1 Analysis Internal Financial Statements by Binam Ghimire

Learning Objectives 1.Fixed and variable costs 2.Contribution margin 3.Margin of Safety 4.Application of Break Even and Du Pont Analysis

Introduction  So far we have analysed the Published Financial Statements:  Balance Sheet  Income Statement  Cash Flow Statement  But what about the following statement (Exhibit 3.4).

Internal/Management Financial Statements  The first thing you should notice is that the Income Statements are not presented in the published format in accordance with IAS 1  These statements are for internal use (management use) and as a result reveal some interesting information not normally available to the outside analyst:  Fixed Costs and  Variable Costs  What are they ?

Fixed & Variable Costs  Fixed costs  Costs which remain fixed at a given level of output  E.g. Central Widget have Fixed Costs of $300M  Variable costs  Those costs that vary in direct proportion to the level of output  E.g. Central Widget have Variable Costs of $ 8.50 per unit  At an output of 250M units this is: 250Mx $8.50 = $2,125,000

Analysis  Presenting data in this manner rather than the published format provides additional information to aid decision making  It can be used to calculate the Break Even Point and the impact of Increases and Decreases in sales  First of all, calculate the Break Even Point for both companies

Break Even Point  It is the point at which you neither make a Profit or a Loss.  This is an alternative approach to sensitivity analysis considered later.  If we consider the behaviour of costs the Break Even Point may be presented graphically as follows:

Central Widget – Break Even Point  Step 1 – Calculate the contribution per unit, =Sales$10.00 less variable costs$ 8.50 Contribution$ 1.50

 Step 2 – calculate the break-even point. Break-even point (units) =Total Fixed costs Contribution per unit $ 300 M = 200 M units $ 1.50  i.e. they need to sell 200M units in order to break even (cover Total Costs) which in terms of sales revenue equals: 200 M units x $ 10 selling price per unit = $ 2,000 M

Excelsior Widget – Break Even Point  Calculate the Break Even Point of Excelsior Widget

Excelsior Widget – Break Even Point  Step 1 – Calculate the contribution per unit, =Sales$10.00 less variable costs$ 8.50 Contribution$ 1.50  Step 2 – calculate the break-even point. Break-even point (units) =Total Fixed costs Contribution per unit $ 47 M = M units $ 1.50

Margin of Safety  Break Even Point:  Central Widget M units  Excelsior Widget M units  But Central have greater capacity.  The Margin of Safety is the amount by which forecast sales exceed the break-even point.

CentralExcelsior Forecast sales250 M100%30.00 M 100% Break-even point200 M 80%31.33 M 104% Margin of safety 50 M 20% M 4% Unless Excelsior increase sales by 4% they will not Break Even and their capacity is only 36M units Income before Income tax is in fact a Loss of $2 M not a Profit

Increasing Production

Economies of Scale Break-even point (units) = Total Fixed costs$ 313 M = M units (200 M) Contribution per unit $ 1.50 Margin of Safety Forecast sales280100%250 M100% Break-even point %200 M 80% Margin of safety % 50 M 20%

Operational Leverage  We know what Financial Leverage is:  The extent to which the business is financed by:  Equity or  Debt  What is Operational Leverage ?

Operational Leverage  The extent to which the business operates with:  Fixed costs Or  Variable costs

High Fixed High Variable Sales units10,000 10,000 Sales (at £10 per unit)£100,000 £100,000 less Variable costs £ 50,000£ 70,000 Contribution£ 50,000£ 30,000 less Fixed costs£ 40,000£ 20,000 Net Profit£ 10,000£ 10,000 Who has the best Operational Leverage ?

The Best Operational Leverage  In order to assess this we need to consider the impact of:  An increase in sales/output (to say 12,000 units) and  A decrease in sales/output (to say 8,000 units)  Followed by the ability of the company to adjust their costs structure

An Increase in Sales/Output High Fixed High Variable Sales units10,000 12,00010,000 12,000 Sales (at £10 per unit)£100, ,000 £100,000 £120,000 less Variable costs (£5 & £7)£ 50,000 60,000£ 70,00084,000 Contribution£ 50,000 60,000£ 30,00036,000 less Fixed costs£ 40,000 40,000£ 20,00020,000 Net Profit£ 10,000 20,000£ 10,00016,000

A Reduction in Sales/Output High Fixed High Variable Sales units 10,000 8,00010,000 8,000 Sales (at £10 per unit)£100,000 80,000 £100,000 £ 80,000 less Variable costs (£5 & £7)£ 50,000 40,000£ 70,00056,000 Contribution£ 50,000 40,000£ 30,00024,000 less Fixed costs£ 40,000 40,000£ 20,00020,000 Net Profit£ 10,000 NIL£ 10,000 4,000

Assumptions  Costs can be defined as fixed or variable.  Fixed costs will remain constant.  Variable costs vary proportionally with output (linear relationship).  The only factor affecting costs and revenue is volume.  Technology and production methods remain unchanged.  Price stability.  The analysis relates to one particular product or a constant product mix.  No stock level changes.

In Practice  Managerial decisions can alter costs, e.g. they can replace a small labour team (variable cost) with an automatic machine (fixed cost).  Fixed costs do not remain fixed:  At a certain levels of output more factory space may be required. This can, however, be built into the break- even analysis, giving a stepped fixed cost line  If output is hit managers may take action to reduce fixed costs, e.g. by moving to cheaper locations (rent costs) or reducing management costs  At certain levels of production savings may be made, e.g. direct material; at low levels of production you may pay £10 per unit but at higher levels of production you may be able to get a discount for bulk buying.  Some costs are semi-variable, an element of fixed and variable.

Example Balance Sheet as at 31st Dec 20xx Non Current Assets Equity 130,000 Tangible Land130,000 Debt 54,500 Equipment20,000 Vehicles10,000 Fixtures5, ,000 Intangible Goodwill3,000 Research5,000 8,000 Current Assets Stock2,000 Debtors8,000 Bank1,000 Cash500 11, ,500

Sales Unit PriceEx Rate£ PriceVolumeIncome Product A$10.00$1.30 £ £ 115,385 Product B £ £ 60,000 Product C £ £ 54,000 TOTAL £ 229,385 Total Costs Direct Material Direct LabourOverhead Unit CostVolumeCosts Product A£3.00£1.00 £ £75,000 Product B£1.00 £2.00£ £48,000 Product C£2.00£1.00 £ £36,000 Total £159,000 Fixed Costs£20,000 TOTAL £179,000

Required  We could calculate the:  Contribution per Unit for each product  Contribution for each Product as the given output  Break Even Point & Margin of Safety  We can also used this information to perform:  Du-Pont Analysis and  Sensitivity Analysis

Du-Pont Analysis Net Profit Margin XTotal Asset Turnover =Return on Investment (ROI) XFinancial Leverage (Gearing) =Return on Equity (ROE) Net Profit Sales X Total Assets =Net Profit Total Assets X Equity =Net Profit Equity Have a go.

Sales229,385 less Variable Costs159,000Net Profit50,385 x 100 Contribution 70,385Sales229,385 less Fixed Costs 20,000 Net Profit 50, % Sales229,385 x 100 = % Total Assets184,500 Net Profit 50,385 x 100 = 27.31% Total Assets184,500 Total Assets184,500 x 100 = % Equity130,000 Net Profit 50,385 x 100 = 38.76% Equity130,000

Du-Pont Analysis Net Profit Margin XTotal Asset Turnover =Return on Investment (ROI) XFinancial Leverage (Gearing) =Return on Equity (ROE) Net Profit Sales X Total Assets =Net Profit Total Assets X Equity =Net Profit Equity 21.97%X124.33%=27.31%X141.92%=38.76%

The Use of Du-Pont  It assesses how the various individual financial measurements work together to produce an overall return to the firms shareholders, (ROE)  You will recall that the objective of the firm is to maximize shareholder wealth.  A useful technique for exploring performance shortfalls is to review the business’s financial return and to drill down through the components of this return to locate and assess the key determinants of performance.  Alternatively managers may wish to assess the impact of changes in selling price; costs or exchange rates

Sales Unit PriceEx Rate£ PriceVolumeIncome Product A$10.00$1.30 £ £ 115,385 Product B £ £ 60,000 Product C £ £ 54,000 TOTAL £ 229,385 Total Costs Direct Material Direct LabourOverhead Unit CostVolumeCosts Product A£3.00£1.00 £ £75,000 Product B£1.00 £2.00£ £48,000 Product C£2.00£1.00 £ £36,000 Total £159,000 Fixed Costs£20,000 TOTAL £179,000 Assess the impact of: $/£ exchange rate changing to $1.50£ An increase in labour costs to £2 (for all production)

Sales Unit PriceEx Rate£ PriceVolumeIncome Product A$10.00$1.50 £ £ 100,000 Product B £ £ 60,000 Product C £ £ 54,000 TOTAL £ 214,000 Total Costs Direct Material Direct LabourOverhead Unit CostVolumeCosts Product A£3.00£2.00£1.00£ £90,000 Product B£1.00£2.00 £ £60,000 Product C£2.00 £1.00£ £45,000 Total £195,000 Fixed Costs£20,000 TOTAL £215,000

Summary  Analysing Internal/Management Financial Statements provides additional information such as the cost structure (Operational Leverage - Fixed & Variable Costs)  These can be used to undertake both:  Break Even Analysis and  Du-Pont Analysis