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Financial Management Assignment: Case Analysis Of AL Pty Limited

Question

Task:
Financial Management Assignment Task:
Context
You are part of the management team of Amazing Lounge Pty Ltd (AL Pty Ltd). AL Pty Ltd is a private company specialising in the retailing of high-end home furniture. During the annual strategic review for 2021, a key focus is on analysing the financial performance of the company and mapping its growth pathway for the next 5 years. Financial information and ratios for the past 5 years have been calculated and provided to the management team.

The company has been investing substantially in capital projects and building its stock in the last few years. The Vice President (VP) of Operations is very keen to keep increasing the stock level as it provides a wide range of goods available for sale, and to continue spending on capital by opening new stores (the company has limited online presence to-date).

Print version: AL Pty Ltd Financial Ratios 2016-2020

Written Report
Write a report for the management team that addresses points 1 to 5 below:
Comment on the performance trends for current ratio and return on total assets of AL Pty Ltd using the ratios provided and noting 2020 was impacted by COVID-19 lock-downs. AL Pty Ltd operates in the furniture retail industry. Choose another company in the same industry, preferably a publicly listed company with easy access to the required relevant financial information. Using the DuPont Method, provide a critical analysis of AL Pty Ltd’s Return on Equity performance for the last 5 years relative to the competitor you have chosen. Please complete the analysis using publicly available data for the competitor (e.g. IBISWorld and/or annual reports).

Comment on the view taken by the VP of Operations that the company should be increasing stock level and opening new stores. Take into account all key finance principles, concepts and theories which are relevant. Also, 2020 was not a good year for AL Pty Ltd and 2021 started quite slow with the business seeing a large number of returns of furniture (refunds). The VP of Operations has proposed that these refunds be posted in the 2022 results to give some breathing space for 2021. Discuss the ethical implications of this proposal from the VP of Operations.

One of the suggestions from the CEO is to consider floating the company to raise capital. Evaluate the pros and cons of listing the company and becoming public.

Identify and discuss the limitations of your analysis.

Based on your analysis and discussion, make recommendations as to whether AL Pty Ltd should continue on the same trajectory and whether listing the company would be beneficial. Suggest other alternative growth options for the company as well.

Answer

Executive Summary
This is a financial management assignment presents the financial management of a business. Financial management requires the application of all general principles of the management to procure the financial resources. A financial evaluation is undertaken for both the Option A and Option B available with AL Pty Limited. The Option A directs using NPV and simple Payback Period to examine the feasibility of the business. In both the scenario, the NPV of Option A is positive and the payback period is within the managerial expectation therefore making Option A feasible. Moreover, a sensitivity analysis for the next 5 years is analysed to ascertain the cash flow for the project.

Option B related to using break-even analysis. Two options are available for the business which includes prior to outsourcing of business and post outsourcing of business. From the calculation of break-even analysis, it is opine that AL Pty Ltd must outsource its manufacturing unit to a foreign land to earn lower break-even units and facilitate more profits for itself. A non-financial implication about Option B is highlighted to understand the needs of the stakeholders. The third part of this report indicates the various possible situations wherein a company can extend its credit policy by extending its payment terms. Both pros and cons of extension of credit payment terms are highlighted to analyse the impact on business. A list of recommendation explaining the disadvantages of net present value, payback period and break-eve n point is discussed in depth.

Introduction
Financial management is defined as the strategic process of planning, organising, directing and controlling financial activities in the organisation. It involves the application of adequate management principles to the financial assets of the business that plays the decision-making role in fiscal management. As opined by Madura(2020), financial management provides a gateway to recover the organisational goals and objectives in the business. The main role of a financial manager is to measure the organisational efficiency and effectiveness by means of proper allocation, acquisition of assets and management of resources. Financial management helps in making financial decisions, investment decisions and dividend decisions of the business.

1. Conduct the financial evaluation of Option A
Option A

Items

$

Initial investment

20000000

Project estimated life

5 years

Working capital requirement

2000000

Depreciation Method

Straight line

Depreciation expenses

4000000

Unit sales (per year)

100000

Unit prices

4200

Variable cost per unit

2500

Discount rate

10%

Tax rate

30%


Computation of NPV

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

 

420000000

420000000

420000000

420000000

420000000

Less: Variable costs

 

250000000

250000000

250000000

250000000

250000000

Less: Depreciation expenses

 

4000000

4000000

4000000

4000000

4000000

Operating profit

 

166000000

166000000

166000000

166000000

166000000

Less: Tax

 

0

0

0

0

0

Net Operating Profit After Tax

 

166000000

166000000

166000000

166000000

166000000

Add: Depreciation expenses

 

4000000

4000000

4000000

4000000

4000000

Add/Less: Increase in CAPEX

20000000

       

0

Add/Less: Increase in Working Capital

2000000

       

2000000

Cash Flow

22000000

170000000

170000000

170000000

170000000

172000000

Present Value

22000000

154545454.5

140495867.8

127723516.2

116112287.4

106798467.6

Net Present Value

623675593.4

         

 

Computation of Payback Period

Year

Cash Flow

Net Cash Flow

0

-22000000

-22000000

1

170000000

148000000

2

170000000

318000000

3

170000000

488000000

4

170000000

658000000

5

172000000

830000000

 

The calculation above shows the financial evaluation of Option A for AL Pty Ltd using NPV and a simple Payback Period. The NPV depicted the results as $623675593.4 at the end of 5 years for a discounting rate of 10%. According to the decision criterion of NPV, Option A stands to be feasible for the entity as the NPV is positive or more than 1. A positive NPV suggests that cash inflow is greater than the cash outflow or the initial cost of investment, and hence it is feasible. The initial cost of investment is $22000000, whereas the NPV is $623675593.4, indicating a higher cash flow for Option A and, therefore, is positive as well as feasible.

The payback period for Option A is 0 years. This means by the commencement of Year 1, and AL Pty Ltd shall receive back its initial cost of investment which is $22000000. The cut-off period of the payback period decided by the company is 2 years for the evaluation. According to the payback period principles, the actual payback period should is less or equal to the cut-off period for the project to be feasible for the entity (Loke 2017). In the given case, the calculated payback period is lower (0 years) than the cut-off period (2 years). Hence, Option A is feasible for the business.

Between NPV and Payback Period, NPV is a better capital budgeting method than other methods, as NPV uses the concept of discounted cash flows to analyse the favourable attribute of the business. This makes NPV more precise than the Payback Period as it considers both risk and time variables. NPV allows the business managers to make better decisions in comparison to the payback period while making a capital investment, as relying solely on the payback method might result in taking poor financial decisions (Masharskyet al., 2018). In most organisations like AL Pty Ltd, both methods are used simultaneously to make optimal investment and financing decisions. While discussing the advantages, the payback period is the simplest method of capital budgeting and easier to compute for small, repetitive investments and factors like tax and depreciation rates.

On the other hand, NPV is the most accurate and efficient method to measure the cash flows and not profits and these results in investment decisions giving more added value. Considering the disadvantages, NPV assumes that there will be a constant discount rate over the entire life of the investment and, therefore, limited in making a prediction of future cash flows (Yapet al., 2018). The cons of the payback period involve that it does not take into consideration of the cash flows and profits after deriving the payback period. Moreover, it ignores the money value and financial risks prior to or during the investment.

Sensitivity Analysis

Items

$

Initial investment

20000000

Project estimated life

5 years

Working capital requirement

2000000

Depreciation Method

Straight line

Depreciation expenses

4000000

Unit sales (per year)

100000

Unit prices

4200

Variable cost per unit

2500

Discount rate

15%

Tax rate

30%

 

Computation of NPV

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

 

420000000

420000000

420000000

420000000

420000000

Less: Variable costs

 

250000000

250000000

250000000

250000000

250000000

Less: Depreciation expenses

 

4000000

4000000

4000000

4000000

4000000

Operating profit

 

166000000

166000000

166000000

166000000

166000000

Less: Tax

 

0

0

0

0

0

Net Operating Profit After Tax

166000000

166000000

166000000

166000000

166000000

Add: Depreciation expenses

 

4000000

4000000

4000000

4000000

4000000

Add/Less: Increase in CAPEX

20000000

       

0

Add/Less: Increase in Working Capital

2000000

       

2000000

Cash Flow

22000000

170000000

170000000

170000000

170000000

172000000

Present Value

22000000

147826087

128544423.4

111777759.5

97198051.75

85514398.47

Net Present Value

548860720.1

         

 

Sensitivity analysis is the financial model that is computed to determine how the target variables are influenced based on the changes in the other related variables known as the input variables (Brighamand Houston, 2021). A sensitivity analysis on the NPV is conducted for AL Pty Ltd by bringing a change in the discounting rate from 10% to 15%. It can be observed that at a 10% discounting rate, the NPV is $623675593.4, whereas, at a 15% discounting rate, the NPV is $548860720.1. It marks a difference of $74814873.3 of NPV. This is due to an increase in the discounting rate leading to a downfall of NPV. There is an inverse relationship between the NPV and discount rate. A higher discount place gives more priority to the earlier cash flows, which are generally the cash outflows. In case the value of outflow is more than inflows, the NPV is negative.

The investment principle states the risk-return tradeoff indicates that the higher the risk, the higher is the potential to secure reward in the form of return. Investors take into account the risk-return tradeoff for an individual investment portfolio to make investment decisions. For AL Pty Ltd, investing in a new product shall be classified as a risky investment decision as the company needs to prosper on its existing product line rather than investing in new products (Prihartonoand Asandimitra, 2018). The risk shall be applied here in the decrease of the sales price per unit of the company for the new products. The demand for the new products may not be large, therefore, hampering the overall sales revenue of the business. With a view to secure more revenue and profit by the company from the new products, the company may lose out on its customers by offering products that are not demanded.

2. Critical assessment of Option B using break-even analysis
Before outsourcing

Break-even analysis (in cash basis) = Fixed Costs- Non-cash expenses/ Selling price per unit- Variable cost per unit

= 10000000-400000/1000-400

= 6000000/600

= 10000 units

Break-even analysis (in accounting basis) = Fixed Costs / Selling price per unit- Variable cost per unit

= 10000000/1000-400

= 10000000/600

= 16667 units

Option B is related to outsourcing of current manufacturing plant in the foreign country by AL Pty Limited. Prior to outsourcing decisions, the BEP is calculated both for cash basis and accounting basis. According to the cash basis, the break-even point for the manufacturing plant is 10000 units. This means the company needs to sell at least 10000 units to surpass the loss-making situation. Any unit beyond 10000 units shall be considered as profit for AL Pty Limited. A cash break-even analysis implements the equation that involves the removal of non-cash expenses like depreciation (Ameliawatiand Setiyani, 2018). It causes a difference in the result and provides the business analysts with a greater insight into the financial condition of the entity. In the given case, the BEP is 10000 units that show the minimum amount of sales that are required by AL Pty Ltd with positive cash flows.

This method is undertaken by the business as AL Pty Ltd has limited availability of cash. Moreover, holding excess cash requires AL Pty Limited to pass on alternative opportunities that are more beneficial, which costs the business money in losing out opportunities if it decides to hold onto the cash. In the second case, the BEP is computed on an accounting basis. It delivered a result of 16667 units. This means, at the sales level of 16667 units, AL Pty Ltd shall generate exactly zero profits at the respective fixed costs. This method of BEP assumes that the business follows the accrual basis of accounting; therefore, the portion of the fixed costs of the calculation includes all expenses- both cash expenses and non-cash expenses under the accrual basis of accounting (Changet al., 2020). It can be observed that a higher proportion of BEP is recorded for an accounting basis, as it includes the depreciation expense within the computation of break-even units.

After outsourcing
Break-even analysis (in cash basis) = Fixed Costs- Non-cash expenses/ Selling price per unit- Variable cost per unit

= 7000000-400000/1000-300

= 3000000/700

= 4286 units

Break-even analysis (in accounting basis) = Fixed Costs / Selling price per unit- Variable cost per unit

= 7000000/1000-300

= 7000000/700

= 10000 units

After taking into account the outsourcing decision to another country to manufacturing the present model of lounge, it is anticipated that the variable cost shall decrease to $300, and the total fixed cost shall drop to $7000000. Again, BEP for both cash method and accrual method are computed and derived results of 4286 units and 10000 units, respectively. It can be observed that there has been a fall in the BEP for both cases after considering the outsourcing decisions. According to the principles of break-even point, a lower BEP level in units is said to be more favourable. A low BEP means that the business can start making profits earlier in comparison to high BEP (Bulturbayevichet al., 2020). Therefore, AL Pty Ltd must outsource its manufacturing unit to a foreign land to derive lower BEP and, therefore, earn quick profits.

The non-financial implications of Option B state that-
Satisfied stakeholders: A faster and quicker profit earned by AL Pty Ltd shall enable the company to make high returns to its shareholders in the form of dividends and interests. This will enable the stakeholders to be satisfied and engaged with the project for a long-term basis.

Increased brand awareness: Overseas venture of AL Pty shall allow the company to mark prominence in the international market. This shall leverage the company to engage more customers and draw in more demand for lounge making businesses.

3. Discussion of possible scenarios to extend payment terms
With an extension in the credit period to the buyers of AL Pty Ltd for their purchases, the company shall be able to increase its sales and expand the universe for the buyer. This shall enable the company to meet the sales target of the entity by increasing the due time. The existing credit period is 30 days for the customers to make payment which is decided to extend to 60 days for the customers. This shall mean instead of a month; the customers shall have a time period of 2 months to make payment of their dues against the credit sales. The following the pros that AL Pty Ltd shall experience from the extension of payment terms are-

Increased sales: The customers of AL Pty Ltd shall tend to purchase more if they do not have to pay for the goods and services immediately (Mashudet al., 2020). This indicates higher sales that result in high profit for the business.

Competitive edge: Extension of credit to the customers will allow the customers to add on the competitors who do not extend the payment period to their customers. Customers may be encouraged to do business with AL Pty Ltd against the competitors that do not extend credit to their customers.

Customer loyalty: Over the period of time, the customers of AL Pty Ltd shall build trust with the customer to provide them with products and services as they need without having the liability to pay upfront (Disemadiand Shaleh, 2020). This allows the customers to build a long-term and profitable relationship with the customers for the upcoming years.

4. Recommendation
Based on the analysis undertaken in points 1 and 2 about the investment project in AL Pty Limited, it is recommended to consider both Option A and Option B simultaneously for the company. In both scenarios, Option A offers a positive of $ 623675593.4, and Option B instructs the company to outsource its manufacturing unit to a foreign land. Implementation of both the cases shall derive the company with financial benefit from the investment decision. However, there are following disadvantages that AL Pty Ltd shall suffer from the use of both the options-

Disadvantages of NPV
The main disadvantage of NPV is that it requires some assumptions about the firm's cost of capital. This requires the assumption of a cost of capital and leads to suboptimal investment if the investment is too low (Singh et al., 2021). On the other hand, the assumption that the cost of capital is too high causes the investment to be too cheap. In addition, the present value method is unfavorable when comparing two investment projects of different sizes. Since the result of the present value method is given in $, the size of the present value is usually determined by the size of the input.

Disadvantages of payback period
The main disadvantage of NPV is that it requires some assumptions about the firm's cost of capital. This requires the assumption of a cost of capital and leads to suboptimal investment if the investment is too low (Singh et al., 2021). On the other hand, the assumption that the cost of capital is too high causes the investment to be too cheap. In addition, the present value method is unfavorable when comparing two investment projects of different sizes. Since the result of the present value method is given in $, the size of the present value is usually determined by the size of the input.

Disadvantages of break-even point

  • Assume that the selling price is constant at all stages of production
  • Receive production and sales at the same rate
  • Profitability charts are time consuming
  • Applies to individual products

Conclusion
It can be concluded that financial management facilitates the business in making decisions for the entity. It takes into account various financial management tools to make optimal decisions for the business. Regular activities of financial activities may be difficult for managers; however, the financial management activities help the companies to run efficient businesses. The functions involved in financial management involves record-keeping, financial reporting and rising of funds to help the business reaching to financial success. Solvency is a key factor of financial management for the repayment of the loan in maintaining the strong balance sheet performance.

Reference List
Bulturbayevich, M.B., Sharipdjanovna, S.G., Ibragimovich, A.S. and Gulnora, M., 2020. Modern features of financial management in small businesses. International Engineering Journal For Research & Development, 5(4), pp.5-5.http://iejrd.com/index.php/%20/article/view/768

Chang, C.L., McAleer, M. and Wong, W.K., 2020. Risk and financial management of COVID-19 in business, economics and finance.https://www.mdpi.com/721044

Ameliawati, M. and Setiyani, R., 2018. The influence of financial attitude, financial socialisation, and financial experience to financial management behavior with financial literacy as the mediation variable. KnE Social Sciences, pp.811-832.https://www.knepublishing.com/index.php/KnE-Social/article/view/3174

Prihartono, M.R.D. and Asandimitra, N., 2018. Analysis factors influencing financial management behaviour. International Journal of Academic Research in Business and Social Sciences, 8(8), pp.308-326.

https://www.researchgate.net/profile/NadiaAsandimitra/publication/334243518_Analysis_Factors_ Influencing_Financial_Management_Behaviour/links/5dff62f7a6fdcc28373597b0/Analysis- Factors-Influencing-Financial-Management-Behaviour.pdf

Brigham, E.F. and Houston, J.F., 2021. Fundamentals of financial management. Cengage Learning.

Yap, R.J.C., Komalasari, F. and Hadiansah, I., 2018. The effect of financial literacy and attitude on financial management behavior and satisfaction. BISNIS & BIROKRASI: Jurnal Ilmu Administrasi dan Organisasi, 23(3), p.4.https://scholarhub.ui.ac.id/jbb/vol23/iss3/4/

Masharsky, A., Azarenkova, G., Oryekhova, K. and Yavorsky, S., 2018. Anti-crisis financial management on energy enterprises as a precondition of innovative conversion of the energy industry: case of Ukraine.https://essuir.sumdu.edu.ua/handle/123456789/68764

Loke, Y.J., 2017. The influence of socio-demographic and financial knowledge factors on financial management practices of Malaysians. International Journal of Business and Society, 18(1).https://publisher.unimas.my/ojs/index.php/IJBS/article/view/488

Madura, J., 2020. International financial management. Cengage Learning.

Disemadi, H.S. and Shaleh, A.I., 2020. Banking credit restructuring policy amid COVID-19 pandemic in Indonesia. Jurnal Inovasi Ekonomi, 5(02).https://ejournal.umm.ac.id/index.php/JIKO/article/view/11790

Mashud, A.H.M., Hasan, M.R., Wee, H.M. and Daryanto, Y., 2019. Non-instantaneous deteriorating inventory model under the joined effect of trade-credit, preservation technology and advertisement policy. Kybernetes.

https://www.aimsciences.org/article/id/f7dddcfc-5cb6-4601-a9b0-ec288c8bea90

Singh, S.R., Yadav, D., Sarkar, B. and Sarkar, M., 2021. Impact of energy and carbon emission of a supply chain management with two-level trade-credit policy. Energies, 14(6), p.1569.https://www.mdpi.com/1031204

Titman, S, Martin, T, Keown, AJ & Martin, JD 2019,?Financial management: Principles and applications, 8th?edn, Pearson Australia, Melbourne.?

Wang, D., Lin, J., Cui, P., Jia, Q., Wang, Z., Fang, Y., Yu, Q., Zhou, J., Yang, S. and Qi, Y., 2019, November. A semi-supervised graph attentive network for financial fraud detection. In 2019 IEEE International Conference on Data Mining (ICDM) (pp. 598-607). IEEE.

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