Executive Summary

The report exclusively deals with the Accounting and Financial Management. The report has been divided into two broad types. The first part deals with the calculations regarding the payback period, average accounting return and break-even analysis. This part of the report also explains the various aspects of the same. The next half of the report is based on the calculations related with the Horizontal and vertical analysis. Further, it also explains the different patterns and trends present in the Income Statement and Balance Sheet based on the calculations done.

Introduction

The primary objective of accounting in any business is to help that business make the maximum profit after tax. Unless accounting makes its full contribution to that objective, its cost cannot be justified. In today’s industry, one of the ways accounting pays for itself is to help management to control operations. Another way is to help management utilize its working capital to the greatest possible advantage.

Every business has important financial concerns and its success or failure depends in a large part on the quality of its financial decisions. Effective financial decision making requires an understanding of the goal(s) of the firm. The widely accepted objective of the firm is to maximize the value of firm for its owners, i.e. to maximize shareholders wealth (MAYER, R. et al, 2005).

Hence, the accounting and financial management has become an integral part of business in the twenty-first century. The concept of payback period, average accounting return, breakeven analysis, trend analysis and vertical analysis are very important for any business, big or small.

Discussion

2.1 Problem 1

A company is considering a capital project costing £ 400,000. The sales forecasts, together with the forecast expenditure are shown below:

Table 1: Sales and Expenditure Forecast

Year

Sales (£)

Cost of Sales (£)

Other variable costs (£)

Fixed costs except depreciation (£)

Depreciation (£)

1

200,000

60,000

20,000

30,000

100,000

2

300,000

90,000

30,000

30,000

100,000

3

400,000

120,000

40,000

30,000

100,000

4

300,000

90,000

30,000

30,000

100,000

1,200,000

360,000

120,000

120,000

400,000

The above problem can be formulated in the form of Income Statement as below:

Table 2: Income Statement of the Company

Years

1

2

3

4

Sales

200,000

300,000

400,000

300,000

Cost of Sales

(60,000)

(90,000)

(120,000)

(90,000)

Gross Profit:

140,000

210,000

280,000

210,000

Variable Cost

(20,000)

(30,000)

(40,000)

(30,000)

Earnings before Fixed Charges:

120,000

180,000

240,000

180,000

Fixed Cost

(30,000)

(30,000)

(30,000)

(30,000)

Earnings before tax and depreciation:

90,000

150,000

210,000

150,000

Depreciation

(100,000)

(100,000)

(100,000)

(100,000)

Net Income:

-10,000

50,000

110,000

50,000

2.1.1 Calculation of Payback period for the Project

The payback period for the project is the length of time to get your money back (FABOZZI and PETERSON, 2003). In this problem, the company has invested £ 400,000.

The table below shows the expected cash flows in the four years:

Table 3: Expected Cash Flows of the Company

End of Year

Expected Cash Flows

Accumulated Cash Flows

1

90,000

90,000

2

150,000

240,000

3

210,000

450,000

4

150,000

600,000

From the table above, it is clear that at the end of Year 2, the full £400,000 will not be paid back. We need to have some amount from Year 3 as well. The amount needed from Year 4 will be £400,000 – 240,000 = £160,000.

Hence, the payback period is calculated as:

Payback Period:

2 years + 160,000/210,000

= 2.762 years

= 2 years and 9 months (Approx.)

Thus, the Payback period for the company is 2 years and 9 months.

Calculation of the Average Accounting Return

The Average Accounting Return (AAR) measures the return on an investment, after taxes and depreciation, over a specified period. Mathematically, the ratio is equivalent to the expected average earnings less taxes and depreciation, divided by the average book value over the duration of the investment.

According to table 2 above, we need to find the values of:

  • Average project earning after tax and depreciation

Average Net Income = Sum of all Net Incomes / No. Of Years

= (-10,000 + 50,000 + 110,000 + 50,000) / 5

= £ 50,000

  • Average book value of the investment during its life time

The depreciation for each year is £ 100,000. Thus, the yearly book value of investment is given by:

Table 4: Book Values

Year

Book Value

1

400,000

2

300,000

3

200,000

4

100,000

5

0

Average book value = Sum of all book values / No. Of years

= 400,000 + 300,000 + 200,000 + 100,000 + 0 / 5

= £ 200,000

Average Accounting Return (AAR) = 50,000 / 200,000

= 0.25

Therefore, the Average Accounting Return for the invested £ 400,000 after taxes and depreciation is 25 %.

Break-Even Analysis for the Project

One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs (HOLLAND, 1998). At this point, no profit is made and no losses are incurred. The break-even point can be expressed in terms of unit sales or pound sales.

That is, the break-even units indicate the level of sales that are required to cover costs. Sales above that number result in profit and sales below that number result in a loss. The break-even sales indicate the pound of gross sales required to break-even. So, a break-even cannot be calculated only once. It should be calculated on a regular basis to reflect changes in costs and prices and in order to maintain profitability or make adjustments in the product line. 1

Break-even (Sales) = Total Fixed Cost / (1- Total Variable Cost / Sales)

For Year 1,

BEP (Sales) = 130,000 / (1- 80,000 / 200,000)

= £ 216,666.67

For the Year 2, 3 and 4 also same BEP (Sales) value came due to proportionate change in total fixed cost, total variable cost and sales.

This figure is the level of sales that the company must reach in order to break even. Again, if the company is reaching more than this, then it should be making a profit and if it is not, the company will not be selling enough to cover the fixed expenses.

Thus, no profits are made from the sale of product until more than £ 216,666.67 in gross sales is generated.

____________________

Source: 1, HODGETTS & KURATKO,1986.

As sales increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, costs are greater than income. At the point of intersection (total sales and total cost intersection), costs are exactly equal to income, and hence neither profit nor loss made. This point of intersection is called the Break-even point which is found to be £ 216,666.67.

In the first year, the total sale made by the company is £ 200,000. But BEP (Sales) is found to be £ 216,666.67. That means, the company is still short of £ 16,666.67 in order to make neither profit nor loss i.e. BEP.

In the second year, the total sale made by the company is £300,000. Compared to the BEP (Sales) which is £ 216,666.67; the company is now making profit. And it continues to do that for year 3 and 4 as well.

Thus, break-even analysis helps a company to maintain profitability when costs and prices changes.

2.2 Problem 2

The Horizontal and vertical analyses on financial statements of the Geneva Palace Hotel are as follows:

Table 5: Income Statement (Horizontal Analysis)

Income Statement

Geneva Palace Hotel

For the Years Ending 31 December 2005, 2006 and 2008

2005

% ( 2005-2006)

2006

% (2006-2007)

2007

Food Sales Revenue

£ 1,700,500

5.26

£ 1,790,000

4.00

£ 1,861,600

Cost of Goods Sold

471,128

6.38

501,200

8.00

541,296

Gross Profit

1,229,372

4.83

1,288,800

2.44

1,320,304

Operating Expenses

Salaries and Wages

541,654

12.36

608,600

9.00

663,374

Employee Benefits

63,008

13.64

71,600

11.00

79,476

Laundry Expenses

17,005

5.26

17,900

3.50

18,527

Supplies Expenses

52,089

3.09

53,700

3.50

55,580

Advertising

16,826

6.38

17,900

6.00

18,974

Utilities

36,860

3.09

38,000

1.50

38,570

Maintenance

16,910

12.36

19,000

10.00

20,900

Other Expenses

38,800

3.09

40,000

1.50

40,600

Total Operating Expenses

783,152

10.67

866,700

8.00

936,001

Income Before Fixed Charges

446,220

-5.41

422,100

-8.95

384,303

Fixed Charges

Rent

19,400

3.09

20,000

4.00

20,800

Property Taxes

9,400

6.38

10,000

5.00

10,500

Insurance

4,250

17.65

5,000

20.00

6,000

Interest

76,000

5.26

80,000

4.00

83,200

Depreciation

19,200

4.17

20,000

4.00

20,800

Total Fixed Charges

128,250

5.26

135,000

4.67

141,300

Income before Income Tax

317,970

-9.71

287,100

-15.36

243,003

Income Tax

111,290

-9.71

100,485

-15.36

85,051

Net Income

206,680

-9.71

186,615

-15.36

157,952

Table 6: Income Statement (Vertical Analysis)

Income Statement

Geneva Palace Hotel

For the Years Ending 31 December 2005, 2006 and 2008

2005

As a % of Sales

2006

As a % of Sales

2007

As a % of Sales

Food Sales Revenue

£1,700,500

100.00

£1,790,000

100.00

£1,861,600

100.00

Cost of Goods Sold

471,128

27.71

501,200

28.00

541,296

29.08

Gross Profit

1,229,372

72.29

1,288,800

72.00

1,320,304

70.92

Operating Expenses

Salaries and Wages

541,654

31.85

608,600

34.00

663,374

35.63

Employee Benefits

63,008

3.71

71,600

4.00

79,476

4.27

Laundry Expenses

17,005

1.00

17,900

1.00

18,527

1.00

Supplies Expenses

52,089

3.06

53,700

3.00

55,580

2.99

Advertising

16,826

0.99

17,900

1.00

18,974

1.02

Utilities

36,860

2.17

38,000

2.12

38,570

2.07

Maintenance

16,910

0.99

19,000

1.06

20,900

1.12

Other Expenses

38,800

2.28

40,000

2.23

40,600

2.18

Total Operating Expenses

783,152

46.05

866,700

48.42

936,001

50.28

Income Before Fixed Charges

446,220

26.24

422,100

23.58

384,303

20.64

Fixed Charges

Rent

19,400

1.14

20,000

1.12

20,800

1.12

Property Taxes

9,400

0.55

10,000

0.56

10,500

0.56

Insurance

4,250

0.25

5,000

0.28

6,000

0.32

Interest

76,000

4.47

80,000

4.47

83,200

4.47

Depreciation

19,200

1.13

20,000

1.12

20,800

1.12

Total Fixed Charges

128,250

7.54

135,000

7.54

141,300

7.59

Income before Income Tax

317,970

18.70

287,100

16.04

243,003

13.05

Income Tax

111,290

6.54

100,485

5.61

85,051

4.57

Net Income

206,680

12.15

186,615

10.43

157,952

8.48

Table 7: Balance Sheet (Horizontal Analysis)

Balance Sheet

Geneva Palace Hotel

31 December 2005, 2006 and 2008

2005

% (2005-2006)

2006

% (2006-2007)

2007

Fixed Assets

Land

£ 30,000

0.00

£ 30,000

0.00

£ 30,000

Building

960,000

0.00

960,000

0.00

960,000

Furniture and Equipment

234,000

5.98

248,000

5.65

262,000

Accumulated Depreciation

- 30,000

16.67

- 35,000

14.29

- 40,000

China and Glass

17,000

5.88

18,000

5.56

19,000

Total Fixed Assets

1,211,000

0.83

1,221,000

0.82

1,231,000

Current Assets

Cash

41,000

- 10.98

36,500

-6.85

34,000

Accounts Receivable

2,850

19.30

3,400

17.65

4,000

Inventories

4,500

11.11

5,000

10.00

5,500

Prepaid Expenses

3,200

-18.75

2,600

-23.08

2,000

Total Current Assets

51,550

-7.86

47,500

-4.21

45,500

Current Liability

Accounts Payable

29,000

-13.79

25,000

-16.00

21,000

Accrued Expenses

5,000

40.00

7,000

28.57

9,000

Current Position of Long Term Mortgage

16,000

0.00

16,000

0.00

16,000

Total Current Liability

50,000

-4.00

48,000

-4.17

46,000

Long Term Liability

Mortgage

946,000

-0.63

940,000

-0.64

934,000

A - L

266,550

5.23

280,500

5.70

296,500

Owner's Equity

Capital

165,000

0.00

165,000

0.00

165,000

Retained Earning

101,550

13.74

115,500

13.85

131,500

266,550

5.23

280,500

5.70

296,500

Table 8: Balance Sheet (Vertical Analysis)

Balance Sheet

Geneva Palace Hotel

31 December 2005, 2006 and 2008

2005

As a % of Total Assets

2006

As a % of Total Assets

2007

As a % of Total Assets

Fixed Assets

Land

£ 30,000

2.38

£ 30,000

2.36

£ 30,000

2.35

Building

960,000

76.04

960,000

75.68

960,000

75.21

Furniture and Equipment

234,000

19.64

248,000

19.55

262,000

20.52

Accumulated Depreciation

- 30,000

-2.77

- 35,000

-2.76

- 40,000

-3.13

China and Glass

17,000

1.43

18,000

1.42

19,000

1.49

Total Fixed Assets

1,211,000

96.71

1,221,000

96.26

1,231,000

96.44

0.00

Current Assets

0.00

Cash

41,000

2.89

36,500

2.88

34,000

2.66

Accounts Receivable

2,850

0.27

3,400

0.27

4,000

0.31

Inventories

4,500

0.40

5,000

0.39

5,500

0.43

Prepaid Expenses

3,200

0.21

2,600

0.20

2,000

0.16

Total Current Assets

51,550

3.76

47,500

3.74

45,500

3.56

Current Liability

Accounts Payable

29,000

1.98

25,000

1.97

21,000

1.65

Accrued Expenses

5,000

0.55

7,000

0.55

9,000

0.71

Current Position of Long Term Mortgage

16,000

1.27

16,000

1.26

16,000

1.25

Total Current Liability

50,000

3.80

48,000

3.78

46,000

3.60

Long Term Liability

Mortgage

946,000

74.45

940,000

74.10

934,000

73.17

A - L

266,550

22.22

280,500

22.11

296,500

23.23

Owner's Equity

Capital

165,000

13.07

165,000

13.01

165,000

12.93

Retained Earning

101,550

9.15

115,500

9.11

131,500

10.30

266,550

22.22

280,500

22.11

296,500

23.23


Financial statement information is used by both external and internal users. They include investors, creditors, managers, and executives of the business. These users analyze the financial information in order to make business decisions. Among different methods of analyzing financial statements, the horizontal and vertical analyses are the two important methods.

Horizontal method of financial statement analysis involves comparing specific items over a number of accounting periods. Vertical analysis on the other hand compares each separate figure to one specific figure in the financial statement. This method compares several items to one certain item in the same accounting period.

2.2.1 Analysis of the Income Statement

Horizontal analysis of the Income Statement of Geneva Palace Hotel shows that the sales trend is growing. Though the later rate is a bit less in percentage than the earlier, still it shows that growth is there. This is good from company point of view because net sale is one of the most important individual accounts that need to be positive. But as we compare the cost of sales, it is also growing which is not a good sign. Due to this, the gross profit is being affected in the later year.

Comparing the operating expenses, it is increasing in the later years. It might be due to the fact that the company has hired more employees and spend much on their benefits and maintenance. But at the end of the year 2007, we could find that the company has managed to drop the percentage from 10.67 to 8 which is quite appreciable.

The fixed charges have also increased from yester years. But the accounts such as Property tax, interest and depreciation increment in percentage is low compared to other fixed charges which is a good sign.

Finally, talking about the net income, though company is making profit each year by increasing the selling of their goods and service, the net income percentage is going down. Thus, the company needs to increase sales as well as take an eye on the cost incurred.

Vertical analysis the Income Statement of Geneva Palace Hotel is useful since it highlights relative accounts movements that absolute figures may not detect. It shows the percentage of each and every account in terms of sales of the company in each year.

If we see the trend, the company’s cost of goods sold is being increased each year in compare to the actual sales. And hence the gross profit is decreasing. The increase in cost and decrease in gross profit is gradual but will have a negative effect in the long term. If we compare the sales with operating expenses, it shows similar pattern as with cost of goods sold. But the most significant comparison of expense is with the salaries and wages which shows that the percentage over 30. That means a major part of the expense is due to salaries and wages.

If we look at the fixed charges, the total shows around 7 to 8 percent of the sales amount which is again very less in comparison to operating expenses. But when we actually compare with the net income it shows 12.15 percent in the year 2005 and goes decreasing to 8.48 in the year 2007. This means, the company is losing on its profits though the sales are increasing yearly.

2.2.2 Analysis of the Balance Sheet

Horizontal analysis of the Balance shows that the company has no plan to buy fixed assets such as land and building for now. However, the company is spending on furniture, china and glass. But it is very less, merely 1 percent, when we compare the overall fixed assets.

Analysing the current assets, the company is decreasing in its cash amount and increasing in credit which it needs to take from its debtors. Though the company has collected some amount from debtors in the year 2007, the recovery rate is relatively low. The company has tried to have low inventory and is maintaining it in later years as well.

As far as the current liability is concerned, the company has paid off to creditors and reduced some amount that needs to be cleared. With accrued expenses, the company is increasing it may be due to the fact that it is expanding and more money needs to be kept aside for these expenses. And there is no effect on the long term mortgage yet the company is paying fixed value for that which makes less than a percent compared to previous years.

Talking about owner’s equity, the capital remains the same while the retained earnings have increased by thirteen and half percent each year.

If we summarise the facts, the fixed assets have not been much changed while the current asset is decreasing each year. The current liability is though decreasing, but at a low rate. The asset minus liability graph is good compared to yester year. And the retained earning is increasing each year.

Vertical analysis of the balance sheet shows that building, equipment and furniture makes the most part of the total assets in all the three years. The building and equipment makes more than 76 percent while furniture makes around 20 percent. While cash makes the most out of current assets than accounts receivable, inventories and prepaid expense. This shows that company assets are more of fixed type and has little money to spend and is not a characteristic of a commercial firm.

With current liability, it is only around 3 percent when compared to total assets. While the long term liability makes 74 percent of the assets. It shows that company do not have much of liquid cash and the assets it has is on long term liability i.e. mortgage.

The owner’s capital is only around 13 percent of its total assets and the retained earnings is also low and is around 10 percent. This shows that the owner’s equity makes just 23 percent of the total assets the company owns. This composition of higher long term liability than capital indicates weak solvency.

In summary, other than reflecting a great deal of stability or instability within the company, the vertical analysis tells us relatively little without a further basis for comparison. However, the demonstrated instability is a useful observation when considered within the rest of the analysis. We can anticipate that, with the proposed changes, there is chance of company’s improvement if the company generated more of assets (current) and reduce the liability (long term) in the future.

Conclusions

The Payback period of the company was calculated which gives the length of time the investor will get his/her money back. Similarly, average accounting return was calculated which gives the return on an investment, after taxes and depreciation, over a specified period. And the break - even analysis was done to know the level of sales that are required to cover costs for a company.

Furthermore, trend and vertical analysis of the Geneva Palace Hotel was also carried out which shows the pattern and comparative study of company’s financial statements.

These techniques have their own advantages and disadvantages but we should know the limitation and use these methods in the best way to explore the business opportunities.

References

  • MAYER, R. et al (2005), ‘Contemporary Financial Management’, Thomas South-Western
  • FABOZZI, Frank J. et al (2003), ‘Financial Management and Analysis’, Second Edition, John Wiley & Sons, Inc., Hoboken, New Jersey
  • HOLLAND, Rob, (September 1998), ‘Break-Even Analysis’, Agricultural Extension Service, The University of Tennessee, Agricultural Development Center
  • HODGETTS, Richard & KURATKO, Donald, (1986), ‘Management’, Second Edition.
  • EDMUNDS, C., OLDS, T., & SCHNEIDER, N. (2006), ‘Fundamental Managerial Accounting Concepts’, 3rd Edition, New York: McGraw-Hill Irwin.
  • [http://www.quickmba.com/accounting/fin/statements] (Online accessed on 9/08/2008)
  • Finance and accounts, ‘Breakeven’, (Accessed on 9/08/2008) [http://tutor2u.net/business/gcse/finance_breakeven.htm] (online)
  • ‘Recovering the costs of investments, Explanation of Payback Period’, (Accessed on 29/07/2008) [http://www.12manage.com/methods_payback_period.html] (online)