Accounting and Decision Making: Pink Ltd

1.0 Financial performance evaluation of Pink Ltd:

Sales revenue:

The sale revenue reflects the performance of the concerned organisation through representing the earning capabilities. According to Oppermann et al. (2013), revenue helps the firm to achieve the desired profit margin that the expected market share could be attained over its rivals. The sales revenue of Pink Ltd has been increased by 62% in 2013 over the previous year. The reason behind such increment could be identified as the introduction of online purchasing facility that has enabled the firm to reach greater volume of customers in the wider market region. However, Chapman (2008) acknowledged that greater revenue could also be earned through enhancing the product price that the higher profit margin could be earned. The cost of production of its main product, Tincture is £35 where the selling price of the product at the market is £50. However, the organisation has initiated to sell the product at £62 with the Bagnolo logo.

Cost of sales:

The main cost of sales of the organisation is its cost of production spent in acquiring the ingredients. The cost of sales for Pink Ltd has been hiked by 57.64% where the reasons behind such fluctuation could be defined as various ways. According to Vintila and Nicoleta (2006), switching the suppliers for better service and quality could also be termed as responsible for such increment in this section. Kaya and Halil (2010) observed that such increment in cost of sales could lead to reduce the profit margin in future resulting lower growth of the firm.

Gross profit

Gross profit allows the company to gauge whether the organisation is capable to retain a significant amount in terms of profitability. In this context, Brealey et al. (2006) stated that external investors are highly concerned about the gross margin of the organisation to ensure whether the concerned firm could serve return on the capital employed. Therefore, higher gross margin attracts the investors to invest in the organisation. The gross profit of Pink Ltd has been increased by 72.70% due to its hiked income due to the operational diversification in both the online and offline trading policies. Mallin (2006) acknowledged that proper management of the financials also help the firm to gain the desired profitability through effective cost reduction process.

Overheads:

The overheads for the Pink Ltd are the administration expenses and the distribution costs where both the expenditures have been increased during the concerned years. The total overhead has achieved the growth of 73.47% due to its additional investments into the advertisement and transportation as switched to the online trading system. Oppermann et al. (2013) observed that the increment in the employee remuneration could also be termed as the cause to increase the overheads. However, it has been observed that the remuneration of the key shareholders have not been increased as expected. Therefore, the organisation has faced increased overheads due to increment in other financial areas. Spanyi (2008) mentioned that the overheads of the organisation could be minimised through utilisation of the resources optimally.

Analysis of cash flow:

The organisation has observed negative cash generation during 2013 over the positive in the previous years. According to Vintila and Nicoleta (2006), the negative cash flow in account of the firm indicates the poor cash management of the organisation that needs to be addressed immediately to recover the losses for a greater financial position and recovery of the losses. in this context, Yan (2009) stated that working capital is one of the crucial part of the financial management that could help the firm to meet the long and short-term financial objectives. Thus, working capital needs to be maintained at optimum position to maintain the desired liquidity that daily operation of the firm could be consistently maintained for a longer sustainable operation. The working capital of the firm could be then demonstrated as follows:

Operating cycle
Particulars 2012 2013 Variances
Inventory turnover 138.11 93.86 (44.24)
Add:
Receivable turnover 30.58 27.68 (2.9)
Less:
Payable turnover 53.27 32.45 (20.82)
Net operating cycle 115.42 89.09

 

Based on the above result it could be inferred that the operational efficienmcy of the firm is sound as the inventory turnover has attained a significant reduction of turnover in days. It indicates that the finished goods are sold out relatively faster than the usual that could lead to enable the firm earning high turnover. However, the payable turnover has also been reduced that implies that the firm needs to pay off the liabilities relatively earlier than the previous requirements. In this context, Mallin (2006) suggested to maintain the gap between the payable account and the receivable account to keep the balance of profit margin.

Risk and solvency evaluation:

Instead of having higher financial position in terms of profitability and liquidity, the risk associated with the organisation also shows relatively high due to the increment in debt amount over the equity capital. In this context, Chapman (2008) stated that investors could face comparatively higher risk profile while attempting to invest in the organisation. Thus, Pink Ltd serves both the risk and return at higher rate to enhance the capital base of the organisation. Referring to the debt issues, the firm could raise its capital through issuing equity capital more over the debt that same level of return could be offered at relatively lower risk level (refer to appendix).

Profitability analysis:

According to the profitability ratios as mentioned in the appendix, the profitability of the organisation has attained a steady growth. However, the growth rate of the organisation for the profitability ratios becomes lower due to significant increment in the corresponding expenditures. Wagner (2010) stated that increased profitability could attract potential investors through serving the understanding whether the firm could disburse the expected rate of return on the amount invested into the organisation.

Referring to the above discussion, it could be derived that the organisation has attained a sound financial position resulting long run financial stability that needs to be maintained consistently to ear better positioning and market in the form of profitability and competitive customers base. In that case, Pink Ltd needs to optimise the resources that associated costs could be minimised effectively. Moreover, the operating cycle of the firm needs attention to maintain the adequacy in short term capital amount that the daily requirements could be efficiently obligated.

2.0 Role of accounting information in managerial decision making and its limitations:

The accounting information comprises of diversified segments of the financial transactions as conducted by the concerned organisation. Therefore, prompt delivery of suitable and necessary accounting information could be beneficial for the organisation to conduct effective financial management practices. In addition, Cotter et al. (2009) segregated the accounting information into the income statement, balance sheet and cash flow statement that enables the organisation to judge different spheres of the organisation. Managers of an organisation are benefitted from different accounting information while tending make decision regarding the organisation.

According to Gebhardt and William (2007), the accounting information enables the firm to deliver the financial state to its stakeholders to enhance the involvement of the same into organisational procedure. On the other side, right financial information also assist the managers to decide the financial disbursements in terms of dividends and interest on the investments.

Accounting information allows the managers to develop suitable and potential accounting policies, in order to conduct better management of the finances and other financial activities towards attaining expected profitability. In this context, Deloof (2006) depicted that right information with accurate representation also enables the managers to identify the area of financials to be improved, in order to recover the gap identified.

Accounting information in terms of profit margins and the risk factors associated with the organisation assist the managers to judge the competency of the organisation that could be utilised to fulfil the requirements of stakes. In that case, Degtiareva (2006) suggested to conduct periodic assessment of the financial performance that further action could be eased to perform.

On the other hand, instead of being capable in making sound financial decision, a number of drawbacks have also been found in the accounting information to misguide the management.

A major part of the organisational decision making is based on the non-financial activities where the accounting information could misguide in accumulating suitable conclusion. Referring to this fact, Hicks (2009) recommended to consider a combination of both qualitative and quantitative factors could enhance the effectiveness of firm’s decision making process.

Graham and Harvey (2007) encountered that the managers generally follow the historic data that enlightens only the monetary issues arisen in the firm. However, such information is incapable in shedding light on the strategic future. The reasons of the concerned gaps could be defined as the changes in technologies, economic situations and the political instability.

The reflection of the real value of strategic management in terms of goodwill and natural circumstances affecting operation could not be delivered by the accounting information. Moreover, devaluation of some asset classes are not delivered by the accounting information generally misguides the financial managers to calculate the value of firm. Hence, historic information of the accounting activities may affect the profitability and efficiency of the firm.

3.0 Recommendation whether Pink Ltd should rent or buy the labelling machine:

The management of Pink Ltd. needs to decide on whether to use the labeling machine on rental basis or buy a new labeling machine. The finance manager of Pink Ltd. has applied various investment appraisal tools to evaluate the suitability of each of these decisions. In this context, Langfield (2011) mentioned that proper understanding if the investment appraisal tools is necessary for sound evaluation of investment options. In present scenario, the finance manager of Pink Ltd. has used Net Present Value (NPV), Payback period, and Accounting Rate of Return (ARR) techniques to evaluate the financial suitability of the two given choices.

In the view of Lazaridis (2006), a key benefit of NPV method is that it considers both net cash flows arising before and after the project life span. NPV is simply the difference between the present values of future cash inflows and cash outflows. This approach considers cash flows prior to and after the project life span. In addition, time-value is given due recognition under this approach. Thus the accuracy of the calculations is enhanced. In contrast, Omar (2011) observed that determination of the discount rate is a difficult task under NPV approach. Inappropriate discount rate might result in wrong decision. In addition, projects with different life span but with similar initial investment might result in different NPVs. In present scenario, 10% discount factor has been applied to determine NPV of the two projects. The NPV obtained from annual lease rental of the labeling machine is greater than the NPV related to the buying of the machine. This suggests that the labeling machine should be taken o rental basis.

Payback method:

The finance manager of Pink Ltd. has also applied Payback method to judge the acceptability of the given alternatives. Payback period refers to the period of time required to get back the investments made on a concerned project. This is a simple and easy method to evaluate investment projects. However, Marquardt and Wiedman (2012) expressed that investment decisions made during Payback period are not correct due to absence of time-value of money. In contrast, O’Hanlon and Anthony (2008) argued that liquidity factor is a prime focus of the payback period which makes this method suitable for firms having liquidity problems. Generally, shorter payback period implies greater acceptability of the project and vice-versa. Here, the payback period associated with the purchase of the machine is 3.5 years only which makes buying decision appropriate for Pink Ltd. because the company is currently facing tough liquidity issues with zero cash balance in 2013. Hence, shorter payback period ensures quick recovery of cash which is essential for Pink Ltd.

Accounting rate of return:

Accounting Rate of Return (ARR) refers to the ratio obtained by dividing the expected accounting profit from a concerned project by the average investments made on a project. The finance manager of Pink Ltd. has also taken the help of ARR technique to evaluate the suitability of the two investment options. The greatest advantage of ARR method is that the calculation is based on the accounting profit expected from a project. Thus, accuracy of the decision is increased. In contrast, Otley (2009) argued that ARR does not recognizes cash flow and terminal value of a project which reduces the accuracy of the investment decisions made under this approach. In addition, the time-value of money is also ignored under this approach. In general, a project is accepted if it generates an ARR which is greater than or at least equal to the required rate of return. In the present scenario, the required rate of return for Pink Ltd. is 20%. However, the ARR in respect of buying the machine is 24%. Hence, buying of the labelling machine seems to be appropriate for Pink Ltd.

On the whole, it is advisable for Pink Ltd. to buy the labelling machine due to positive NPV, short payback period, and higher ARR than the target ARR. However, Qizhi (2009) expressed that qualitative factors associated with a particular project need due consideration for arriving at an effective investment decision. Therefore, the impact of buying the machine on the work force of Pink Ltd needs to be considered.

4.0 Source of funding the new machine:

Buying of the labelling machine seems has been found to be appropriate for Pink Ltd. after conducting thorough investment appraisal of the available alternatives. However, Pink Ltd. needs to choose an appropriate source to fund the buying decision. In this context, Uhrig-Homburg (2011) mentioned that cost of capital, repayable period, and payment frequency are the vital factors to be considered for selection of financing options. In the present context, Pink Ltd. is facing severe liquidity problems.

The key sources of funding could be equity financing, debenture issue, bank loan, and retained earnings. Equity financing would result in dilution of ownership and hence the management control system might get disturbed by the same. As regard to the debentures, frequent interest payment is a major concern associated with debentures which adversely affects the short-term liquidity position of an organization. Bank loan could have been a good choice but Pink Ltd. has already availed a high amount of bank loan and that the bank is currently concerned with the credibility of Pink Ltd. to pay-off the bank loan. In addition, raising bank loan would involve higher interest rate as the loan is an unsecured one. Hence, it is advisable for Pink limited to use its retained earnings to fund the purchase of labelling machine. As mentioned by Otley (2009), retained earnings are a good financing option as it does not create any direct liability. Utilizing retained earnings would enable Pink Ltd. to derive the benefits associated with the purchasing of the machinery with any direct cash outflow.

5.0 Impact on liquidity and solvency of Pink ltd.

The current balance of the retained earnings of Pink Ltd. is £512,000 for the financial year ending 2013. The impact of using retained earnings on the liquidity and solvency position of Pink Ltd. is presented below:

Impact on liquidity position:

Use of retained earnings for the acquisition of the machinery would not affect the liquidity position of Pink Ltd. because both the current and liquidity ratios would remain unaffected by the decrease in the quantum of retained earnings.

Ratio Before using retained earnings After using retained earnings
Current ratio 3.49 3.49
Quick ratio 1.06 1.06

 

Impact on solvency position:

Decrease in retained earnings would have a direct impact on the solvency position of Pink Ltd.

Ratio Before using retained earnings After using retained earnings
Gearing ratio 31.13% 37.15%

 

There would be a marginal increase in the gearing ratio of Pink Ltd. by 6.02% as a result of using retained earnings for the acquisition of the labeling machine.

 

 

References:

Brealey, B., Richard, A. and Myers, C.S. (2006) Principles of Corporate Finance. Seventh edition, McGraw-Hill publications.

Chapman, C. S. (2008), Controlling Strategy: management, accounting, and performance measurement, Oxford University Press, Oxford.

Cotter, J., Marcum, B. and Martin, D. (2009), “A cure for outdated capital budgeting techniques”, Journal of Corporate Finance and Accounting, 14(3), pp. 71-80.

Degtiareva, E. (2006), “Minimizing risk by analyzing a lessee’s financial position: Analysis of financial position and projected cash flow.” Leasing-Courier, 5(17), pp. 1-5.

Deloof, M. (2006), “Does working capital management affect profitability of Belgian firms?” Journal of Business Finance and Accounting, 30(3), pp. 573-587.

Gebhardt H. and William, R. (2007), “Toward an implied Cost of Capital.” Journal of Accounting Research, 39(1), pp. 135-176.

Graham, J. and Harvey, C. (2007), “The theory and practice of corporate finance: evidence from the field”, Journal of Financial Economics, 60(2-3), pp. 187-243.

Hicks, D. T. (2009), “Good decisions require good models: Developing activity-based solutions that work for decision makers”  Cost Management, 19(3), pp. 32-40

Kaya J. and Halil, D. (2010), “The effect of firm characteristics on choice of debt financing.” International Journal of Management, 28(4), pp. 199-208.

Langfield, K. (2011), “Strategic management accounting: how far have we come in 25 years?”, Accounting, Auditing & Accountability Journal, 21(2), pp. 204-228

Lazaridis, I. T. (2006), “Capital budgeting practices: A survey in the firms in Cyprus.” Journal of Small Business Management, 42(4), pp. 427-433.

Mallin, C. (2006). Corporate governance. 1st ed. Oxford: Oxford University Press.

Marquardt, C., and Wiedman, C., (2012), “Earnings management through transaction structuring: contingent convertible debt and diluted earnings per share.” Journal of Accounting Research, 43(5), pp. 205–243

O’Hanlon, John and Anthony, S. (2008), “Estimating the equity risk premium using accounting fundamentals.” Journal of Business Finance & Accounting, 27(9), pp. 1051-1082.

Omar, O. (2011). International marketing. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.

Oppermann, H., Booysen, S. and Van der Merwe, N. (2013). Accounting standards. 1st ed. Lansdowne: Juta.

Otley, D. (2009), “Extending the boundaries of management accounting research: developing systems for performance management”, British Accounting Review, 33(3), pp. 243-261

Qizhi, H. (2009), “Decision-making for Investment Based On Option and Term Structure.” Journal of software, 4 (3), pp. 191-198

Spanyi, A. (2008), “Strategic achievement”. Industrial Engineer, 35(3), pp. 40-43.

Uhrig-Homburg, M. (2011), “Cash-flow Shortage as an Endogenous Bankruptcy Reason.” Journal of Banking and Finance, 6(9), pp. 1509-1534.

Vintila F. and Nicoleta, D. (2006), “Real options in capital budgeting: Pricing the option to delay and the option to abandon a project.” Journal of Applied Corporate Finance, 17(3), pp. 47-58.

Wagner, S.M. (2010), “Cost management practices for supply chain management: an exploratory analysis.” International Journal of Services and Operations Management, 4(3), pp. 296–320.

Yan, A. (2009), “Leasing and Debt Financing: substitutes or complements?” Journal of Financial and Quantitative Analysis, 41(3), pp. 709-731.

 

 

Appendix:

Figure 1: Ratios of pink Ltd

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