be justified for those concerns having considerable agreements with bankers to provide funds, as needed. Under such situation, it might be perfectly ideal if current assets are slightly more or identical to current liabilities (Hoskin, Fizzell and Cherry 2014).

AC 2.1 Financial barriers and target accomplishments, legal needs and accounting conventions at the time of budget formulation:

Budget helps in providing comprehensive financial insight of planned company operation. The budgets are prepared with the intent so that the incomes could be planned and the expenses could be controlled by the organisation. The objectives of Sainsbury Plc drive its budget preparation so that it could be compared with the actual outcomes (Barr and McClellan 2018). Many business variables could be budgeted including output, sales, variable and fixed cost, cash flow, profits and capital investment. Budget needs to be SMART, which is specific, measurable, achievable, realistic and time bound; whereas, in opposition, budget would not be effective.

The strategic goal of Sainsbury Plc is the initial factor, which requires to be taken into account at the time of preparing budgets, since failure would be obvious, if the budgets are not aligned with the strategic objectives. After this step, it is necessary to identify the limiting factor that the firm is encountered, which is identified as impediment. This might be restriction on the selling volume of the business or direct labour hours of a specific kind of workforce. At the time organisation detects the limiting factor, budgetary principle is set. The next step is coordination and evaluation of internal factors, which are employee resources and capabilities along with draft department budget (Irimia-Dieguez, Medina-Lopez and Alfalla-Luque 2015). Once when the step is over, the organisation needs to evaluate the external factors like estimated political, economic and international environment, which enables in reducing the risk related to budget. Finally, Sainsbury should coordinate the overall department budget that include production budget, sales budget, labour budget, material and overhead budget or master budget (Nilsson and Stockenstrand 2015).

The master budget is an overview of the plans of an organisation for setting particular targets for financing and distribution activities along with sales production. This is culminated generally in budgeted profit and loss statement, cash budget and a budgeted balance sheet. The initiation of master budget is made with sales estimations, which could be conducted by critical evaluation of the previous selling trend, sales force estimations, actions of the competitors, general economic conditions, variation in the prices of the organisation, market research along with promotion plans for sales and advertising (Henderson et al. 2015). Sales estimations results in sales budget, which is a detailed overview of the estimated sales for the budget period. This could be represented in the form of currency and units. Thus, one of the significant pillars of master budget is sales budget.

Capital Investment Evaluation Criteria and Methods

After sales budget, production budget is necessary for Sainsbury, since it determines the production volume based on the expected sales volume along with beginning and ending inventories (Lafond, McAleer and Wentzel 2016). Another budgeting component is material budget, which represents the cost and volume of buying materials for planned inventories and production. Labour budget reflects the budget for both skilled and unskilled labour based on the production level. Finally, Sainsbury Plc could prepare overhead budget for showing quantities of a bigger number of cost items. These items include electricity, rent, salary and administrative expenses (Karadag 2015). When all these budgets are prepared for Sainsbury, it could formulate projected profit and loss statement, cash budget, cash inflows and outflows and budgeted balance sheet.

AC 2.2 Analysis of the budget outcomes against organisational objectives and identification of alternatives:

The actual performance and the budgeted performance often resemble each other and the significant budgeting goal is to reduce the gap between actual performance and budgeted performance. Because of faulty assumptions in budget numbers, mistakes in arithmetic of the actual results, incorrect budget assumptions and actual results, timing variations and price variance might take place. With the help of budget, it is possible to gauge the performance for conducting the comparison between actual performance and budgeted performance (Martin 2016). Variances are utilised for gauging the gap between actual performance and budgeted performance. This analysis helps the managers in identifying issues requiring additional examinations for adopting corrective actions. Variances could be labour variance, material variance and overhead variance.

In case of the provided budget, increase in sales receipts could be observed over the months and the organisation has earned loan proceeds due to which the cash receipts are the highest in the month of January. Positive variance could be observed in wages, as it has declined over the half-year period. However, fixed costs have increased over the months, as more units are produced in the later months of the year, due to which there is overall increase in the cost of goods sold. Another reason that the net cash flow of the organisation has been negative from February is due to the lease of new building, the payment of which has continued until June. Advertising fees have been charged from the month of February, which remained same until April with a slight increase in May; however, no such fees are charged in June. The organisation has budgeted half-yearly tax payment scheduled to be paid in the month of June. On the other hand, the most significant reason that the net cash flow of the organisation has been negative in most of the months is due to the estimated capital expenditure in the month of March. Finally, loan repayments are projected to begin from April to June due to which the overall payments have increased. In this case, the closing cash balance is observed to be negative in the months of May and June. The organisation has a bank overdraft of £750,000, which could help in offsetting the negative cash flow.

This particular situation could be addressed with the help of variance analysis. In this respect, labour rate and efficiency variances along with material price and volume variances are benchmarks of efficiency and economy (Matthew 2017). With the help of selling price and volume variances, it would become possible for the organisation to signify the effect on performance due to the change in demand and price levels. The management could detect the reasons behind ineffective performance by evaluating variances. For instance, in case of the provided organisation, material variances might take place due to increase in prices of raw materials or damaged quality of raw materials resulting in greater levels of wastage (McKinney 2015). Therefore, corrective actions could be undertaken to reach desired level of performance and it becomes easier to undertake corrective actions after the identification of ineffective performance. Therefore, the three alternatives through which the organisation could identify the issues include bank overdraft, effective production level and variance analysis.

AC 3.1 Identification of criteria for judging proposals:

Any organisation needs to evaluate the various alternative proposals, which provide yield efficiency. Basically, an effective proposal could be selected based on the accepted risk level, greatest benefit level, cost benefit ratio and lowest cost (Schipper, Francis and Weil 2017). Therefore, the organisation could set the criteria for choosing the proposal including financial project feasibility, effect on strategic objective, future financial ratios and significant financial indicators coupled with the weaknesses and strengths of the project. The five question model of Tucker is effective in evaluating the projects, which help the managers to undertake decisions. The questions are summarised briefly as follows:

• Is the project profitable?
• What is the fairness of the project to the stakeholders?
• Does the project meet legal requirements?
• Is the project scrupulous?
• What is the chance of project sustainability?

With the help of such criteria, the managers could choose the effective project containing lower risk and suitable implementation.

AC 3.2 Viability of the proposal for expenditure:

Capital expenditure takes into account large amount of money and it has impact on future business plan. Therefore, the organisations need to analyse projects to check its feasibility and profit generating capacity in contrast to original investment. A project is considered to be feasible when there is generation of more revenue than expenditure spent on the project. In case of Marvina Consolidated Industries, the viability of the two projects is assessed with the help of the two techniques, which include net present value and internal rate of return. The detailed calculations are demonstrated briefly in the forms of tables as follows:

Calculation of Selling Price Per Unit
Particulars	Units
Administrative staff cost per hour	£           40
Time savings in minutes	15
Number of minutes in an hour	60
Value of time saving per unit	£           10

Calculation of Cash Flows:-
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Sales volume	18,000	18,000	21,000	24,000	27,000
Value of time saving per unit	£           10	£             10	£               10	£           10	£            10
Total value of time saving	£ 180,000	£   180,000	£     210,000	£ 240,000	£  270,000
Maintenance charges for the new system	£    50,000	£      50,000	£        50,000	£    50,000	£     50,000
Maintenance charges for the existing system	£    30,000	£      30,000	£        30,000	£    30,000	£     30,000
Resale value of the new system	£           –	£              –	£               –	£           –	£     80,000
Resale value of the existing system	£           –	£              –	£               –	£           –	£     15,000
Cash flows for the new system	£ 130,000	£   130,000	£     160,000	£ 190,000	£  300,000
Cash flows for the existing system	£ 150,000	£   150,000	£     180,000	£ 210,000	£  255,000

Year	Cash Flows-New System	Cash Flows-Existing System	Cost of Capital	Discounting Factor Value	Present Value of Cash Flows-New System	Present Value of Cash Flows-Existing System
0	-£     500,000	-£     300,000	15%	1	-£        500,000	-£         300,000
1	£     130,000	£     150,000	15%	0.87	£         113,043	£         130,435
2	£     130,000	£     150,000	15%	0.76	£            98,299	£         113,422
3	£     160,000	£     180,000	15%	0.66	£         105,203	£         118,353
4	£     190,000	£     210,000	15%	0.57	£         108,633	£         120,068
5	£     300,000	£     255,000	15%	0.50	£         149,153	£         126,780
Net Present Value (NPV)					£74,330.89	£  309,057.50
Internal Rate of Return (IRR)					20.27%	49.00%

NPV is the technique of discounted cash flow used in capital budgeting and time value of money is considered in this method. NPV contrasts the monetary value today to the identical monetary value in future by taking into account returns and inflation (Trotman, Carson and Gibbins 2015). A project with positive NPV needs to be selected and negative NPV needs to be rejected, since the cash flows would be negative as well. In case, there are two mutually exclusive projects, the project with higher NPV would be accepted. This is the superior technique of capital investment appraisal among the other methods, since in case of any conflict among projects, NPV is used for making decision.

In terms of NPV, it could be seen that the existing system of the organisation would provide greater monetary benefits, as the NPV of the new system would be lower than the existing system. Moreover, as the systems are mutually exclusive, it is recommended to Marvina Consolidated Industries to select the existing system for maximising its overall profitability. However, in practice, it is complicated to derive estimated cash flows and gauging the discount rate, which are the major drawbacks of NPV (Trucco 2015).

Internal rate of return is a capital budgeting tool that makes NPV of all cash inflows from a specific project identical to zero. The higher the IRR of a project, the more feasible it is to undertake in order to earn better returns on investment (Wagenhofer 2015). The primary advantages of IRR are that it considers the time value of money and it does not need hurdle rate, which is difficult to be ascertained. In case of Marvina Consolidated Industries, the IRR for the existing system is computed as 49%, while the IRR for the new system is obtained as 20.27%. Therefore, the existing system needs to be continued for maximising the overall return on investment. However, this method ignores the real monetary value of benefits and it makes unrealistic implicit assumptions of reinvestment rate (Wang 2014).

By continuing with the existing system, Marvina Consolidated Industries could be able to extend its product range by supplying more insurance policies, as demanded by the customers. This investment would help in boosting the brand of the organisation by forming effective relationships with the customers. Another advantage of this investment proposal would be the key skills to be learnt by the business and the expected future opportunities (Zietlow et al. 2018). However, such investment might restrict the flexibility of the organisation in making response to future modifications. For instance, investing in a new system without knowing about the demand of the product might lead to investment risk. Moreover, the shareholders might opt for investments providing quick returns. The effects of the proposal on the strategic objectives of the organisation consist of the following:

• Identifying, characterising and assessing threats
• Evaluating the vulnerability of critical assets to particular threats
• Determination of risks
• Identification of techniques for minimising these risks
• Prioritisation of risk minimisation measures

References:

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