Profitability of the Business Paper Example

Introduction

Profitability is one of the essential aspects considered when starting a business. A business must be profitable to justify its formation and existence. The profitability of the firm is assessed through the budgeted net income as well as break-even analysis (Weygandt, Kimmel & Kieso, 2015). As shown on the budgeted income statement in Appendix 1, the business will make a net income of PS1,655 in the first month of operations. It indicates that the business will be profitable right from the first month. The net income in the second month is expected to be PS1,355, with the reduction resulting from the interest expense the business will incur from the second month. The expected net profit margin is 10.61% indicating that the firm will generate a net income of PS0.1061 for every pound of revenue earned from selling personal computers (Gibson, 2013). It implies that the business will generate sufficient earnings to cover all the costs of production and other operating and financing expenses.

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Break-even analysis determines the minimum number of computers the business must sell to avoid losses (Weygandt, Kimmel & Kieso, 2015). The margin of safety compares the break-even quantity to the actual sales level. It shows how much the current sales of the firm would fall to reach the break-even point. Appendix 2 shows that the contribution margin for all the three models is positive. A positive contribution margin is a precondition for profitability. The firm's break-even point is 11 computers. It implies that it needs to sell a total of eleven units in every month to avoid making losses. The break-even point for High-end gamer personal computers is 1 unit while that of professional work PC is three units. The break-even point for Mid-range home PC is seven units. The initial evaluation of the break-even points indicates that the business will be profitable since the BEP is less than the expected sales level. A comparison of the three models indicates that the professional work personal computers generate the highest contribution per unit of all the three models while the high-end gamer computers have the lowest contribution margin.

The overall margin of safety for the firm is 45% indicating that the business will start making losses if the actual sales fall by 45% from the expected monthly sales (Gibson, 2013). The margin of safety for High-end gamer personal computers is 50% implying that the expected sales will be twice as much as the amount required to guarantee profits. The professional work PC segment is also expected to have a 50% margin of safety while that of Mid-range home personal computers is 41.67%. The overall margin of safety and that of each of the models are high indicating the risk of making losses due to a fall in sales level is low. It is highly unlikely that the actual sales will be less than the budgeted sales by more than 40%. The fact that the business is targeting local student population as well as eBay shows that the business will have a diversified market that will enable it to generate adequate revenues to cover its production and operating costs.

Funding Requirements

Initial capital requirements include the purchase of non-current assets, working capital requirements, including rent, which is paid at the beginning of the month. Scott has to buy adequate components to assembly one PC of each model for display in the showroom. This is essential since it may be difficult to get customers without displaying any of his completed works. He also needs an inventory of components sufficient to assembly two units of each model. It will enable him to meet the client's orders promptly. As shown in Appendix 3, the estimated total initial capital required is PS14,445. It excludes expenses payable at the end of the month. Such expenses shall be paid using cash received from sales since the firm expects to make sales from the first month and all transactions will be in cash.

The business will borrow PS15,000 to fund its initial operations. If Scott gets the government free start-up loan, the amount will be repaid in 57 monthly installments of PS263.16 each. Without the government loan, Scott will be forced to take a bank overdraft at 24% per annum. The draft will be payable in one year, and the monthly installment will be PS1,481.

Liquidity and Ability of the Business to Service the Loan

The ability of the firm to service the loan is determined by analyzing the budgeted income statement and the cash budget. Liquidity is influenced by the ability to generate sufficient cash flows and earnings (Gibson, 2013). As shown in Appendix 1, the income before interest and taxes for the first operating month will be PS1,655. This is greater than the expected monthly loan repayment of PS1,481. The coverage is higher than one indicating that the firm will generate sufficient earnings to cover its obligations. As shown in Appendix 4, the business will make sufficient cash to service the loan. If advanced the loan, the expected cash balance at the end of the first month is PS4,237. This implies that the cash generated will adequately cover the principal and interest on the loan. The cash balance will increase in each of the subsequent months. The ability to service the government loan is even higher since the monthly payment for the government loan is lower than that of the bank overdraft. Thus, the business is expected to have strong liquidity. This partly because all purchases and sales will cash or bank transactions.

The Impact of Government Free-Interest Loan

The profitability and liquidity of the business will improve if Scott secures the government free-interest start up loan. Firstly, the net income will increase since the business will not be paying interest on the loan. The interest on the bank overdraft is PS300 in the second month. Thus, the firm's income before taxes will be PS300 more if the start-up is funded through the government loan than when it is financed through a bank overdraft. It will also reduce the monthly fixed costs by 300 thus lowering the break-even point. Appendix 4 indicates that the break-even point falls from 11 to 9 while the margin increases from 55% to 45%. A lower break-even point and a higher margin of safety is a positive change and implies an improvement in profitability.

Appendix 5 shows that the liquidity of the firm will also increase. The government loan is payable over a longer period than the overdraft hence the monthly payment is lower. The balance at the end of the second and third months will increase by more than PS1,400 while the subsequent months will see an improvement of about PS1,200 in the monthly cash balance.

Conclusion

Analysis of the budgeted financial statements of the business shows that Scott's idea is viable. It will make a profit in each of the months, and its cash inflows are expected to exceed monthly cash flows. The margin of safety is also high indicating that there is a low risk of making losses. The business will be able to service the loan used to finance its start-up.

References

Gibson, C. (2013). Financial statement analysis. Mason, Ohio: South-Western.

Weygandt, J., Kimmel, P., & Kieso, D. (2015). Financial accounting. Hoboken, NJ: John Wiley & Sons, Inc.