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Business Accounting: The case of Wonderland Home PLC
Table of Content
1 Introduction .......................................................................................................................... 3
2 Task 1: Calculate the net present value and internal rate of return ...................................... 3
3 Task 2: Break even and profit-loss analysis ........................................................................ 5
3.1 Break-even point ........................................................................................................... 5
3.2 New Break-Even Point when the prices changed ......................................................... 8
4 Task 3: Key indicators of the company's performance ...................................................... 11
4.1 Financial sustainability ............................................................................................... 11
4.2 Liquidity analysis ....................................................................................................... 12
4.3 Profitability ratios ....................................................................................................... 12
4.4 Calculation .................................................................................................................. 13
5 Task 4: Discussion ............................................................................................................. 14
5.1 Performance analysis .................................................................................................. 14
5.2 Break even analysis .................................................................................................... 19
5.3 Project appraisal ......................................................................................................... 20
6 Conclusion ......................................................................................................................... 21
References ................................................................................................................................ 22
1 Introduction
Business accounting is considered as one of essential process of information for various
purposes including: provide records of assets owned, amount owed to others and monies
invested; provide report to show financial position and the profitability of one company’s
operation; help management actually manages their firm; provide ways to measure firm’s
effectiveness; help stakeholder in monitoring their firm activities and performances; and enable
potential investor or funder in evaluating the firm and making decision.
This report takes Wonderland Home PLC, a small but fast growing firm in the furniture
industry as the case study. Throughout the report, the firm’s business and investment activities
are considered through several accounting techniques such as appraisal evaluation techniques,
break even analysis and ratio analysis.
2 Task 1: Calculate the net present value and internal rate of return
In order to calculate the net present value and internal rate of return, on the basic of
information provided, the cash flow of each project is indicated as following:
Project 1: Schedule of Cash Flows Discounted at 9%
Year Outflows Inflows Net Cash Flow
Discounted Cash
Flow
0 £4,000,000
-£4,000,000 -£4,000,000
1
£700,000 £700,000 £642,202
2
£756,000 £756,000 £636,310
3
£816,480 £816,480 £630,472
4
£881,798 £881,798 £624,688
5
£952,342 £952,342 £618,957
6
£948,530 £948,530 £565,577
Totals: £4,000,000 £5,055,150 £1,055,150 -£281,793
Note: The project cost in year 6 is £80,000
Project 2: Schedule of Cash Flows Discounted at 9%
Year Outflows Inflows Net Cash Flow
Discounted Cash
Flow
0 £4,200,000 -£4,200,000 -£4,200,000
1 £1,500,000 £1,500,000 £1,376,147
2 £800,000 £800,000 £673,344
3 £800,000 £800,000 £617,747
4 £700,000 £700,000 £495,898
5 £650,000 £650,000 £422,455
Totals: £4,200,000 £4,450,000 £250,000 -£614,409
Net present values (NPV) is defined as the differences between the present value (PV) of all
future cash flows producing through rental properties and the amount of cash investments (or,
initial investments; down payments and closing cost) required in property purchasing. Internal
rate of return (IRR) is defined as the discount rate generally used in capital budgets, which make
the NPV of all cash flows from a particular project equal to zero.
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed.
Therefore NPV is the sum of all terms,
0
( , )(1 )
Nt
tt
RNPV i N
i
Of which, t is the time of each cash flows; i is the discount rate of return or the opportunity
cost of capital; and Rt is the net cash flows whether in or out at indicated time t.
With the company cost of capital is 9% and the cash flow shown in Table above, following
Eqs mentioned, NPV and IRR for both projects calculated:
Project 1 Project 2
NPV -£281,793 -£614,409
IRR 6.73% 2.27%
3 Task 2: Break even and profit-loss analysis
3.1 Break-even point
The formula used to calculate the number of units for breakeven:
Total fixed costsNumber of units
(unit selling price - variable unit cost)
The formula used to calculate the value in dollars for breakeven:
Total fixed costsDollar value
1- (total variable costs/total sales)
Price Fixed costs Material costs Labour Variable costs
Home furniture £1,200 £600,000 £290 £180 £130
Office furniture £800 £600,000 £290 £180 £130
Break-even point Profit -loss at 1,200 units
In units Sales value Total Revenue Total Variable Costs Profit
Home furniture 1,000 £1,200,000 £1,440,000 £720,000 £120,000
Office furniture 3,000 £2,400,000 £960,000 £720,000 (£360,000)
Home furniture:
Profit by Units Sold
Units Fixed Cost Total Cost Total Revenue Profit
0 £600,000 £600,000 £0 -£600,000
100 £600,000 £660,000 £120,000 -£540,000
200 £600,000 £720,000 £240,000 -£480,000
300 £600,000 £780,000 £360,000 -£420,000
400 £600,000 £840,000 £480,000 -£360,000
500 £600,000 £900,000 £600,000 -£300,000
600 £600,000 £960,000 £720,000 -£240,000
700 £600,000 £1,020,000 £840,000 -£180,000
800 £600,000 £1,080,000 £960,000 -£120,000
900 £600,000 £1,140,000 £1,080,000 -£60,000
1000 £600,000 £1,200,000 £1,200,000 £0
1100 £600,000 £1,260,000 £1,320,000 £60,000
1200 £600,000 £1,320,000 £1,440,000 £120,000
Office furniture
Profit by Units Sold
Units Fixed Cost Total Cost Total Revenue Profit
0 £600,000 £600,000 £0 -£600,000
100 £600,000 £660,000 £80,000 -£580,000
200 £600,000 £720,000 £160,000 -£560,000
300 £600,000 £780,000 £240,000 -£540,000
400 £600,000 £840,000 £320,000 -£520,000
500 £600,000 £900,000 £400,000 -£500,000
600 £600,000 £960,000 £480,000 -£480,000
700 £600,000 £1,020,000 £560,000 -£460,000
800 £600,000 £1,080,000 £640,000 -£440,000
900 £600,000 £1,140,000 £720,000 -£420,000
1000 £600,000 £1,200,000 £800,000 -£400,000
1100 £600,000 £1,260,000 £880,000 -£380,000
1200 £600,000 £1,320,000 £960,000 -£360,000
3.2 New Break-Even Point when the prices changed
Price Fixed costs Material costs Labour Variable costs
Home furniture £1,040 £600,000 £290 £180 £130
Office furniture £640 £600,000 £290 £180 £130
Break-even point Profit -loss at 1,200 units
In units Sales value Total Revenue Total Variable Costs Profit
Home furniture 1,364 £1,417,520 £1,248,000 £720,000 -£72,000
Office furniture 15,000 £9,600,000 £768,000 £720,000 -£552,000
Home furniture
Profit by Units Sold
Units Fixed Cost Total Cost Total Revenue Profit
0 £600,000 £600,000 £0 -£600,000
100 £600,000 £660,000 £104,000 -£556,000
200 £600,000 £720,000 £208,000 -£512,000
300 £600,000 £780,000 £312,000 -£468,000
400 £600,000 £840,000 £416,000 -£424,000
500 £600,000 £900,000 £520,000 -£380,000
600 £600,000 £960,000 £624,000 -£336,000
700 £600,000 £1,020,000 £728,000 -£292,000
800 £600,000 £1,080,000 £832,000 -£248,000
900 £600,000 £1,140,000 £936,000 -£204,000
1000 £600,000 £1,200,000 £1,040,000 -£160,000
1100 £600,000 £1,260,000 £1,144,000 -£116,000
1200 £600,000 £1,320,000 £1,248,000 -£72,000
Office furniture
Profit by Units Sold
Units Fixed Cost Total Cost Total Revenue Profit
0 £600,000 £600,000 £0 -£600,000
100 £600,000 £660,000 £64,000 -£596,000
200 £600,000 £720,000 £128,000 -£592,000
300 £600,000 £780,000 £192,000 -£588,000
400 £600,000 £840,000 £256,000 -£584,000
500 £600,000 £900,000 £320,000 -£580,000
600 £600,000 £960,000 £384,000 -£576,000
700 £600,000 £1,020,000 £448,000 -£572,000
800 £600,000 £1,080,000 £512,000 -£568,000
900 £600,000 £1,140,000 £576,000 -£564,000
1000 £600,000 £1,200,000 £640,000 -£560,000
1100 £600,000 £1,260,000 £704,000 -£556,000
1200 £600,000 £1,320,000 £768,000 -£552,000
4 Task 3: Key indicators of the company's performance
4.1 Financial sustainability
Debt-to-equity ratio (financial leverage):
Total liabilities/
Total equityD E
Debt ratio (debt to assets ratio)
Total liabilities/
Total assetsD A
Long-term debt to Equity
Non-current liabilities/
Total equity LD E
Capitalization ratio
Non-current assets
Total equity+Non-current liabilities CR
Fixed assets to equity
Non-current assets/
Total equity FA E
Current liability ratio
Non-current liabilities
Total liabilities CLR
4.2 Liquidity analysis
Current ratio (working capital ratio)
Current assets /
Current liabilities A L
Quick ratio (acid-test ratio)
Current assets - Inventories - Accounts Receivable
Current liabilities QR
4.3 Profitability ratios
Gross profit margin ratio
Gross profit
Revenue GPR
Operating profit margin ratio
Operating profit
Revenue OPR
4.4 Calculation
Input data:
Income Statement
For the year ended 31 December 2012
31/12/2012 31/12/2011
£'000 £'000
Revenue 322,917 304,818
Gross Profit 184,642 164,208
Operating Profit 44,677 36,853
Balance Sheet
as at December 2012
31/12/2012 31/12/11
£'000 £'000
Non- Current Assts 90,297 70,986
Intangible Assets 8,000 8,000
Property and Equipment 82,297 62,986
Current Assets 55,817 42,616
Inventories 31,453 27,268
Trade Receivables 24,364 6,783
Cash at bank and in hand - 8,565
Total Assets 146,114 113,602
Current Liabilities 83,504 65,239
Non- Current Liabilities 5,001 2,785
Capital and Reserves 57,609 45,578
Output data:
31/12/2012 31/12/11
D/E 1.54 1.94
D/A 0.61 0.78
LD/E 0.09 0.06
CR 1.44 1.47
FA/E 1.57 1.56
CLR 0.06 0.03
A/L 0.67 0.65
QR 0.29 0.13
GPR 0.57 0.54
OPR 0.14 0.12
5 Task 4: Discussion
5.1 Performance analysis
Financial stability:
The dynamics of the main ratios of financial stability of Wonderland Home is shown as
following:
Firstly, attention should be drawn to the debt-to-equity ratio and debt ratio, which have
similar meanings and indicators of describing the capital structure. At first glance, the debt ratio
of Wonderland Home is less than 1, which would indicates that the company has more assets
comparing to debts. Inconsideration of debt-to-equity ratios, for the fiscal year ended 31
December 2012, this ratio is 1.54, which is 1.94 for the fiscal year ended 31 December 2011
comparing to the industrial average value of 1.33. The high debt/equity ratio of Wonderland
Home would mean that the firm has been aggressive in financing its growths with debts.
However, the firms’ ratio has the significant decrease of more than 20 percent within a year. The
current situation of the firm is possibly resulted through volatile earnings as results of the
additional interest expenses.
Moreover, the long-term debt to equity ratio is calculated in this case to express the
relationships between long-term capital contributions of creditor as related to that contributed by
owner or investor. It is considered as oppose to the debt-to-equity because of its expression to the
protection level providing through the owner for the long-term creditor. Since the higher the
ratio, the greater the company’s leverage, the significantly low ratios of 0.09 (2012) and 0.06
(2011) of Wonderland Home shows the low level of business risks, which in turns present the
high capability of the firm in meeting principles and interests on its obligation.
In terms of fixed assets to equity, the ratio is more than 1, in particular of 1.57 for year 2012
and 1.56 for year 2011, which would mean that stockholders’ equity is less than the fixed assets.
In order word, the firm is financed by its debts rather than its fixed assets. With this high ratio,
Wonderland Home should understand that they at least have valuable fixed assets that they can
turn into cash if needed. Besides, the current liability ratios (6% in 2012 and 3% in 2011) show
that the amount of long-term debts of Wonderland Home is significantly higher comparing to the
amount of short-term debts, (94% and 97% respectively of total liabilities). In general, liability
with short maturity is less preferred than long-term liability in regards to financial stability. Thus,
the firm is considered as relatively stable in borrowing capital.
To sum up, although the firm financed its growth by its debts rather than its equity, the
financial status of the firm is considered as relatively stable because of its high level in
borrowing capital and meeting the financial obligations.
Liquidity analysis
The dynamics of the main ratios of liquidity of Wonderland Home is shown as following:
Although the current ratio is relatively simple, it is considered as an effective tool using to
have an accurate image of one firm’s liquidity status. In general, a firm which has a high ratio of
asset to liability is in a good financial condition. In the case of Wonderland Home, these ratios
are less than 1, which would suggest a pressed liquidity problem, particularly an inability in
generating sufficient cash in order to meet upcoming demand. Specifically, when the current
ratio is relatively constant (equalled 0.67 and 0.65 for yearend 2012 and 2011, respectively).
Comparing to that of industry (1.61), this would mean that the firm possibly anticipates problem
in being capable to honour short-term debts, which would have been acquired in purpose of
enhancing some portions of the producing or replacing equipments. In addition to the relatively
constant current ratio, these figures signal troubles ahead of Wonderland Home, because this
would present that the firm is amassing asset at the expenses of receivable and cash.
In terms of quick ratio, it is an indicator of a company's short-term liquidity. Since the higher
the ratio, the better the firm’s position, with these ratios increased from 0.13 in 2011 to 0.29 in
2012, Wonderland Home has significantly gaining better position in terms of its capability in
meeting its short-term obligation through its most liquid asset. However, comparing to the
average value of furniture industry of 0.38, these values may indicate that Wonderland Home
relies too much on inventories or other asset in paying its short-term liability.
To sum up, in consideration of liquidity ratios, there are signs to show the instability of
Wonderland, obviously, more financial indicators are required in order to see clearly this
problem.
Profitability ratios
A ratio of profitability measures how much out of every dollar of sales a company actually
keeps in earnings. The dynamics of the main ratios of profitability of Wonderland Home is
shown as following:
The gross profit margin ratio is used as one indicator of a business's financial health. It shows
how efficiently a business is using its materials and labours in the production process and gives
an indication of the pricing, cost structure, and production efficiency of the business. Since the
higher the gross profit margin ratio the better, the slightly higher the percentage, the little more
the business of Wonderland Home retains of each dollar of sales, which means more money is
left over for other operating expenses and net profit. However, comparing to that of industry of
0.92, these values are much lower (0.57 and 0.54 respectively for 2012 and 2011), which may
means that the business generates a low level of revenue to pay for operating expenses and net
profit. It indicates that either the business is unable to control production or inventory costs or
that price are set too low. Operating profit margin is used to measure a company's pricing
strategy and operating efficiency. A relatively low operating profit margin and slightly growth
over the period analyzed of Wonderland Home (0.14 in 2012 and 0.12 in 2011) may indicate that
has not very good cost control and/or that sales are not much increasing as fast as costs.\
To sum up, the profitability ratios of Wonderland Home indicates that the firm is not very
effective and efficient in generating profits as well as in operating.
5.2 Break even analysis
The breakeven points are the points at which incomes and expense are exactly equal whether
in unit or in sales volume. This analysis is considered as significantly important for any business
owners, since they will be aware about the exact moment once their business generated profits.
These points indicate the lowest limitation on determination of profit margins. For example, in
the case of Wonderland, with its specific fixed costs of £600,000 and total variable costs of £600,
it should sell at least 1,000 units of home furniture at the price of £1,200 or £1,200,000 in sales
value in order to generate profits. While, these values are 3,000 units and £2,400,000 in sales
value for office furniture at the price of £800.
What if the sales volume changed?
This may happen when the company is in a recession and the sales might drop. Thus, the firm
is not able to sale enough units or sales value to make the breakeven point. In the example of the
Wonderland Home, the firm might sell only 1,200 units rather than the 3,000 units’ necessary to
breakeven its business of producing office furniture causing the loss of £360,000. There are two
solutions advised. First option is to raise price of products that was only £800. For example, the
home furniture at the price of £1,200 still generates £120,000 at the similar number of products
sold. Second option is to find the new way to cut the costs whether fixed costs or variable costs
or both.
What if the sales price per unit had changed?
In this case, all the cost lines would remain the same only the total revenue line would be
affected, which would in turn affect the breakeven point. For the case of Wonderland, following
with the fall by £160 of the sales price per unit, the firm would earn fewer contributions per
furniture sold, and therefore has to sell more products in order to cover its fixed costs. In order
word, the breakeven points would have risen, particularly, for home furniture, from 1,000 units
to 1,364 units or £1,200,000 to £1,417,520; and for office furniture, from 3,000 units to 15,000
units or £2,400,000 to £9,600,000. And both cases present the losses (£72,000 and £552,000,
respectively) if the firm only sales 1,200 products.
5.3 Project appraisal
NPV decision rule indicates that the firm should accept the project only if the calculated NPV
is positive or zero. Alternatively, firm is advised to reject the project that has negative NPV. In
the case of comparison between two or more exclusive projects having positive NPVs, accept the
one with highest NPV. IRR decision rule indicates that the higher the value the greater the
amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. In
the case of comparison between two or more exclusive projects with equivalent degrees of risks,
accept the once with the highest IRR.
As the advice for Wonderland Home, it should not accept the both two proposed projects
since they both have the negative NPVs of -£281,793 and -£614,409, respectively. In case, there
is a must of selecting one of them, the first project is preferable with the higher value of IRR.
6 Conclusion
The business activity, project investment and financial stability of Wonderland Home PLC
have been reviewed in this report through several research methodology including appraisal
evaluation techniques, breakeven analysis and ratio analysis.
This document is provided by:
VU Thuy Dung (Ms.)
Manager
Center for Online Writing Resources
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References
Geddes, R. (2002). Valuation and investment appraisal. Lessons Professional Pub
Stermole, M.J. (2009). Economic Evaluation and Investment Decision Methods. Investment
Evaluations Corporation
Cafferky, M., & Wentworth, J. (2010). Break Even Analysis. Business Expert Press
Scott, W. R. (2000). Financial accounting theory. Prentice Hall Canada
Horngren, C. T., Sundem, G. L., Elliott, J. A., & Philbrick, D. R. (2002). Introduction to
financial accounting. Prentice Hall.
