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LGB524 Project and Financial Management
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Aims and Objectives In this lecture you will:
- Understand the two methods of Depreciation - Straight line method and
the Reducing Balance method.
- Analyse the methods of depreciation and consider how they fit into the
financial statements.
- Interpret and Analyse financial statements:
- The Balance Sheet
- The Income Statement
- The Cash Flow Statement
- Critically evaluate how the Statements are used together to provide
financial information for business decision making.
- Explain ratio analysis and application to business uses.
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Depreciation
Straight Line Method
Cost of Bowing Machine £78,124 Estimated Residual Value at the end of its useful life £2,000 Estimated Useful Life 4 Years 78,124 – 2,000 = 76,124 76,124 / 4 = £19,031 £19,031 is the charge that appears in the income statement for each of the 4 years the asset appears in the accounts. Simplest and most commonly used depreciation method. It is calculated by taking the purchase or acquisition price of an asset subtract the residual value (what you could sell it for), divided by the total productive years the asset can be reasonably expected to benefit the company.
Depreciation
Reducing Balance Method
Applies a fixed % rate of depreciation to the carrying amount of an asset each year. Cost of Bowling Machine £78,124 Yr 1 Depreciation charge (60% of cost) (48,874) Carrying amount 31,250 Yr 2 Depreciation charge (60% of carrying amount) (18750) Carrying amount 12,500 Yr 3 Depreciation charge (60% of CA) (7,500) Carrying amount 5,000 Yr 4 Depreciation (60% of CA) (3,000) RESIDUAL VALUE 2,000 This method assumes the asset loses more value in the early years of its life. Depreciation is recorded on both the balance sheet and the profit and loss accounts.
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Depreciation
Analysis If the Profit of the company who held the Bowling machine had a profit of £40,000 for each of the 4 years in which the asset was held the profit would be: Straight-Line Method – Each year: 40,000 (profit before depreciation) – 19,031 (Depreciation) = 20,969 Reducing-balance Method – Year 1 40,000 46,874 (6,874) Year 2 40,000 18,750 21,250 Year 3 40,000 7,500 32,500 Year 4 40,000 3,000 37,000 R-B method realises the cost in the majority of the first year.
- Take 5 minutes to analyse this information. What conclusions can you make?
Depreciation
Evaluations SL method – constant profit figure. RB Method changing profit figure over time. Same amount of depreciation over the 4 year period. Only allocation between years differs. Calculating depreciation is a simple task, although some estimations have to be made. How do we realistically value goodwill of a business or a professional footballer? The figures sometimes cannot be 100% accurate and this has to be accepted. Historical data and past residual values help to reduce the inaccuracy but this can only be possible for industries that have this historical evidence.
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Depreciation Research Task
Depreciation Research
- You need to do some research on depreciation, bring your findings
to the seminar.
- What journals can you find that discuss how effective depreciation
calculations are?
- Find a sports case study where depreciation has been used in the
accounting process and find out which method of depreciation is being used and why?
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Analysing and Interpreting Financial Statements
Classification The primary purpose of the income statement is to report a companies earnings to investors over a specific period of time. From this information financial ratios show the relationships between the figures and give further information to owners, investors and managers.
The ratios focus on the following key area’s:
- 1. Profitability
- 2. Efficiency
- 3. Liquidity – meeting obligations
- 4. Financial gearing – contribution made by owners and ratio of lenders.
- 5. Investment – assessing returns.
The balance sheet tells investors how much money the company has, how much it owes, and what is left for the stockholders. The cash flow statement is like the checking account; it shows you where the money is spent. The income statement is a record of the company's profitability. It tells you how much money a corporation made (or lost).
Analysing and Interpreting Financial Statements
Ratios Investors in Sports businesses will need to be able to calculate basic financial ratios. Ratios are used to evaluate the overall financial position of a corporation. You can assess the strengths and weaknesses of a company through the financial ratios. The ratios are used in accountancy by managers, owners and investors. Each party require different information as they have differing motivations.
Ratio Analysis:
- 1. Past period – improvement over time?
- 2. Trends
- 3. Similar Businesses – operating in the same industry
- 4. Planned Performance – targets, benchmarks
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Profitability Ratio
Essentially profitability can be seen as the difference between the purchase price and the costs of bringing the product/service to market.
1. Return on ordinary shareholders’ funds 2. Return on capital employed 3. Operating profit margin 4. Gross profit margin
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Return on Ordinary Shareholders Funds
What does the Return On Shareholders Funds (ROSF) Ratio Mean to Industry and the Investor? Investors & the industry will look at the relative size of the Return On Shareholders Funds ratio. This is because a high ROSF percentage indicates that a company is profitable and has more profit available for shareholders. Why is Return On Shareholders Funds (ROSF) Considered Important? This is a narrower assessment of profitability (compared with ROCE) and therefore gives the investor a deeper insight into the profitability that they are concerned with. It is always critical to take professional investment advice before making any investment decisions.
ROSF = Profit for the year (net) less any dividend
- Ordinary share capital + Reserves
The ROSF compares the amounts of profit for the period available to the owners with the
- wners average stake in the business.
The Return On Shareholders Funds (ROSF) ratio has historically been used by industry investors as a measure of the profit for the period which is available to the owner’s stake in a
- business. The Return On Shareholders Funds ratio is therefore a measure of profitability
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Return on Capital Employed
ROCE = Operating Profit
ROCE is a fundamental measure of business performance. Expressing the relationship between operating profit over a period and the average long-term capital invested in the business during that period. This ratio effectively measures the input and output and thus measure EFFICIENCY over a period of time of that business. ROCE compares earnings with capital invested in the company. It is similar to Return on Assets (ROA), but takes into account sources of financing. ROCE is used to prove the value the business gains from its assets and liabilities, a business which owns lots of land but has little profit will have a smaller ROCE to a business which owns little land but makes the same profit.
Operating Profit Margin
OPM = Operating Profit
Focuses on the relation ship between profit and sales. Operational performance is used as a basis for comparison between types of business. For Example, sports equipment manufacturers might operate on low prices and thus look to function on low operating profit
- margins. This is done to stimulate sales and increase operational sales through volume sold.
Factors that effect this ratio: degree of competition, type of customer, economic climate and industry characteristics. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
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Gross profit represents the difference between sales revenue and the cost of sales. The ratio is therefore a measure of profitability in buying (or producing) and selling goods/services before any other expenses are taken into account.
- Bottom Line – Profit for the year. Can be effected by this ratio.
- Gross Profit = Sales Revenue – Cost of sales
The gross margin is not an exact estimate of the company's pricing strategy but it does give a good indication of financial health. Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future. Cory's Tequila Co. has a gross margin of 65% therefore their mark-up is over 100% of the cost. In general, a company's gross profit margin should be stable. It should not fluctuate much from one period to another, unless the industry it is in has been undergoing drastic changes which will affect the costs of goods sold
Gross Profit Margin Ratio Videos In the following slides you will see short clips on the following ratios: Return on Investment Ratio (ROI) Debt to Equity Ratio (DOE) Price to Earnings Ratio (P-E) Return on Assets Ratio (ROA) Write notes on the video and bring these to the seminar. Research all
- f the ratio’s you have been introduce to and consider who would want
to use this information within a sporting business.
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Return on Assets (ROA) ROA is an indicator of how profitable a company is relative to its total
- assets. It gives an indication on how efficient assets are being utilised by
the business. Return On Investment Calculation (ROI) ROI is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.
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Debt to Equity Ratio (DOE) DOA – A measure of a companies financial leverage calculated by dividing its total liabilities by stockholders’ equity. It shows what proportion of equity and debt the company is using to finance its assets. Price to Earnings Ratio (P-E) P-E ratio – is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.
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Summary
Depreciation needs to be accounted for within the accounting process. Some products will have greater rates of depreciation and will effect the business accordingly. Financial decision makers will use this information to forecast costings based on the prior knowledge. JJB recently changed the way they depreciated their assets and this made the accounts look better than was previously predicted. The timing of the change was important as business perception is important within the financial sector. Profitability is imperative for the private sector business. Decision makers need as much information as possible on profitability so they can lead the business in the right direction. Nova Ltd who run the Great North Run tried to set up an running event in Australia. Feedback suggested the event was going to be profitable but a lack of research into the timing of the event caused the event to fail and they made a loss. Sponsorship and endorsement deals from marketing are important as they can generate profitability through generating interesting. Goodwill and other intangible assets can be hard to value in the financial statements.
Summary of Lecture
In this lecture you have covered:
- Depreciation methods and analysed when each method
should be used.
- Ratios and interpreting financial data
- Profitability ratio focus – Evaluate each ratio and apply it
to business contexts.
- Investment ratio explanation
- Ratio application to the balance sheet, income statement
and the cash flow statement.
