The value of prudent management accounting for any company cannot be understated. They’re going a long way to ensure that the Company Enterprise remains afloat. Before deciding on any major project, the management of the Company should assess the effects of the proposed projects. This paper aims to analyze the planned project of ABC Company as well as the financial consequences of the project.
Company’s Risk Profile
In order to assess the current performance of the Company, we shall first analyze the perception of the risk profile of the Company by measuring the appropriate operating ratios.
Present ratio tests the willingness of the Organization to fulfill its short-term obligations. as and when they fall due. It’s an important measure of liquidity. The rule of the thumb supposes that a ratio of more than 1 is desirable whereas a ratio of less than 1 implies that a Company cannot comfortably settle its short term obligations as and when they fall due (Brigham, 2013). Current ratio is given as Current assets/Current liabilities. In our case study the ration is given as
Current Assets/Current Liabilities
Current Assets= Cash+ Accounts Receivable+ Merchandise Inventory+ Common stock
Current Liabilities= Accounts Payable+ other payables
Current Ratio= 760,000/250,000= 3.04
The ratio as clearly indicated above is more than 1 which implies that ABC Company is in a position to settle its short term obligations without facing financial difficulties as per the 2002 financial results.
Similarly, the 2001 current ratio is given as Current assets/Current Liabilities
Current Assets= 70,000+180,000+ 240,000=490,000
Current Liabilities= 210,000
Current Ratio= 490,000/210,000= 2.333
Just like the 2002 ratio, that is more than 1 which implies that the Company has been experiencing a steady state of healthy financial conditions.
Inventory Turnover Ratio
This ratio is used to measure how effectively a business utilizes its assets to generate revenues. It’s calculated by comparing the cost of sales with the average inventory. In other words, the ratio gauges the rate at which the Company is sold during certain period of the year. The rule of the thumb supposes that if a Company purchases huge quantity of stock, the Company will have to ensure that it sells greater amount of stock for it to be able to ensure that it experiences high turnover (Weygandt, 2015). The ratio is given as Cost of goods sold/ Average Inventory.
In 2001, ABC Company’s ratio was 800000/240000=3.3333 times.
The above ratio implies that the Company depleted its entire stock within the financial year.
It is used to measure the ability of the Company to settle its obligations from liquid assets. Its formula is given by:
Quick ratio = (current assets – inventories) / current liabilities
Current Assets- Inventories= 50,000
Current Liabilities= 250,000
Q. Ratio= 50,000/250,000
The 2002 ratio is less than 1 which implies that the Company’s liquid inventory is less than 1 which implies that the Company may be in financial difficultness as far as settling the short term obligations from its liquid assets is concerned.
In 2001 the Company’s quick ratio can be given by 70,000/210,000= 0.3333 which also falls short of the required 1.The implication of the above ratio is that the Company has over time been experiencing financial difficultness in settling obligations from its liquid assets.
Cash flow statement is important to any business Organization because it determines whether a business has enough cash to enable it run its operations.
Cash flow Statement
Reported Net Profit (50,000)
Add Depreciation Expenses 70,000
Add Income Taxes 30,000
Cash at start 70,000
Less: shares purchased (100,000)
Cash at the end 20,000
From the cash flow statement above its clear that the Company is quite facing some cash constraints. The shares purchased during the year in one way or another contributed to the present condition of the Company.
In this section we focus on the new proposal by the Company. The analysis will centre on the additional revenue the Company will get from the new product.
Current Pdct New Pdct
Direct materials $1.30 $5.60
Machine hour per unit (40,000/80,000) $0.5 $0.125
Direct labor ($’s) $2.80 $2.80
Factory overhead (Variable) $ 1 $1
Selling Expenses $0.20 $0.20
Total Production cost per unit 5.3 9.6
Factory Overhead $198,000
Fixed Selling Expenses $191,250
From the above table it is clear that the introduction of the new product will have significant effect on the Company as a whole. The new product line will lead to an increase of the direct raw materials per unit from $1.30 to $5.60. This implies that the cost of production will increase when the direct materials costs are factored into the equation. This is clearly shown in the table above. The machine hours per unit required by the new product on the other hand is smaller as compared to the machine hours being utilized by the existing product. Direct labor per dollar remains the same across the two products and as such with the addition of the new product there will be no significant increase in the product costs. Factory overheads as well as the selling expenses remain the same despite the addition of the new product. The same thing can be said of the factory fixed overheads which tend to be the same.
Having analyzed the line by line effect of introduction of the new product on the Company, we now delve into understanding the total effect of the product on the Company’s bottom line. In this section we seek to understand the profitability of the Company with the introduction of the new product.
Details Product 1 Product 2
Sales 580,000( 14.50*40,000) 128000(25.60*5000)
Machine Hours 40,000 5,000
Direct Materials 104,000 28,000
Direct Labor 224,000 (2.80*80,000) 20,000 ( 4*5,000)
Variable Factory Overhead 40,000 5,000
Variable Selling expenses 16,000 1,000
Fixed Factory Overhead 198,000 198,000
Fixed selling expenses 191,250 191,250
Profit 389,250 69,000
Note: Price of the new Product is gotten by (5,000+28,000+20,000+5,000+1,000) + (191,250+198,000)/45,000
This gives us 20.45
Given the fact that the Company’s growth rate from the previous period was 25%, the selling price of the new product can be estimated as 20.45*1.25= 25.60
The determination of the profit levels above have been done without factoring in the fixed factory overheads as well as the fixed selling expenses. The two have been left out because the Company will still incur them even if it were to stop its operations. Were they to be factored, the profit levels would look as follows:
Profits before fixed overheads 458,250
Fixed Overheads 389250
Net Profit 69,000
The Company would still get a positive profit after the fixed overheads have been subtracted.
Year 1 2 3 4 5
Returns 15,000 13,000 10,000 10,000 6,000
PVIF 0.870 0.76 0.66 0.57 0.50
P.V 13,050 9,880 6,600 5,700 3,000
Total P.V= 13050+9880+6600+5700+3000= 38,230
Net Present Value= 38230- Initial Investment= 38,230- 42,000= (3770)
The Net present value criterion supposes that a project is viable when the net present value of the returns is more than 1 (Wahlen, 2014). From the above calculation it’s clear that the net present value is negative which implies that the project is not viable.
ABC’s fixed factory overheads are 198,000. However, with the addition of the new equipment, the overheads will shoot to 198,000+ (42,000/5) = 206,400 per year. The will also make the Company struggle financially because of the huge capital outlay required. As such, this will have a negative effect on the Company’s cash flow.
The paper has been able to utilize various criterions in evaluat5ing the options available to the Company. The new product line will add substantial revenues to the Company and therefore ought to be pursued in order to ensure that the Company reaps big time from the investment. The fact that the product is in a position to add extra revenues to the overall revenues of the Company makes this statement holds waters. On the other hand, it was clear that investment in the new equipment may not be viable as a result of the negative net present value result gotten.
Boulmetis, J. &. (2014). The ABCs of evaluation: Timeless techniques for program and project managers (Vol. 56. John Wiley & Sons.
Brigham, E. F. (2013). Financial management: Theory & practice. Cengage Learning.
Wahlen, J. B. (2014). Financial reporting, financial statement analysis and valuation. Nelson Education.
Weygandt, J. J. (2015). Financial & Managerial Accounting. John Wiley & Sons.