Financial And Break-Even Analysis Of FridgeFeeze Plc And Washbug Ltd Essay.

FridgeFeeze Plc

You are a financial analyst at FridgeFeeze Plc; a public limited company specialising in manufacturing and distributing refrigeration equipment. The Board of Directors have looked into the financial statements of the company for the last two years and have raised concerns regarding both the company’s profitability and liquidity. The financial statements of FridgeFeeze for the last two years are given below:
Statement of Comprehensive Income for the year ended 31 December
2018 2017
£000 £000 £000 £000
Revenue 38,550 29,950
Less: Cost of sales:
 Opening Inventory 3,875 4,535
 Manufacturing costs 22,140 13,250
26,015 17,785
 Less: Closing Inventory (6,225) (3,875)

(19,790) (13,910)
Gross profit 18,760 16,040
Less: Expenses
Selling & distribution expenses 8,135 4,380
Administrative expenses 2,100 990
Bad debts written off 1,040 565
(11,275) (5,935)
Operating profit 7,485 10,105
Less: Interest payable (1,690) (380)
Profit before tax 5,795 9,725
Less: Income tax (900) (1,920)
Profit after tax 4,895 7,805
Less: Dividends paid (2,100) (2,100)
Retained profit for the year 2,795 5,705

Statement of Financial Position as at 31 December
2018 2017
£000 £000 £000 £000
Non-current assets (net)
Land and building 24,590 19,280
Equipment 4,380 3,200
Motor vehicles 1,900 1,650
30,870 24,130
Current assets
Inventory 6,225 3,875
Trade Receivables 5,900 4,500

Cash 0 560
12,125 8,935
Current liabilities
Trade Payables (5,100) (4,885)
Taxation (1200) (1,490)
Bank overdraft (2,180) 0
Net current assets 3,645 2,560
34,515 26,690
Non-current liabilities
Loan stock (4,575) (1,250)
29,940 25,440
Equity
Ordinary shares of £1 each 26,035 24,330
Accumulated profit 3,905 1,110
29,940 25,440

Required:
1. Prepare a report for the Board of FridgeFeeze Plc. that evaluates the performance of FridgeFeeze in relation to profitability, liquidity, gearing, asset utilisation, and investor potential. Your report must be supported by the calculation of relevant ratios in the five evaluation areas mentioned above. 
2. Calculate the Working Capital Cycle in days for FridgeFeeze Plc based on the information above, assuming 365 days, for the years 2015 and 2014 AND briefly comment on the company’s liquidity position in 2018 compared to 2017. 
3. Critically evaluate the limitations of using ratio analysis for both cross-sectional and time-series comparisons.

Washbug Ltd is specialized in producing and selling domestic washing machines. In 2017,the manufacturing cost per unit included:
Direct material 125
Direct labor (20 minutes per unit) 15/hour
Variable manufacturing overhead 20
Variable selling expenses 15
Variable administrative expenses 10
Fixed costs for the year ended 31 December 2017 were:
£000

Fixed manufacturing 1,650
Fixed selling and distribution 2,850
Fixed administrative 930
The company produced and sold 45,000 units at £300 per unit.
In 2018, management has decided to increase the selling price by 20% and to maintain the same contribution margin ratio as last year. This increase in price is to meet an increase of £1,450,000 in fixed costs in 2015. The company has produced and sold the same quantity in 2018 as last year.
Required:
1) Calculate the break-even point and margin of safety in both units and revenue for the two years, 2017 and 2018, and briefly analyse the results.
2) Critically evaluate the key assumptions that underpin the break-even model, assessing and analysing whether the model can be applied within the context of today’s global business environment.
All calculations should be clearly shown including all appropriate workings, and should be made to the nearest £000 or two decimal places where required.

Required:
1. Financial managers can fund potential investments and expansion plans through accessing a range of differing sources of finance. Explain and critically evaluate a single source of both internal and external finance that could be used by companies to finance further investment programmes. 
2. Critically evaluate the key benefits and limitations of each of the differing investment appraisal techniques, supporting the response with relevant academic research as to whether the differing techniques are applied in practice.

1. In the given case, the Board of Directors of the company are not happy and satisfied with the performance of the company over the past 2 years and hence they have raised the concern with respect to the company’s profitability and liquidity. The financial statements of the company for the last 2 years has been shown below(Arnott, et al., 2017). The performance has been analysed and evaluated using some key ratios with respect to profitability, liquidity, asset utilization, gearing and investor potential ratios, all of which has been shown below.

From the above ratio analysis, we can see that the company is performing well in terms of the profitability ratios but the same has dropped drastically when compared to the last year. The Gross profit ratio which is the measure of what has been the profit of company post deduction of cost of goods sold or direct expenses has dropped from 53.56% to 48.66% (Alexander, 2016).

This shows that the cost of the goods sold or the direct expenses of the company has increased. Similarly, the net profit ratio which is the measure of profit post deduction of all the direct and indirect expenses has decreased staggeringly over the past year from 32.47% to 15.03% which has had a huge hit on the performance of the company. This shows that the company has not been able to control on the indirect expenses particularly the selling and distribution costs, administrative expenses and interest costs and thereby the company has suffered in terms of lower bottom-line for the year ended 2018 (Calvasina & Calvasina, 2017).

In terms of the liquidity ratios, the company’s current ratio has increased marginally from 1.40 times to 1.43 times in 2018. This shows that the liquidity of the company has improved over last year and now it is in a better position to meet the current liabilities, however, it is still much below the industry trend of 2 times. In terms of the liquid ratio, the company again faced a set de-growth as it reduced from 0.79 times to 0.70 times in 2018. Again, this is below the industry trend of at least 1 times and it shows that the company may suffer in meeting the short term obligations or liabilities (Bromwich & Scapens, 2016).

In terms of the gearing ratios which shows the company equity share capital as against the funds borrowed from outside for doing business, FridgeFreeze Plc2 has increased the proportion of debt in the overall capital from 4.91% to 15.28% in 2018. This clearly shows that the company wants to make use of the cheaper capital and thereby increase the profit by making use of leveraging. On the other hand, the interest service coverage ratio which has declined from 26.59 times to 4.43 times be indicative of the fact that the company’s interest payment ability has declined drastically and it is due to have a major impact on the fund providers (Choy, 2018).

In terms of the asset utilization ratios, the company’s fixed assets turnover has almost been constant at 1.25 times which is again on the lower side indicating that the company is achieving sales of 1.25 times of its net fixed assets. Similarly, the total assets turnover ratio has been nearly constant at 0.90 times indicating that the company needs to improve on the productivity of the assets and improve on the sales out of it (Werner, 2017).

Lastly, in terms of the investor potential ratios, the return on equity has declined drastically and has almost halved from 38.23% to 19.36%, which indicates that the shareholders expectations has not been when as compared to the last year. Similarly, the dividend per share as well as the earnings per share both have declined stating that the company has earned less distributable profit due to which the share with the shareholders has been less (Venezia, 2017).

1. The working capital cycle shows the time taken by the company to convert the working capital into revenue. It indicates the efficiency of the working capital and the short term health of the company. Mathematically, the working capital is the difference of the current assets and the current liabilities. The working capital cycle is calculated by multiplying the working capital with 365 days and dividing the result by the sales of the company(Sithole, et al., 2017). In the given case, the same has increased and it shows that the company has been able to increase the sales and thereby collecting the revenue quickly as well. It is used as one of the fundamental tools in the analysis of companies.

Statement of Comprehensive Income for the year ended 31 December

As explained above as well, the liquidity ratios have almost been same in terms of the current ratio whereas the liquid ratio has declined much as compared to the last year. But both of them is below the industry trend and it therefore shows that the company needs to improve the working capital to improve its ability to meet the short term obligations of time (Goldmann, 2016). The company needs to further consolidate on the liquid cash balance and those assets which are readily convertible to cash so that in case it is required to make quick payment, it is able to do so.

1. Ratio analysis is one of the wide spread analytical tool which is being used by the management as well as the auditors and other stakeholders to analyse the performance of the company but it suffers from a number of limitations at the same time(Jefferson, 2017). Some of those limitations from the cross sectional as well as time series comparisons are shown below:
2. The benchmarking should be done to the industry leaders and should change from industry to industry rather than using the industry averages as it gives the distorted information to the management at times(Goldmann, 2016).
3. Inflation is something which is uncontrollable but often the same is being ignored by the ratio analysis.
4. It is just a kind of the numerical analysis and does not really establishes the cause and effect relationship and thereby can be irrelevant at times when the management wants to know what are the changes required in the organization.
5. Different divisions of the company may need comparison to different industry averages.
6. Ratio analysis generally ignores the effect of the change in the accounting policies and the accounting practices, if any by the company(Heminway, 2017).
7. Ratio analysis is one tool that can be manipulated quite easily and thus window dressing can be done to manipulate the results in the financial statements.
8. It considers the historical data and information and is thus not futuristic in nature.
9. There are various seasonal effects which could impact the results of the ratio analysis and thus may lead to false or incorrect interpretation of the ratios at times.
10. It does not takes into effect the operational changes that may have occurred in an organization and thus ignores the qualitative data. Thus, it gives misleading information many a times.
11. There is no standard formula for many ratios and thus keeps on changing depending on the company and industry and thus there is huge scope of manipulation.

1. In the given case, break-even point needs to be computed for the company Washbug Ltd. in terms of units as well as revenue. The same has been computed below for both the years 2018 and 2017. The inputs for the question is:

From the above calculations, it can be seen that the break even in terms of units for the year 2017 was 43440 which has increased to the level of 45867 in the year 2018. Even though the contribution percentage has been same for both the year at 41.67%, but the still the break even in terms of units as well as the revenue has increased which is indicative of the fact that the fixed expenses have increased a lot due to which additional sales are required to cover the same (Knechel & Salterio, 2016).

2. The concept of break-even works on a number of assumptions which have been stated below:
3. All the costs of the given company needs to be split between the fixed and the variable costs, be it production, selling, distribution or administrative costs.
4. The selling price per unit of the product is assumed to be same and constant at each change in the level of sales even with the change in the supply of the product.
5. The cost behaviour is assumed to be linear i.e., in case the same is plotted on the graph, it would be a straight line(Meroño-Cerdán, et al., 2017).
6. The total fixed costs will remain constant at each level of output whereas the variable costs will increase/decrease in direct proportion of the output.
7. There is no change in the technology or the methods of production and the efficiency of the labour as well as the machines is considered to be the same.
8. The revenues as well as the costs are being compared on the common activity base, being the sales value or the number of units being produced(Linden & Freeman, 2017).
9. The product mix does not changes and is assumed to be more or less constant.
10. There is no inventory at the start or at the end of the accounting period and is assumed to be constant throughout the year.
11. Prices which are being paid for the material, labour and advertisement are assumed to be constant.

Considering the present scenario of business and that the global business environment is changing, it is be said that the break-even analysis do not hold good anymore except in a few circumstances, where the business structure is very flat and predictable (Appelbaum, et al., 2018). The break-even analysis would generally result in the distorted picture and would not give a true and fair view to the management as the technology as well as the efficiency, the cost as well as the prices, all are changing quite rapidly. Furthermore, there are many costs which are semi variable in nature and hence it is difficult to get the correct contribution per unit.

1. Investment as well as the expansion plans are being funded by the managers through accessing a range of sources of finance. It can be both internal as well as external source which can be used for financing any investment programmes. The same has been shown below:
2. Internal source: Internal source are the sources of finance or capital for investment programmes which are arranged or being generated internally by the business itself in the normal course of the business. They key feature of this is that there is no external dependency and no finance cost is being paid outside the company(Kim, et al., 2017). Some of the very common sources of the internal funding include the retained profits or earnings, the sale of the assets, sale of stock, investment by the owner and the reduction in the working capital. Here we discuss one of the internal sources as the retained earnings. It is called as one of the internal sources simply because of the fact that it is the end product of running a given business. It is sometimes called as the ploughing back of the profits. It is the left over profit post payment of dividend or drawings by the owners of the business. There are many benefits of using it as it is one of the long term finance and no repayment obligation is there. Furthermore, since additional equity is not to be issued, there is no dilution of control and ownership in the business, there is no fixed instalment and interest payment obligation, there is no issue cost and therefore it is cost effective as well. Lastly in case the IRR of the given project or the investment opportunity is more than the ROI of the business, then the same will have a positive impact on the shareholder’s wealth and the management objective will thereby be served (Mubako & O'Donnell, 2018).
3. External source: external sources are the sources of finances which are arranged from outside the business. Some of the most commonly used external sources of financing are leasing, equity issue, debt capital, venture capital, term loans, debentures, preferred stock, trade credit, bank overdraft, factoring, hire purchase, etc. Here the source which has been discussed about is the issue of the equity share capital. It is one of the most widely used sources of capital arrangement. It cannot be used by all the companies as there are a lot of legal obligations and regulations which needs to be adhered to and followed. One of the key features of this is the sharing of the ownership rights and that the rights of the existing shareholders are being diluted to some extent. It is considered to be costly source of finance as compared to the debt as the return on the equity shares in the form of the dividend or the bonus shares is not tax deductible in the hands of the company. But the advantage of raising the finance through the equity issue is that the company consolidates on the leveraging position and the overall ownership increases(Erik & Jan, 2017).

2. There are various investment appraisal techniques which is being applied day in and day out to check which would give the best result and which one to rely upon. There are different benefits as well as limitations of each one of them. Some of them have been enlisted below:
3. Payback period: It is one of the most popular and traditional techniques which is being used for capital budgeting and evaluating the investment proposals. It gives the number of years that will be required to recover back the initial capital outlay which was being invested in the project and the same is computed by dividing the cash outlay by the annual cash inflows.

The advantages of this is that the company can have favourable effect on the earnings per share by having a relatively shorter payback period. It is also easy to understand and emphasizes on the liquidity aspect. It is simple and easy to use and minimises the need of further analysis (Bennouna, et al., 2010).

Some of the disadvantages of using this method is it ignores the time value of money, it also ignores the cash flow after the payback period and there is hardly any consideration for the duration of the investment. It also does not cover up the risks properly and ultimately does not leads to value maximisation decisions.

1. Accounting Rate of return: The ARR method uses the accounting information from the financial statements to calculate the profitability of the given project. It is calculated by dividing the average income after taxes by the average investment amount.

The major advantages of using this method is that it is simple to use and interpret, it can be readily calculate using the financial statement and therefore there is hardly any dependency. Furthermore, it uses all the streams of income in calculating the rate (Belton, 2017).

Some of the disadvantages of using this method includes the method ignores the time value of money, it does not considers the length or duration of the investment projects. The major shortcoming is that it uses the accounting profit and not the cash flows in project appraisal mechanism and lastly, it does not considers the profit reinvestment thing.

1. Net present value method: It is the most widely used and accepted method of project appraisal. It is a process whereby the present values are being calculated for both the inflows as well as the outflows using the appropriate cost of capital as the discounting factor and then finding out the net profit value by subtracting the present value of outflows from the present value of the inflows(Cheatham & Cheatham, 1996).

Statement of Financial Position as at 31 December

The advantages of using this technique include due importance to the time value of money, consideration of the overall life or duration of the project and it also maximises the wealth of the owners.

The limitations of using this method is that it is difficult to use and comprehend, it may not be an appropriate method to use when there are several investment opportunities available with different amounts. Lastly, it uses the firm’s cost of capital as the discounting factor, which is usually not the case and difficult to determine.

1. Internal Rate of return: Under this method, the present value of the inflows is equated with the present value of the outflows. It is being called the internal rate of return as it is solely dependent on the capital outlays and the inflows associated with the same and no external rate is being used(Vieira, et al., 2017).

Some of the advantages of using this method includes consideration of the time value of money and the overall life of the project. It is a transparent method and assures the investors of the rate of return on the capital. It is in line with the objective of maximising the owner’s welfare.

Some of the disadvantages of using this method include complication calculations. It may also yield negative or multiple rates depending on the circumstances and it also assumes that the intermediate cash flows are being reinvested at the internal rate of return.

1. Profitability Index: It is the ratio of the present value of the inflows divided by the present value of the outflows, which are being discounted at the required rate of return.

The advantages of using this method is that it again considers the time value of money and considers the overall life of the project (Truong, et al., 2008).

The limitation of this method is that it requires more computation than the traditional methods but less than the IRR.

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