Financial Decision Making for Managers

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 Executive Summary

Manger of any organization took the key responsibilities to take financial decisions of that
organization. In managerial decision making process its not realistic to use only the assumptions
of the manager. Rather manger should use financial information of the organization and the
economy in which business operates. Mangers use different financial tools to gather information
in decision making process such as ratio analysis, cash budgeting, projects evaluation techniques
etc. Ratio analysis of First Derivatives plc show that the company able to maintain a steady
profitability every year. First derivatives plc uses moderate level of debt in its capital structure.
Cash budgeting of Green Limited shows that the company will have excess cash. So the
company can invest its excess cash in short term securities. Hanley Manufacturing Limited is
considering evaluating its two mutually exclusive projects. Among the four evaluation technique
NPV provide better result. So the company should use NPV for the evaluation of the projects.

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 Contents

Executive Summary ........................................................................................................................ ii

Introduction ..................................................................................................................................... 1
1 Selection of Company for Ratio Analysis ............................................................................... 1
1.1 Financial Highlights of First Derivative plc for the year 2011 and 2012 ........................ 1
1.2 Ratio Analysis of First Derivatives plc ............................................................................ 2
1.3 Business Structure and Financial Structure ...................................................................... 4
1.4 Business finance ............................................................................................................... 5
1.5 Advices to potential investor ............................................................................................ 5
1.6 Suitable sources of finance ............................................................................................... 6
1.6.1 Recommended source of Finance ............................................................................. 6
1.7 Working capital management........................................................................................... 7
2 Cash Flow Forecast for Green Limited ................................................................................... 8
2.1 Cash budget for Green Limited for 6 months .................................................................. 8
2.2 Recommendations for managing cash flow ..................................................................... 9
3 Assessment of the project using different project evaluation techniques .............................. 10
3.1 Evaluations of projects using accounting rate of return ................................................. 10
3.2 Evaluation of projects using Payback period method .................................................... 11
3.3 Evaluation of projects using Net Present Value (NPV) method .................................... 12
3.4 Evaluation of projects using Internal Rate of Return (IRR)........................................... 13
3.5 Final recommendation for project selection: .................................................................. 15
Conclusion .................................................................................................................................... 16
References ..................................................................................................................................... 17

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Introduction

Managers in business organizations have to take financial decisions. They need to analyze
financial information regularly. In analyzing financial information managers use different
techniques. Managers need to conduct ratio analysis, evaluating different projects profitability,
making cash budget and many other functions. This report will make us understand how to
analyze the financial statement of an organization and take major financial decisions base on this
analyzed data.

1 Selection of Company for Ratio Analysis

First Derivatives plc is a renowned institution in capital market industry. It provides financial
products and consulting services for different parties in capital market. This company started its
operations in 1996. First Derivatives plc is listed in London Stock Exchange (LSE) and Irish
Stock Exchange. It has 700 employees worldwide (Firstderivatives.com, 2014).

1.1 Financial Highlights of First Derivative plc for the year 2011 and 2012

Particulars 2011(000) 2012(000)

Revenue 36,740 46,087
Gross profit 13,317 15,915
Cost of sales 23,423 30,172
Finance expense 723 648
Tax expense 1,383 1,001
Net Profit 5,112 5,946
Profit before interest & tax 7,218 7,595
Trade and other receivables 12,563 13,767
Cash Flow From Operations 5,361 8,154
Current assets 16,064 16,683

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Current liabilities 18,273 14,761
Total assets 70,395 70,720
Loans and borrowings (Long 21,544 18,598
Term)
Equity attributable to 24,888 32,236
shareholders
No of share Outstanding 15,415 16,510
Source: Annual Report of First Derivatives plc 2012

1.2 Ratio Analysis of First Derivatives plc

In ratio analysis four categories of ratio are calculated. They are Liquidity Ratio, Profitability
Ratios, Activity Ratios and Solvency Ratios (Firstderivatives.com, 2014).

Liquidity Ratios: These ratios measure the ability of a firm to meet up its current
obligations (Bhat and Rau, 2008). Here the summarize result of Liquidity ratios of First
Derivatives plc given below

Particulars 2011 2012

Current Ratio 0.879 1.130
operating Cash flow Ratio 0.29 0.55
Source: (MS Excel)
Current ratio in 2012 is 1.13 which is higher than 2011. That indicates First derivatives
current asset increases. Operating cash flow in 2012 also increases relative to current
asset.
Activity Ratios: These ratios measure the relative efficiency level of a firm
(Prenhall.com, 2014). Activity ratios of First Derivatives plc are-

Particulars 2011 2012

Average Collection 123 108
Period

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 Total Asset Turnover 0.52 0.65
Ratio
Source: (MS Excel)
The company accelerates its collection process thats why collection period decreases.
Total asset turnover also increases in 2012. Revenue increases compare to assets.

2011 2012
Profit Margin Ratio 13.91% 12.90%
Gross Profit Ratio 36.25% 34.53%
Return on Asset 7.26% 8.41%
Earnings Per Share 0.33 0.36
Return on Equity 20.54% 18.45%
Profitability Ratios: Profitability ratios indicate the capability of a business to generate
earnings. Summary of First Derivatives plc given below-

Source: (MS Excel)

Profit margin and gross profit ratio slightly decrease in 2012 compare to 2011. Net
income and EPS increase compare to total asset. Return on equity of the company
decreases in 2012.

Solvency Ratios: Its measure the financial strength of a business (Prenhall.com, 2014).
Solvency ratios of First Derivatives plc are-

2011 2012
Debt to Equity Ratio 0.87 0.58

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 Debt to Total Asset 0.31 0.26
Times Interest Earned 9.98 11.72
Source: (MS Excel)
First derivatives plc uses high leverage in 2011 but in 2012 the company repay its debt.
Debt to total asset also reduces because of the repayment of debt. Companys ability to
pay interest also increases in 2012.

1.3 Business Structure and Financial Structure

Business structure: First Derivatives is a public limited company. Its management is

separate from ownership. Stockholders of a First Derivatives enjoy the benefits of limited
liabilities. Stockholders receive dividends from company in exchange of their investment.
Financial Structure: First Derivatives plc is a moderately levered company because its
debt equity ratio is 58%.
Reporting requirements: As a public limited company its compulsory for first
derivatives to publish audited financial statement every year (Companieshouse.gov.uk,
2014).
Relative advantages of the structure of First Derivatives plc: There are also two more
types of business structure sole proprietorship and partnership. In a sole proprietorship
there is only one owner who supply all the capital needed by firm. Liability of the owner
is not limited for this reason his personal property is liable for the business liability
(Miles and Snow, 1978). Sole proprietorship doesnt need to follow hard and fast rules
and regulations. It is not required to publish its financial statements but it prepares its
own statement which includes income statement and balance sheet
(Companieshouse.gov.uk, 2014).

First Derivatives plc, as a public limited company gets some extra advantages compare to
other business structure-
First derivatives stoke holders enjoy the advantage of limited liabilities.
It can raise capital easily by issuing share to general public.

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 For its financial capabilities it can employ more efficient management staff.
Its can comfortably take large project which is not possible to take in other form of
business.
First Derivatives plc is strictly regulated. People invest in this type of business
confidently (Morebusiness.com, 2014).

1.4 Business finance

First Derivatives plc is listed in stock market. So it can issue securities to pubic to raise fund.
Amount of debt and equity in First Derivatives plc as follow-

Particulars 2011(000) 2012(000)

Loans and borrowings (Long 21,544 18,598
Term)
Equity attributable to 24,888 32,236
shareholders
Source: Annual Report of First Derivatives plc 2012

First Derivatives debt equity ratio in 2011 is 87% which is decline to 58% in 2012. Main reason
behind this reduction in debt equity ratio is repayment of long term debt. Significant increase in
retained earnings in 2012 is also another reason for reduction in debt equity ratio. It meets its
short term fund need by lengthening its accrued expense, accelerating the collection of
receivables. It also takes loan to meet up medium term fund requirement from banks
(Businessfinance.com, 2014).

1.5 Advices to potential investor

Current deposit accounts interest rate is around 3% for 50000 (Moneynet.co.uk, 2014).
Return on equity of First Derivatives plc is 18.45%. So the return on First Derivatives plc is
much higher than the interest on current deposit account. First derivatives plc also maintain a
steady profit every year. They also try to expand their business globally. As First Derivatives plc
uses debt in its capital structure so its quite risky for the investor to invest in it. First Derivatives
plc use moderate debt in its capital structure but its return is around 6 times higher than the

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interest on current deposit account. So as a rational investor he/she should invest in the securities
of First Derivatives plc.

1.6 Suitable sources of finance

First Derivatives plc requires 50000 for some business purposes. As a public limited company
it can raise this fund from several sources. Four main sources of fund for First Derivatives plc
are-

Borrowing from banks: Borrowing from banks is the main sources of fund for
companies. Because public limited companies are large organizations so its easy for
them to collect fund from bank with reasonable interest rate.
Retained earnings: First Derivatives plc has large retained earnings in 2012. Its not
mandatory for public limited companies to pay dividend. So First Derivatives plc can use
retained earnings as a source of fund (Ross, Westerfield and Jordan, 1995).
Issuing bonds: First Derivatives plc use moderate capital in their capital structure so they
can issue bond for the fund required. Payment of interest is the obligation for accompany.
If the company cant pay interest than the company might default.
Issuing Stock: This is another source of fund for First Derivatives plc. But issuing stock
is more costly than other sources of fund. Flotation cost is very high in share issuing.

1.6.1 Recommended source of Finance: retained earnings

So the best option for the company is to raise fund from retained earnings. There is no flotation
cost related to retained earnings. First Derivatives plc doesnt need to pay interest on its
financing from retained earnings. In case of debt financing the lender impose many covenants
which arent beneficial for company. Financing from retained earnings doesnt impose any
covenants (Ross, Westerfield and Jordan, 1995).

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1.7 Working capital management

Current ratio and operating cash flow ratio for First Derivatives plc are 1.13 and .55 respectively.
From current ratio we can say that First Derivatives plc has enough liquid assets to meet up the
current liabilities. Operating cash flow of the company is also satisfactory. Receivable turnover
for First Derivatives plc is 108 day. So firm should accelerate the collection process of account
receivable (Preve and Sarria-Allende, 2010).

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2 Cash Flow Forecast for Green Limited

To forecast cash flow of an organization, its necessary to prepare a cash disbursement schedule
and cash collection schedule first.

Cash collection schedule from debtors

Cash collection (From Debtors) Schedule

Jul Aug Sept Oct Nov Dec
000 000 000 000 000 000
106 114 118 124 104 96
Source: (MS Excel)

Cash disbursement schedule for inventory purchase

Cash disbursement schedule for material

Jul Aug Sept Oct Nov Dec
000 000 000 000 000 000
64 64 66 70 59 54
Source: (MS Excel)

2.1 Cash budget for Green Limited for 6 months

Cash collection schedule and cash disbursement schedule for material purchase are completed;
the cash budget is prepared using the given information.

Cash Budget for Green Limited

Particulars Jul Aug Sept Oct Nov Dec
000 000 000 000 000 000
Beginning Bank Balance 90 108 134 117 147 33
Add: Cash receipt from customer 106 114 118 124 104 96
Total cash available 196 222 252 241 251 129
Less: Disbursements

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Cash paid to supplier 64 64 66 70 59 54
Salaries and wages 20 20 20 20 20 20
Electricity 20 34
Other overheads 4 4 4 4 4 4
Delivery van purchase 25
Total disbursement 88 88 135 94 83 112
Excess cash available for disbursement 108 134 117 147 168 17
Financing:
Repayment of Bank Loan 135
Ending Bank Balance 108 134 117 147 33 17
Source: (MS Excel)

Green Limited cash position is quite well because the company has cash balance after every
month. That is after meet up all the expenses the company has excess cash. So there is no need
for borrowing. Rather the Green Limited can invest its excess cash in short term liquid asset
(Jury, 2011).

2.2 Recommendations for managing cash flow

1. Commercial paper: Commercial is unsecured short term debt which is issued by large
corporations. As Green Limited has excess cash in hand so the company can invest in
commercial paper. This will provide the company some returns.
2. T-bill: T-bill is the risk free investment. No other securities are safer than T-bill. So
green limited can invest in T-bill. This in the most liquid investment.
3. Short term fixed deposit: Now a days banks provide the facilities for the depositors to
deposit for short term which is fixed in nature. This type of deposits provides more
interests than current account.
4. Intercompany Lending: Green Limited can also use excess cash in lending to other
companies which are in need of finds.
5. Money market mutual fund: This is another important sector of investment for short
term. These securities provide some sort of risk diversification (Entrepreneur, 2014).

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3 Assessment of the project using different project evaluation
techniques

3.1 Evaluations of projects using accounting rate of return

Accounting rate of return (ARR) can be found by dividing average income with average
Investment (Ferran, 2008). ARR is used in evaluation process of project. In comparing two
projects with ARR the projects which ARR is higher will be selected.

Project 1

Average income: (58000-2000+4000)/3 = 20000

Average Investment: (200000+7000)/2 = 103500

20000
So, accounting rate of return = 103500 = 19.32%

Hanley Manufacturing Ltd can earn 19.32 % on its invested capital according to accounting rate
of return. It does not consider time value of money. Undiscounted cash flow is used here.

Project 2

Average net income = (36000-4000+8000)/3 = 13333

Average book value = (100000+12000)/2 =56000

13333
Accounting rate of return =56000 = 23.81%

Hanley Manufacturing can earn a return of 23.81% on its invested capital, if the company accept
project 2.

So if the company use accounting rate of return than the company should take project 2.

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3.2 Evaluation of projects using Payback period method

Payback period is the time by which an investor can get back the full investment from a project.
The project which payback period is shorter is more preferable than other projects. Investors
always prefer early return from the projects. When actual pay back period of a project I equal or
shorter than the expected payback period time than the project will be accepted otherwise the
project will be rejected (Ferran, 2008).

Project-1

Cash flow of project 1

Year Op. profit Depreciation Residual Cash Flow Cumulative

Value Cash Flow
1 58000 64333 122333 122333
2 -2000 64333 62333 184667
3 4000 64333 7000 75333 260000
Source: (MS Excel)

200000184667
Payback Period = 2 + = 2.20 years
75333

Payback period of Hanley Manufacturing Limiteds project 1 is 2.2 years. So Hanley

Manufacturing Limited can earn its investment in project 1 within 2.20 years.

Project-2

Cash flow of project 2

Year Op. profit Depreciation Residual Cash Flow Cumulative

Value Cash Flow
1 36000 29333 65333 65333
2 -4000 29333 25333 90667
3 8000 29333 12000 49333 140000
Source: (MS Excel)

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 10000090667
Payback Period = 2+ = 2.19 years
49333

According to payback period method, the company earns its initial investment from project 2 in
2.19 years.

3.3 Evaluation of projects using Net Present Value (NPV) method

Net present value (NPV) is the difference between initial investment or outflow and discounted
cash inflow. When the NPV of a project is positive than the project will be elected otherwise the
project will be rejected. If projects NPV is larger than it will benefitted its stockholder more
(Ross, Westerfield and Jordan, 1995).

Project-1

Cash flow of project 1

Year Op. profit Depreciation Residual Value Cash Flow

1 58000 64333 122333
2 -2000 64333 62333
3 4000 64333 7000 75333
Source: (MS Excel)

Project 1

122333 62333 75333

NPV = + + - 200000 = 19325
1.1 1.12 1.13

The NPV of Hanley Manufacturing Limiteds project 1 is positive by 19325. It indicates Hanley
Manufacturing Limiteds earns more than its cost of capital. So the company should accept
project 1.

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Project-2

Cash flow of project 2

Op. profit Depreciation Residual Value Cash Flow

36000 29333 65333
-4000 29333 25333
8000 29333 12000 49333
Source: (MS Excel)

NPV = + + -100000 = 17395
. . .

The net present value of Hanley Manufacturing Limiteds project 2 is also positive. So it would
be beneficial to the stakeholders if the company accept the project.

But the NPV of project 1 is higher than project 2. Project 1 is more preferable than project 2.

3.4 Evaluation of projects using Internal Rate of Return (IRR)

Internal rate of return is the return which a company can actually earns from the investment. If
the internal rate of return is greater than the required return of a project than the project will be
accepted otherwise the project will be rejected (Ross, Westerfield and Jordan, 1995).

Project-1

Cash flow of project 1

Year Op. profit Depreciation Residual Value Cash Flow

1 58000 64333 122333
2 -2000 64333 62333
3 4000 64333 7000 75333
Source: (MS Excel)

NPV @ 10% = 19325

NPV @ 18% = -5711

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 19325
So, IRR = .10+19325(5711)*(.18-.10) =16.18%

IRR of Hanley Manufacturing Limiteds project 1 is 16.18%. The discount rate of Hanley
Manufacturing Limited is 10%. So Hanley Manufacturing Limited earns more than its cost of
capital and should accept the project.

Project-2

Cash flow of project -2

Year Op. profit Depreciation Residual Value Cash Flow

1 36000 29333 65333
2 -4000 29333 25333
3 8000 29333 12000 49333
Source: (MS Excel)

NPV @ 10% = 17395

NPV @ 22%= -2260

17395
So, IRR =.10+ 17395(2260)*(.22-.1)

= 20.62%

IRR of Hanley Manufacturing Limiteds project 2 is 20.62%. So Hanley Manufacturing Limited

earns more than its discount rate in project 2 also. According to IRR, the company should accept
the project.

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Summary of the results and comparison

Methods Project-1 Project-2 Decision

ARR 19.32% 23.81% Accept project 2
Payback Period 2.20 years 2.19 years Accept project 2
NPV 19325 17395 Accept project 1
IRR 16.18% 20.62% Accept project 2
Source: (MS Excel)

3.5 Final recommendation for project selection: Net Present Value Method

Hanley Manufacturing Limited should take decision of accept and reject of projects based on
NPV and accept project 1. As we know that if the propjets are mutually exclusive than NPV will
provide better result. Here Hanley Manufacturing Limited cannot take the two projects at a time,
because of the shortage of fund. Both ARR and payback period are undiscounted techniques
which do not take consideration of time value of money. These techniques might give poor
answer to the investors which might be harmful. IRR doesnt provide accurate answer in case of
mutually exclusive project even though this technique use discounted cash flow. So this
technique should not be used here as the projects are mutually exclusive. So NPV gives the most
appropriate result in this case of Hanley Manufacturing Ltd. So the company should follow the
results NPV and select project 1. By choosing the project 1, the company will be able to increase
its actual value by 19325 (Ross, Westerfield and Jordan, 1995).

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Conclusion

Ratio analysis provides a clear understanding about the financial condition of the First
Derivatives plc. This analysis helps the manger to take better decisions such as level of debt to be
used in capital structure, source of capital to be used to raise new capital and the implications of
different sources. Cash budget of Green Limited indicate that in near future it will have ample
cash. So it can use its cash to short term investments. Hanley Manufacturing Limited should use
NPV to evaluate its projects because other techniques may provide erroneous results. These
financial tools used by mangers to evaluate the performance of the business and take timely
decisions.

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References

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BS Publications.
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Jun. 2014].
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http://www.companieshouse.gov.uk/ [Accessed 10 Jun. 2014].
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http://www.entrepreneur.com/article/66008 [Accessed 10 Jun. 2014].
Ferran, E. (2008). Principles of corporate finance law. 1st ed. New York: Oxford University
Press.
Firstderivatives.com, (2014). First Derivatives plc. [online] Available at:
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Miles, R. and Snow, C. (1978). Organizational strategy, structure, and process. 1st ed. New
York: McGraw-Hill.
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[online] Available at: http://www.moneynet.co.uk/Banking-Saving/Current-Account/Results
[Accessed 10 Jun. 2014].
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http://www.morebusiness.com/getting_started/incorporating/d934832501.brc [Accessed 10
Jun. 2014].
Prenhall.com, (2014). Ratio Analysis. [online] Available at:
http://www.prenhall.com/divisions/bp/app/cfl/RA/RatioAnalysis.html [Accessed 10 Jun.
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Chicago: Irwin.

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