3.7 - Investment Appraisal&Assessing Business Performance Flashcards
Investment appraisal techniques are used to decide whether returns received will be enough to justify initial capital expenditure
What are the 3 investment appraisal techniques?
1 - payback
2 - average rate of return (ARR)
3 - net present value (NPV)
What is payback as an investment appraisal technique? What should you be aware of the question mentioning?
Give 2 advantages and 2 disadvantages of payback
Just birefly not needed
Measures time period required for earnings from an investment to cover initial costs (inflows & outflows)
If given a residual value add to inflows-produce extra inflow at end of investment eg/sell machine at end of 4 years for £50,000
+ accurate as measures STM (less accurate further into future)
+ good for business with cash flow problems who may set criteria of short payback periods
- ignores timing of receipts&any profits received after payback
- danger of short termism (eg/expand in UK vs abroad)
What is average rate of return (ARR) as an investment appraisal technique? What are the 3 steps to calculate it? Give 2 advantages and 1 disadvantage of ARR
Compares rate of average annual profit generated by investment with amount of money invested in it
Allows 2/more potential projects to be compared to find out which has best return/comparison with other investment opportunities eg/banks
Any investment=risk&returns may not be forecast so investment should earn significantly bigger return than rate of interest in bank
+ straightforward to calculate&quicker than payback
+ looks at whole profitability of project (key=shareholders)
- takes no account of the time value of money
What is net present value (NPV) as an investment appraisal technique?
How can an appropriate discount factor be selected?
What 3 things must businesses consider in relation to investment and the time value of money/opportunity cost?
What does the results of NPV show?
Process of discounting cash flow & takes into account time value of money (£100 now worth more than £100 in future)
PV=cash flowxdiscount factor (do for each, + all together to get net then is it +/-?)
Know for discount factor: (given)
- how many years money ill be received (further ahead=less worth)
- what rate of interest=likely to be
1 rate of return on money invested
2 opportunities given up as result of investment (eg/ prevents firm enjoying return on money left in back with interest being added when money tied up in investment)
3 timing of inflows of diff. projects need considered (what’s firm missing when waiting for diff. inflows)
If NPV=negative investment not worth undertaking (PV of earnings is less than cost of investment, more profitable approach would be to invest capital in interest-bearing account earning at least rate of interest used for discounting)
When considering no. projects, NPV can be used to rank, business may choose it with highest NPV so most worthwhile in financial terms
What 3 things are included in an investment criteria?
Rate of interest
(ARR & NPV produce figures to compare with rate of interest-ARR to compare with investing in bank, NPV to produce positive NPV)
Level of profit
(target may be set for a return to match/exceed certain level-possibly ROCE)
Alternative investments (consider range of projects so rank them before choosing)
What are the 2 risks and uncertainties of investing?
List 3 ways a business could manage these risks
1 COSTS HIGHER THAN EXPECTED
- purchase materials on foward market
- build in allowances for fluctations in revenue&costs
- ensure sufficient financial assets available
2 SALES LOWER THAN EXPECTED
- timescales
- new markets (no experience)
- competitors reactions
What is sensitivity analysis?
(how does it work and how what is its use to managers)?
Used to assess likely outcome of decision, determining how diff costs/investments will affect profit&other financial indicators (quantitative techniques)
Change 1 variable at a time & see what happens to outcome you’re trying to measure eg/profit
- helps judge max expected loss (pessimistic estimate)&if can afford such loss
- helps judge degree of risk in decisions&identify which variables have greatest impact on outcome of decisions
- recognises no such thing as accurate forecast
- considers one variable/assumption at a time
Who are legally required to conduct and publish a sensitivity analysis?
PLCs-expected to inc results within published annual accounts as form of risk assessment, specifically expected to show possible impact of changes in external variables most notably interest & exchange rates on business’ financial performance
(allowing investors to assess likely impact on profit & expected dividend level changes)
Businesses can reduce risks identified by sensitivity analysis (perhaps hold supply of money)
What is the calculation for breakeven?
BE = fixed costs/contribution per unit
Can be used in sensitivity analysis
What is a balance sheet and what does it show and to who?
What 3 things can it help assess to do?
Snapshot statement of assets, liabilities&capital (how much invested)
Shows wealth & debt (important for shareholders, managers & financiers)
Its always balanced due to double entry book keeping (2 entries cancel, every figure that comes in also goes in somewhere else)
Can assess whether/not to:
1 invest in business (health of business-is it doing well, is it worth it)
2 lend money to business (too much debt, are they likely to payback)
3 buy a business aka takeover (what its actually worth)
What are assets?
Inlude 3 short term/current assets and 4 long term/non-current assets?
ASSESTS = WHAT YOU OWN
Current=assets business owns either cash, cash equivalents, or expected to be turned into cash during the next 12 months
Non-current=purchased&expects to keep in business for more than 1 year
CURRENT ASSETS (SHORT TERM)
- inventories
- receivables (payment due from customers)
- cash
NON-CURRENT ASSETS (LONG TERM)
- land & buildings
- machinery & equipment
- vehicles
- copyright
What are liabilities?
Include 2 ST current liabilities and 2 LT/non-current liabilities
LIABILITIES = WHAT YOU OWE
Current=due to be paid within next 12 months
Non-current=not expected to be paid within one year
CURRENT LIABILITIES (SHORT TERM)
- payables
- tax
- ST borrowings
NON-CURRENT LIABILITIES (LONG TERM)
- loan
- mortgage
In relation to assets and liabilities, what’s the difference between long term & short term?
LONG TERM - things needing paid over longer period of time, more than a year (fixed & standardised)
SHORT TERM - could change everyday, less than a year (vary)
What’s involved in the capital section within balance sheets?
Share capital (money invested by shareholdesr)
Reserves (profits not paid out to shareholders/retained profit)
What are income statements and he 4 things inc in its basic structure?
Who looks at it & why?
What 4 reasons are income statements used for?
Records all revenues & costs within given trading period (usually 1 year), shows various kinds of profit & are used to judge success
1 Gross profit (rev-variables)
2 Operating profit (gross-expenses)
3 Profit before tax (interest received & paid so is either deducted or added to operating profits)
4 Profit after taxation (tax payable deducted & shows net amount earned for shareholders)
Shareholders (assess profitability)
Government agencies (calculate corporation tax)
Suppliers (reliability, stability, creditworthiness)
Potential shareholders & bankers (sound investment)
1 measure success compared to previous years
2 assess actual performance against expectations
3 help obtains loans/other credit
4 enable owners to plan future investment
In relation to income statements, what 2 things happen to profit after taxation?
Distributed profit (paid to shareholders in form of dividends)
Retained profit (good mangers use some profit to reinvest for future aka reserves)
What is dividend cover and how is it calculated?
What would be the views of the 2 types of shareholders involved with the business in relation to these payments?
How many times over dividends can be paid out using profits
total profit/dividend given
Good (for business) for dividend cover to be high but could result in pressure from shareholder wanting more, some may sell shares bc not satisfied=risk of takeover & lower share price
- but if they’re LT shareholder don’t pressure bc know business uses profit to make business better, so better benefits in LT eg/increased share value
What is ratio analysis and the 4 main types?
Examination of accounting data by relating 1 figure to another, allowing for more meaningful interpretation of data & identification of trends
1 profitability (net profit margin & gross profit margin) 2 liquidity (how much money in business) 3 gearing (how much is borrowed) 4 efficiency (how effectively cash & stock=managed)
As a type of ratio analysis
What are LIQUIDITY ratios aka current ratio and what do they focus on?
How are they calculated and 3 ways can the ratio be improved What are the problems?
Investigate ST financial stability/health (enough to get by?) by examining whether there’s sufficient ST assets to meet ST liabilities
Shows relationship between CA&CL=liquidity position
current assets/current liabilities
To improve (more cash needed): 1 sell under-used fixed assets 2 raise more share capital 3 increase long term borrowing (then reflects other figures in balance sheet)
Problems
- assumes all stocks sold&receive all receivables, in reality don’t sell all/trusting customers pay on time (will it be on time/get full amount) might have to sell off receivables to debt factoring (don’t get all)/put prices down to sell&get money but then don’t get full amount=unable to pay off liabilities/have money left
As a type of ratio analysis
What are GEARING RATIOS as 1/3 EFFICIENCY ratios and what do they focus on?
How is it calculated?
Measures amount of LT liabilities (LT borrowing) relative to capital employed (total amount invested)
- examines extent business is dependent on borrowed money (indicating how vulnerable to financial setbacks, eg/interest changes-harder to payback money aka LT risk)
- looks at company’s LT financial position (main measure of financial health)
non current liabilities (ST owe)/capital employed (invested) x100
capital employed=total equity+noncurrent liabilities
As a type of ratio analysis
What do PROFITABILITY RATIOS show?
What are the 3 types and how theyre interpreted?
How can they be improved (+) and what’s the problem if theyre too low (-)? How are they interpreted?
Allow comparisons (figures compared as % allowing easier comparisons) to assess returns from activities and investment
1 Gross profit margin=GP/revenue x 100
(shows value added to product-how much added to price, shows whether sales are sufficient to cover costs)
+ put prices up
+unit variable costs down
-may not be enough gross profit to cover overheads
2 Operating/net profit margin=OP/revenue x100
(tells you how efficiently business generates profit from core operations)
+boost gross profit margins
+cut overheads per £ of sales
+increase sales
- may not be enough operating profit to reinvest into business&grow
3 ROCE(measures efficiency with which firm generates profits from funds invested)
OP/capital employed (amount invested aka LT debt+equity) x100
High suggests resources being used efficiently, good profitability&shareholders=happy
Evaluate effectiveness of investent into return
Benchmark to compare with competitors in terms of efficiency&profitability (must be compared to determine if figure=satisfactory)
If ROCE=lower than rate of interest bank offered, owner would’ve been better keeping money in bank, taking little risk
NO right level of ROCE-most happy with 20% but many accept lower
+increase level of profit generated by same amount of capital
+maintain level of profits generated but decrease amount of capital needed to do so
As a type of ratio analysis
What are efficiency ratios?
As 1/3 EFFICIENCY RATIOS what is INVENTORY TURNOVER?
How is it calculated and results interpreted?
How can the ratio be altered aka improved?
How well business manages resources aka working capital, looks at management of stock, receivables & payables
INVENTORY TURNOVER (how many times business replaces its stock in year)
cost of goods sold/inventories held= no. times per year business sells & replaces stock
365/inventory turnover=how long holding onto stock for (high for perishable goods & tech-cant hold stock too long)
-depends on industry/type of good sold (if higher=small amount more often, smaller stock room needed&less workers needed to manage, less cash tied in stock, stops products going out of date/obsolete/economies of scale allows bulk buying)
+reduce level of inventory held (eg/JIT)
+increase rate of sales without increasing level of inventory held
What is working capital? What can it be used for?
Measures how efficiently business is at operating & how financially stable it is in ST
indicates liquidity levels of business for managing day-to-day expenses & covers inventory, cash, accounts payable, accounts receivable and short-term debt that’s due
What is debt factoring?
What are 3 advantages and 2 disadvantages?
External, ST source of finance, business can raise cash by selling outstanding receivables to a 3rd party (factoring company) at a discount-business gets up to 90% of their invoice value in cash now (rather than waiting)
+ Receivables turned into cash quickly
+ Business can focus on selling rather than collecting debts
+ Facility is practically limitless, therefore suits a fast-growing business
- Quite high cost-charge made by factoring company
- Customers may feel relationship with business has changed
(may shop elsewhere & damage reputation)
What’s the difference between income statements and balance sheets?
Balance sheet displays what company owns (assets)&owes (liabilities), as well as LT investments, investors scrutinize balance sheet for indications of effectiveness of management in utilizing debt&assets to generate revenue
Income statement shows financial health of a company & whether/not a business is profitable, both revenue & expenses are monitored closely (crucial for management to grow revenue while keeping costs under control)
Together provide fuller picture of business’ current health & future prospects
