Analysis of Frank Smith Plumbing’s Financial Statement
Finance for Business
Introduction
Frank informs his family during dinner that his time to let go the plumbing business and consider employment elsewhere had come. He has done financial reasoning and seen he could not stay in business anymore. He needs a new truck and believes he cannot stay in business if he has to pay for a new truck. The following is an analysis of Frank’s financial options and the conclusion made based on the statistics.
Explain why limited leverage is good for business
Financial leverage is good for business as it assist a business acquire additional assets through use of debt. The more debt financing a company uses the better its financial leverage. This assist a business to increase the size or profitability and in Frank Smiths business, acquisition of a truck (asset) to generate more income. It is important to understand that financial leverage comes at a cost, the revenues generated might not cover the interest payments. Many factors can make interest rate higher than usual making payments difficult that is why it is important to limit leverage to reduce debt. Leverage ratio relates a company’s debt to its assets. Leverage ratio assists a company to measure its ability to meet its prospect requirements given the current debt financed by a company. Too much debt escalates a company leverage ratio while less debts reduces the ratio. When one has high leverage ratio it can result to the inability of meeting daily expenses and may lead a company to bankruptcy, hence, a limited leverage ratio advised. A limited leverage ratio means a company may seek loans or debt so as to finance its activities; hence, a lower or limited leverage ratio is advised. Leverage ratio =total debt/total equity.
Show the profitability of the project so that Stephanie can convince her father to purchase the truck by borrowing money.
According to Stephanie her father’s income is suitable to get a good loan from the bank at a good rate. Creditors rely on business financial condition for risk purposes and profitability of their investments. Using an income statement a bank can evaluate past income performances and observe if there is uncertainty of future cash flows. In Frank smiths financial statement we can observe that the company has enough cash to pay for expense and asset. For Stephanie to appropriately advise her father she needs to calculate the leverage and the profitability index of his business. In case the plumbing business indicates a low leverage ratio and a profitability index of above 1, then it is advisable for Frank to take a loan to continue operation of the business.
Profitability index is a ratio that identifies the relationship existing between the cost of an investment and the benefits of a proposed project. Profitability index = present value of future cash flows/ initial investment.
For Frank to purchase a new truck, the profitability index of above 1 is needed to undertake to invest in a new truck with the purpose of the business ability to make a profit in the long run.
According to the excel sheet attached the profit index is 1.1% and this ascertains the exact rate of return of the project. This means that the project can be accepted because a profitability index of 1 indicates break even and attractiveness of project. Stephanie can show Frank Smith how much money he can make after borrowing money. The profitability ratio is important and is determined if the Net Present Value is positive thus showing that the profitability index would be higher. A profitability index of 1 shows a profit from the investment while a profitability index below 1 means a loss incurred.
Assumed the profitability index for the calculation is above 1
Following the calculation of the profitability index from the investment of a new truck in the Frank Smith Plumbing, Stephanie would advise her father to take a bank loan and finance the purchase of the truck. A profitability index above one implies the investment in a new truck would result in increased profits and increased cash flow.
Explain how Stephanie should convince her mother that it is inappropriate to call the bank manager and his wife for assistance in getting the loan approval?
Stephanie should explain to her mother that when she calls the bank’s manager and wife to request for a bank loan, that shall lead bank manager to be bias with the implication the bank manager will authorize a loan without evaluating Frank Smith Plumbing finances. That action is unethical since if known the manager did not perform his full duties in evaluating Frank’s business an authorized the loan, the bank manager would lose his job and Frank Smith Plumbing may get sued. A lack of evaluation of the business loan would be discovered during the auditing of the banks books of accounting performed every year.
From this, Stephanie needs to explain the consequences to her mother, as well as tell her the correct procedure to follow when applying for a business loan.
Analyze whether the investment in the truck is profitable – My analysis is based on a profitable investment.
Based on the analysis results of the profitability index, Internal rate of return, Net present value, discounted payback period and payback period the investment is worth undertaking.
The profitability index is to be filled means that the investment is profitable. The internal rate of return is to be filled because the calculated internal rate of return is greater than the minimum required an internal rate of return it is advisable to invest in the acquisition of the new truck. Since the net present value is positive, it is desirable to undertake the investment.
The discounted payback period and payback period indicate the cost of the loan will be repayable before the truck ends its usefulness life. Therefore, it is advisable to take the loan to enable the purchase of the new truck.
Because all the investment decision ratios indicate that the investment is viable, Stephanie can advise her father to go head and seek the loan from the bank.
Explain whether it is more beneficial for Frank to close his business.
Taking loan is more advisable than closing the business. The closing of business implies that Frank will be jobless and will need to seek a new job. Moreover, the closing of his business shows Frank could be a subject to lower salary compared to his income return from his business. When Frank decides to close down the business, he will have to sell all his assets and selling remain assets would raise minimal return since the only remaining items would be his tools and his old truck. In this case, borrowing to finance the purchase of a new truck will be the best option since it will ensures business continuity as well as personal income.
Explain what you would do in this same situation
In conclusion, one would prefer to secure a loan since the analysis presents facts and proves the business to have the correct investment decision based on the calculations made.
Accepting the loan is a better choice rather than closing the business and seeking formal employment. In addition, Elena should avoid at all cost giving the bank manager and is wife a call since it is unethical. Unethical business practices have undesirable consequences in future transactions. As the NPV, of the Project, is Positive as well as Profitability Index is greater than 1, the truck is recommended to purchase. The IRR, i.e., the rate at which the NPV is zero is 16.66%, greater than the cost of capital. Therefore, I would recommend Frank to purchase the truck at 12%.
Reference
Finance by Cornett/Adair/Nofsiger Introduction to Financial Management
