The Return On Capital Employed Accounting Essay

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Profitability ratios provide the insight to degree of success in achieving profit. They express the profit made in relation to other key figures in the financial statement or to business resources.

Profitability ratio shows specific analysis on margin of profit . These ratios will identify the changes in expenses from year to year.

1. Return on Capital Employed (ROCE)

ROCE is the relation between the operating profit and also the long term capital invested in the business. The ROCE ratio of Hone has decreased from 20% to 17%. For the Over the ROCE has not changed and been remained as 21%. It managed to maintain its profit considering the increase in the expenses with respect to the increase in the revenue and able to maintain the balance.

2. Return on Equity

Hone has been decreased from 26% to 22% over the period on one year. But the Over showed the decrease of 3% declining from 40% to 37%. Though both showed a decrease Over shows a higher ROE than the Hone.

3. Gross Profit Margin

IT relates the gross profit and the sales revenue generated for the same period. Cost of sales being the important factor for many businesses, it can show a positive impact on the change of ratios. The decrease in percentage of Gross profit margin for Over was more than the decrease in percentage of Hone. Hone showed a decrease of 4% and Over showed a decrease of 5% from the percentage of 53% to 48%.

4. Operating Profit Margin

Operating profit margin gives the ratio between operating profit and the sales revenue. Operating profit is the actual profit made by the business before paying any interests and taxes. It is mostly used to evaluate the operational performance of the business with respect to profit and revenue. The Profit margin has decreased from 35% to 30% and Over has been decreased from 38% to 34% making the operating profit margin of Over higher than that of the Hone.

5. Return on Sales

The return on sales is calculated from the net profit because it is the actual profit made after deducting all the expenses and taxes. This ratio shows the actual percentage of profit made in relation to the total revenue generated. The percentage has been changed from 22% to 18% for Hone and Over has decreased from 19% to 18%.

6. Asset Turnover

This is the important ratio as it shows the relation between the assets and the revenue. This shows how much revenue has been generated by using the various assets of the business. Hone showed increase from 0.77 to 0.80 and Over has increased from 0.96 to 1.01. This shows Over has used its assets more efficiently than Hone.

Liquidity Ratios

"Liquidity ratios are concerned with the ability of the business to meet the short term financial obligations". Atrill (2008)

Current Ratios

Current ratio includes the current asset and the current liability of the business. Usually it is believed that current assets should be two times the current liability so that when there is a requirement to pay off the current liability or a part of it then the current assets can be turned into cash quickly. Though the requirement differs from business to business, the ratio should be 2:1 in general. The higher the ratio the more liquid the business is. But it should not be very high as it means that a lot of cash or liquid assets are not being used in a productive way. Current ratio of Hone was 1.53 which has increased to 1.67. Over has shown the increase of 2.00 from 1.81. It shows that Over is in a better position to pay off its current liabilities than Hone.

Acid Test Ratio

"Acid test ratio is very similar to the current ratio stringent test of liquidity." Atrill(2008) The ratios are calculated between the current liabilities and current assets excluding inventories. Sometimes the inventories cannot be converted in the current assets very easily leaving the exclusion of the inventories in the acid test ratio. The minimum level of this ratio is stated as 1.0 times. The acid test ratio for Hone has remained the same for last two years which is 1 but it has increased for Over from 1.2 to 1.3.

Thus calculating all the ratios of profitability and liquidity Over shows more successful business when compared with Hone. The profitability shows that Over is more successful in business and Liquidity proves that it is more stable in respect of the assets.

b) These companies cannot be compared only on the basis of the profitability and liquidity ratios. There are lots of other factors which is used to judge between the success and the loss of the company. The assets which these companies used and acting on are not the entire backbone of the business. The calculated ratios show Over is more successful in business. But there are various other factors which should be taken into account while comparing between two companies for acquisition. To find out these factors we need more detailed information about the companies. For which we need the cash flow statement, share capital, number of shares etc.

The other problem rising is regarding the inventories. The inventories of business differ from each other. Consider in a manufacturing company there are very high level of inventories because it has to store raw materials finished goods etc but in case of the retail business the inventory level is very low as it has to sell the stock at per day basis and according to the demand. It may also happen that the sales are not taking place and the inventories are stacking up. With all these factors in the scenario it is really hard to judge between the selections of companies. Therefore we need a detailed information of both the companies to take a decision.

Part B.

a) Contribution per unit:

Total Variable Cost

60,000

56,000

24,000

Variable cost per unit

6

7

6

Contribution per unit

4

5

2

Kg's per unit

8

4

1

Contribution per raw materials

0.5

1.25

2

Hence C produces the highest contribution followed by B and then A

Calculating contribution for C

C = 4,000 units *1 kg = 4,000 KG

4000kg* 2pounds = 8000 pounds.

Hence the contribution of C is 8000 pounds.

Calculating the contribution for B

B = 8,000units *4 kg = 32,000 KG

32,000kg*1.25 pounds= 40,000 pounds

Hence the contribution of B is 40,000 pounds

Calculating the contribution of A

A =7,000units * 8 kg = 56,000 KG

56,000kg*0.5pounds= 28,000 pounds

Hence the contribution for A is 28,000 pounds

Therefore the total contribution in pounds comes to 76,000.

Deducting the General fixed cost (30,000+27,000+10000=67,000) from the contribution gives 9000 pounds.

The net profit is 9000 pounds.

b) "When optional decisions are being considered, the aim will always be to maximize contribution because the greater the contribution then the more chance there is of covering the fixed costs and of making a profit." Dyson (2007) Fixed cost remains the same irrespective of the products produced. The profit is affected by the fixed cost to a large extent. Since there is a limiting factor the production of the units cannot be exceeded by that. The fixed cost does not depend on the volumes produced. So every business has to recover the amount involved in the fixed cost but when a limiting factor involved in it then the business emphasises more in covering the fixed cost than profit. So the product with the higher the contribution is always considered as the most suitable product to be produced, when production is carrying a limiting factor.

In this case C has the highest contribution which makes it to be produced to cover the fixed costs.

Part C.

a)

1.

(a) the payback period(PP):

Cash flow before depreciation

(pounds)

Cumulative cash flow

(pounds)

Year 1

60,000

60,000

Year 2

60,000

120000

Year 3

60,000

180,000

year 4

60,000

240,000

Year 5

60,000

300,000

Payback period = 3years and 4months

(b) Accounting Rate of Return (ARR):

Depreciation = total investment - scrap value

No. of years

= £200,000 -£ 40,000

5

= 32,000

Average accounting profit each year = (profit each year- running cost - depreciation)

= £70,000 - 10,000 -32,000

= £28,000

ARR = (average profit each year/ initial investment)* 100

= £28,000/ £200,000 * 100

= 14%

(c) Net Present Value (NPV):

Year

Cash Outflow

Cash Inflow

Net Cash flow

Discount factor(10%)

Present value

0

(200,000)

-200,000

1.00

(200,000)

1

60,000

60,000

0.87

52,174

2

60,000

60,000

0.76

45,369

3

60,000

60,000

0.66

39,451

4

60,000

60,000

0.57

34,305

5

100,000

100,000

0.50

49,718

NPV

21,016

(d) Internal Rate of Return (IRR):

Calculating the negative NPV at 20%

Year

Cash Outflow

Cash Inflow

Net Cash flow

Discount factor (20%)

Present value

0

(200,000)

-(200,000)

1.00

(200,000)

1

60,000

60,000

0.83

50,000

2

60,000

60,000

0.69

41,667

3

60,000

60,000

0.58

34,722

4

60,000

60,000

0.48

28,935

5

100,000

100,000

0.40

40,188

NPV =

(4,488)

By using the positive NPV at 15% cost of capital and negative NPV at 20% cost of capital the IRR is calculated as follows:

IRR = 10+ {210,160/ (21016+4488) *20-10}

= 19.12%

Therefore the internal rate of return comes to 19.12%

b) Payback period

Payback period is easy and simple to calculate but it has certain drawbacks. It ignores the time value of money. It only calculates the return period of initial investment. It leads to invest excessively in short term projects. It does not consider the cash flow which is generated at the end of the payback period. But this method can be used for the initial judgement of any investments if the payback period is low then it's the good investment but if the payback period is high then the investment should be considered. In this situation the payback period is 3years and 4 months which is a decent. Thus the investment here can be considered taking payback period into the account.

Accounting Rate of return

.

ARR gives better insight on the investment than payback period. If the Accounting Rate of Return is high then there is a better chance of investing in that case. Even this doesn't consider the time value for money. This also ignores time for the payback period of the initial investment. In this case the ARR is good with 14%.

Net Present Value

Net present value considers the value in per year basis. It does not consider the same value for all the years. Every year the value changes at the certain amount. Hence the net present value multiplies the current value for that year to get the value of that year. It considers the actual cash flow between these years. Since it helps giving the entire insight of the investment this method is preferred as the best method to consider for the future of investment. Since the NPV has the values in either negative or positive ways the decision to either take or drop the investment becomes very easy.

Internal Rate of Return

IRR gives the investment a clear go if the IRR is higher. If it is higher, then the investment can be easily done. The present value of money is taken care in the IRR. IRR does not consider the life of investment. It calculates on the basis of two NPVs, Positive and negative. Therefore it gives a direct judgement on whether the investment is to be done or not.

Part D

Budgeting

Budgeting plays a key role in a Organisation's financial control. "The literature of management accounting emphasises that budgeting is an essential technique for planning and controlling the activities of an organisation." Drury (1993). Budgeting demands the management to think about the future of the business. The work of the management is to look forward and set the targets and goals for each unit of the business with the help of the budgets so that the business gets a direction. It helps the business in looking forward. It gives the clear direction on whether the business or a part of the business is going on the right part. Every organisation has their set of goals and budgeting helps the organisation to achieve that goals.

Planning and controlling

Planning a budget is really a important factor in the company's financial activities. Without the budgeting the company won't have a proper direction on where the organisation is heading. "It is vital that businesses develop plans for the future. Whatever a business is trying to achieve, it is unlikely to come about unless its managers are clear what the future direction of the business is going to be" Atrill(2008). Every planning has certain objectives with which the entire strategy is built. The mission we call it helps us decide the purpose of the ongoing business. Thus this mission will have a definite goal and the organisation will take steps keeping this goal in presence. While planning the company should consider the current position of where it is standing right now and where it aims to reach. The plans should be made on how to reach from current position of the financial status to the aimed status. Since the plan is a short term plan there should be the minimal scope of error in formulating this plan. The budget helps in setting the targets when it comes to labour requirements, inventory requirements, production requirements and products or services provided by the business. By comparing the end results of these the management can decide whether they are moving according to the plan or not.

Advantages:

Planning: planning is required in every sector of life, Let it be business or it the house. Budgeting helps in planning and setting targets for the various departments of the business. It provides a sense of direction to the business to work upon.

Decision making- the business need to work according to a frame work set from before. Budgets help the business in deciding this frame work.

Resources allocation- the budgets help in resources allocation in various department of the business. The management looks into the budgets prepared and accordingly decides how much fund should be allocated to what department.

Discover potential bottlenecks- budgeting helps in finding the potential problems that may arise in the future. These problems are referred as bottlenecks. The management discovers them with the help of the budgets and finds a way to overcome these bottle necks.

Communication- budgeting brings together all the financial budgets and plans laid down by the business. This helps in improving the communication between the superiors and the employees.

Performance measurement: budgeting provides base to check the variations between the actual performance and the target set. And if the management finds any variation then it takes the remedial measure. The budget is a yardstick against which actual performance is assessed.

Motivation: it gives an essence of motivation to the employees. The targets set according with the help of the budgets, motivates the employees to achieve the goal.

Coordination: budgeting promotes coordination among the employees and between various departments of the business because they have to achieve a common goal or target. And this gaol is set by the budgets.

Disadvantages:

Pressure on the employees: budgets can lead to a heavy pressure on the employees which leads to bad employee relation and inaccurate record keeping

Departmental conflict: it causes disputes among the departments on the funds allocation. Conflict arises as departments blame each other for not attaining the targets.

Overestimation: the managers overestimate the budgets so that they won't be blamed later if the over spend.

Customer service and quality: budgeting only takes into account the financial part of any business. It ignores the customer service and quality.

De-motivation: sometimes it works as a de-motivating factor when the employees are not able to achieve the targets set which may be because the targets are too high to be achieved by them.

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