Abstract
The report shows step by step on how to calculate revenue, costs and net profits. It also shows on how to prepare profit and loss statement showing clearly how costs are classified and how profits are arrived at. It further highlights how cash flows are generated and how they are used to determine the viability of projects looking at the NPV and IRR ways of determining the viability of the project. This report also gave the two methods of representing data (financial cash flows). It data through pie charts and bar graph. It further gives highlights on how to use excel financial formula in calculating and finding out values in large excel data.
Introduction
The financial statement is a statement that shows the financial position, performance and cash flows of an entity at a certain period. The most financial statement used is profit and loss account and balance. This report will deal with how to arrive on net profit and finally cash flows. It also highlights how to use cash flows in making decisions of capital budgeting in nature. It further highlights how data is represented in graphs and charts and how formulas are used in excel to calculate data.
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Profit and Loss Statement
The Profit and loss statement refers to a financial statement which shows how an entity is generating revenues and uses this revenue in meeting operating expenses and other costs involved in the trading of the business of the company. Profit and loss statement shows revenue and costs incurred to generate a net profit of a company in a specific period, usually, one year/fiscal period. This statement, furthermore, it shows how an organization is increasing net profits either by increasing sales revenue and maintenance costs or by reducing expenses/costs as sales revenue is maintained. It provides information on the ability or inability of the company to generate profits from their day to day trading activities. The following procedure prepares P&L statement: First, all revenues are listed for a certain period, in our case, it is shown in the profit and loss statement as Total Revenue (TR) at the close of each year from year 1 through to year 5. Secondly, all expenses and costs are itemized according to the cost of goods sold (COGS) and operating costs (expenses). In our case, Total Trading Cost is itemized as below as shown in the P&L Statement as Labour, material and overhead costs. This is calculated for each period from year one through year five as shown in the P&L Statement below. This forms our Total Cost (TC) shown in the P&L below. Thirdly, Total Cost (TC) is deducted from Total Revenue (TR) to get Profit before Depreciation, Interest, and Tax (PBDIT) and it is calculated for each period from year 1 to year 5 using the following equation/formulae
The fourth step is to deduct annual depreciation from PBDIT to get Profit before Tax (PBT). We ignore, the Interest because it is not provided in this case.
After getting PBT, then taxation is applied at the rate provided (20%). After deducting the taxation from the PBT, the result will be the Profit after Taxation (PAT) which forms our net income (Net Profit) for the year or period for the company.
Net profit/ Net income/Profit after Tax is the income after deducting all expenses and costs incurred by an entity from its total sales revenues. This provides information about the ability or inability of the firm generating revenues to pay the liabilities when they fall due. It shows whether an entity has made a loss or profit in the course of carrying its business.
In general Profit and loss statement is a significant statement in an organization, since, it gives an indicator of profitability and also shows the classification of costs and expenses that were incurred in generating the revenues. It is a timely report that shows the direction to which the entity is heading. It performs a company in a nutshell.
Net cash flows
Cash flow is referred to as the amount of money that is being generated or consumed by an organization in carrying their activities. Cash flows are used by the firm to conduct investment appraisals and determination of project viability by calculating their present value of cash flows expected to accrue in the future. There are different types of cash flows such as investing, operating and financing cash flows (Baker, 2011).
In the case above, to get cash flows, depreciation is added back, to the net income (profit after tax) to get the net cash flows for the period. Depreciation is then added since it is not an actual cash outlay but a method used by the firm to allocate the expense to calculate taxes. Depreciation expense is referred to as a notional expense and not a real expense. Since depreciation is a minor way of allocating cost to revenue to machines and assets used to generate the revenue, it is prudent to add it back to get the correct net cash flows. In the case above, we had an initial cost of the plant of which is used in in the calculation of cash flows and is indicated at year zero (meaning) as initial cash outflow. The financial analysis is integral in monitoring the financial status of the company and provides a framework for developing an evidence-based decision on the management of its assets. The outcome of the case suggests that the company has faced challenges in creating a profitable enterprise.
Net Present Value (NPV).
This is referred to as the difference between the present value of all cash inflows generated by an organization and the present value of cash outflows incurred during the accounting period (Baker, 2011).
This method discounts both inflows and outflows and ascertains the net present value by deducting discounted outflows from discounted inflows to obtain net present cash inflows. For example, the present value method will involve selection of rate acceptable to the management or equal to the cost of finance and this will be used to discount inflows and outflows. Similarly, the net present value will be equal to the present value of inflow minus the present value of outflow. When the net present value is positive, then it is advisable to invest. In contrast, it is wrong to invest in a negative NPV.
In the case presented above, the NPV is calculated at a discounting rate of 10%. We used in the excel formula to get the NPV stated as:
A company should only accept an investment venture if N.P.V. is positive. For instance, the present value of cash outflows may exceed that of cash inflows or be equal to zero. (NPV ≥0). It gives it the highest rank to that venture with the highest NPV as it has the highest cash inflow or capital gain to the company. In this case, the NPV is positive at £190,000/= hence the management is advised to invest in the projects since its NPV is positive.
Internal Rate Return (IRR)
This method is a discounted cash flow technique which uses the principle of NPV. It is defined as the rate which equates the present value of cash outflows of an investment to the initial capital.
or
It is also called the internal rate of return because it depends wholly on the outlay of investment and proceeds associated with the project and not a rate determined outside the venture.
Finding r, we used by trial and error method.
Acceptance Rule:
The IRR will only accept a venture if its IRR is higher than or equal to the minimum required rate of return. In most instances, this is usually the cost of finance. It is also known as the cut off rate or hurdle rate. In this case, the IRR will be the highest rate of interest a firm would be ready and able to pay to finance a project using borrowed funds. Furthermore, it should ensure that it is not financially worse off by paying back the principal and accrued interest from the returns of that project. Thus, IRR is the breakeven rate of borrowing from commercial banks.
In the case above we used the Excel formula to calculate the value of IRR as shown below;
Where A is the discounting rate where NPV is positive and B the guessed rate
Where NPV is negative at the speculated rate.
N is negative NPV and P is positive NPV.
Since the IRR is higher than the cost of capital, the project is viable to invest in.
Presentation of Cash flows for the Five Years
The bar graphs used in this gives a visual representation of the data (cash flows). It is easier to identify the highest cash flows easily. From the graph, at zero years it shows the negative cash in-flow invested in the plant, i.e. Plant Cost (£1,000,000. This is the cost of the machine which is expected to generate the cash flows as indicated on the graph. From the bar graph, Year one the machine generated the highest Cash flows comparing all the years while year four it generated the lowest cash flows.
A pie chart is used to give a visual presentation of data in the diagrammatical form. It gives a clear representation of data. Pie charts can be used to give a physical representation of data. It is easy to interpret data when using Pie charts. From the Pie Chart above we can quickly identify that Year zero occupied the most significant portion of cash flows while year 4 registered the lowest portion/share of the pie chart.
Conclusion
The profit and loss statement shows clearly how the revenues generated are used to finance operating expenses to generate income. It also clearly shows how costs are classified, and finally, it gives us the net profit generated at the end of the period. Cash flows are generated when depreciation is added back to profits since they are not real expenses but notional expenses. Cash flows are used to determine the viability of the plant or project. Bar graphs and Pie charts are some of the methods of presenting data in visual diagrammatic format. They are easy to draw and gives the whole performance of the entity at a glance. Excel formulae are used to calculate some of the information easily such as IRR and NPV. The report has demonstrated the importance of profit and loss statements in enabling an organization to measure its financial performance. In particular, it is evident that accounting plays a fundamental role in shaping the decision-making process of managers in for-profit enterprises.
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References
Baker, H. K. (2011). Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. Hoboken: John Wiley & Sons
Kanjilal, J., & Khule, B. (2007). ASP.NET data presentation controls essentials: Master the standard ASP.NET server controls for displaying and managing data. Birmingham, U.K: Packt Pub.