Example Assignment 7003 Financial Management Introduction:

This assignment is an attempt to demonstrate that I have achieved the following three Learning outcomes: LO 1: Be able to analyze financial data. LO2: Be able to assess budgets based on financial data to support organizational objectives. LO3: Be able to evaluate financial proposals for expenditure submitted by others. In order to achieve these LOs I have to meet the assessment criteria under each LO.

LO 1:
1.1

Be able to analyze financial data.

Determining how to obtain financial data and assess its validity:

In order to show the ability to do the analysis of financial data of an organisation I have chosen a publically listed pharmaceuticals company called Abcam Plc. There are number of sources that can be used to obtain financial data of a business to use for the purposes of analysis and draw conclusions about its performance and financial health. For public companies, this information is available to public because the government regulatory bodies, international accounting standards etc. require such companies to disclose certain information about their operations to public. Since such organisations are large and affect many people (termed as stakeholders), there are all sorts of checks and balances on the managers to produce reliable, accurate and timely information. This however, does not always happen so care should be taken when using such information for the purposes of financial analysis. External sources: Companies house, HMRC, Financial websites, Stock exchanges, Libraries etc. provide various types of information about businesses to the public. Most significant source of financial information for organisations is their annual reports that are to be published in order to meet the needs of various stakeholders. All kinds of organisations produce annual reports including forprofit businesses, charities, government departments, educational institutions etc. These annual reports contain a set of financial statements that are required to do financial analysis. These include an income statement for the year, a balance sheet as on the last date of the year in question and a statement of cash flows for the yearly period. Although there is room for manipulation and disinformation in annual reports, for all practical purposes they provide reliable financial information. The reason for this reliability is that there are a number of checks and balances on such organisations to ensure accuracy of data.

Compliance with the accounting standards is required when preparing financial statements. This helps improve the reliability and consistency of financial data. Tax regulations of a country play their part to make it difficult for any manipulations taking place. All financial statements need to be audited by external auditors. This process of audit is very comprehensive and auditors make sure that the annual reports show a true and accurate picture of the actual conduct of the business.

Internal sources: The accounting system, customer records, suppliers databases, managers reports etc. are examples of internal sources of financial information. It is an organisations accounting system that is used to record transactions, classify them into logical categories and produce summary information that is further processed to produce meaningful information. Therefore, great efforts are made to ensure that accounting systems operate in a reliable and accurate way with the possibilities of errors minimised. 1.2 Applying different types of analytical tools and techniques to a range of financial documents and formulate conclusions about performance levels and needs of stakeholders.

Various types of entities (both individuals & organisations) are affected by the operations of organisations these entities are called the stakeholders. They include customers, shareholders, creditors (suppliers, banks, and lenders), competitors, government bodies, consumer groups, community groups, media etc. Various stakeholders have differing needs of information about the organisation. One of the strongest groups of stakeholders relies for decision making on the financial information provided by the organisation. To help achieve this there are certain analytical tools that are applied to the data provided by financial documents. In terms of financial management, these tools can be termed as Ratio Analysis. From the figures provided in financial statements, certain ratios are calculated and interpreted to reflect upon the activities of the organisation. Major groups of ratios are:

Profitability ratios Liquidity ratios Efficiency ratios Shareholders ratios

As the name suggest, profitability ratios tell us about the profitability of the company. Gross profit ratio and operating profit ratios are easy to calculate and give a good idea of how good the operations of a business have been. Return on Equity, Return on Assets is measures of how good our investment is doing. Making profit is of course the ultimate objective of a business but in order to keep going through good and bad times liquidity is extremely important. Cash is the lifeblood of organisations so you have to be able to meet all your financial

obligations as they fall due in order to survive and grow. Current Ratio and Quick Ratio (also called acid-test ratio) are most commonly used liquidity ratios. Efficiency Ratios show how well the organisation utilises its resources and how efficient it is in converting efforts into cash. This group includes asset utilisation ratio, stock turnover (how quickly the stock of goods is sold and converted into cash), debtors turnover (how quickly customers pay for the sales done). A set of shareholders ratios are mainly used by potential investors to make decisions of whether to invest in the company or not or when to buy or sell shares. A typical investor will look at EPS, PE ratio, Dividend yield, sales growth, EPS growth etc. Here we have data extracted from the annual reports of Abcam plc. In addition, Skye pharma for the year 2009. The figures shown here are from the income statement and balance sheet they are not the complete statements but only the figures needed to be used to calculate certain ratios are provided: Abcam 2009 2008 000 000 56801 36598 19420 14389 37381 22209 18433 12421 3076 15872 2417 7371 Skyepharma 2009 2008 m m 55.9 62.2 15 19.6 40.9 42.6 6.2 6.6 19.6 15.1 1.4 13.7 13.3 38.9 25.1 10.9 28.5 -17.6 14.7 44.9

Continuing operations Revenue Cost of sales Gross profit Administration Expenses Research and development expenses Pre-exceptional Operating profit Exceptional items Operating profit/(loss) Interest Fixed Assets Current Assets Inventories Trade and other receivables Cash & Cash Equivalents Non-current assets held for sale Short term deposits Derivatives Total Current Assets Total Assets Current Liabilities

15872

7371

4995

6796 6486 25501

4506 4860 13473 1020

1.3 16.5 27

1.5 19.4 35.7 3.9

1338 40121 45116 8565

23859 23859 4748

44.8 83.7 28.1

60.5 105.4 40.4

Total Shareholders' Equity (Net Assets/Liabilities) Non-current Liabilities Total Capital

36468 83 36551

24122 187 24309

-79.6 135.2 55.6

-89.8 154.8 65

Various ratios have been reproduced here from the above data:

Profitability: GP Operating Profit Ratio ROE ROCE Liquidity: Current Ratio Quick Ratio Efficiency: Return on Assets Stock Turnover A/R turnover Shareholder Ratios: EPS PER Debt/Equity Debt Ratio (Total Debt/ Total Assets) Interest cover Sales growth Gross Profit growth

Abcam Skyepharma 2009 2008 2009 2008 65.81 60.68 73.17 68.49 % % % % 27.94 20.14 27.01 17.52 % % % % 43.52 30.56 18.97 12.14 % % % % 43.42 30.32 27.16 16.77 % % % %

Sect or 2009 70.00 % 25.96 % 43.00 % 47.55 %

4.68 3.89

5.03 4.08

1.59 1.55

1.50 1.46

1.7 1.3

35.18 % 2.86 8.76

30.89 % 3.19 7.53

18.04 % 11.54 3.39

10.34 % 13.1 3.21

10.00 % 2.9

34.83 25.29 n/a

16.88 (6.0)p 2.9 n/a -1.7 1.95 0.97 -10% -4%

(247.4) p 10.03 -1.71 1.85 -0.83 50% 67%

0.19 0.21 N/A N/A 55% 68% 49% 53%

A glance at the above numbers and on the Abcam annual report for 2009 shows that the company is in very good financial health; the profitability levels are good, liquidity is very good, and it is growing at a very fast pace. The set of financial statements does not show everything but it gives a very good starting point for further investigation.

1.3

Conducting comparative analysis of financial data:

Now we will compare the financial data of Abcam in 2009 against the previous year, against another pharmaceutical company Skyepharma plc and the pharmaceutical sector. Here is an extract from the 2009 annual report:

Revenue increased by 55.2% to 56.8m and by 27.8% on a constant currency basis Pre-tax profits increased by 105.0% to 16.3m Product range grew by 19.1% to approximately 52,400 antibodies and related products Net cash increased by 11.0m to 25.5m EPS increased by 106.3% to 34.83p per share Proposed final dividend of 9.40p per share giving increase of 116.2% in total dividend for the year to 12.11p

These highlights show that Abcam is growing sustainably 55.2% revenue growth coupled with 19.1% growth in the product range is a good sign. Operating profit has also grown to 27% compared to 20% in 2008. 34.83 p Earnings per share is a strong figure in the sector with being more than doubled over the last year. Gross profit at 65% also shows signs of growth compared to 60% last year and is slightly below the industry average of 70%. It is also negligibly below that figure for Skyepharma. However, deeper investigation may show that there is no cause of concern as Abcam being relatively young company at 11 years old is still in a growth phase; also, the growth in GP is encouraging. The operating profit shows a more positive picture with it being above industry average of 25%. This may mean that Abcam is more efficient company than the most in pharmaceutical sector with better control over expenses. This ratio for Skyepharma has also grown between years 2008 and 2009. Another measure of profitability Return on equity (ROE) for Abcam is good with it being in line with the sector average of 43%. The reason that ROE and ROCE are about the same is that Abcam has hardly any debt equity (that is long-term borrowed funds). By contrast, Skyepharma has negative ROE which is a bad sign but all these numbers must be read in conjunction with each other. The reason for this negative number is that Skyepharma has 135.2 million of debt and it has negative equity because accumulated losses over the past years. In short, Abcam is doing much better than Skyepharma for shareholder returns. The liquidity of Abcam is phenomenally stronger than Skyepharma and the sector with its current ratio at 4.68 compared to only 1.7 as the industry average. Asset utilisation at 35% is a sign of efficient operations but stock turnover of only 2.86 shows a slow movement of stock this means it would take 127 days to convert stock into sales. However, this is in line with the industry average of 2.9 showing that pharmaceutical companies may need to hold a lot of inventory of stock.

In summary, though Skyepharma is much more established company, it is in a much weaker position than Abcam and it will take few more profitable years for it to be able to write off all it accumulated losses and start paying dividends. 1.4 Reviewing and questioning financial data: Care must be taken when using financial data for the purposes of making investment decisions and others. The quality and reliability of financial information produced will largely depend on the quality of source data that has been used to produce that information. Some of the measures that are used to ensure the quality of financial information are:

Most businesses have internal auditors who make sure that the accuracy, reliability and timeliness of financial information is maintained. Their job is to cross examine the financial records, ensure the accounting systems are robust and reporting is timely. The authority matrix of an organisation The accounting and management information systems External audits

The assurance that in an organisation e.g. Abcam the systems of producing financial information are robust and well maintained will have impact on the authenticity of the annual report and particularly the financial statements thus providing a realistic picture of the actual business.

LO 2: Be able to assess budgets based on financial data to support organizational objectives.

Despite all the criticism of budgeting process and the use of budgets, it remains a reality that most organisations use budgeting in one form or the other, to smaller extent or larger as a management tool. The biggest reason why budgeting is still popular despite all the new theories and concepts, is the simplicity with which they can be prepared and modified as well on a continuous basis. Other tools and systems used in modern management include strategic plans, business plans, balanced scorecards, key performance indicators (KPIs) etc. The main goal of all these tools and techniques is to be able to predict the future as accurately as possible. 2.1 Identify how a budget can be produced taking into account financial constraints and achievement of targets, legal requirements and accounting conventions I discuss the budget preparation process in my company Evocern Production a business that manufactures chemicals used as raw materials and supplies by pharmaceutical companies. Our clients include Skye Pharma, Alliance Pharmaceuticals, Eli Lilly and GSK. We use the traditional method of Incremental Budgeting where annual budgets are prepared based on the previous years budgets and actual performance. Budgeting is the responsibility of a budget committee that is headed by the CFO and the members include the MD, Director Sales & Marketing, Director HR, Production Manager, Purchasing Manager and the Management Accountant.

The budgeting process begins in October every year with the review of current years performance against the targets. The budget officer receives sales forecasts from Sales & Marketing department and the director S&M is requested to submit a Sales budget. Once first drafts of departmental budgets are prepared, budgeted set of financial statements, (Income statement, Balance sheet and cash budgets are prepared. Sales Budget: Product 1 Sales volume 2 xcd4528 xcd3843 Zyt-6750 Others Total Sales budget may seem straightforward to prepare but there are significant financial constraints that we face. Some of them are highlighted here: Sales Revenue 3 Opening stock 4 Required Closing Stock 5 Productio n Required 6

The required volumes of our products are dictated by our customers. It is quite uncertain market out there in ever-changing field of pharmaceuticals. There are certain chemicals that are universal and command a steady demand but on the other hand, certain high margin products have very fluctuating demands. The prices are affected by the market conditions and of late, it has been very competitive. Innovation and R&D play a vital part ion being competitive. We have to ensure that there is an optimal balance between the high volume - low margin and the low volume - high margin products.

Annual production requirements from Column 6 of Sales budget are agreed with the production departments for various products. Once the costing for all the products has been finalised after revisions and modifications Production budgets are prepared. These budgets provide a picture of the requirements of raw materials, labour hours, other overheads etc. that will be required over the coming year. The constraints faced by production include direct costs (raw materials, direct labour etc.) and indirect costs (premises, maintenance, supplies etc.) Production Budget: Materia l 1 rmt-cml4 Annual Requirem ent 2 Opening stock 3 Required Closing Stock 4 Annual Production 5

rmt-crt3 rsu-jtn3 Others ..... ..... Production budget is used to prepare the Raw materials usage, direct labour, indirect labour and production overheads budgets. Major constraints on financial performance in production department are applied by the factors affecting direct and indirect materials and labour costs. In order to meet or even improve upon the budgeted targets for the productions costs our production departments work closely with the purchasing departments and the HR department. Significant effort is required to command good prices of raw materials with the assurance of quality standards to minimize wastage costs as well. On the labour costs, front measures are taken to acquire suitably skilled labour force. The training and conditions have to be managed efficiently in order to ensure that good quality labour force is available from the competitive job market of today. Production budgets in turn provide the starting points for the budgets of purchasing and HR departments. 2.2 Analysing the budget outcomes against organizational objectives and identifying alternatives: Evocern Production has adopted a modified approach to traditional budgetary control methods whereby the management keeps a close eye on the actual performance on a monthly basis. This performance is constantly compared against the budgets in order to detect variances as soon as possible, use them in order to investigate the causes that have produced them and provide solutions to take corrective actions. There is a flexible approach being applied where strict and inflexible adherence to the annual budgets is not promoted. Instead, annual budgets are broken down into monthly budgets and these are flexible so that if the investigation into certain variances reveals that the initial targets were not realistically achievable, those targets can be revised and the whole set of budgets may be adjusted. Before we can relate the budgetary control system to our organisational goals, it is useful to present the organisational goals here: To maintain preferred supplier status of constituent materials to certain established pharmaceutical products by our established clients. Maintain successful JIT relationships with our clients and rollover this arrangement to more products. Ensure that efficiencies are improved in our supply chain so that healthy profit margins on our products are maintained as well as good value (optimal price-quality balance) is created for our customers. The operations are carried out in an efficient manner so that significant cost savings are made without compromises on quality and operations.

This should imply that our purchasing is competitive, aggressive, innovative and efficient. Similarly, human resources are efficiently utilised. Since budget is only a numerical representation of financial plans of an organisation, the above stated goals of Evocern production are the sources of all the budgets that are prepared annually and monthly. As discussed above a whole set of budgets is prepared on an incremental basis and then actual performance is monitored by using variance analysis. Major variances used at Evocern are as follows: Sales price variances Sales volume variances Raw materials price variances Raw materials usage variances Labour rate variances Labour efficiency variances.

All these variances are continuously calculated and analysed for the purposes of operational and financial control. Certain causes of variances are given below with examples: Cause of Variance Incorrect assumptions Examples from recent past budget The annual sales volume of xcd-3843 was forecast at 234,000 litres for the year 2010 on the basis of 10% more than the previous year but the customer who purchased this product is phasing down its use over coming years. The actual demand for it for 2010 will only be 176,000 units. There was a failure of information gathering and communications between the client and marketing department. Timing Some of the components used in our products have increased in price but the change has been applied to the costs of production straightaway. Most of these components are in stock for about 3 months hence the new price should have been only applied on the new supplies.

Price & Cost changes Volume changes Human error

LO3: Be able to evaluate financial proposals for expenditure submitted by others.

3.1 Identifying criteria by which proposals are judged: It is important that financial proposals for expenditure meet certain criteria in order to make sense to the managers who are going to use them for making

decisions. Though different organisations will have different needs as to the presentation of financial proposals, there should be certain qualities that most such documents should possess in real world situations. Following is a list of criteria that can be helpful in judging financial proposals to select them for further consideration:

Presentation: when preparing financial proposals you should bear in mind that people with different skills will use them some will be experts on financials, others wont be. So it is important that such documents have the right balance of technical and non-technical information, they should not be too much cluttered with numbers; use of graphs and charts is a good idea to help non-accounting managers get an insight into what has been proposed. Obviously, managers need as much detail of the proposed project as possible but there should be accurate and effective summary included in such reports for quick reference and a birds eye look at the whole project. Accuracy and Relevancy: so important it is to have correct figures used in financial proposals the effects of lacking accuracy and timeliness would have disastrous effects on the project and since it is all about money, miscalculations can even have fatal effects on the organisation as a whole. Life is full of capital expenditure disasters from Computerization at NHS, Tax credits system at the HMRC, Eurotunnel etc. All these projects have resulted in billions of pounds of losses to the country. Mapping to Strategic Objectives: The proposals should directly relate to the overall strategic objectives of the organisation e.g. BHP Billiton largest mining company in the world is sitting on billions of dollars of spare cash with which it is trying to expand its mining operations by organic growth or acquisitions. The proposals of buying other mining companies would be in line with the strategic objectives of BHP but financial proposals to set up a bank would not make much sense. Picture of Financial Impact: No proposal for a capital expenditure project would be complete without showing its true and realistic financial impact. Therefore, such reports should clearly show the projected financial numbers to help managers make their decisions. Presentation of Financials: the skills and capabilities of the report writer are tested when it comes to communicate the financial numbers to managers with different styles of communication, different skills-set, different attitudes to risk etc. Scenario planning: it is very useful and practical to include various scenarios and alternatives in your financial proposal. However, this has to be done without creating unnecessary complications in the presentation. Generally, most of these financial proposals include a worst-case scenario that provides a good starting point for the project risk assessment. Risk assessment: For any capital expenditure project, assessing the risks is the most important activity. It is critical that all risks have been considered and the risk mitigation strategies devised. Selling the benefits: despite all the negativity and critical analysis of a project proposal it has to carry significant financial benefits. If such proposals fail to sell the benefits, the whole exercise becomes futile what

is the point of proposing a financial project and you cannot convince the audience about the benefits that it will bring. 3.2 Analysing the viability of a proposal for expenditure:

The chart below shows the analysis of a capital expenditure proposal at Evocern. The proposal was submitted to the board of directors in 2009 to install a production plant for material xtc-7852 that is used in some skincare products. The market research showed that there is an increasing demand for this product that will peak in 2012. Results of three methods of analysis has been produced we will discuss the use of these results and their strengths and weaknesses. 2009 sales price ( per litre) sales volume (litres) Variable costs ( per litre) Fixed costs 0 0 0 100000 2010 86 1150 50 30000 2011 100 1500 50 30000 15000 0 75000 30000 45000 43600 2012 120 1800 40 30000 21600 0 72000 30000 11400 0 70400 2013 95 1400 30 30000 13300 0 42000 30000 61000 13140 0 59790 0 24650 0 22000 0 1314 00 Total

Sales Revenues Variable Costs Fixed costs Net cash flow Cumulative Cash flow NPV - 8% Payback period PV of fixed costs Break Even NPV of Sales Revenue

0 0 100000 -100000 -100000 78,212.50 2.4 years 199,363.81 332,273.01 453,149.66

98900 57500 30000 11400 88600

Break-even analysis is the simplest tool used this shows the minimum amount of sales revenues required to be generated in order to break even while achieving 60% Gross profit margin. The formula is simple for it i.e. Total fixed costs over the duration of the project divided by the GP rate. In this analysis, PV at a discount rate of 8% of total fixed costs has been used for improved accuracy. With the net present value of Sales revenue of 453,150 this tool shows strong favour for the project, as we only require 332,273 to breakeven at 60% GP. So if only this tool was used simple decision would be to go ahead with the proposal but the limitations of break-even analysis should be considered before any final decisions are made. One of the problems with BE

analysis is that it oversimplifies the calculations, however, the advantage lies in just the opposite i.e. this is an easy calculation and can be understood by most decision makers. Net Present Value calculated using 8% return for this proposal is 78,212 which is positive. The idea behind NPV is that the projects with highest NPV at a given rate of return should be accepted. This is a good tool to compare various alternatives however; care should be taken as just the numbers do not reflect many other non-financial factors that would in the long run affect the project returns and overall business. Sometimes among alternatives suggest the project with highest NPV may have less favourable impact on quality and reputation of the company, involvement of staff etc. Payback Period for this proposal is quite good that is less than 3 years. Simply put this is the time required to return the initial investment. The limitation with this method is that it does not account for real time value of money. In real practice, 40,000 received in two years time is not exactly equivalent to 40k, instead due to the inflation and other factors its present value in todays terms is less. In doing the break even analysis we somewhat compensated for the time value by using the present value of revenue stream but that cannot be done with payback period method without making the calculations too complicated. Able managers will have keen eye to look through the numbers into a financial proposal. A prudent decision maker will look at the above proposal with some suspicion of mistakes, unrealistic assumptions, oversimplification etc. All three methods used are showing much better picture than realistically achievable. A management team may send this kind of proposal back for revisions regarding forecast sales prices, variable costs used, expected volumes of sales orders etc. Two key factors are to be considered while analysing any proposal: Cost of capital used; and The ability to reliably measure the cash inflows and outflows.

For the first, it is the rate of return to be used in the calculations of present values, IRR etc. It can be anything from the simplest rate of inflation or more complex interest rates on loans, rate of return required by investors, combination of inflation, expected returns by shareholders and interest required by the creditors etc. The later seems simple enough in theory but can be a difficult and complex process for many organisations in reality. E.g. For a project that is totally independent of the mainstream business operations it will be relatively straight ford to forecast the cash flows but for other types where it is not easy to separate the costs and revenues between different operations this could be a huge challenge. 3.3 Identifying the strengths and weaknesses and giving feedback on the proposal Since there goes a lot of effort in preparing a financial proposal, it is only fair that the decision makers give it a thorough reading and provide proper feedback. The strengths and weaknesses of a proposal are not stated in absolute terms. Same attribute can be a strength in some situations whereas it can be a weakness in others. So it is a subjective area where the judgement of the decision makers play a significant role. The strengths and weaknesses for the xtc-7852 production plant are stated below:

Strengths

Weaknesses

Simple and easy to understand. It does Possibly over-simplified lacking detail. not involve complex calculations The breakdown of costs should have been included Assuming that forecasts are fairly The underlying assumptions should reliable, it provides a quick payback have been included that were used to period. forecast the sales and expenses figures. Focuses on the new project without mixing it with the existing operations. This is useful when there is good expectation of reliable measurement of cash flows in the future but can be a weakness in some cases. Only provides one option a more useful version would include more than one alternatives to choose from and provide a means of comparative analysis.

In most practical situations, financial proposals will be revised after feedback from management a number of times before a final version can be approved. The feedback system should have certain capabilities to assess projects including: Financial viability Strengths and weaknesses Impact on organisational objectives Organisational risks Impact of financial ratios and KFIs

The decision making machinery should also be capable of prioritising between various proposals as to the best cost-benefit ratio, lowest risks etc. 3.4 Evaluating the impact of the proposal on the strategic objectives of the organisation The proposal for Evocern appears to contribute towards the organisational objectives: The new material proposed to be produced is a useful addition to the portfolio of marketable products in the pharma and healthcare sector. This should have positive non-financial effects by expanding the range of products and number of potential clients. The new product does not need new skills and existing labour force can be easily used after minimal training. The proposed gross profit margin of 60% is a healthy one and will help improve existing set of financial ratios. The new plant should be easily used to produce other similar products in which Evocern specialises; so even if the new products life cycle is not long enough, the plant should have much longer life span to be used by the company.

With being in the same sector, the organisational risks of this proposal are minimal. As mentioned above, even if the product is not profitable the new facility can easily be switched to the production of other products.