In this assignment, I will write a report assessing the working capital management of Tesco. I will identify and explain the main component of the working capital and carry out the relevant calculation. I will also interpret the ratios calculated to assess adequacy of working capital management and suggest suitable improvement.
Working capital is amount of money that is available to Tesco for its day to day purpose. It can be calculated by using (current assets – current liabilities). Working capital is used to buy resources, such as raw materials, components, vehicles, fuel and to meet other costs such as wages, utility bills, rent, fees and insurance. The working capital is the amount of the money left over after all short term debt has been met. It is the quantity of liquid assets owned by Tesco less the amount of money owed by the business in the short term. Liquid assets are those that can be converted into cash within a year.
Possession of working capital depends on the nature of business. Tesco tends to hold less working capital because most of their sales are for cash which is immediately available for making payments. Tesco should have current assets twice and one and a half times the size of its current liabilities. Tesco has a total current assets amounting £4576m, while their current liabilities is £3576m for year 2006. The value of current assets is about 1.3 times the value of the current liabilities. This is not an ideal but satisfactory comparison. Though Tesco doesn’t have ideal ratio it is not really worrying matter because Tesco is retailer and all of its sales are usually for cash. It does not have to wait for customers to pay, that’s why they can still operate in less working capital and in additional to that Tesco is a food retailer business.
Current assets are the assets which can be sold usually within period of one year. Tesco current assets consist of Inventories, Trade and other receivables, derivative financial instruments, current tax asset, cash and cash equivalent.
An inventory is amount of goods and materials themselves available in stock by business. Inventories consist of goods held for resale and properties held for, or course of, development and are valued at the lower of cost and fair value less costs to sell using the weighted average cost basis. From 2005 to 2006 Tesco’s goods held for resale appears to increase from 1457m to 1911m by 454m which is an increase of 23.7%.
It is not healthy for Tesco to hold large amount of stock and it is not a great indication, an increase issues arise where capital is tied up in stock earns a zero financial return. This year Tesco’s 454 m is stuck in stocks. Tesco could have used this money to input its expansion project. The storage and handling is another issue. Tesco have to spend money in warehousing space, lighting, heating and labour. Having large amount of stock can also lead to perished or become outdated. Tesco can also constantly face stock being theft and shrinkage. Large stock holding can also become target for theft by staff and others. Tesco’s inventories also include development properties and developing properties amounting 20m. Last year the development properties amounted 7m, total increase of 13m by 65%.
Trade and other receivables
Under Tesco’s current assets includes trade and other receivables including debtors. These are the amount money that debtors owe to Tesco. Tesco prepayment and accrual income for year 2006 is 128m, which is an increase of 42m compare to last year.
It is very good that Tesco has increased its income though Tesco should be able to receive money as soon as possible because the risk of debt increased as more time is given to debtors. Tesco also lease equipments and different premises to different groups. Tesco has recently entered into leasing arrangement with UK staff for certain of its electronic equipment as part of the computer for staff scheme. The fair value of the groups finance lease receivables at 24 February 2006 is estimated 12m (2005 = 17m). It is also very surprising that even though the sales growth has decreased compare to last year, from 23.0% to 17.9% their revenue still tends to be high.
Derivative financial instruments and current tax assets
Another important part of the current assets is the derivative financial instruments and current tax assets. Tesco uses the interest rate swaps and cross currency swaps to hedge the fair value of fixed assets bonds. The total national amount of outstanding swaps used for fair value hedging is £2033m till 2033 but for this year the amount for interest rate swaps is £12m. Tesco also uses forward foreign currency contracts and currency options to hedge the cost of future purchase of goods for resale, where purchase are dominated in a currency other than the functional currency of the purchasing company. The total amount of forward foreign currency contracts are £96m. The total amount for derivative financial instruments is £108m (£12m £96m). The current tax assets amount to £8m.
Cash at hand and cash in bank
Cash at hand and cash in bank is the amount of money that Tesco can use when it needs. Tesco also has short term deposits. This is the amount of liquid resources Tesco has available to fund its daily trading. In this year Tesco has cash amounting £902m. The amount has drastically decreased by 62m which is 6.8%. There are various reasons as why Tesco might have reduced its cash. It has recently invested £89m establishing operation in United States and the investment is steadily increasing to £250m by this year. Dividend to share holders has increased by 14.4%.The trade and payables has also increased by £963m which means more money is paid hence reducing cash.
It is very vital for Tesco to have large amount of cash at bank and cash at hand. Tesco can be better off having more cash than unused assets because it might take time for Tesco to sell its assets (at least 12 month) when cash is needed. It is not great sign for Tesco to reduce its cash as it might create working capital problems.
The non-current assets classified as held for sale consist mainly of properties held for sale, including the UK assets disposal. For year 2006 non current assets classified as held for sale is £408 m, an increase of £240m compare to last year.
Current liabilities are debt or liabilities that have to be settled in cash with in fiscal year. Tesco’s current liabilities includes Trade and other payables (creditors), Financial liabilities such as borrowing and derivative instruments and other financial instruments and other liabilities, current tax liabilities and provisions.
This year Tesco has current liabilities of £3,576m, decrease of £23m compare to last year. The major reduction is in derivative financial instrument and other liabilities, total reduction of 152m.
Tesco has been able to reduce £152m by decreasing interest swaps and similar instruments by £61m and foreign currency contracts by £114m. The interest swaps and similar instrument amounted 170m last year, while this year it is 56m which is total reduction of 61m.
Tesco has also reduced its borrowing by 92m, which helped Tesco immensely to reduce its current liabilities. Though Tesco has high bank overdraft and bank loan compare to last year they are able to get rid of different other liabilities such as unsecured deep discount loan stock, medium term note and other MTNs amounting £527m. Rather than borrowing, Tesco has used other source of finance such as retained profit to finance its business. It is interest free money which has no risk and can be used without any obligations and issues without any repayment worries.
For this year Tesco has to pay its creditors or suppliers the amount of £6046m, which comes under trade and other payables. All these expenses has incurred during the process of buying, importing, transportation and cost of raw material and goods, tax, social security, dividend and joint ventures and associates.
Property provisions comprise of rents payable, provision for terminal dilapidations and provisions for future rents above market value on unprofitable stores. Tesco current provision is 4m while noncurrent provision is 25m adding to 29m but we only take account of 4m because it is the cost due to fiscal.
Current asset is important to Tesco because an increase of current assets to total debt is a positive sign, showing Tesco has better ability to satisfy its debt obligation using current assets. Current assets are important because Tesco can pay its obligation by selling its current assets when required. Current assets can be turned into cash within one year. Current assets can also increase the value of business, hence increasing the share price.
Working capital cycle
It is the amount of cash or other liquid resources into and out of the Tesco PLC. It is also known as operating cycle. Managing working capital properly will help to generate cash and help improve profits and reduce risks. Tesco will run out of cash and expire if they are not able to generate cash surpluses. The working capital cycle can be portrayed in diagram. The diagram shows different cash sources and how cash are drained from the business. In Tesco’s working capital the main source of cash into the business is from selling its shares in stock exchange market.
The traditional and modern approach to working capital management:
Traditional method of managing working capital would include obtaining trade credit from suppliers, use bank overdraft to make payment such as utility bills or short term expenditure. Traditional method is very logical and can be very important way of managing working capital. Tesco has t be very careful, it is completely insensible for Tesco to buy raw material using bank loan because bank loan repayment period usually extend for long time while the resources will be used and paid by customers with in short period, and thus this makes the loan payment impossible and sunk Tesco in debt.
The basic concept used in traditional method of managing working capital is to use right source of finance for right expenditure. Tesco has to make £3,317m payment for its trade payable which includes utility bills, rent, leases etc. Tesco has more advantages of using bank overdraft than bank loan in this case because it is easy and flexible and interest is only paid when Tesco is overdrawn. Using bank loan can be potentially disadvantage because the payment will be in long term and such resources have either been used already or will be used soon.
Debtors Collection period
Debtors collection period = Debtors / Turnover * 365
This number shows how effectively Tesco is able to collect money owed from its customers. The reducing period of time each year indicates the increase of efficiency and progress. For year 2002 Tesco’s debtor collection period was 7 days (debtors days=£454m / £23,656m * 365), for year 2005 it was 8.5days (debtors days = £ 892m/ £38,300m * 365) and for year 2006 it is 8.5days (debtors days = £1079m/ £46,600 * 365)
The trend does not seem to be very impressive as instead of lowering the number of days it has increased. Though the increase is not so drastic it is still vital for Tesco to reduce its number of debtor collection period. Late payment erodes profit and they can also lead to bad debt. Ensuring the quick collection from debtors will help to run the cash flow smoothly. Tesco’s debtors do not include customers who buy goods and service from Tesco. All payments and transaction are made when the customers exit the stores as no trade credit is provided to customers. Tesco’s main debtors are joint ventures and associates (£168m), lessee or tenant (£12m), prepayments and income (£128m) and other receivables (£771). Morrison seems to be collecting its money faster than Tesco. In 2005 Morrison debtors collection period was 5days (£157.4m /£12,114.8 * 365) while in 2006 it was 4 days (£150.6/£12,451.5 * 365). There are various reason as why Morrison have better debtors collection period perhaps one could be they have better method of collection such as they urge their debtor to pay earlier by providing cash discount. Another reason might be Morrison doesn’t tend to lease its property as Tesco therefore it does not have to bother about collecting rent. Though reducing debtor’s collection period might help Morrison to run its cash flow smoothly it does not guarantee profit. Morrison has better debtors collection period but Tesco still makes more profit compare to Morrison.
Tesco can ensure that the collection is done as soon as possible by taking different measures such as invoice promptly and clearly, charging penalties for overdue account, consider accepting debit and credit cards as payment options, be professional when accepting new accounts, continually review and set limit for each customer, monitor debtor balances and ageing schedules, and don’t let any debts get too large or too old. Check out each customer thoroughly before offering credit. Use different agencies such as credit agencies, bank references, industry sources etc to check the credit history; if Tesco can take these measures they can definitely improve the debtor collection period figures.
Creditor’s payment period
Creditor payment period = Trade creditor / cost of goods sold * 365
Creditor’s payment period shows how long it takes Tesco to pay its supplier for goods that have been bought on credit. Creditor’s payment period can vary and can be negotiated with creditors. Tesco will always have benefit if it can extend the credit payment period as long as it can without damaging relationship with suppliers.
For year 2002 Tesco’s creditors payment period is 80days (£4,809 / 21,866 * 365), for year 2005 it is 51days (£ 5083/ 36,426 * 365) and for year 2006 the creditors payment period is 15 days (£6046/ £39,401*100). In year 2002 it was 80 days but the days has gradually declined to 51 and finally 15. It is always benefiting for Tesco to extend its creditors payment period as much as it can. Increasing the amount of creditor’s payment period means Tesco has money in bank which earns interest. Delaying the payment can always benefit Tesco but Tesco has to be also very careful because too much delay can damage relation between suppliers and Tesco. Morison has a better figure for creditor’s payment period, for year 2005 it was 46days (1471.2/ 11793* 365) while for 2006 it was 46.3days (1501.1/11825.5 *365). Morrison tends to have better creditors payment period.
This shows that Morrison is more organized in both paying and collecting. Tesco should compare its both debtors collection period and creditor’s payment period. Tesco will be in better position if the debtor’s collection period is shorter than the credit payment period. Tesco will suffer from poor working capital if debtors collection period is longer than credit payment period because Tesco has to pay its supplier and if the debtors haven’t paid them it will be harder for Tesco to pay its supplier hence creating shortage in working capital but since the creditors payment period is shorter than debtors the problem doesn’t seem to exist.
Stock turnover = Stock/ Cost of goods sold * 365
Stock turnover measures how well Tesco coverts stock into sales. It is closely similar to assets turnover and is also a measure of efficiency. Stock turnover is basically the indication of sales volume. It measures how well Tesco is making use of the part of its working capital that has been invested in stock.
For year 2002 Tesco stock turnover amounts 16days (£929/ 21866 * 365), for year 2005 Tesco stock turnover amounts 15days (£1464 / £36,426 * 365) and for year 2006 it is 18days (£1931/ £39,401* 365).It is very common to have quick turnover for supermarket such as Tesco because they sell the value of their average stock every two to three weeks. All supermarkets have very quick turnover for example Morrison, for year 2005 the stock turnover was 12 days while for 2006 it was 11 days. Tesco has made improvement in 2005, in 2002 it took 16 days to sell stock while in 2005 it went to 15 days but in 2006 it got worst. The stock took 18 days to get sold. Tesco should try to lower the stock turnover because the money is then tied up for less time in stocks. A quicker stock turnover means that Tesco gets to make its profit on the stock quicker, and it should be more competitive. Morrison have a very quick stock turnover, it does not even take 2 weeks to sell all its stock. It can also reduce the cost of storage and mess in warehouse.
We cannot still assume that every business have very short stock turnover. Manufacturers usually have much slower turnover because of the time spending processing raw material. Business like luxury cars and expensive items have low turnover because consumers are limited, production is rare and stock turnover is very high but this doesn’t means that those business is making loss.
There are several ways Tesco can improve its stock turnover figure. Tesco must grasp just- in- time technique to reduce stock holding, which involves ordering stock when they are required in the production process. If necessary start different offers such as buy one get one free, buy one get another half price.
Current assets = Total current assets / Total current liabilities
Current ratio show how much working capital does Tesco have. It examines if the company liabilities can be covered by company assets. It is an ideal if the current ratios of business are between 1.5 and 2.
For year 2005 current ratio for Tesco is 1.08:1 (£3,919 / £3,599) while for year 2006 it is 1.27:1(£ 4,576 / £3576). If Tesco can sell its assets within 12 months such assets are current assets. Current Liabilities are amount that are due to pay within the coming 12 months. For year 2006, 1.27 times means that Tesco should be able to lay hands on £1.27 for every £1.00 they owe. Less than 1 time e.g. 0.5 means that Tesco could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands but Tesco does not seems to have any problem with current ratios. Compare to its counterpart Morrison, Tesco is more adequate and optimistic. For year 2005 Morrison has current ratio of 0.9:1, while for year 2006 it has 1:1. The ratios shows Morrison have liquidity problem. As ratio of 2006 it shows that Morrison has current assets of 1 for every current liabilities of £1, meaning they have problem covering their day to day expenses and Morrison’s current assets would hardly cover its liabilities. Tesco is doing very well compare to Morrison. Compare to last year it has been able to improve too.
The Current ratio shows the status of relation between current assets and liabilities of business. Tesco have neutral level of current ratio but not ideal it has to be still careful as if the ratio exceeds above 2 it might be said that the business has too many non productive liquid resources.
Acid Test Ratio
Acid test ratios = Current assets- stock / current liabilities
It is the test that indicates whether Tesco has enough short term assets to cover its immediate liabilities without selling its inventories. The ratio should be at least above 1 to make sure that all liabilities are sufficiently covered.
For year 2005 acid test ratio is 0.68(£3910-1464/ 3599), while for year 2006 it is 0.73 (£4576 – £1931/ £3576). This means that for every pound Tesco’s current liabilities, the firm has 0.68 and 0.73 of very liquid assets to cover those immediate obligations. Compare to its counterpart Morrison Tesco’s has better figure but still it is not ideal. In year 2006 Morrison has acid test ratio of 0.20(£749.6-£367.9/£1806.8) while for year 2005 it was 1.16 (£692.1-£399.4/£1806.8). It is always consider as the higher the ratio, the more financially secure a company is in the short term but in case of Tesco and Morrison we have low quick ratio which means that Tesco and Morrison is over- leveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly.
This is well below ideal of 1. This suggests that both of them could have inadequate working capital. They both are supermarket therefore there are lot of things they can do to improve working capital. Tesco and Morrison should start spending less money in storing stock and try to work with Just In Time approach. Try to get rid of all the stock as soon as possible by introducing different offers which will lead to sell of stock and flow of money hence improving the working capital. Computerized stock control is also another way of keeping tight control on stock levels. Computer can be used to decide when and how much stock to order hence reducing the stock being accumulated. Another way of improving working capital is by doing close cash flow forecasting. Cash flow forecast shows the expected cash in flow and outflow each month for future period. Based on this cash flow and the money that the business had to start with, it is possible to calculate the expected monthly cash balances which will allow improving working capital.
Assets Turnover Assets turnover = Turnover/ Net assets
It indicates Tesco’s efficiency of using its assets and generating sales revenue. The ratio calculates the total sales for every pound of assets Tesco owns. The highest the number is the better the performance.
In 2005, Tesco had turnover of £38,300m and £10,571m in assets respectively therefore the turnover rate was 3.6. In 2006 Tesco’s turnover was £46,600m while net assets valuing £8,444m when applied to assets turnover formula, we find that Tesco’s turn rate of 5. There are several general rules that should be kept in mind when calculating assets turnover. First, assets turnover is meant to measure Tesco’s efficiency in using its assets. The figure for 2006 is higher than 2005 which indicates that Tesco is making good use of its assets available. The figure means that figure is 3.6 for year 2005 and 5 for year 2006 bigger than total assets. Another way of saying that is Tesco was able to generate sales of £3.6 for every £1 of assets it owned for the end of year 2005 while for the end of the year 2006 it was able to generate £5 for every £1 of assets it owned. If we compare to its counterpart Morrison who had assets turnover of 3.17(£12461.5/ £3927) for year 2006 and 3.32 (£12,114.8/£3648.5) for year 2005, Tesco seems to be very well organized and efficient when using the assets that they owe.
The only way Morrison can improve its figure is by selling all unwanted assets. All the assets that are not productive and useable have to be brought to market. Increasing sales with same amount of assets,Same volume of sales with reduced assets, increase sales more than relative increase in assets. Point is to make most efficient use of assets possible.
There are many ways in which Tesco can reach the ideal boundary while Morrison improves its figure. They should both desperately try to sell off their stocks, below the cost if necessary, as soon as possible as selling stock means money coming into business. Tesco and Morrison should start selling their more shares hence raising fund to pay all the creditor and debt. They can also increase their long term loan or overdraft to pay creditors. They should consider selling off their unwanted assets that are not used and if possible sell the current owned assets too and lease them back. They should cancel non vital expenditure and reduce drawing as much as possible. Morrison might consider selling its debt to debt factor. If these steps are taken methodically, Tesco and Morrison can improve their working capital.
Business Studies, Third Edition A Level Applied Business for EDEXCEL
Determining How To Obtain Financial Data And Assess Its Validity Accounting Essay
This study is based on 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: 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. 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:
Profitability Ratio 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
Where 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 taken 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. The formula is:
Net Profit Margin = Profit before tax (PBT) Ã- 100
Efficiency Ratio 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) Current Ratio
This ratio signifies a company’s ability to cover its short term liabilities with its short term assets.
Current ratio = Current assets
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
Long term Solvency Ratio (Stability Ratio) Gearing Ratio
Shareholders Investment Ratio 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) Where,
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
Analysis: 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.
Total Cost Total Revenue FC VC Sales Unit Sales cost