Managerial Accounting and Capital Budgeting

Arend Pryor
Jan 15, 2022
8 min read

Updated: Jan 17, 2022

Author: Arend Pryor | Created: 06/27/2021

Details: Sharing content created as part of pursuing my MBA degree

Assignment Details: This assignment is comprised of the two sections described below.

Section 1 - Ratio Analysis:

Financial statement analysis focuses primarily on isolating information that is useful for making a particular decision. Through ratio analysis, users of financial data can analyze various relationships between items reported.

Describe the 3 main categories of ratios and provide a specific example of a ratio that is used in each category. For each of the 3 ratios you selected, describe how it is used in managerial decision-making.

Section 2 - Analytical Techniques:

Managers can choose from several analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages. Distinguish between the 3 capital investment techniques of:

Net Present Value
Internal Rate of Return
Payback Method

Describe what you consider to be the top 2 advantages and 2 disadvantages of each technique and provide an example to support your top advantage of each method.

The late great Peter Drucker once said about managing, “Management is doing things right; leadership is doing the right things” (Rockwood, 2017). However, knowing what those right things are is often where the challenge lies. With regard to managerial accounting and decision-making, the art of knowing can be the result of utilizing the right analysis and analytical techniques. For instance, when it comes to analyzing financial statements to determine the health of a company as part of making an investment decision, the categories of liquidity, profitability, and solvency can paint an incredibly detailed picture. For instance, liquidity and solvency ratios can determine a company’s ability to pay short-term and long-term debt obligations, while profitability ratios can aid in determining the ability to generate revenue. All of which are helpful tools for business owners, lenders, and investors. Analytical techniques are another commonly used tool, however, these are typically used for the purposes of deciding whether the company should pursue a capital investment opportunity that will create additional revenue. This post will cover three of the most frequently used techniques, including net present value (NPV), internal rate of return (IRR), and the payback method. Each of these offers unique advantages and disadvantages, which speaks to the importance of using more than one technique before making a final decision.

The ability to analyze financial statement data is one of the most necessary skills for determining the liquidity, solvency, and profitability of a company. Commonly used ratios exist for each of these categories and can aid in managerial decision-making, investment opportunities, and decisions related to establishing credit terms. The area of liquidity for instance includes ratios that determine a company’s ability to pay their short-term debts and takes into account current assets and liabilities. The quick ratio, also known as the acid-test ratio, is an example of a liquidity calculation that is used for this purpose (Edmonds et al., 2019). This ratio assesses a company's ability to meet current debt obligations using their most liquid assets without the need to obtain money from other sources such as financing or selling inventory (Seth, 2021).

The area of solvency on the other hand includes ratios aimed at determining a company’s ability to pay long-term debts. A ratio that most have heard of in this category is the debt-to-equity ratio, sometimes referred to as the leverage ratio. This calculation considers total liabilities and total stockholder’s equity to tell us how much each dollar of a company’s equity is made up of debt. For example, when comparing the results of two companies using this ratio we might see that company ABC has twenty cents of debt for each dollar of equity, while company XYZ has seventy cents of debt for each dollar. If these two companies were applying for loans, this calculation could be used and would result in company XYZ being given a larger interest rate on their loan as they pose a larger lending risk (Corporate Finance Institute, 2020).

The third and final category is that of profitability, which tells us how well a company is doing at generating earnings, but can also be used in evaluating the performance of a manager. The net margin ratio is an extremely popular profitability ratio and is used to determine how much net income the company retains based on their sales. This ratio is also helpful for investors who can use it to determine if management for a particular company is making enough money from sales and if operational and overhead costs are under control (Murphy, 2021).

Companies generate revenue in a variety of ways, one of which is in the purchasing of capital investments. This typically involves the purchase of some type of asset that will generate revenue for the company on an annual basis. Before deciding to pursue capital investment opportunities, such as the purchase of a delivery vehicle or equipment that will generate rental income, managers will perform a detailed analysis using multiple analytical techniques. The goal of which is often to determine which option offers the most optimal return on investment. Calculating the net present value of a capital investment opportunity is one such calculation. This involves determining the total value of future inflows of cash and subtracting them from the initial cost of the investment, also referred to as the cash outflow. One important note, calculations that determine future inflows of cash are based on the required rate of return, which are used to identify a multiplication factor, which is then used to determine the depreciated future value of cash the company expects to receive. Once calculated, a positive NPV will indicate an investment that meets or exceeds the required rate of return, while a negative value points to an opportunity that is below the company’s minimum required rate of return (Edmonds et al., 2019).

One of the main benefits of using NPV to analyze capital investment opportunities is in its consideration of the time value of money, which states that money today is worth more than money received at a future date. Without this consideration, managers would overestimate the cash inflows expected to be received for a project. The secondary benefit of this technique is in the ease of interpreting the results to identify whether an investment opportunity meets the required rate of return by way of a positive or negative calculation. In terms of disadvantages, a company’s required rate of return is used to determine the factors used to discount future cash inflows, however, there are no standards when it comes to the rate selected by the company. Without performing calculations using a variety of return rates, managers would not be aware of achieving an alternative rate of return. The NPV calculation also lacks the ability to compare projects that vary in size, particularly, large projects versus small ones (Thakur, 2021). Without this understanding, a smaller less profitable project may appear like the better option.

Managers who want the most detailed analysis of their capital investment opportunities will almost always use more than one technique when performing their analysis. This approach allows visibility into more pieces of the puzzle for a clearer picture. One such technique that is also commonly used is to calculate the internal rate of return (IRR). While calculating NPV will tell us if an investment opportunity will exceed our required rate of return, it will not specifically tell us what rate of return we can expect based on the NPV calculation (Edmonds et al., 2019). Thus, IRR is used to pinpoint this value.

One of the benefits of this calculation is in its use of the time value of money to evaluate the timing of all future cash flows, which are equally weighted. Additionally, much like the process of determining NPV, calculating IRR is also easy to do and comprehend. This to me is one of the major benefits of this technique, as it can be shared with stakeholders and easily understood. Another similarity between the two is in the disadvantage of accurately comparing projects of varied sizes. A smaller project may appear more lucrative while the higher cash flows of the larger project are not realized. Equally as important to point out is that the IRR approach lacks the ability to take future required costs into account as part of its calculation (Lanctot, 2019). For example, the cost of investing in a new production system might not take into account the certification training now required by employees.

The last technique we will cover is the payback method, which reveals the time it will take to recoup the cost of a company’s initial investment. Out of the three techniques covered, the formula for calculating the payback period is probably the easiest of the three and requires dividing the net cost of the investment by the annual net cash inflow (Edmonds et al., 2019). The results produce a payback period timeframe, making it easy to use and very straightforward to comprehend. Again, for ease of sharing this information with stakeholders, this is a major benefit of the payback method technique. As an added benefit, being easy to use means that managers are more likely to include it as a part of their decision-making process (Borad, 2018). The fact that this technique is easy to use however, also contributes to being one of its disadvantages, as it does not take the time value of money into consideration. Thus, when comparing the payback period of two projects, it will not provide you with details on the cash inflow amounts expected to be received in the future and does not calculate a project’s return on investment (Woodruff, 2019). Both of which are limitations most should be aware of when using this technique.

The best decision-makers are generally the ones who utilize all of the information available when performing their due-diligence and avoid taking shortcuts. For example, when analyzing the current financial health of a company, it would be wise to use several ratios for the areas of liquidity, solvency, and profitability in your research as this would provide a view of the bigger picture. As discussed above, we also know that a quick ratio will help us determine a company’s ability to pay short-term debts using their most liquid assets, while the debt-to-equity ratio will provide us with a percentage view of how much debt a company has per dollar of equity. A very important calculation used to determine the risk and subsequently the interest rates for a requested loan. For investors, there are also ratios for examining the profitability of a company, which can aid in making investment decisions. Lastly, we also discussed the use of analytical techniques and the value they provide in helping managers decide on the strength of capital investment opportunities. Each of which takes a different approach in making these determinations, but also have their own advantages and disadvantages. The most common advantage being their ease of use, and the various disadvantages which point to the importance of using more than one technique to ensure all of the necessary factors are weighed.