Determining how to obtain financial data and assess its validity Applying different types of analytical tools and techniques to a range of financial documents and formulate conclusions about performance levels and needs of stakeholders and conducting comparative analysis of financial data (1.3).
Review and question financial data
2.1 Identify how budget can be produced talking into account financial accounts and achievement of targets, legal requirements and accounting convention:
2.2 Analysing the budget out comes against organisational objectives and identifying alternatives
3.1 Identify criteria by which proposals are judged
3.2 Analyse viability of a proposal for expenditure
3.3 Identify the strengths and weaknesses and give feedback on the financial proposal
3.4 Evaluating the impact of the proposal on the strategic objective of the organisation
This study is based on financial analysis of world's leading electronic and software based company Apple Inc. which is known as computer giant and it has already placed its identity as an innovative company and it has demonstrated that innovation can lead to market dominance. Apple encompasses a range of electronic and software product and services such as PC, Mac Book, iPhone, iPad, Apple TV, iTunes, Mac OS X, iLife, iWork, Safari and enormous range of applications.
Determining how to obtain financial data and assess its validity:
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Financial data provide raw material to drive conclusion of business financial position. The analysis of financial data provides information to manage and track financial activities. Basically, organization can gather financial data from internal resources and external resources. Internal resources refer to business's own records and external resources means third party sources. As other organisation, Apple may obtain financial data from those resources.
Internal financial data is usually obtained from organization's accounting system, report prepared by control function such as reports prepared by sales department, report prepared by other departmental managers, supplier, customer and employees. These reports take account of the financial aspect of the departments operations and hence give the accounting and finance division with essential expenditure and revenue details incurred and generated over a time period. As these reports detailed, the financial department can easily gather and interpret data in order to produce information to conclude financial position of the company.
The other sources of financial data of the business are Companies House, company's website, data base of financial information, libraries, research reports which are known as external sources of financial data.
Internal and external sources of financial data are often complementary to each other as one source facilities the accuracy of another source. So it is essential to gather financial data from both resources in order to produce accurate information to determine actual financial position of the business.
Validity refers to the correctness and reasonableness of financial data which produce appropriate quality information in order to determine actual financial position of a particular company. So company needs to assess and appraise the data which are obtained on regular sampling basis for its validity which could be done by internal and external auditor.
Internal auditors are the employee of the company and assessor of the business accounting and operations who assist to bring systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes to accomplish company's objective. Even though, internal auditors are not totally independent because they are employed by organization and responsible to senior management. In some cases, they cannot report the fraud/error to senior management because of perceived threats to their continued employment with in the company.
External auditors ensure current auditing standards require that independent auditors provide reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud, to render an unqualified opinion on the financial statements. However, External auditors are not and should not be expected to provide absolute assurance regarding validity and reliability of financial statements. It only audit published accounts and only ensures that certain rules have been followed and certain standards adhered to and they do not ensure that the information produced by the company is in a comparable format to others or check whether or not the rules have been followed in one of the many differing and allowable ways.
Applying different types of analytical tools and techniques to a range of financial documents and formulate conclusions about performance levels and needs of stakeholders and conducting comparative analysis of financial data (1.3).
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Ratio analysis is the most powerful tools of financial statement analysis and interpretation, it determines financial performance levels and formulates conclusions which help in decision making process, forecasting and planning process and controlling.
Mainly, there are five types of ratios to analysis financial performance level of a business which are as follows:
Return on Capital Employed (ROCE)
ROCE is probably the most important single ratio of all which is known as primary ratio which investigates the efficiency of the business as a whole by showing how well a business has generated profit from its long term financing. It also helps to determine what would be the cost of extra borrowing if company needed additional loans. So generally increase in ROCE is considered as improvement and higher ROCE shows the higher performance of the business which indicates the efficient utilization of assets and can be calculated as follows:
Return on Capital Employed (ROCE) = Profit before Interest and Tax (PBIT) Ã- 100
The figure of PBIT can be taken from income statement and capital employed is the sum of shareholder's equity and longs term borrowings of the business and can be obtained from liabilities side of balance sheet.
Gross Profit Margin:
The difference between the sales and the cost of sales is known as gross profit that can be obtained from income statement. It shows the performance of business at the direct trading level which can be affected by changing in selling price, sales volume and cost of sales. An increase margin indicates the healthier performance of the business. It can be calculated as follows:
Gross profit margin = Gross Profit Ã- 100
Net Profit Margin
Net profit margin shows the net benefit to the business per unit of sales and indicates how well business has managed to control its indirect cost which can be affected by two key factors: volume of income and volume of expenses. An increased net profit represents the healthy sing of the business. To calculate this ratio the both figure can be taken from income statement. The formula is:
Net Profit Margin = Profit before tax (PBT) Ã- 100
Receivables collection period
This ratio measures how effective the company's credit policies are. It shows how quickly the business is collecting money from its debtors. If the collection period is high, it may point out the business is being too generous granting credit or having difficulties collecting from its customer. Therefore, lower collection period represent the effective credit control policies and efficient management. It can be calculated as follows.
Receivables collection period = Receivables Ã- 365
The figure of receivables can be obtained from asset side of balance sheet and credit sales can be obtained from income statement.
Total assets turnover ratio
This is a catch of all efficiency ratios that point out how effectively the management is using its both long term and short term assets. It is a measure of how well the assets are being used to generate sales. All else equal, the higher turnover indicates healthy sign of the business. The formula is:
Total assets turnover ratio = Sales
The figure of total assets is obtained from balance sheet it's the sum of long term and short term assets.
Short term Solvency Ratio (Liquidity Ratio)
This ratio signifies a company's ability to cover its short term liabilities with its short term assets.
Current ratio = Current assets
The figure of current assets can be obtained from asset side of balance sheet and current liabilities can be taken from labiality side.
This ratio is a tougher test of liquidity than current ratio. But it excludes certain current assets which are difficult to convert in cash at short period like inventory and prepaid expenses. This ratio examines the accurate liquidity position of the company whether the company is able to cover its current liabilities or not. It can be calculate as follows:
Quick ratio = Quick assets
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Long term Solvency Ratio (Stability Ratio)
Gearing ratio is the measure of financial leverage which shows the proportion of a company's capital structure that is owner's funds (equity) versus creditor's funds (debt). It the measure of risk in the sense of that a company highly geared is more vulnerable to downturns in the business cycle.Â A greater proportion of equity provides a cushion and is seen as a measure financial strength. It can be calculated as follows.
Gearing Ratio = Debt Ã- 100
Debt + Equity
The required figure can be obtained from liabilities side of the balance sheet.
Interest Coverage Ratio
This ratio used to determine how easily a company can pay interest expenses on outstanding debt. In other word, it measures weather the business is generating enough profits to pay its interest comfortably or not. Generally, if a business's interest coverage ratio is only 1.5 or lower, its ability to pay interest charge may be questionable.
Interest coverage ratio = Profit before Interest and Tax (PBIT) Ã- 100
The both required figure can be taken form income statement.
This ratio measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. It can be helpful for investor because this ratio determine company's level of risk. It can be calculated as follows.
Debt ratio = Debt
The required figure can be obtained from balance sheet.
Shareholders Investment Ratio
1. Earning per share (EPS)
It is the measure of the amount of net profit allocated to each outstanding ordinary share which serves as an indicator ofÂ a business's profitability. So high EPS helps to attract investor and build up confidence of share holders. The figure of profit and preference dividend can be obtained from income statement and no of shares can be taken form balance sheet.
Earning per share = Profit after tax - preference dividend
Number of ordinary shares
2. Price Earning Ratio (P/E Ratio)
It is a valuation ratio of company's current share price compared to earning per share. Generally, high P/E suggests that investors are expectingÂ higher earningsÂ growthÂ in the future compared to companies with aÂ lower P/E. It can be calculated as follows:
P/E ratio = Market price per share
Earning per share
Ratio analysis of Apple Inc.
After conducting in depth research on Apple Inc, the financial performance of the company has been assessed using ratio analysis technique. The analysis has been carried out taking into consideration five different ratios which are profitability, efficiency, short term liquidity, long term liquidity and investor's ratio.
Profitability Ratio :
By analyzing ROCE it can be concluded that the Apple is getting value of money for borrowing some how and it is not in risk due to commercial borrowing rates. According to ROCE they seem steady because there is ignorable increment (i.e. 3.20%) in ROCE from 2009 to 2010. By this we can say that the management of apple is efficient some how. In the net profit prospective they also in the situation of status quo i.e. net profit margin in 2009 and 2010 is 28.12% and 28.42% respectively. There is huge increment in sales by 52.02%, however, they are not able to bust net profit margin this may be due increased cost of sales (i.e. material and labour cost might be increased) which decrease the gross profit and may be because of incremented operating expenses.
Receivables collection period has increased by 2 days form 2009 to 2010 which may point out inefficiency from management part in terms of setting credit policy and collection or Apple is trying to follow the industry norms. More over, the total assets turn over ratio has been decreased slightly by 3.33% which may indicate the inconsistency in assets utilization by management side and there is also ideal capacity.
According to current ratio it can be conclude that the liquidity position of Apple is satisfactory and it is able to maintain liquidity position according to industry norms. In the liquidity prospective they are in safe zone. They have tried to follows ideal ratio (i.e. 2:1) in the sense of that they have decreased current ratio from 2009 to 2010 (i.e. 2.74:1 to 2.01:1). By analyzing quick ratio it can be conclude that Apple has strong liquidity position in the sense of that the quick ratio has exceeded the industry norms (i.e. 1:1) which indicate that Apple is holding ideal working capital. However, they try to minimize ideal working capital because we can see the decline in quick ratio from 2009 to 2010 (i.e. 2.70:1 to 1.96:1) this may because increased inventory level.
Long term liquidity Ratio:
According to gearing ratio it can be argued that Apple is favorably geared company and the amount of debt financing is satisfactory. This will have repercussion on shareholders in the sense of that normally shareholders are keen to invest in such a company because of satisfactory dividend payout and there is little chance to face liquidity problem and low chance to turn out to be insolvent. Moreover, by analyzing debt ratio it can be said that company's financial position is healthy because of low level of debt financing which indicates the low level of risk.
Shareholder's investment Ratio:
Based on the information collected and calculation it is obvious that EPS has increased significantly by 67.14% from 2009 to 2010. This will make investment attractive because of increased dividend payout and also may increase the morale of shareholders for additional investment. Reason behind this is the increased sales and net profit. The P/E ratio assesses the relative risk. According to Apple's ratio there has been slight decrease from 2009 to 2010 by 4.01% although there is increased EPS. This will add value to the unattractiveness of further equity capital somehow. The reason behind this may be increased market price of share and inability to maintain its EPS therefore rendering this investment risky.
Reviewing and questioning financial data
Financial records of a company need to be verified and seen as being true and fair. To ensure accuracy and verity of financial records need to check through various assessments criteria and it is obliged by law to conduct independent checks on business financial operation in order to protect shareholder's interests. Mainly, internal and external auditors are responsible for ensuring accuracy and verity of financial records.
Internal auditors are an employee of an enterprise charged with providing independent and objective examination of business activities and operations including corporate governance and also present evaluation of operational efficiency and will usually report to senior management on how to improve the overall structure and practices of the company. They conduct auditing on the regular sampling basis and examine the all ledgers a business maintains with relevant control accounts weather any inconsistency is matched and accounted immediately or not. They may query any particular department where impartiality is essential.
External auditor performs independent, third-party review of a company's financial records. He examines on a one off basis transactions and record relevant to the financial statements, evaluates financial records with vouching and provides an accurate unbiased analysis of the company's financial condition. If he finds any irregularities and inconsistency related to accounting methods and principles, internal controls or spending habits, accounting standards etc, he documents them and makes notes on suggested improvement.
2.1 Identifying how a budget can be produced taking into account financial constraints and achievement of targets, legal requirements and accounting conventions:
Budget provides comprehensive financial overview of planned company operation. A company's objectives budget is the overall financial plan showing expenditure of the available funds. Apple's budget is driven by the aims and objectives of the Apple as well as what it can actually accomplish. Many variables in a business can be budgeted which includes sales, output, cost- (variable and fixed), profits, cash flow, capital investment. Budget should be SMART, that is specific, measurable, achievable, realistic, and with time bound otherwise budget will be ineffective.
Strategic objective of the Apple is the first factor that needs to be considered when formulating budgets because unaligned budget with strategic objective lead to failure. The next step of budgeting is identifying the limiting factor that the organization is faced with which is known as constraint which may be a limit on the number of goods a business could sell (demand is limiting factor) or on the number of hours a particular type of skilled workforce could work etc. Once organization identifies the limiting factor they set the budgetary principle. The next step is assessment and coordination of internal factors i.e. capabilities of employees and resources and draft departmental budget. After this step the organization should assess the external influencing factor such as forecasted economic, political and global environment which helps to minimize the risk associate with budget. Finally company need to coordinate the entire departmental budget i.e. sales budget, production budget, material budget, labour budget, overhead budget which is known as master budget.
The master budget is a summary of a company's plans that sets specific targets for sales production, distribution and financing activities which generally culminates in a cash budget, a budgeted income statement and a budgeted balance sheet.
Master budget starts with sales forecasting which can be done by in-depth analysis of past sales trend, estimation made by the sales forces, general economic condition, competitor's actions, change in the firm's prices, change in product mix, market research, advertising and sales promotion plans. Sales forecasting leads to the sales budget that is a detailed schedule showing the expected sales for the budget period. It can be expressed in units and currency both. The sales budget is the main pillar of the master budget. The next budget is production budget which determines quantity of production depends upon the number of units to be sold and upon the number of units in the ending and opening inventories. Another component of budget is material budget which shows the quantity and cost of purchasing material for planned production and inventories. Labour budget shows the budget for all type of labour i.e. skilled and unskilled which depend upon the level of production. Another budget is the overhead budget that shows quantities of a large number of items of costs i.e. salary, electricity, rent, administrative expenses. After this organization prepare projected income statement, cash budget: inflow and outflow of cash and budgeted balance sheet.
2.2 Analysing the budget outcomes against organizational objectives and identifying alternatives:
There is highly unlikely that actual performance is same as budgeted performance and the main objective of the budget is to minimize the gap between budgeted performance and actual performance. Due to faulty arithmetic in the budget figures, errors in the arithmetic of the actual outcome, wrong budget assumptions and actual outcome, timing differences, price variance it may occur. Budget is the measure of performance which allows the comparison between budgeted and actual performance. Variances are used to measure the gap between expected performance and actual performance. By analysing variances managers able to identify problem which needs further investigation with a view of implementing corrective action. Variances can be material variance, labour variance, and overhead variance.
Labour rate and efficiency variances, material price and volume variances are yardstick of economy and efficiency. Sales price and volume variances demonstrate impact on performance because of the change in price and demand levels. Management can identify the reason behind the poor performance by analysing variances, for example material variances may occur just because of raw material price rises or damaged poor quality raw material leading to high wastage levels. It is essential to take corrective action to get high performance level and it is easier to take corrective action once reason of poor performance is identified. Hence, Variances helps to find the gap between expected performance and actual performance and take corrective action.
Identifying criteria which proposals are judged.
Business needs to assess its proposal to select the most effective investment proposal that generate yield efficiency. Generally, a best proposal can be select according to the acceptable level of risk (minimum risk), largest level of benefit (profitability), lowest cost and best cost benefit ratio. Although, organization can set the criteria to select the proposal that may include financial viability of project, impact on strategic objective, organizational risk, impact on future financial ratios and key financial indicators (KFI), strength and weakness of the project.
The Tucker's five question model is also the effective technique to judge the projects that allows manager insight into the decision making process. The five questions are:
Is the proposal profitable?
Does the proposal satisfy legal requirement?
Is the proposal fair to all stakeholders?
Is proposal ethical?
Is the proposal sustainable?
By using these criteria managers can select the best proposal which leads to low risk and effective implementation.
Analysing viability of a proposal for expenditure.
Capital expenditure include huge money and affect the long term business plan so business organization needs to assess its investment proposal whether the investment is worth doing or not, will it able to generate profit on the original investment? A project is viable when it generates more revenue than expenditure incurred in the proposal with required rate of returns on capital employed of the project. To analyse the viability of a proposal the various tools can be use however, this study is going to discuss the following technique.
1. Break even analysis
Break even is that sales point where a business generates neither profit nor loss and in this sales point, the fixed costs are fully absorbed and contribution margin is equals to fixed cost. It helps to determine the optimal level of output, minimum cost for the given level of production and find the selling price which would prove most profitable to the firm. The following formula is used to calculate the BEP.
BEP = TFC / (SPU-VCPU)
BEP = Break even point
TFC = Total fixed cost
SPU = Selling price per unit
VCPU = Variable cost per unit
Assume that Apple is planning to lunch iPhone 5 and the total fixed cost of apple is £2000000 and the unit selling price of the iPhone is £800 and the variable cost is £600, what may be the BEP analysis of iPhone 5.
Total fixed cost (TFC) = £2000000
Selling price per unit (SPPU) = £800
Variable cost per unit (VCPU) = £600
By the formula,
Break even point (BEP) = TFC / (SPPU-VCPU)
= £2000000 / (£800-£600)
= 10000 Units
Apple should sell 10000 Units of iPhone 5 in order to stand in BEP where apple neither generates profit nor suffers from loss. If apple able to sell more than 10000 units of iPhone 5 it will generate profit and if it sell less than 10000 units of iPhone it will suffers from loss. So management should take decision whether it will be able to sell the required units (e.g.10000) or not if not the projects is not viable and the project should not be launched. It can be shown in following diagram.
Sales cost & profit
Figure: BEP analysis
Generally, most of the businesses firms use the BEP analysis to analyse the viability of the investment project. However, it stands with following limitations.
It several assumptions like selling price will be constant but in future period selling price may vary due to inflation, demand etc.
It does not consider time lag between production and sales.
Factors like plant size, technology of production have to be kept constraint in order to an effective BE analysis which factors are may vary according to time.
This analysis ignores the capital employed to the production and its cost which is a vital consideration in profitability decision.
The payback period is the time it will take for the original investment to pay for itself through its cash inflow. To use payback period to make investment decision a business firm sets a decision criteria maximum acceptable payback time-period and if the investment projects are mutually excusive the company prefer the project which has lower period to recover its original investment. It is the simplest technique to assess the viability of the project. Although it is not elsewhere from limitations as follows:
It ignores any benefitsÂ that occur after the payback period so it does not measure profitability.
It does not consider the time value of money.
3. Net present value (NPV):
NPV is the discounted cash flow technique of capital investment appraisal which considers time value of money. NPV compare the value of money today to the value of same money in the future, considering inflation and returns. The NPV shows the return on investment less the cost of the project. Prospective project with the positive NPV should be accepted and with negative NPV probably rejected because cash flow also will be negative. If the projects are mutually exclusive, project with the higher NPV will be accepted. This is the best technique for investment decision because if there is any conflict between other techniques i.e. Internal Rate of Returns (IRR) among projects, usually the NPV technique is used to make decision. Although, it has some limitation which as follows:
In practice, it is difficult to obtain projected cash flow.
It is quite difficult in practice to precisely measure the discount rate (cost of capital).
In mutually exclusive projects, there should be equal lives of proposals to make appropriate decision.
Identifying the strengths and weaknesses and giving feedback on the proposal:
Each and every business house use capital budgeting techniques to make effective investment decision. However, these methods have certain weakness but also strengths over other methods.
Break even analysis indicates the lowest amount of business activity necessary to prevent the loss. This technique is realism in the sense of that it sets out clear prerequisites for selected projected to be successful but business needs to know that one project is preferable over the other only as long as they are able to sell as per expected forecasts.
Break even analysis is the static approach that assumes that the business house faces liner total revenue and total cost function in many cases but it may not in practice i.e. a dramatic increase in sales may allow to get the discount from supplier but company may also have to hire additional support staff raising indirect cost. It ignores the changes of occurring semi variable cost and less focuses on liquidity. BEP is often limited to the short term only.
Payback period is the relatively simplest technique to assess the proposal. It provides some indications of risk by separating long term projects from short term project because it consider that longer the period greater the risk i.e. project with shorter payback should be accepted. It can be consider as an objective approach in the sense of that it focuses cash flows and time than profitability only. Generally, proposals which are assessed with payback method are quick growth generator because of quick liquidity and investment recovery.
However, payback does not measure the profitability and ignores the time value of money. It also ignores the financial performance after the break-even period. So project with shorter payback may have shorter operation life and hence may be less useful later. It may also possible in case of two proposals that they have similar payback period though their pattern of inflows may be different, one, for instance, being more liquid initially than the other.
NPV technique is realistic in the sense of that it considers time value of money and measure all the projected cash flows and profitability. Managers consider this method as a most effective technique to assess investment proposal. However, it needs large volume of calculation and it is difficult to identify the correct discount rate for calculations.
Hence, to make effective decision manager needs to use more than one method for investment proposal because each and every technique has weakness however, weaknesses of one technique is somehow eliminated by strengths of the other technique.
Evaluating the impact of the proposal on the strategic objectives of the organisation.
The main concern of Apple is to offer the range of best possible innovative technological product and services and put that technology in the hand of as many people as possible. Apple leading towards market dominance through its innovation and Apple has already demonstrated it by offering innovative products like iPod, iPhone, iPad.
To accomplish these strategic objectives Apple needs to invest either in new project or expand existing project. Furthermore, the main focus of the Apple is innovative product which needs huge investment in research and development project. For those projects Apple may have several alternatives. To select the appropriate project Apple needs to keep its strategic objective in the central of heart by setting the selection criteria for investment proposal considering positive as well as negative effect of proposal on strategy. Otherwise, it's hard to accomplish strategic objective.
Calculation of Ratios of Apple Inc,
ROCE = PBIT Ã- 100%
18358 x 100%
11740 x 100%
Other non current liabilities is taken as long term debt
Net Profit Margin = PBT x100%
18540 x 100%
12066 x 100%
Receivables collection period = Receivables Ã- 365
5510 x 365
= 31 days (approx)
3361 x 365
= 29 days (approx)
Total assets turnover ratio =
= 0.87 times
= 0.90 times
Short Term Liquidity Ratio:
Current ratio = Current assets
Quick ratio = Quick assets
= 1.96 :1
Long term Liquidity Ratio:
Gearing ratio = Debt Ã-100%
Equity + Debt
5531 x 100%
3502 x 100%
Other non current liabilities is taken as long term debt
Shareholders Investment Ratio
P/E ratio = Market price per share
Earning per share
*MPPS based on yahoo finance news.1
Earning per share =
Profit after tax and preference dividend
Number of ordinary shares
*MPPS:-Market price per share