Managing Financial Principles and Techniques
Explain the Various forecasting methods and techniques used for decision making purpose. Include their advantages and disadvantages.
Forecasting is a prediction of what will occur in the future and it is an uncertain process.
It is a best estimated basted on certain assumptions about the conditions that are expected to apply. A budget in contrast is a plan of what the organization is aiming to achieve and what it has set as a target. A budget should be realistic and so it will be based to some extent on forecasts prepared. It has been said that budgeting is more a test of forecasting skill than anything else and there is a certain amount of truth in such a comment. Forecasts need to be made of sales volumes and prices, wages rates and earnings, materials availability and prices, rates of inflation the cost of bought in services and the cost of overhead items such as power. However it is not sufficient to simply add a percentage to last year's budget in the hope of achieving a realistic forecast. It is an uncertainty the accuracy of a forecast is as important as the outcome predicted by the forecast. This site presents a general overview of business forecasting techniques as classified in the following :
Forecasting using Historical Data
Many techniques have been developed for using past costs incurred as the basis for forecasting future values. These techniques range from simple arithmetic and visual methods to advanced computer based statistical systems. With all techniques, however, there is the presumption that the past will provide guidance to the future.
* The time period should be long enough to include any periodically paid costs but short enough to ensure that averaging of variations in the level of activity has not occurred.
* The data should be examined to ensure that any non activity level factors affecting costs were roughly the same in the past as those forecasts for the future. Such factors might include changes in resources costs, strikes, and weather condition and so on. Changes to the past date are frequently necessary.
* Appropriate choices of dependent and independent variables must be made.
Forecasting methods and techniques
* High low method: In method is used to identify the fixed and variable elements of cost that are semi-variable. It selects the highest and lowest activity level, the inflation makes it difficult to compare costs adjust by indexing up or down.
To calculate the High low method:
Total cost at high activity level- total cost a low activity level
Total units at high activity level-total units at low activity level
= Variable cost per unit (V).
* Linear regression Analysis : Liner regression analysis also know as the least square technique is a statistical method of estimating cost using historical data from a number of previous accounting periods
o Liner regression analysis is used to derive a line of best fit which has the general form y= a +bx, where
o Y, the dependent variable =total cosrt
o X,the independent variable=the level of activity
o A, the intercept of the line of the y axis=the fixed cost
o B, the gradient of the line=the variable cost per unit of activity.
o A Liner cost function should be assumed: This assumption can be tested by measures of reliability such as the correction coefficient and the coefficient of determination which ought to be reasonably close to 1.
o Interpolation means using line of best fit to predict a value within the two extreme points of the observed range.
o Extrapolation means using a line of best fit to predict a value outside the two extreme points.
o It must be assumed that the value of one variable y, can be predicted or estimated from the value of one other variable x.
* Scatter Diagrams and Correlation: A scatter diagram is a toll for analyzing relationships between two variables. One variable is plotted on the horizontal axis and the other is plotted on the vertical axis. The pattern of their intersecting points can graphically show relationship patterns. Most often a scatter diagram is used to prove or disapprove cause and affect relationship. While the diagram shows relationship, it does not by itself prove that one variable causes the other. In addition to showing possible cause and effected relationships a scatter diagram, can show that two variables are from a common cause that is unknown or that one variable can be used as a surrogate for the other. By using this method, we can get the cause and effect relationships and to search for root causes of an identified problem.
o Interpret the data: Scatter diagrams will generally show one of six possible correlations between the variables:
o Strong Positive Correlation: The value of Y clearly increases as the value of X increases
o Strong Negative Correlation: The value of Y clearly decreases as the value of X increase
o Weak Positive Correlation: The value of Y increases slightly as the value of x increases.
o Weak Negative correlation: The value of Y decrease slightly as the value of X increase.
o No correlation: There is no demonstrated connection between the two variables.
* Sales Forecasting: The sales budget is frequently the first budget prepared since sales is usually the principal budget factor, but before the sales budget can be prepared a sales forecast has to be made. Sales forecasting is complex and difficult and involves the consideration of a number of factors.
As bearing in mind those factors, management can use a number if forecasting methods, often combining them to reduce the level of uncertainty.
o Sales personnel can be asked to provide estimates.
o Market research can be used for new products or services
o Mathematical models can be set up so that repetitive computer simulations can be run which permit managers to review the results that would be obtained in various circumstances.
o Various mathematical techniques can be used to estimate sales levels.
* Time Series Analysis: A further method of presenting a numeric trend over a time series such as sales or profit over a period of years is converting the numbers in question into an index number sequence. The trend is the underlying long term movement over time in value of data recorded.
Seasonal variations are the short term fluctuations in recorded values, due to different circumstances which affect results at different times of the year, on different days of the week at different times of day or whatever.
Cyclical variations are medium term changes in results caused by circumstance which repeat in cycles. In business cyclical variations are commonly associated with economic cycle's successive booms and slumps in the economy. Economic cycles may last a few years. Cyclical variations are longer term than seasonal variations.
An index is a sequence of values where the first or base value is equated to 100 and the subsequent values are proportionally related to 100. The additive model expresses a time series as Y = T+S+R.
The disadvantaged of Forecasting are:
All forecasting are subject to error, but the likely errors vary from case to case
* The further into the future the forecast is for, the more unrealizable it is likely to be.
* The less data variable on which to base the forecast the less reliable the forecast.
* The pattern of trend and seasonal variation may not continue in the future
* Random variations may upset the pattern of trend and seasonal variations
* Changes in interest rates, exchanges rates or inflation can mean that future sales and cost are difficult top forecast in political and economic changes
* The opening of high speed rail links might have a considerable impact on some companies markets with the environmental changes
* Along with the Social change, alterations in taste, fashion and the social acceptability of products can cause forecasting difficulties.
Revenue Forecast: Budget revenue forecast have a very mixed coverage. More than half of the sampled countries the forecast do not extend beyond central government activities. The scope of coverage is related to a country's level of economic development with higher income countries in particular those in the western, having more comprehensive public sector coverage. These revenue forecasts include sub national governments and public enterprises. A few countries also include forecasts of the social security administration.
A second dimension of forecast coverage is the time horizon. Most developed countries have shifted using binding medium term forecast as a planning tool. Similar imitative have been proposed for low income countries. Two third of the sampled countries only produce one year ahead estimated still a large minority produces medium term forecasts. This number may, however overstate the preponderance of medium term forecaster. Among counties with multiyear forecast, the most common forecasting horizon is three years. Higher income in the sample use this more frequently.
The other side of the forecasting relates to within year forecasts. Effective cash flow and debt management required detailed technical within year forecast. In the majority of countries, revenue forecasts are broken down into monthly targets. A slightly more aggregated approach is used in 15 percent of the sample, which produces quarterly forecasts. Approximately two countries generate forecasts exclusively on an annual basis.
Conclusion: Management should have reasonable confidence in their estimates and forecasts. The assumptions on which the forecasts/estimates are based should be properly understood and the methods used to make a forecast or estimate should be in keeping with the nature, quantity and reliability of the data on which the forecast or estimate will be based. There is no point in using a sophisticated technique with unreliable data; on the other hand, if there us a lot of accurate data about historical cost it would be a waste of data to use the scatter diagram method for cost estimating.
Explain the various internal and external sources of finance available to a business. How does the Shareholders and market perceive it?
A company would choose from among various Sources of finance depending on the amount of the capital required and the term for which it is needed. Finance sources can be divided into three categories, namely traditional sources, ownership capital and non ownership capital.
Internal resources have traditionally been the chief sources of finance for a company internal resource could be a company's assets, personal savings and profit that have not been reinvested or distributed among shareholders. Working capital is a short term source of finance and is the money used for a company's day to day activities, including salaries, rent, payments for raw materials and electricity bills.
Ownership capital is the capital owned by the shareholders of a company. A company can raise substantial find through an IPO (initial public offering). These funds are usually used for large expenses, such as new product development, expansion into a new market and setting up a new plant. The various types of share are:
Ordinary Share: These are also known as equity shares and give the owner the right to share the company's profits and vote at the firm's general meetings.
Preference shares: The owners of these shares may be entitled to a fixed dividend, but usually do not have the right to vote.
Companies that are already listed on a stock exchange can opt for a rights issue, which seeks additional investment from existing shareholders. They could also opt for deferred ordinary share wherein the issuing company is not required to pay dividends until a specified date or before the profits reach a certain level.
Deferred ordinary shares are a form of ordinary share, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary share:
Ordinary share holders put funds into their company:
1. by paying for a new issues of shares
2. Through retained profits.
Simply retaining profits, instead of paying them out in the form of dividends, offers and important simple low cast source of finance although this method any not provide enough funds for example of the firm is seeking to grow
A new issue of shares might be made in a variety of different circumstances:
a. The company might want to raise more cash. If it issues ordinary share for cash, should the share be issued pro rate to existing share holders, so that control or ownership of the company is not affected? If for example a company with 100,000 ordinary share in issued decides to issue 25000 new share to raise cash, should it offer the new share to existing share holders or should it sell them to new shareholders instead?
1. If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, we have rights issue. In the example above, the 25,000 share would be issued as a one in four rights issue, by offering shareholders one new share for every four shares them currently hold.
2. If the number of new share being issued is small compared to the number of shares already in issue, it might be decided instead to sell them to new shareholders , since ownership of the company would only be minimally affect
b. The company might want to issue share partly to raise cash, but more importantly to float its share on a stick exchange.
c. The company might issue new shares to the shareholders of another company, in order to take it over.
New Shares issues
A company seeking to obtain additional equity funds may be:
a. An unquoted company wishing to obtain a Stock Exchange quotation.
b. An unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation
c. a company which is already listed on the stock exchange wishing to issue additional new shares.
The methods by which an unquoted company can obtain a quotation on the stock market are:
a. an offer for sales
b. a prospectus issue
c. a placing
d. an introduction.
Unquoted companies (those not listed on stock exchanges) can also issue and trade their share in over the counter markets.
Sources of Finance can be clubbed into the following depending on the date of maturity
Short term Source of finance
* Trade Credit
* Commercial banks
* Fixed deposit for a period of 1 year or less
* Advances received form customers
* Various short term provisions.
Medium term Sources of finance
* Preference Shares
* Public deposits/fixed deposits for duration of three years
* Commercial banks
* Financial Institutions
* State financial corporations
* Lease financing/ hire purchase financing
* Euro issues
* Foreign currency bonds
Long term source of finance
* Share capital or equity share
* Preference shares
* Retained Earnings
* Debentures/Bonds of different types
* Loans from financial institutions
* Loan from state financial corporation
* Venture Capital funding
* Asset Securitization.
Explain the various investment appraisal techniques along with their advantages and disadvantages. How do theses vary for the private and public sector?
A company can be offered a number of possible investments projects, each of which might appear attractive in the return it offers as assessed by investment appraisal techniques such as discounted cash flow.
The Capital Investment appraisal is concerned with only the last two steps of a more complex process of strategic decision making. This process has four stages.
* Perception of the need for an investment, or awareness of a potential opportunity.
* Formulation of alternative courses of action
* Evaluation of the alternatives
* Choice of one of the these alternatives for implementations
Strength: Millions of capital available. Production expertise and appropriate marketing skills
Weakness: Heavy reliance on a small number of customers. Limited product range, with no new products and expected market decline. Small marketing organization.
Threats: Major competitor has already entered the new market.
Opportunities: Government tax incentive for new investment. Growing demand in a new market although customers so far relatively small in number.
Recommendation: The Company must look for new opportunities in the longer term
1. In the short term, current strengths must be exploited to continue to increase market share in existing markets and product development programmers should also continue.
2. In the longer term, the company must diversify into new markets or into new products and new markets. Diversification opportunities should be sought with a view to exploiting and competitive advantage or synergy that might be achievable.
3. The company should use its strengths (whether in R & D, production skills or marketing expertise) in exploiting any identifiable opportunities.
4. Objectives need to be quantified in order to assess the extent to which new long term strategies are required.
The Investment Appraisal:
The Payback Period: Payback is the time it takes the cash inflows from a capital investment project to equal the cash outflow, usually expressed in years.
The Return on Capital Employed: The Return on Capital Employed is also called accounting rate of return of appraising a capital project is to estimate the accounting rate of return that the project should yield. It is exceed a target rate of return, the project with be undertaken.
Discounted Cash Flow: Discounted cash flow in short DCF, is am investment appraisal technique which takes into account both the timings of cash flow and also total profitability over a project life.
Two important points about DCF are as follows:
1 .DCF looks at the cash flows of a project, not the accounting profits. Cash flows are considered because they show the cost of a project will be the original cash outlay, and not the notional cost of depreciation.
2. The timing of cash flow is taken into account by discounting them. The effect of discounting is to give a bigger value per £1 for cash flow that occur earlier £1 earned after one year will be worth more than £1 earned after two years, which in turn will be worth more than £1 earned after five years and so on
The two methods of using DCF to evaluate capital investments
1. The Net present value (NPV) method
2. The Internal rate of return (IRR) method or DCF yield method.
NPV: Net present value is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target rate of return or cost of capital.
The Internal Rate of Return: IRR method is to calculate the exact DCF rate of return which the project is expected to achieve, in other words the rate at which the NPV is Zero. If the expected rate of return exceeds a target rate of return the project would be worth undertaking.
Investment Analysis for private and public sectors
Timing is everything. To have money sooner rather than later increase the range of alternatives open to us.
Value of futurity
· We continually return to the idea of the value of futurity- a far off cost or benefit must be marked down or discounted, its value is always greater now.
· The basis question tackled by investment appraisal methods is whether to incur an expense now so that benefits can be enjoyed in later periods (investment) or whether the funds should be used tp generate immediate benefits, now (consumptions)
· In economic terms, we are considering the time preference for consumption.
The Nature of Decision Making in the Public Sector
* So far we have no real distinction between the type of financial evaluation normally encountered in the private sector and that special type of appraisal that needs to be employed in the government sector.
* Discounted cash flow techniques are used in both domains to ensure that the estimated of net benefits of alternative courses of action are strictly comparable over time.
* However, the interpretation of “ net benefits” is considerably more complex in the government sector. A private firm usually seeks to optimize the use of their own share holder's funds to generate their own financial returns. By contrast, the government sector is concerned to use community resources to generate community benefits.
Discounted Cash Flow Analysis
* As a professional at work you will be expected to competently perform the calculations, so learning the techniques thoroughly will help to convince them of the correctness of the procedures.
* The relationship between future dollar value (FV) and present dollar value(PV) is as follows:
* (1) FV = PV (1+ i) n
* Where I is the interest rate and n is the number of time periods (Say years) elapsing between the present and future date.
Alternative Decision Methods
* The preference in these notes is to use the NPV method supplemented by the B/C method for project ranking suitable modified for consideration of mutually exclusive projects and postponement.
* Recommended practice of NSW and Victorian Treasuries bodies whose instructions guide the appraisal of the majority of transport investment in Australia is also strongly in favor of the NPV criterion because in practice governments wish to maximize aggregate NPV from the total of available funds. This is possible by admitting projects to the program with the highest per dollar outlaid, until the available budget is exhausted.
Treatment of Risk and Uncertainty
* The environment within which projects are undertaken is forever changing. The estimates that are made about benefits and costs are often be based upon sets of quite debatable assumptions. However reasonable these assumptions might be it is clearly important to distinguish between two projects that say have the same NPV but for which we have different degrees of confidence about underlying assumptions.
* Risk and uncertainty are therefore important dimensions of a project's desirability. Conceptually we can distinguish between:
* Risk-probabilities of outcome are know
* Uncertainty- probabilities of outcome (or even the outcomes themselves) cannot be predicated
Finally to Consider all Alternatives for public and private Sector
* Although there is an obligation to consider the ‘do- nothing' case other alternative should also be examined to ensure that the design project is the best way of achieving project aims. For example, it is desirable to consider:
1. Alternative scale or standard of project. Would a lesser quality be adequate?
2. Alternative phasing or location (Do the most pressing parts first? Consider a reestablishment as an alternative to a new distribution scheme?
3. Alternative operating methods.
4. Alternative types of project.
5. In practice it is often simply not feasible to consider all alternative.
Compare and explain the payback method and return on capital employed. What are the advantages and disadvantages of each?
The Payback Period
Payback is the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years.
Payback is often used as first screening method. By this, we mean that when a capital investment project is being considered, the organization might have a target payback, and so it would reject the capital project unless its payback period were less than a certain numbers of years.
The reason why payback should not be used on its own to evaluate capital investment should seems fairly obvious for two mutually exclusives projects.
Let explain with examples:
Project A Project B
Capital Asset £60,000.00 £60,000.00
PBT (app of cash flow)
Year 1 £20,000 £50,000
Year 2 £30,000 £20,000
Year 3 £40,000 £5,000
Year 4 £50,000 £5,000
Year 5 £60,000 £5,000
Project A pay back in year 3. Project B pays back half way though Year 2. Using payback alone to judge capital investments, Project B would be preferred.
The Return on Capital Employed Method
The return on capital employed method (ROCE) is also called the accounting rate of return method or the return on investment ROI method of appraising a capital project is to estimate the accounting rate of return that the project should yield.
They are several different definitions of ‘return on investment'. One of the most popular is as follows:
ROCE = Estimated average profits___ X100%
Estimated average investment
The others include
Estimated total profits x 100%
ROCE= Estimated initial investments
There are arguments in favour of each these definitions. The most important point is, however that the method selected should be used consistently.
Examples for ROCE:
When the ROCE from a project varies from year to year, it makes sense to take an overall or ‘average' view of the project return. In this case, we should look at the return as a whole over the four year period
Total profit before depreciation over four years 105,000
Total profit after depreciation over four year 25,000
Average annual profit after depreciation 6,250
Original cost of investment 80,000
Average net book value over the four year period (80,000+0)/2= 40,000
ROCE = 15.6%
The project would not be undertaken because it would fail to yield the target return of 20%.
The advantages and disadvantages of Pay back period and ROCE are as follows:
PAY BACK PERIOD
Advantages of Pay Back Period
1. It is simple to calculate and simple to understand. This may be important when management resources are limited. It is similarly helpful in communicating information about minimum requirements to mangers responsible for submitting projects.
2. It can be used as a screening device as first stage in eliminating obviously inappropriate projects prior to more detailed evaluation.
3. The fact that it tends to bias in favour of short term projects means that it tends to minimise both financial and business risk.
4. IT can be used when there is a capital rationing situation to identify those projects which generate additional cash for investment quickly.
Disadvantage of Payback Period
1. It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.
2. Payback is unable to distinguish between projects with the same payback period.
3. The choice of any cut off payback period by an organisation is arbitrary.
4. It takes account of the risk of the timing of cash flows but not the variability of those cash flows.
RETURN ON CAPITAL EMPLOYED
Advantages of ROCE
1. It is a quick and simple calculation.
2. It involves a familiar concept of a percentage return.
3. IT looks at the entire project life.
4. It is understood by non financial managers.
5. It is a measure used by external analysis which should therefore be monitored by the company.
Disadvantage of ROCE
1. It is based on accounting profits and not the cash flows. Accounting profits are subject to a number of different accounting treatments.
2. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.
3. It takes no account of the length of the project.
4. Like the payback method, it ignores the time value of money.
Table 1 : Comparison between pay back period and Return on capital employed Interpret Financial Statement by using Ratios:
In profitability, both current and quick ratios have not improved because this is due mainly to the decrease in stock levels and the decline in current liabilities, the composition of which is unknown. However the current ratios remain below the sector average. The decrease in both stock levels and stock days together worth the fact that the stock days is now above the sector average may indicate the current products are becoming harder to sell, a conclusion supported by the failure to decrease turnover and the reduced profit margin.
The increase in the debtor's ratio is not an encouraging sign, but the interpretation of the decreased working capital ration is uncertain. While the decrease could indicate less aggressive working capital management, it could also indicate that trade creditors are less willing to extend credit or that stock management is poor.
The gearing of the company has fallen, Interest cover has declined since interest has increased and operating profit has fallen. Given the constant long term debt, the increase in interest although small could indicate an increase in overdraft finance.
Ratios analysis offers evidence that the financial performances have been disappointing in terms sales, profitability and stock management. It may be that the management has seen the increase in capacity as a cure for the company's declining performance.
For Audit Performance, An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimated made by the management as well as evaluating the overall consolidated financial statement presentation. We believe that out audit provides a reasonable basis for our opinion.
The Consolidated financial statements have been prepared by the company's management in accordance with the requirements of Accounting Standard 21 Consolidated Financial Statements, Accounting Standard 23- Accounting for Investments in Associates in Consolidated Financial Statements and accounting Standards, Financial Reporting of Interests in Joint Ventures.
Cox D and Fardon M - Management of Finance
Berry A and Jarvis R – Accounting in a Business context
Security Analysis and Portfolio management- Donald E.Fischer, Ronald J.Jordan