To:

Directors of Rock Field Plc

From:
Management Accountant

Date: Tuesday, September 15, 2009.

Sub: Financial Management

Section 01

BRIEF INTRODUCTION

Financial Management:

Financial Management is the management of financial resources – how to best

find and use investments and financing opportunities in an ever-changing and
increasingly complex environment. (Brigham and Gapenski: 1991)

Analysis of Financial Statements:

Analysis of financial statement is one of the most common techniques of financial

analysis, in which the financial performance and financial health of a company are
analyzed based on its past performance. The following financial statements are
used in the analysis process.

Profit & Loss Statement or Income Statement

Income statement reflects the operating efficiency or profitability of a company as
a result of its operations along with the net profit available to the shareholders for
a given year (usually one accounting period). This statement provides the analyst
with some insight into the financial performance of the company.

(Gitman: 1995)

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o Balance Sheet
Balance Sheet is a snap-shot of an organization’s financial health at a particular
time. It shows what assets are owned by the business and the sources of acquiring
these assets.

o Statement of Shareholders’ equity

Statement of shareholders’ equity provides the share of the owners in the business.

o Statement of Cash Flows

Statement of cash flows explicitly reflects the cash movement (inflows and
outflows) during the operations in an accounting period.

Taken together, these statements give an accounting picture of the firm’s

operations and financial position. Financial statements report what has actually
happened to the assets, earnings, and dividends over the years. The analysis of the
information contained in these statements help management of the organization to
evaluate the performance and activities of the concern; it also helps the investors
and creditors to have an idea of the profitability potential and creditworthiness of
the business.

Validity of Financial Data

If the financial data used for ration calculations and for other purposes is valid or
authentic, then results will also be accurate and vice versa. So a finance manager
can check the validity of financial data by using the different tools and techniques.
Some of them are given below.

 Internal audit
 Financial systems design
 Internal checks and controls
 Authority levels
 Complexity of the accounting system
 Complexity of financial reports
 The culture of the organization regarding importance of finance
 Accounting standards
 Auditing standards
 Interpretation of the generally accepted accounting principles (GAAP)

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  Accounting statement formats
 Nationality of parent company
 The auditing/accounting firm employed
 The approach of the publisher to standardizing the financial statements
 The accuracy of the translation from published data into the preferred
format

Tools/techniques to analyze the performance level:

We will use the following tools and techniques to analyze the performance of
Rock Field Plc. We will calculate the said ratios for a period of three years so that
we could compare them and could come to a conclusion.

Ratios and Ratio Analysis

LIQUIDITY & SOLVENCY RATIOS:

Current Ratio: Current ratio is a ratio between current assets and liabilities,
which tells that for every dollar in current liabilities. Generally, the higher the
ratio, the better it is considered, but too high a ratio may imply less productive use
of current assets. A ratio of two to one (2:1) is considered ideal.

= Current Assets / Current Liabilities

Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity.

The ratio is obtained by subtracting inventory from current assets and dividing the
result by current liabilities. A desirable quick ratio can range from (0.8:1) to
(1.5:1) depending on the nature of the business.

= (Current Assets – Inventory) / Current Liabilities

Working Capital: Working Capital is more a measure of cash flow than a ratio.
The result of this calculation must be a positive number. It is calculated as shown
below:

Working Capital = Total Current Assets - Total Current Liabilities

Company’s look at Net Working Capital over time to determine ability to weather
financial crises. Loans are often tied to minimum working capital requirements.

3
PROFITABILITY RATIOS:

Profit Margin (on sales): This ratio tells the percentage of profit for every dollar
of revenue earned. This ratio is usually expressed in terms of percentage and the
general rule is, the higher the ratio, the better it is

= [Net Income / Sales] X 100

Return on Assets: It shows the profitability of the company against each dollar
invested in total assets. This ratio is also expressed in percentage terms.

= [Net Income / Total Assets] X 100

Return on equity: This ratio shows that for each dollar in equity how much profit
is generated by the company.

= [Net Income/Common Equity]

ASSET MANAGEMENT RATIOS

Inventory Turnover: Inventory turnover shows the number of times the

inventories are replenished within one accounting cycle. This ratio is also used in
measuring the operating cycle and cash cycle of the firm. A higher turnover is
desirable as it reflects the liquidity of the inventories.
= Sales / inventories

Total Assets Turnover: An effective use of total assets held by a company

ensures greater revenue to the firm. In order to measure how effectively a
company has used its total assets to generate revenues.

= Sales / Total Assets

Debt-Equity: Another commonly used ratio, debt to equity, explicitly shows the
proportion to debt to equity. A ratio of 60 to 40 is used for new projects, i.e., for a
project it is permitted to raise its finances 60 percent from the debt and 40 percent
from equity.
= Total Debt / Total Equity

4
Analysis of Ratios

Rock Field Plc’s Gross profit margin is 45.29 for year 2007 and is higher than
2006 and 2007. So in year 2007 its performance is good. Operating profit margin
in year 2007 is 28.50 and is higher as compared to year 2006 and 2008. Net assets
turn over in year 2008 is 96.41 and is higher as compared to year 2006 and 2007.
Current ratio in year 2008 is 1.05 and is better than other years. It means
company’s assets can be quickly and easily converted into cash. Quick ratio for
the year 2008 is 0.47 and is higher than other years. Inventory turn over ratio for
the year 2008 is 122.64 and is higher than the year 2006 and 2007. Trade
receivables for the year 2008 is 58.19 and are higher than the other years whereas
trade payable are lower in year 2006 as compared to other financial years. The
company financial gearing in year 2008 is 0.32 as compared to other financial
years.

CONCLUSION

From the above discussion, I have come to a conclusion that Rock Field Plc’s
financial position was better in year 2008 and as compared to the other financial
years 2006 and 2007 due to the following reasons. Rock Field Plc’ current ratio
was better and up to the standard. It means the company had more asset than the
liabilities. Rock Field Plc’ quick ratio was also good. It means if the company had
to pay its obligations, it can easily pay back it. Rock Field Plc’ financial gearing
was satisfactory which means that there was no need for the company to take
more loans to meet its obligations.
So in the year 2008 the Rock Field Plc’ financial position was more strong as
compared to the other financial years 2006 and 2007.
(Note: Please errors and omissions may be omitted)

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Section 02

Budgeting
Budget: A detailed schedule of financial activity, such as an advertising budget, a
sales budget, or a capital budget. It provides a forecast of revenues and
expenditures. (Cheney, and Moses: 1995)

Types of Budgets

1. Master Budget: A master budget is an overall financial and operating plan for
a forthcoming calendar or fiscal year. It is usually prepared annually or quarterly.

2. Cash Budget: The cash budget is for cash planning and control. It presents
expected cash inflow and outflow for a designated time period.

3. Capital Expenditure Budget: It is a listing of important long-term projects to

be
Undertaken and capital (fixed assets such as plant and equipment) to be acquired.

4. Rolling Budget: A method of budgeting in which as each month passes, an

additional budget month is added such that there is always a 12-month budget.

5. Program Budget: Programming is deciding on the programs to be funded and

by how much. A common application of program budgets is to product lines.

6. Incremental Budget: Incremental budgeting looks at the increase in the budget

in terms of dollars or percentages without considering the whole accumulated
body of the budget.

7. Add-on Budget: An add-on budget is one in which previous years’ budgets are
examined and adjusted for current information, such as inflation and employee
raises.

8. Supplemental Budget: Supplemental budgets provide additional funding for an

area not included in the regular budget.

9. Activity-based Budget: Activity-based budgeting budgets costs for individual

activities.

10. Continuous Budget: A continuous (rolling) budget is one that is revised on a

regular (continuous) basis. Typically, a company extends such a budget for
another month or quarter in accordance with new data as the current month or

6
quarter ends. For example, if the budget is for 12 months, a budget for the next 12
months will be available continuously as each month ends.

Advantages and Disadvantages of Budgets

Advantages:

Budgeting involves cost and time to prepare. The benefits of budgeting must out-
Weigh the drawbacks. A budget can be advantageous because it:

 Links objectives and resources

 Communicates to managers what is expected of them. Any problems in

communication and working relationships are identified. Resources and
requirements are identified

 Establishes guidelines in the form of a road map to proceed in the right

direction.

 Improves managerial decision making because emphasis is on future events

and associated opportunities.

 Encourages delegation of responsibility and enables managers to focus

more on The specifics of their plans and how realistic the plans are, and
how such plans May be effectively achieved

 Provides an accurate analytical technique

 Provides better management of subordinates. For example, a manager can

use the budget to encourage salespeople to consider their clientele in long-
term strategic terms

 Fosters careful study before making decisions

 Helps management become aware of the problems faced by lower levels

within
 The organization. It promotes labor relations

 Allows for thinking how to make operations and resources more

productive, efficient, competitive, and profitable. It leads to cost reduction

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  Allows management to monitor, control, and direct activities within the
company. Performance standards act as incentives to perform more
effectively

 Points out deviations between budget and actual, resulting in warning

signals for changes or alterations

Disadvantages:

A budget promotes gamesmanship in that those managers who significantly inflate

requests, knowing they will be reduced, are in effect rewarded by getting what
they probably really wanted.

A budget may reward managers who set modest goals and penalize those who set
ambitious goals that are missed. There is judgment and subjectivity in the
budgeting process.

Managers may consider that budgets redirect their flexibility to adjust to changing
conditions.

A budget does not consider quality and customer service.

Suggesting the better budget system for Rock Field Plc

From the above discussion, I have come to a conclusion that not all types of
budgets are suitable for a single company and it depends upon the nature of
businesses, corporate culture and the internal and external environment of the
company. For Rock Field Plc I would like to suggest the Activity Based
Budgeting due to the following reasons,

• It is more performance oriented in nature

• It Provides opportunity to test and refine the system
• It can anticipate problems prior to full-scale implementation
• It provides opportunity to build support among non pilot departments
• It allows for more individual assistance and attention
• It requires less overall time for implementation
• Here the Training and assistance can be provided uniformly for all
departments

8
 Variance and Variance Analysis

Variance is the difference between a budgeted, planned or standard amount and

the actual amount incurred/sold. Variances can be computed for both costs and
revenues. (Charles P. 2001)

Variance Analysis Variance analysis is a tool of budgetary control by evaluation

of performance by means of variances between budgeted amount, planned amount
or standard amount and the actual amount incurred/sold. Variance analysis can be
carried for both costs and revenues.

Variable cost variances

 Direct material variances

 Direct labor variances
 Variable production overhead variances

Fixed production overhead variances

 Sales variances

Material Cost Variance can be divided into:

- Price Variance: When the Actual Materials Price is higher than the Standard
Materials Price, the variance is said to be unfavorable

- Usage Variance Usage Variance can be further sub-divided into Mix Variance
and Yield Variance

Direct labour cost variance is the difference between the standard cost for actual
production and the actual cost in production. There are two kinds of labour
variances. Labour Rate Variance is the difference between the standard cost and
the actual cost paid for the actual number of hours. Labour efficiency variance is
the difference between the standard labour hour that should have been worked for
the actual number of units produced and the actual number of hours worked when
the labour hours are valued at the standard rate.

Sales variance is the difference between actual sales and budget sales. It has
further two sub categories,

Sales price variance: The sales price variance is calculated as: Actual quantity sold
* (actual selling price-planned selling price).

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Sales Volume Variance is calculated as: Budgeted price * (actual volume-planned
volume).

Rules for calculation of Variance Analysis

There are two important rules:

1. The level of variance analysis should be decided by the needs of the decision
maker, not the convenience of the reporter.

2. The budget must always be flexed for volume changes to produce realistic
variances.

PROPER VARIANCE ANALYSIS

This requires some thought and some simple calculations. It has 4 stages:

1. Flexing the budget

2. Analyzing the variances

3. Identifying the causes

4. Taking appropriate action

Since only the last of these is a value adding activity, the first three are only worth
Doing if step 4 is taken in time to help future results. This may mean the first three
Steps have to be done fast even if that reduces their accuracy.

Example

Rock Field Plc budgets to sell 100 units - being 50 units of Product A at £10 per
unit and 50 units of Product B at £11.The company actually sold 120 units - being
80 units of Product A at £9 and 40 units of Product B at £12. A Sales Mix
Variance can arise selling more than one product. In practice it is caused by the
use of average prices for families of products or customers. At the individual
product line level the only variances which can arise are price and volume. The
same analysis can be done for costs within products or at margin level. There are

10
also approaches that derive the averages based on the percentage the product
formed of the total. In all cases the approach adopted should be designed to help
the manager to help make decisions. Thus from the example above the variable
costs and margins would need to be calculated to identify if the results of the
manager of A’s tactics of lower price to gain more volume was “better” than those
of the manager of Rock Field Plc.

Causes of Budgeted Sales, Material, Labour and FOH Variances

The following may be the potential reasons for budgeted variances,

Faulty Arithmetic in the Budget Figures: It is perfectly possible to have an error in
the budget. This includes errors of commission or duplication as well as pure
arithmetic. One action is to make a note to ensure it does not happen again when
the next budget is being done.
Errors in the Arithmetic of the Actual Results: It is perfectly possible for the
actual results to be reported wrongly. This includes the use of the wrong category,
omission of costs, double counting of income etc.
Reality is wrong: Sometimes the Actual results are useless as an indicator. A
strike or natural disaster will have an impact on results.
Differences between Budget Assumptions and Actual Outcome: This is the key
issue and the one which involves the use of variance analysis techniques.
Remember that all budgets contain errors in the assumptions.

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Section 03

Investment Proposal
Concept of Capital Budgeting

Capital budgeting is about investment in fixed assets. Fixed assets are the part of
long term assets in the balance sheet and working capital is net position of current
assets and current liabilities on the balance sheet. (Martin, and Scott: 1990)

Techniques of capital budgeting:

1. Return on capital employed ratio

2. Pay back period
3. Return on investment (ROI)
4. Net Present Value (NPV)
5. Profitability Index (PI)
6. Internal Rate of Return (IRR)

Return on Capital Employed Ratio

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn
from the investments the shareholders have made in their company. Think of it
this way: if we had a savings account with a bank and we'd been paid, say, £25
interest at the end of a year; and we had saved £500, we could work out the rate of
interest we had earned:

Interest earned 25 1 100

Rate of interest = * 100 = * 100 = * 100 = = 5%
Amount saved 500 20 20

So, we have earned 5% interest on our savings.

Imagine now that instead of talking about a savings account, we were talking
about a company and the profit for the year and its capital employed had been £25
and £500 respectively then the ROCE for that company would be 5% too.

Profit for the Year 25 1 100

ROCE = * 100 = * 100 = * 100 = = 5%
Equity Shareholders' Funds 500 20 20

ROCE should always be higher than the rate at which the company borrows,
otherwise any increase in borrowing will reduce shareholders' earnings.

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Disadvantage of ROCE

The main drawback of ROCE is that it measures return against the book value of
assets in the business. As these are depreciated the ROCE will increase even
though cash flow has remained the same. Older businesses with depreciated assets
will tend to have higher ROCE than newer, possibly better businesses. In addition,
while cash flow is affected by inflation, the book value of assets is not.
Consequently revenues increase with inflation while capital employed generally
does not (as the book value of assets is not affected by inflation).

Net Present Value (NPV):

NPV is a mathematical tool which uses the discounting process and is defined as
the value today of the Future Incremental After-tax Net Cash Flows less the initial
investment.

Internal Rate of Return (IRR):

IRR is a widely used and an important measure, which is more common in

practice than the NPV. IRR, unlike NPV that is expressed in dollar amounts, is
always quoted in terms of percentage, which makes it comparable to the other
market interest rates or the inflation rate. IRR calculation involves the same
equation that we have earlier used for the calculation of NPV. The only difference
is that while calculating IRR we would set the value of NPV equal to zero and
then solve the equation for the value.

NPV and IRR Differentiation

The internal rate of return is different from the discounting rate that we use in the
calculation of the NPV. In the NPV formula, we used the discount rate as the
required rate of return that we expected the project to generate. In case of IRR, we
used the existing cash flows to find the forecasted return.

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Pay back period:

In this technique, we try to figure out how long it would take to recover the
invested capital through positive cash flows of the business. For this an initial
investment of £200,000 is required to start the business; £10,000 per month is
expected to be earned for the first year, and £20,000 would be earned every month
in the second year. Now according to the aforementioned assumptions, in the first
year, you earn £10, 000 per month, which make £120,000 for the year (twelve
months). Since you had invested £200,000 initially of which £120,000 have been
recovered in the first year, you are still £80, 000 short of recovering your initial
investment. In the second year, you would be earning £20,000 per month, so the
remaining £80, 000 can be recovered in the next four months. We can say that the
initial invested capital can be recovered in 16 months, or the payback period for
this investment is 16 months. The shorter the payback period of a project, the
more an investor would be willing to invest his money in the project.

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 APPENDICES

(Calculations for Rock Field Ltd.)

A.

1 .EBIT(Operating Ratio) Operating 4586x10 5387x10 4959x100

Income 0 0 19845
=========== 18000 18900 =25%
Total Revenue =25.47% =28.50%
2.Net Profit Margin Net Income 3882x10 4572x10 3909x100
Total Revenue 0 0 19845
18000 18900 =19.7%
=21.6% =24.2%
3.Return On Assets(ROA) Net Income 4586x10 4572x10 4959x100
Total Assets 0 0 27425
23621 26117 =18.1%
=19.41% =17.5%
4.ROCE(Return on Capital EBIT 4586x10 5387x10 4959x100
Employed) Total Assets-CL 0 0 20584
19434 20313 =24.1%
=23.60% =26.2%

5.Return On Equity Net Income 3882x10 4572x10 3909x100

Total Equity 0 0 15584
14434 15313 =25.1%
=26.9% =29.9%

B. Liquidity Ratio

2006 2007
2008

1.Current Current Assets 3265x100 4976x100 7214x100

Ratio Current Liabilities 4187 5804 6841
=78% =85.7% =105.4%

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2.Quick Current Assets – 1490x100 2313x100 3219x100
Ratio(Acid Test Inventory 4187 5804 6841
Ratio) Current Liabilities =35.5% =40% =47%

2006 2007 2008

1.Inventory turn Over C.G.S 10440 10340 11890
Ratio Inventory -------- ------- ------
1775 2663 3995
=5.88 =3.88 =2.98 time
times times
2.Inventory Holding Total Days in A 365 365 365
Days Year ---- --- -----
I.T.O 5.88 3.88 2.98
=62 days =94 days =122 days

3.Debtor Turn Over Credit Sale 18000 18900 19845

Ratio Debtor --------- -------- ------
1440 2260 3164
=12.5 =8.36 =6.3 times
times times

4.Debtor Days Total days in a 365 365 365

year ------ ----- -------
---------------------- 12.5 8.36 6.3
D.T.O =29.5 days =43.6 58 days
days
5.Creditor Turn Over C.G.S 10440 10340 11890
Ratio --------- ------- ------- -------
Creditors 390 388 446
=26.76 26.6 time =26.7
time
6.Creditor Days Total days in a 365 365 365
year ---- ----- ----
-------------------- 26.76 26.6 26.7
C.T.O 14 days 14 days 14 days

D.Gearing Ratio

2006 2007 2008

1.Debt-to-Equity Total Debt 9187x10 10804x10 11841x100
Ratio

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 Total Equity 0 0 15584
14434 15313 =76%
=63.64% =70.56%
2.Total Debt Total Debt 9187x10 10804x10 11841x100
Ratio Total Assets 0 0 27425
23621 26117 =43.2%
=39% =41.4%
3.Interest Earnings Before Interest and 4586x10 5387x100 4959x100
Coverage Ratio Taxes(EBIT) 0 600 600
Interest Expenses 600 =897.8% =826.5%
=764%

E. variance Analysis
Formula £ Favourable/unfavourable
1.Sale Actual Unit Sale (Stand.Priec 240000(5-4.5) 120,00 Un favourable
Variance –Actual Price) 0
2.Labour Actual labour cost-stand. 110000-120000 10000 Favourable
Variance labour cost
3.Material Actual Mat. Cost-ST. Mat. 240000(2.67-2) 40,000 Unfavourable
Variance Cost
4.Gross Actual G.P-ST.G.P 60000-630000 30000 Favourable
profit
variance

F.1
Year Cash Flow Pvf(10%) pv
0 (89000) 1 (89000)
1 24000 .909 21816
2 49000 .826 40474
3 30000 .751 22530
4 20000 .683 13660
Np=9480

Year Cash Flow Pvf(20%) Pv

0 (89000) 1 (89000)
1 24000 .833 19992
2 49000 .694 34006
3 30000 .579 17370
4 20000 .482 9640
NP=-7992
7992
IRR=10%+( ------------------------)(20%-10%)
7992+9480

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=14.5%

F.2
Year Cash Flow Pvf(17%) PV
0 (89000) 1 (89000)
• 1 • 24000 • .854 • 20496
2 49000 .73 35770
3 30000 .624 18720
4 20000 .534 10680
NP=-3334

References

Books

Block and Hirt. Foundations of Financial Management. 6th edition. Richard Irwin
& Co, 1992.

Bowlin, Martin, and Scott. Guide to Financial Analysis. 2nd edition. McGraw-Hill,
1990.

Brigham and Gapenski. Financial Management: Theory and Practice. 6th edition.
Dryden Press, 1991.

Campsey and Brigham. Introduction to Financial Management. 3rd edition.

Dryden Press, 1991.

Cheney, and Moses. Fundamentals of Investments. West, 1997.

Eun, Cheol S. and Bruce G. Resnick. International Financial Management. New

York: Irwin McGraw-Hill, 1998.

Fraser, Lyn M. Understanding Financial Statements. NJ: Prentice Hall, 1992.

Gitman. Principles of Financial Management. 6th edition. Harper/Collins, 1995.

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Hampton. Financial Decision Making: Concepts, Problems, and Cases. 4th edition.
Prentice Hall, 1989.

Hirt, and Block. Fundamentals of Investment Management. 3rd edition. Irwin,

1990.

Jones, Charles P. Investments: Analysis and Management. 8th Edition. Wiley,

John & Sons, Inc. 2001

Websites

http://69.175.2.130/~finman/Publications/FMSummer2009.htm

http://www3.interscience.wiley.com/journal/fm118902563

http://www.ehlers-inc.com/links.htm

http://www.essaytown.net/db/search?KEYW=Financial+Management

http://financialmanagementdevelopment.com/

http://www.iadb.org/idbamerica/English/JUN01E/jun01e7.html

http://www.managers.org.uk/client_files/user_files/Rattigan_8/Pathways/Unit
%207003%20Sample.pdf

Journals

Evidence of Bank Market Discipline in Subordinated Debenture Yields,” Journal of

Finance, (September 1996): pp. 1347-1377.

Golden Years Carry a Hefty Price Tag.” Wall Street Journal, 24 August 1999, C1.

ISI Journal Citation Reports® Ranking: 2008: 26/48 Business, Finance

Impact Factor: 0.778

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