QUESTIONS AND ANSWER FFM

Chapter 1

1. Define overtrading and explain the symptoms associated with overtrading.

Overtrading is
When a business has higher level of sales than its working capital
can normally sustain, without sufficient long-term capital available, it
is overtrading.
Many companies which overtrade are profitable and commercially
successful, but an increase in sales demand leads to higher
receivables and inventory which reduces liquidity and the ability to
pay debts as they fall due.
Without new capital (or better control of growth and working capital)
companies which overtrade risk liquidity problems and insolvency.
Symptoms
– A rapid increase in revenue. An increase in demand for a
company’s products will often be accompanied by an increase in
receivables. In effect, a cash out-flow.
– An increase in inventories. Inventories are necessary to ensure that
sales demand can be achieved but financing the inventory and its safe
storage causes cash deficits.
– An increase in current liabilities. In order to finance the receivables
and inventory, payments to suppliers are delayed.
Because the company is not financing growth using long-term capital
but is trying to grow using short-term
credit. The insufficient provision of long-term finance will result in a
reduction in a company’s liquidity ratios.

2. Give the formula for the following

a. Operating margin
b. Return on capital employed
c. Net asset turnover
d. Quick (acid test) ratio
e. Payable days

The following is an extract from Top Co’s financial statements:

 
$
Revenue 500,000
Gross profit 275,000
Operating profit 200,000
 Non-current assets 800,000
Inventory 50,000
Receivables 100,000
Cash at bank 7,000
Non-current liabilities 860,000
Payables 100,000
Assume 365 days in a year

Operating margin ($200,000/$500,000) = 40%

– Return on capital employed ($200,000/($800,000 + $50,000 + $100,000 + $7,000 –
$100,000)) = 23·3%
– Net asset turnover ($500,000/($800,000 + $50,000 + $100,000 + $7,000 – $100,000)) =
0·58
– Acid test ($100,000 + $7,000/$100,000) = 1·07:1
– Payable days ($100,000/($500,000 – $275,000)) x 365 = 162 days

Chapter 4,5,6
Cash

3. Explain THREE benefits to a company of cash budgeting. 

(6 marks)

A cash budget will help to identify where a company is likely to have cash
shortages and enable a company to fund any forecast deficits.
Deficits can be funded by borrowing money, selling any short-term
investments or
Delaying payment to suppliers.

A cash budget is a plan for the future and therefore it can act as a control
mechanism. When actual cash balances are
compared against budgets and a difference is identified, the company can
investigate the cause of the difference and rectify
it. For example, lower cash receipts than budgeted could indicate poor credit
control, which could be improved by structured training in the credit control
department.
A cash budget will predict the amount of funding needed and the amount of
time it is needed for. This will enable the company to arrange the best form of
 funding.
A cash budget will also help to identify where a company has cash surpluses
which need investing. Cash surpluses held in
business current accounts usually earn very low interest, if any at all.
Depending on the size of the surplus and the time when
it is likely to be available, a company can receive good returns by investing in
a deposit account or in the money markets.

4. Match the following

Discretionary Speculative Transaction

Cash for paying √
operational expenses like
workers salaries, utilities
Cash held to invest in √
money market
Cash held for
contingencies or
unexpected purposes

Money in the economy

Medium term Sources of finance
Long term sources of finance

5. List the following motive for holding cash according to Keynes

Answer: Transaction precautionary and speculative

6. Write a brief description of the real rate of interest?

Real rate of interest is the rate of return investor is getting after adjusting for the rate of
inflation.
Rate of interest after adjusting for inflation

7. Standard and Poor the bond rating agency reclassify your company’s bond rating from
AA+ to AA. The likely effect of on company’s bond will be which of the following?
 Investors will prefer your company’s share
 The price will rise
 The price will fall
 Your company will find it difficult to issue new bond

8. What type of risk is known as being specific to market sectors?

Answer

Unsystematic

9. What are the main principles when deciding about investing surplus funds.

Answer
Profitability
Liquidity
Safety

Chapter 12

10. Briefly explain three rights banks have in relation to their customers
Answer
To charge any reasonable charges and commissions
To use customers’ money in any legal and morally acceptable way.
To be repaid for any overdrawn balance on demand.
Duty of care from customer to ensure cheques forgery is not possible
To retain possession of customers’ property to clear the customers debt to bank
To be indemnified against possible losses when acting on customers behalf

11. If it is given that the real rate of interest is negative and the nominal rate is 5%.
Which of the following statement is/are true?
i. The rate of inflation is lower than 5%.
ii. The rate of inflation is higher than 5%
iii. The rate of inflation is exactly 5%
 Answer is The rate of inflation must be higher the 5%. Logically if inflation is so high
it will not generate any real return to investor. The investor loses. Purchasing power is
decreased.
If you want to use formula*
r = 1+i/1+h-1 . h is hinflation?, i% is nominal rate
negative r arise if 1 h is higher than i. Assume h is 8%
r= 1.05/1.08 -1= -2.77

12. When interest rates of a currency are high, why does an investor NOT want to hold
surplus funds in that currency? Why?

Higher interest rates will cause value of money to decline.

I f we need 100 borrow at l% it cost you $106 as compared to when the % is lower lets
say at 3% it cost 103. To get that 100 worth of goods . This is why value of $$
decrease. This will cause currency value to be less.
Reduce your surplus cash in that currency. Better to save it. What can we say about that
currency value , it is declining
No This might cause exchange rate to decline.

13. Government taxation is a policy within the monetary policy? Yes or NO.
No.Taxation and spending are considered as fiscal policy.
While Monetary refers to interest rates

14. When interest rates have risen what is the effect on monetary policy ?
Answer :
MONETARY being strict or tightened
Higher interest rates means money supply will be reduced .This the govt way of trying
to reduce the supply of money.

15. Suppose that inflation falls say 10% to 3% while interest rates remain the same. Is that
good news for borrowers and lenders.

For borrower bad news

Why? Because what borrower are paying is worth more than what they borrowed.
Paying more for borrowing less. Paying 1000 now which is worth more as compared to
before during higher inflation.

For lender good news what they are getting for their lending is worth more than
what they lent in the past.
16. Match the repayments methods

Balloon Pay once at the end of loan period to settle in full

Bullet Pay during early stage of loan period and settle the loan.

Amortisation Pay at early stages and also pay substantial amount at the end
of loan period to settle the loan
Pay through regular intervals during loan period.

17. Fill in the following

Criteria for lending decisions

Meaning Method or data

Character of borrower Past records
Interview
Ability to borrow and Financial statements
Ability pay back Financial records
Ability to repay
Margin of profit % of interest rates
Margin of return
Margin of profit
Purpose of loan Risky
Reason for loan Legality , legal or illegal
Amount of loan Sufficiency
Amount of borrowing
Amount needed
Repayment terms How long term of loan
Repayment period No of Instalment /bullet
Repayment policy
Insurance against Insurance policy on
default borrower.
Insurance against Requiring
borrower not collateral/security
repaying
Insurance against non
collectible

18. Which of the following would be considered as

positive covenant :P
negative :N
quantitative :Q
not a covenant : X
 P or N or Q or
X
Allowing the bank to become part of the shareholders
fund.
Send all incoming emails from other lenders to the bank
Provide the bank with management accounts
Allow the bank to monitor the proportion of borrowings in
relation shareholders capital.
Comply with specified limitations on financial positions
of borrower.
Submit financial statements to the bank.

Submit certificates of compliance to loan terms

Not to undertake additional borrowing while still repaying
the current loan.

19. Given a requirement:

“Borrower needs to maintain debt ratio up to a lower than or a maximum 50% at
all times “
This is an example of
 Positive covenant
 Negative covenant
 Quantitative covenant
 Gearing covenant

20. Which of the following is true about overdraft?

I.Overdraft may be used to finance factory equipment of a manufacturer.
II.Overdraft is not repayable upon demand
III.Overdraft financing usually last for several years
IV.Interest is payable only on overdrawn balance

21. A term loan is

Answer
An agreement to borrow a fixed amount for a specified period of time and to
repay the interests and capital on or before agreed date .
22. Leasing is defined as
Answer
A contract between lessor and lessee for the lessee to hire for use a specified asset
taken from a vendor or seller for a period of time.

The lessee will pay lease rental for the use of the asset to the lessee.
The lessor retain or has title of the asset and
Lessor has responsibility for maintaining servicing and repairing the asset.

23. Write down four features of leasing clearly. This is to help your answer writing
skills.

Answer
A contract to allow lessee to use asset in exchange for lease rental
Lessee does not own asset
Lessee uses the asset.
Service and maintenance of asset is responsibility of lessor
At the end of lease term lessee has option to buy

24. Write down any four features of hire purchase clearly. This is to help you
learn better so that you can answer questions and score.
Answer
Hire purchase is a sale of asset.
Supplier sells to finance institution
The buyer buys the asset from finance ins
The buyers has possession of the asset bought in hire purchase
The buyer pays the finance institution instalments
The buyer has legal title of the asset at the end of hire purchase period
Capital payment within the hire purchase is NOT allowable expense for tax
Interest payment hire purchase is allowable expense for tax

25. What are the exception to the bank’s duty to maintain the confidentiality of
customers’ details or affairs?
The bank is required by the court
The bank is required by law
 The bank is given consent by customer to do so
The bank is taking legal action against customer
The bank is doing so to protect its right
There is public duty to disclose

26. The bank does not honour a customer cheque. Is this allowed?

The bank should honour customer cheques.

But If the customer does not have sufficient amount in their accounts, the bank is
allowed to do this.

27. Which of the following is true about Public Sector Borrowing Requirement
(PSBR)
 Government spending is more than government revenue
 Government will issue gilts or bills to get funds
 Government debt is high
 There is a budget deficit

28. A company selling consumer electrical products like washing machines kitchen
appliances has a large overdraft in its account. The interest rates decrease
significantly. What is the effects to the company?
Answer
Falling interest rates means the money cost goes down. Getting money is now
cheaper. The cost of the company overdraft will be lower.
The borrowing rate lower encourages people to get money to borrow and get.
This will encourage spending to company’s product and fund it with loans or
credit card.
Sales of company products might increase.

29. Identify which are features of overdraft facility ( OD) and/or bank loan(BL)

Repayable on demand OD
 Use funds until the end of agreed period BL
Interest already specified BL
Revocable at any time OD
Interest payable on balance BL
Require security or charge over assets BL OD

30. Which of the following is the most fundamental factor considered by banks
when setting interest rate on loan?
A Amount of the loan
B Purpose of the loan
C The competence of the borrower
D The risk in the borrowing proposal

31. Buying an asset without having to pay immediately the purchase price
best describes
 Operating lease
 Hire purchase
 Financial lease

32. Which is NOT a distinguishing feature between hire purchase and normal
purchase agreement?
 Asset cost is higher in hire purchase
 Asset belongs to buyer as soon as asset is delivered
 Buyer pays by instalments

33. A company has 12% loan notes already issued. It has a market value of $136 per
$100 nominal value.
Required
What is the nominal rate?
What is the interest yield?
Answer
Nominal rate is the rate given for the instrument or security which includes inflation.
Here it is 12%

Interest yield
 Coupon rate/Market price X 100
12/136 x100
= 8.82%

34. A 20 year semi annual 8% bond with a $1,000 face value. Its current market
value is $ 1,020. What is the redemption yield?

35. Rights issue is

Answer

Offer to existing shareholder to buy more shares of the company at a special price in
proportion to the shares they presently own

or

When existing shareholder can buy additional shares in the co based on their existing
proportion of shares held at a lower price.

36. Existing shareholders have pre-emptive rights. Describe them

1. The right to appeal to stock exchange to cancel new issue of shares
2. The right to buy more shares of the company at discount.
3. The right to maintain percentage of ownership even if there is new share issue.
4. The right to buy more shares than other shareholders

37. Gearing refers to

The extent to which company’s capital is financed by debt as compared to shareholder
capital
A measure of how much of the capital is from debt like loan preference share
compared with equity
Shows how much of company’s capital is financed by lenders as compared to
shareholders
 The measure of proportion of capital from debt to equity

38. Debt ratio is

i. Total debt/ total assets
ii. Total debt/total equity
iii. Total equity/total debt

39. Which of the following may be acquired from the capital market
i. Commercial paper
ii. Debt securities
iii. Equity securities
iv. Deposits

40. How does a company raise funds?

I Issue share capital
II Redeem preference shares
III Issue loan notes
IV Retaining profits

41. Explain the main features of convertible loan notes and explain TWO reasons
why a company might issue them.
 
(5 marks)

42. Explain the main similarities and differences between a lease and a hire
purchase agreement.
Similarities
– Both leasing and hire purchase allow a company to acquire the use and rewards of
an asset by paying a fee which is usually set at regular intervals.
– Both hire purchase and leases are medium-term financing agreements which cannot
be withdrawn as long as the agreed payments are made.

Thus, both types of finance offer some certainty for cash budgeting.
 –Throughout the term of both hire purchase and lease agreements, legal title is
retained by the finance company, therefore the asset itself provides some security
against the loan.

Differences
– With a hire purchase agreement legal ownership passes automatically on final
payment (or on payment of an option-to-purchase fee) whereas under a lease
agreement legal title does not usually pass to the lessee.
– With a lease agreement the lessor claims the capital allowances against taxation
whereas with a hire purchase agreement the user is treated as the owner of the
equipment and benefits directly from the capital allowances.

 
(5 marks)

Chapter 16 & 17

43. Discuss the benefit of NPV compared to the Accounting rate of return.
(5 marks)

NPV considers the time value of money whereas the accounting rate of return (ARR)
does not. The timings of the cash flow are not recognised in the ARR calculation and
thus a $1 received in 15 years’ time is deemed to be of equal value to a $1 now. This is
rarely the case and therefore is an inaccuracy inherent in the model. NPV uses cash
flow whereas the ARR uses accounting profit. Cash flow is considered to be more
accurate and objective for investment appraisal as accounting profit can be calculated
using different accounting policies which can result in different profit figures
depending on which is used.

The NPV is an absolute measure of the benefit of the project which indicates the
increase in shareholder wealth which will result from a project with a positive NPV.
ARR on the other hand is a relative measure which makes comparison difficult
between projects and the likely impact on shareholders. The ARR can be calculated
using different methods and assumptions which can make comparison difficult,
whereas NPV is calculated using universally accepted methods.
Chapter : Accounts Receivable, Debt collection , AR policy

44. Explain TWO benefits of employing a factor company.

(4 marks)

Benefits of using a factor – A factor company is an outsourcing company which will

take over the entire credit control function of a company.

The main advantage of this is that it frees up the time of management to focus on the
core products or services of a company. – Factoring is a source of finance which grows
along with the business. As the factor advances a proportion of the receivables
balance, the extension in working capital is controlled.

– To small companies particularly, the non-recourse agreements which some factor

companies provide can equate to a huge reduction in risk. – In addition, the factor
company is an expert in credit control and will often reply to customer queries and
requests in a systematic and professional manner. This may mean that customers’
perception of the company is enhanced.