Executive Summary
By theoretical and statistical analysis, this report delved in Oktra limited financial information with the goal of evaluating two of its aspect. First, analysing its sources of finance. Second, calculating ten of its financial ratios. Further, the report aimed to discuss three investment appraisal techniques, and two business valuation methods. Additionally, the report aimed to discuss the impact of ethics on SMEs decision making. Focusing on the company’s financial statement, books and academic journals, the findings showed that Oktra uses retained earnings and equity as its sources of finance.
Moreover, all its ten computed financial ratios improved in 2018 from those of 2017. In addition, the findings indicated that NPV, IRR and Payback method can be used in investment appraisal but all have their strengths and limitations. Likewise dividend growth method and DCF were noted to be business valuation models with each method having its strengths and limitations. Lastly, ethics were noted to influence decision making of SMEs managers strive to engage in business undertakings as per their company’s ethics.
1. Introduction
2. SMEs Sources of Finance
Amissah and Gbandi (2014) postulate that like individuals, SMEs put a side some portion of their profits to finance their future operations. This amount of profit retained by the company that is not paid as dividend to stakeholders is referred to as retained earnings. Some advantages of this source of finance include, cheaper source of capital, strengthening financial stability of a company, and stable dividends. However, there are some limitations associated with this source such as that when it is not implicitly stated how retained earnings will be spent, it may result to inappropriate utilization of funds (Zidana, 2015).
Additionally, Brealey et al., (2015) put forth that SMEs can raise funds through equity financing, that is, by selling their shares to willing investors. Like retained earnings, this method provide cheaper cost of capital since a company have no loans to repay. Moreover, investors may come up with valuable ideas that may help he company grow, and they are always available to fund the company further if it continues to generate profits. Nonetheless, this method is time consuming and may lead to loss of control of a firm if investors acquire a majority stake.
Further, SMEs may raise funds through debt financing which entails borrowing money in forms of overdrafts and bank loans and repaying the loan with interest (Zidana, 2015). This method of financing has merits such as it allows maintains a company’s ownership as it was before financing unlike equity financing which leads to dilution of ownership. Furthermore, a company only pays loan interest and does not have to share its profits. However, banks are often reluctant to finance new SMEs. And failure to repay the loan in time may lead to poor credit rating.
2.1 A critical discussion of Oktra sources of finance
According to Oktra limited (2018) the company’s profit and loss reserves increased by £2.02 million from 2017 amounting to £4.77 million in 2018, meaning that the company is more dependent on internal financing sources (Retained earnings). Consequently, the company enjoys reduced cost of capital which would not be experienced if the firm was mostly dependent on external sources (Brealey et al., 2014). However, Chiaramonte and Casu (2017) contend that relying on retained earnings as a source of finance may lead to liquidity distress because a lot of cash is used to finance projects which may leave small businesses with inadequate funds for day to day operations.
Furthermore, Oktra is financing its operations using equity financing and has recorded an increase of total equity to £5.91 in 2018 from £3.89 in 2017. This improvement will reduce the company’s cost of capital as the company have no loan to repay, and unlike debt financing from financial institutions, it does not need collateral. Nonetheless, equity financing has some limitations such as the company does not enjoy tax benefit like the ones enjoyed in debt financing. More so, despite having no loans to pay, the price paid through equity financing is dilution of ownership which may cause conflicts due to shared ownership fostering different management styles and vision of the company (Atril and Mclaney, 2015).
3. A critical analysis of Oktra performance
3.1 Profitability Ratios
Laitinen (2017) explicates that these ratios are used to evaluate a firm’s ability to earn profits relative to its resources.
According to figure 1 below, as a result of improvement in sales efficiency, the company’s gross margin (gross profit ÷ sales revenue ×100%) increased to 29.67% in 2018, from 28.81 % in 2017.
Similarly, operating profit margin (operating profit ÷ revenue × 100%) increased to 8.12 % in 2018 from 6.07 % in 2017. Further, the net profit margin (net profit ÷ revenue × 100%) improved to 6.51 % in 2018 from 4.79 % in 2017. According to Okra Limited (2018) the increase in revenue in 2018 is because of improved customer satisfaction and market reputation.
Figure 1: Profitability Ratios
Source: Author Based on Oktra Limited (2018)
3.2 Liquidity Ratios
Nahu (2014) elucidates that these ratios evaluate a company’s ability to settle current debts without relying on external capital. Figure 1 below shows that the current ratio, that is, current assets ÷ current liabilities, increased to 1.37 in 2018 from 1.28 in 2017. Further, the quick ratio, that is, [(current assets – inventory) ÷ current liabilities] increased to 1.35 in 2018 from 1.25 in 2017, while the cash ratio also increased in 2018. This increase in liquidity is due to increase in current assets such as cash, stock and cash equivalent which according to Beltratti and Paladino (2015), means that the company can meet its current liabilities.
Figure 2: Liquidity Ratios
Source: Author based on Oktra Limited (2018
3.3 Efficiency Ratios
Nuhu (2014) postulates that the ratios evaluate a firm’s ability to utilise its assets and ability to effectively manage its liabilities in the short-term. Table 1 below shows that inventory turnover, that is, cost of goods sold ÷ inventory, increased to 140.2 in 2018 from 103.11 in 2017, implying that there was higher demand for the company’s products in 2018. But according to Oktra Limited (2018), asset turnover, that is, revenue ÷ assets, decreased to 3.13 in 2018 from 3.38 in 2017 as a result of improvement in total assets.
Table 1: Efficiency Ratios
| Efficiency turnover | 2017 | 2018 |
| Inventory turnover | 103.11 | 140.20 |
| Asset turnover | 3.38 | 3.13 |
Source: Author based on Oktra Limited (2018)
3.4 Gearing Ratios
These ratios assess how much a company’s activities are financed by equity capital as compare to debt (Situm, 2014). According to table 2 below, debt to equity ratio ((total liabilities ÷ total equity) decreased to 2.96 % in 2018, from 3.37 % in 2017. Consequently, the reducing debt is attributed to the fact that the company does not have long term debt, whereas the capital improved due to recalled share capital.
Table 2: Gearing Ratios
| Gearing Ratios | 2017 | 2018 |
| debt to equity ratio | 3.37 | 2.96 |
| debt to asset ratio | 77.09% | 74.74% |
Source: Author based on Oktra Limited (2018)
In sum, the company’s profitability, liquidity and efficiency improved in 2018, but due to lack of long-term debt, its gearing ratios declined.
4. Investment appraisal techniques
The process of assessing investments alternatives requires a lot of thought and analysis so that a company can select the most suitable project based on its needs and resources available, as such three appraisal techniques used to determine suitability of a project are discussed below.
4.1 Net Present Value (NPV)
Zizlavska (2014) explains that this is the difference between present value of cash inflows and outflows over a certain period. This technique posit that only investments with positive NPV should be undertaken since they will be profitable while those with negative NPV should be forsaken as a company would suffer loss. Based on calculations in appendix 2, the project is viable since its NPV is 16430.
According to Atril and Mclaney (2015) this technique considers the concept of time value of money, and due to using discounted rates in evaluating it, it factors in the risk associated with undertaking a project. However, the method requires guessing a company’s cost of capital, it is not appropriate when making comparison of projects that are of different size, and does not factor in any hidden costs as it is only concerned with cash inflows and outflows.
4.2 Internal Rate of Return (IRR)
El-Otaibi and El-Tahir (2014) point out that this method evaluates the rate of return (often in %) of predicted cash flows produced by a company’s capital investment. According to computation in appendix 2, the project’s 1RR is 18.38%, which is higher than the cost of capital (13%), meaning that the company can earn a profit.
Some advantages of this method are that it is simple to use and understand and takes into account the time value of money. However, the method has some shortcomings such as the impractical assumption rate of reinvestment, and it ignores the size of the projects and future costs (Brealey et al., 2014).
4.3 Payback Period
Azar (2014) puts forth that this method assesses the time taken to recover investment cost. It would take 3.58 years to recover the project’s investment cost based on the calculations in appendix 2. Of all the most used investment appraisal methods, this is the easiest to calculate, understand and interpret. Further, the method is most suitable for SMEs with limited resources as it prefers projects with shorter payback duration which are less risky and which would aid these firms to recover their investments quickly. Nonetheless, the method does not factor the time value of money and ignores profitability since shorter payback period does not necessarily means that project will be profitable. Moreover, it ignores cash flows that could be lucrative in later years after the payback period (Al-Ani, 2015).
5. Business valuation techniques
5.1 Dividend Growth Model
Ana and Sasa (2015) point that this the most used technique used by investors to value the stock of a firm issuing dividends.
The formula used to calculate value using this model is shown below:
Where:
P= Value of the Company
D1= Current dividend/ share
g = Expected dividend growth rate
K = required rate of return
D1 = current dividends times (1 + dividend growth rate)
As Bancel and Mitto (2014) hold, the method is useful to value firms with stable dividend but not for those with fluctuating dividends. Furthermore, the model is simple as it requires few information as shown above. The model is used in valuation of a certain stock without factoring in market conditions effects, and does not take into account intangible assets, for example, brand name, which if were factored in would increase stock value.
5.2 Discounted Cash Flow Model (DCF)
This technique values an investment based on expected future cash flows. This method seek to assess an investment value at the present time, based on predictions of how much profit it will produce in future. Its formula is depicted below:
Where:
CF= the cash flow
i = the discounting factor
n = period from period 1 to t
TV= the total value.
Laitinen (2019) asserts that one of the major advantage of this method is that it simplifies an investment into one figure, and a positive net present value signifies that that an investment is profitable, while a negative means that losses will be suffered. Additionally, DCF aids in comparing different projects and if only one is to be undertaken, investment with highest net present value is to be undertaken. However, the method has some limitations such as relying on assumptions such as estimating future cash flows which is dependent on several factors such as demand and rate of economy growth. Consequently, if cash flows are estimated very high, it would make one to choose lose making investments, while if they are estimated very low, it would make an investment seem expensive in theory leading to lose of profitable investment.
6. Ethics and its potential impact on SMEs’ decision making
Few, if any, SMEs managers will not appreciate importance of good relations with customers, employees, suppliers and other stakeholders because the success of any business, whether large or small, relies on its relations with all its stakeholders (Hasnah et al., 2015). In addition, SMEs managers also notices how vital business ethics are especially when their business partners behaves unethically, for example, when suppliers intentionally fails to meet agreed upon terms and conditions, thereby affecting their companies’ operations. Additionally, the need to promote trust among stakeholders with increased pressure from the society at large, should make SMEs managers to evaluate the extent to which its ethical values directs its behaviour by impacting its decision making.
Branko et al. (2014) adds that for most SMEs, ethical values are often not stated explicitly like in large firms, but are influenced by managers/ owners whose behaviours signifies to employees what ethical behaviours are to be tolerated in the firm and are thus not formal. Nonetheless, ethical policies that are formal that is, those that are explicitly stated, have advantages in that firstly, they buttress and explicitly state what values are part of a firm’s culture. In this regard, a company that has explicitly stated not to tolerate corruption will not engage in any dealing that it deems corrupt and thus against their business ethics. Relatedly, firms that put more emphasis on high quality products will strive to always produce products that meet their standards. For example, explicitly stated ethical behaviour of Oktra Ltd stated in the company’s mission statement, impacts its decision making as it ensures that the company provide high quality products to their clients. Secondly, they offer a set of guidance on how employees are to undertake their roles and thus provides a framework for them to decide the right thing to do, which in turn improves employees morale.
7. Reflection and application
7.1 Financial accounting
Before this module, I did not fully grasp what business moguls such as Warren Buffet and others meant when they were talking of financial ratios. But this has changed after learning this course as I have come to understand and calculate different ratios like the ones discussed in this assignment. Further, I have realised that each class of financial ratios (profitability, liquidity, efficiency and gearing ratios) are used to achieve certain objectives. In addition, I have learnt how to analyse and interpret financial information included in companies financial statements.
In plain terms, financial accounting entails communication of a firm or any other organisation information to help concerned parties evaluate its financial position. Against this backdrop, the knowledge I have gained in this module will help me to analyse information of which of the company that I would like to work for has the probability to experience more success in the future. Moreover, whether a company is a giant such as Barclays bank or a small store with one employee, I can assess which business has potential to be successful in the future and thus suitable to invest in. Consequently, the skills gained from this module make me feel prepared for career opportunities such as financial analyst, financial manager, personal financial advisor and so on.
Nonetheless, this module is very technical and demands clear understanding of objectives. As such, in the start of the subject I experienced difficulties in understanding the ratios and knowing where I can use them in practice.
7.2 Managerial accounting
In the beginning of this module, I did not quite understand the difference between financial accounting and managerial accounting. However, by the end of the course, I had learnt that the most important distinction between the two is that while financial accounting is most useful and prepared for use by external parties, managerial accounting is used to provide information for internal parties, that is, company’s management. Consequently, I have learnt that managerial accountants produce more comprehensive information than financial accountants since apart from calculating ratios, for example, they include other information in their statements such as competitor analysis, constraint analysis and trend analysis. Using this information, they can help a company’s management in planning, controlling, problem-solving, and in other decision making processes.
Managerial accounting, for example daily, weekly or monthly budgeting are vital tools used by companies and other organisations, and having gained this knowledge from this course, I can apply this skill in my personal and future career as a future managerial accountant. In addition, as a result of this module, I have learnt that as a managerial account, my task should be to present and interpret financial information to a company’s management in non-technical manner accompanied with suggestions so that they can understand them with ease.
7.3 Financial management
As a result of this module I have learnt that financial management is a fundamental concern of managers and business owners and it is paramount to assess potential consequences of any decision on cash flow, profits and the overall financial position of the company. In addition, I have learnt how vital it is to have a deeper insight of it since to start or run a successful enterprise or to manage other institutions, one must be well informed on strategic planning, directing, organising and controlling of an enterprise financial undertakings.
Furthermore, the skills gained in this course can be used in future career as a financial manager. This is because one gains skills such as calculating amount of capital required, investing in worthwhile investments, profits allocation, and financial control, that are necessary for a career as a financial manager. Relatedly, though it has a narrow focus it provides diverse career opportunities. As such there are other career opportunities both in public and private sectors such as investment banking, brokerage firms, entrepreneurship and financial and managerial accounting which after completion of the module, I feel more prepared for. Moreover, this course has made me understand more about financial management and am already applying some of the knowledge I have learnt to manage my personal finances.
8. Summary
The report has noted that Oktra funds its operations using retained earnings and equity finance. Further, its profitability ratios, liquidity ratios, efficiency ratios, and gearing ratios for 2018 improved from those of 2017. Furthermore, NPV, IRR and payback methods have been discussed, while dividend growth model and DCF have been noted as methods used value businesses. In addition, the report has discussed how ethics can impact SMEs decision making by making the firms to strive to achieve their goals to act ethically with undertakings with its stakeholders. Lastly some knowledge and skills gained in the course of financial accounting, managerial accounting, and financial management which are applicable in personal and future career have been discussed.
References
Al-Ani, M. (2015). ‘A Strategic Framework to Use Payback Period in Evaluating the Capital Budgeting in Energy and Oil and Gas Sectors in Oman.’ International Journal of Economics and Financial Issues, 5 (2): 469-475.
Amissah, G., and Gbandi E. (2014). ‘Financing options for small and medium enterprises (SMEs) in Nigeria, European Scientific Journal, 10(1), 324-340
Ana, M. and Sasa, P. (2015). ‘Towards and Effective Financial Management: Relevance of Dividend Discount Model in Stock Price Valuation.’ Economic Analysis Vol. 48, No. 1, 39-53)
Atrill, P., and McLaney, E. (2015). Accounting & Finance for Non-specialists. Harlow: Financial Times Prentice Hall. 9th Edition. eBook.
Azar, S. (2014). ‘The Discounted Payback in Investment Appraisal: A Case Study.’ International Journal of Business Administration 5(5) August 2014
Bancel F., and Mittoo, U. (2014). ‘The gap between theory and practice of firm valuation: Survey of European valuation experts.’ Journal of Applied Corporate Finance, 26 (4), 106-117
Beltratti, A. and Paladino, G. (2015). ‘Bank leverage and profitability: Evidence from a sample of international banks.’ Review of Financial Economics, 27, 46–57.
Branko, M., Drago, C. and Zoran, S., (2015). ‘Role of business ethics in management of human resources.’ Januar-mart 61(1), 85–96.
Brealey, R., Myers, S., and Allen, F. (2014). Principles of corporate finance (11th global edition). New York: McGraw-Hill.
Chiaramonte, L. and Casu, B. (2017). ‘Capital and liquidity ratios and financial distress. Evidence from the European banking industry.’ The British Accounting Review, 49(2), 138–161.
El-Otaibi, D. and El-Tahir, Y. (2014). ‘Internal Rate of Return: A suggested Alternative Formula and its Macro-economics Implications.’ Journal of American Science, 2014; 10 (11)
Hasnah, H., Ishak, I. and Sobei, O. (2015). ‘Ethics, corporate social responsibility and the use of advisory services provided by SME: Lessons learnt from Japan.’ Asian Academy of Management Journal 20(1), 71–100.
Kaptein, M. (2017). ‘The battle for business ethics: a struggle theory.’ Journal of Business Ethics, 144(2), 343-361.
Laitinen, E. (2017) ‘Profitability Ratios in the Early Stages of a Startup.’ The Journal of Entrepreneurial Finance, 19, 1-28.
Laitinen, E. (2019). ‘Discounted Cash Flow (DCF) as a Measure of Startup Financial Success.’ Theoretical Economics Letters, 9 (8):2997-3020
Nuhu, M (2014). ‘Role of Ratio Analysis in Business Decisions: A Case Study NBC Maiduguri Plant.’ Journal of Educational and Social Research, 4 (5): 105–118.
Situm, M. (2014). ‘The inability of gearing-ratio as predictor for early warning systems.’ Business Systems Research Journal, 5(2), 23–45.
Zidana, R. (2015). ‘Exploring Alternative Sources of Financing Small and Medium Enterprises (SMEs) in Malawi: Lessons from Elsewhere.’ SSRN Electronic Journal 3(2):455-460
Zizlavskya, O. (2014). ‘Net present value approach: method for economic assessment of innovation projects.’ Procedia – Social and Behavioral Sciences 156 506 – 512
Appendices
Appendix 1: Performance Ratios
| a) Profitability Ratios | ||
| 2017 | 2018 | |
| Gross profit | 16,552,680 | 21,740,765 |
| Revenue | 57,444,805 | 73,283,319 |
| Gross profit margin = gross profit/revenue | 28.81% | 29.67% |
| Operating profit | 3,488,138 | 5,950,662 |
| Revenue | 57444805 | 73283319 |
| Operating profit margin = operating profit/revenue | 6.07% | 8.12% |
| Net profit | 2,753,219 | 4,769,256 |
| Revenue | 57,444,805 | 73,283,319 |
| Net profit margin = net profit/revenue | 4.79% | 6.51% |
| b) Liquidity Ratios | ||
| Current assets | 16,380,770 | 22,853,238 |
| Current liabilities | 12,827,320 | 16,709,532 |
| Current ratio= current assets/current liabilities | 1.277022 | 1.3676767 |
| Current assets | 16,380,770 | 22,853,238 |
| Less Inventories | (396,604) | (367,635) |
| Liquid assets = current assets less inventories | 15,984,166 | 22,485,603 |
| Current liabilities | 12,827,320 | 16,709,532 |
| Quick ratio = liquid assets/current liabilities | 1.2461033 | 1.3456752 |
| Cash and cash equivalent | 4,446,050 | 6,724,776 |
| Current liabilities | 12827320 | 16709532 |
| Cash ratio = cash and cash equivalent/current liabilities | 0.3466079 | 0.4024515 |
| c) Efficiency Turnover | ||
| Cost of sales | 40,892,125 | 51,542,554 |
| Inventory | 396,604 | 367,635 |
| Inventory turnover = cost of sales/inventory | 103.10568 | 140.20035 |
| Sales | 57444805 | 73283319 |
| Total assets | 16990904 | 23,387,265 |
| Asset turnover = sales/total assets | 3.3809152 | 3.1334711 |
| d) Gearing Ratios | ||
| Total liabilities | 13098480 | 17478558 |
| Total equity | 3,892,424 | 5,908,707 |
| Debt to equity ratio = total liabilities/total equity | 3.37 | 2.96 |
| Total liabilities | 13098480 | 17478558 |
| Total assets | 16990904 | 23387265 |
| Debt to asset ratio = total liabilities/total assets | 77.09% | 74.74% |
Appendix 2: Appraisal methods
| Cost of Capital | 13% | ||
| period | Cash flow | Discounting factor | Present value |
| 0 | -100,000 | 1 | -100000 |
| 1 | 18,000 | 0.885 | 15930 |
| 2 | 24,000 | 0.783 | 18792 |
| 3 | 30,000 | 0.693 | 20790 |
| 4 | 48,000 | 0.613 | 29424 |
| 5 | 58,000 | 0.543 | 31494 |
| Net Present Value | 16430 | ||
| Internal Rate of Return | |||
| Discounting factor | 19% | ||
| period | Cash flow | Discounting factor | Present value |
| 0 | -100000 | 1 | -100000 |
| 1 | 18000 | 0.84 | 15120 |
| 2 | 24000 | 0.706 | 16944 |
| 3 | 30000 | 0.593 | 17790 |
| 4 | 48000 | 0.499 | 23952 |
| 5 | 58000 | 0.419 | 24302 |
| net present value | -1892 | ||
| ra = 13%, rb= 19%, Na = 16430, Nb = -1892 = 13% + [(16430/ (16430+1892)*(19%-13%)] = 18.38% | |||
| Payback period | |||
| period | Cash flow | cumulative cash flow | |
| 0 | -100000 | -100000 | |
| 1 | 18000 | -82000 | |
| 2 | 24000 | -58000 | |
| 3 | 30000 | -28000 | |
| 4 | 48000 | 20000 | |
| 5 | 58000 | 78000 | |