Introduction to Financial Accounting and Ratio Analysis

CHAPTER ONE : INTRODUCTION 1.1 Definitions o Bookkeeping is the keeping of accounts in a regular and systematic manner.
That is it is the recording of the financial transactions. o Accounting deals with the collection, recording and summarizing of business transaction to provide information for day-day management. o Financial Accounting : This is the method of reporting the results and financial position of a business. o Management Accounting: This seeks to provide in information which will be used for decision making purposes (e.g. pricing, investment) for planning and control. Differences Between Financial Accounting and Management Accounting Financial Accounting Management Accounting 1. Financial report are governed by the 1. Management report are not governed by Company Act and Accounting Standards. any law or standards. Thus, they takes any Thus, financial reports are prepared as per format that suits management. given format (Law). 2. Financial reports concern themselves 2. Management reports deals with both with monetary matters. monetary and no-monetary issues. 3. Financial reports are for both internal 3. Management reports are only for internal and external users. use. 4. Financial reports only report on past 4. Management reports report on both past events. and expected future events. o 1.2 The Purpose of Accounting A business proprietor normally runs a business to make money. He or she needs information to know whether the business is doing well. The following questions might be asked by the owner of a business: How much profit or loss has the business made? How much money do I owe? Will I have sufficient funds to meet my commitments? The purpose of conventional business accounting is to provide the answers to such questions by presenting a summary of the transactions of the business in a standard form.
Prepared by : Mr. Arona JOHN
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1.3 Business Entities A business can be organized in one of several ways: Sole Trader / One-Man Business a business owned and operated by one person. Partnership a business owned and operated by two or more people. Company a business owned by many people and operated by many people, who may or may not be the same. Advantages Sole Trader 1. Legally it is easy to form 2. Not much capital is needed to set-up the business 3. Profit is not to be shared Partnership 1. Relative to forming company, partnership is legally it is also easy to form. 2. Division of labour exist 3. Continuity may not be a problem as compare to a sole trader Company 1. Can go public, i.e. it can raise funds by issuing out shares 2. A limited liability company has a separate legal identity. That is a company can sue and it can also be sued in court. 3.It has tax advantages 4. Unlike the first two with a company it is relatively easier to transfer shares from one owner to another. 5. Limited liability makes investment less risky than investing in a sole trader or partnership.
Disadvantages Sole Trader 1. Continuity could be a problem 2. There is no division of labour 3. There is limited capital contribution
Partnership 1. Liability of the partners is unlimited 2. Cannot go public 3. Continuity may also be a problem
Company 1. Have to publish annual financial statements 2. Have to comply with legal and accounting requirements 3. Financial statements have to be audited annually 4. Issue of share regulated by law .
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1.4 The Financial Statements This is the name given to the set of documents that present the information recorded. The three main documents produced are the: Balance Sheet list the assets and liabilities of the business at a point in time and the amount invested in the business by the owner(s)- capital, i.e it is a snapshot of the financial position of the business at the end of the period. Income Statement summarizes the income and expenditure of the business for a period of time (usually a year) up to the date of the balance sheet. Cash Flow Statement shows and compare the cash inflows and cash outflows to give the net cash flow in the form of either cash surplus or cash defecit. The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. 1.5 Users of Financial Statements and Accounting Information 1. Shareholders / Owners of the business : They want to be able to see whether or not the business is profitable. In addition they want to known what the financial resources of the business are 2. Employees: They would want to know whether the business would not have a goingconcern problem. 3. Banks : If the owner wants to borrow money for use in the business, then the bank will need such information. 4. Tax Authorities : They need it to be able to calculate the tax payable. 5. Government and their agencies are interested in the allocation of resources and therefore in the activities of business entities. 6. Supplier / Creditors : They need it to be able to supply goods on credit. 7. Potential Investors : If the owner(s) want(s) to share ownership with someone else, then the would-be partner will want such information. 8. The public may make a substantial contribution to a local economy by providing employment and using local suppliers.
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1.6 The Qualitative Characteristics of Financial Statements Relevance : Information is relevant if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions. Reliability : Information is reliable if : a) it can be depended upon by users to faithfully represent what it is trying to represent. b) it is free from deliberate or systematic bias i.e. it is neutral. c) it is free from material error d) it is complete e) In conditions of uncertainty, a degree of caution has been applied in exercising the necessary judgement i.e prudence is exercised. Comparability : Information is made more useful if it can be compared with similar information about the same entity for some other period or point in time or it can be compared to similar information about other entities. Comparability is usually achieved through consistency and disclosure of accounting policies. Understandability : Users need to be able to perceive the significance of information. Materiality : Information that is material should be given in the financial statements but information that is not material need not be given. Information is considered to be material if its misstatement or non-disclosure would affect the decisions made by the users of the accounts. 1.7 Limitation of Financial Statements Financial statements suffer from the following limitations: They are subject to uncertainty as they must inevitable incorporate estimates. The process of allocating the effects of transactions to separate accounting periods adds further to the uncertainty. Information that cannot be expressed in monetary terms cannot be reflected in the primary financial statements. Information in financial statements is largely historical in that it relates to the position at a point in time and the performance for a prior period.
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1.8 Profit & Loss Account / Income Statement The profit and loss account is a financial statement that measures the financial performance of the business over a given account period of time, usually one year. 1.8.1 Proforma - Company XYZ Profit and Loss Account for the year ended 31 December 2011 Sales (Turnover) Less : Return Inwards Net Sales Cost of Sales: Opening Stock X X X Purchases Add : Carriage Inwards X Less: Return Outwards (X) X Less: Closing Stock (X) Gross Profit Add : Discount Received Less Expenses: Depreciation Electricity Rent Carriage Outwards Bad Debt Net Profit / (Loss) Taxation Profit After Tax (PAT) Dividend Retained Profit Profit Brought forward Profit Carried forward Note: 1. The profit and loss account statement has two sections: a) the trading account statement, which shows how profitable the businesss trading activities have been generated Prepared by : Mr. Arona JOHN Page 5 of 75
X (X) X
X X X
X X X X X
X X / (X ) (X) X (X) X X X
b) the profit and loss account, which show other sales and expenses 2. The profit and loss account nets off the balance on the expense account against those of the revenue accounts to show the net profit ( or loss) for the period which is used as a measure of financial performance of the business. 1.9 Balance Sheet / Statement of Financial Position This shows the financial position of the business as at a given date. 1.9.1 Proforma - Balance Sheet XYZ Balance Sheet as at 31 December 2011 Cost / Revalued Accumulated Amount Depreciation X X X X X X X X X X X X (X) (X) (X) (X)
NBV X X X X
Fixed Assets: Property Fittings & Fixtures Van Current Assets: Stock Debtors Prepayments Cash at bank
Less Current Liabilities: Creditors Accruals Bank Overdraft Taxation Net Current Asset ( Working Capital) Less Long Term Liabilities: Bank Loan NET ASSET Capital & Reserves: Ordinary Shares Share Premium Reserves
(X)
X (X) X
X X X X
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CHAPTER TWO : RATIO ANALYSIS There are four main techniques that one can use in interpreting a set of financial statements: horizontal analysis, trend analysis, vertical analysis and ratio analysis. Horizontal Analysis: This technique involves making a line-by-line comparison of the companys account for each accounting period chosen for the investigation. Trend Analysis: This is similar to horizontal analysis except that all the figures in the first set of accounts in a series are given a base line of 100 and the subsequent sets of accounts are converted to that base line. For instance, if sales for 2010 were $50m, $70m for 2011 and $85m for 2012, the sales of $50 for 2010 would be given a base line of 100, the 2011 sales would then become 140 (70 x 100/50), and the 2012 sales 170 (85 x 100/50). This method enables one to grasp much more easily the changes in the absolute costs and sales values shown in the financial statements . Vertical Analysis: This technique requires the figures in each financial statement (usually restricted to the profit and loss account and the balance sheet) to be expressed as a percentage of the total amount. 2.1 Why Ratio Analysis? Ratio Analysis is a tool for interpreting and analyzing financial statements. It helps management in providing an overall plan to achieve profitability and maximization of shareholder value. Ratio Analysis can also help to establish whether or not a business entity is going concern. 2.2. Ratio Analysis Tools Ratio can be classified into four main groups as shown below: Type Profitability Ratios Examples 1. Return on Capital Measure performance of the Employed (ROCE) company and its managers 2. Gross Profit as % of sales 3. Net Profit as % of sales 4. Mark-up Ratio 1.Stock (Inventory) Turnover Measure the efficiency of 2. Debtors (Accounts assets usage of the company Receivable) Collection Period 3. Creditors (Accounts Payable) Payment Period 4. Fixed Assets Turnover Ratio 5. Return on Assets (ROA) Goal
Management Efficiency Ratios
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Financial / Liquidity Ratios
Measure the financial structure and stability of the company Measure the extend of the relationship of the number of ordinary shares and their price to the profit, dividends and assets of the company
1. Current Ratio 2. Liquid Ratio 1. Earning per share (EPS) 2. Price / Earning Ratio 3. Dividend Cover 4. Dividend Yield 5. Earning Yield 6. Debt Ratio 7. Times-Interest Earned Ratio 8. Gearing 9. Equity Gearing
Investment Ratios
Profitability Ratios These measure the performance of a company and its managers. They indicate how efficiently the organization has used its available resources. The profitability ratios are normally presented as percentages and, in generally, the higher the profitability percentage, the better is the aspect of the organizations performance to which the ratio relates. Return on Capital Employed (ROCE) : This measures the size of the profit figure relevant to the size of the business, size being express in terms of the quantity of capital employed by the business. It reflects the earning power of the business operations. This is also known as the primary ratio because it is often the most important measure of profitability. It is measure in several ways. 1. ROCE based on total capital employed in the business is calculated as follows: ROCE = ( PBIT Capital Employed ) x 100 Where Capital Employed = Total Assets Current Liabilities 2. ROCE based on equity shareholders capital employed is calculated as follows: ROCE = [ Profit after tax & preference dividend ( Ordinary Share Capital + Reserves ) ] x 100 Gross Profit-Sales This determines how much profit the business has earned in relation to the amount of sales that it has made. It is calculated as follows: Gross Profit-Sales % = (Gross Profit Sales) x 100 Prepared by : Mr. Arona JOHN Page 8 of 75
Net Profit as % of Sales Sometimes we will want to compare the net profit with the sales revenue. The formula to be used is : Net Profit as % of Sales = Net Profit Sales x 100
Mark-up Ratio The Mark-up ratio measures the amount of profit added to the cost of goods sold. The cost of goods sold plus profit equals the sales revenue. It is calculated as follows: Mark-up Ratio = (Gross Profit Cost of Sales) x 100
Management Efficiency Ratios This measures the efficiency of asset usage. It includes the following ratio types: Stock Turnover (Period): This ratio measures the average length of time during which a firm holds the stock. A long holding period, implying high stock level relative to the amount of goods sold, has some advantages, for example it reduces the risk of stockout and the resultant inability to satisfy demand, and it provides more scope for bulk buying which may produce quantity discount and other economics of scale. Alternatively it might indicate the existence of slow-moving or obsolete stock. It is calculated as follows: Stock Turnover (Period) =[ (Average Stock Cost of goods sold)] x 365 days The stock turnover can also be expressed in times as follows: This measures the number of times a company sells its average level of stock during a year. A high rate of turnover indicates relative ease in selling stock, whereas a low times turnover indicates difficulty in selling. However, a higher value can mean that the business is not keeping enough stock on hand, and inadequate stock can result in lost sales if the company cannot fill a customers order. Therefore, a business strives for the most profitable rate of stock turnover, not necessarily the highest. The stock turnover (times) is calculated as follows: Prepared by : Mr. Arona JOHN Page 9 of 75
Stock Turnover (Times) = Cost of goods sold / Average Stock = X times Debtors Collection Period : This measures the average length of time taken by debtors to pay amount due to the business. It is an important aspect of the assessment of managements ability to control working capital. A long debtor collection period have disadvantages. For instance, the business may incur high interest cost on the working capital to finance debtors, and so run the risk of incurring bad debts. It is expressed in days and is calculated as follows: Debtors Collection Period =[ (Average Trade Debtors Credit Sales)] x 365 days The debtor collection period can also be expressed in times : Debtors Collection (Times) = Credit Sales / Average Trade Debtors = X times Creditors Turnover (Period) : Measures the companys ability to pay cash to its suppliers. A long creditor payment period has an advantage to the company. This is because it serves as a source of financing to the company. The creditors payment period is computed as follows: Creditors Payment Period = [ (Trade Creditors Cost of Sales) ] x 365 days It can also be expressed in times as follows: Creditors Turnover (Times) = Cost of Sales / Average Trade Creditors = X times NB : If the cost of sales figure is not given then use the purchase figure as a proxy. The Length of Working Capital Cycles (days) = Debtors Collection Period + Stock Turnover Period Creditors Payment Period Fixed Assets Turnover Ratio This measures the efficiency with which a business uses its fixed assets. It is calculated as follows: Fixed Assets Turnover ratio = Sales Fixed Assets at Net Book Value This ratio is really only useful if it is compared with previous period or with other companies. In isolation it does not mean very much. NB: The ratio could also be expressed as a percentage.
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Return on Assets (ROA) : This measures the success a company has in using its assets to earn a profit. It is calculated as follows: ROA =[ (Net Profit + Interest Expense) Total (Average) Assets )] 100
Financial / Liquid Ratios These ratios measure the financial structure of the company. These ratios include: Current Ratio : Indicates the businesss ability to meet its short term cash obligations (current liabilities) out of its current assets without having to raise finance by borrowing, using more shares, or selling fixed assets. It is calculated as follows: Current Ratio = Current Asset Current Liabilities = A : 1 Liquid Ratio : This is also known as Acid Test / Quick Ratio. It tells us whether the firm business could pay all its current liabilities if they come due immediately. It is a more stringent test of a firms ability to pay its debt as they fall due. This is computed as follows: Liquid/Acid Test / Quick Ratio = (Current AssetStock) Current Liabilities = A : 1
Investment Ratios These ratios measure the relationship of the number of ordinary shares and their price to the profit, dividend and assets of the company. Earning Per Share (EPS) : This is the most widely quoted of all financial statistics. The EPS is the only ratio that must appear on the face of the profit and loss account . It is the amount of net profit per share of the companys issued ordinary share. Preference dividends are subtracted from net profit because the preference shareholders have prior claim to their dividends. It is calculated as follows: EPS = (Net Profit Preference Dividends) No. of Ordinary Shares Issued = X Price / Earning (P/E) Ratio: This is the market price of an ordinary share of the companys earning per share. It shows how long it would take for the investors to recover his outlay at a particular EPS. It is measure as follows: Price / Earning Ratio = Market Price Earning Per Share
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Dividend Yield : Measures the ratio of dividends per share to the shares market price per share. This ratio gives the percentage of a shares market value that is returned annually as dividends, an important concern of shareholders. It is computed as follows: Dividend Yield = Dividend Per Share Market Price Per Share Dividend Cover : Shows by how much earnings should fall for dividend not to be paid. It is calculated as follows: Dividend Cover = Total Earnings Total Dividend OR EPS Dividend per share Earning Yield : This expresses the earning per share as percentage of the current share price. It is computed as follows: Earning Yield = (EPS Current Share Price) x 100 OR 1 PE Ratio (This would implies the earning yield is merely the reciprocal of the PE ratio Long-Term Solvency : This is concern with the ability of a company to survive over many years. Survival of a company may be affected by the long-term financial commitments. These commitments are often related to the manner in which the company finances its operations. Debt Ratio : This tells us about the proportion of the companys assets that it has financed with debt. If the debt ratio is 1, then debt has been used to finance all the assets. Similarly a debt ratio of 0.5 means that the company has used debt to finance half of its assets and that the owners of the business have financed the other half. The higher the debt ratio, the higher the strain on the firm, to pay interest each year and the principal amount at maturity. It is calculated as follows: Debt Ratio = Total Liabilities Total Assets
Capital Gearing = Debt Capital Employed Sometimes in ratio analysis for time series financial statements of a company it may be of importance to also examine the reason(s) for the changes in the cash balances under heading Cash Flow. As this is a liquidity Ratio Analysis we will classified it as Liquidity. Even if we are have not been provided with a cash flow statement we will be using the following to examine the reason(s) for the changes in the cash balance.
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Cash Flow Statement for the year ended (Current Date) Net profit before debenture interest and tax Decrease in stock / (Increase in stock) Decrease in debtor / (Increase in debtors) Increase in creditors / (Decrease in creditors) Increase in fixed assets Interest paid Tax paid Dividends paid Increase in Cash / (Decrease in cash) during the year Cash at Previous Year end date Cash at Current Year end date Limitations of Ratio Analysis
$000 XX XX / (XX) XX / (XX) XX / (XX) (XX) (XX) (XX) (XX) XX / (XX) XX XX
In interpreting the financial statements of companies we should always bear in mind that the analysis are based on profit and loss accounts and balance sheets which are subject to all the limitations of historical cost accounting. Inflation, specific price changes and differing bases of valuation are likely to distort comparisons, whether cross sectional or time series. RATIO FORMULA LIST FORMULA (Gross Profit Sales) x 100 (Net Profit Sales) x 100 (Gross Profit + Cost of Sales ) x 100 (PBIT Capital Employed) x 100. where capital employed is just the business Net Assets.
RATIO Profitability Ratios 1. Gross Profit as % of Sales (Gross Profit Margin) 2. Net Profit as % of Sales (Net Profit Margin) 3. Mark-up Ratio
HOW IS IT PRESENTED? The answer is always expressed in % terms The answer is always expressed in % terms It is also expressed in %. And it measures the amount of profit added to the cost of sales. It measures the size of the profit figure relevant to the size of the business, size being express in terms of the quantity of capital Page 13 of 75
4. ROCE
employed by the business. It reflects the earning power of the business operations. It is also expressed in % . Efficiency Ratios 1. Stock Turnover (Period) (Average Stock Cost of goods sold) x 365 days This ratio measures the average length of time during which a firm holds the stock. A long holding period, implying high stock level relative to the amount of goods sold. It is expressed in days. This measures the average length of time taken by debtors to pay amount due to the business. It is expressed in days. Measures the companys ability to pay cash to its suppliers. A long creditor payment period has an advantage to the company. It is expressed in days. This measures the efficiency with which a business uses its fixed assets. It is really only useful if it is compared with previous previous period or with other companies.
2. Debtors Collection (Period)
(Average Trade Debtors Credit Sales) x 365 days
3. Creditors Payment (Period)
(Trade Creditors Cost of Sales) x 365 days If the cost of sales figure is not given then use the purchase figure as a proxy. (Sales Fixed Assets @ Net Book Value) x 100
4. Fired Assets Turnover Ratio
Length of Working Capital Cycles (days)
Debtors Collection Period + Stock Turnover Period Creditors Payment Period
Liquidity Ratios 1.Current Ratio
(Current Assets Current Liabilities) = X :1
Indicates the business ability to meet its short term cash obligations (current liabilities) out of its current Page 14 of 75
2. Liquid / Acid Test / Quick Ratio
(Current Assets less Stock) Current Liabilities = X :1
assets without having to raise finance by borrowing. It tells whether the firm could pay all its current liabilities if they come due immediately.
Investment Ratios 1. Earnings per Shares (EPS)
(Net Profit Preference Dividends) No. of Ordinary Shares Issued
2. Price / Earning (P/E) Ratio
Market Price Earning Per Share
3. Dividend Yield
(Dividend Per Share Market Price Per Share) x 100
4. Dividend Cover
5. Earning Yield
(Total Earnings Total Dividend) x 100 OR (EPS Dividend per share) x 100 (EPS Current Share Price) x 100
It is in this form X. This is the most widely quoted of all financial statistics. The EPS is the only ratio that must appear on the face of the profit and loss account. It is the amount of net profit per share of the companys issued ordinary share. Preference dividends are subtracted from net profit because the preference shareholders have prior claim to their dividends. This is the market price of an ordinary share of the companys earning per share. It shows how long it would take for the investors to recover his outlay at a particular EPS. Measures the ratio of dividends per share to the shares market price per share. This ratio gives the percentage of a shares market value that is returned annually as dividends, an important concern of shareholders. Shows by how much earnings should fall for dividend not to be paid. This expresses the earning per share as percentage of Page 15 of 75
6. Debt Ratio
7. Gearing
the current share price. OR (1 PE Ratio) , This would implies the earning yield is merely the reciprocal of the PE ratio Total Liabilities Total This tells us about the Assets proportion of the companys assets that it has financed with debt. If the debt ratio is 1, then debt has been used to finance all the assets. (Debt Capital Employed) This is expressed in %. x 100 In interpreting the financial statements of companies we should always bear in mind that the analysis are based on profit and loss accounts and balance sheets which are subject to all the limitations of historical cost accounting. Inflation, specific price changes and differing bases of valuation are likely to distort comparisons, whether cross sectional or time series.
Limitations of Ratios
Worked Examples 1. Bond Ltd and Fraser Ltd Bond Ltd and Fraser Ltd are companies operating in a similar market. Your manager has asked you to help her review the performance of both companies from their financial statements which are summarized. Profit and Loss accounts for the year ended 31 October 2008 Sales 23,800 24,000 Cost of sales 17,850 16,800 Prepared by : Mr. Arona JOHN Page 16 of 75
Gross Profit Expenses Profit before tax Tax on profit Profit after tax Retained Profit
5,950 2,500 3,450 900 2,550 1,000 1,550
7,200 4,800 2,400 600 1,800 900 900
Balance Sheet as at 31 October 2008 Bond Limited 000 000 Fixed Assets 15,000 Current Assets Stock 500 Debtors 2,000 Bank 100 2,600 Current Liabilities Creditors 775 Overdraft Tax 900 1,675 Net Current Assets 925 15,925 Debentures 300 Net Assets Capital and reserves 1 Ordinary shares Reserves 15,625 12,000 3,625 15,625 Required :
Fraser Limited 000 000 24,000 1,200 600 1,800 150 55 600 805
995 24,995 1,000 23,995 20,000 3,995 23,995
(a) Calculate four profitability ratios and two liquidity ratios for Bond Ltd and Fraser Ltd. Show all workings. (12 marks) (b) Comment briefly on the performance of two companies as indicated by the ratios you have calculated in Part (a). (8 marks) (20 Marks) Answer : Bond Ltd and Fraser Ltd Prepared by : Mr. Arona JOHN Page 17 of 75
Ratio Profitability Ratios Gross profit % Net Profit % Mark-up Ratio Return on capital employed Liquidity ratios Current ratio Acid test ratio
Formulae (Gross profit Sales) x 100 (Net profit Sales) x 100 (Gross Profit Cost of Sales) (Net profit Capital employed) x 100 (Current Assets Current Liabilities) :1 ((Current Assets Stock) Current Liabilities) : 1
Bond Limited (5,950 23,800) x 100 = 25% (3,450 23,800) x 100 = 14% 5,950 17,850 = 0.33 (3,450 15,625) x 100 = 22% (2,600 1,675) :1 = 1.6 : 1 (2,100 1,675) :1 = 1.3 : 1
Fraser Limited (7,200 24,000) x 100 = 30% (2,40024,000) x 100 = 10% 7,200 16,800 = 0.30 (2,400 23,995) x 100 = 10% (1,800 805) : 1 = 2.2 : 1 (600 805) : 1 = 0.7 : 1
(b) Profitability ratio Gross profit percentage : Fraser Ltd has a higher gross profit percentage than Bond Ltd. The companies both operate in a similar market and have similar turnovers, so it is unclear why there is a difference. Possibly Fraser is better at keeping supplier costs. Net profit percentage : Bond does better than Fraser on net profit percentage, reversing the gross profit percentage finding. The company is obviously better at controlling its expenses, which are around half those of Fraser. Mark-up Ratio : Bond Ltds mark-up ratio is 0.33 (33%) while that of Fraser Ltds is 0.30 (30%). Thus the mark-up ratio for the two companies are almost the same. Return on capital employed : Bond Ltds return on capital employed is double that of Fraser Ltd. Fraser Ltd has more money invested, in both shares and loans, but is not making an effective use of the capital employed. Liquidity Ratios Current ratio : Both companies have sufficient assets to cover their liabilities. The current ratio of Bond Ltd is not as high as that of Fraser Ltd. However, it is important to look at the individual companies of working capital.
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Both Ltds cash position (100,000) is more favourable than Fraser Ltds 55,000 overdraft). Acid test ratio : Much of Fraser Ltds working capital is tied up in stock. When this is taken out to give the acid test ratio, Bond Ltds is better. Fraser Ltd may be storing up liquidity or cash flow problems. Conclusion : Overall Bond Ltd looks to be the better performer, both in term of liquidity and profitability. It would be helpful to have more background information about the market in which the companies operate, for example industry average ratios, and also to see the trend compared with previous years. 2. You are presented with the following information relating to Success Power Limited. Profit and Loss accounts for the year ended 31 March 2011 2012 000 000 Sales 160 200 Cost of sales (96) (114) Gross Profit 64 86 Operating expenses (30) (34) Debenture interest (5) (5) Profit before tax 29 47 Tax on profit (9) (12) Profit after tax 20 35 Dividend paid: Preferece shares (2) (2) Ordinary Shares (8) (10) Retained Profit 10 23 Balance Sheet as at 31 March Fixed Assets (@NBV) Current Assets Stock Debtors Bank Current Liabilities Creditors Net Current Assets Capital and reserves 1 Ordinary shares Prepared by : Mr. Arona JOHN 000 15 40 3 58 (25) 33 333 200
2011
000 300
000 20 50 1 71 (35)
2012
000 320
36 356 200 Page 19 of 75
(Share Capital) Preference share (1 shares, 8%) Retained earnings Long-Term Liabilities : Debenture (10%)
25 58 283 50
25 81 306 50 356
333 Additional information: 1. 2. 3. 4.
All sales and purchases are on credit terms. The opening stock at 1 April 2010 was 20,000. There were no accruals or prepayments at end of either 2011 or 2012. Assume that both the tax and the dividends had been paid before the end of the year. 5. The market price of the ordinary shares at the end of both years was estimated to be 126p and 297p respectively. Required : (a) Calculate appropriate liquidity, profitability, efficiency and investment ratios for both 2011 and 2012. (b) Comment briefly on the companys financial performance for the year to 31 March 2012. Answer: Ratio Liquidity ratios Current ratio Acid test ratio Profitability Ratios Gross profit % Net Profit % Mark-up Ratio Return on capital employed Formulae (Current Assets Current Liabilities) ((Current Assets Stock) Current Liabilities) (Gross profit Sales) x 100 (Net profit Before Tax Sales) x 100 (Gross Profit Cost of Sales) x 100 (Net profit Before Tax Capital 2011 2012
(58 25) = 2.3 : 1 (71 35) = 2.0 :1 ((58-15) 25) = ((71-20) 35) 1.72 : 1 = 1.5 : 1 (64 160) x 100 = 40% ( 29 160) x 100 = 18.1% (64 96) x 100 = 66.7% (29 283) x 100 = 10.2% (86 200) x 100 = 43% (47200) x 100 = 23.5% (86 114) x 100 = 75.4% (47 306) x 100 = 15.4% Page 20 of 75
Efficiency Ratios Stock Turnover (Times) Debtors Collection period Creditor Payment Period Fixed Asset Turnover Investment Ratios Dividend Yield *Divided per share Dividend Cover
employed) x 100 Cost of Goods Sold Stock (Trade Debtor Credit Sales) x 365 Days (Trade Creditor Cost of Sales) x 365 Days Sales Fixed Assets (NBV) (Dividend per share Market price per share) x 100 (Dividends No. of Ordinary Shares Issued) x 100 Net Profit after tax & preference dividend Ordinary Dividends Net Profit after tax & preference dividend No. of Ordinary Shares Market price per share Earnings per share (Preference Shares + Long-term loans) (Shareholders fund + Long-Term loans) 96 15 = 6.4 times (40 160) x 365 Days = 92 days (25 96) x 365 Days = 95 days 160300 = 0.5 times 11420 = 5.7 times (50 200) x 365 Days = 92 days (35 114) x 365 Days = 112 days 200320 = 0.6 times
(4* 126) x 100 = (5* 297) x 3.2% 100 = 1.7% ($8 200) = 4p (20-2) 8 = 2.25 times (20-2) 200 = 9p ($10200) = 5p (35-2)10 = 3.3 times (35-2)200 = 16.5p 29716.5 = 18 ((25+50) 356) x 100 = 21.1%
Earnings per share
Price / Earnings Ratio Capital gearing Ratio
126 9 = 14 ((25+50) 333) x 100 = 22.5%
(b) Comments on the companys financial performance for the year to 31 March 2012 Liquidity The company had a small cash balance at the end of each year: $3,000 (2011) and $1,000 (2012). Even though we have not been provided with a cash flow statement but it is possible to prepare a simple one for 2012. Cash Flow Statement for the year ended 31 March 2012 Prepared by : Mr. Arona JOHN Page 21 of 75
Net profit before debenture interest and tax (47+5) Increase in stock Increase in debtors Increase in creditors Increase in fixed assets Interest paid Tax paid Dividends paid Decrease in cash during the year Cash at 1.4.11 Cash at 31.3.12
$000 52 (5) (10) 10 (20) (5) (12) (12) (2) 3 1
Increase in stock and debtor balances of $15,000 were offset by a smaller increase in creditors of $10,000. An increase in fixed assets and tax paid was largely responsible for a decrease in the cash position at the end of 2012. Both the current assets and the acid test ratios were well within the generally accepted ranges. Profitability All measures of profit show a healthy return on capital employed in both years with an increase in 2012. We do not, however, know how the ROCE ratio compare with other companies. The increase may have been partly due to a significant increase in mark-up on sales. If this is so, this would suggest that the company is selling in an elastic market and that it has been able to increase its selling price without any great difficulty resulting in an increase in sales of 25% (from $160,000 to $200,000). The gross profit ratio showed a reasonable increase in 2012. Similarly the net profit ratio shows a healthy increase indicating that operational expenses are under control despite the company being busier. Efficiency The stock turnover ratio has fallen from 6.4 times to 5.7 times. In other words the stock is not being used in production quite as quickly in 2012 as it was in 2011. This needs to be investigated. It may well be that the company has purchased more stock than was needed to meet the 25% increase in sales. The debtor position is very high (92 days in each year). This may be the industrial sector norm but still needs investigation. The company could run into cash flow problems if its customers are slow to pay. This ratio may be related to the even higher creditor payment Prepared by : Mr. Arona JOHN Page 22 of 75
period (95 days and 112 days respectively). If the company is not receiving cash from its debtors it will not have the cash to pay its creditors. There is, therefore, a danger that it could possible be going to run into a severe cash problems. The fixed assets turnover is very low in both years although it did increase slightly in 2012. Indeed it would appear that the company is not recovering in sales what it has invested in fixed assets. Perhaps this is because here is a long-term lag between the installation of plant and machinery and the expected upturn in sales. Again this is something that needs further investigation. Investment This is a private company so it is difficult to read too much into the investment ratios. The dividend yield has fallen by nearly half but the dividend cover shows a healthy increase. The increase in the earning per share is much more than healthy; it increased by over 83% in 2012. The market appears to view the prospects for the company favourable as the price / earnings ratio increased from 14 to 18. At just over 20% the capital gearing is sufficiently low to satisfy the ordinary shareholders that if future profits increase their dividends are likely to grow without any problems arising. Similarly if profit fall, the payment to both debenture holders and preference shareholders will not swallow up a huge proportion of whatever profits are made, leaving the ordinary dividend fairly safe. Conclusion There are few limitations : (1) we dont have any information about the overall environment in which the company operates; (2) we are provided with only limited internal data; (3) we only have the accounts for a two-year period; and (4) we dont know how this company compares with other private companies in the same industries. The company appear to be profitable, generally efficient and not huge investment risk. There is a peculiar relationship between the fixed assets and the sales and the underlying cash flow position is weak because the company is not chasing up its debtors fast enough. As a result it is not able to pay it creditors very quickly. This means that if they begin to demand quicker payment the company could find itself facing great financial difficulties. If it cannot obtain the necessary credit then there may even be questions about whether it is able to continue as a going concern and it might then have to go into liquation.
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3. The following are the recent final accounts of Chelsea plc: Income Statement year to 31 August: 2011 000 Turnover (all credit sales) 8,740 Cost of sales (4,500) Expenses ------Operating profit (PBIT) 1,340 Interest paid (20) ------Profit before tax 1,320 Provision for tax (160) ------Profit after tax 1,160 Proposed dividend (450) ------Retained profit 710 ==== 2012 000 10,150 (5,100) (2,900) ------1,500 (110) ------1,390 (180) ------1,210 (605) ------605 ====
(3,550)
Summarised balance sheet (position statement) as at 31 August: 2011 2012 Non-current assets 2,800 3,600 Cumulative depreciation (700) (1,200) ------------2,100 2,400 ------------Current assets Inventory 380 990 Accounts receivable 540 1,100 Bank 10 ------------930 2,090 ----------Total Assets Equity and Reserves Share Capital Retained profit Non-current liabilities Loans Prepared by : Mr. Arona JOHN 3,030 ===== 750 1,000 --------1,750 200 4,490 ===== 1,000 1,605 ---------2,605 800 Page 24 of 75
Current liabilities Accounts payable Bank overdraft Tax owing Dividends
470 160 ------1,080 ------3,030 =====
Total liabilities
200 100 180 450 ------1,085 ------4,490 =====
605
For information the average number of employees in the year ended 31 August 2011 was 80. For information the average number of employees in the year ended 31 August 2012 was 88. TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS as you feel able to do. b) Use the ratios in order to analyse the performance of Chelsea plc.[5] c) Explain the importance of financial ratios to a business.[4] Answer: 3. (a) Ratio Liquidity ratios Current ratio Formulae (Current Assets Current Liabilities) ((Current Assets Stock) Current Liabilities) (Gross profit Sales) x 100 2011 (930 1,080) =0.86: 1 2012 (2,090 1,085) = 1.93 :1 Comments
[16]
Acid test ratio
Profitability Ratios Gross profit %
Current ratio is better in 2012 (550 1,080) = (1,100 Acid Test 0.509: 1 1,085) = 1.014 ratio is :1 better in 2012 (4,240 8,740) x 100 = 48.5% (5,050 10,150) x 100 = 49.8% There is no much difference in this ratio for the two periods. 2011 ratio Page 25 of 75
Net Profit %
(Net profit
(1,320 8,740)
(1,390
Mark-up Ratio Return on capital employed
Total Expenses to Sales Ratio Efficiency Ratios Stock Turnover Period Debtors Collection period Creditor Payment Period Fixed Asset Turnover Shareholder Fund / Investment Ratios Earning per share (EPS)
Before Tax Sales) x 100 (Gross Profit Cost of Sales) x 100 (Net profit Before Tax Capital employed) x 100 NB: CE = Total Assets less Current Liabilities (Total Expenses Sales) x 100% (Inventory Cost of Goods Sold ) x 365 (Trade Debtor Credit Sales) x 365 Days (Trade Creditor Cost of Sales) x 365 Days Sales Fixed Assets (NBV) Net Profit After Tax & Preference Dividend No. of Ordinary Shares
x 100 = 15.1% (4,240 4,500) x 100 = 94.2% (1,320 1,950) x 100 = 67.7%
10,150) x 100 = 13.7% (5,050 5,100) x 100 = 99.0% (1,390 3,405 ) x 100 = 40.8%
is better 2012 is better 2011 ratio is better
(2,900 8,740) x 100% = 33%
(3,550 10,150) x 100% = 35%
Expenses Sales ratio is better in 2011.
(380 4,500) x 365 = 31 Days (540 8,740) x 365 Days = 23 days (470 4,500) x 365 = 38 Days 8,7402,100 = 4.16 times
(9905,100) x 2011 is 365 = 71 Days better (1,100 10,150) x 365 Days = 40 days (2005,100) x 365 = 14 Days 10,1502,400 = 4.23 times 2011 is better 2011 is better 2012 is better The higher the ratio the better. Thus, if say the EPS drop from $0.14 in 2011 to $0.10 in 2012 this implies that the market does not Page 26 of 75
Dividend per share
Dividend Cover
Debt Ratio
Total Dividends No. of Ordinary Shares Issued Net Profit After Tax & Preference Dividend Ordinary Dividends Total Liabilities Total Assets
appear to view the prospectus for the company favourable. However, if say the EPS increase say from $0.14 in 2011 to $0.18 in 2012 then we would comment that the market appears to view the prospects for the company favourable as the EPS increased from $0.14 to $0.18.
This ratios tells us about the proportion of the companys assets that has been Page 27 of 75
financed with debt. Thus, the higher the debt ratio suggests that most of the companys assets was financed with debt. The implication of this high debt ratio is that the company will be paying high interest on its debt and this can affects its profitability and liquidity position if it is not controlled. (b) Conclusion There are few limitations : (1) we dont have any information about the overall environment in which the company operates; (2) we are provided with only limited internal data; (3) we only have the accounts for a two-year period; and (4) we dont know how this company compares with other private companies in the same industries. The company appear not to be profitable, generally inefficient and huge investment risk. There is a peculiar relationship between the fixed assets and the sales and the underlying cash flow position is weak because the company is not chasing up its debtors fast enough. As a huge investment risk company, its creditors are now asking for early settlement of the amount owed to them. This means that the company would be facing great financial Prepared by : Mr. Arona JOHN Page 28 of 75
difficulties. If it cannot obtain the necessary credit then there may even be questions about whether it is able to continue as a going concern and it might then have to go into liquation. ( c) Importance of financial ratios to a business: - Financial Ratios are tools for interpreting and analyzing financial statements. - They help management in providing an overall plan to achieve profitability and maximization of shareholder value. - Financial Ratios can also help to establish whether or not a business entity is going concern.
PRACTICE QUESTIONS Please refer to the past exam questions below for some practice questions.
CHAPTER THREE : MARGINAL COSTING AND BREAK EVEN ANALYSIS Marginal Cost Equation Derivation and its Importance Sales Revenue (S) Total Costs = Profit (or Loss) Prepared by : Mr. Arona JOHN (1) Page 29 of 75
But, Total Costs = Variable costs + Fixed cost Now substituting equation (2) into equation (1) gives:
(2)
Sales Revenue (S) (Variable costs (V) + Fixed costs (F)) = Profit (or Loss) (3) Rearranging gives: SV=F+P Equation (4) above is known as the Marginal cost equation But, S V = Contribution (C) Thus, from equations (5) and (6) we have: C=F+P In order words, contribution can be regarded as being either the difference between the sales revenue and the variable costs of that sales revenue or the total fixed cost plus profit. The marginal cost equation is important for two reasons. First, fixed costs can often be ignored when taking a particular decision because, by definition, fixed costs will not change irrespective of whatever decision is taken. Second, managers can concentrate on decisions that will maximize the contribution, since every additional $1 of contribution is an extra amount that goes towards covering the fixed costs. Once the fixed costs have been covered then every extra $1 of contribution is an extra $1 of profit. Break-Even Analysis The term break-even analysis is given to the interrelationships between costs, volume and profit at various levels of activity. The level of activity which produces neither profit nor loss is referred to as the break even point. An alternative term of break even analysis is the cost-volume-profit analysis or C-V-P analysis, is frequently used. C-V-P analysis uses many of the principles of marginal costing and is an important tool in short-term planning. It explores the relationship which exist between costs, revenue, output levels and resulting profit and is more relevant where the proposed changes in the level of activity are relatively small. Typical short-term decision where C-V-P analysis can be useful include; choice of sales mix, pricing policies, multi-shift working , and special order acceptance. Assumptions Behind C-V-P Analysis (5) (4)
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All cost can be resolved into fixed and variable elements. Fixed cost will remain constant and variable costs vary proportionately with activity. Over the activity range being considered costs and revenues behave in a linear fashion. That technology , production methods and efficiency remain unchanged. Particularly for graphical methods that the analysis relates to one product only or to a constant product mix. There are stock level changes or that stocks are valued at marginal cost only.
C-V-P Analysis By Formula C-V-P analysis can be undertaken by a simple formulae or graphical means. Below are some formulae to learn: 1. Break-even-point (in units) = Fixed Costs Contribution per unit 2. Break-even-point ($ Sales) = (Fixed Costs Contribution per unit) x Sales Price per unit Where, = Fixed Costs x ( C/S ratio)
C / S Ratio = ( Contribution per unit Sales Price per unit ) x 100 3. Level of Sales to results in target profit ( in units) = ( Fixed Costs + Target Profit ) Contribution per unit 4. Level of Sales to results in target profit after tax (units) = {( Fixed Cost + ( Target Profit (1 Tax Rate))} Contribution per unit Note : The above formulae relate to a single product firm or one with an unvarying mix of sales. With a multi product firm it is possible to calculate the break even point as follows: Break-even-point ($ Sales) = (Fixed Costs Contribution per unit) x Sales Value Example One A company makes a single product with a sales price of $10 and a marginal cost of $6. Fixed costs are $60,000 per annum. Calculate a. Number of units to break even Prepared by : Mr. Arona JOHN Page 31 of 75
b. c. d. e. f.
Sales at break-even-point C /S Ratio What number of units will need to be sold to achieve a profit of $20,000 p.a. What level of sales will achieve a profit of $20,000 p.a. If the taxation rate is 40% how many units will need to be sold to make a profit after tax of $20,000 p.a. g. Because of increasing costs the marginal cost is expected to rise to $6.50 per unit and fixed costs to $70,000 p.a. If the selling price cannot be increased what will be the number of units required to maintain a profits of $20,000 p.a. (Ignore tax) Answer: Contribution = Selling price marginal cost = $10 - $6 = $4 a. Break-even-point (in units) = Fixed Costs Contribution per unit Break-even-point (units) = $60,000 $4 = 15,000 units b. Break-even-point ($ Sales) = (Fixed Costs Contribution per unit) x Sales Price per unit = 15,000 x $10 = $150,000 c. C / S Ratio = ($4 x 100 ) $10 = 40 % d. Number of units for target profit = ( Fixed Costs + Target Profit ) Contribution per unit = ( $60,000 + $20,000 ) $4 = 20,000 units e. Sales for target profit = Number of units for target profit x Sales price per unit = 20,000 x $10 = $200,000 f. Number of units for target profit after tax = {( Fixed Cost + ( Target Profit (1 Tax Rate))} Contribution per unit 23,333 units = {( $60,000 + ( $20,000 (1 0.4))} $4 =
g. With changes in the fixed costs, marginal cost and contribution, Number of units for target profit = ($70,000 + $20,000) $3.5 = 25,714 units Example Two Prepared by : Mr. Arona JOHN Page 32 of 75
2.
A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 50 Direct labour cost per unit 42 Variable overhead cost per unit 40 Selling price per unit 242 Fixed costs allotted to the product951,500 The budgeted production and sales is 17,500 units. The maximum output, based on the existing resources, is 25,500.
TASKS a) Calculate the profit if 17,500 units are made and sold.[3] b) Calculate the break-even point (in units) based on the above data.[2] c) The company had spent 12,000 trying to get a large order from Faye Ltd, a major retailer. Faye Ltd did not place any such order. However, another retaile Ebrima Ltd, have approached the company to supply an own brand version of the product to sell in their stores. Weston Ltd are offering to buy 4,000 units at 230 each. The own brand version will involve an extra 5 per unit spending on very minor changes to the colour of the product and the packaging. Advise the manufacturing company as to whether or not they should accept the order. You are advised to show your supporting calculations.[5] c) Sketch a break-even graph/diagram based on the original 2. Total Variable cost per unit: Direct material cost per unit Direct labour cost per unit Variable overhead cost per unit Total Variable cost per unit Selling price per unit Contribution per unit (i.e. Unit Contribution) (50) (42) (40) (132) 242 110
Total Contribution = Unit Contribution x Quantity i.e. Total Contribution = 110 x 17,500 = 1,925,000 (1 Mark) Total Fixed Cost = 951,500 (a) Profit = Total Contribution - Total Fixed Cost i.e. Profit = 1,925,000 - 951,500 = 973,500 (2 Marks) (b) Break-event point = Total Fixed Cost Contribution per unit i.e. Break-event point 951,500 110 = 8,650 units Prepared by : Mr. Arona JOHN (2 Marks) Page 33 of 75
(c) The 12,000 spent trying to get a large order from Faye Ltd, who did not place any such order is a sunk cost in our decision whether to accept Ebrimas order or not. Thus, we have two options to consider either to accept Ebrima Ltds order given his companys order condition or to sell the product to other customers. Hence, the decision rule here is to compare the profit we will get in the above two cases and accept the one that gives us the best (higher) profit amount or least (lower) loss figure. Case I : Selling the 4,000 units to other customers Profit = Total Contribution - Total Fixed Cost Using the information given but with quantity now be 4,000 units Profit = Total Contribution - Total Fixed Cost Profit = (= 110 x 4,000) - 951,500 = 440,000 - 951,500 = (511,500) i.e . Loss = 511,500 Case II : Accept Ebrima Ltds Order and Terms & Conditions New Contribution per unit will be: Total Variable cost per unit: Direct material cost per unit (50) Direct labour cost per unit (42) Variable overhead cost per unit (40) Extra Variable cost per unit (5) Total Variable cost per unit (137) New Selling price per unit 230 New Contribution per unit (i.e.New Unit 93 Contribution) New Total Contribution = 93 x 4,000 = 372,000 (1 Mark) Total Fixed Cost = 951,500 New Profit = New Total Contribution - Total Fixed Cost New Profit = 372,000 - 951,500 = (579,500) i.e . Loss = 579,500 As it appears that the loss to be incurred by selling the proposed 4,000 units to our other customers (511,500) is lower that the loss to be incurred by accepting the order from Ebrima Ltd (579,500) then we would recommend that the order from Ebrima Ltd should be rejected. (d) Note: to sketch a break-even graph requires us to sketch the following graphs : - Sales Revenue line, which is defined as, Sales = P x Q, where P = Selling price per unit and Q = Quantity - Total Cost line, Total Cost = (VC x Q) + Fixed Cost, where VC = total variable cost per unit. Also remember that to sketch a straight line graphs two points (coordinates) suffice. Thus, here we go: Since the question specifically requires us to use Q = 17,500 P = 242 For Sale = P x Q, will have Prepared by : Mr. Arona JOHN Page 34 of 75
Sales = 242 x 17,500 = 4,235,000, So we will have this point on this line ( 17,500, 4,235,000) And Total Cost = (VC x Q) + Total Fixed Cost = (110 x 17,500) + 951,500 = 1,925,000 + 951,500 = 2,876,500 So we will have this point on this line (17,500, 2,876,500) For simplicity, let the other point be where Q = 0 Thus, Sales = 0 So we will have this point on the sales line ( 0, 0) as our second point. And for Total Cost = 0 + Fixed Cost = 951,500 So we will have this point on the total cost line ( 0, 951,500 ) as our second point. Now we will sketch these line in class using the above points. Margin of Safety (MOS) Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production. Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business. Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio. Margin of safety = Sales at selected activity Sales at BEP = Profit at selected activity P/V ratio
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken. a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold. Prepared by : Mr. Arona JOHN Page 35 of 75
b. Reducing fixed costs c. Reducing variable costs d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output e. Modernization of production facilities and the introduction of the most cost effective technology Problem 1 A company earned a profit of $. 30,000 during the year 2000-01. Marginal cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the margin of safety. Solution Margin of safety = Profit P/V ratio
Limiting Factors When optional decisions are being considered, the aim will always be to maximize contribution because the greater the contribution then the more chance there is of covering the fixed costs and of making a profit.When managers are faced with a choice, therefore, between (say) producing product A at a contribution of 10 per unit or of producing product B at a contribution of 20 per unit, they would normally choose product B. Sometimes, however, it may not be possible to produce unlimited quantities of product B because there could be limits on how many units could either be sold or produced. Such limits are known as limiting factors (or key factors). Limiting factors may arise for a number of reasons. It may not be possible, for example, to sell more than a certain number of units, there may be production restraints (such as shortages of raw materials, skilled labour or factory space), or the company may not be able to finance the anticipated rate of expansion. If there is a product that cannot be produced and sold in unlimited quantities, then it is necessary to follow a simple rule in order to decide which product to concentrate on producing. The rule can be summarized: choose the work that provides the maximum contribution per unit of limiting factor employed. Technique is to: Prepared by : Mr. Arona JOHN Page 36 of 75
1 Calculate the contribution made by each product. 2 Divide the contribution that each product makes by the number of limiting factor used in making each product. 3 This gives the contribution per the limiting factor). 4 Select the project that gives the highest contribution per unit of limiting factor. So, if we had to choose between two jobs (say) A and B, we would convert As contribution and Bs contribution into the amount of contribution earned for every limiting factor on A and on B respectively. We would then opt for the job that earned the most contribution per limiting factor. Example: MDI Ltd manufactures a product for which there is a shortage of the new material known as ICM. During the year to 31 March 2012, only 1,000 kilograms of ICM will be available. ICM is used by MDI Ltd in manufacturing both Product X and Product Y. The following information is relevant: Per unit: Product X Product Y $ $ Selling price 300 150 Less: Variable costs 200 100 Contribution 100 50 P/V ratio (($100300) x 33.33 33.33 100) and (($50150) x 100) Kilogram of ICM required 5 2 Required: State which products MDI Ltd should concentrate on producing. Answer: Contribution per unit (C) Limiting factor per unit (kg) (LF) Contribution per Limiting Factor ( CLF) Decision Rule : MDI Ltd should contribution per limiting factor. Product X $ 100 5 20 first Product Y $ 50 2 25 concentrate on the product with highest
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Therefor from the above result, since Product Y s contribution per limiting factor ($25) is greater than that of Product X, MDI Ltd should concentrate on Product Y. This is because this will yield a greater maximum contribution. Check: Maximum contribution of Product X: 200 units ( 1000kg5) x contribution per unit = 200 x $100 = $20,000 Maximum contribution of Product Y: 500 units ( 1000kg2) x contribution per unit = 500 x $50 = $25,000
CHAPTER FOUR : CONCEPTS & THEORIES RELATED TO SHORT-TERM DECISION MAKING Definitions Controllable and non-controllable costs. Costs may be classified in management reporting systems according to whether they are controllable or non-controllable. This means that the costs which are within the control of management are highlighted in the reports so that management action is directed where it is most worthwhile. Normal and abnormal costs. A normal cost is one which management was expecting to incur and which is of the expected order of magnitude. An abnormal cost is one which was not expected or which is larger or smaller than expected. This type of classification is used to draw managers attention to the cost of abnormal events. Relevant and non-relevant costs. This method of classification divides costs according to whether they are relevant to a decision being taken, or not relevant to the decision. Relevant costs are those future cost that are likely to be affected by a particular decision. It follows that non-relevant cost are those that are not likely to be affected by the decision. This means that nonrelevant costs, such fixed costs (although they are not always irrelevant), can be exclude from any cost analysis. Examples of non-relevant costs are sunk costs or past costs. A sunk cost is a cost that has already been incurred in the past. Fixed cost
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A fixed cost is a cost which is incurred for an accounting period, and which, within certain output or turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover). Another term that can be used to refer to a fixed cost is a period cost. This highlights the fact that a fixed cost is incurred according to the time elapsed, rather than according to the level of activity. A fixed cost can be depicted graphically as shown below:
Examples of fixed costs are rent, rates, insurance and executive salaries. The graph shows that the cost is constant (in this case at GMD5,000) for all levels of activity. However, it is important to note that this is only true for the relevant range of activity. Consider, for example, the behaviour of the rent cost. Within the relevant range it is possible to expand activity without needing extra premises and therefore the rent cost remains constant. However, if activity is expanded to the critical point where further premises are needed, then the rent cost will increase to a new, higher level. This cost behaviour pattern can be described as a stepped fixed cost as shown below:
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The cost is constant within the relevant range for each activity level but when a critical level of activity is reached, the total cost incurred increases to the next step. Variable cost A variable cost as a cost which varies with a measure of activity. Examples of variable costs are direct material, direct labour and variable overheads. Below is graph of variable cost per unit:
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The above graph depicts a linear variable cost. It is a straight line through the origin, which means that the cost is nil at zero activity level. When activity increases, the total variable cost increases in direct proportion, that is, if activity goes up by 10 per cent, then the total variable cost also increases by 10 per cent, as long as the activity level is still within the relevant range. The gradient of the line will depend on the amount of variable cost per unit. Semi-variable cost A semi-variable cost is also referred to as a semi-fixed or mixed cost. It is defined as a cost containing both fixed and variable components and which is thus partly affected by a change in the level of activity. A graph of a semi-variable cost look like this:
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Examples of semi-variable costs are gas and electricity. Both of these expenditures consist of a fixed amount payable for the period, with a further variable amount which is related to the consumption of gas or electricity. Committed Costs These are costs that arise out of a decision that has previously been taken, although the event has not yet taken place. For example, a proposal to increase the capacity of a factory from 1000 to 1600 units per annum will result in increased capital expenditure. A decision to accept the proposal means that certain costs are committed and it only becomes a matter of time before there is a cash flow. Once the proposal has gone ahead and it has been paid for, the cost become sunk cost. Committed cost (like sunk costs) are not relevant as far as future decisions are concerned. Opportunity Cost This is a measure of the net benefit that would be lost if one decision is taken instead of another decision.
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Importance of Knowledge of Cost Behaviour

Cost behaviour refers to the manner in which a cost changes as a related activity change. Knowing how costs behave is useful to management for a variety of purpose. E.g. a) Knowing how costs behave allow managers to predict profit as sales and production volumes change b) Its also useful for estimating cost. Estimated costs, in turn, affect a variety of management decisions, such as whether to use excess machine capacity to produce and sell a product at a reduce price. The three most common classification of cost behaviour are: 1) Variable Costs- when the level of activity is measured in units produced; direct materials and direct labour costs are generally classified as variable cost. Variable costs are costs that vary in proportion to changes in the level of activity. 2) Fixed costs- are costs that remain the same in total dollar amount as the level of activity changes. 3) Mixed costs- have the characteristics of both a variable and fixed cost. For example, over one range of activity, the total mixed cost may remain the same. It thus behaves as fixed cost. Over another range of activity, the mixed cost may change in proportion to changes in the level of activity. It thus behaves as a variable cost. Hence mixed cost are sometimes called semi variable or semi fixed costs Types of Decision Below are some specific decisions that managers may have to take Type Question Closure and shutdown Will it be temporary or permanent? Make or buy Do we make our own or buy outside? Pricing Should it be market based or cost based? Special orders Will it be profitable? Capital Investment How much will it cost? A Closure decision Worked Example Success Power has three main product lines: 1, 2 and 3. The company uses an absorption costing system, and the following information relates to the budget for the year 2012. Product line 1 2 3 Total Budgeted sales (units) 10,000 4,000 6,000 $000 $000 $000 $000 Prepared by : Mr. Arona JOHN Page 43 of 75
Sales revenue Direct materials Direct labour Production overhead Non-production overhead Profit (loss)
300 100 50 75 15 240 60
200 40 70 30 10 150 50
150 60 80 35 5 180 (30)
650 200 200 140 30 570 80
Additional information: 1. Both direct materials and direct labour are considered to be variables. 2. The total production overhead of $140,000 consists of $40,000 variable costs and $100,000 fixed costs. Variable production overheads are absorbed on the basis of 20 per cent of the direct labour costs. 3. The non-production overhead of $30,000 is entirely fixed. 4. Assume that there will be no opening or closing stock. Required: Determine whether product line 3 should be closed Answer Hint: To determine whether we should recommend a closure of product line 3 we will first calculate the contribution that each product line makes. Product line Budgeted sales (units) Sales revenue Less Variable Cost Direct materials Direct labour Variable Production overhead (20% of direct labour cost) Contribution Less: Fixed Costs: Production overheads ($140-40) Prepared by : Mr. Arona JOHN 1 10,000 $000 300 100 50 10 160 140 2 4,000 $000 200 40 70 14 124 76 3 6,000 $000 150 60 80 16 156 (6) Total $000 650 200 200 40 440 210 (100) Page 44 of 75
Non-production overheads (see question note 3) Profit Observations
(30) 80
It would appear that product line 3 neither makes a profit nor contributes towards the fixed costs. Should it be closed? Before such a decision is taken a number of other factors would have to be considered. These are as follows: Are the budgeted figure accurate? Have they been checked? How reliable are the budgeted data? What method has been used to identified the direct material costs that each product line uses? Is it appropriate for all three product lines? The question states that direct labour is a variable cost. Is direct labour really a variable cost? Is the assessment of its cost accurate and realistic? Variable production overheads are absorbed on a very broad basis related to direct labour costs. Does this method fairly reflect product line 3s use of variable overheads. Product line 3 appears to result is only a small negative contribution. Can this be made positive by perhaps a small increase in the unit selling price or by the more efficient use of direct materials and direct labour? Assuming that the cost data supplied are both fair and accurate, would the closure of product line 3 affect sales for the other two product lines or the overall variable costs? If closure of product line 3 is recommended , should it be closed permanently or temporarily? More information is needed of it prospcts beyond 2012. The decision Clearly, without more information it is impossible to come to a firm conclusion. Assuming that the cost accounting procedures are both accurate and fair, it would appear that on purely financial grounds, product line 3 should be closed. However, until we have more information we cannot put this forward as a conclusive recommendation. A Make or Buy Decision Worked Example Zam Limited uses an important component in one of its products. An estimate of the cost of making one unit of the component internally is as follows: $ Direct materials 5 Direct labour 4 Variable overhead 3 Total variable cost 12 Prepared by : Mr. Arona JOHN Page 45 of 75
Additional Information 1. Fixed costs specifically associated with manufacturing the components are estimated to be $8000 per month. 2. The number of components normally required is 1000 per month. An outside manufacturer has offered to supply the components at a cost of $18 per component. Required: Determine whether Zam Limited should purchase the components from the outside supplier. Answer: Hint: First calculate the cost of manufacturing the components internally. Total cost of manufacturing internally 1000 units per month of the component: Total variable cost (1000 x $12) Associate fixed costs Total Cost Total unit cost ($20,0001000) $ 12,000 8,000 20,000 20
Unit cost of ordering the component is $18 (given). While unit cost of manufacturing it internally is $20. The decision Given the data above, it would be cheaper to purchase the component externally. This would free some resources within Zam limited enabling it to concentrate on manufacturing its main product. However, there are a number of other considerations that need to be taken into account. In particular the following questions would need to be asked. How accurate are the cost data? How variable is the monthly activity level? Is the external suppliers component exactly suited to the companys purposes? How reliable is the proposed supplier? Are there other suppliers who could be used in an emergency and at what cost? What control could be exercised over the quality of the component received? How firm is the quoted price of $18 per component, and for what period will that price be maintained? Page 46 of 75
How easy would it be to switch back to internal manufacturing if the supplier proved unreliable? It follows that much more information would be required before a conclusive decision could be taken. PRACTICE QUESTIONS 1. A business makes a single product. The business plans to make and sell 100,000 units in the next budget year. It has the capacity to make up to 150,000 units without incurring additional fixed cost expenditure. Details of budgeted costs and revenues are as follows: Direct material cost per unit 40 Direct wage cost per unit 20 Variable overhead cost per unit 80 Selling price per unit 200 Total fixed cost 3,000,000 REQUIRED a) Calculate the existing budgeted profit.[3] b) Calculate the existing budgeted breakeven point.[2] c) Calculate the profit if the selling price was set at 215 and 91,000 units were made and sold. [3] d) Calculate the profit if the selling price was set at 190 and 125,000 units were made and sold. [3] e) Calculate the profit if the appearance and quality of the product was improved by spending 10 more per unit on material and packaging and spending 75,000 more on advertising f) Explain the importance of calculating the breakeven point of a business.[4] 2. A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 35 Direct labour cost per unit 25 Variable overhead cost per unit 45 Selling price per unit 165 Fixed costs allotted to the product550,000 The budgeted production and sales is 20,000 units. The maximum output, based on the existing resources, is 21,000. TASKS a) Calculate the profit if 20,000 units are made and sold. b) Calculate the break-even point (in units) based on the above data. Prepared by : Mr. Arona JOHN Page 47 of 75
[3] [2]
c) A well-known retail store is interested in placing an order for 10,000 units of this product, at a price of 140 per unit. It will insist on using its own brand label, and a mino has equipment which has a written down value of 80,000, and was about to be sold to a scrap calculations. [8]
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CHAPTER FIVE: INVESTMENT APPRAISAL Investment (project) appraisal is a process whereby proposed projects are appraise in terms of their expected returns. Due to limited resources available we are to select the project that yields the highest expected returns. The term investment (project) appraisal is synonymous to the term capital budgeting. Capital budgeting is the process of planning expenditure on assets whose cash flows are expected to extend beyond one year. We will first examine and discuss some basic concepts necessary for our understanding and application of project appraisal techniques. Basic Concepts Time Value of Money: This suggests that money has a time value. That is a dollar in hand is worth more than a dollar to be received in the future because, if you had it now, you could invest it, earn interest, and end up with more than one dollar in the future. Dollars that are paid or received at two different points in time are different, and this difference is recognized and accounted for by the time value of money (TVM) analysis. Time Line : An important tool used in time value of money analysis; it is a graphical representation which used to show the timing of cash flows. Example of time line: Present Value : Is the beginning amount, in your account. Future Value: This is the amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate. Compounding: This is the arithmetic process of determining the final (future) value of a cash flow or series of cash flows when compound interest is applied. i.e. FVn = PV (1 + r)n Where, PV = Present Value r = interest rate the bank pays per year. The interest earned is based on the balance at the beginning of each year, and it is assume that is paid at the end of the year. Note that r here is expressed as a decimal. Thus, if r = 5% it is inputted as 0.05.
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n = number of periods involved in the analysis. FVn = future value, or ending amount, in your account at the end of n years. Capital Expenditure : This is expenditure which results in the acquisition of fixed assets, or an improvement in their capacity. Capital expenditure is not charged as an expense in the profit and loss account of a business enterprise, although a depreciation charge will usually be made to write off the capital expenditure gradually over time. Instead capital expenditure in fixed assets results in the appearance of a fixed asset in the balance sheet of a business. Revenue Expenditure is an expenditure which is incurred for the purpose of the trade of the business or to maintain the existing earning capacity of the fixed assets. Capital Investment involves expenditure on fixed assets for use in a project which is intended to provide a return by way of interest, dividends or capital appreciation. Methods of Appraisal for Capital Projects 1. Accounting Rate of Return (ARR) The ARR is the ratio of average profits, after depreciation, to the capital invested. This is a basic definition only and various interpretations are possible i.e. a) Profits may be before or after tax b) Capital invested may be the initial capital invested or the average capital invested over the life of the project i.e. Initial Investment 2 c) Capital may or may not include working capital Note: Alternative names for the ARR are : Return on Capital Employed and Return on Investment
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Example A firm is considering three projects each with an initial investment of 2,500 and a life of five years. The estimated annual profits are as follows: After Tax and Depreciation Profits Year Project A Project B 1 250 500 2 250 450 3 250 100 4 250 100 5 250 100 Total 1,250 1,250 Calculate the ARR based on: a) Initial capital invested b) Average capital invested. Solution Average Profits ARR (based on initial capital of 2,500) ARR (based on average capital of 2,500) Project A Project B Project C 1,250 5 =250 pa. 1,250 5 =250 pa. 1,250 5 =250 pa. =(250 2,500) x 100% = 10% =(250 2,500) x 100% = 10% =(250 2,500) x 100% = 10% Project C 100 100 100 450 500 1,250
=(250 1,250) x 100% = 20%
=(250 1,250) x 100% = 20%
=(250 1,250) x 100% = 20%
Advantages of ARR The only advantage that can claimed for ARR is simplicity of calculation. Disadvantages of ARR 1. It ignores the timing of outflows and inflows. 2. Uses a measure of return the concepts of accounting profit. Profit has subjective elements, is subject to accounting conventions and is not as appropriate for investment decision making as the cash flows generated by the project. Prepared by : Mr. Arona JOHN Page 51 of 75
3. There is no universally accepted method of calculating ARR. 2. Payback Period Method This method measures the time to be taken to recover the initial investment (capital outlay). The method is particularly relevant if there are liquidity problems, or if distant forecast are very uncertain. The payback period method was the first formal budgeting projects. method used to evaluate capital
Decision Rule: The shorter the payback period, the better the project Example One Consider the case of two machines for which the following is available: Machine P Machine Q Cost 10,000 10,000 Cash inflow year 1 1,000 5,000 2 2,000 5,000 3 6,000 1,000 4 7,000 500 5 8,000 500 Calculate the payback period for each of the project and state which one of the projects should be chosen. Solution Machine P Cash Flow (CF) 0 1 2 3 4 5 (10,000) 1,000 2,000 6,000 7,000 8,000 Cumulative Cash Flow (CCF) (10,000) (9,000) (7,000) (1,000)
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Note: The payback period is more than three years but less than four years. This is so because the balance of the outlay to be recovered at the end of the three year period is just 1,000, which is less than the cash flow of 7,000 in the year four. Therefore the payback period is between three and four years. The payback period is therefore calculated as follows: Payback Period = 3 years + (1,000 / 7,000) = 3.14 years Machine Q Cash Flow (CF) 0 1 2 3 4 5 (10,000) 5,000 5,000 1,000 500 500 Cumulative Cash Flow (CCF) (10,000) (4,000)
Note: The payback period is just two years. This is so because the balance (5,000) of the outlay to be recovered at the end of the two year period. The payback period is 2 years. Therefore, machine P pays back after 3 years 1 month and machine Q at the end of year two. Since the project with a shorter payback period should be preferred, therefre machine Q should be chosen. Example Two Consider the following: Outlay Project Cost - Working Capital Investment Inflow year 1 2 3 4 Calculate the projects payback period. Prepared by : Mr. Arona JOHN Page 53 of 75 80,000 10,000 30,000 40,000 40,000 50,000
Solution
Year 0 1 2 3 4 5
Cash Flow (CF) (90,000) 30,000 40,000 40,000 50,000 8,000
Cumulative Cash Flow (CCF) (90,000) (60,000) (20,000)
Thus, the payback period = 2 years + (20,000 / 40,000) = 2.5 years Advantages of the Payback Period It is simple to understand and explain, It is risk reducing measure. It has the correct emphasis for firm with limited cash resources. Disadvantages of the Payback Period It does not appraise the whole period of the investment (i.e it ignores any cash flows that occur after the project has paid for itself. It ignores the time value of money. The selection of a target payback period may be arbitrary Total profitability is ignored. Discounted Cash Flows (DCF) Methods There are two basic DCF methods, namely; Net Present Value (NPV) and Internal Rate of Return (IRR).Both methods recognize the time value of money, the time preference for receiving the same sum of money sooner rather than later. Before going further it is important to know that only relevant costs need to be considered in our project appraisal. Relevant cost are costs incurred as a result of taking up the project. Non-relevant cost, such as depreciation and sunk costs are to be ignored. Depreciation is a non-cash flow item and should therefore be ignored. Prepared by : Mr. Arona JOHN Page 54 of 75
Sunk Costs are expenses / costs already incurred, well before the project starts. They include; land already bought and any other expenses / expenditure already made. Discounting and Compound Interest If we were to invest 1,000 now in a bank account which pays interest of 10% per annum, with interest calculated once each year at the end of the year, we would expect the following returns: (a) After one year, the investment would rise in value to: 1,000 + (1,000 x 10%) = 1,000 (1 + 10%) = 1,000 x 1.10 = 1,100 Interest for the year would be 100 , i.e. 10% x 1,000. We can say that the rate of simple interest is 10%. (b) If we keep all our money in the bank account, after two years the investment would now be worth: 1,100 x 1.1 = 1,210 i.e. 1,000 x (1.10) x (1.10) = 1,000 x (1.10)2 = 1,210 Interest in year two would be : 1,210 - 1,100 = 110 Similarly, if we keep the money invested for further year, the investment would grow to 1,000 x (1.10) x (1.10) x (1.10) = 1,000 x (1.10)3 = 1,331 at the end of the third year. Interest in year three would be : 1,331 - 1,210 = 121. This example show how compound interest works, Compound interest arises when accrued interest is added to the capital outstanding and it is this revised balance on which interest is subsequently earned. A formula which can be used to show the value of an investment after several years which earns compound interest is: F = P x (1 + r)n Where, F = future value of the investment after n years P = the amount invested now , i.e . the present value r = the rate of interest, as a proportion for example. 10% = 0.10 n = the number of years of the investment Prepared by : Mr. Arona JOHN Page 55 of 75
Note : The present value is the cash equivalent now of a sum receivable or payable at a future date. The formula for the Present Value (P) of a single sum, F receivable in n years time, given the interest rate ( a discount rate) r is given by: P = F x 1 / (1 + r)n The Net Present Value (NPV) Method of DCF The NPV method of evaluation is as follows: (a) Determine the present value of costs. Let this C. (b) Calculate the present value of future cash benefits from the project. To do this we take the cash benefit in each year and discount it to a present value. By adding up the present value of the benefits for each future year, we obtain the total present value of benefits from the project. Let this B. (c) Compare the present value of cost C with the present value of benefits B. The NPV is the difference between them : B - C. (d) Decision Rule: If the NPV is positive accepts / take the project. This means that the present value of benefits exceeds the present value of cost. It also means that the project will earn a return in excess of the cost of capital. If the NPV is negative reject, that is dont take the project . The negative NPV means that it would cost us more to invest in the project to obtain the future cash receipts than it would cost us to invest somewhere else, at rate of interest equal to the cost of capital, to obtain an equal amount of future receipts. Examples 1. Suppose that a company is wondering whether to invest 18,000 in a project which would make extra profits (before depreciation is deducted) of 10,000 in the first year, 8,000 in the second year and 6,000 in the third year. Its cost of capital is 10% (in other word, it would require a return of at least 10% on its investment). Advise the company whether it should take on this project or not.
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Solution Year 0 1 2 3
Cash Flow (18.000) 10,000 8,000 6,000
Present Value Factor@10% 1 / 1+1.10)n 1.000 0.909 0.826 0.751
Present Value (18,000) 9,090 6,608 4,506 NPV = 2,204
Since the projects NPV is positive it means that the project will earn more than 10%. Therefore the project should be accepted . 2, A project would involve a capital outlay of 24,000. Profit (before depreciation) each year would be 5,000 for six years. The cost of capital is 12. Is the project worthwhile? Solution Year 0 1 2 3 4 5 6 Cash Flow (24.000) 5,000 5,000 5,000 5,000 5,000 5,000 Present Value Factor@12% 1 / 1+1.12)n 1.000 0.893 0.797 0.712 0.636 0.567 0.507 Present Value (24,000) 4.465 3,985 3,560 3,180 2,835 2,535 NPV = (3,440)
The projects NPV is negative and so the project is not worthwhile. Annuities In discounted cash flow the term annuity refers to an annual cash payment which is the same amount every year for a number of years, or also an annual receipt of cash which is the same amount every year for a number of years. The general equation used to find the present value of an annuity (PVA) is as follows:
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i.e. PVA = PMT (1 / (1+r)1) + PMT (1 / (1+r)2) + PMT (1 / (1+r)3) + ........+ PMT (1 / (1+r)n) Using geometric progression solution process the PVA is found to be: i.e PVA = PMT(1 / r ) ( 1 (1 / 1+r)n) Equation **
Thus use equation ** above to answer annuities questions. Where (1 / r ) ( 1 (1 / 1+r)n) is the discount factor for the annuities . Examples 1. A project would involve a capital outlay of 50,000. Profit before depreciation would be 12,000 per year. The cost of capital is 10%. Would the project be worthwhile if it last the following number of years? (a) Five years. (b) Seven years. Solution (a) When n = 5 years, then the discount factor is: i.e. discount factor = (1 / 0.1 ) ( 1 (1 / 1.10)5) = 3.791 Year Cash Flow Present Value Factor@10% 1 / 1+1.12)n 0 (50.000) 1.000 12,000 per annum 3.791 1-5 Present Value (50,000) 45,492 PVA = (4,508)
The project is not worthwhile if it last only for five years, since its NPV (PVA) is negative. (a) When n = 7 years, then the discount factor is: i.e. discount factor = (1 / 0.1 ) ( 1 (1 / 1.10)7) = 4.868 Year Cash Flow Present Value Factor@10% 1 / 1+1.12)n 0 (50.000) 1.000 12,000 per annum 4.868 1-7 Present Value (50,000) 58,416 PVA = 8,416 Page 58 of 75
The project would be worthwhile if it last for seven years since its NPV (PVA) is positive. The decision to accept or reject the project must depend on management view about its duration. 2. A project would cost 39,500. It would earn 10,000 per year for the first three years and then 8,000 per year for the next three years. The cost of capital is 10%. Is the project worth undertaking? Solution When n = 3, the discount factor : i.e. discount factor = (1 / 0.1 ) ( 1 (1 / 1.10)3) = 2.487 When n = 6, the discount factor : i.e. discount factor = (1 / 0.1 ) ( 1 (1 / 1.10)6 ) = 4.355 Therefore the discount factor for the period 4 6 would be = 4.355 2.487 = 1.868 Year Cash Flow Present Value Present Value Factor@10% 1 / 1+1.12)n 0 (39.500) 1.000 (39,500) 10, 000 per annum 2.487 24,870 1-3 8,000 per annum 1.868 14,944 4-6 PVA = 314 The NPV is positive, but only just 314. The project therefore promise a return a little above 10%. If we are confident that the estimates of cost and benefits for the next six years are accurate, the project is worth undertaking. However, if there is some suspicion that earnings may be a little less than the figures shown, it might be prudent to reject it. Exercise A project should involve the purchase of some plant for 25,000 and an investment in working capital of 6,000. It would earn 10,000 per year for four years. The cost of capital is 9%. Is the project worthwhile? Internal Rate of Return (IRR)
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The IRR is that discount rate which gives an NPV of zero. It is useful for conventional projects where once cash outflow is followed by a series of inflows. The IRR method involves two steps: (a) Calculate the rate of return which is expected from a project. It is general calculated by trial and error interpolating between one discount rate that gives a positive NPV and another that gives a negative NPV. A formula for making this calculation (which is known as interpolation) is as follows: i.e. IRR = A + { ((a (a+b)) x (B-A)%} where A = the discount rate which provides the positive NPV a = the amount of positive NPV B = the discount rate which provides the negative NPV b = the amount of negative NPV but the minus sign is ignored. The IRR Decision Rule: (a) Accept the project when the IRR is more than the target rate of return of cost of capital. (b) Reject the project when the IRR is less than the target rate of return or cost of capital. Examples 1. A machine requires an outlay of 1.5 million to produce three annual inflows of 0.7 million. Estimate the IRR, given NPV at 10% to be 241,000, at 20% to be (26,000) and decide whether the machine should be bought. Solution IRR = A + { ((a (a+b)) x (B-A)%} Where A = 10%, a = 241,000
B = 20% , b = 26,000 IRR = 10% + { ((241,000 (241,000+26,000)) x (20-10)%} = 19% Prepared by : Mr. Arona JOHN Page 60 of 75
Since the IRR (19%) is more than the cost of capital of 10% , then it means that the machine should be bought. 2. Suppose that a project would cost 20,000 and the annual net cash inflows are expected to be as follows: Year Cash Flow 1 8,000 2 10,000 3 6,000 4 4,000 What is the internal rate of return of the project? Solution The IRR is the rate of interest at which the NPV is zero and the discounted (present) values of benefits add up to 20,000. Thus, we need to find out what interest rate or cost of capital would give an NPV of zero. We might begin by trying discount rates of 10% , 15% and 20%. Year Cash Flow 0 1 2 3 4 NPV (20,000) 8,000 10,000 6,000 4,000 1.000 0.909 0.826 0.751 0.683 Discount Factor @10% Present Value @10% (20,000) 7,272 8,260 4,506 2,732 2,770 1.000 0.870 0.756 0.658 0.572 Discount Factor @15% Present Value @15% (20,000) 6,960 7,560 3,948 2,288 756 1.000 0.833 0.694 0.579 0.482 Discount Present Factor @20% Value 20% (20,000) 6,664 6,940 3,474 1,928 (994)
The IRR is more than 15% but less than 20%. Prepared by : Mr. Arona JOHN Page 61 of 75
Thus, using the IRR formula, IRR = A + { ((a (a+b)) x (B-A)%} Where A = 15%, a = 756
B = 20% , b = (994) IRR = 15% + { ((756 (756+994)) x (20-15)%} = 15% + 2.16% = 17.16% Advantage of the IRR Method The IRR is fairly easily understood since it is expressed in percentage terms. Disadvantages of the IRR Method It ignores the relative size of investments The method gives either no IRR or multiple IRRs in a non-conventional projects. A non-conventional project is one where the direction of cash flows varies during the course of the project (i.e. when there are changes in sign in the pattern of cash flows). In such cases use the NPV method Note: The NPV is always the preferred method. So when there is a conflict in the decision rule between the IRR and the NPV, the NPV rule is chosen. That is: . (a) If the NPV methods says we accept the project but the IRR method advices us to reject the project we should go by the NPV decision rule. (b) Similarly , if the NPV method says we reject the project but the IRR advices us to accept the project we should go by the NPV decision rule. Thus, the project should be rejected. Sensitivity Analysis This is one of the most useful and widely used techniques for allowing for risks. When a project is evaluated a large number of assumptions (or forecast) have to be made. For example, estimates would have to be made about the life of the project, its annual revenues, its annual labour costs, its annual material costs; etc. Suppose that all these estimates are made and, on the basis of an NPV analysis, the project has a +NPV of 250. Therefore the investment decision advice is to accept.
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What sensitivity analysis does is to look to see by how much each individual estimate can change before the decision advice to accept is overturned, (i.e. the NPV becomes negative). This analysis will enable management to identify which estimates are particularly critical to the NPV advice. For example suppose the sensitivity analysis indicated that the annual labour costs would only have to be 5% higher than estimated for the NPV to become negative. Management would then be able to re-examine the labour cost estimate to try and ensure that it is as accurate as possible. PRACTICE QUESTIONS 1. DEC Ltd has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,800,000 2,800,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 700 800 Year 2 1,100 1,200 Year 3 1,300 1,300 Year 4 700 600 Year 5 200 300 The cost of capital to DEC Ltd is 8%. Extracts from NPV tables are as follows; Year 8% 10% 1 .926 .909 2 .857 .826 3 .794 .751 4 .735 .683 5 .681 .621 REQUIRED a) b) c) d) 2. Calculate the payback period for EACH project.[3] Calculate the accounting rate of return for EACH project.[4] Calculate the NPV for EACH project.[8] State which project you would recommend (if any).[1]
12% .893 .797 .712 .636 .567
CAR Ltd has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,800,000 2,800,000 Expected life 5 years 5 years Page 63 of 75
Residual value nil Budgeted cash inflows: 000 Year 1 700 Year 2 1,000 Year 3 1,300 Year 4 1,000 Year 5 600 The cost of capital to CAR Ltd is 8%. Extracts from NPV tables are as follows: Year 8% 9% 1 .926 .917 2 .857 .842 3 .794 .772 4 .735 .708 5 .630 .650 REQUIRED a) b) c) d)
nil 000 800 1,100 1,800 700 200 10% .909 .826 .751 .683 .621
Calculate the payback period for EACH project.[3] Calculate the accounting rate of return for EACH project.[4] Calculate the NPV for EACH project.[8] Explain which project you would recommend (if any).[5]
3. REM Ltd has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 1,800,000 1,800,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 800 600 Year 2 1,000 900 Year 3 1,200 1,500 Year 4 700 800 Year 5 300 200 The cost of capital to REM Ltd is 8%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .909 .893 2 .857 .826 .793 3 .794 .751 .712 4 .735 .683 .567 5 .630 .621 .507
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REQUIRED a) b) c) d) Calculate the payback period for EACH project.[3] Calculate the accounting rate of return for EACH project.[4] Calculate the NPV for EACH project.[8] Explain fully which project you would recommend.[5]
4, You work in the management accounts department of a large organisation, which is in the process of allocating funds to one project from a choice of two. The following data applies: Project X Y Original investment 2,600,000 2,600,000 Net surplus returns: Year 1 600,000 400,000 Year 2 800,000 700,000 Year 3 900,000 1,000,000 Year 4 500,000 700,000 Year 5 200,000 400,000 The firms average cost of capital is 8%. Discount factors 8% Future years: 1 .926 2 .857 3 .794 4 .735 5 .681 6 .630 REQUIRED a) Calculate the payback period, for both projects.[3] b) Calculate the accounting rate of return, for both projects.[4] c) Calculate the net present value (NPV), for both projects.[8] d) State which project, if any, should be chosen.[1] e) Explain what non-financial factors should also be considered in the decision-making process. [4] 10% .909 .826 .751 .683 .650 .564
5. Anderson Ltd has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,400,000 2,700,000 Expected life 5 years 5 years Prepared by : Mr. Arona JOHN Page 65 of 75
Residual value nil Budgeted cash inflows: 000 Year 1 190 Year 2 900 Year 3 1,200 Year 4 700 Year 5 400 The cost of capital to LBW Ltd is 9% Extracts from NPV tables are as follows: Year 9% 10% 11% 1 .920 .909 .893 2 .842 .826 .793 3 .772 .751 .712 4 .708 .683 .567 5 .650 .621 .507 REQUIRED
nil 000 310 1,000 1,300 500 200
a) Calculate the payback period for EACH project.[3] b) Calculate the accounting rate of return for EACH project.[4] c) Calculate the NPV for EACH project.[8] d) State which project you would recommend (if any).[1] e) Explain why it is important to use investment appraisal techniques, and to monitor actual results.[4]
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CHAPTER SIX : BUDGET AND BUDGETARY CONTROL Definition of Budget: A budget is a comprehensive and coordinated plan, expressed in financial terms. It is a predetermined detailed plan of action developed and distributed as a guide to current operations. Budgeting: Budgeting is the process of preparing and using budgets to achieve management objectives. It is the systematic approach for accomplishing the planning, coordination, and control responsibilities of management by optimally utilizing the given resources. Difference Between Budgeting and Financial Planning: 1. Budgets are usually developed to match revenues against planned expenditures and comply with the institutions budget development and reporting requirements. The purpose of strategic financial planning is to project the longterm sources and uses of funds, evaluate the effectiveness of programs and departments. 2. The budgeting process usually involves routine review of annual expenditures. Financial planning, on the other hand, takes the institution through an evaluation process that identifies areas in which institution funds are being overspent or spent on ineffective programs. 3. The focus of a budget is on taking care of day-to-day operating needs. Financial planning focuses on allocating resources efficiently, making long-range plans for new funds. 4. The Managing Director, business heads and the people who report directly to them are involved in financial planning, which plays a more strategic role than traditional budgeting and places accountability on those managing budgets and departments. 5. Most traditional budgets focus on the collection of details , from head counts to supply use to salaries. Strategic financial planning uses this information as a foundation and build on it. 6. Traditional budgets usually provide data for the budget year and the previous year. Financial plans, in contrast, generally provide two or more years of history Prepared by : Mr. Arona JOHN Page 67 of 75
and a three- to five-year projection of future expenditures based upon strategic documents. 7. Traditional budgets ask, how is your department or program going to spend its funds next year? Strategic financial plans ask, what will you achieve with the level of funding requested for the next five years, and how does that compare to other alternatives for the same goal or service? 8. Budgets address the immediate operating needs of the organization: how much money is spent on salary versus supplies, for example, and how much is spent on each department. Strategic financial plans address critical issues, such as when new funding will be needed. 9. Traditional budgets affect what happens during the coming year, while strategic planning affects results for up to five years. 10. Traditional budgets show categorical spending only. Strategic financial plans show whether the funds are being used effectively. Objectives of Budgeting The main objective of budgeting is to assist the management in its main functions of planning, coordination and control. In fact, budget is an important instrument of communication through which management communicates its policies and targets to the persons doing work. Definitions: 1. Budget Centre: It is that part of the organization for which the budget is prepared. It may be a department or any other part of the department. It is essential for the appraisal of performance of different departments so as to make them responsible for their budgets. 2. Budget Officer: A Budget Officer is a convener of the budget committee. He coordinates the budgets of various departments. The managers of different departments are made responsible for their departments performance. 3. Budget Manual: It is a document which defines the objectives of budgetary control system. It spells out the duties and responsibilities of budget officers regarding the preparation and execution of budgets. 4. Budget Committee: The members of this committee may sometimes take collective decisions, if necessary. In small organizations, the accountant is made responsible for the same work. The need for coordination in the planning process is paramount. The Prepared by : Mr. Arona JOHN Page 68 of 75
interrelationship between the functional budgets (e.g. sales, production, purchasing) means that one budget cannot be completed without reference to several others. 5. Budget Period: It is the period for which a budget is prepared. 6. Determination of Key Factor (Principal budget factor) : The principal budget (key budget) factor is the factor which limits the activities of the organization. The early identification of this factor is important in the budgetary planning process because it indicates which budget should be prepared first. Types of Budgeting: Budget can be classified into three categories from different points of view. They are: 1. According to Function 2. According to Flexibility 1. According to Function: Sales Budget: This is a budget which estimates total sales in terms of items, quantity, value, periods, areas, etc. Production Budget: It estimates quantity of production in terms of items, periods, areas, etc. It is prepared on the basis of Sales Budget. Cost of Production Budget: This budget forecasts the cost of production. Separate budgets may also be prepared for each element of costs such as direct materials budgets, direct labour budget, factory materials budgets, office overheads budget, selling and distribution overheads budget, etc. Purchase Budget: This budget forecasts the quantity and value of purchase required for production. It gives quantity wise, money wise and period wise particulars about the materials to be purchased. Personnel Budget: This is a budget that anticipates the quantity of personnel required during a period for production activity. Capital Expenditure Budget: This budget provides a guidance regarding the amount of capital that may be required for procurement of capital assets during the budget period. Master Budget: It is a summary budget incorporating all functional budgets in a capsule form. It interprets different functional budgets and covers within its range the preparation of projected income statement and projected balance sheet. 2. According to Flexibility: Prepared by : Mr. Arona JOHN Page 69 of 75
On the basis of flexibility, budgets can be divided into two categories. They are: i. Fixed Budget ii. Flexible Budget FIXED AND FLEXIBLE BUDGET Fixed budget is also known as Static Budget. This budget is prepared for single level of activity and single set of business conditions. Fixed budget is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. A Flexible budget consists of a series of budgets for different level of activity. Therefore, it varies with the level of activity attained. A Flexible Budget is, a budget designed to change in accordance with level of activity attained. It is prepared by taking into account the fixed and variable elements of cost. This budget is more suitable when the forecasting of demand is uncertain. Points to be remembered while preparing a flexible budget : 1. Cost can be classified into fixed and variable cost. 2. Total fixed cost remains constant at any level of activity. 3. Total Variable cost varies in the same proportion at which the level of activity varies. 4. Fixed and variable portion of Semi-variable cost is to be segregated. Importance of Flexible budget: Advantages of marginal analysis: flexible budget presents details regarding output, costs, sales and profit at different levels of business activity and on these basis advantages of the technique of marginal analysis can be obtained. Comparison with actual performance: as this budget provides data for varying level of business operations, it makes possible the comparison of actual performance and budgeted one for actual level of operation is a very easy way. Tool of effective cost control: flexible budget in a useful tool for achieving the objective of cost reduction and cost control. More practical: under the conditions of competition and continuous changing situations it becomes difficult to make exact and precise forecasts. As such it is useful to forecast for varying levels of operation. Thus, flexible budgetary system is more useful and practical.
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METHODS OF BUDGETING Zero Base Budgeting (ZBB): It is a management technique aimed at cost reduction. It was introduced by the U. S. Department of Agriculture in 1961. Peter A. Phyrr popularized it. In 1979, president Jimmy Carte issued a mandate asking for the use of ZBB by the Government. ZBB Definition : It is a planning and budgeting process which requires each manager to justify his entire budget request in detail from scratch (Zero Base) and shifts the burden of proof to each manager to justify why he/she should spend money at all. The approach requires that all activities be analyzed in decision packages, which are evaluated by systematic analysis and ranked in the order of importance. It implies thatEvery budget starts with a zero base No previous figure is to be taken as a base for adjustments Every activity is to be carefully examined afresh Each budget allocation is to be justified on the basis of anticipated circumstances Alternatives are to be given due consideration Advantages of ZBB: 1. Effective cost control can be achieved 2. Facilitates careful planning 3. Management by Objectives becomes a reality 4. Identifies uneconomical activities 5. Controls inefficiencies 6. Scarce resources are used beneficially 7. Examines each activity thoroughly 8. Controls wasteful expenditure 9. Integrates the management functions of planning and control 10. Reviews activities before allowing funds for them. Incremental budgeting This approach is to take the previous years results and then to adjust them by an amount to cover inflation and any other known changes. It is the most common approach, is a reasonably quick approach, and for stable companies it tends to be fairly accurate. However, one large potential problem is that it can encourage the continuation of previous problems and inefficiencies. The reason for this is that the budget is a plan for the coming year not simply a financial forecast.
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If we require a wages budget, we will probably ask the wages department to produce it and they (using an incremental approach) will assume that our workers will continue to operate as before. They will therefore simply adjust by any expected wage increases. As a result, the plan for our workers stays the same as before. Nobody has been encouraged to consider different ways of operating that may be more efficient. It is at budget time that we perhaps should be considering different ways of operating. IMPORTANCE OF BUDGETARY CONTROL TO A COMPANY Budgetary control is a cost control method that enables actual results to be compared with the budget, thereby enabling any necessary corrective actions. It has the following important features 1. To Use the Forecasting Techniques It is the importance of budgetary control that with this, we can use the forecasting techniques. Three departments work hard for calculating best estimation of future. Accounting department provides old data. Statistical department provides the tools and techniques of forecasting like probability, time series other sampling methods. Management department uses both department services to estimate the expenditures and revenue of business under the normal conditions of business. So, no department say anything wrong in making of budget. So, it is necessary for business to use budgetary control techniques. 2. It Fix the Responsibilities of Departments and Managers : Managerial responsibilities are clearly defined. 3. Action Plan : The budgetary control ensures that individual budgets lay down a detailed plan of action for a particular sphere of responsibility. 4. Adherence and Effective Utilization of Company's resources Managers have a responsibility to adhere to their budgets once the budgets have been approved. Company can only effective use its resources, if someone stops misuse of money and fund of company. If budgetary control is used in Prepared by : Mr. Arona JOHN Page 72 of 75
company, at that time, no action will be taken before making budget. Responsible personal of company will be accountable for his action. Suppose, company has fixed the target of company's annual Sale is $ 40,00,000 after participating sales manager in the setting of this sale budget. Now, after one year, if sale is just $ 1,00,000. This sale manager must say what is the reason for not selling the product up to standard level of sale. 5.Monitoring : The actual performance is monitor constantly and compare with the budgeted results. 6. Corrective Action: Budgetary control ensures that corrective actions are taken if the actual results differ significantly from the budget. 7. Approval : As a form of budgetary control measure any departure from the budget are only permitted if they have been approved by senior management. 8. Variance : Budgetary control will ensure that variance that are unaccounted for will be subject to individual investigation. LIMITATIONS OF BUDGETING OR BUDGETARY CONTROL:Though budgetary control is an important device of management control, it suffers from the following limitations: 1) Budgets are based on Plan Estimates: budgets are based on estimates made for planning. Naturally the success or failure of budget depends to a large extent upon the accuracy of these estimates. 2) Budgeting is not a substitute of management: budget is not a substitute of management; it is only a tool of management for achieving the objectives of the concern. Hence, the success of budgeting depends on the ability and efficiency of those persons who are responsible for budgetary system. 3) Operation of the Budget plan is not automatic: mere preparation of budget cannot ensure the advantages of budgeting. The execution of budget is as important as its preparation. However, its operation is not automatic. In this context it is required that each executive must feel his responsibility and should make necessary efforts to attain the budgeted goals.
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4) Time effect: it takes some time in preparing budgets and during this period many such changes may occur due to which it becomes difficult to maintain the accuracy of budget. 5) Prohibitive cost: the installation of budgeting system involves too much time and costs. 6) Effects of changing conditions: in rapidly changing conditions it may not be possible to achieve the budgeted targets. Budgets may have to be revised from time to time but frequent revision of targets reduces the importance of budget and involves additional expenditure too. 7) Constraints on managerial initiative: budgetary control may serve as constraints on managerial initiative because every executive tries to achieve the budgeted targets only. There may be some efficient persons who can exceed the targets but they will also feel contended by reaching the targets. 8) Conflicts among functional executives: budgetary control may lead to conflict among functional executives because every executive may try to secure a larger share of budgetary allocation, while the success of budgetary control depends upon the team work. PRACTICE QUESTIONS 1. a) Explain the stages of a budgetary control system.[10] b) Explain the benefits of an efficient budgetary control system.[10] Budgetary control is at the centre of the financial management system of most organisations. Discuss.[10]
2.
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CHAPTER SEVEN : FINANCIAL MANAGEMENT AND SOURCES OF FINANCE Financial Management Definition: Financial Management is the management related to the financial structure of the company and therefore to the decision of source of funds. The Nature and Scope of Financial Management The role of the Financial Manager is to make the right decisions in order to achieve the objectives of the company in the future. The three key areas that the Financial Manager is concern with are as follows: (a) The raising of long-term finance: The company needs finance for investment and in order to expand. Finance can be raised from shareholders or from debt it is the job of the Financial Manager to be aware of the different sources of finances and decides which source to use. (b) The investment decision: Decisions have to be made as to where capital is to be invested. For example, is it worth launching a new product? Is it worth expanding the factory? Is it worth acquiring another company? It is the Financial Managers role to decide on which criteria to employ in making this kind of investment decision. (c) The management of working capital: In order for the company to operate, it will have to accept a certain level of debtors and it will have to carry a certain level of stock. Although these are needed to operate the business successfully, they require long-term investment of capital that is directly earning profits. Debtors and stock are just two component of working capital (working capital = current assets less current liabilities) and it is a job of the Financial Manager to ensure that the working capital is managed properly i.e. that it is high enough to enable the company to operate efficiently, but that it does not get out of control and end up wasting money for the company.
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Sources of Funds (Finance) Once a decision has been taken to invest in a particular project it is then necessary to search out a suitable method of financing it. For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for the success of the business. It is important, therefore, that you understand the various sources of finance open to a business and are able to assess how appropriate these sources are in relation to the needs of the business. Internal Sources Traditionally, the major sources of finance for a limited company were internal sources:

Retained profit Working capital Sale of assets
External Sources The external source of finance could take any of the three forms: Short-term finance, medium-term finance and long-term finance. Short-Term Finance: There five major sources of external short-term finance. Trade credit: This is a form of financing common in all companies. An entity purchase goods and services from suppliers and agrees to pay for them some days or weeks after they have been delivered. By delaying the payment of considered. Bank overdraft: This is a loan where the banks customer is allowed to draw out more from the bank than has been deposited. The advantages of overdraft are that it is flexible and that interest is normally only charged on the outstanding balance. creditors, the entitys immediate cash needs are less strained and it may be able to finance project that otherwise could not be
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Factoring:
This relates to an entitys debtors. There are two types of
factoring, namely Recourse Factoring, where an entity obtains a loan on the amount of its debtor balances and Non-recourse Factoring, where the debtor balances are sold to a factor and the factor then takes responsibility for dealing with them. Factoring is a convenient way of obtaining ready cash but either the interest rate on the loan or the discount on the invoices may be high. Bill of exchange: This is simply an invoice that has been endorsed (accepted) by a merchant bank. It can then be sold by the legal holder to obtain immediate finance. The interest charged depends on the creditworthiness of the parties involved, and if accompany has a poor reputation then it will expect to pay more interest. Commercial paper: This is a form of short-term borrowing used by large listed companies. It is bearer document, i.e. a person to whom the document is payable without naming that person. Medium Term Finance Bank loan: Banks may be prepared to lend a fixed amount to a customer over a medium- to long-term period. The loan may be secured on the companys assets and the interest charge may be variable. Credit sale: This is a form of borrowing in which the purchase agrees to pay for goods (and services) on an installment basis over an agreed period of time. Once the agreement has been signed, the legal ownership of the goods is passed to the purchaser and the seller cannot reclaim them. Hire purchase: This is similar to a credit sale except that the seller remains the legal owner of the goods until all payments due have been completed. An immediate deposit may be necessary, followed by series of regular installments. HP is usually an expensive method of financing the purchase of fixed assets. Prepared by : Mr. Arona JOHN Page 77 of 75
Leasing: This is a form of renting. A fixed assets remains legally in the ownership of the lessor.
Long-Term Finance -Debentures: These are formal long-term loans made to a company, they may be for a certain period or open-ended. Debenture are usually secured on all or some of entitys assets. Interest is payable but it is allowable against corporation tax. Debentures can be an economic method of financing specific projects. - Shares: Expansion of the company could be financed by increasing the number of ordinary shares available, either on the open market or to existing shareholders in the form of a rights issue. An increase in an entitys ordinary share capital dilutes the holding of existing shareholders and all shareholders will expect to receive increasing amounts of dividend. Alternatively new or additional preference shares could be offered; preference shareholders would have an automatic right to a certain percentage level of dividend and so the issue of preference shares limits the amount of dividend available to ordinary shareholders.
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CHAPTER EIGHT : PAST EXAM QUESTIONS
FINANCIAL DECISION MAKING

RATIO ANALYSIS 1. Scenario: Presto plc is a well-established UK-based company. Originally it was a brewery with a large number of pubs; however, in the early 1990s it diversified into hotels and restaurants and coffee houses. During the rest of the 1990s it sold off all its brewing facilities and pubs. As a consequence the group has expanded. The group specialises in three main brands: First Hotels, Cosy Coffee and Caf Blue. The First Hotel brand is a chain of standardised good-quality, budget-priced hotels situated in most, but not all, major towns and cities. Income Statement year to 30 November: Revenue Cost of sales Distribution expenses Administration expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax Profit/(loss) after tax 2012 m 1,600 (240) (890) (165) ------305 (39) ------266 (50) ------216 ==== 2011 m 1,435 (215) (830) (140) ------250 (43) ------207 (48) ------159 ====
Summarised balance sheet (position statement) as at 30 November: 2012 2011 Non-current assets Intangible 200 150 Property 2,420 2,310 -------------2,620 2,460
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Current assets Inventory Accounts receivable Bank
Total assets 2,760 Equity and reserves Share capital Retained profit Non-current liabilities Loans Current liabilities Accounts payable Tax owing
18 84 38 ------140 ----2,617 ===== 145 1,090 --------1,235 1,080 395 50 ------445 ------2,760
17 93 47 ------157 ------===== 145 960 ---------1,105 1,000 464 48 ------512 ------2,617
Total liabilities TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do.[10] b) Use the ratios AND the information provided in the scenario to analyse the performance of Presto plc. [16] c) Discuss the merits of how Presto plc has adapted its business model over the last 20 years. [8] (Dec 2012) 2. Scenario: Styleway Homes plc is a well-established house-building company specialising in private home building. It trades wholly in the UK. The trading conditions in the UK have been extremely challenging over the last few years. Income statement year to 30 August: Revenue Cost of sales Expenses Operating profit (PBIT) Net interest paid Profit before tax Provision for tax Profit/(loss) after tax 2011 m 410 (350) (25) ------35 (5) ------30 (10) ------20 ==== 2012 m 430 (375) (27) ------28 (5) ------23 (6) ------17 ====
Summarised balance sheet (position statement) as at 30 August: 2011 2012 Non-current assets 55 62
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-------1,200 60 80 ------1,340 ------1,386 ===== 200 890 --------1,090 125
------1,244 80 ------1,324 ------===== 200 910 ---------1,110 80
Total assets 1,395 Equity and reserves Share capital Retained profit Non-current liabilities Loans Current liabilities Accounts payable Loans Tax owing
130 150 40 40 10 6 ------------180 196 ------------Total liabilities 1,395 1,386 ===== ===== Note: The inventory is made up of land holdings, houses under construction and unsold completed houses. TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do. b) Use the ratios AND the information provided in the scenario to analyse the performance of Styleway Homes plc. c) Suggest ways in which Styleway Homes plc may improve future profitability.[6] ( Sept 2012) 3. Scenario: Scotts plc is a well-established cruise operating company specialising in European/Mediterranean cruises. It mainly has outlets in the UK and mainland Europe. In November 2011 there was a disaster for the industry, in as much as a cruise liner sank with much loss of life in the Mediterranean. Scotts plc has probably been slow to adjust its business model as regards the increased use of the internet by customers.
[12] [16]
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Income Statement year to 31 May: Revenue Cost of sales Expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax Profit/(loss) after tax
2011 m 9,800 (7,700) (1,700) ------400 (10) ------390 (80) ------310 ====
2012 m 8,200 (7,000) (1,450) ------(250) (100) ------(350) (nil) ------(350) ====
Summarised balance sheet (position statement) as at 31 May: 2011 2012 Non-current assets 6,500 6,800 -------------Current assets Inventory 50 40 Accounts receivable 1,550 1,320 Bank 800 ------------2,400 1,360 ------------Total assets 8,900 Equity and reserves Share capital Retained profit Non-current liabilities Loans Current liabilities Accounts payable Bank overdraft Tax owing 8,160 ===== 500 3,600 --------4,100 200 4,520 80 ------4,600 ------8,900 ===== ===== 500 3,250 ---------3,750 800 3,370 240 nil ------3,610 ------8,160 =====
Total liabilities
TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do. b) Use the ratios AND the information provided in the scenario to analyse the performance of Scotts plc. c) Suggest ways in which Scotts plc may change its business model in the future. ( June 2012)
[12] [16]
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4.
Scenario: Great Travel plc is a well-established tour operator specialising in package holidays. It mainly has outlets in the UK, Germany and Spain. It also specialises in offering holidays in North Africa e.g. Tunisia and Egypt. Great Travel plc has probably been slow to adjust its business model as regards the increased use of the internet by customers. Income Statement year to 30 April: Revenue Cost of sales Expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax Profit/(loss) after tax 2011 m 9,200 (7,400) (1,500) ------300 (10) ------290 (70) ------220 ==== 2012 m 8,300 (7,050) (1,400) ------(150) (100) ------(250) (nil) ------(250) ====
Summarised balance sheet (position statement) as at 30 April: 2011 2012 Non-current Assets 6,200 6,730 -------------Current assets Inventory 50 45 Accounts receivable 1,530 2,345 Bank 910 ------------2,490 2,390 ------------Total Assets Equity and Reserves Share capital Retained profit Non-current Liabilities Loans Current Liabilities Accounts payable Bank overdraft Tax owing 8,690 ===== 400 3,500 --------3,900 100 4,620 70 ------4,690 ------8,690 9,120 ===== 400 3,250 ---------3,650 900 4,320 250 nil ------4,570 ------9,120
Total liabilities
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TASKS a) For BOTH years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do. b) Use the ratios AND the information provided in the scenario to analyse the performance of Great Travel plc. c) Suggest ways in which Great Travel plc may change its business model in the future. ( May 2012) 5. The following are the recent final accounts of MBA plc: Income Statement year to 28 February: Turnover (all credit sales) Cost of sales Expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax Profit after tax Proposed dividend Retained profit 2011 000 8,740 (4,500) (2,900) ------1,340 (20) ------1,320 (160) ------1,160 (450) ------710 ==== 2012 000 10,150 (5,100) (3,550) ------1,500 (110) ------1,390 (180) ------1,210 (605) ------605 ====
[12] [16]
Summarised balance sheet (position statement) as at 28 February: 2011 2012 Non-current assets 2,800 3,600 Cumulative depreciation (700) (1,200) ------------2,100 2,400 ------------Current assets Inventory 380 990 Accounts receivable 540 1,100 Bank 10 ------------930 2,090 ----------Total Assets Equity and Reserves Share Capital Retained profit 3,030 ===== 750 1,000 --------1,750 4,490 ===== 1,000 1,605 ---------2,605
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Non-current liabilities Loans Current liabilities Accounts payable Bank overdraft Tax owing Dividends
200
800
470 200 100 160 180 450 605 ------------1,080 1,085 ------------Total liabilities 3,030 4,490 ===== ===== For information the average number of employees in the year ended 28 February 2011 was 80. For information the average number of employees in the year ended 28 February 2012 was 88. TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS as you feel able to do. b) Use the ratios in order to analyse the performance of MBA plc. c) Explain the importance of financial ratios to a business. [8] ( March 2012) 6. The following are the recent final accounts of RSK plc: Income statement year to 30 November: 2010 000 Turnover (all credit sales) 8,500 Cost of sales (4,400) Expenses (2,800) ------Operating profit (PBIT) 1,300 Interest paid (10) ------Profit before tax 1,290 Provision for tax (110) ------Profit after tax 1,180 Proposed dividend (130) ------Retained profit 1,050 ==== 2011 000 9,800 (4,700) (3,150) ------1,950 (90) ------1,860 (180) ------1,680 (180) ------1,500 ====
[8]
[18]
Summarised balance sheet (position statement) as at 30 November: 2010 2011 Non-current assets 2,400 3,500 Cumulative depreciation (600) (900) ------------1,800 2,600 ------------Current assets Inventory 360 1,090 Accounts receivable 530 1,300 Bank 10 ------------900 2,390
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------Total assets 2,700 Equity and reserves Share capital Retained profit Non-current liabilities Loans Current liabilities Accounts payable Bank overdraft Tax owing Dividends 4,990 ===== 800 1,120 --------1,920 100
------===== 1,450 1,620 ---------3,070 900
440 410 250 110 180 130 180 ------------680 1,020 ------------Total liabilities 2,700 4,990 For information the average number of employees in year ended 30 November 2011 was 78. For information the average number of employees in the year ended 30 November 2011 was 87. TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do. b) Use the ratios in order to analyse the performance of RSK plc. c) Explain why companies use a range of performance indicators to monitor performance.[8] (Dec 2011) 7. The following are the recent final accounts of FGH plc: Income Statement year to 30 April: Turnover (all credit sales) Cost of sales Expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax Profit after tax Proposed dividend Retained profit 2010 000 6,900 (3,900) (2,600) ------400 ------400 (70) ------330 (120) ------210 ==== 2011 000 8,100 (4,500) (3,000) ------600 (70) ------530 (110) ------420 (190) ------230 ====
[8]
[18]
Summarised balance sheet (position statement) as at 30 April: 2010 2011 Non-current assets 2,300 2,660 Cumulative depreciation (600) (800)
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------1,700 ------410 560 20 ------990 ----2,690 ===== 1,300 810 --------2,110 390 70 120 ------580 ------2,690
------1,860 ------1,290 1,400 ------2,690 ------4,550 ===== 1,660 1,040 ---------2,700 1,000 340 210 110 190 ------850 ------4,550
Total assets Equity and reserves Share capital Retained profit
Total liabilities
For information the average number of employees in the year ended 30 April 2010 was 80. For information the average number of employees in the year ended 30 April 2011 was 91. TASKS a) For both years, calculate TWO liquidity ratios and the gearing percentages. b) For both years calculate a MINIMUM of FOUR profit ratios. c) For both years calculate a MINIMUM of THREE efficiency ratios. d) Fully comment on the financial performance of FGH plc. e) Explain why business organisations make use of financial indicators as part of their financial control systems. 8. The following are the recent final accounts of WUL plc: Income Statement year to 31 May: Turnover (all credit sales) Cost of sales Expenses Operating profit (PBIT) Interest paid Profit before tax Provision for tax 2010 000 7,500 (4,200) (2,700) ------600 ------600 (100) 2011 000 8,500 (4,600) (3,100) ------800 (80) ------720 (120)
[34] (Sept 2011)
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Profit after tax Proposed dividend Retained profit
------500 (110) ------390 ====
------600 (130) ------470 ====
Summarised balance sheet (position statement) as at 31 May: 2010 Non-current assets 2,500 Cumulative depreciation (700) ------1,800 ------Current assets Inventory 380 Accounts receivable 520 Bank 20 ------920 ----Total Assets Equity and reserves Share capital Retained profit 2,720 ===== 1,000 1,050 --------2,050 -
2011 2,800 (800) ------2,000 ------1,100 1,200 ------2,300 ------4,300 ===== 1,180 1,520 ---------2,700 800
460 370 180 100 120 110 130 ------------670 800 ------------Total liabilities 2,690 4,300 ===== ===== For information the average number of employees in the year ended 31 May 2010 was 82. For information the average number of employees in the year ended 31 May 2011 was 89. TASKS a) For both years calculate as many PROFITABILITY, LIQUIDITY and EFFICIENCY RATIOS that you feel able to do. b) Use the ratios in order to analyse the performance of WUL plc. c) Explain the use of financial ratios. [34] (June 2011)
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9.
The following are the recent final accounts of Ettluc plc: Profit and loss (income statement) extract year to 28 February: 2010 2011 000 000 Turnover (all credit sales) 6,900 8,300 Cost of sales (3,400) (3,900) Expenses (2,300) (2,410) ------------Operating profit 1,200 1,990 Interest paid (100) ------------Profit before tax 1200 1,890 Provision for tax (280) (400) ------------Profit after tax 920 1,490 ==== ==== Summarised balance sheet (position statement) as at 28 February: 2010 2011 Fixed assets (non-current assets) 2,200 5,420 Cumulative depreciation (700) (1,200) ------------1,500 4,220 ------------Current assets Inventory 380 1,100 Accounts receivable 530 1,200 Bank 30 ------------940 2,300 ----------Current liabilities Accounts payable 220 340 Bank overdraft 100 Tax owing 280 400 ------------500 840 ------------Long-term loan 1,500 -----------1,940 4,180 ----------------Capital and reserves: Ordinary share capital (1) 1,250 2,000 Retained profit 690 2,180 -----------------1,940 4,180 ===== ===== For information the average number of employees in year ended 28 February 2010 was 100. For information the average number of employees in the year ended 28 February 2011 was 110.
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TASKS
a) From the above data calculate appropriate profitability, liquidity, efficiency and shareholder ratios/performance indicators. You are advised to show all your workings AND then tabulate a list of all your ratios under the headings of profitability, liquidity, efficiency and shareholder ratios. [14] b) Making use of your ratios fully evaluate the financial performance of Ettluc plc. You are expected to suggest possible explanations for any significant dif ferences between the two years. [20] (March 2011)
SOURCES OF FINANCE 1. You work as a financial consultant to a listed company. The company has a number of new ventures that it wishes to pursue. Most of these ventures are currently expected to be profitable. The company lacks both the short- and long-term funds to implement them. TASKS a) Outline the potential sources of long-term finance. b) Outline the potential sources of short-term finance. c) Suggest which sources of long-term finance you would recommend, and give your reasons. d) Suggest which sources of short-term finance you would recommend, and give your reasons.[8] (Dec 2012)
[ [ [
2. A profitable multi-national company (registered in the UK) has a large number of long-term loans due to be redeemed/paid off over the next 1224 months. Suggest the various funding options available to refinance the company. [33] (Sept 2012) 3. You work as a consultant to a medium-sized (non-listed) company. The company has a number of new ventures which are ready for the market. All of these ventures are considered to be commercially viable. The company lacks both the short- and long-term funds. TASK Explain what funding options are advisable to your client company.[33] ( June 2012) You work as a consultant to a non-listed company. The company has a number of new products which are ready for the market. All of these products are considered commercially viable. The company lacks both the short- and the long-term funds. TASK Explain what funding options are available to your client company. ( May 2012) a) Fully explain the principal sources of long-term finance available to a large company. b) Fully explain the principal sources of short-term finance available to a large company.[13] (March 2012) You work as a consultant to a successful limited company. The company is probably well ahead of all its competitors in respect of products which are in the latter stages of development. Most of these products are considered commercially viable. The company lacks both the short- and longterm funds to bring most or all of these products to market. TASK Explain what funding options are advisable to your client company. [33] ( Dec 2011) A large, well-run and profitable company wishes to diversify, and requires several million pounds of additional long-term finance. Explain the financial options which should be available to it. [33] (Sept 2011) A large plc is planning to expand substantially. Explain a range of funding options that will be available to finance both the long- and short-term assets that it will need. [33] (June 2011) [20]
4.
5.
6.
7.
8.
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9.
You work as a consultant to a medium-sized company, which is looking to expand. The company is expecting to obtain additional premises, machinery, vehicles and computers and to carry higher stocks and debtors. Discuss how the company may finance its expansion plans. [33] (March 2011)
BREAK-EVEN ANALYSIS 1. A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 40 Direct labour cost per unit 20 Variable overhead cost per unit 40 Selling price per unit 160 Fixed costs allotted to the product 700,000
The budgeted production and sales is 30,000 units. The maximum output, based on the existing resources, is 40,000. TASKS a) Calculate the profit if 30,000 units are made and sold.[3] b) Calculate the break-even point (in units) based on the above data.[2] c) Calculate the profit if only 22,500 units are made and sold.[3] d) A well-known retail store is interested in placing an order for 8,000 units of this product, at a price of 140 per unit. It will insist on using its own brand label, and a minor modification to the existing product. The cost of this modification is 5 per unit. The manufacturer has an unused part of the factory, called workshop Q, which is suitable to make this order. Workshop Q has equipment which has a written down value of 50,000, and was about to be sold to a scrap dealer for 8,000. It will cost 11,000 to get workshop Q ready for use. Advise the company on whether this order should be accepted or rejected. You are advised to show clearly your supporting calculations. e) Sketch a fully labelled break-even chart based on the above company selling 30,000 units at 160 per unit. f) Explain why a business of any size is advised to calculate the annual level of activity/business they need to achieve in order to break even.[10] ( Dec 2012) 2. A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 20 Direct labour cost per unit 15 Variable overhead cost per unit 40 Selling price per unit 120 Fixed costs allotted to the product 860,000 The budgeted production and sales is 28,000 units. The maximum output, based on the existing resources, is 40,000. TASKS a) Calculate the profit if 28,000 units are made and sold. b) Calculate the break-even point (in units) based on the above data. c) A well-known retail store is interested in placing an order for 36,000 units of this product, at a price of 110 per unit. It will insist on using its own brand label, and a minor modification to the existing product. The cost of this modification is 4 per unit. The retail store will require a 24,000 contribution towards the advertising costs. Production will be at the rate of 3,000 units per month,
[3] [2]
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and all payments from the retailer will be monthly in advance. Advise the company whether this order should be accepted or rejected. You are advised to show clearly your supporting calculations. [8] d) Explain briefly the following terms: i fixed costs ii variable costs iii contribution iv margin of safety [5 each] (Sept 2012) 3. A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 40 Direct labour cost per unit 30 Variable overhead cost per unit 40 Selling price per unit 175 Fixed costs allotted to the product 690,000 The budgeted production and sales is 24,000 units. The maximum output, based on the existing resources, is 40,000. TASKS a) Calculate the profit if 24,000 units are made and sold. [3] b) Calculate the break-even point (in units) based on the above data. [2] c) A well-known national retailer is interested in placing an order for 15,000 units of this product, at a price of 158 per unit. It will insist on using its own brand label, and a minor modification to the existing product. The cost of this modification is 2 per unit. The manufacturer has an unused part of the factory, called workshop Q, which is suitable to make this order. Workshop Q has equipment which has a current book value of 62,000, and was about to be sold to a scrap dealer for 8,000. It will cost 11,000 to get workshop Q ready for use. Advise the company whether this order should be accepted or rejected. You are advised to show clearly your supporting calculations. [8] d) Explain why a knowledge of cost behaviour is important. [20] (June 2012) 4. A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 30 Direct labour cost per unit 25 Variable overhead cost per unit 40 Selling price per unit 155 Fixed costs allotted to the product 590,000
The budgeted production and sales is 25,000 units. The maximum output, based on the existing resources, is 29,000. TASKS a) Calculate the profit if 25,000 units are made and sold. [3] b) Calculate the break-even point (in units) based on the above data. [2] c) A well-known retail store is interested in placing an order for 12,000 units of this product, at a price of 135 per unit. It will insist on using its own brand label, and a minor modification to the existing product. The cost of this modification is 3 per unit. The manufacturer has an unused part of the factory, called workshop Z, which is suitable to make this order. Workshop Z has equipment which has a written down value of 70,000, and was about to be sold to a scrap dealer for 6,000. It will cost 9,000 to get workshop Z ready for use. Advise the company whether this order should be accepted or rejected. You are advised to show clearly your supporting calculations. [8] d) Explain briefly the following terms: i fixed costs ii variable costs iii semi-variable costs iv break-even point [5 each] (May 2012)
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5.
an
A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 42 Direct labour cost per unit 31 Variable overhead cost per unit 49 Selling price per unit 203 Fixed costs allotted to the product 790,000 The budgeted production and sales is 15,000 units. The maximum output, based on the existing resources, is 20,000. TASKS a) Calculate the profit if 15,000 units are made and sold. [3] b) Calculate the break-even point (in units) based on the above data. [2] c) The company had spent 9,000 trying to get a large order from Giles Ltd, a major retailer. Giles Ltd did not place any such order. However, another retailer, Weston Ltd, have approached the company to supply own brand version of the product to sell in their stores. Weston Ltd are offering to buy 4,000 units at 192 each. The own brand version will involve an extra 3 per unit spending on very minor changes to the colour of the product and the packaging. Advise the manufacturing company as to whether or not they should accept the order. You are advised to show your supporting calculations. [5] d) Sketch a break-even graph/diagram based on the original data i.e. selling 15,000 units at 203 each.[5] e) Explain briefly the following terms: i fixed costs ii variable costs iii semi variable costs [6 each] ( March 2012) A company is about to bring a new product to market. The following budgeted data has been drawn up: Direct material cost per unit 35 Direct labour cost per unit 25 Variable overhead cost per unit 45 Selling price per unit 165 Fixed costs allotted to the product 550,000
6.
The budgeted production and sales is 20,000 units. The maximum output, based on the existing resources, is 21,000. TASKS a) Calculate the profit if 20,000 units are made and sold. [3] b) Calculate the break-even point (in units) based on the above data. [2] c) A well-known retail store is interested in placing an order for 10,000 units of this product, at a price of 140 per unit. It will insist on using its own brand label, and a minor modification to the existing product. The cost of this modification is 2 per unit. The manufacturer has an unused part of the factory, called workshop 5, which is suitable to make this order. Workshop 5 has equipment which has a written down value of 80,000, and was about to be sold to a scrap dealer for 5,000. It will cost 8,000 to get workshop 5 ready for use. Advise the company whether this order should be accepted or rejected. You are advised to show clearly your supporting calculations. [8] d) Explain briefly the following terms: i fixed costs ii variable costs iii semi-variable costs iv break-even point [5 each] (Dec 2011)
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7.
Explain the following terms: a) Fixed costs b) Variable costs c) Contribution d) Break-even analysis e) Sunk costs Explain the following terms: a) Fixed costs b) Variable costs c) Semi variable costs d) Break-even analysis e) Sunk costs [33] (June 2011) Explain the importance of knowledge of cost behaviour. [33] (March 2011)
8.
9.
BUDGETING 1. a) Explain the process of preparing a budget up to the implementation stage.[12] b) Explain the benefits of using budgetary control.[12] c) Explain why it is important for all employees in a business to be aware of the main budgetary objectives of their organisation.[9] ( Dec 2012) 2. a) Explain the process of setting and implementing a system of budgetary control. b) Explain the following terms: i Master budget ii Flexible budget iii Cash budget iv Variance [4 each] (Sept 2012) 3. 4. 5. 6. 7. 8. Explain the PROCESS of setting and IMPLEMENTING a system of budgetary control to a company.[33] (June 2012) Explain the importance of budgetary control to a company. [33] (May 2012) Budgetary control is at the centre of all management information systems. Discuss. [33] ( March 2012) Explain the importance of budgetary control to a company. [33] ( Dec 2011) Explain the role of budgetary control within a large organisation. [33] ( Sept 2011) Explain the PROCESS and BENEFITS of introducing budgetary control. [33] ( June 2011)
[17]
9. Budgetary control is at the centre of most successful companies Management Accounting systems. Discuss. [33] (June 2011)
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Introduction to Financial Accounting and Ratio Analysis

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Introduction to Financial Accounting and Ratio Analysis

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CHAPTER ONE : INTRODUCTION 1.1 Definitions o Bookkeeping is the keeping of accounts in a regular and systematic manner.

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Management Efficiency Ratios

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Financial / Liquidity Ratios

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$000 XX XX / (XX) XX / (XX) XX / (XX) (XX) (XX) (XX) (XX) XX / (XX) XX XX

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2. Debtors Collection (Period)

(Average Trade Debtors Credit Sales) x 365 days

3. Creditors Payment (Period)

4. Fired Assets Turnover Ratio

Length of Working Capital Cycles (days)

Debtors Collection Period + Stock Turnover Period Creditors Payment Period

Liquidity Ratios 1.Current Ratio

(Current Assets Current Liabilities) = X :1

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2. Liquid / Acid Test / Quick Ratio

(Current Assets less Stock) Current Liabilities = X :1

Investment Ratios 1. Earnings per Shares (EPS)

(Net Profit Preference Dividends) No. of Ordinary Shares Issued

2. Price / Earning (P/E) Ratio

Market Price Earning Per Share

(Dividend Per Share Market Price Per Share) x 100

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5,950 2,500 3,450 900 2,550 1,000 1,550

7,200 4,800 2,400 600 1,800 900 900

995 24,995 1,000 23,995 20,000 3,995 23,995

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36 356 200 Page 19 of 75

333 Additional information: 1. 2. 3. 4.

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Earnings per share

Price / Earnings Ratio Capital gearing Ratio

126 9 = 14 ((25+50) 333) x 100 = 22.5%

$000 52 (5) (10) 10 (20) (5) (12) (12) (2) 3 1

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Current liabilities Accounts payable Bank overdraft Tax owing Dividends

470 160 ------1,080 ------3,030 =====

200 100 180 450 ------1,085 ------4,490 =====

Acid test ratio

Profitability Ratios Gross profit %

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Mark-up Ratio Return on capital employed

is better 2012 is better 2011 ratio is better

(2,900 8,740) x 100% = 33%

(3,550 10,150) x 100% = 35%

Expenses Sales ratio is better in 2011.

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Dividend per share

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