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NOTES & EXERCISES ON Financial Management -For ICMStudents

CHAPTER ONECOMPANY ACCOUNTS

INTRODUCTIONA company is an association of people who have contributed money forthe purpose of carrying on business to make a profit. A company isformed using contributions from many people each putting in a share of the total money required to operate the business. All companies areregulated by the Companies Act 1985 (as Amended by 1989). Thecompanies Act of 1985 & 1989 therefore sets out the basic format andcontent of a published accounts. The people who contribute the money in forming the company are calledthe shareholders. They own the company but usually do not participatein the management of the company. The shareholders therefore appoint

Directors to management the company on their behalf.

FORMATION OF A COMPANY A company cannot form itself. Companies are formed by promoters. Apromoter is a person who sees to the formation of a company. In smallcompanies, they are usually the owners who act as the promoters of thecompany. The formation of a company requires only a minimum of twofounders who are willing to subscribe (buy) the share capital. There is nomaximum limit. The procedure involved in forming a limited company is alittle more complex than the procedures involved in other business units.

A company is formed by the issue of certificate of registration by theRegistrar of Companies. To obtain a certificate of incorporation twoimportant documents are required to be sent to the Registrar atCompany House. These documents are Memorandum of Associationand Article of Association.

MEMORANDUM OF ASSOCIATION AND ARTICLE OF ASSOCIATIONA limited company must prepare two important documents that will besent to the Registrar of Companies, at Company House for thecompany to obtain approval before it can start business. There documentsgovern the company. The documents are:

1. MEMORANDUM OF ASSOCIATION: The memorandum of associationis a document which contains information concerning a company’srelation with the external world/outsiders. The document gives theexternal view of the company to the public, including details of its name,addresses, registered office, share capital, a statement indicatingwhether it is a Limited company or not and the objectives or purposes of the company.2. ARTICLE OF ASSOCIATION: This document gives the internal viewof the company and relates to the rules and regulations governing the

internal organization of the company such as voting rights, powers of directors and conduct of meetings.

More Lecture Series – by TIMORE B. F1




The purpose of the Memorandum of Association and the Article of Association is to define what the company is and how its business andaffaires are to be conducted. The memorandum sets out the basic elements and the articles are mainlyinternal rules.

THE CORPORATE CONSTITUTION (The Contents of the Article &Memorandum of Association)

The constitution of a company consists of its memorandum of associationand its articles of association.

1. The Memorandum of Association

For a company limited by shares, the memorandum must contain thefollowing:

(a) Name Clause

CA 1985, s.25 - the name of a public limited company must end with thewords "public limited company", (PLC), the name of a private limitedcompany must end with the word "Limited". Abbreviations may be usedinstead: "plc" or "Ltd". A company cannot be registered under a namewhich is identical to a name already registered.

A company must have its name printed on all business documents and it

must be displayed at the registered office and all business premises.

A company can change its name by special resolution.

(b) Registered Office Clause

This establishes company’s nationality and its domicile, but not itsresidence.

(c) Objects Clause

Company’s memorandum must contain an objects clause - a clause whichstates the purpose or purposes for which the company was incorporatedor established.

The Ultra Vires Rule

If the company does something beyond the scope of its objects clause,this is said to be ultra vires (beyond the powers of the company).

A director may be liable to the company for any costs incurred by the

company on an ultra vires transaction.





Problems from this rule can be avoided by stating in the memorandumthat, the object is to carry on as a general commercial company.

(ii) Change of Objects Clause

A company can change its objects clause by special resolution.

(d) Limitation of Liability Clause

If members’ liability is to be limited, this must be stated in thememorandum.

(e) Capital Clause

Limited companies with share capital must have a clause stating the totalamount of share capital with which it proposes to be registered and thedivision of that capital into shares of a fixed amount.

(f) Alteration of Memorandum

A company cannot change its memorandum except in the circumstancesand manner expressly provided for in the Act. Memorandum can bealtered to change company from public to private and vice versa.However this requires special resolution of shareholders. Company can bechanged from unlimited company to limited by special resolution - changefrom limited to unlimited requires written consent of all the members.

Reduction of share capital requires special resolution

When company resolves to alter its memorandum, a copy of theresolution, and the amended memorandum, must be sent to the Registrarwithin 15 days - failure to do this is a criminal offence punishable by afine.

2. Articles of Association

(a) Articles Generally

The articles govern the internal management and organization of thecompany. The articles are secondary to the memorandum - if there isconflict between the articles and the memorandum, the memorandumprevails.

3. Legal Effect of Memorandum and Articles

The memorandum and articles operate as a contract between thecompany and its members, which both parties are bound to honour. Theeffect of this is:





(a) Each member, in his capacity as a member, is bound to the companyas if he personally had signed the memorandum and articles.

(b)The company is bound to each member in his capacity as a member.

(c)The memorandum and articles do not constitute a contract binding thecompany or any member to an outsider - or to a shareholder in any othercapacity than as a member.

(d) A member has a right to compel the company to act according to thearticles even if not enforcing a right which is personal to himself as amember.

(e) The memorandum and articles constitute a contract between eachmember and every other member.

MEETINGS AND RESOLUTIONS

1. Shareholders and Shares

It must be noted that the day to day management of a company is in thehands of the directors, not the shareholders - but the shareholders retainsome important powers - many decisions require a resolution of theshareholders and cannot be decided by the directors alone.

(a) Who is a "Member?" A member is:

(i) Anyone who subscribes the memorandum.

(ii)Any other person who agrees to become a member and whose name isentered on the register of members.

(b) Register of Members

CA 1985 requires every company to keep a register of its members. Theregister must show:

- Name and address of each member.

- Date each person became a member and, where applicable, the date heceased to be a member.

- The number of shares held by each member and the amount paid onthem.

2. MEETINGS

Kinds of Meetings





(a) Annual General Meeting

Most companies must hold an AGM.

An AGM must be held every calendar year with not more than 15 months

between meetings. A newly incorporated company must hold its first AGMwithin 18 months of incorporation. If a company does not hold an AGM asrequired, any member can apply to the Secretary of State to call or todirect the calling of the meeting.

Members of a private company can choose to dispense with the holding of an AGM by elective resolution - but any member of such a company canrequire that an AGM be held in a particular year by giving notice at least 3months before the end of the year.

(b) Usual Business of an AGM

Directors lay before the company annual accounts and reports for themost recent financial period.

Auditor's term of office ends at AGM, so they must be re-appointed or newauditors must be appointed. Director's recommendation for the dividendto be paid to shareholders will be voted on.

The Articles may provide that directors are to retire in rotation. Somedirectors will retire at the AGM and must be re-appointed or replaced.

Resolutions may be required to pay directors’ and auditors’ fees. (Nownormally fixed by contract).

Shareholders may have their own resolutions placed on the agenda.

(c) Extraordinary General Meetings

This is any meeting which is not an AGM. Table A provides that onlydirectors can call an EGM, unless there are too few directors in the UK tomake up a quorum - then any member can call one.

Public company must hold an EGM if the company’s net assets have fallento less than half of its called up capital. Meeting must be called within 28days of the directors becoming aware of the loss of capital, and must beheld within 56 days of that date.

Where auditor has resigned and has made a statement of circumstanceshe thinks should be brought to the attention of creditors and shareholders- the auditor can requisition the directors to hold an EGM so that he canexplain the circumstances of his resignation.

TYPES/ CLASSIFICATION OF COMPANIES





Companies are usually classifies asa) Limited Companies or Unlimited Companies

b) Private Companies or Public CompaniesNOTE: The word limited liability means that shareholders liability is“limited” to the unpaid nominal capital for which they have subscribed for.

A) LIMITED COMPANIES AND UNLIMITED COMPANIES.LIMITED COMPANIES These are companies that have the liability of its members limited. Theliability of the members in these types of companies depends on whetherthe company is any of the following

i. A Company Limited by Shares: This is the type of company inwhich the liability of the members is limited to the amount of moneythey owe in respect of the shares they subscribes (applied). Themembers liability to contribute towards the debt of the company(e.g. if the company is owing and about to be wound up andtherefore cannot pay its debts) is limited to the shares for whichthey have subscribed and once the shares have been paid up, theyare not under any further liability.

ii. Companies Limited by Guarantee There are no shares in this type of company. Any person who is acceptedas a member of the company is made to make a promise or guarantee of an amount that he will contribute upon the liquidation of the company. The members’ liability is limited to the amount they guarantee. That is,the amount each member has pledged to contribute in the event of thecompany being wound up. Such companies are non-profit organizations

such as charities and Trade Association.

UNLIMITED COMPANIES In this type of company, the liability of the members is unlimited,meaning that, shareholders can be made personally liable for the debts of the company even if they have finished paying for their sharessubscribed. It is the direct opposite of limited companies. The position of the members is like that of partners in a partnership firm.

B: PRIVATE OR PUBLIC COMPANIES

PRIVATE COMPANY : A private company is any company that is notregistered as a public company. Private companies can not invite thepublic to subscribe (buy) their shares. That is they cannot sell their sharesto the public.

PUBLIC COMPANIESA public company is the one which

i. Is limited by shares or guarantee and has a share capitalii. Is registered as a public company; and

iii. Whose memorandum states that it is a public company.

iv. Its name must have the words “ Public Ltd Company or PLC”





ADVANTAGES OF COMPANIES The advantages of forming a company are as follows:

a) It has a separate legal entity from the shareholders.

b) There is limited liability. The liability of its members is limited to theamount (if any) which remains unpaid on their shares.

c) Ownership and management of the business is separate so thatinvestors can put money into shares without taking part in runningthe company.

d) Large amount of capital can be raised from many investors.e) There is perpetual succession. That is the continuation and legal

standing of a company is not affected by the death of a director orwithdrawal of a director of the company. This is not so in soleproprietorship businesses.

DISADVANTAGES OF COMPANIESa) The procedure for forming a company is costly and complicated as

compared to other forms of business ownership. b) Public companies are more venerable to takeovers.c) Mangers are not likely to put in much of their efforts as in the case

of sole proprietorship.d) Shareholders (i.e. the owners of the company) may have little

control and involvement in the management of the companyespecially with PLCs.

FINAL ACCOUNTS OF LIMITED COMPANIES

THE CAPITAL OF A COMPANY

Nature of Shares and Share Capital

A company raises capital by the issue of shares. Shareholders are thenissued a share certificate which shows their ownership in the company. Ashareholder is therefore a part-owner of a company.

What is a Share?

A share is the unit of a capital structure of a company. That is the unit of measure for determining a member’s interest in the company.

TYPES OF SHARES

There are two main types of share;

1) Ordinary shares / Equity shares

2) Preference share





ORDINARY SHARES: Ordinary shares are the shares which do not carry afixed dividend. Instead, the directors decide how much to pay to theshareholders each year. Ordinary shares are the most common type of shares issued by a company. The normal rights of ordinary shareholdersare to vote at company meetings and to receive dividends from profit.

PREFERENCE SHARES: Preference shares are shares carrying fixed rateof dividend. The dividend is paid first before any dividend is paid toordinary shareholders. Preference shares usually give a preferential rightto repayment of capital on a winding up. Preference shareholdersnormally have restrictions placed on their power to vote at generalmeetings.

TYPES OF PREFERENCE SHARES1. Cumulative preference shares: This is the type of preference

shares in which unpaid dividends are accumulated and carriedforward. That is if the company is not able to pay for dividends dueto losses or low profit, the unpaid dividend is carried forward to thefollowing year and paid in the following year(in addition to thedividend payable in the current year).

2. Participating preference shares: Theses shareholders have theright to participate in the sharing of profit after the entire capital hasbeen paid during the winding up of a company.

3. Non-participating preference shares: These shareholders donot have such right to participate in the sharing of profit after the

entire capital has been paid during the winding up of a company.4. Redeemable preference shares: These are the shares which

allows the company to buy back (redeem) the shares from theshareholders after sometime.

5. Irredeemable preference shares: These shares cannot bebought back by a company.

THE SHARE CAPITAL OF A COMPANY

We shall now look at some terms which are used in company accounts.

1. STATED CAPITAL

This is the capital of the company that has been provided by themembers or owners of the company. This amount may include thefollowing:

i. The total amount (proceeds) received from the sale of the issue of shares.

ii. Any other value received apart from cash.

iii. Any other transfer to reserves.





2. AUTHORIZED SHARE CAPITAL

This represents the maximum amount of shares that the company isallowed to allot or issue to the public. It is also known as nominal orregistered capital.

3. ISSUED SHARE CAPITAL/ ALLOTTED SHARE CAPITAL: This is thatpart of the authorized shares that the company has actually allotted orissued to the public for subscription.

4. PAID-UP SHARE CAPITAL: This is the amount that members havepaid on their shares, excluding any premium. That is, the amount of called–up capital that has actually been paid by shareholders.

5. CALLED-UP SHARE CAPITAL: This is the part of issued share capitalwhich has been demanded by the company from shareholders. Thishappens because sometimes a company may not need the full amount of shares from the shareholders at once. Therefore the company calls forsuch money when it needs it.

6. UNCALLED CAPITAL AND RESERVE CAPITAL: Uncalled capital is theamount owing on partly paid shares which members have not yet beencalled on to pay. Reserve capital is uncalled capital the company hasresolved not to call unless the company is wound up.

7. UNISSUED CAPITAL: This is the part of the authorized capital which

has not yet been issued to the public.

DIVIDEND: This is the interest payable on the shares to the shareholders.Dividend is charged against the appropriation accounts. Dividend can beeither interim or final.

I Interim dividend : This is the dividend which is declared and paidduring the year by the board of directors.

Final Dividend : This is dividend which is paid at the end of theyear. It is proposed by the Directors and approved by management.

RIGHT ISSUE

A right issue is a situation where a company issues its shares to theexisting shareholders in proportion to their existing shareholding at afavorable price. To do this the company contacts the existing shareholdersand informs them of the number of shares which each one of them isentitled to buy of the new issue. It is one way through which to reduce the cost of

raising new shares. It is a device used by companies whose shares are listedon the stock to raise additional capital. Existing ordinary shareholders are





given a right certificate which entitles them to take up a specified numberof shares at a specified price. The right issue price is sufficiently belowlisted price to make the offer attractive.Shareholders who do not wish to exercise any or all of their rights may sellthem to third parties who then apply for the shares or he may renounce

his right.

DEBENTURES

A debenture is defined as a written acknowledgement of debt by a company, containing

provisions as to the payment of interest and the repayment of the principal.

FORMS/ TYPES OF DEBENTURES

Debentures can take any of the following forms.

1. Naked (unsecured) debenture: They are debentures which have not been guaranteed

with any collateral. It is not secured against any property. It does not carry any fixed

charge against the assets of the company.

2. Secured/ mortgage debenture: This debentures are secured and carry a fixed charge

on the assets to the company.

3. Redeemable debentures: These are debentures which the company aggress to repay at

a fixed determinable future date.

4. Irredeemable debentures: These are debentures which the company cannot redeem

or payback.

THE PROFIT AND LOSS ACCOUNT AND THEBALANCE SHEET

THE TRADING ACCOUNT

It shows the total sales revenue less the cost of goods sold. It is the first to be prepared and

therefore comes before the profit and loss account. The difference between the sales

revenue and the cost of goods sold is termed GROSS PROFIT.

FORMAT FOR INTERNAL USEMORE LTD

TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 31ST DECEMBER 2006£ £

£Sales XXXLess: Returns inwards XXNet sales XXX

Less Cost of Sales:Opening stock XX





Add: purchases XXCarriage inwards XX

Less returns outwards XXGoods available for sale XXLess closing stock XX Cost of salesXXXGross profitXXXAdd other income:

Rent received XXDiscount received XXDecrease in provision for bad debt XX

Profit on sale of assts XXInvestment income XX

XXX

XXXLess expense:Rent and rates XXSelling and distribution expenses XXWages and salaries XXLight and heating XXPostage and stationary XXDiscount allowed XXInterest XXInsurance XXIncrease in provision for bad debt XXBad debt written off XXLoss on disposal/ sale of asset XXVehicle expenses XXAuditors fees XXGeneral expenses XXDepreciation XXOther expenses XXXXXNet profit before taxXXX

Taxation(XX)

Net profit after taxXXX

Dividends: Interim dividends paid XXProposed dividends XX

(XX)

XX Transfer to capital reserves(XX)

Profit and loss c/dXXX





BALANCE SHEET AS AT 31 AUGUST 2005

FIXES ASSETS COST DEP. NBV

£ £ £Intangible (e.g. Goodwill) XXX XX XXXPremises/ Land& buildings XXX XX XXXFurniture and fittings XXX XX XXXMotor vehicles XXX XXXXXOther assets XXX XXXXXEquipment XXX XXXXX

XXX XXXXXCURRENT ASSETS:Stocks XXX Trade debtors XXXLess provision for bad debt (XX) XXXPrepayment XXXOther receivables XXXCash & Bank XXX

XXXCURRENT LIABILITIES:

Trade creditors XXXDebenture interest unpaid XXXOther owing XXXProvision for taxation XXXProposed dividends XXX (XXX)

Working capitalXXX

Net assetsXXX

Financed by:

£1 ordinary share capitalXXX

Profit and Loss accountXXX

DebenturesXXX

Long term LoanXXX

Net WorthXXXX





FOR PUBLICATIONThis section concentrates on the syllabus of financial management. However,students who have difficulty or whose first time in accounting is at this levelshould refer to page (xxx) for brief introduction before reading this section.

If the final account is for publication or for presentation to members(shareholders), the Profit and Loss Account and the Balance Sheet areprepared in a summarized form and the details are then presented in theform of a “note to the accounts”. The format for accounts for publicationis provided by the companies Act 1985. The format may be different frombusiness to business and a particular format to use in an examinationdepends on the question given. (For details of the format, refer to Frank Wood Business Accounting 2)

The format is presented below. Once again students must remember that,for our examination purpose, the format has been limited the questionsset in our examination for easy understanding.Notes to the accounts are not required by the syllables and therefore it isexcluded from this manual.A specimen format is presented below:

THE PROFIT AND LOSS ACCOUNTABC LTD

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST DECEMBER 2006£ £

Turnover XXXCost of sales (XX)Gross operating profit/ (loss) XXDistribution cost XXAdministrative Expenses XX XXNet profit before interest and tax XXInterest (XX)Net profit before taxation XX Taxation for the year (XX)Net profit after tax XX

Dividends (proposed and paid) (XX) Transfer to capital surplus (XX)





Net profit c/d XXX

THE BALANCE SHEETABC LTD

BALANCE SHEET AS AT 31ST DECEMBER 2006££ £

Fixed AssetsIntangible assets (e.g. Goodwill) XXX Tangible assets XXXLong term investment XXX

XXXCurrent AssetsStocks XXXDebtors XXXCash XXXBank XXX

Prepayment XXXOther receivables XXX

XXXCurrent liabilities Trade creditors XXXBank overdraft XXX Taxation XXXProposed dividends XXXAccrued expenses (owing) XXXOther payables XXX (XXX)Working capital XXX

XXXDebentures XXXOther Long term liabilities XXX (XXX)Net assets XXXXCAPITAL AND RESERVES:Ordinary share capital XXXPreference share capital XXXShare premium XXXProfit and loss account/Revenue reserves XXXCapital reserves XXX

Shareholder’s fund/Net worth XXX





Tutorial:i. The format provided above does not contain all items in the

format as contained in the companies Act 1985. The standardformat can be obtained from Frank Wood Accounting 2.

ii. Debentures and other long term loans: These can be deducted

from the assets or added to capital and reserves.iii. Debtors are stated after deducting provision for bad debt.

Example1. The following information has been extracted from the mores of FordhamLtd as at 31st December 2007

Dr CrBank 2,000Capital: 100,000 ordinary shares fully paid (£1 each)

100,0008%50,000 preference shares fully paid (£1 each)50,000

Debenture loan stock (10%-repayable 2009)30,000

Debenture loan interest 3,000

Discount allowed 2,000Discount received 5,000Dividend received 700Dividend paid: ordinary interim 5,000

Preference 4,000Freehold land (at cost) 200,000Investments (listed: market value at 31/12/2007- £11,000) 10,000Office expenses 15,000Office salaries 35,000Motor van (at cost) 15,000Motor van: accumulated depreciation (1/1/2007)

6,000Motor van expenses 2,700Purchases 220,000Sales 300,000Retained profit (1/1/2007) 9,000Share premium account

10,000Stocks (1/1/2007) 20,000 Trade creditors 50,000 Trade debtors 27,000

560,700 560,700





Additional information1. The stocks as at 31st December 2007 were valued at cost at £40,0002. Depreciation is to be charged on the motor van at a rate of 20% per

annum on cost. No depreciation is to be charged on the freehold

land.3. Corporation tax (based on profits for the year at the rate of 35%)

has been estimated at £ 10,0004. The directors proposed a final ordinary dividend of 10p per share.5. The authorized share capital of the company is as follows:

a) 150,000 ordinary shares of £1 each andb) 75,000 preference shares of £1 each

REQUIRED:a) Prepare Fordham Ltd’s trading, profit and loss account for

the year end 31st December 2007b) The balance sheet as at that date

Solution

QUESTION 2 You have obtained the following information in respect of BOB Ltd. For the

year ended30th June 2007

£000Sales (all credit) 1,800Cost of sales 700Administration expenses 400Distribution costs 250Interest paid 10Provision for taxation 50Proposed dividend 80

TASKS

Prepare a summarised Profit & Loss account for the year 30 June2007.

Solution:

a) BOB LTDPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007

£ £ Turnover 1,800,000





Less cost of sales 700,000Gross Profit 1,100,000Less Expense:Administrative Expenses 400,000Distribution cost 250,000 (650,000)

Net profit before interest and Tax 450,000Less Interest paid 10,000Net profit before Tax 440,000Less Provision for taxation 50,000Net profit after tax 390,000Less Proposed Dividends 80,000Net profit c/d 310,000

QUESTION 3 (JUNE 2005) Q.2

The following information relates to TLC Ltd. and has been taken fromtheir books as at 31 May 2005:

£ Turnover 990,000Administration expenses 140,000Cost of sales 370,000 Taxation for the year 40,000Interest paid 20,000Distribution costs 190,000Proposed dividends 40,000

OTHER INFORMATION:• There are 500,000 £1 ordinary shares in issue.• The market price of an ordinary share on 31 May 2005 was £6.00

per share. TASKS

a) Prepare the Profit & Loss account of TLC Ltd. for the year ended 31 May2005.

b) Calculate the followingi. The EPSii. The PE ratio

iii. The dividend per shareiv. The interest coverv. The profit after tax to sales percentage

SOLUTION TO QUESTION 2:a)

TLC LtdPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005

£ £ Turnover 990,000

Cost of sales (370,000)Gross profit 620,000





Less Expenses:Administration expenses 140,000Distribution costs 190,000 (330,000)Net profit before Interest & Tax

290,000

Interest Paid (20,000)Net profit before Tax 270,000 Taxation for the year (40,000)Net profit after tax

230,000Proposed dividends (40,000)Profit & Loss Account c/d 190,000b)

i. Earnings Per Share (EPS) = Net profit after tax – Preference sharedividend

No. of ordinary sharesNote: there are no preference shares. We only have ordinary shares of

500,000 shares in the question.

= £230,000 X100= 46p per share (or£0.46 per share)500,000 shares

ii. Price Earnings (P E ) ratio = Market Price per shareEPS

= £6.0 = 13.04 times£0.46

iii. Dividend per share = dividend paid/proposedNo. of shares

= £40,000 X 100 = £0.08 or 8% pershare = 8P per share

500,000iv. Interest cover = Net profit before Interest and Tax

Interest

= £290,000 = 14.5 times£20,000

v. Profit after tax to sales percentage = Net profit after tax X 100Sales

= £230,000 X 100£ 990,000

= 23.23%

QUESTION 3 (September 2005 Q.2)

The following information relates to AVCE Ltd. and has been taken fromtheir books as at





31 August 2005£

Turnover 1,120,000Administration expenses 170,000Cost of sales 460,000

Taxation for the year 90,000Interest paid 25,000Distribution costs 210,000Proposed dividends 90,000OTHER INFORMATION:• There are 500,000 £1 ordinary shares in issue.• The market price of an ordinary share on 31 August 2005 was

£4.90 per share. TASKSa) Prepare the Profit & Loss account of AVCE Ltd. for the year ended 31August 2005b) Calculate the following

i. The EPSii. The PE ratioiii. The dividend per shareiv. The interest coverv. The profit after tax to sales percentage

SOLUTION TO QUESTION 3:a)

AVCE LtdPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST AUGUST

2005£ £

Turnover 1,120,000Cost of sales (460,000)Gross profit 660,000Administration expenses 170,000Distribution costs 210,000 (380,000)Net profit before Interest & Tax 280,000Interest Paid (25,000)

Net profit before Tax 225,000 Taxation for the year (90,000)Net profit after tax 165,000Proposed dividends (90,000)Profit & Loss Account c/d 75,000

b)i. Earnings Per Share (EPS) = Net profit after tax – Preference share

dividend

No. of ordinary shares





Note: There is no preference share dividend in the question and sonothing was deducted

= £165,000 = 33p per share (or £0.33 per share)500,000 shares

ii. Price Earnings (P E ) ratio = Market Price per shareEPS

= £4.90 = 14.84 times£.0.33

iii. Dividend per share = dividendNo. of shares

= £90,000 = 18P per share or 18% pershare

500,000iv. Interest cover = Net profit before Interest and Tax

Interest= £280,000 = 11.2 times

£25,000v. Profit after tax to sales percentage = Net profit after tax X 100

Sales

= £165,000 X 100£ 1,120,000= 14.73%

QUESTION 4 You have obtained the following information/data of Slingsbury Ltd. as at31 May 2005:

£Stock 130,000Creditors 210,000Fixed assets at cost 350,000Cumulative depreciation of fixed assets 65,000£1 Ordinary share capital 100,000Debtors 140,000

Proposed dividend 30,000Provision for company tax 20,000Bank overdraft 13,000Long-term loans outstanding 40,000Share premium account 20,000Revenue reserves 122,000

TASKSa) Prepare the balance sheet of Slingsbury Ltd. as at 31 May 2005.b) Calculate TWO liquidity ratios.





SOLUTIONQUESTION 4(a)

SLINGSBURY LTD

BALANCE SHEET AS AT 31 MAY 2005

ASSETS: COST DEP.NBV

£ £ £Fixed Assets 350,000 65,000285,000

350,000 65,000285,000CURRENT ASSETS:Stocks 130,000Debtors 140,000 270,000CURRENT LIABILITIES:Creditors 210,000Bank overdraft 13,000Provision for taxation 20,000Proposed dividends 30,000 (273,000)Working capital(3,000) Net assets282,000

Financed by:£1 ordinary share capital100,000Revenue reserves (P&L)122,000Share Premium Account20,000Long term Loan40,000Net Worth

282,000b) TWO LIQUIDITY RATIOS

i. Current Ratio = Current Assets : 1 = 270,000 : 1 = 0.99:1Current Liabilities 273,000

ii. Quick/Acid Test Ratio = Current Assets – Stocks: 1Current liabilities

= 270,000-130,000 :1 =140,000 :1

273,000 273,000





= 0.51:1

QUESTION 5 The following list of balances as at 31 August 2005 of GHB Ltd. has been

taken from the books

AFTER the trading account has been completed:£000 £000

Dr CrGross profit for the year 270Equipment at cost 280Equipment depreciation (01 09 04) 112Ordinary share capital 200Distribution costs 110Administration expenses 90Interim dividend paid 10Stock at 31 08 05 240 Trade debtors 190 Trade creditors 70Cash and Bank 206% Debentures (redeemable 2009) 200Profit & Loss account (01 09 04)

88940 940

Notes:• Equipment is to be depreciated at 10% on cost.

• Interest on debentures is still unpaid.• The provision for tax is estimated at £12,000.• A final dividend of 10 pence per share is proposed.

TASKSa) Prepare the Profit & Loss and appropriation account for the yearended 31 August 2005.b) Prepare the balance sheet as at 31 August 2005.c) Calculate the EPS.d) Calculate the dividend cover.

SOLUTION: question 5a)

GHB LTDPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST 2005

£ £Gross profit

270,000Distribution cost 110,000Administrative expenses 90,000

Depreciation (280,000 X10%) 28,000 (228,000)Net profit before interest and tax 42,000





Debenture interest unpaid (6% X 200,000) (12,000)Net profit before tax 30,000 Taxation (12,000)Net profit after tax 18,000Profit and Loss account balance b/d 88,000

106,000Dividends: paid 10,000

Proposed (10% 200,000) 20,000 (30,000)Profit and Loss c/d 76,000b)

GHB LTD

BALANCE SHEET AS AT 31 AUGUST 2005

FIXES ASSETS : COST DEP. NBV£ £ £

Equipment 280,000 140,000140,000

280,000 140,000140,000CURRENT ASSETS:Stocks 240,000 Trade debtors 190,000Cash & Bank 20,000 450,000CURRENT LIABILITIES:

Trade creditors 70,000Debenture interest unpaid 12,000Provision for taxation 12,000Proposed dividends 20,000 (114,000)336,000 Net assets476,000

Financed by:£1 ordinary share capital200,000

Profit and Loss account76,000Long term Loan200,000Net Worth476,000

c) The EPS.Earnings Per Share (EPS) = Net profit after tax – preference shares

dividend

No. of ordinary shares





= £18,000 = 9 pence per share (or £0.09 per share)£200,000

d) The dividend cover = Net profit after tax = £18,000Dividend £30,000

= £0.6 per share (or 60 pence per share)

QUESTION 6 The following trial balance has been extracted from the books of

Dessorch plc. for the year ended 28 February 2007:£dr £cr

Land and Buildings at cost400,000Plant and Machinery at cost150,000Office equipment at cost60,000Vehicles at cost 50,000Depreciation accounts (01 03 06):

Plant and machinery 50,000Office equipment 20,000Vehicles 25,000

Trade debtors 155,000Bank overdraft 10,000Cash 3,000 Trade creditors 120,000Long-term loan 80,000Sales (all on credit) 2,230,000

Purchases 1,300,000Stock (01 03 06) 200,000Wages and salaries 450,000Business rates and insurance60,000Heating and lighting 30,000Vehicle expenses 31,000Distribution costs 45,000Interest paid 6,000Profit and loss account (01 03 06) 205,000£1 Ordinary shares 200,000

---------- ----------

2,940,000 2,940,000NOTES at 28 February 2007:

• Stock in hand was valued at £105,000.

• Wages owing amounted to £5,000.

• Business rates prepaid amounted to £1,000.

• Plant and machinery is to be depreciated at 25% on cost.

• Office equipment is to be depreciated at 20% on cost.

• Vehicles are to be depreciated at 25% of net book value.

• It has been established that included in the £155,000 of tradedebtors is an amount of £5,000 owing from a company which

has ceased to trade, and has large debts. Consequently it is feltthat the whole amount should be written off.





• It has been decided to create a provision for doubtful debtsequal to 5% of the final end of year trade debtor figure.

• The directors estimate the tax liability to be £30,000.

• The directors have declared a final dividend of 9p.TASKS

a) Prepare the trading and profit and loss account for the year ended28 February 2007.

b) Prepare the balance sheet as at 28 February 2007.

SOLUTIONQ6. (a)

DESSORCH PLC TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED

28 FEBRUARY 2005

£ £Sales 2,230,000Cost of sales (1,395,000)Gross profit 835,000Distribution cost 45,000Administrative expenses 643,500 (688,250)Net profit before interest and tax 146,750Interest paid (6,000)Net profit before tax 140,750 Taxation (30,000)Net profit after tax 110,750

Dividends: Proposed (9% x 200,000) (18,000)92,750Profit and Loss account balance b/d 205,000Profit and Loss c/d 297,750

(b)DESSORCH PLC

BALANCE SHEET AS AT 28 FEBRUARY 2005

FIXES ASSETS : COST DEP.NBV

£ ££Land & Buildings 400,000 -400,000Plant & Machinery 150,000 87,50062,500





Motor Vehicle 50,000 31,25018,750Office Equipment 60,000 32,00028,000

660,000 150,750

509,250CURRENT ASSETS:Stocks 105,000 Trade debtors (155,000 – 5,000 -7,500) 142,000Rent prepaid 1,000Cash & Bank 3,000 251,500CURRENT LIABILITIES: Trade creditors 120,000Wages owing 5,000Bank overdraft 10,000Provision for taxation 30,000Proposed dividends 18,000 (183,000)68,500Net assets577,750Capital & Reserves

£1 ordinary share capital200,000Profit and Loss account297,750

Long term Loan80,000Net Worth577,750Workings: 1. COST OF SALES: £Opening stock 200,000Purchases 1,300,000

1,500,000Closing stock (105,000)Cost of sales 1,395,000

2. ADMINISTRATIVE EXPENSES£ £

Wages and salaries 450,000Add wages owing 5,000 455,000Heating and lighting 30,000Vehicle expenses 31,000

Business rates 60,000Less prepaid 1,000 59,000





Bad debt written off 5,000Provision for bad debt (155,000-5,000) x 5% 7,500Depreciation:Plant and machinery (150,000x25%) 37,500Office equipment (60,000x20%) 12,000

Vehicles (50,000-25,000) x 25%) 6,250 643,250QUESTION 7 You are the account officer of MORE LTD which has a registered capital of £1,500,000 divided into 2,400,000 ordinary share of 50p each and600,000 8% preference shares of 50p each. The following balances havebeen extracted from the books of the company after preparing the tradingprofit and Loss Accounts for the year ended 30 June 2007.

Dr Cr£ £

Ordinary share capital 300,0008% preference shares 90,000General Reserve 15,000Premises (cost) 420,000Bank 24,600Light & heating owing 2,640Profit & Loss A/c bal (1July 2006) 57,600Debtors & Creditors 17,400 3,360Stocks 115,020Cash 120Plant & Machinery (at cost) 150,000

Net profit for the year ended (30 June 2007)121,800Insurance prepaid 2,460Provision for depreciation:

Plant & Machinery90,000

705000705,000Additional information: The directors of MORE LTD have made the following Recommendations.

1. Corporate tax provision of £25,200

2. The payment of preference share dividend3. A maximum dividend on ordinary shares which would maintain a

working capital ratio of 1:5:1, the balance remaining from profits tobe transferred to general reserves.

Required:a) Prepare the profit and loss A/c for the year ended 30 June 2007b) Prepare the balance sheet as at 30 June 2006.

SOLUTION: Q7

Note: The additional information on ordinary share dividends requires thepreparation of the balance sheet first





MORE LTDProfit and Loss Account for the Year ended 30th June 2007

£ £Net profit for the year 121,800 Taxation provision (25,200)

Net profit after tax 96,600Dividend: Preference shares (8% x 90,000) 7,200Ordinary shares (w1) 27,000 34,200General reserve (Balance remaining) (62,400)P & L Bal b/d 57,600

57,600

MORE LTDBALANCE SHEET AS AT 30 TH JUNE 2007


£ ££Premises 420,000 -420,000Plant & Machinery 150,000 90,00060,000

570,000 90,000480,000

CURRENT ASSETS:Stocks 115,020 Trade debtors 17,400Insurance prepaid 2,460Cash 120 135,000CURRENT LIABILITIES: Trade creditors 3,360Light & heating owing 2,640Bank overdraft 24,600Proposed dividends: ordinary shares 27,000

Preference shares 7,200Provision for taxation 25,200 (90,000)45,000Net assets525,000

Capital & Reserves£1 ordinary share capital300,000Preference shares

90,000





Profit and Loss account297,750General reserves (15,000 +62,400)77,400Net Worth

525,000

WORKINGS: DIVIDENDSPreference share dividends: (90,000x 8%) 7,200Ordinary shares dividend:After paying the ordinary shares the working capital ratio (currentassets divided by current liabilities) must give a ratio of 1.5:1(i.e.should be 50% more than the current liabilities).The total current asset was £135,000. This means that to get a current

ratio of 1.5:1 and the total current liabilities must be £90,000. Totalliabilities before ordinary shares were £63,000. Therefore 27,000 mustbe paid as dividends on ordinary shares to make total liabilities equal£90,000 (£63,000 +£27,000) which will give a working capital ratio of 1.5:1 (135,000 ÷ 90,000). The remainder of the profit for the year£62,400 is transferred to the general reserve in the balance sheet.

QUESTION 8(MARCH 2007) The following information relates to Rollo Ltd and has been extracted from

their books as at 28 February 2007:£

Turnover 2,900,000

Selling and distribution costs250,000 Taxation for the year 160,000Stock at 01 03 06 360,000Purchases 1,200,000Stock at 28 02 07 380,000Administration expenses 240,000Interest paid 110,000Proposed ordinary dividend100,000

Issued ordinary share capital 1,000,000

Current market price per ordinary share 16 TASKSa) Prepare the profit and loss account for the year ended 28February 2007.b) Calculate the following:

i the gross profit to sales percentageii the profit after tax to sales percentageiii the earnings per share (EPS)iv the PE ratiov the stock turnover period in days

c) Comment on the financial performance via the use of ratios.





SOLUTION: a)

ROLLO LTDPROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 28 TH FEBRUARY 2007

£ £ Turnover 2,900,000Cost of sales (1,180,000)Gross profit 1,720,000Administrative expenses 240,000Selling and distribution expenses 250,000 (490,000)Net profit before interest and tax 1,230,000Interest paid (110,000)Net profit before Tax 1,120,000 Taxation (160,000)Net profit after tax 960,000Proposed dividends (100,000)Profit and loss c/d 860,000

b)i. Gross profit percentage = Gross profit X 100 = £1,720,000 X 100

Sale £2,900,000 =59.3%

ii. Profit after tax to sales percentage = Net profit after tax X 100Sales

= 960,000 X 1002,900,000

= 33.1%

iii. EPS = Net profit after tax = £960,000 = 96p per shareNo. of shares 1,000,000

iv. PE ratio = Market price per share = £16 = 16.67

timesEPS £ 0.96

v. Stock turnover (in days) = Average stock X 365 days Cost of sales

Average Stock = opening stock + closing stock= £360,000+380,000 = £370,000

2 2Stock turnover = £370,000 X 365 days

£ 1,180,000

= 114 days





c) Comment of the financial performance of Rollo Ltd: The gross profit of 59.3% seems fairly good even though previous year’sperformance is not available for comparison. The EPS seems highcompared with the 1,000,000 shares in issue. However, the company isnot able to sell its stock quickly enough. This may suggest lack of demand

for the goods otherwise management are taking advantage of bulkpurchase as the stock turnover stood at 114days.

QUESTION 10(MARCH 2008-ACCOUNTING III)The following trial balance has been extracted from the books of Yousef plc for the year

ended 29 February 2008:

£dr £cr

Premises 400,000

Machinery 150,000

Vehicles 60,000

VAT refund due 10,000

Trade debtors 360,000

Prepayments 4,000

Bank 6,000

Cash 1,000

Trade creditors 140,000

Long-term loan 110,000

Hire purchase account 90,000

Sales (all on credit) 2,076,000

Purchases 990,000

Stock (01 03 07) 59,000

Wages and salaries 410,000Business rates 70,000

Energy costs 65,000

Interest paid 8,000

Vehicle running expenses 36,000

Distribution costs 42,000

Advertising expenses 65,000

Communication expenses 70,000

Profit and loss account (01 03 07) 237,500

£1 Ordinary shares 100,000

Machinery depn. a/c (01 03 07) 37,500

Vehicle depn. a/c (01 03 07) 15,000---------- ----------

2,806,000 2,806,000

======== ========

Notes at 29 February 2008:

•Stock was valued at £64,000

•The analysis of the hire purchase account revealed that £20,000 falls due for

payment by 30 June 2008 and that the rest falls due for payment in the year 2012.

•Machinery AND vehicles are to be depreciated at 25% on cost.

•The directors have decided to provide the following provisions:

o Corporation tax of £56,000

o An ordinary dividend of 80 pence per share





TASKS

a) Prepare the trading and profit and loss account for the year ended 29 February2008.

[9]

b) Prepare the balance sheet as at 29 February 2008.[8]

c) Calculate the following accounting ratios:

i gross profit percentageii the profit before tax percentage of sales

iii the current ratio

iv the acid test

SOLUTION: Q 8 (a) YOURSEF PLC

TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 29TH

FEBRUARY 2008

₤ ₤Sales

2,076,000Opening stock 59,000Purchases 990,000

1,049,000Closing stock (64,000) (985,000)Gross profit 1,091,000

EXPENSES:Wages & salaries 410,000Business Rates 70,000

Energy costs 65,000Interest paid 8,000Vehicles running expenses 36,000Distribution costs 42,000Communication expenses 70,000Advertising 65,000Depreciation:

Machinery (25% X 150,000) 37,500Vehicle (25% X 60,000) 15,000 (818,500)

Net profit before tax 272,500Corporation tax (56,000)

Net profit after tax 216,500Dividends (0.8 X 100,000) (8,000)Retained profit for the year 208,500Net profit b/d 237,500Net profit c/d 446,000





(b) YOUSEF PLC

BALANCE SHEET AS AT 29 TH FEBRUARY 2008


£ ££Premises 400,000 -400,000Vehicles 60,000 30,000 30,000Machinery 150,000 75,00075,000

610,000 105,000

505,000CURRENT ASSETS:Stocks 64,000 Trade debtors 360,000Vat refund 10,000Bank 6,000Cash 1,000Prepayments 4,000 445,000CURRENT LIABILITIES: Trade creditors 140,000

Hire purchase 20,000Corporate tax 56,000Dividends 8,000 (224,000)221,000

Hire purchase account (90,000-20,000) (70,000)Long term loan (110,000)Net assets546,000

Capital & Reserves





£1 ordinary share capital100,000Net profit 446,000Net Worth546,000

(c)i. Gross profit percentage = Gross profit X 100 = £1,091,000 X100 = 52.55%

Sale £2,076,000 ii. Profit before tax to sales percentage = Net profit before tax X100

Sales= 272,500 X 100

= 13.1%2,076,000

iii. Current Ratio = Current Assets = 445,000 = 1.98:1Current Liabilities 224,000

iv. Quick/Acid Test Ratio = Current Assets – Stock = 455,000 –64,000 = 381,000 = 1.7:1

Current Liabilities 224,000224,000

QUESTION 9 ( past Question) The following trial balance has been taken from the books of RAB Ltd. as

at 30 April 2007:£ £

Turnover 1,960,000Purchases 1,120,000Stock (01 05 06) 76,000Communication expenses28,000Rent, rates and insurance53,000Marketing expenses 95,000Heating and lighting 29,000

Auditor’s fee 7,000Salaries 168,000Debenture interest 3,000Wages 210,000Creditors 55,000Provision for doubtful debts 2,000Equipment at cost 530,000Depreciation of equip. (01 05 06) 90,000Debentures (6%) 50,000Ordinary share capital (£1) 200,000

Profit and loss a/c bal (01 05 06) 102,000Debtors 130,000





Bank balance 10,000 -------2,459,000 2,459,000

Notes at 30 April 2007:

• Stock is valued at £74,000.

• Salaries owing amounted to £6,000.• Marketing expenses prepaid amounted to £8,000.

• The provision for doubtful debts is to be increased to £4,000.

• The equipment is to be depreciated by 25% pa on cost.

• The directors wish to provide £38,000 for corporation tax.

• The directors have declared an ordinary dividend of 12p pershare.

TASKSa) Prepare the profit and loss account for the year ended 30 April

2007.b) Prepare the balance sheet as at 30 April 2007

Solution: Q9(b) RAB LTD

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 TH APRIL 2007£ £ £

Turnover1,960,000Cost of sales:Opening stock 76,000Purchases 1,120,000Cost of goods available for sale 1,196,000Closing stock (74,000)Cost of sales(1,122,000)Gross profit838,000

EXPENSES:Communication expenses 28,000Rent, rates & Insurance 53,000Marketing expenses 95,000Less prepaid (8,000) 87,000Heating and lighting 29,000Auditor’s fees 7,000Salaries 168,000,Add owing 6,000 174,000Wages 210,000Increase in prov. for bad debts (4,000 -2,000) 2,000

Debenture interest 3,000





Depreciation: equipment (25%x 530,000) 132,500(722,500)Net profit before tax115,500 Taxation

(38,000)Net profit after tax74,500Proposed dividends (12% x 200,000)(24,000)Retained profit for the year50,500P & L Account Bal. b/d102,000P&L Account c/d152,500

RAB LTDBALANCE SHEET AS AT 30 APRIL 2007


£ ££

Equipment 530,000 222,500307,500

530,000 222,500307,500CURRENT ASSETS:Stocks 74,000Debtors 130,000Less provision for bad debt 4,000 126,000Marketing expense prepaid 8,000Bank balance 10,000 218,000CURRENT LIABILITIES: Trade creditors 55,000

Salaries owing 6,000Provision for taxation 38,000Proposed dividends 55,000 (123,000)95,000

402,5006% Debentures(50,000)Net assets352,500

Capital & Reserves





£1 ordinary share capital200,000Profit and Loss account152,500Net Worth

352,500

TRY QUESTIONS:1. You work as the accountant for a client named Dusty, and have just

taken out the trial balance as at 30 April 2007:£ dr £ cr

Capital as at 01 05 06 219,000Long-term loan 40,000Sales 1,879,000Purchases 1,210,000Stock as at 01 05 06 74,000Debtors 82,000Prov. for doubtful debts 1,000Creditors 67,000Business rates 38,000Insurances 45,000Light and heat 42,000Motor expenses 18,000Staff salaries 82,000Loan interest 2,000Buildings at cost 400,000

Vehicles at cost 50,000Vehicle depreciation 01 05 06 20,000Wages 155,000Bank 6,000Cash 1,000Drawings 21,000

2,226,000 2,226,000======== ========

Notes at 30 April 2007:

• Stock was valued at £71,000.

• Insurance prepaid amounted to £2,000.

• Wages owing amounted to £5,000.

• The accountant’s fee outstanding is estimated to be £4,000.

• The accountant has reviewed the debtors outstanding andadvises Dusty to write off £2,000.

• After writing off the bad debt you suggest that the provision fordoubtful debts should be increased to £3,000.

• The vehicles are to be depreciated by 20% on cost. TASKSa) Prepare Dusty’s trading and profit and loss account for the yearended 30 April 2007.

b) Prepare Dusty’s balance sheet as at 30 April 2007.Question 2.





The following information relates to Status Ltd. and has been taken fromtheir books as at 31 March 2006:

£ Turnover 1,400,000Administration expenses210,000

Cost of sales 480,000 Taxation for the year 100,000Interest paid 20,000Distribution costs 230,000Proposed dividends 80,000OTHER INFORMATION:• There are 500,000 £1 ordinary shares in issue.• The market price of an ordinary share on 31 March 2006 was

£11.20 per share. TASKSPrepare the Profit & Loss account of Status Ltd. for the year ended 31March 2006.Question 3

The following are the assets and liabilities of Chantal Ltd. as at 30April 2007:

£000Premises 800Bank overdraft 130Creditors 110Goodwill 150Debtors 400

Vehicles (net) 190Ordinary share capital 700Preference share capital 300Share premium 140 Tax owing 110Dividends owing 80Equipment 460Closing stock 300Profit and loss account balance 400Long-term loans 330

The following information has also been gathered:Credit sales 3,400Opening stock 260Purchases 1,500

TASKSa) Prepare the balance sheet of Chantal Ltd. as at 30 April 2007.b) Calculate the following ratios:

i currentii acid test

iii the debtor collection period in days

iv the rate of stock turnover





c) Comment briefly on the liquidity position of Chantal Ltd. as at 30 April2007.

Question 4 The following are the assets and liabilities of RebEt Ltd. as at 30

November 2005:£000

Equipment (net) 280Bank overdraft 110Creditors 156Goodwill 190Debtors 412Vehicles (net) 140Ordinary share capital 500Preference share capital 200Share premium 120 Tax owing 90Dividends owing 100Premises 700Closing stock 224Profit & Loss account balance 390Long-term loans 280

TASKSa) Prepare the balance sheet of RebEt as at 30 November 2005.b) Calculate the following ratios:

i current

ii acid testc) Comment briefly on the liquidity position of RebEt as at 30 November20

CHAPTER THREEACCOUNTING RATIOS

INTRODUCTION

An accounting ratio is a mathematical relationship between twoaccounting figures which can be presented in the form of numerals,percentage, a fraction or a decimal. Each expression attracts aspecial care.

Financial ratios or Accounting ratios are useful indicators of a firm'sperformance and financial situation. Ratios can be used to analyze trends





and to compare the firm's financials position to those of other firms. Insome cases, ratio analysis can predict future bankruptcy.

USERS OF ACCOUNTING RATIOS1. Trade Creditors: These groups of people are interested in the

company’s ability to pay its short term debts as and when they falldue. Their analysis will usually concentrate on the evaluation of thecompany’s liquidity position (i.e. Liquidity ratios).

2. Lenders of long term loan (e.g. debenture holders): They areconcerned with the company’s long term solvency and its survival inthe future. Their analysis will concentrate on the firm’s profitabilityover time, its ability to generate cash to pay them (i.e. the lenders)their interest when due and the payment of the principal money. Their focus will be on the company’s capital structure (i.e. therelationship between the various sources of funds- equity and debtcapital)

3. Investors: These people are mostly concerned with the company’searnings. Investors have more confidence in companies that showsa steady growth in earnings. Their analysis concerns an evaluationof the company’s present and future profitability. They are alsointerested in the capital structure of the company to prevent greaterrisks and any structure which can influence the earrings ability of the firm.

4. Management: Management/Directors of the company are thestewards of the company. They are therefore interested in everyaspect of the analysis.

CATEGORIES /TYPES OF ACCOUNTING RATIOFinancial ratios can be classified according to the information theyprovide. They can be classified in to five main groups.

1. PROFITABILITY RATIOS2. LIQUIDITY RATIOS3. ACTIVITY RATIOS OR EFFICIENCY RATIOS4. LONG-TERM SOLVENVY/GEARING OR LEVERAGE RATIOS5. INVESTMENT/ STOCK MARKET RATIOS.

In general, Profitability ratios measures the overall performance of thecompany, Liquidity ratios measures the firms ability to meet current

debts as they become due for payment, Activity/ efficiency ratiosreflects the firms efficiency in utilizing its assets, Gearing/Leverageratios measures the proportion of debt and equity in financing the assetsof the company and Stock market ratios evaluate the firms growthearnings. These categories have a number of ratios under each type. These arediscussed in details below.





1) PROFITABILITY RATIOS

These ratios measure the business’s potential to make profit in excess of its operating cost. It is one of the most important measures of acompany’s success. These ratios are used to measure the trading

performance of the business in terms of profit to sales or capital.

They compare profits at different levels with other figures and are oftenpresented as percentages. The main purpose of these ratios is tomeasure the profit made by a business within one year.Profitability is a primary measure of the overall success of acompany. Indeed, it is necessary for a company’s survival.

The main profitability ratios are:a) Gross Profit (Margin) percentage/ratiosb) Net profit percentage/ ratioc) Return On Capital Employed (ROCE)d) Return on Total Assetse) Return on Net Worthf) Expenses to Net profit ratio (percentage.)g) Expenses to sales percentage

A) GROSS PROFIT PERCENTAGE: This is Gross Profit divided be Sales. This ratio measures the averagegross profit/margin on sales of goods. It expresses the proportion of theselling price which represents gross profit.It is calculate by the formulae below:

Gross profit percentage = Gross Profit X 100Sales The answer you get represents the amount of gross profit for every₤100 of sales revenue. For instance, if the answer is 20%, this wouldmean that for every ₤100 of sale you make, ₤20 gross profit is madebefore any expense is paid.

Interpreting the gross profit percentageNormally this ratio is expected to remain reasonably constantovertime. Manufacturing industries with high operating cost/overheadswould usually have higher margins whilst industries with high volumes

of sales like food retailing have low margins. Low margins usually suggest poor performance.

But sometimes it may be due to expansion cost undertaken by the company such as launching a new product, trying to increasemarket share etc.

Above average margins are usually a sign of good management.

However, too high margins may make competitors enter themarket to compete with the business.

High profit margins could also mean the effectiveness of thesales team, pricing policies, purchasing methods, and the

production process.





The ratio is expected to remain constant over time. Therefore if there isa change in this ratio over various accounting periods, the change maybe traced to a change in any of the following:

a) Selling price- increase or decrease in selling price over theperiods, which is sometimes deliberate; perhaps in order to

increase sales.b) Stocks- wrong valuation of stocks or errors in accounting for

stocks etc.c) Production cost- increase or decrease in the production cost over

the period e.g. Increase in raw materials which has not beenpossible to pass on to customers in the form of higher prices.

d) Sales mix- a change in sales mixed; if several different productsare been sold they will not all be equally profitable; it is possiblethat in the current year, the company sold a higher proportion of less profitable products.

Assuming you calculate the ratio and there is a decline or reduction,how do you interpret this? Possible factors for interpreting this mayinclude

• Sales revenue declined

• Sales revenue remained the same, but costs increased overthe year

• Sales increased, but costs increased in greater proportion

• Suppliers increased their prices or the business lost tradediscount

• There was a change in the sales mix; more of less profitablegoods were sold this year.

B) NET PROFIT RATIO (PERCENTAGE) The net profit percentage expresses an organization’s net profit as apercentage of total sales.It is calculated as:Net profit percentage = Net profit x100

Sales The factors that affect the gross profit as stated above affects the netprofit percentage in the same way. Other factors affecting the Netprofit which will cause the percentage to change over accounting

period or between companies more importantly includes the following:i. Depreciation policy adoptedii. Change in selling and administrative expenses.

C) RETURN ON CAPITAL EMPLOYED (ROCE)It is the net profit before interest and tax divided by capital employed.ROCE is the most important profitability ratio and is probably the mostimportant of all the other ratios. It states the profit as a percentageof the amount of capital employed. It is often referred to as the primary ratio. In its simplest form, it attempts to measure theperformance of the business by comparing profit with the funds used to

generate them. It is considered the most important because, growth of





profit can only be assessed properly when the profit is related to thecapital used or employed in generating the profits.

ROCE = Profit before Interest & Tax X 100Capital Employed

Unfortunately, the term capital employed has more than one meaning. The most common meanings are: Capital Employed= TOTAL ASSETS -CURRENT LIABILITIES (i.e. Fixed Assets +Current Assets – CurrentLiabilities)

ORCapital employed = shareholder’s fund + Long term creditors(amount falling due after more than one year) + any long term

provision for liabilities and charges.

D) RETURN ON NET WORTHThis ratio expresses the net profit as a percentage of owner’s equity.It is calculated as: Net profit X 100

Net worth (owner’s equity)

E) RETURN ON TOTAL ASSETS This is the net profit expressed as a percentage of total assets. It iscalculated as:

= Net profit X 100Total Assets

F) EXPENSES TO NET PROFIT PERCENTAGE: This is the total expenses expressed as a percentage of Net profit. It iscalculated by the following formulae:Total expenses to Net profit percentage = Total expenses X 100

Net profit This ratio shows how net profit can pay off expenses. The usefulness of this ratio is that, it helps management to take steps tocontrol expenses when the ratio is getting high. For example if the totalexpenses amount to ₤5,000 and the net profit is ₤10,000, this means that,expenses is 50% of net profit. Thus net profit can pay off expenses twice over. A low rate means good

expenditure control.

Thus Expenses to Net profit percentage = ₤5,000 X 100 = 50%₤10,000

If in the subsequent period, expenses to net profit percentage is 75%,thus if expenses has increased to ₤7,500, then this is an indication tomanagement to take steps to control the level of expenditure in thebusiness.

NOTE: The individual expenses ratios can also be calculated in the same

way. For example, Distribution cost to net profit ratio, administrativeexpenses to net profit ratio etc.





G) Expense to Sales Ratio This is the total expenses expressed as a percentage of sale revenue orturnover. It is calculated by the following formulae:Expenses to sales percentage= Total expenses X100

SalesEXAMPLE 1: You have obtained the following information in respect of BOB Ltd. For the

year ended30th June 2007

£000Sales (all credit) 1,800Cost of sales 700Administration expenses 400Distribution costs 250Interest paid 10Provision for taxation 50Proposed dividend 80Closing value of fixed assets 700Closing stock 90Closing debtors 100Closing cash/bank balance 30Closing creditors 40Issued ordinary share capital (£) 500

TASKSa) Prepare a summarised Profit & Loss account for the year 30 June

2007b) Calculate the following ratios:

i the gross profit to sales percentageii the net profit before tax as a percentage of salesiii the operating profit as a percentage of salesiv the total expenses as a percentage of sales

Solution:

a) BOB LTDPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007

£ £Sales 1,800,000Less cost of sales700,000Gross Profit 1,100,000Less Expense:Administrative Expenses 400,000Distribution cost 250,000Interest paid 10,000 660,000





Net profit before Tax 440,000Less Provision for taxation 50,000Net profit after tax390,000Less Proposed Dividends 80,000

Net profit c/d 310,000

b)i) The gross profit percentage = Gross Profit X 100 = 1,100,000 X 100 =

61.1%Sales 1,800,000

ii) Net profit before tax as a percentage of sales=Net profit before tax X100 = 440,000 X 100 =24.4%

Sales 1,800,000iii) The operating profit as a percentage of sales

= Net profit after tax X 100 = 390,000 X100 =21.67%Sales 1,800,000

iv) The total expenses as a percentage of sales = Total expenses X 100 =660,000 X 100 = 36.67%

Sales 1,800,000Example 2

Study the following information regarding Companies A and B for theyear ended 30 June 2007Profit and Loss account Company A Company B

£ £ Turnover 9,000 24,000

Cost of goods 5,000 10,500Other expenses:Selling 500 4,750Administration 750 2,250Financial 300 500 TASKS:

a) Prepare the Profit and Loss Accounts for the year ended 30th

June 2007b) Calculate the following ratios:

i. Gross profit percentageii. Net profit percentage

Solution:a) Profit and Loss account for the year ended 30th June 2007Company A B Turnover 9,000 24,000Cost of sales (5,000) (10,500)Gross profit 4,000 13,500

Selling expenses (500) (4,750)Administrative expenses (750) (2,250)





Financial expenses (300) (500)Net profit 2,450 6,000

b) i) Gross profit percentage:Gross profit X 100 4,000 X100

13,500 X100Turnover 9,000

24,000= 44.44%

= 56.25%ii) Net profit Percentage

= Net profit X100 = 2,450 X100= 6,000 X100

Sales 9,00024,000

= 27.22%= 25%

LIQUIDITY RATIOS

These ratios measure the ability of a business to pay its current liabilities as and when they fall due. It is also known as short-termsolvency ratios.

A liquidity ratio measures the extent to which current assets can bequickly turned into cash. In other words they show how much cash theentity has available in the short term. Liquidity ratios are probably the

most commonly used of all the business ratios. A company’s creditorsmay often be particularly interested in this because they show the abilityof the business to quickly generate the cash needed to pay its bills.

Liquidity is the amount of cash a company can put its hands on quickly tosettle its debts. Liquidity ratios are sometimes called working capital ratios because that, in essence, is what they measure.

Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to thoseextending short-term credit to the firm.

TYPES OF LIQUIDITY RATIOS

Two frequently-used liquidity ratios are

A. THE CURRENT RATIO (OR WORKING CAPITAL RATIO)B. THE QUICK RATIO/ ACID TEST RATIO

A. CURRENT RATIO: It is current assets divided by current liabilities. The current ratio is used to evaluate the liquidity or the ability tomeet short term debts. The standard test of liquidity is the Current

Ratio. The current ratio measures the adequacy of current assets tomeet short term liabilities. The current ratio is the ratio of current


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assets to current liabilities. It is calculated by the followingformulae:

Current ratio = Current assetsCurrent liabilities

The answer is expressed as a factor, e.g. 2 to 1 or 2:1, 3:1, 1.6:1 etc. The idea behind this is that the company should have enough currentassets to pay off its current liabilities. Obviously, a ratio in excess of 1.0should be expected. Otherwise there would be the prospect that thecompany might be unable to pay its debts on time. Traditionally, a current ratio of 2 or higher was regarded as appropriatefor most businesses to maintain credit worthiness.However, in recent times a ratio of 1.5 may be regarded as the norm.

Short-term creditors prefer a high current ratio since it reduces their risk.Shareholders may prefer a lower current ratio so that more of the firm'sassets are working to grow the business. Typical values for the currentratio vary by firm and industry. For example, firms in cyclical industriesmay maintain a higher current ratio in order to remain solvent duringdownturns.

One drawback/disadvantage of the current ratio is that inventory mayinclude many items that are difficult to liquidate quickly and that haveuncertain liquidation values.

Interpretation

A reducing current ratio might mean a sign of deteriorating financialcondition. It might also be the result of eliminating obsolete stock.

An increasing current ration may mean a good financial situation. But itcan also mean an unnecessary piling of stock which may have othernegative effects like increase in stockholding cost.

A low current ratio has any of the following consequences:

i. Delays in payment to creditors. This will lead to loss of discount

ii. Creditors will withhold supplies because of late paymentsiii. There will be constant problem as to how to find cash to pay weekly

billsiv. Investment plans will have to be postponed

Too high ratios on the other hand may have the followingconsequences:

NB: The current ratio is very useful in assessing the performance of abusiness but very tricky to interpret the answer. Therefore it is useful that

the analyst take a careful look at the individual assets and liabilities when





interpreting the ratio. Consider the individual assets and liabilities andnote any changes too much stock, higher bad debt provision etc.

B. QUICK RATIO/ACID TEST RATIO

This is the current assets less closing stock divided by current liabilities. The quick ratio is an alternative measure of liquidity that does not includeinventory in the current assets. Most companies are not able to convert alltheir current assets into cash very quickly. Manufacturing companies inparticular may hold large quantities of raw materials stock, finishedgoods, WIP. For this reason we calculate an additional liquidity ratioknown as the Quick / Acid test ratio.

The quick ratio is defined as follows:Quick or Acid test ratio = Current Assets - stock

Current Liabilities

This ratio should ideally be at least 1.0 for companies with a slow stockturnover, for companies with a fast stock turnover; a quick ratio can becomfortably less than 1.0 without suggesting that the company shouldbe in cash flow trouble.

Example 3: The following information relates to MORE LTD at the end of threeconsecutives years ending 31 December 2006.

Year 2004 20052006

£ ££Creditors 6,480 9,740

12,565Bank - -1,500Loan (long –term) 12,500 10,50010,000Capital 24,100 24,180

26,22043,080 44,420

50,285 Cash in hand 100 100250Bank 1,450 1,750-Debtors 8,455 7,9409,165

Stocks 4,575 6,23010,120





Shop fittings 3,500 3,4005,750Premises 25,000 25,00025,000

43,080 44,420

50,285

TASKS:a) Calculate the amount of the working capital at the end of each yearb) Calculate the ratio of current assets to current liabilities to one

decimal place at the end of each yearc) Calculate the acid test correct to one decimal place at the end of

each yeard) Which year do you consider has been the safest as far as MORE

LTD’s debt paying ability is concern?Solution:MORE LTD

BALANCE SHEET AS AT2004 2005

2006£ £ £ £ £ £ £ £

£Fixed assetsPremises 25,000 25,00025,000Shop fittings 3,500 3,4005,750

28,500 28,400

30,750Current AssetsCash in hand 100 100250Bank 1,450 1,750 -Stocks 4,575 6,23010,120Debtors 8,455 7,9409,165

14,580 16,02019,535Current LiabilitiesCreditors 6,480 9,740 12,565

Bank Overdraft -- (6,480) -- (9,740) 1,500(14,065)Working capital 8,100 6,2805,470Net Assets 36,600 34,68036,220

Financed by:Capital 24,100 24,18026,220Long –term Loan 12,500 10,50010,000

36,600 34,68036,220





a) Working capital at theend of each period =£ 8,100 £6,280£5,470

b) Current ratio = Current Assets

Current Liabilities

Years 2004 2005 2006Current Ratio = 14,580 16,020 19,535

6,480 9,740 14,065

= 2.3:1 =1.6:1 = 1.4:1

c) Acid test ratio = Current Assets – stocksCurrent Liabilities

Years 2004 2005 2006

Acid Test ratio = 14,580 – 4575 = 16,020 – 6,230 = 19,535 –10,120

6,480 9,740 14,065 = 1.5:1 =1:1 =0.7:1

EXAMPLE 4: The following trial balance has been extracted from the books of TouristPLC. for the year ended 31 August 2005:

£dr £crProperty (31 08 05) 340,000Plant and Machinery (31 08 05) 36,000Office equipment (31 08 05)40,000Vehicles (31 08 05) 30,000VAT refund due 46,000 Trade debtors 533,800Prepayments 4,200

Bank overdraft 160,000Cash 2,000 Trade creditors 270,000Long-term loan 80,000Hire purchase account 48,000Sales (all on credit) 1,980,000Purchases 1,200,000Stock (01 09 04) 100,000Wages and salaries 420,000Business rates 48,000

Heating and lighting 30,000Vehicle expenses 22,000





Distribution costs 46,000Interest paid 10,000Depreciation for the year20,000Profit & Loss account (01 09 04) 190,000£1 Ordinary shares 200,000

2,928,000 2,928,000

NOTES at 31 August 2005:• Stock was valued at £108,000.• The analysis of the hire purchase account revealed that £8,000falls due for payment by 31 March 2006, and that the rest falls duefor payment after 1 September 2006.• The directors have decided to provide the following provisions:

Corporation tax of £65,000An ordinary dividend of 10 pence per share

TASKSa) Prepare the Trading and Profit & Loss account for the year ended 31

August 2005.b) Prepare the balance sheet as at 31 August 2005.c) Calculate the following accounting ratios for the two years:

i gross profit percentageii the profit after tax percentageiii the acid testiv the current ratio

TOURIST PLC. TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST

2000£ £

£Sales1,980,000Cost of sales:Stock 100,000Purchases 1,200,000

1,300,000

Closing stock (108,000)(1,192,000)Gross profit788,000Wages 420,000Business rates 48,000Heating and lighting 30,000Vehicle expenses 22,000Distribution costs 46,000Depreciation for the year 20,000

Interest paid 10,000(596,000)





Net profit before tax192,000 Taxation(65,000)Net profit after tax

127,000Dividend (200,000X10%)(20,000)

107,000Profit and Loss Account bal. b/d190,000Profit and Loss Account bal. c/d297,000

TOURIST PLC.BALANCE SHEET AS AT 31 AUGUST 2000

FIXES ASSETS :NBV

£ ££Property

340,000Plant & Machinery36,000Vehicle30,000Office Equipment40,000

446,000CURRENT ASSETS:Stocks 108,000 Trade debtors 533,800

Vat refund due 46,000Prepayment 4,200Cash 2,000 694,000CURRENT LIABILITIES: Trade creditors 270,000Bank overdraft 160,000Hire purchase account 8,000Provision for taxation 65,000Proposed dividends 20,000 (563,000)

171,000





617,000Long term liabilities:Long term loan 80,000Hire purchase account (48,000 - 8,000) 40,000

(120,000)Net assets497,000

Capital & Reserves£1 ordinary share capital200,000Profit and Loss account297,000Shareholders fund497,000

c)i. Gross profit percentage = Gross profit X100 = 788,000 X 100

Sales1,980,000

= 39.79%

ii. Profit after tax percentage = Net profit after tax X100Sales

= 127,000 X 100

1,980,000 = 6.4%

iii. Acid Test ratio = Current Assets – Stock = 694,000 –108,000

Current Liabilities 563,000= 1.04: 1

iv. Current Ratio = Current Assets = 694,000Current liabilities 563,000

= 1.2: 1

2) EFFICIENCY RATIO/ACTIVITY RATIOS These ratios show how effective the resources of the business havebeen utilized to generate income. They measure the efficiency of themanagement of assets (both fixed assets and current assets). Thusactivity ratios measure how well the assets of the organization havebeen used to attain the objectives of the organization. The following are the major activity or efficiency ratios.

A). STOCK TURNOVER RATIO





Stock turnover refers to the number of times/days that stocks are soldand replenished during a year. It is an indication of a business sellingefficiency.The stock turnover can be measured in two ways.The stock turnover ratio is calculated as follows:

1. Stock turnover ratio (in days) = Average stock x 365days

Cost of sales2. Stock turnover (No. of times) = cost of sales

Average stock

Average Stock = opening stock + closing stock 2

Note that, one is the opposite of the other .

The greater the stock turnover, the more efficient the entity would appear

to be in purchasing and selling goods. A stock turnover of say 2times would suggest that the company has about six month of sales in stock.

Interpretation:When interpreting the stock turnover, it is important to compare or relatethe answer with the previous years’ stock turnover.If the rate of turnover is slowing down (i.e. reduction in the stock turnover)it might mean that, the business is holding or keeping too much stock- i.e.waste of resources.It can also mean that business is slowing down and that customers are not

buying the product anymore. (e.g. Stocks may be pilling up and not beingsold and this could lead to liquidity problems).however, the increases in stock may be deliberates (management mayintentionally increase stock to take advantage of discounts on largepurchase or management may anticipate shortage in stock in the nearfuture and therefore may decide to keep stock levels high to meet longterm demand). A slow rate will affect the cash position of the business-cash used in buying the stocks are not realised early.Increase in stock turnover may indicate greater efficiency. The rate of stock turnover depends on the type of goods sold. Forexample supermarkets may have high stock turnover because it sells

daily. Goods like cars may have a low turnover rate. The stock turnover should be compared with the gross profit percentageto see the effect of selling price on turnover. If say stock turnoverincreases, it may mean that the company has reduced its selling price inorder to increase sales.

B). Debtors Collection Period (Average Collection Period)

This is the average length of time taken by customers to settle theiraccounts. Thus the number of days it takes the company to collect itsdebts.

It is calculated by the following formula:





Debtors Collection Period (in days) = Debtors (Closing Balance) X365 days

SalesInterpretation:The result (answer) you get should be compared with the credit

policy (the number of days’ credit normally allowed by thebusiness to its customers.The ideal collection period should by some what 30 days. This is becausesales are usually made in terms of payment within 30 days or at the endof the month following the month in which the invoice is sent out.Therefore debtors’ collection period which is too much in excess of 30days might indicate poor management of funds. Thus a long averagecollection period indicates a poor credit control. However, somecompanies may also give long credit period in order to attract customers.The answer you get depends on the type of organisation and the industry of that business.

ASSET TURNOVER RATIO

It is a measure of how effectively the assets of the company are beingused to generate income. They sometimes are referred to as assetutilization ratios, or asset management ratios. It is calculated bythe following formulae:

Asset Turnover Ratio = net profit Total Assets

Note that Total assets – current liabilities = Capital Employed

Interpretation: Low Assets turnover: Where the Asset Turnover Ratiois lower than that of competitors; it might mean over- investment inassets. However it may also mean that the assets are new (hence theyhave high values) than that of competitors. Again it could mean thatdepreciation charges are lower that that of competitors.

High Asset Turnover: A high Asset turnover ratio suggests that sellingprices have been reduced or suppressed in order to increase sales

volume.

CASH OPERATING CYCLE/(WORKING CAPITAL CYCLE)

This is the period of time that elapse between the payment for the goodssupplied and the receipts of cash from customers in respect of the salesmade.





That is the length of time between when the business makes payment toits suppliers for the materials and stock and when the business receivespayment for the resources from its customer.

The number of days in the cash operating cycle equal to:

Debtors collection period XX

Add stock turnover (in days) XXX

Less creditors payment period (days) XXX

CASH OPERATING CYCLE XXX

THE CONCEPT OF OVERTRADING

Overtrading occurs when a firm has inadequate finance to support itslevel of trading activities. This is when a firm tries to undertake morebusiness than is financial resources permit.

Overtrading is a common source of a business’s insolvency and explainswhy a firm which makes high profit can fail to pay its short term debts asand when they fall due.

COMMON SIGNS OR SYMPTONS OF OVERTRADING

The following, when seen in the business operation van indicate that thebusiness is overtrading.

1. rapid growth in sales2. static long term finance3. a sharp increase in debtors and debtors collection period4. a sharp increase in creditors and creditors payment period5. a sharp fall in cash balances and increase in overdraft6. A sharp change in stocks. An increase in stock means that excess

production or lack of demand for the product. A decrease meansthat the company is not able to produce to meet demand.

7. a sharp decrease in profit margin8. A sharp increase in asset turnover ratio.

INVESTORS RATIO/STOCK MARKET RATIO

These ratios focus more on the investor’s viewpoint. Investment ratiosprovide information to investors to enable them judge the profitability of the investment.It tells whether current investors should continue to hold their investmentin the company or they should sell their investment.

Potential investors also use these ratios to decide which company theyshould invest. These ratios cornered mostly ordinary shareholders.





The major ratios under these sets are:1. Price Earnings Ratio (P/E)2. Earnings Per Share (EPS)3. Dividend Per Share4. Dividend Cover

5. Dividend Yield6. Earnings Yield

1) PRICE/ EARNINGS RATIO(P/E RATIO) This ratio expresses the current market price (market value) as a multipleof the Earnigns Per Share (EPS). It indicates the number of years it wouldtake to recover the share price (cost of the investment in shares) out of the current earnings of the company. The P/E ratio is simply a measure of the relationship between the market value of a company’s share and theearnings from those shares. It is the most important yardstick forassessing the relative worth of a share.P/E Ratio = Market Price per share

Earnings per share (EPS)

For example a P/E ratio of 12.5 (i.e. £2÷£0.16), this means that, it willtake about 12 and half years to repay the cost of investment in theshares. The higher the P/E, the longer the payback. The lower the P/Eratio, the better the investment. The value of the P/E ratio reflects the market’s appraisal of the share’sfuture prospects. In other words if one company has a higher P/E ratiothan another, it is because investors either expect its earnings to increase

faster than the other’s or investors consider that, it is less risky companyor it is in a more secure industry The P/E ratio is expected not to vary much over time. If there is a changein the P/E ratios of companies overtime, it may be due to several factors:

I. If interest rate goes up, investors will be attracted away from sharesand into debt capital will generate high interest. Share price will falland so P/E ratio will fall. The opposite happens when interest ratesgoes down.

II. If the future prospects of the company’s profit improves, shareprices will go up and P/E ratios will rise. Share prices depend onexpectations of future earnings, and so a change in prospects,

perhaps caused by a substantial rise in international trade oreconomic recession will affect prices and P/E ratios

Earnings Per Share (EPS) : The earnings per share looks at the profitwhich could be in theory be paid to each ordibnary shareholder. It isusually looked at from the ordinary shareholder

It is calculated by the following formularEPS = Net profit after tax – Preference Share Dividends

No. Of ordianry shares in issue

DIVIDEND COVER (DIVIDEND PAYOUT):





This measures the ability of the firm to pay current dividend level in thefuture. It indicated the proportion of the Net profit which is retained for bymanagement for future investment. The dividend cover is calculated as follows:Dividend cover = Net profit after tax& preference share dividends

Ordinary share dividend

LONG-TERM SOLVENCY /GEARING /LEVERAGE RATIOS These ratios are used to help predict the long term solvency of a firm. These ratios indicates the relationship between funds provided by theactual owners of the company and the funds provided by outsiders/ longterm creditors such as debenture holders. They emphasizes on the capitalstructure of the firm and how the company is financed by debt capital orlong term loan. Solvency refers to the ability of a company to pay its longterm debts. The following ratios are mostly used to measure solvency ratios.

i. Debt- equity ratioii. Interest coveriii. Fixed dividend coveriv.

It is measured as:Prior charge capital

Total capital*prior charge capital is capital carrying a right to a fixed return. It willinclude preference share and debentures.

Total capital = ordinary shares capital and reserves +prior capital plusany long term liabilities and provisions. OR TOTAL ASSETS- CURRENT LIABILITIESrovide an indication of the long-term solvency of the firm.Unlike liquidity ratios that are concerned with short-term assets andliabilities, financial leverage ratios measure the extent to which the firm isusing long term debt.

The debt ratio is defined as total debt divided by total assets:

INTEREST COVER

This ration indicates whether a company is earning enough profit to meetinterest payment. That is whether net profit before interest and tax is ableto pay for the interest. Thus how well the firm's earnings can cover theinterest payments on its debt. This ratio is calculated as follows:

Interest Cover = Net profit before interest and tax

InterestADVANTAGES OF ACCOUNTING RATIOSRatios are the most powerful tools for analysing financial statement. Thefollowing are the advantages of ratio analysis.

1. ratios helps to know the ability of the company to pay its shortterm debts





2. it also helps us know the extent to which the company has used itsassets effectively and efficiently

3. it helps to assess the overall operating efficiency and effectiveperformance of the organisation

4. ratios provide a simple and convenient way of comparing

companies5. the pattern of performance over several years can be clearly

identified

LIMITATIONS/DISADVANTAGES OF RATIO ANALYSIS1. Ratios are normally calculated from past historical accounting

figure and therefore might not be indications of current/ futureevents

2. inflation/price level changes can render the interpretation of ratiosrisky

3. Accounting policies of companies can influence ratios. Example,the type of depreciation policy adopted and the rates used canaffect the net profit ratio greatly. This can make comparison verydifficult.

4. Management of a company can influence the ratios by engaging inwindow dressing actions prior to the preparation of financialstatement to make them look better.

5. There is more than one definition for some of the ratios, makingthem difficult to compare with other companies in the sameindustry.

QUESTIONS AND ANSWERSQUESTION 1. (Past question)

You have obtained the following information/data in respect of threecompanies for the year ended 31 May 2005:

Company X Y Z£000 £000 £000

Sales (all on credit) 750 950 1,200Cost of sales 310 390 510Administration expenses 160 190 210Distribution costs 100 130 160

Interest paid 5 5 5Provision for taxation 20 50 70Proposed ordinary dividend 15 30 90Issued share capital (£1 ordinary)200 200 400Long-term loans outstanding 100 100 100Retained profit (01 06 04) 130 210 300 TASKS

a) Prepare summarised Profit & Loss accounts (for EACH company) forthe year ended 31 05 05. [b) Calculate the following ratios (for EACH company):

i the gross profit as a percentage of salesii the operating profit as a percentage of sales





iii the earnings per share (EPS)iv the dividend coverv the gearing percentage

c) Explain the significance of a company’s Price Earnings Ratio(PE ratio).

SOLUTION TO QUESTION 1a)PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005

Company X YZ

£ ££Sales 750,000 950,0001,200,000Cost of sales (310,000) (390,000)(510,000)Gross profit 440,000 560,000690,000Administrative expenses (160,000) (190,000)(210,000)Distribution costs (100,000) (130,000)(160,000)Net profit before interest and tax 180,000 240,000320,000Interest paid (5,000) (5,000)

(5,000)Net profit before tax 175,000 235,000315,000 Taxation provision (20,000) (50,000)(70,000)Net profit after tax 155,000 185,000245,000Proposed dividend (15,000) (30,000)(90,000)Net profit for the year 140,000 155,000155,000

Net profit b/d 130,000 210,000300,000Net profit c/d 270,000 365,000455,000

b)COMPANY X

Y Xi) The gross profit as a percentageof sales:





= Gross Profit X 100 440,000 X100 560,000X100 690,000 X100Sales 750,000 950,000

1,200,000= 58.67%

58.95% 57.5%ii) Operating profit as a percentage of sales:= Net Profit before Interest &Tax X 100 180,000 X 100

240,000 X100 320,000 X100Sales 750,000

950,000 1200,000 = 24% =25.26% = 26.67%

iii) The earnings per share (EPS)= Net profit after tax = 155,000 =

185,000 245,000No. of shares 200,000

200,000 400,000

= £0.775 =£0.925£0.0.62 iv) The dividend cover

= dividend = 15,000 30,00090,000 =

Net profit after tax 155,000185,000 245,000

= 0.097 times = 0.162 times=0.37 times

v) The gearing percentage= long term debt = 100,000 X100 =

100,000 X100 = 100,000 X 100Capital employed 300,000

300,000 400,000 = 33.33%

33.33% 25%

QUESTION 2Barclays Bank Ltd and Standard Chartered Bank Ltd are two independentcompanies in the banking industry. The following information has beenextracted from the books of the two companies for the year ended 31st

July 2007.Stanbic Bank

Stanchat Bank £ £ £ £

Net Fixed assets 58,500 6,000Intangibles 6,000 -





Investments (Long term) 3,000 67,500 13,50019,500

Stocks 40,500Debtors 37,500

Advances 31,500Cash & liquid assets - 88,500Investments 4,500 82,500 10,500130,500,

150,000150,000

Taxation 1,500 1,500Creditors 72,000Current and deposits accounts136,500Bank 10,500 84,000 ---138,00010% debenture stock 49,500750Shareholders’ funds£1 ordinary shares 15,000 3,000Reserves 1,500 16,500 8,25011,250

150,000150,000

Additional information:1. The Net Profit before tax for the companies are:

Stanbic Bank Ltd £3,750Stanchat Bank Ltd £ 3,900

2. proposed dividends for the year are:Stanbic Bank Ltd £1,050

Stanchat Bank Ltd £ 600

REQUIRED:As a young financial adviser, you have been asked to assess the situationof both companies. Choose the appropriate ratios that you consider will

reveal the differences between the two companies. Discuss yourcalculations from the point of view of profitability and financial stability.

SOLUTION:Note:

Profitability measures the relationship between the profit and theassets or resources used in generating the profit.

Financial stability measures the ability of a firm to pay its debtswhen due to prevent it from collapse.

STANBIC

STANCHAT





Current ratio =Current assets = 82,500 =130,500


= 0.98:1

= 0.96:1

Acid test ratio=Current Assets- stocks = 82,500 – 40,500 =130,500


= 0.5:1= 0.96:1

Earnings per share=Net profit after tax = 3,750 -1,500 =3,900 -1,500

No. of shares 15,0003,000

= 15p per share =80p per share

Dividend per share = dividend = 1,050 =600


= 7p per share= 20p per share

Dividend cover = net profit = 3,750 -1,500 =3,900 – 1,500

Dividend paid 1,050 600= 2.1 times = 4

times

Gearing Ratio = long term debt = 49,500 X100 =750 X100

Capital employed 66,00012,000 = 75% =6.25%QUESTION 3

You have obtained the following information in respect of BOB Ltd. For theyear ended 30 June 2008

£000Sales (all credit) 1,800

Cost of sales 700Administration expenses 400





Distribution costs 250Interest paid 10Provision for taxation 50Proposed dividend 80Closing value of fixed assets 700

Closing stock 90Closing debtors 100Closing cash/bank balance 30Closing creditors 40Issued ordinary share capital (£) 500 TASKS

a) Prepare a summarised Profit & Loss account for the year.

b) Calculate the following ratios:i the gross profit to sales percentageii the net profit before tax as a percentage of salesiii the operating profit as a percentage of salesiv the earnings per share (EPS)v the debtor collection period in daysvi the total expenses as a percentage of salesvii the current ratioviii the acid test

SOLUTION: QUESTION 3a) BOB LTDPROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007

£ £Sales 1,800,000Less cost of sales700,000Gross Profit 1,100,000Less Expense:Administrative Expenses 400,000Distribution cost 250,000Interest paid 10,000 660,000Net profit before Tax 440,000

Less Provision for taxation 50,000Net profit after tax390,000Less Proposed Dividends 80,000Net profit c/d 310,000

b)i) The gross profit percentage = Gross Profit X 100

Sales

= 1,100,000 X 100 = 61.1%1,800,000





ii) Net profit before tax as a percentage of sales=Net profit before tax X100 = 440,000 X 100 =24.4%

Sales 1,800,000

iii) The operating profit as a percentage of sales= Net profit after tax X 100 = 390,000 X100 =21.67%

Sales 1,800,000

iv) The earnings per share (EPS) = Net profit after tax = 390,000 =₤0.78 per share

No. of shares 500,000

v) The debtor collection period in days = Trade debtors X 365 days =100,000 X 365days = 21 days

Sales1,800,000

vi) The total expenses as a percentage of sales = Total expenses X 100Sales

660,000 X 100 = 36.67%1,800,000

vii) Current ratio =Current assets = 220,000Current Liabilities 170,000

= 1.29:1viii) Acid test ratio=Current Assets- stocks = 220,000 – 90,000

Current Liabilities 170,000= 0.76:1

Workings:Current assets:

Closing stock 90,000Closing debtors 100,000Closing cash/bank balance 30,000 Total current assets 220,000

Current liabilitiesProvision for taxation 50,000Proposed dividend 80,000Closing creditors 40,000 Total current liabilities 170,000

QUESTION 4(COMPREHENSIVE QUESTION) You are provided with the following information relating to KASAPA LTD.

KASAPA LTD.Trading Profit and Loss Account for the year ended 31st December

2007 2006 2007





₤’000 ₤’000 ₤’000 ₤’000Sales 240 270Less cost of sales:Opening stock 15 21Purchases 150 195

165 216Closing stock (21) (144) (56)

(180)Gross profit 96 90

EXPENSES:Administrative expenses 27 36Loan Interest 1.5 1.5Selling &Distribution expenses 18 (46.5) 24

(61.50)Net profit before tax 49.50

28.50 Taxation (22.50)

(9.00)Net profit after tax 27

19.50Dividends: Preference shares (paid)3 3Ordinary shares (Proposed) 12 (15) 7.5

(10.50)Retained profit 12 9Net profit b/d 6 18

Profit and Loss account c/d 1827

KASAPA LTDBALANCE SHEET

2006 2007FIXES ASSETS COST DEP. NBV COST DEP NBV

₤’000₤’000₤’000 ₤’000₤’000₤’000Freehold property90 - 90 90 - 90Vehicles 63 21 42 72 33 39

153 21 132 162 33 129CURRENT ASSETSStocks 21 36Bank 4.5 90Debtors 30 1.5

55.55 277.50CURRENT LIABILITIESCreditors 15 93 Tax 22.50 9Proposed dividends 12 (46.50) 6 7.5 (109.50)18

138 147

Financed by:Ordinary share capital ₤1.00 60 60





10% preference shares 30 30Profit and loss account 18 27Shareholder’s fund 108

1175% debenture loan 30 30

138 147Additional information:

1. Purchases and sales were made evenly throughout the year.2. all purchases and sales were made on credit3. assume the prices were stable throughout the year4. The company sells only one product. In 2006 60,000 mobile phones

were sold and in 2007, 90,000 were sold.5. no fixed asset was sold during the year6. the market value of the ordinary shares are estimated to be ₤3.45

per share at 31 December 2006 and ₤2.70 per share at 31December 2007.

REQUIRED: CALCULATE the following ratiosa) PROFITABILITY RATIO

i. Return On Capital Employed\ii. Gross profit percentageiii. Net profit Percentage

b) LIQUIDITY RATIOi. Current Ratioii. Acid test ratio

c) EFFECIENCY RATIOi. Stock turnover (rate & in days)ii. Fixed assets turnoveriii. Debtors collection periodiv. Creditors payment periodd) INVESTMENT RATIO

i. P/E ratioii. EPSiii. Dividend coveriv. Capital Gearingv. Dividend per share

vi. Dividend yielde) Comment on the results of KASSAPA LTD for the year to 31

December 2007

SOLUTION: Q42006 2007

a) PROFITABILY RATIO

Gross profit percentage:

Gross profit X 100 4,000 X10013,500 X100





Sales 9,000 24,000

= 44.44%= 52.25%ii) Net profit Percentage

= Net profit X100 = 2,450 X100 =6,000 X100

Sales 9,00024,000

=27.22%= 25%

Current ratio =Current assets = 82,500 =130,500


= 0.98:1= 0.96:1

Acid test ratio=Current Assets- stocks = 82,500 – 40,500 =130,500


= 0.5:1

= 0.96:1

Earnings per share=Net profit after tax = 3,750 -1,500 =3,900 -1,500


= 15p per share =80p per share

Dividend per share = dividend = 1,050 =

600No. of shares 15,000

3,000= 7p per share

= 20p per share

Dividend cover = Dividend = 3,750 -1,500 =3,900 – 1,500

Net profit after tax 1,050600

= 2.1 times = 4times





Gearing Ratio = long term debt = 49,500 X100 =750 X100

Capital employed 66,00012,000

= 75% =6.25%

QUESTION 5: (September 2005 ACCOUNTING 2) The following details have been obtained from the final accounts of REM

plc for the last three years:2002 2003 2004

£m £m £mSales all on credit110 140 210Cost of sales 70 80 90 Total expenses 30 40 50Closing debtors 21 22 24Average stock 11 12 13 TASKSa) Calculate for EACH of the three years:

i the gross profit percentageii the net profit percentageiii the expenses to sales percentageiv the debtor collection period in daysv the stock turnover in days

b) Comment on the trends as revealed by your answer to a) above.

SOLUTION:REM PLC

PROFIT AND LOSS ACCOUNT2002 2003

2004£’m £’m

£’mSales (all on credit) 110 140

210Cost of sales (70) (80)

(90)Gross profit 40 60

120 Total expenses (30) (40)

(50)Net profit 10 20

70

i) Gross profit percentage:

= Gross profit X100 = 40 X100 = 60 X100= 120 X100





Sales 110 140210

=36.36% = 42.87%= 57.14%

ii) Net profit percentage:Net profit X100 =10X100 = 20 X100

= 70 X100Sales 110 140

210 = 9.09 14.28%

=33.33%

iii) Expenses to sales percentage:

= Total expenses X 100 = 30 X100 = 40 X100= 50 X100Sales 110 140210

= 27.27%=28.57% =23.8%

iv) Debtors collection period:

= Debtors X 365 days = 21 X 365 =22 X 365= 24 X365

Sales 110 140210

= 70days =57days =42days

v) Stock Turnover (in days):

= average Stock X 365days = 11X 365 =12 X 365= 13 X365

Cost of sales 70 8090

= 57days 55days53days

b) Comment of the financial performance of the company:

QUESTION 6: (MARCH 207 ACCOUNTING 3) The following summarised information has been extracted from the

accounts of three companies:Profit and loss extracts for year ended 28 February 2007:

D E F

£ £ £Profit before tax 13,000 9,000 5,000





Taxation (3,000) (2,100) (1,800)

Profit after tax 10,000 6,900 3,200Dividends (4,000) (2,000) (1,000)Retained profit for the year 6,000 4,900 2,200

Balance sheet extracts as at 28 February 2007:

Ordinary share capital (£1) 5,000 3,000 1,000Long-term loans nil 2,000 5,000Cumulative retained profit 8,000 4,000 2,000

On 28 February 2007 the market price of an ordinary share was:Company D £15Company E £24Company F £35 TASKSa) Calculate the following for EACH of the three companies:

i the profit after tax as a percentage of shareholders’ fundsii the earnings per share (EPS)iii the PE ratioiv the dividend coverv the gearing percentage

b) From the standpoint of a potential investor comment on theperformance of the three companies.

Solution: The shareholder’s fund is calculated as follows:SHARESHOLDERS FUND: D E F

£ £ £Ordinary shares 5,000 3,0001,000Cumulative retained profit 8,000 4,0002,000Shareholders fund 13,000 7,0003,000

Company D E

Fa)i) Profit after tax as a percentage of Shareholder’s fund:= Net profit after tax X 100 = 10,000 X100 = 6,900 X100

= 3,200 X100Shareholder’s fund 13,000 7,000

3,000 = 76.9% = 98.6%= 106%





ii) EPS = Net profit after tax = 10,000 = 6,900= 3,200

No. of shares 5,000 3,0001,000 = £ 2 per share =£2.3 per share

= £3.2 per share

iii) P/E ratio:

=Market price per share = £15 = £24= £35

EPS £2 £2.3£3.2 = 7.5 times =10.4 times= 10.9 times iii) Dividend Cover:= Net profit after tax = 10,000 = 6,900= 3,200

Dividend 4,000 2,0001,000 = 2.5 times = 3.45 times= 3.2 times

vi. Gearing Percentage

= Long term debt X 100 0 x, 100 2000X1005,000 X 100

Capital employed 13,000 9,0008,000

= 0% = 22.22%= 62.5%

b) Comment on the performance of the three companies

Question 7:Study the following information regarding Companies A and BProfit and Loss account Company A Company B

£ £ Turnover 9,000 24,000Cost of goods 5,000 10,500Other expenses:Selling 500 4,750Administration 750 2,250Financial 300 500

Balance Sheet Fixed assets 7,000 10,000





Current assets 4,275 6,750Current Liabilities 2,000 3,500 TASKS:a) Prepare the Profit and Loss Accounts for the year ended 30th June

2007 and the Balance sheet as at that date

b) Calculate the following ratios:iii. Gross profit percentageiv. Net profit percentagev. Return on capital

c) The working capital and working capital ratiod) A brief comment on the results comparing the two firms.

SOLUTION: Q7a) PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007

COMPANY AB

£ ££ £ Turnover 9,00024,000Cost of goods 5,00010,500Gross profit 4,00013,500Less: expensesSelling expenses 5004,750

Administrative expenses 7502,250Financial charges 300 (1,550)500 (7,500)Net Profit 2,4506,000

BALANCE SHEET AS AT 30TH JUNE 2007COMPANY AB

£ £ £ £

Fixed Assets 7,00010,000Current Assets 4,2756,750Current liability (2,000) 2,275(3,500) 3,250

9,27513,250

TRY QUESTIONS

QUESTION 1 You have obtained the following data in respect of two firms:





X Y£000 £000

Sales (all on credit) 400 820Cost of sales 190 330 Total expenses 130 190

Closing debtors 35 45Average value of stock 17 21

TASKSa) For both companies calculate the following:

i the gross profit percentage.ii the net profit percentageiii the expenses percentageiv the stock turnoverv the debtor collection period

b) Compare the financial performance of BOTH firms.

QUESTION 2: The following summarised information has been extracted from theaccounts of three companies:

Profit and loss extracts for year ended 28 February 2007:D E F£ £ £

Profit before tax 13,000 9,000 5,000 Taxation (3,000) (2,100) (1,800)

Profit after tax 10,000 6,900 3,200Dividends (4,000) (2,000) (1,000)

Retained profit for the year 6,000 4,900 2,200

Balance sheet extracts as at 28 February 2007:Ordinary share capital (£1) 5,000 3,000 1,000Long-term loans nil 2,000 5,000Cumulative retained profit 8,000 4,000 2,000

On 28 February 2007 the market price of an ordinary share was:

Company D £15Company E £24Company F £35 TASKSa) Calculate the following for EACH of the three companies:

i the profit after tax as a percentage of shareholders’ fundsii the earnings per share (EPS)iii the PE ratioiv the dividend coverv the gearing percentage

b) From the standpoint of a potential investor comment on theperformance of the three companies.





QUESTION 3 The following details have been obtained from the final accounts of Kulioplc for the last three years:

2003 2004 2005

£m £m £mSales all on credit 140 190 290Cost of sales 70 85 100 Total expenses 40 50 65Closing debtors 20 23 26Average stock 12 14 14Closing creditors 8 10 12 TASKSa) Calculate for EACH of the three years:

i the gross profit percentageii the net profit percentageiii the creditor payment period in daysiv the debtor collection period in daysv the stock turnover in days

b) Comment on the trends as revealed by your answer to a) above.QUESTION 4:Explain the purpose of the following rations:

i. Current ratioii. Assets turnoveriii. Interest coveriv. Dividend per share

v. Net profit ratio

QUESTION 5 The following figures have been extracted from Horace Ltd.’s accounts for

the two years to 30 November 2006:2006 2005

BALANCE SHEET CLOSING BALANCES:Stock £170,000 £120,000Debtors £350,000 £190,000Cash in bank - £40,000

Creditors £230,000 £210,000Bank overdraft £50,000 -

Long-term loans £600,000 £300,000

Issued share capital £500,000 £500,000Retained profit £260,000 £210,000 TASKSa) For BOTH years calculate the following:

i the current ratio[3]

ii the acid test ratio[3]iii the gearing percentage[3]





b) Comment on the liquidity position of Horace Ltd.[5]c) Explain the importance of preparing and monitoring a cash

budget.[6]

SUMMARY OF RATIOS

i. Gross profit ratio = Gross profit X100Sales

ii. Net profit ratio = Net profit before tax x100

Sales

iii. ROCE = Net profit after tax X 100Share holder fund

OR ROCE = Net profit before tax and interest X 100

Share holder’s fund +long term loan

OR ROCE = Net profit before tax X 100 Share holder’s funds

iv. Expenses to Net profit percentage = Expenses x100Net profit

v. Expenses to sales percentage = Expenses X 100Sales

LIQUIDITY RATIO:i. Current ratio= Current Assets

Current Liabilities

ii. Acid Test ratio = Current Assets - StocksCurrent Liability

EFFICIENCY RATIOS /ACTIVITY RATIOS

i. Stock Turnover ( in days) = Average Stock X 365 days

Cost of sales





ii. Rate of stock Turnover = Cost of salesAverage Stock

iii. Debtors Collection Period = Trade Debtors X 365 daysCredit Sales

iv. Creditors Payment Period = Creditors X 365 daysCredit purchases

v. Fixed Assets Turnover = Total Sales X 100Fixed Assets

INVESTORS RATIOS/ STOCK MARKET RATIO

i. Earnings Per Share (EPS) =Net profit after tax & preferenceshare dividend

No. of ordinary shares inissue

ii. Price Earnings(P/E) Ratio = Market price per shareEPS

iii. Dividend Per Share = DividendNo. of shares

iv. Dividend Cover = Net profit after tax & preference share

dividendsDividend

v. Dividend Yield = Dividend per shareMarket price per share

LONG-TERM SOLVENCY RATIO:





CHAPTER THREECASH FLOW STATEMENT

IntroductionHistorically the financial statements of a business have been two;

a) The Profit and Loss Account, showing increase or decrease inthe wealth of the business for a given period.

b) The Balance Sheet, showing the position of the business atone point in time.

However, during the late 1960’s and the early 1970’s, the AccountingStandards Committee (ASC) considered it necessary to have a thirdtype of statement which will focus on the flow of resources through abusiness between two balance sheet dates. The aim of the statement wasto show the sources and application of funds. The statement was alsoaimed at highlighting a business’s cash flow position for a particularaccounting period. The concept of Fund Flow Statement was thenintroduced into UK accounting standards.

In 1975, the ASC produced a standard, SSAP 10 (The Statement forSources and Application of Funds) to deal with this issue. It wasnamed Funds Flow Statement.

Note that, Standards produced by ASC were called SSAPs.SSAPs = Statement of Standard Accounting Practices.

In August 1990, a new independent body called the Accounting

Standard Board (ASB) was formed to takeover the responsibilities of the ASC. Standards Produces by ASB were called Financial ReportingStandards.

In September 1991, the ASB issued its first standards, known as theFinancial Reporting Standards No.1 (FRS 1): The Cash Flow Statement.FRS 1 came to replace SSAP 10, hence SSAP 10 ceased to apply.FRS 1 basically has the same purpose as the old SSAP 10 (Funds Flow

Statement). That is, they all emphasize on a business’s cash inflow andoutflow of cash during the financial year.In 1996, FRS1 was revised to include a statement which reconciles cash

flow to movement in net debt .





FRS 1 requires large companies/organizations preparing “true and fair” accounts to prepare CASH FLOW STATEMENT. Smaller companies arealso encouraged to do so, though some Small & Medium Enterprises useFRSSE.

ADVANTAGES OF CASH FLOW STATEMENTCash flow statements help users understand performance and position of the company better by explaining the difference cash inflows/outflows andprofit & Loss. The main advantages of cash flow statements include:

1. The cash flow statement helps in assessing the current liquidityposition of the business.

2. It also provides additional information on business activities3. It provides a mechanism for estimating the future cash flow of the

business4. It helps in determining cash flows generated from trading as

opposed to other sources of finance.5. The statement also allows the user to see the major types of cash

inflows and outflows of the business6. It helps the user to estimate the future cash flows of the business7. It helps in comparing the performance of different enterprises

because it eliminates the effect of different treatments of the sametransaction by these companies.

8. It helps evaluate management performance9. It commits management to consider the going concern of the

organization10. Creditors can assess the companies ability to pay amount owed

them.

DISADVANTAGES OF CASH FLOW STATEMENTCash flows statements have some limitations. They include the following

a. They place undue reliance on cash flow. Although cash flow isimportant, it is not enough in assessing the performance of thecompany.

b. Too much cash in the short term will prevent future growth.

WHY DOES PROFIT NOT EQUAL TO CASH?If a company makes higher profit, it does not necessarily mean the

company has more cash. In the short term, profits and cash/bank neednot be equal and a high profit does not necessary mean the company hasgenerated large cash surplus. The following are some of the reasons why profit may not be equal tocash.

1) Profit is calculated on accrual basis. Thus revenue is recognized(recorded) when it is earned, not when it is received and expensesare recorded when it is incurred, not when it is paid. On the otherhand, cash/bank will change only when money is paid or moneyreceived. Therefore cash and profit will differ due to certain items

such as accruals, prepayment, unpaid debtors etc.





2) The calculation of profit is affected by certain items which do notaffect cash or affects it differently. For example, depreciation affectsprofit but do not affect cash, because depreciation does not involvethe payment (movement) of cash. Also provision for doubtful debtsaffects profit but do not affect cash. Other items include taxation in

the current year, proposed dividends, profit or loss on disposal of fixed assets etc. These items affect cash differently.

3) Cash is affected by transaction such as purchase of fixed assetswhich do not affect profit. Profit is only affected by the depreciationof the fixed asset. Items such as repayment of loan, issue of sharesetc do not affect profit but does affect cash.

In the long term, profits will be equal to cash. For instance, debtors will berealized (i.e. collected), the depreciation charged will be equal to the totalcash expended and provisions will either be written back and accruedincome received.However, since short term position of the business is relevance toshareholders, there should be proper cash management for thecompany’s survival. Many businesses fail and are wound up because of cash shortages, despite adequate profit made.Cash flow statements help to notify the possibility of cash shortage

FRS 1: STANDARD HEADINGS OF CASH FLOW STATEMENTIn 1996, the ASB (Accounting Standards Board) revised FRS1, extendingthe analysis to eight (8) key headings. The standard headings include thefollowing:

1. Operating activities: These are cash flows relating to operating or

trading activities. They are cash flows generated from themain/principal revenue generating activities of the business.

2. Dividends from joint ventures and associates (not examinableat ICM level):

3. Returns on investment and servicing of finance: These arereceipts resulting from investment in other companies andpayments made for the providers of finance to the company (thosewho have invested in the company). Cash inflows under thisheading may include interest received, dividend received. Cashoutflows include interest paid, dividend paid on non-equity share(Preference shares).

4. Taxation: This heading covers the cash outflows (and sometimesinflows) to tax authorities (IRS) relating to profits and capital gains.It does not include VAT .

5. Capital expenditure and Financial Investment: This covers allpurchase and sale of fixed assets. Cash inflows include sale(disposal of fixed assets and cash outflows are the purchase of fixedassets.

6. Acquisition & Disposals: This relates to cash flows arising fromacquisitions or disposals of a trade or business or an investment in asubsidiary, associate or joint venture. (This is not examinable at ICM

level).





7. Equity dividend paid: This relates to cash outflows relating toequity dividend paid. (That is dividend on ordinary shares)

8. Management of liquid resource: These are cash flows relating towithdrawal from short-term deposits (not examinable)

9. Financing Activities: These are receipts or payments of principal

for or to external providers of finance. Cash Inflows include cashreceived from shares issued and debentures (long term loans).Outflows include payment of Loans/debentures the capital elementof finance lease (though not examinable at ICM level), payment of expense on share issues etc.

The individual items under the above standard headings are as follows.a. operating activities:

a) Net profit before taxationb) Adjustments for non-cash flow expenses like deprecation, loss

on disposal of asset, profit on sale of asset etc.c) Adjustments to the movement in working capital (stock,

debtors and creditors)b. Returns on investment and servicing of finance:

a) Interest received/ investment income receivedb) Dividend receivedc) Interest paid

c. Taxationd. Capital expenditure and financial investment:

a) Purchase of fixed assets

b) Sale/disposal of fixed assetse. Acquisitions and disposals:

a) Cash flow from the acquisition of businessb) Cash flow from the disposal of business

f. Equity dividend paidg. Management of financial resources

a) Cash flow from the acquisition or disposal of short-terminvestment

h. Financing:a) Issue of shares or debentures

b) Payment of shares or debenturesc) Payment of other long term loan.

This is summarized in the table below

PREPARING THE CASH FLOW STAMENTWe have explained the standard headings under which cash flowstatements are prepared as required by FRS1. Students must note thesequence of the headings when preparing the cash flow statement. Thestandard format in which cash flow statement should be prepared is given

in this chapter but for the purpose of our exams, some of the items arenot applicable at our level.





For the purpose of our study, the following sequence should be notedwhen preparing the cash flow statement.

1. Net cash flow from operating Activities: These are flows whichresulted from trading (operation) activities. They are primarilyderived from the principal revenue generating activities of the

business.2. Returns on investment and servicing of finance: These are

items such as interest paid, interest received, dividend received,preference share dividend paid etc.

3. Taxation: These are cash flows resulting from tax paid during theyear to the Inland Revenue.

4. Investing activity/ capital expenditure/financial Activities: These cash flows arise from the purchase or sale of fixed assets.

5. Equity dividend paid: this is sometimes classified under returnson investment and servicing of finance but can also be classifiedseparately. These cash flows relate to payments of dividends toordinary shareholders.

6. Financing Activities: These are cash flows resulting from thecapital structure of the business. Cash inflows items under thisheading include issues of shares (both preference and ordinaryshares), additional long term loans obtained, and debenture loans.Cash outflows include repayment of loan and debentures andexpenses relating to issue of shares.

Students should note that depending on the question given, some of theitems listed under the various headings may not be available. Wheresome of the items are not given in the question, proceed to the next.

Remember also that the starting point of the preparation of the cash flowis the calculation of the Net cash flow from operating activities. Theformat for preparing cash flow statement is discussed below. Two formatsare provided; the standard format which is provided be FRS1 (CASHFLOW STATEMENT) The second format is a summarized form of the standard as a result of thenature of ICM questions. Students should therefore not get confusedabout the formats. What is important is to grasp the principles behind thecash flow statement and you can solveany question given in the exams.

FORMAT OF CASH FLOW STATEMENT

FORMAT A- For the purpose of exams:Note that, this is provided based on the nature of ICM questions. It may not be the same for all questions.MORE LTDCASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006

₤₤

Net cash inflow/ (outflow) from operating activities (note1)xx





Returns on investment &serving of finance:Interest received xxInterest paid (xx)Preference dividend paid (xx)

Net cash inflow/ (outflow) from return on investment &serving of finance

xx Taxation paid xxCapital expenditure & financial investment:

Payment to acquire tangible fixed assets (xx)Receipts from sale of fixed assets xx

Net cash inflow/ (outflow) from capital expenditure/financial activities xxEquity dividend paidxxFinancing Activities:Issue of ordinary share capital xx

Repurchase of debenture (xx)Issue of loan and debentures xxNet cash inflow/ (outflow) from financing activitiesxx Increase/ (decrease) in cashxxxFORMAT B- STANDARD FORMAT MORE LTDCASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006

₤₤Net cash inflow/ (outflow) from operating activities (note1)xxDividends from joint venture xxReturns on investment &serving of finance:

Interest received xxInterest paid (xx)Preference dividend paid (xx)

Net cash inflow/ (outflow) from return on investment &serving of finance

xx Taxation paid xxCapital expenditure & financial investment:

Payment to acquire intangible fixed assets (xx)Payment to acquire tangible fixed assets (xx)Receipts from sale of fixed assets xx

Net cash inflow/ (outflow) from capital expenditure/financial activities xx Acquisition and disposals: Purchase of subsidiary (xx)

Sale of business xxNet cash inflow/ (outflow) from acquisitions and disposal

xxEquity dividend paidxxManagement of liquid resources:





Cash withdrawn from deposit xxPurchase of government securities (xx)Sale of corporate bond xx

Net cash inflow/ (outflow) from management of liquid resources xx

Financing Activities:

Issue of ordinary share capital xxRepurchase of debenture loan (xx)

Issue of loan and debentures xxExpenses paid in connection with share issue (xx)Net cash inflow/ (outflow) from financing activities

xx Increase/ (decrease) in cashxxx

THE CASH FLOW FROM OPERATING ACTIVITIES:

The starting point for cash flow statement is the Net cash flow fromoperating activities. There are two alternatives ways in which FRS1 allowscash flows from operating statement may be calculated.

1) The Indirect Method (Net method)2) The Direct method (Gross Method).

Both methods give the same value for Net cash flows from operatingactivities.THE INDIRECT METHOD (exam approach) This method starts with the operating profit and makes adjustment tonon-cash flow items (such as depreciation) and changes in working capital(i.e. changes in stock, debtors and creditors) so that one figure of operating cash flow is shown. Thus we reconcile the operating profit to thenet cash inflows or outflows so that we show only one figure in the cashflow statement.Using the indirect method, the Net cash flow is calculated as follows: The indirect method is one often used and this book focuses the indirectmethod

USING THE INDIRECT METHODRECONCIALIATION OF OPERATING PROFIT TO NET CASH INFLOWS/

(OUTFLOWS) FROM OPERATING ACTIVITIES

£’000Operating profit xxxAdd: Depreciation charges for the year xx

Loss on sale of assets xxLess: Profit on sale of asset xx(Increase)/Decrease in stock xx(Increase)/Decrease in Debtors xxNet cash inflows/outflows from operating activities xxxNote: readers must note that, the reconciliation of operating profit to netcash flow does not form part of the statement. It is shown as a note to thestatement.

EXPLANATION:





1. Operating profit: This is given in the exams and it is the net profitbefore interest and tax but after depreciation has been deducted.Profit increase cash but a loss reduces cash – i.e. takes away cashfrom the business.

2. Depreciation: The purpose of charging depreciation in the profit

and loss account is that sales during the year benefited from theuse of the assets on which depreciation is charged. Depreciationtherefore reduces profit made but depreciation does not involvecurrent cash outflow. Therefore add back depreciation chargedfor the current year to the operating profit. Note that were the profitis given as ‘ profit before depreciation’ it means that depreciationhas not been deducted from the profit and therefore no need to addback depreciation again.

3. stocks: a) Decrease in stock: Compare the stocks of the previous year

to the stocks for the current year in the balance sheet. If thereis a decrease in stock (i.e. if last years stock is lower that thisyears’ stock), the business has been able to sell more of itsgoods to customers (hence the reduction in stock). If morestocks are sold during the year, then more cash has come intothe business (cash inflows). Therefore add decrease instocks.

b) Increase in stock: Again compare the stocks figure in thebalance sheet. If there is an increase, it means that moremoney has been used to purchase stocks during the year. Thisrepresents a cash outflow (cash gone out of the business).

Therefore deduct all increases in stock during the year.4. Debtors:

a) Decrease in debtor: When the amount of debtorsreduces during the year, it means that, debtors (people who oweus) have paid us their debts, so we have received cash/cheque. This increases our cash balance in the business, hence increase indebtors represents cash inflowsb) Increase in debtors: An increase in debtors meansthat, goods/services are sold without collecting the cash.Customers are allowed more credit terms and are required to paylater. Thus allowing the debtors balance to increase means

stopping cash from coming in.5. Creditors:

a) Increase in Creditors: When there is an increase, it meanswe have taken more credit from our suppliers and did not paycash for the goods. More we have therefore saved cash in thebusiness which are supposed to be paid to suppliers/creditors

b) Decrease in creditors: A decrease in creditors means wehave paid our creditors.

THE DIRECT METHOD: This method calculates the cash flow by comparing the cash received

from customers (cash inflows) with the cash out for goods and servicespaid to suppliers and employees.





Thus it involves showing all the individual operating cash receipts andpayments such as cash receipts from customers, cash payment tosuppliers and cash payment to employees.Using the Direct method the Net cash flows from operatingactivities is calculates as follows:

DIRECT METHOD£ £

Sale (Receipts from Customers) XXXCash paid for:Purchases (suppliers) XXXPayment to employees XXXOther cash payment XXX XXXNet cash flow from operating activities XXX

The purchases and sales must be calculated as follows:

SALE PURCHASES£ £

Bal. in P&L account xxx xxxAdd: opening debtors & creditors BAL. xxx xxxLess: Closing debtors & Creditors xxx xxxCash from sales & purchases xxx xxx

NOTE: The opening balances of debtors (customers) and creditors(suppliers) are added to sales and purchases respectively. This is becausethey represent cash flow transactions which took place the previous but

are received in the current year. The closing balances are deductedbecause those cash are going to be received next year hence they are not cash inflows and outflows for the current year.

QUESTION 1: (ICM-Financial Management- March 2007) The summarised financial statements of Carla Ltd. for 2005 and 2006

were as follows:Carla Ltd. balance sheets as at 31 December

2005 2006£000 £000 £000 £000

Fixed assets at cost15,000 18,000

Depreciation (7,000) 8,000 (9,000) 9,000

Current assetsStock 7,000 9,000Debtors 11,000 10,000Bank 3,000 4,000

-------- --------21,000 23,000-------- --------

Current liabilities

Creditors 6,000 3,000 Taxation 4,000 5,000





Dividends 3,000 4,000-------- --------

13,000 12,000-------- --------

Working capital 8,000 11,000

Long-term loans (3,000) (4,000)-------- --------

13,000 16,000-------- --------

Capital and reserves:Ordinary shares (£1) 9,000 11,000Profit and loss account 4,000 5,000

13,000 16,000

Carla Ltd. profit and loss account for the year ended 31 December 2006:£000

Operating profit 11,000Interest paid (1,000)

Profit before tax 10,000

Taxation (5,000)Profit after tax 5,000Dividend (4,000)

--------Retained profit 1,000

TASKSa) Prepare a cash flow statement for Carla Ltd. for the year ended31 December 2006.b) Calculate the following:

i the dividend per share for BOTH years

ii the EPS for year ended 31 December 2006

c) Comment briefly on the financial performance during year ended31 December 2006.

QUESTION 1: SOLUTIONCARLA LTD

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER2006 £’000 £’000

Net cash inflows from operating activities (note 1 )9,000





Returns on investment and servicing of Finance:Interest paid (1000)

Net cash outflows from returns on investment & servicing of finance(1000)

Tax paid (4,000)

Capital Expenditure/financial investment:Purchase of Fixed asset (18,000 -15,000) w2

(3,000)Net cash outflows from capital expenditure/financial investment

(3,000)Equity dividend paid (w3)

(3,000)Financing Activities:

Long term loan (4,000 -3,000)1,000

Issue of ordinary Shares (11,000 -9,000) 2,000Net cash inflows from financing Activities

3,000Increase in cash & cash equivalents/net cash inflows

1000

NOTE 1:NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASHINFLOWS

£Operating Profit

11,000Add: depreciation (9,000 – 7,000)

2,000Increase in stock (9,000 – 7,000)

(2,000)Decrease in Debtors (11,000 – 10,000)

1,000Creditors (Decrease) 6,000 -3,000

(3,000)Net cash Inflows from operating Activities9,000

WORKINGS:(W1)

TAXATION ACCOUNT£ £

Bank (bal. figure) 4,000 Balance. b/d4,000

Balance c/d 5,000 P& L5,000

9,000

9,000





W3EQUITY DIVIDEND ACCOUNT

£

£ Bank (bal. figure) 3,000 Bal. b/d3,000

Bal. c/d 4,000 P & L4,000

7,0007,000W2

FIXED ASSETS ACCOUNT

££ Bal. b/d 15,000

Purchase (bal. figure) 3,000 Bal. c/d18,000

18,00018,000

ANALYSIS OF MOVEMENT IN CASH2005 2006 Changes during the Year

Bank balance 10,880 - (10,880)Bank overdraft - (2,320) (2,320) (13,200)

NOTE:i. Net cash inflows form operating activity: the first figure we need for

the cash flow statement is the cash flow from operating activity.This is usually done in a reconciliation statement by adjusting theoperation profit before interest and tax with the changes in stocks,debtors and prepayments (if any) and creditors and accruals

ii. Deprecation: the deprecation charge for the year (which is thedifference between the two depreciation amounts is always added.This is not a cash flow item and therefore should not be deductedfrom profit

b)i) Dividend Per Share 2005

2006= Dividend = 3,0004,000






= ₤0.33 Per share= ₤0.36 Per share

ii) EPS = Net profit after tax= 5,000

No. of shares11,000

=₤0.45 Per share

QUESTION 2: (I C M) You work for a small limited company and are assisting in the preparationof the annual accounts for the year ending 30th may 2007

ASPEN LIMITEDBALANCE SHEET AS AT 30TH MAY

20052006

£ £ £ ££ £Fixed assets (at cost) 173,000243,400Less depreciation 57,800 115,20078100 165,300Current assets:

Stock 74,40072,080Debtors 97,920100,020Bank 10,880-

183,200172,100Current Liabilities:Creditors 41,44037,080

Overdraft - 2,320Provision for tax 17,120 12,400Proposed dividends 10,000 (68,560) 114,640 12,000(63,800) 108,300

229,840273,600Financed by:£1 ordinary shares 200,000220,000Reserves 29,840

53,600





229,840273,600ASPEN LTDProfit and Loss account for the year ended 30th May 2007

£

Operating profit for the year 49,160Interest payable (1,000)Profit after interest 48,160Provision for tax (12,400)Profit after tax 35,760Proposed dividend (12,000)

23,760Profit & Loss balance b/f 29,840Profit & Loss balance c/f 53,600

Requires:a) Prepare a cash flow statement of MORE LTD for the year ended 30 May2007b) Compute the current ratios for both yearsSOLUTION TO QUESTION 2:

ASPEN LTD

CASH FLOW STATEMENT FOR THE YEAR ENDED 30 TH MAY 2007£

£Net cash inflows from operating activities (note 1)

65,320Returns on investment and servicing of Finance:Interest paid(1,000) Taxation(17,120)Capital Expenditure/financial investment:

Purchase of Fixed asset(70,400)Net cash outflows from capital expenditure/financial investment(70,400)

Equity dividend paid (W2)(10,000)Financing Activities:

Issue of Shares (220,000-200,000) –W320,000Net cash inflows from financing Activities

20,000Decrease in cash

(13,200)





NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASHINFLOWS

£ £Operating Profit

49,160

Add: depreciation (78,100-57,800) *20,300Decrease in Stocks (44,400-72,080)

2,320Increase in Debtors (100,020-97,920)

(2,100)Creditors (Decrease) (41,400-37,080)

(4,360)Net cash Inflows from operating Activities65,320

WORKINGS:W1



Balance c/d 12,400 P& L12,400

29,52029,520

W2EQUITY DIVIDEND ACCOUNT

££ Bank (bal. figure) 10,000 Bal. b/d10,000

Bal. c/d 12,000 P & L12,000

27,00027,000W3

FIXED ASSETS ACCOUNT

££ Bal. b/d 173,000


243,400243,000

ANALYSIS OF MOVEMENT IN CASH





2005 2006 Changes during the YearBank balance 10,880 - (10,880)Bank overdraft - (2,320) (2,320) (13,200)

Note: The depreciation calculation can also be controlled in a “T”Account as follows

DEPRECIATION ACCOUNT£ £

Balance. b/d57,800

Balance c/d 78,100 P& L (balancing fig.)20,300

78,10078,100

QUESTION 3 (I C M)

You work in the accounts office of XYZ Ltd and the accountant hasprovided you with the following information at the end of the financial

period, 2007BALANCE SHEET OF XYZ AS AT 31 December 2007

2006 2007 20062007

£ £ £ £Freehold property (cost) 25,000 25,000 Issued share capital 30,00030,000Equipment (note 1) 18,000 22,200 Profit and Loss A/c 27,00033,000Stock in trade 16,400 17,800 Corporation Tax due:Debtors 13,600 14,000 1 January 6,000-Bank 2,000 1,000 1 January -4,000

Creditor 12,00013,000

75,000 80,000 75,00080,000

The company’s summarized profit calculation for the ended 31 March 2007revealed:

2006 2007£ £

Sales 95,000 100,000Profit on sale of equipment 2,500





95,000 102,500LESS:

Cost of sales and other expenses 84,800 92,500Net profit before tax 10,200 10,000Corporate tax on profit of the year 6,000 4,000Retained profit of the year after tax 4,200 4,000NOTE 1: Equipment movements during the year ended 31 March 2007.

Cost Deprecation Net£ £ £

Balance at March 2006 30,000 12,000 18,000Additions during the year 9,000 - -Depreciation provided during the year - 3,800 -

39,000 15,800 -Disposals during the year (4,000) (3,000) -Balance at 31 March 35,000 12,800 22,200

Required: Prepare a cash flow statement for the year ended 31 March 2007.

QUESTION 3:SOLUTIONABC LTD

CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST MARCH 2007£

£Net cash inflows from operating activities (note 1 )

57,275Returns on investment and servicing of Finance:

Preference shares dividend paid(2,000)Net cash outflows from returns on investment & servicing of finance(2000)Taxation: tax paid(12,500)Capital Expenditure/financial investment:

Purchase of Fixed asset(63,000)Net cash outflows from capital expenditure/financial investment

(63,000)Equity dividend paid(6000)Financing Activities:

Debenture loan (50,000 -35,000)15,000

Preference Shares (25,000 -15,000)10,000Net cash inflows from financing Activities

25,000Decrease in cash

(1,225)






£Operating Profit 44,150Add: depreciation 8,000

Stocks (decrease) 1950Debtors (Increase) (3725)Creditors (Increase) 6900Net cash Inflows from operating Activities57,275

WORKINGSTAXATION ACCOUNT

£ £Bank (bal. figure) 12,500 Balance. b/d

12,500Balance c/d 15,000 P& L

15,00027,500

27,500

ORDINARY DIVIDEND ACCOUNT£

£ Bank (bal. figure) 6000 Bal. b/d (y1)6,000

Bal. c/d 6,500 P & L 6,50012,500

12,500FIXED ASSETS ACCOUNT

££ Bal. b/d 140,000 Depreciation8,000


203,000203,000

ANALYSIS OF MOVEMENT IN CASH Year 1 Year 2 Changes during the Year

Cash balance 500 500 -Bank 4,150 2925 (1225)

4,650 3425 (1225)





INTERNATIONAL ACCOUNTING STANDARDS 7 (IAS 7): CASH FLOWSTATEMENTApart from FRS 1, there is IAS 7(International Accounting Standard- 7)which also requires companies to prepare a cash flow statement. The twostandards are similar; the only difference is that IAS 7 is less detailed than

FRS 1.Under IAS 7, the Cash flow statement is prepared under three (3) majorheadings. The headings under IAS7 are:

i. OPERATING ACTIVITIES ( i.e. cash flow from operationactivities)

ii. INVESTING ACTIVITIES (i. e. cash flows from investingActivities)

iii. FINANCING ACTIVITIES (i.e. Cash flows from financingactivities)

CHAPTER QUESTIONS AND SUGGESTED SOLUTIONQUESTION 1 You have just been employed as the accountant of Timore Ltd and yourfirst assignment is to prepare the cash flow statement to be included inthe annual report for the year ended 2007. The following information ismade available to you by the managing director.

TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31DECEMBER 2007

£ £Sales 1,500,000Less cost of sales:

Opening stock 300,000Purchases 1,050,000

1,350,000Less closing stock 450,000 900,000Gross profit 600,000Operating expenses (375,000)Net profit 225,000 Taxation 75,000Net profit after tax 150,000Dividends 90,000Retained profit for the year 60,000

TIMORE LTDBALANCE SHEET AS AT 31 DECEMBER 2007

2006 2007£ £ £ £

Fixed assets (at cost) 1,350,000 1,575,000Less accum. Dep. 225,000 1,125,000 382,5001,192,500

Current asset:Stock 300,000 450,000





Trade debtors 180,000 225,000Cash 30,000 67,500

510,000 742,000

Current liabilities:

Trade creditors 105,000 135,000 Taxation 60,000 75,000Proposed dividends 45,000 90,000

210,000 300,000 300,000442,500

1,425,0001,635,000

Capital & Reserves:Ordinary share capital (£1) 1,125,0001,125,000Profit and Loss Account 300,000360,000

1,425,000 1,485,000Loans:10% debenture stock -- - -150,000

1,425,000 1,635,000

REQUIRED:Prepare the cash flow statement for the year ended 31 December 2007NB: Show all workings.

SUGGESTED SOLUTION: QUESTION 1 TIMORE LTD

CASH FLOW STATEME NT FOR THE YEAR ENDED 31ST DECEMBER 2007£

£Net cash inflows from operating activities (note 1)232,500

Returns on investment and servicing of Finance:Interest Paid(10% debentures)

(15,000)Net cash outflows from returns on investment & servicing of finance(15,000) Taxation: Tax paid(60,000)Capital Expenditure

Purchase of Fixed asset(225,000)

Net cash outflows from capital expenditure/financial investment(225,000)





Equity dividend paid(45,000)Financing Activities:

Debenture loan150,000

Net cash inflows from financing Activities150,000Increase in cash

37,500


£Operating Profit (225,000 +15,000) (10% interest on debentures)

240,000Add: depreciation (382,500-225,000)157,500Increase in stocks (450,000 – 300,000)(150,000)Increase in debtors (225,000-180,000)(45,000)Increase in creditors (135,000 – 105,000)30,000Net cash Inflows from operating Activities232,500



Balance c/d 75,000 P& L75,000

135,000135,000

ORDINARY DIVIDEND ACCOUNT£

£ Bank (bal. figure) 45,000 Bal. b/d (y1)45,000

Bal. c/d 90,000 P & L90,000

135,000135,000FIXED ASSETS

Opening balance 1,350,000Closing balance 1,575,000





Additional purchase 225,000ANALYSIS OF MOVEMENT IN CASH

2006 2007 Changes during the YearCash balance 30,000 67,500 37,500

Increase in cash 37,500

Question 2 You are presented with the following information:

MORE LTDBALANCE SHEET AS AT 31 DECEMBER 2006

31/12/200531/12/2006

£ £ ££Fixed Assets:Land & Buildings at cost 900,0001,050,000

Current Assets:Stocks 150,000180,000Debtors 300,000375,000Cash 9,000 15,000

459,000570,000

Current Liabilities:Creditors (270,000) 189,000(330,000) 240,000

1,089,0001,290,000Capital & Reserves:£1 ordinary share capital 1,050,0001,200,000Profit & Loss Account 39,00090,000

1,089,000

1,290,000

Task: prepare the cash flow statement for MORE LTD for the year ended31 December 2006.

SUGGESTED SOLUTION: QUESTION 2MORE LTD

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2006

£ £Net cash inflows from operating activities 6,000





Capital expenditure/investing activities:Purchase of fixes assts(150,000)Financing activities:Issues of ordinary share capital

150,000Increase in cash6,000

Reconciliation of operating profit to net cash inflows fromoperating activities

£Operating profit (90,000 - 39,000)51,000Increase in stock (180,000 – 150,000)(30,000)Increase in debtors (370,000 - 300,000)(75,000)Increase in creditors (330 - 270)60,000Net cash inflows from operating activities6,000

Analysis of movement /changes in cash: 2005 2006 change

during the year£ £ £

Cash balance 9,000 15,0006,000Increase in cash6,000

QUESTION: 3 The following information relates to CAR Ltd for the year ended 30 June2007

Profit and Loss account for the year ended 30 June 2007

££Gross profit322,000Administrative expenses 106,400Loss on sale of vehicle 4,200Increase in provision for bad debt 1,400Depreciation (vehicles) 49,000

(161,000)





Net profit before tax161,000 Taxation(91,000)Net profit after tax

70,000Dividends(35,000)Retained profit for the year35,000

BALANCE SHEET AS AT 30 JUNE 20072006

2007Fixed assets: £ £ £ £ ££Vehicles at cost 210,000280,000Less depreciation (105,000)(140,000) 105,000

140,000 Current Assets:Stocks 84,00070,000Debtors 112,000 140,000provision (5,600) 106,400 (7,000)133,000Cash 8,40011,200

198,800214,200

Current Liabilities: Trade creditors 84,000 74,200 Taxation 72,800 91,000Proposed dividends 28,000 (184,800) 14,000 35,000(200,200) 14200 119,000154,000

Capitals & Reserves:





Ordinary share 105,000105,000Profit and Loss account 14,00049,000 119,000

154,000

Additional information:i. During the year, the company sold a vehicle for £16,800 in cash.

The vehicle had originally cost £35,000 and a depreciation chargesamounted to £14,000

ii. A new vehicle costing £105,000 was purchased during the year.Required: You are required to prepare the Cash Flow statement for theyear ended 30 June 2007. QUESTION 7: (SEPTEMBER 2005 ACCOUNTING II) The summarised financial statements of Axenby Ltd. for 2003 and 2004

were as followsAxenby Ltd. balance sheets as at 31 December:

2003 2004£000 £000 £000 £000

Fixed assets at cost 13,000 28,000Depreciation (6,000) 7,000 (8,000) 20,000Current assets:

Stock 8,000 16,000Debtors 6,000 8,000

Bank 1,000 2,00015,000 26,000

Current liabilities:

Creditors 3,000 6,000 Taxation 1,000 2,000Dividends 2,000 3,000

6,000 11,000

Working capital 9,000 15,000Long-term loans (5,000) (9,000)

11,000 26,000

Capital and reservesOrdinary shares (£1) 5,000 10,000Profit & Loss account 6,000 16,000

11,000 26,000

Axenby Ltd. Profit & Loss account for the year ended 31 December2004:

£000Operating profit 16,000





Interest paid (1,000)

Profit before tax 15,000 Taxation (2,000)Profit after tax 13,000

Dividend (3,000)

Retained profit 10,000

TASKSa) Prepare a cash flow statement for Axenby Ltd. for the yearended 31 December 2004.b) Calculate the following for BOTH years:

i the current ratioii the acid test

c) Comment briefly on the financial performance during 2004.

AXENBY LTDCASH FLOW STATEME NT FOR THE YEAR ENDED 31ST DECEMBER 2004

£ £Net cash inflows from operating activities (note 1)11,000Returns on investment and servicing of Finance:

Interest Payable (1,000)Net cash outflows from returns on investment & servicing of finance(1,000)

Taxation(1,000)Capital Expenditure/financial investment:

Purchase of Fixed asset (15,000)Net cash outflows from capital expenditure/financial investment(15,000)Equity dividend paid(2,000)Financing Activities:

Debenture loan (9,000 - 5,000) 4,000Ordinary Shares (10,000 - 5,000) 5,000

Net cash inflows from financing Activities9,000Increase in cash

(1,000)


£Operating Profit 16,000Add: depreciation (8,000- 6,000) 2,000

Increase in stocks (16,000 – 8,000) (8,000)Increase in Debtors (8,000 – 6,000) (2,000)





Increase Creditors (6,000 -3,000) 3,000Net cash Inflows from operating Activities11,000

TAXATION ACCOUNT

£ £Bank (bal. figure) 1,000 Balance. b/d

1,000Balance c/d 2,000 P& L

2,0003,000

3,000 NB: the tax paid during the year is sometimes (but not always) equal tothe tax figure for the previous year in the question given you.

DIVIDEND ACCOUNT£

£ Bank (bal. figure) 2,000 Bal. b/d2,000

Bal. c/d 3,000 P & L 3,0005,000 5,000

FIXED ASSETS£

Opening balance at cost (2003) 13,000

Closing balance at cost (2004) 28,000Purchased during the year 15,000

ANALYSIS OF MOVEMENT IN CASH 2003 2004 Changes during the Year

Bank 1,000 2,000 1,000Increase in cash (1000)

b) Year 2003 2004

i) Current ratio= Current Assets = 15,000 X100 =26,000 X100

Current liabilities 6,00011,000 = 2.5:1= 2.36:1 ii) Acid Test Ratio =Current Assets- stocks = 15,000 - 8,00026,000 -16,000

Current liabilities 6,00011,000





= 1.16:1= 0.9:1

QUESTION 7 :( MARCH 2006 FINANIAL MANAGEMENT)a) Prepare a cash flow statement of a company called LED plc for the year

ended 31 March 2006 from the following data:£000

Purchase of new machinery 180Purchase of new vehicles 80 Tax paid 110Equity dividends paid 90Proceeds from share issue 510Repayment of long-term loans370Interest paid 40Interest received 5Investment income 15Cash inflow from operating activities 190

b) Comment on the cash flow position of LED plc during year ended 31March 2006.

SOLUTION TO QUESTION 7:LED PLC

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 2006

£

£Net cash inflows from operating activities190,000Returns on investment and servicing of Finance:

Interest Paid (40,000)Interest Received 5,000Investment income 15,000

Net cash outflows from returns on investment & servicing of finance

(20,000) Taxation(110,000)

Capital Expenditure/financial investment:Purchase of new machinery

(180,000)Purchase of Vehicle

(80,000)Net cash outflows from capital expenditure/financial investment(260,000)Equity dividend paid(90,000)Financing Activities:0

Proceeds for issue of shares 510,000





Repayment of long term loan(370,000)Net cash inflows from financing Activities140,000Decrease in cash

(150,000)

CHAPTER FOURCAPITAL INVESTMENT APPRAISAL

Introduction Capital investment decisions are those decisions that involve current outlays(cash outflow) in return for future benefits (cash inflows). In other words,when a company makes a capital investment, it makes an initial cash outlay (outflow) for benefits to be received or realized in the future.Such investments are made in the long-term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firm is used to invest

in assets that will enable the firm to generate revenues several years into thefuture. Normally the funds raised to invest in such assets are not available.





Therefore the firm must budget/plan correctly, how these funds will beinvested.

DEFINITION: CIMA defines Capital Investment Appraisal as follows: ‘An evaluation of the costs and benefits of a proposed

investment in operating assets’Capital Investment Appraisal (sometimes called capital budgeting) istherefore the process of planning capital investment and evaluating andselecting from a range of possible choices /alternatives.

Because capital budgeting decisions have a major impact on the firm forseveral years, they must be carefully planned. A bad decision can have asignificant effect on the firm’s future operations. Again, the timing of thedecisions is important. Many capital budgeting projects take years toimplement. If managers do not plan accordingly, they might find that the

timing of the capital budgeting decision is too late (i. e costly with respect tocompetition.

Decisions that are made too early can also be problematic because capitalbudgeting projects generally are very large investments, thus early decisionsmight generate unnecessary costs for the firm.

A proposed investment is judged by a number of appraisal techniquesbefore they are undertaken and therefore Capital budgeting is a requiredmanagerial tool. One duty of a financial manager is to chooseinvestments with satisfactory cash flows and rates of return. Therefore, a

finance manager must be able to decide whether an investment is worthundertaking and be able to choose intelligently between two or morealternative projects/investments. A sound procedure to evaluate,compare, and select projects is needed by the finance manager.

REASONS WHY COMPANIES USE APPRAISAL TECHNIQUES The following are some reasons why companies evaluate potentialinvestment projects before beginning such projects

1. It involves substantial expenditure. The sum (cash) involvedis relatively large hence a bad decision and choice may have

very serious consequence on the company.2. The benefits may be spread over many years. The time

scale over which the benefits (cash inflows) will be received isrelatively large and cover a series of years hence properassessment of the project must be made.

3. Capital investment, when undertaken, are irreversibledecisions, hence they require proper analysis.

4. Uncertainty : The expected cash flows are computed based onfuture expectations. Since the future is uncertain, correctdecisions may sometimes prevent disastrous consequences.





CHARACTERISTICS/ FEATURES OF CAPITAL INVESTMENTDECICIONS

Capital investment decisions have certain characteristics which are notalways present in other management decisions, and as a result, specialtechniques are required to ensure that only the best information isavailable to the decision maker. These characteristics are:

1. A significant outlay of cash;2. Long term involvement with greater risks and uncertainty(because forecasts of the future are less reliable)3. Irreversibility of some projects due to the specialised natureof, for example, plant which having been bought with a specificproject in mind may have little or no scrap value;4. A significant time lag between commitment of resources and

the receipt of benefits;5. Project completion time requires adequate continuous controlinformation as costs can be exceeded by a significant amount.

INVESTMENT APPRAISAL TECHNIQUES/METHODS There are several methods for evaluating capital expenditure projects butno matter what method is used it is important to realize that theinformation used for the evaluation has to be properly screened as it canmaterially affect the evaluation. The most commonly used techniques can be classified into two maingroups.

A) NON-DISCOUNTED CASH FLOW TECHNIQUES These are sometimes referred to as the traditional appraisal techniques The two popular traditional methods of comparing the attractiveness of competing projects are:1) The Accounting Rate of Return (ARR)2) The Payback period

B) DISCOUNTED CASH FLOW TECHNIQUES3) Net Present Value (NPV)

4) Internal Rate of Return (IRR)5) Profitability Index (P I)

Each of these methods will be described and an example given of thecalculations involved. Then the acceptance criterion for each will be stated. We share considerinvestment projects in circumstances

1. ACCOUNTING RATE OF RETURN (ARR) It is defined as the ratio of average profit, after depreciation, tothe capital invested. That is, the average earnings/profit of a projectexpressed as a percentage of the average or initial capital invested in theproject. This is sometimes known as the Return On Capital Employed

(ROCE).





It is calculated by the formulae: ARR= Average annual profit after depreciation X 100

Initial Investment

Average Annual profit=Total annual profit (cash inflows minusdepreciation) x100

No. of years

Note that Capital invested is the cost of the project. In the calculationthe initial investment or Average investment can be used i.e. ARRcan be calculated using either the total initial investment (total cost of the project) or on the Average initial investment (half of the cost of the project)Where ARR is calculated using average investment, the formulabecomes

ARR= Average annual profit after depreciation X 100Average Investment

Note that, AVERAGE INVESTMENT= TOTAL INVESTMENT2

DEPRECIATION:From our previous discursion on company accounts, we learnt that, whenwe buy assets, its value reduces every year. In project appraisal, the

general assumption still holds that, when a project is undertaken, thevalue of the project losses its value every year. The ARR method of investment appraisal uses Accounting profit but notthe cash flow in the assessment of the project’s worthiness. Rememberthat profit is not necessarily the same as cash.Since Net profit is different from cash flow, we must calculate thedepreciation and deduct from the cash flow from the project to get theprofit. We can then use the profit in the calculation of the ARR.

There are a number of methods that can be used to calculate thedepreciation of a fixed asset. The most commonly used ones are the

Reducing Balance method and the Straight Line method. In thischapter, we shall assume that only the straight line method is used incalculation of the project’s depreciation. The formula for the depreciation using the straight line method is:

Depreciation = cost –residual valueNo. of years

In the project appraisal, it is usually assumed that the residual value or scrap value will be zero but this is not true for all cases. In some casesthere could be residual value at the end of the projects life.

Let us consider the following examples and see how the ARR is calculated





Example 1Etienne Ltd is considering investing in a project which has the following

cash flows:£000

Initial investment 2,100Cash flows:

Year 1 500 Year 2 900 Year 3 1,000 Year 4 800 Year 5 500

TASKS: Calculate the ARR (accounting rate of return)

Solution :( with explanation) example one

ARR= Average annual profit (after depreciation) X 100Initial investment

Average Annual Profit= Total annual Profit (after depreciation)No. of years

Note: in the example, we are given the case flows for the project over 5years. These case flows are not profit. It means that we need tosubtract the depreciation of the project to get the profit.

Annual depreciation = cost- residual value = £ 2,100,000 = £420,000No. of years 5 years

That is, the depreciation for every year is £420,000. Therefore we haveto deduct this depreciation from each year’s cash flow to get the profit.

Cash flows Depreciation Annualprofit

Year 1 500,000 420,000 80,000 Year 2 900,000 420,000 480,000 Year 3 1,000,000 420,000 580,000 Year 4 800,000 420,000 380,000

Year 5 500,000 420,000 80,0003,700,000 2,100,000

1,600,000 now since the profit has been calculated,ARR can now be calculated

ARR= Average annual profit X 100Initial investment

Average Annual Profit= Total annual Profit = 1,600,000 = £320,000No. of years 5 years

Therefore ARR = £320,000 X 100 = 15.23%2,100,000





Tutorial The solution appears to be too long. This is due to the explanation. The explanations

is not necessary in exams. Let us now take a look at some few points in the abovesolution.

a. The general assumption is that the straight line method will be used inthe calculation of the depreciation. Therefore remember to use it whenno other method is given to you.

b. From example one, the annual depreciation was £420,000. You can seethat the total depreciation for the years is equal to the cost of the

project which is £ 2,100,000. The reason is that, there is no scrap or residual value at the end of the project’s life. Therefore we can assumethat the total annual depreciation is equal to the cost of the project. T his cost of the project can therefore be used as the total depreciation whenthe straight line method is used and there is no residual value

c. Unless you are told to use the average investment, always use the initialinvestment

Let us look at the example below. This time no explanation is provided.

EXAMPLE 2Mars Ltd is considering investing in a project which has the following cash

flows:£000


Year 1 600 Year 2 1,000 Year 3 1,100 Year 4 700 Year 5 300

Calculate the ARR (accounting rate of return).

SOLUTION: EXAMPLE 2ARR= Average annual profit X 100

Initial investment

Annual Profit = Total cash inflows – Total depreciation Total cash inflows (£’000) = 600+1,000+1,100+700+300 = £3,700 Annual depreciation = cost- residual value = £ 2,500 - £ 0= £500,000

No. of years 5 years Total depreciation for years = 500,000X 5 = £2,500,000

Note: Total depreciation = cost of project = 2,500,000

Average Annual profit = 3,700,000 – 2,500,000 = 1,200,000 = £240,0005 years 5





There fore ARR = 240,000 X 100 = 9.6%2,500,000

Example 3: GATO Ltd is considering investing in a new project. The details

of the projects are as follows.Cost of project£10,000Estimated life 10 yearsEstimated net profit:

Year £1 24,0002 36,0003 60,0004 50,0005 10,000 Total net profit 180,000

Note: the estimated residual value of the project at the end of the 10years is £20,000

REQUIRED: calculate the Accounting Rate of Return (ARR) usingb)The initial capital investedc) The average capital invested

ADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR)

1) It is simple to calculate2) It is easy to understand3) It is consistent with the short-term profit maximizing objectives4) It is consistent with Return-on Investment (ROI); a measure which is

used in most companies to compare divisional performance.5) The Data for its calculation is readily available to calculate it.

DISADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR)1) It does not allow for the timing of outflows and inflows. That is, since

it is an average, it takes no account of the timing of the profit2) It does not take account of the size of the investment

3) It uses accounting profit as a measure. Accounting profit is affectedby accounting concepts and conventions such as the method of depreciation of assets. These are subjective, hence not appropriatefor investment decisions.

4) There is no universally accepted method of calculating AccountingRate of Return

THE PAYBACK (PB) METHODPayback period is defined as the ‘the time required for the cashinflows from a capital investment project to equal the cash

outflow ‘. Thus the period of time required for the return on an investment to "repay" the





sum of the original investment. This period is the number of years it takes to recoup the

original investment.

It is the length of time it takes a project to recoup its initial cost out of thecash receipts that it generates. This period is referred to as ‘the period that it takes the project to pay for itself’. It is intuitively the measure that

describes how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods.

Note: this is a cash measure and therefore measures the number of years taken to recoup the

investment in cash.

PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOW

Where the cash flow is constant over the period, (i.e. where there is evencash inflow) the pay back is calculated as follows:

Payback = Initial Investment

Annual Cash inflows

PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOWWhere the cash flow is constant over the period, (i.e. where there is evencash inflow) the pay back is calculated as follows:

Payback = Initial InvestmentAnnual Cash inflows

Example1: PROJECTS WITH EQUAL (EVEN CASH FLOW)MORE LTD is considering an investment in a new plant. The followinginformation has been provided on the project:Cost of plant (Initial Investment) £50,000 Yearly Cash inflows: £ Year 1 12500 Year 2 12500 Year 3 12500 Year 4 12500

Year 5 12500 Year 6 12500Required: Calculate the payback period for the projectSOLUTION: EXAMPLE 3NB: the yearly cash inflows are constant (i.e. £12,500 for each year)

Payback Period = Initial InvestmentTotal Net cash inflows= £50,000 = 4yrs

£12,500





Therefore it will take 4 years to get the amount invested in theproject (i.e. £50,000)

**Check: 12,500 X4 years =£50,000

Note: projects with equal cash flow hardly appear in our exams.So we will concentrate more on projects with unequal cash flowas this is the usual way of the questions.

PROJECTS WITH UNEQUAL CASH FLOWS

Where there are uneven cash flows, the payback period is calculated asfollowsPayback period = year(s) before full recovery + unrecovered costat beginning of the year

Cash flows during the year

Example 1

More Investments Ltd is considering an investment in a machine. Themachine would cost $50,000 and would generate net cash receipts asfollows:

1st year 15,000

2

nd

year 30,000

3rd year 10,000

4th year 5,000

5th year 2,000

It is expected that, the machine will last for five yearsRequired:Calculate the payback period of the machine.

Solution:Payback period = 2yrs + 5,000 X 12 months

10,000= 2years 6 months.

Tutorial:1. after one year we would have recouped $15,0002. after the 2rnd year the total would be (15,000 + 30,000) =

45,0003. we will be left with $5,000 to achieve the total of $50,000, i.e.

the initial investment but the 3rd years cash inflows is $10,000,which is more than the $5,000 we need.

4. This means that, when we enter year 3, we will need about 6months (half of the year) to get the $5,000.





5. The remaining balance is therefore divided by the cash inflowsduring that year (5,000 ÷ 10,000). Since it is less than ayear, we will express it in months by multiplying it by 12months.

QUESTION 2

You are working on the evaluation of a number of potential projects, oneof which involves the opening of a training centre for your firm’s staff. Itwould cost £120,000 to renovate and refurbish a building ready fortraining purposes. Your company expects to save the following net cashcosts on external training fees over the next five years at present dayprices:

Year 1 £42,000 Year 2 £53,000 Year 3 £59,000 Year 4 £61,000 Year 5 £65,000 TASKSa) Calculate the payback period.

SOLUTION:Payback period = 2 yrs + (120,000 – 95,000) X 12 months 59,000

= 2 yrs + 25,000 X 12 months 59,000

= 2yrs + 5.08 months Therefore the payback period of the project is 2years 5 months.

Tutorials6. At the end of year 2, only £95,000 (i.e. 42,000 + 53,000) have

been recouped or realised from the project. Since the cost of the project is £ 120,000, we need about £25,000(£120,000 -£95,000) before the cost is fully recouped.

7. If we add year 3 cash flows, the total will be more than £120,000(£95,000 +59,000)

8. So we need only £25,000 from the £59,000 to top up.9. Note how the payback is expressed. That is in years and in

month.

Example 3.

MORE LTD has an investment projects. The estimated costs and returnsare as follows:

Project A

£

Cost 215,000 Year 1 Cash inflows 44,000 Year 2 Cash inflows 96,000

Year 3 Cash inflows 90,000 Year 4 Cash inflows 70,000





Tasks:Calculate the payback period of project A (in years and months)

SOLUTION

a) Payback period: PROJECT A£’000

Year 1 Cash inflow 44,000 Year 2 Cash inflows 96,000

140,000

Payback period = 2years + (215,000 -140,000) X 12 months90,000

= 2yr + 75,000 X 12 months90,000

= 2yrs 9.99 months= 2yrs 10 months

ADVANTAGES OF PAYBACK METHOD1. It is simple to calculate and understand2. It is more objectively based because it uses the projects cash flows

instead of the accounting profit which is very subjective and can bemanipulated

3.

DISADVANTAGES OF PAY BACK PERIOD

• simple payback does not take into account the time value of money• it ignores cash flows received after the end of the payback period• it does not take into account the overall profitability of the project

Net Present Value (NPV)

DISCOUNTED CASH FLOW TECHNIQUES

The discounted cash flow (or DCF) approach describes a method tovalue a project using the concepts of the time value of money. All futurecash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital.

The main methods under this approach are:

1) Net Present Value (NPV)2) Internal Rate of Return (IRR)


http://en.wikipedia.org/wiki/Time_value_of_money

http://en.wikipedia.org/wiki/Cash_flow

http://en.wikipedia.org/wiki/Present_value

http://en.wikipedia.org/wiki/Cost_of_capital

http://en.wikipedia.org/wiki/Time_value_of_money

http://en.wikipedia.org/wiki/Cash_flow

http://en.wikipedia.org/wiki/Present_value

http://en.wikipedia.org/wiki/Cost_of_capital




3) Profitability Index (PI)

Discount factor

The discount factor, P (T), is the number by which a future cash flow to

be received at time T must be multiplied in order to obtain the currentpresent value. Thus for a fixed annually compounded discount rate r wehave

The discount Factor is usually provided in an exams in the form of a discount factor table. However, let us see how this is calculatedusing our own calculators

Question

Calculate the discount factor for the following discount rates

a) 8%b) 9%c) 10%d) 15%e) 20%

THE NET PRESENT VALUE (NPV)

NPV is concerned with cash flows (based on relevant costs and benefits)rather than profits. The net present value method of project appraisal is amore sophisticated technique than payback since it takes into account thetime value of money while considering relevant cash flows over the entirelife of the project.

By identifying an appropriate cost of capital and utilizing discount tables,this enables us to calculate the present values of cash flows over the lifeof a project. The total of the discounted cash flows is known as the netpresent value (NPV).

Using this technique, so long as a project yields a positive NPV (at therelevant cost of capital) it will be recommended on financial grounds. Anegative NPV will result in the project being rejected. The higher the NPV,the more desirable a project is on financial grounds. With mutuallyexclusive projects the project with the highest NPV would be preferred.By taking into account the time value of money and discounting cashflows according to when monies are paid out or received, projects can beappraised before the investment decision is made. It is important to note

that it is the cash flows of the project that are discounted, not the profits.





When performing NPV calculations, the following approach should betaken:

• identify the relevant cash inflows and outflows of the project, notforgetting the initial investment

• set up a table and discount each of the cash flows to its presentvalue, using the company's required rate of return - discount tableswill be provided on the day to facilitate calculations

• calculate the net present value of the project by taking the outflowsaway from the inflows

• decide whether or not the project should be accepted on the basisof whether or not it has a positive NPV.

The advantages and disadvantages of NPV as a method of projectappraisal are set out below:

Advantages

shareholder wealth is maximised

• it takes into account the time value of money• it is based on cash flows, which are less subjective than profits.

Disadvantages

• it can be difficult to identify an appropriate discount rate•

Cash flows are usually assumed to occur at the end of a year, but inpractice this is over simplistic.

INTERNAL RATE OF RETURN (IRR)

IRR can be defined as the Discount rate which gives zero NPV. TheInternal Rate of Return (IRR) is the discount rate that will cause thepresent value of the benefits to equal the present value of the cost. Inother words, the IRR is the situation described in the middle line of theabove table. We use a trial-and-error process to find this percentage rate.

Once the IRR has been computed, it is compared to the company’sRequired Rate of Return (cost/ discount factor). The required rate of return is simply the minimum rate of return that an investmentproject must yield to be acceptable. If the IRR is greater then or equalto the required rate of return, then the project is acceptable. If the IRR isless than the required rate of return, then the project is rejected. The IRRcan be estimated by the following formulae:

IRR = Positive rate + Positive NPV X (Positive-Negative

Positive NPV + Negative NPV





OR

IRR = L + NL x ( H - L )NL - NH

WHERE:

L = Lower Rate of interest

H = Higher rate of Interest

NL = NPV at Lower rate of interest

NH = NPV at Higher rate of interest

The reasons are that if a project cannot earn returns which is more orgreater than the cost of investment (the cost of capital) then the project isnot profitable).

In order to calculate IRR it is necessary to calculate the NPV of theinvestment at two different costs of capital rates. (one cost of capitalgiving a positive NPV and the other a negative NPV.)

Having calculated the two NPVs, the technique is to interpolate to try toestimate the IRR.

The internal rate of return tells us the rate at which the NPV of a project isneither positive nor negative. There are four steps to an IRR calculation:

1. Calculate the project's NPV at any reasonable discount rate (thismay be given to you in the exam).

2. If the above NPV is positive, choose a higher discount rate (againthis may be given in the exam) and calculate the NPV again. If theabove NPV was negative, choose a lower discount rate.

3. Either way, you must end up with one positive and one negativeNPV. You must now calculate Where A is the lower discount rate andB is the higher rate, a is the NPV at the lower rate and b is the NPVat the higher rate.

4. The IRR must then be compared to the company's required rate of return. If it is higher than the required rate of return, the projectshould be accepted. If it is lower than the required rate of return,the project should be rejected.

EXAMPLE 1:





MORE LTD is considering investment of $ 24,000 in a project which isexpected to generate the following cash flows.

Cash inflows ($)

Year 1 7,800

Year 2 6,000

Year 3 4,200

Year 4 7,400

Year 5 9,200

Please note that all workings should be shown when performing NPVcalculations. Even if you are using a sophisticated calculator to help you,you won't gain full marks unless your workings are clearly set out. Suchcalculators are really not that useful in this exam, and will not give you acompetitive advantage. The advantages and disadvantages of IRR as amethod of project appraisal are set out below:

Advantages

• it takes into account the time value of money, which is a good basisfor decision-making

•

results are expressed as a simple percentage, and are more easilyunderstood than some other methods

• It indicates how sensitive decisions are to a change in interest rates.

Disadvantages

• projects with unconventional cash flows can have either negative ormultiple IRRs - this can be confusing to the user

• IRR can be confused with ARR or Return on Capital Employed sinceall methods give answers in percentage terms - hence, a cash-basedmethod can be confused with a profit-based method

• it may give conflicting recommendations to NPV• some managers are unfamiliar with the IRR method• IRR cannot accommodate changes in interest rates over the life of a

project• it assumes funds are re-invested at a rate equivalent to the IRR

itself, which may be unrealistically high.

PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis.

Therefore, the PI is the ratio of the present value of cash flows (PVCF) tothe initial investment of the project.





investmentInitial

PVCF PI =

In this method, a project with a PI greater than 1 is accepted, but aproject is rejected when its PI is less than 1. Note that the PI method is

closely related to the NPV approach. In fact, if the net present value of a project is positive, the PI will be greater than 1. On the other hand, if the net present value is negative, the project will have a PI of less than1. The same conclusion is reached, therefore, whether the net presentvalue or the PI is used. In other words, if the present value of cashflows exceeds the initial investment, there is a positive net presentvalue and a PI greater than 1, indicating that the project is acceptable.

PI is also known as a benefit/cash ratio.

POST-COMPLETION/ POST IMPLEMENTATIONAPPRAISAL This is a review of all aspects of a completed project in order to assesswhether its objectives were achieved or it has lived up to expectation.

IMPORTANCE OF POST-IMPLEMENTAION REVIEW

i. it enables speedy modification of under-performing or over-performing projects, by identifying the reasons for over/underperformance

ii. it provides a means of improving control mechanisms byhighlighting areas where weakness have caused problems.

iii. It highlights reasons for successful projects.

iv. It improves the quality of decision making by providing amechanism whereby past experience can be made available forfuture decision makers. Thus it can produce lessons for decisionmaking process and people will make better evaluation andsignificance of future projects

v. It makes it more likely that ‘bad’ projects areterminated/abandoned and at an earlier stage.

vi. It improves a company’s performance.

vii. It allows changes to be made more swiftly in projects which are notdoing well.

QUESTION 1

MORE LTD has a choice of two investment projects. The estimated costsand returns are as follows:

Project B Project A

£ £





Cost 215,000 154,000Year 1 Cash inflows 44,000 (18,000)

Year 2 Cash inflows 96,000 115,000 Year 3 Cash inflows 90,000 76,000 Year 4 Cash inflows 70,000 57,500

Tasks:a) Calculate the payback period of project B (in years and months)

b) The payback period of A is 2 years 9 months. Advice themanagement of MORE LTD which project is better investment. Givereasons for your answer.c) Using a discount factor of 15%, calculate the net present Valuefor project B.

Extracts from NPV (DCF) tables:Rate of discount8% 9% 10% 15% Year 1 .926.917 .909 .870 Year 2 .857.842 .826 .756 Year 3 .794 .772 .751 .658 Year 4 .735 .708 .683 .572

d) Using the same discount rate of 15%, the Net Present Value of project A is (£4,884) and at a discount rate of 10%, it has a positivevalue of £19,692. Calculate the Internal Rate of return (IRR) of project A.

QUESTION 1:SOLUTION



140,000


= 2yr + 75,000 X 12 months

90,000= 2yrs 9.99 months

= 2yrs 10 months

Explanation: At the end of year 2, £140,000 has been recouped/ earned;remaining £75,000 so that the full amount of £215,000 would berecouped (that is the amount used to invest in the project)

This we will get from year 3 cash inflows which is equal to the cost of theproject less the cash flow./

c)

Year Cash flow (CF) DCF (15%) PV (DCFx CF)





0 (154,000) 1.000(154,000)

1 (18,000) 0.870 (15,660)2 115,000 0.756 86,940

3 76,000 0.658 50,0084 57,500 0.572 32,890

NPV 178

QUESTION 2Marstep Ltd is considering investing in a project which has the following

cash flows:£000



The cost of capital is 8%.Extracts from NPV (DCF) tables:

Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826

Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKSa) Calculate the payback period (in years and months).b) Calculate the ARR (accounting rate of return).c) Calculate the NPV (net present value).d) Explain briefly if you think that the project is viable.e) Explain the benefits of using investment appraisal techniques inthe allocation of large capital sums.

Solution:a) Pay back periodb) Accounting Rate of Return (ARR) = Average Annual Profit (afterdepreciation) X100

Initial Investment

Average annual profit = total annual profitNo. of years

= 600,000 + 1000,000 +1,100,000 +700,000

+300,000 = 3700,000 = £ 740,000





5 years5 years

ARR = £ 740,000 X 100

£2,500,000

=29.6%

c)Year Cash flow (CF) DCF (8%) PV (DCF x CF)

Year 0 (2,500,000) 1.000 (2,500,000) Year 1 600,000 .857 550,200 Year 2 1,000,000 .794 857,000 Year 3 1,100,000 .735 873,400 Year 4 700,000 .681 514,500 Year 5 300,000 .630 204,300

NPV 499,400QUESTION 2 You are working on the evaluation of a number of potential projects, oneof which involves the opening of a training centre for your firm’s staff. Itwould cost £120,000 to renovate and refurbish a building ready fortraining purposes. Your company expects to save the following net cashcosts on external training fees over the next five years at present dayprices:

Year 1 £42,000 Year 2 £53,000

Year 3 £59,000 Year 4 £61,000 Year 5 £65,000

The firm’s cost of capital is 8%.Present Value Factors 8% Year 1 .926 Year 2 .857 Year 3 .794 Year 4 .735 Year 5 .681 Year 6 .630

TASKSa) Calculate the payback period.b) Calculate the Accounting Rate of Return.c) Calculate the net present value.d) Explain briefly whether, in your opinion, the firm should investin the training centre project.e) Explain the importance of capital budgeting.

SOLUTION: QUESTION 2

a) Payback period = 2 yrs + (120,000 – 95,000) X 12 months 59,000





= 2 yrs + 25,000 X 12 months 59,000


b) Accounting Rate of Return (ARR) = Average Annual Profit (afterdepreciation)

Initial investment

Average Annual Profit after depreciation = 280,000 – 120,000 =£32,000

5yearsARR = 32,000 X 100

120,000= 26.67%

Year Cash flow (CF) DCF (8%) PV (DCF x CF) Year 0 (2,500,000) 1.000 (2,500,000) Year 1 600,000 .917 550,200 Year 2 1,000,000 .857 857,000 Year 3 1,100,000 .794 873,400 Year 4 700,000 .735 514,500 Year 5 300,000 .681 204,300

NPV 499,400NET PRESENT VALUE

QUESTION 3SOB Ltd. has a limited capital budget available for investment in suitable

projects this year, and has short-listed two possible choices. Detailsare as follows:

Project X Project YCapital cost £2,200,000 £2,300,000Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows: £000 £000 Year 1 200 300 Year 2 800 900

Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%.Extracts from NPV tables are as follows: Year 8% 9% 10%1 .926 .917 .9092 .857 .841 .8263 .794 .772 .7514 .735 .708 .683

5 .630 .650 .621 TASKS





a) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH projectd) State which project you would recommend (if any).e) Explain why it is important to use investment appraisal techniques, and

to monitor actual results.

QUESTION 4REM Ltd is considering investing in a project, which has the following cash

flows:£000


Year 1 700 Year 2 900 Year 3 1,100 Year 4 800 Year 5 400

The cost of capital is 8%.Extracts from NPV (DCF) tables:Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683

Year 5 .681 .650 .621 Year 6 .630 .596 .564

a) Calculate the payback period (in years and months).b) Calculate the ARR (accounting rate of return).c) Calculate the NPV (net present value).d) Explain briefly whether you think that the project is viable.e) Explain why firms increasingly look at ‘non-financial’ factorsduring the decision-making process.

QUESTION 5

SOB Ltd. has a limited capital budget available for investment in suitableprojects this year, and has short-listed two possible choices. Detailsare as follows:

Project X Project YCapital cost £2,200,000 £2,300,000Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows: £000 £000 Year 1 200 300 Year 2 800 900

Year 3 1,400 1,500 Year 4 700 600





Year 5 400 400 The cost of capital to SOB Ltd. is 9%.Extracts from NPV tables are as follows: Year 8% 9% 10%1 .926 .917 .909

2 .857 .841 .8263 .794 .772 .7514 .735 .708 .6835 .630 .650 .621 TASKSa) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH project.d) State which project you would recommend (if any).e) Explain why it is important to use investment appraisaltechniques, and to monitor actual results.

QUESTION 6DEC Ltd. has a limited capital budget available for investment in suitableprojects this year, and has short-listed two possible choices. Details are asfollows:

Project A Project BCapital cost £2,300,000 £2,300,000Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows:£000 £000

Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400 The cost of capital to FGT Ltd. is 10%.

Extracts from NPV tables are as follows: Year 8% 10% 12%1 .926 .909 .8932 .857 .826 .797

3 .794 .751 .7124 .735 .683 .6365 .681 .621 .567

TASKSa) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH project.d) State which project you would recommend (if any).e) Explain why it is important to monitor the actual performance of the investment choice throughout the lifetime of the project.





QUESTION 6: SOLUTION

a) Payback period: PROJECT APROJECT B

£’000

£’000Cash inflows: year 1 700800

year 2 1,0001,100

1,7001,900

Payback period = 2years + (2,300 – 1,700) X 12 months 2years+ (2,300 – 1,900) X 12months

1,0001,300

= 2yr + 7.2 months =2yrs + 3.69 months

= 2yrs 7months= 2yrs 4 months

b) Accounting Rate of Return (ARR) = Average Annual Profit (after

depreciation) X 100 Initial investment

Average Annual Profit before depreciation£000 £000

Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400

4,000 4,300Note that, the total represents the cash inflows from the project. At the end of the

5years, the total depreciation charges will be equal to the initial cist of the project.

Average Annual Profit after depreciation =total profit – totaldepreciation

No. of yearsPROJECT A

PROJECT B

= 4,000,000 –2,300,000 X100 =4,300,000 –2,300,000 X 100

5years

5years





Average Annual Profit after depreciation =1,700,0002,000,000

5 yrs5yrs

=£340,000

£400,000Accounting Rate of Return (ARR) = 340,000 X 100400,000 X 100

2,300,0002,300,000

= 14.78%= 17.39%

TRY QUESTIONS1. ROB 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 BCapital cost £2,700,000 £2,900,000Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows:£000 £000 Year 1 700 800 Year 2 1,100 1,200 Year 3 1,400 1,900 Year 4 700 1,000 Year 5 200 500

The cost of capital to ROB Ltd. is 9%.Extracts from NPV tables are as follows: Year 8% 9% 10%1 .926 .917 .9092 .857 .842 .8263 .794 .772 .7514 .735 .708 .6835 .630 .650 .621 TASKS

a) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.

c) Calculate the NPV for EACH project.

d) Explain which project you would recommend (if any).

2. (Cost accounting September 2005)HJB Ltd. has a limited capital budget available for investment in suitable


Project X Project YCapital cost £2,400,000 £2,300,000

Expected life 5 years 4 yearsResidual value nil nil





Budgeted cash inflows: £000 £000 Year 1 120 700 Year 2 900 1,400 Year 3 1,100 1,600 Year 4 800 500

Year 5 600 - The cost of capital to HJB Ltd. is 9%.

Extracts from NPV tables are as follows: Year 8% 9% 10%1 .926 .909 .8932 .857 .826 .7933 .794 .751 .7124 .735 .683 .5675 .630 .621 .507 TASKS

a) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project. c)

Calculate the NPV for EACH project.[8]b) State which project you would recommend (if any)c) Explain why it is important to use investment appraisal techniques.

Disadvantages

• simple payback does not take into account the time value of money• it ignores cash flows received after the end of the payback period•

it does not take into account the overall profitability of the project Net Present Value(NPV)

POST-COMPLETION/ POST IMPLEMENTATIONAPPRAISAL This is a review of all aspects of a completed project in order to assesswhether its objectives were achieved or it has lived up to expectation.

IMPORTANCE OF POST-IMPLEMENTAION REVIEWviii. it enables speedy modification of under-performing or over-

performing projects, by identifying the reasons for over/underperformance

ix. it provides a means of improving control mechanisms byhighlighting areas where weakness have caused problems.

x. It highlights reasons for successful projects.

xi. It improves the quality of decision making by providing amechanism whereby past experience can be made available for

future decision makers. Thus it can produce lessons for decision





making process and people will make better evaluation andsignificance of future projects

xii. It makes it more likely that ‘bad’ projects areterminated/abandoned and at an earlier stage.

xiii. It improves a company’s performance.xiv. It allows changes to be made more swiftly in projects which are not

doing well.

QUESTION 1

MORE LTD has a choice of two investment projects. The estimated costsand returns are as follows:

Project B Project A

£ £

Cost 215,000 154,000Year 1 Cash inflows 44,000 (18,000)

Year 2 Cash inflows 96,000 115,000 Year 3 Cash inflows 90,000 76,000 Year 4 Cash inflows 70,000 57,500

Tasks:d) Calculate the payback period of project B (in years and months)e) The payback period of A is 2 years 9 months. Advice the

management of MORE LTD which project is better investment. Givereasons for your answer.

f) Using a discount factor of 15%, calculate the net present Value forproject B.

Extracts from NPV (DCF) tables:Rate of discount8% 9% 10% 15% Year 1 .926.917 .909 .870 Year 2 .857.842 .826 .756 Year 3 .794 .772 .751 .658 Year 4 .735 .708 .683 .572

d) Using the same discount rate of 15%, the Net Present Value of project A is (£4,884) and at a discount rate of 10%, it has a positive

value of £19,692. Calculate the Internal Rate of return (IRR) of project A.

QUESTION 1:SOLUTION



140,000






= 2yr + 75,000 X 12 months90,000

= 2yrs 9.99 months= 2yrs 10 months

Explanation: At the end of year 2, £140,000 has been recouped/ earned;remaining £75,000 so that the full amount of £215,000 would berecouped (that is the amount used to invest in the project)

This we will get from year 3 cash inflows which is equal to the cost of theproject less the cash flow./

c) Year Cash flow (CF) DCF (15%) PV (DCF

x CF)

0 (154,000) 1.000(154,000)

1 (18,000) 0.870 (15,660)2 115,000 0.756 86,9403 76,000 0.658 50,0084 57,500 0.572 32,890

NPV 178

QUESTION 2

Marstep Ltd is considering investing in a project which has the followingcash flows:

£000Initial investment 2,500Cash flows:


The cost of capital is 8%.

Extracts from NPV (DCF) tables:Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS

a) Calculate the payback period (in years and months).b) Calculate the ARR (accounting rate of return).





c) Calculate the NPV (net present value).d) Explain briefly if you think that the project is viable.e) Explain the benefits of using investment appraisal techniques inthe allocation of large capital sums.

Solution:

a) Pay back periodb) Accounting Rate of Return (ARR) = Average Annual Profit (afterdepreciation) X100

Initial Investment

Average annual profit = total annual profitNo. of years

= 600,000 + 1000,000 +1,100,000 +700,000+300,000 = 3700,000 = £ 740,000

5 years5 years

ARR = £ 740,000 X 100

£2,500,000=29.6%

c)Year Cash flow (CF) DCF (8%) PV (DCF x CF)

Year 0 (2,500,000) 1.000 (2,500,000)

Year 1 600,000 .857 550,200 Year 2 1,000,000 .794 857,000 Year 3 1,100,000 .735 873,400 Year 4 700,000 .681 514,500 Year 5 300,000 .630 204,300

NPV 499,400

QUESTION 2 You are working on the evaluation of a number of potential projects, one

of which involves the opening of a training centre for your firm’s staff. Itwould cost £120,000 to renovate and refurbish a building ready fortraining purposes. Your company expects to save the following net cashcosts on external training fees over the next five years at present dayprices:

Year 1 £42,000 Year 2 £53,000 Year 3 £59,000 Year 4 £61,000 Year 5 £65,000

The firm’s cost of capital is 8%.Present Value Factors 8%





Year 1 .926 Year 2 .857 Year 3 .794 Year 4 .735 Year 5 .681

Year 6 .630

TASKSa) Calculate the payback period.b) Calculate the Accounting Rate of Return.c) Calculate the net present value.d) Explain briefly whether, in your opinion, the firm should investin the training centre project.e) Explain the importance of capital budgeting.

SOLUTION: QUESTION 2a) Payback period = 2 yrs + (120,000 – 95,000) X 12 months 59,000

= 2 yrs + 25,000 X 12 months 59,000


b) Accounting Rate of Return (ARR) = Average Annual Profit (afterdepreciation)

Initial investment

Average Annual Profit after depreciation = 280,000 – 120,000 =£32,000

5yearsARR = 32,000 X 100

120,000= 26.67%

Year Cash flow (CF) DCF (8%) PV (DCF x CF)

Year 0 (2,500,000) 1.000 (2,500,000) Year 1 600,000 .917 550,200 Year 2 1,000,000 .857 857,000 Year 3 1,100,000 .794 873,400 Year 4 700,000 .735 514,500 Year 5 300,000 .681 204,300

NPV 499,400

NET PRESENT VALUEQUESTION 3





SOB Ltd. has a limited capital budget available for investment in suitableprojects this year, and has short-listed two possible choices. Detailsare as follows:

Project X Project YCapital cost £2,200,000 £2,300,000

Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows: £000 £000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%.Extracts from NPV tables are as follows: Year 8% 9% 10%1 .926 .917 .9092 .857 .841 .8263 .794 .772 .7514 .735 .708 .6835 .630 .650 .621 TASKS

a) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH projectd) State which project you would recommend (if any).

e) Explain why it is important to use investment appraisal techniques, andto monitor actual results.

QUESTION 4REM Ltd is considering investing in a project, which has the following cash

flows:£000


Year 1 700

Year 2 900 Year 3 1,100 Year 4 800 Year 5 400

The cost of capital is 8%.Extracts from NPV (DCF) tables:Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826

Year 3 .794 .772 .751 Year 4 .735 .708 .683





Year 5 .681 .650 .621 Year 6 .630 .596 .564

a) Calculate the payback period (in years and months).b) Calculate the ARR (accounting rate of return).

c) Calculate the NPV (net present value).d) Explain briefly whether you think that the project is viable.e) Explain why firms increasingly look at ‘non-financial’ factorsduring the decision-making process.

QUESTION 5SOB Ltd. has a limited capital budget available for investment in suitable


Project X Project YCapital cost £2,200,000 £2,300,000Expected life 5 years 5 yearsResidual value nil nilBudgeted cash inflows: £000 £000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%.Extracts from NPV tables are as follows:

Year 8% 9% 10%1 .926 .917 .9092 .857 .841 .8263 .794 .772 .7514 .735 .708 .6835 .630 .650 .621 TASKSa) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH project.d) State which project you would recommend (if any).

e) Explain why it is important to use investment appraisaltechniques, and to monitor actual results.

QUESTION 6DEC Ltd. has a limited capital budget available for investment in suitableprojects this year, and has short-listed two possible choices. Details are asfollows:

Project A Project BCapital cost £2,300,000 £2,300,000Expected life 5 years 5 years

Residual value nil nilBudgeted cash inflows:£000 £000





Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400

The cost of capital to FGT Ltd. is 10%.

Extracts from NPV tables are as follows: Year 8% 10% 12%1 .926 .909 .8932 .857 .826 .7973 .794 .751 .7124 .735 .683 .6365 .681 .621 .567

TASKSa) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH project.d) State which project you would recommend (if any).e) Explain why it is important to monitor the actual performance of the investment choice throughout the lifetime of the project.

QUESTION 6: SOLUTION

a) Payback period: PROJECT A

PROJECT B£’000

£’000Cash inflows: year 1 700800

year 2 1,0001,100

1,7001,900

Payback period = 2years + (2,300 – 1,700) X 12 months 2

years+ (2,300 – 1,900) X 12months1,000

1,300= 2yr + 7.2 months =

2yrs + 3.69 months = 2yrs 7months

= 2yrs 4 months b) Accounting Rate of Return (ARR) = Average Annual Profit (after

depreciation) X 100

Initial investment





Average Annual Profit before depreciation£000 £000

Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300

Year 4 800 700 Year 5 300 400

4,000 4,300Note that, the total represents the cash inflows from the project. At the end of the

5years, the total depreciation charges will be equal to the initial cist of the project.

Average Annual Profit after depreciation =total profit – totaldepreciation

No. of years

PROJECT APROJECT B

= 4,000,000 –2,300,000 X100 =4,300,000 –2,300,000 X 100

5years5years

Average Annual Profit after depreciation =1,700,0002,000,000

5 yrs

5yrs=£340,000

£400,000

Accounting Rate of Return (ARR) = 340,000 X 100400,000 X 100

2,300,0002,300,000

= 14.78%= 17.39%

TRY QUESTIONS

1. ROB Ltd. has a limited capital budget available for investment insuitable projects this year and has short-listed two possible choices.Details are as follows:

Project A Project BCapital cost £2,700,000 £2,900,000Expected life 5 years 5 yearsResidual value nil nil

Budgeted cash inflows:£000 £000 Year 1 700 800





Year 2 1,100 1,200 Year 3 1,400 1,900 Year 4 700 1,000 Year 5 200 500 The cost of capital to ROB Ltd. is 9%.


a) Calculate the payback period for EACH project.b) Calculate the accounting rate of return for EACH project.c) Calculate the NPV for EACH project.

d) Explain which project you would recommend (if any).

2. (Cost accounting September 2005)

HJB Ltd. has a limited capital budget available for investment in suitableprojects this year, and has short-listed two possible choices. Detailsare as follows:

Project X Project Y

Capital cost £2,400,000 £2,300,000Expected life 5 years 4 yearsResidual value nil nilBudgeted cash inflows: £000 £000 Year 1 120 700 Year 2 900 1,400 Year 3 1,100 1,600 Year 4 800 500 Year 5 600 - The cost of capital to HJB Ltd. is 9%.


a) Calculate the payback period for EACH project.





b) Calculate the accounting rate of return for EACH project. c)Calculate the NPV for EACH project.[8]

b) State which project you would recommend (if any)c) Explain why it is important to use investment appraisal techniques.




NOTES & EXERCISES ON Financial Management -For ICM Students

CHAPTER FIVEBUDGETING

THE BASIC FRAMEWORK OF BUGDETINGBudget defined:A budget is a detailed plan for acquiring and using financial and otherresources over a specific period of time. A detailed and formal definition isgiven by CIMA as:“ A quantitative statement, for a defined period of time, which may include planned revenue, expenses, assets, liabilities and cash flows The act of preparing a budget is called budgeting. The use of budgets tocontrol firm’s activities is known as budgetary control (to be discussed later in this chapter).Budgets has four main purposes (1) to co-ordinate the activities of thevarious departments in the organization to achieve a single goal; (2) to

communicate the targets to the departmental managers; (3) to establish asystem of control by comparing the budgeted and the actual results and (4)to compel planning.

FUNTIONS/ OBJECTIVES OF BUDGETSBudgets serve a number of useful purposes which include the following

1) Planning annual operations2) Co-ordinating the activities of the various of the organization and

ensuring that all parts of the organization are in harmony with eachother.

3) Communicating plans to the various responsibilities (departmental)

center managers.4) Motivating managers to strive to achieve the organizational goals5) Controlling activities6) Evaluating the performance of managers

ADVANTAGES OF BUDGETING The advantage of budgeting stems from the functions budget plays in anorganization.Among the benefits that companies realize from budgeting program are:

1. Budgets provide a means of communicating management’s plans

throughout the organization.2. Budgets forces managers to think and plan for the future.3. the budgeting process provides a means of allocating resources to

those parts of the organization where they can be used moreeffectively

4. the budgets process can uncover potential bottlenecks before theyoccur

5. Budgets coordinate the activities of the entire organization byintegrating the plans of the various parts. Budgets ensure thateveryone in the organization is pulling in the same direction.

6. Budgets define goals and objectives that serve as benchmarks for

evaluating performance.





PROBLEMS IN BUDGETING

Whilst budgets may be an essential part of any marketing activity they do have anumber of disadvantages, particularly in perception terms.

1. Budgets can be seen as pressure devices imposed by management, thusresulting in:a) Bad Labour relationsb) Inaccurate record-keeping.

2. Departmental conflict arises due to:a) Disputes over resource allocationb) Departments blaming each other if targets are not attained.

3. It is difficult to reconcile personal/individual and corporate goals.4. Waste may arise as managers adopt the view, "we had better spend it or

we will lose it". This is often coupled with "empire building" in order toenhance the prestige of a department.

Responsibility versus controlling, i.e. some costs are under the influenceof more than one person, e.g. power costs.

5. Managers may overestimate costs so that they will not be blamed in thefuture should they overspend.

DEFINITION OF TERMS:BUDGET : A plan quantified in monetary terms, prepared and approved priorto a defined period of time, usually showing planned income to be generatedand/or expenditure to be incurred during that period and the capital to beemployed to attain a given objective.

BUDGET PERIOD: The period for which a budget is prepared and used,which may then be subdivided into control periods over which controls takesplace.BUDGETARY CONTROL: The establishment of budgets relating theresponsibilities of executives to the requirements of a policy and thecontinuous comparison of actual with actual budgeted results, either tosecure by individual action, the objective of that policy or to provide a basisfor its revision.FIXED BUDGET : A budget which is designed to remain constant(unchanged) irrespective of the volume of output or sales achieved

FLEXIBLE BUDGET : A budget which, by recognizing the difference in costbehavior between fixed cost and variable costs in relation to fluctuations inoutput, turnover or other variable factors such as number of employees, isdesigned to change appropriately with such change or fluctuations.MASTER BUDGET : A budget which is prepared from, the functional budgetsand summarizes the functional budgets.PRINCIPAL BUDGET FACTOR / LIMITING FACTOR:A factor which at any particular time, or over a period will limit the activitiesof an organisation and therefore taking into account in preparing thebudgets.DIRECT EXPENSES: costs other than materials or labour which can be

identified in a specific product or saleable service.





DIRECT LABOUR COST: The cost of remuneration for employees’ effortsand skills applied to a product or saleable service.

BUDGETARY CONTROLDEFINITION: Budgetary control is a system of controlling costs through

budgets. Budgeting is thus only a part of budgetary control. Budgetarycontrol is one of the key tools for planning and control. It involves a constantcomparison of actual performance with budgeted goals of the organization.ICMA (London) defined budgetary control as “the establishment of budgetsrelating to the responsibilities or executives of a policy and the continuouscomparison of the actual with the budgeted results either to secure by individual action, the objectives of the policy or by individual to provide abasis of its revision.

The use of budgets in controlling operations is known as budgetary control.

The centrepiece of budgetary control is the use of budget reports thatcompare actual results with planned objectives.

The budget reports provide the feedback needed by management to seewhether actual operations are on course.

OBJECTIVES OF BUDGETRY CONTROL The objectives of budgetary control are as follows:(1) To Coordinate: Budgetary assists managers in coordinating theactivities / efforts of the organization so that objectives of the organization ingeneral will be in harmony with individual departmental objectives. Budgets

thus help all departments to work in the same direction. For example theproduction budget is prepared in co-ordination with the sales budget.(2)To communicate: A budget is a communicating device. Usually, when abudget is approved, copies are distributed to all management personnel forthem to understand what is expected of them and the policies to be followedto achieve the set targets before the budget is carried out. Thus budgetcommunicates management plans to all people in an organization.(3) To Control: Control is the action which is required to ensure that plansand objectives are being achieved. Thus control is necessary to ensure thatplans and objectives as laid down in the budget are being achieved. Inbudgeting, control is a systematic effort that aims at keeping managementinformed of whether the plans are being followed/ conformed to or whetherthey are not followed.(4) To Plan: A budget provides a detailed plan of action for a business overa definite period of time. Planning helps to anticipate many problems beforethey arise and the possible solutions can be sought to solve these problems.

CHARACTERISTICS / FEATURES OF BUDGETRY CONTROL1. Establishment of performance standards / budget for each department2. Record the actual performance3. Compare the actual performance with the budgeted performance.

4. Evaluate / calculate variances (differences) and analysis the reasons forthe variances





5. Take corrective/ suitable remedial actions to correct the varianceimmediately to achieve performance.

ADVANTAGES /BENEFITS OF BUDGETARY CONTROLBenefits that may be obtained by the business that adopts budgetary control

are as follows.1) Budgetary control coordinates the activities of various departments

and functions of the organization. Co-ordinated managerial activity isfacilitated

2) Budgetary control aims at maximization of profit through carefulplanning and control.

3) It provides a yardstick against which actual results can be compared.4) Budgetary control system creates the necessary condition for the

introduction of standard costing techniques5) Budgetary control creates cost consciousness and introduces an

attitude of mind which waste and efficiency cannot thrive6) The technique relates the overall objectives to specific managers and

identifies the part each executive must play in converting theintentions of top management into reality.

7) Accountability for results is secured in financial terms on an organizedbasis through the medium of plans which have been expressed interms of their profit impact on the company.

8) In the control situation, management is provided with information as aroutine which would be difficult to obtain promptly without thebudgetary control system.

DISADVANTAGES/LIMITATIONS OF BUDGETARY CONTROLBudgetary controls have some drawbacks. Factors preventing the mosteffective budgetary control technique are as follows:

1) Rigidity: There is a danger that the budget program will be too rigidto accommodate changing conditions. A budget program must bedynamic and continuously change with the changing circumstances

2) High cost of installation: The installation and operation of budgetary control system is a costly and expensive as it may call forthe employment of specialized staff and other expenditure. Due to thehigh cost, small businesses can not afford to adopt it.

3) Use of estimates: Budgets are based on estimates and forecast. Thestrength and weakness of a budgetary control therefore based on theaccuracy of the forecast.

4) Staffs regard the technique as a pressure rather than a procedure toassist the executive to do a better job.

5) Because the technique is so closely identified with the managementcontrol process, executives imagine that the technique can replacemanagement. There is no substitute for good management.

6) The required degree of management co-operation may not beobtained and top management support may be inadequate

BUDGET ORGANIZATION AND ADMINISTRATION:





In organizing and administering a budget system the following characteristics mayapply:

a) Budget centreUnits responsible for the preparation of budgets. A budget centre may encompass

several cost canters.

b) Budget committee: This may consist of senior members of the organization,e.g. departmental heads and executives (with the managing director as chairman).Every part of the organization should be represented on the committee, so thereshould be a representative from sales, production, marketing and so on

FUNCTIONS OF THE BUDGET COMMITTEE

Functions of the budget committee include:

a) to provide historical data to all departmental heads to help them inestimation

b) issue instructions to departments regarding requires, dates of submission of estimates etc

c) To defined the general policies of the management in relation to the

budget.d) To record budget estimates from variances departments forconsideration and review.

e) To discuss difficulties with departmental heads and suggest possiblerevision.

f) Coordination of the preparation of budgets, including the issue of a manualg) Issuing of timetables for preparation of budgetsh) Provision of information to assist budget preparationsi) Comparison of actual results with budget and investigation of variances.

c) BUDGET OFFICER: Controls the budget administration. The job involves:

i. liaising between the budget committee and managers responsible forbudget preparation

ii. dealing with budgetary control problemsiii. ensuring that deadlines are metiv. Educating people about budgetary control.

d) Budget manual:

i. details the budget proceduresii. contains account codes for items of expenditure and revenueiii. timetables the process

iv. Clearly defines the responsibility of persons involved in the budgetingsystem.





TYPES OF BUDGETS There are several ways in which budgets can be classified. One way is toclassify them into the different purposes they serve.Budgets can be classified by

1) The coverage the encompassa) Functional budgetsb) Master budgets

2) The capacity to which they are relateda) Fixed budgetb) Flexible budget

3) The condition on which they are baseda) Basic budgetb) Current Budget

4) The period with which they covera) Long-term budgetb) Short-term budgets

COVERAGE CAPACITY CONDITION PERIOD

Functional master fixed flexible basic current long-term short-termBudget budget budget budget budget budget budget budget

FUNTIONAL BUDGET: A functional budget is a budget which relates to anyof the functions of an organization. They are subsidiary to the masterbudget. The most frequently used functional budgets are:

a. Sales budget b. Production budget (which comprise Raw material budget, Labour

budget, overheads etc.)

c. Purchase budgetd. Plant utilization budgete. Capital expenditure budgetf. Administrative cost budgetg. Selling and distribution cost budgeth. Cash budget etc.

MASTER BUDGET: It is defined by the Institute of Cost and Management Accountants as ‘thesummary budget, incorporating its components functional budgets

and which is faintly approved, adopted and employed’

More Lecture Series – by TIMORE B. F

TYPE OF

BUDGEGET

146




The master budget is a collection of the individual budgets thatencompasses the planed operating and financial activities throughout thefirm.

It is a summary of a company’s plans that sets specific targets for sales,

production, distribution and financing activities. It generally culminates in acash budget, a budgeted income statement (profit and loss) and a budgetedbalance sheet. This budget summarizes the various functional budgets toproduce a Budgeted Profit and Loss Account at the end of the budget period. The master budget is prepared by the budget committee on the basis of co-ordinated functional budgets and becomes the basis for the target of thecompany during the budget period when the committee finally approves it.In short, it represents a comprehensive expression of management’s plansfor the future and how these plans are to be accomplished.

MASTER BUDGET INTERRELATIONSHIPS

FIXED BUDGET: It is defined as a budget which is designed to remainunchanged irrespective of the volume of activity or turnover attained. It is abudget prepared for a given level of activity. It is a single budget with noanalysis of cost. It does not take into consideration any change inexpenditure arising out of changes in the level/ volume of activity. The majorpurpose of fixed budget is at the planning stage when it serves to define thebroad objectives of the organization.

FLEXIBLE BUDGET: It is defined as ‘ A budget which, by recognisingdifferent cost behaviour patterns, is designed to change as thevolume of activity changes’

THE BUDGETING PROCESS The stages in the budgetary process can be summarized intothree:





1. . Identify the limiting factor/principal budget factor: Thelimiting factor or principal budget factor is the factor whichlimits the activities of an organization.

2. Prepare the functional budgets. The functional budget may

include the followingi. The sales budgetii. The production budgetiii. The direct material usage budgetiv. Direct material purchase budgetv. Direct Labour cost budgetvi. Overheads cost budgetvii. Selling and administrative cost budgetviii. Capital expenditure budget

ix. The cash budgetx.PREPARING THE BUDGETSSTAGES INVOLVED IN THE PREPARATION OF FUNCTIONAL BUDGETS

1. THE SALES BUDGET: The sales budget is the starting point in thepreparation of the functional budgets. The sales budget is prepared inunits of production and sales value. The finished goods stock budgetcan be prepared at the same time. The finished goods stock budgetshows the planned increase or decrease in stock levels.

2. THE PRODUCTION BUDGET: With the information from the sales andstock budget, the production budget can be prepared. This is simplythe sales budget (plus or minus increase or decrease in the stocklevels). The production budget is stated in terms of production units. Itlists the number of units that must be produced to meet the salesbudget.

THE SALES BUDGETA sales budget is a detailed schedule which shows the expected sales for thebudget period. The sales budget is expressed / prepared in units of production and salesvalue. It is therefore the bases of all the other budgets.

Example 1MORE LTD produces two products: P.K and Tom-tom. The forecasted sales of the two products for the second quarter will be 15,000 units of P.K and22,500 units of Tom-tom. The marketing manager has estimated the selling

price of P.K to be £45 and the selling price of Tom-tom to be £37.5Required: Prepare the sales budget.





Suggested Answer: example 1MORE LTD: Sales Budget

Products P.K TOMTOM TOTALSelling price £45 £37.5

Sales (units) 15,000 22,500Sales budget £ 675,000 £ 843,750£1,518,750

Workings:P.K (15000 units X £45) = £675,000 Tom-tom (22,500 X £37.5) =£843,750

Example 2More Co. Ltd has two core products, A and B. The next year’s forecasts forthe products are estimated to be:A (21,000 units at a selling price of £300)B (19,000 units at a selling price of £310)

Required: Prepare the sales budget

Solution: example 2Products A B TotalSales (units) 21,000 19,000Selling price £300 £310Sales budget £6,300,000 £5,890,000

£12,190,000

EXAMPLE 3: FORDHAM INSTITUTE produces to products, Books and Pens.Sales for the year 2008 are budget to be as follows:Books: 12000 copies @ ₤300Pens : 9000 boxes @ ₤360

Required: Prepare the sales budget for the year 2008.Solution: example 3Products: sales (units) selling priceTotal sales (₤)Books 12,000 ₤ 3003,600,000Pens 6,000 ₤3602,160,000 5,760,000

TRY QUESTION





MORE LTD produces three kinds of medicines which are sold in thegovernment hospitals. The estimated sales for the next 3 months are as follows:Medicine APC PARA B.COSales (In packets) 1000 1,200 1,500

Selling price £110 £80 £100

Required: prepare the sales budget for the three months period.

THE PRODUCTION BUDGET: This is simply the sales budget (plus or minus increase or decrease in thestock levels). The production budget is stated in terms of productionunits/quantities. It lists the number of units that must be produced to meetthe sales budget.It is prepared as follows:

Budgeted sales (units) XXXAdd: Expected closing stock of finished goods XXXXXX

Less: closing stock of finished goods XXXBudgeted production XXX

NB: The production budget changes from the sales budget when there isopening or closing stock. Budgeted production = budgeted sales (units) –opening stock + closing stock

EXAMPLE 4MORE Systems Ltd produces and sells computers. Next year’s budgetedsales are estimated to be as follows:

Computers Laptops DesktopBudgeted sales (quantities) 9,500 14,250

At the beginning of the year, the following quantities were in stock- Laptop950 unites and desktop 4750 units. It is planed that, the stock level of

Laptops should be increased by 10% and decrease the stock level of Desktop by 50%.

Required : Prepare the production budget for MORE Systems LTD

Solution: Production BudgetProducts Laptop DesktopBudgeted sales (units) 9,500 14,250Add: expected closing stock:

Laptops (110% x 950) 1,045Desktop (4750 x 50%) 2,375

Less: Opening stock (950) (4,750)





Budgeted production 9,59511,875

Tutorial:i. Closing stock- the stock levels at the beginning of the year were,

Laptops- 950 and Desktops – 4750 units. The stock level of Laptops isto be increased by 10% (10% x 950 = 95 unites ). Therefore totalclosing stock level for Laptop= 95 +950= 1,045 units. This can becalculated as 110% x 950 = 1,045

ii. Desktop stock level is to be decreased/ reduced by 50% (4750x 50%)= 2,375. Closing stock level will be 4750-2375 = 2375

EXAMPLE 5:FORDHAM INSTITUTE produces to products, Books and Pens. Sales for theyear 2008 are budget to be as follows:Books: 12000 copies @ ₤300Pens : 9000 boxes @ ₤360. The company plans to keep the following asclosing stock at the end of 2008.Books 4,000 copiesPens 3,000 boxesOpening stocks in the warehouse were: books 2,000 copies and Pens 1,600boxes.Required: prepare the production budget for the year 2008.Solution: example 5

Required: Prepare the sales budget for the year 2008.

Solution: Example 5Production BudgetProducts Books PensBudgeted sales (units) 12,0009,000Add: closing stock 4,0003,000Less: Opening stock (2,000)(1,600)Budgeted production 14,00010,400

DIRECT MATERIAL USAGE BUDGETThis budget shows the direct materials that must be purchased in order tomeet production requirement (i.e. the production budget) and sometimes tomeet closing stock requirement.

It is calculated as follows:Raw materials to meet production schedule XXXAdd: expected closing stock of raw materials XXXRaw materials needed XXX

Less opening stock of raw materials XXXRaw materials to be purchased XXX





MATERIAL PURCHASE BUDGET

Example 1 Young Manufacturing Company Ltd manufactures two products, Milo and

Chocolate which uses the same raw materials cocoa and sugar. One unit tinof Milo uses 3kg of cocoa and 4kgs of sugar. One tin of chocolate uses 5kg of cocoa and 2kg of sugar. A kg of cocoa is expected to cost £3.00 and a kg of sugar will cost £7.00 per kg.

Budgeted sales for 2008 were 8,000 tins of Milo and 6,000 tins of Chocolate.Finished goods in stock at 1st January 2008 are; 1,500 tins of Milo and 300tins of chocolate. The company has decided to have a closing stock of 600tins of each product at the end of the year. The stocks of raw materials are; 6,000 kg of cocoa and 2,800kg of sugar asat 1st January 2008. Again the company plans to hold 5,000kg of cocoa and3,500kg of sugar at the end of the year. The warehouse and stores manager has suggested that a provision of shouldbe made for damages and deterioration of items in the store as follows:

Product: Milo loss of 50 tinsChocolate loss of 100 tins

Material: Cocoa loss of 500kgSugar loss of 200kg

TASK: You are required to prepare the material purchase budget for the year

2008.

COMPREHENSIVE QUESTIONMORE INVESTMENT LTD manufactures one product called NOKIA N95. Thefollowing information relates to the preparation of the budget for the year

ended January 2009.

1) Sales budget for the NOKIA N 95 are:Expected sales (units): 10,000Selling price £100.

All sales are made on credit basis2) To manufacture one NOKIA N95 requires 5 units of material E and 10

units of material C. The cost of material E is expected to be £3.00 perunit, and the cost of material C is expected to be £4.00 per unit.

3) Two departments are involved in producing NOKIA N95: Machining and

Assembling. The following information is relevant:





Direct labor per DirectLabour rate

Unit of product (hours) perhour

£Machining 1.00 6Assembling 0.50 8

4) The finished production overhead costs are expected to amount to£100,000.

5) At 1st April 2008, 800 units of NOKIA N95 are expected to be in stock ata value of £52,000, 4500 units of raw material E at a value of £13,500,and 12000 units of raw materials are planed to be 10% above theexpected opening stock levels as at 1st April 2008.

6) Administration, selling and distribution overhead is expected toamount to £150,000.

7) Other relevant information include the following:a. Opening trade debtors are expected to be £80,000. Closing

trade debtors are expected to amount to 15% of the total salesfor the year.

b. Opening trade creditors are expected to be £28,000. Closingtrade creditors are expected to amount to 10% of the purchasesfor the year.

c. All other expenses will be paid in cash during the year.d. Other balances at 1st April 2008 are expected to be as follows:

£ £i. Share capital: ordinary shares

255,000ii. Retained profits 17,500iii. Proposed dividend 75,000iv. Fixed assets at cost 250,000

Less Accumulated depreciation 100,000150,000

v. Cash at bank and in hand 2,000

8) Capital expenditure will amount to £50,000 payable in cash on 1 April2008.

9) Fixed assets are depreciated on a straight-line basis at a rate of 20%per annum on cost.

Required:

Prepare the annual budget for More Investment Ltd for the year to31 January 2009.





SOLUTION To make it easier for you to understand what is happening, the procedurewill be out lined step by step.

Step 1: prepare the sales budgetSALES BUDGET

Sales (Units) 10,000

Selling price per unit (£100)Sales (£) £1,000,000

Step 2: prepare the production budgetPRODUCTION BUDGET

Sales budget (units) 10,000Less : opening stock 800

9,200Add: desired closing stock (opening stock+10%)*

880Production required 10,080

*Desires closing stock= 800x 10% = 88 plus opening stock (800)=880

Step 3: prepare the direct material usage budget

Direct material:E: 5units X 10,080 50,400unitsC: 10units X 10,080 100,800units

• Step 4: prepare the direct materials purchases budget

Direct materialsE C

(units)(units)Usage (as per step 3) 50,400100,800Less: opening stock 4,50012,000

45,90088,800Add:desired closing stock (opening stock + 10%) 4,95013,200

50,850102,000





QUESTION:

MORE COMPUTERS manufactures two products: Keyboard and Mouse. The2009 annual budget is about to be prepared and the following informationhas been gathered

PRODUCT KEYBOARD MOUSEDemand/sales 600 1000Selling price £60 £80Opening stock (finished goods) 500 1400Required closing stock 1200 400Material: A (Kg/unit) 4kg 6kg

B (Kg/unit) 8kg 12kgExpected closing stock of material 200 600Opening stock of material 600 500Direct labour hours required per unit 4hours

6hours

Other information received from the accounts departments shows thefollowing estimates.Material A is expected to cost £3.00 per Kg and material B is expected tocost £4.00 per kg.

SOLUTION:

SALES BUDGET

PRODUCTS Sales (Units) Selling price per unit Total RevenueKeyboard 6,000 £60 360,000

Mouse 10,000 £80 800,000Budgeted sales £1,160,000

PRODUCTION BUDGETKeyboard Mouse

Budgeted sales 6,000 10,000Add expected closing stock 1,200 400

7,200 10,400Less Opening stock 500 1,400Budgeted production 6,700 9,000

MATERIAL USAGE BUDGETMATERIAL A (kg) B (kg)

Keyboard: (6,700X 4kg per unit) 26,800 (9,000 X 6kgper unit) 54,000





Mouse: (6,700X8kg per unit) 53,600 (9,000 X 12kg perunit) 108,000Materials to meet production 80,400

162,000Add expected closing stock 200

60080,600

162,600Less opening stock 600

500Material usage 80,000

162,100

MATERIAL PURCHASE BUDGET

EXAMPLE 3: (MASTER BUDGET)

The following information relates to the accounts of AMBA ltd as at January2008.

£ £ £ Total fixed asset (at cost) 128,000Less accumulated depreciation30,72097,280Current assets:Stocks 38,720Debtors 40,000

78,720Current Liabilities:Bank overdraft 1,600Proposed dividends 14,400 (16,000)

62,720160,000

Long term loan (15%) 64,000Net assets 96,000CAPITAL AND RESERVES:Ordinary shares 64,000

Retained profit 32,00096,000





Additional information:c) The company’s sales, purchases and expenses are estimated to

be as follows:

January February

marchSales 240,000 320,000

480,000Purchases 160,000 240,000

448,000 Total expenses 32,000 40,000

48,000

d) All sales are made on credit. Past experience shows that, 80% of sales made in a particular month are paid in the same month. Adiscount of 4% is given for payment within this period. Theremaining 20% is paid in subsequent month

e) Purchases are paid for in the month of purchase in order to takeadvantage of a 10% discount on the total purchases in the month

f) There are no changes in the stock levels for the periodg) Machinery is depreciated at 12% per annum. This is included in

the total expenses. It is the company’s policy to chargedepreciation on one-month ownership.

h) Expenses are paid for in the month in which they are incurred.i) The 15% loan interest will be paid in march 2008 j) Proposed dividends will be paid in January 2008

REQUIRED:a) Prepare the cash budget for the three month January to march 2008b) Prepare the budgeted profit and loss account for the periodc) Prepare the budgeted balance sheet

SOLUTIONAMBA LTDCASH BUDGET FOR THE PERIOD JANUARY –MARCH 2008

JAN. FEB MARBalance b/d (14,400) 33,600

72,640

RECEIPTSDebtors:

(Current month’s sales)-80% 192,000 256,000384,000

(4% discount) (7,680) (10,240)(15,360)

Previous month’s sales 40,000 48,00064,000

209,920 327,360505,280





PAYMENTSPurchases 160,000 240,000

448,000Discount received (10%) (16,000 ) (24,000)

(44,800)

Expenses (less depreciation) 30,720 38,72046,720

Dividend 1,600Loan interest

2,400176,320 254,720

410,272Balance c/d 33,600 72,640

95,000

AMBA LTDPROFIT AND LOSS ACOOUNT FOR THE PERIOD ENDED 31ST MARCH 2008

£ £Sales 1,040,000Less cost of sales:

Opening stock 38,720Purchases 848,000

Goods available for sale 886,720Less closing stock (38,720) (848,720)Gross profit 192,000

Add discount received 84,000276,800

Expenses (including depreciation) 120,000Interest on loan 2,400Discount allowed 33,280 (155,680)Net profit 121,120 AMBA LTDBUDGETED BALANCE SHEET AS AT 31ST MARCH 2008

CASH BUDGETA cash budget is a statement in which estimated future cash receipts andpayments are tabulated in such a way as to show the forecast cash balance

of the business at defined intervals.





It is a detailed plan that shows how cash resources will be acquired and usedover a specific period of time.OBJECTIVES OF CASH BUDGET The objectives of a cash budget include the following.

i. To anticipate cash shortages or surpluses and how plans should be

made to invest the surplus or go for overdraft.

ADVANTAGES /USEFULNESS OF CASH BUDGET The cash budget has the following benefits

i. It shows the cash effect of all plans made within the budgetaryprocess and hence its preparation leads to the medication of theannual budgets.

ii. It also gives management an indication of potential problems thatcould arise and allows them the opportunity to take action to avoidproblems

iii. Also, it may be used in planning your short-term credit needs.iv. The cash budget determines your future ability to pay debts as well as

expenses.v. Banks and other credit-granting institutions are more inclined to

grant you loans under favourable terms if your loan request issupported by a methodical cash plan.

vi. Also, a monthly cash budget helps pinpoint estimated cash balancesat the end of each month which may foresee short-term cashshortfalls.

FORMAT OF CASH BUDGETMORE LTD

CASH BUDGET FOR THE PERIOD JANUARY –JUNE 2008

JAN FEB MARCH APRILMAY JUNE

BAL b/d XXX XXX XXX XXXXXX XXX

RECEIPTS

DEBTORS XX XX XX XXXX XXINVESTMENT INCOME XX XX XX XXXX XXSALE OF ASSETS XX XX XX XXXX XXGOVERNMENT GRANT XX XX XX XXXX XXCAPITA INTRODUCED XX XX XX XX

XX XX





OTHER ICOMES XX XX XX XXXX XXTOTAL RECEIPTS XX XX XX XXXX XX

PAYMENTSCREDITORS XX XX XXXX XX XXWAGES/SALARY XX XX XXXX XX XXPURCHASE OF ASSET XX ----- --- ---EXPENSES XX XX XXXX XX XXOTHER EXPENSES XX XX XXXX XX XXTOTAL PAYMENTS XX XX XXXX XX XX

EXAMPLES 1: CASH BUDGET

The following is the forecast data of a company for the first three months of its budget cycle:

APRIL MAY JUNE JULY£ £ £ £

Sales 120,000 140,000 180,000 160,000Purchases 70,000 110,000 100,000 90,000Overheads 24,000 24,000 26,000 26,000Wages 20,000 21,000 21,000 22,000Other Information:

• 50% of sales are on a cash basis, and 50% are on a credit basis.

• Debtors are given one month’s credit.

• Suppliers give one month’s credit.

• Overheads are paid one month in arrears.

• Overheads include £4,000 in respect of the depreciation of fixed

assets.• Wages are paid in the month in which they are incurred.

• New equipment costing £80,000 will be paid for in May.

• The sale of old equipment will bring income of £5,000 in June.

• A Government grant of £10,000 is due in June.

• The bank balance is predicted to be £18,000 on 1 May 2007. TASKSa) Prepare a receipts schedule for the period May–July 2007.b) Prepare a payments schedule for the period May–July 2007.c) Prepare a cash budget for the period May–July 2007.d) Outline the benefits of maintaining a budgetary control system.





SOLUTION: EXAMPLE 1

a) RECEIPTS SCHEDULE FOR THE PERIOD MAY – JULY 2007

May June July£ £ £

Debtors: 50% cash 70,000 90,000 80,00050% credit 60,000 70,000 90,000

Sale of equipment --- 5,000 ----Government Grant --- 10,000 ------- Total receipts 130,000 175,000 170,000

b) PAYMENT SCHEDULE FOR THE PERIOD MAY – JULY 2007May June July£ £ £

Purchases 70,000 110,000100,000Wages 21,000 20,000 22,000Overheads 20,000 20,000 22,000Equipment 80,000 --- -- Total payments 191,000 151,000144,000

c) CASH BUDGET FOR THE PERIOD MAY – JULY 2007MAY JUNE JULY

£ £ £Balance b/d 18,000 (43,000)(19,000)Receipts:Debtors 130,000 160,000170,000Government Grant 10,000Sale of equipment 5,000 ---

148,000 132,000

151,000

Payments:Purchases 70,000 110,000 100,000Wages 21,000 21,000 22,000Overheads 20,000 20,000 22,000Purchase of equipment 80,000 --- ---- Total payments 191,000 151,000144,000





EXAMPLE 2 The following information relates to a proposed business partnership, for thesix months ending 31Decmber 2003:a. Sales (in units at £60 per unit)

July Aug Sept Oct Nov Dec

Units 250 425 580 560 770 850b. All sales will be on credit and debtor will be given two months credit.c. Production

July Aug Sept Oct Nov DecUnit 600 450 600 750 750 900d. Materials have been costed at £31 per unit, suppliers give on e month’scredit.e. Direct labour will cost £8 per unit, payable during the month of production.f. The partners will rent a small unit at an annual rent of £6000. However,they have negotiated an initial rent –free period of three months.Subsequent payments are to be made quarterly in advance.g. Office salaries will cost £350 per month for the first four months and thenan office junior will be employed from 1 November at an annual salary of £3000.h. Other fixed costs are anticipated to be at the rate of £425 per month, andvariable cost at the rate of £6 per unit, payable during the month of production.i. A partner (J Raul) has purchased £6000 of equipment personally already,and wishes to be reimbursed in full equally over the three months of production.

j. Additional equipment will be purchased on 1 October at a cost of £2000.k . The other partner (Mrs Smith) will introduce £9000 in cash on 1 July andMr Raul will contribute £5000 on 1 July.l. The partners will cash draw £800 per month from the business, with MrsSmith withdrawing an additional £1,200 in December.

TASKS:Prepare a cash budget for the six month ending 31 December 2003, clearly

showing the net cash flow of funds per month, and cash balance at the endof each month.

SOLUTION: EXAMPLE 2

CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008JULY AUG SEPT. OCT. NOV. DEC.₤ ₤ ₤ ₤ ₤

₤Balance b/d 5625 (20,150) (28,975)(31,650) (35,375)

RECEIPTSDebtors --- ---- 15,000 25,00034,800 33,600

Capital 14,000 ----- ----- ---------- -----





EXAMPLE 3:

You are given the information below by your Director for the period November 2007 to June2009

Sales purchases wages overheads dividendscapital expenditure

November 2007 160,000 80,000 20,000 20,000 --------

December 2007 200,000 120,000 24,000 20,000 40,000---

January 2008 220,000 160,000 32,000 30,000 ---60,000

February 2008 260,000 180,000 40,000 30,000 -------

March 2008 280,000 210,000 48,000 30,000 ------

April 2008 300,000 260,000 56,000 40,000 ----80,000

May 2008 320,000 280,000 64,000 40,000 ------

June 2008 360,000 300,000 72,000 40,000 80,000----

Additional information:

1. Sales are 40% cash and 60% credit. All credit sales are paid in two months after themonth of sales

2. suppliers are paid the month following purchase

3. Wages: 75% of wages are paid in the month they are incurred. The remaining 25% ispaid in the following month.

4. Overheads are paid in the month after they are incurred.

EXAMPLE 4

As the accountant of SUANAD enterprise, you are preparing the budget for thethree months ending June 30 2008. You are given the following data

d) Sales are projected to be

2008 £





January 31,500

February 24,000

March 30,000

April 39,000

May 36,000

June 42,000

July 45,000

e) All sales are on credit and on avereage 80% of the sales resultsin the customer paying in the month of sales, taking a 5%

setlement discount, 10% pay in the month following the saleand 8% in the second month following the sale. 2% proveuncollectable.

f) Goods are purchesed on anticipation os sales in the monthspreceeding the sales. Sales are invoiced at cost plus 20%

g) Suppliers are paid two months after receiveing the goods.h) Overheads are £7,500 per month and are paid as incurred.i) The overdraft as at march 30 2008 will be £4,650

REQUIRED: you are required to prepare:

EXAMPLE 5:

FANMILK Ltd supplies Ice cream in Ghana. The following forecast were made fora quqter of a year ending September 2008.

JUNE JULY AUGUST SEPT.

£ £ £ £CASH SALES 184,000 212,000 220,000

240,000

CREDIT SALES 480,000 520,000 530,000560,000

CREDIT PURCHASES 240,000 360,000 280,000304,000

SELLING EXPENSES 34,000 38,000 42,000

44,000





ADM. EXP. 24,000 32,000 30,00036,000

DEPRECIATION 30,000 30,000 30,00030,000

CAPITAL EXPENDICTURE - - 90,000 -

NOTES:

1. 40% of credit sales are collected the month of sales. The balance of 60%is collected in the month following sales.

2. 50%of credit purchases are paid for in the month of purchase and the restpaid in the next month.

3. The opening balance was in overdraft of £200,000.4. All other expenses are paid for in the month they are incurred except

capital expenditure which is spread over six months starting from themonth it is incurred.

YOU are required to prepare the cash budget for the quarter ending 30September 2008.

SOLUTION:CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008

JULY AUG SEPT.

₤ ₤ ₤Balance b/d (200,000) 138,000 475,000

RECEIPTSDebtors 496,000 524,000 542,000Cash sales 212,000 220,000 240,000

508,000 882,000 1,257,000

PAYMENTSCreditors 300,000 320,000 292,000Selling expenses 38,000 42,000 44,000Administrative expenses 32,000 30,000 36,000Capital expenditure --- 15,000 15,000

370,000 407,000 387,000Bal c/d 138,000 475,000 870,000

WORKINGS:

DEBTORS SCHEDULE

JULY AUG SEPT

June sales (60% X 480,000) 288,000





July sales (40% X 520,000) 208,000

(60% X 520,000) - 312,000

August (40% X 530,000) 212,000

(60% X 530,000) 318,000

September sales (40% X 560,000) 224,000

--------- -------- -----------

496,000 524,000 524,000

CREDITORS SCHEDULE

JULY AUG SEPT

June Purchase (50% X 240,000) 120,000

July purchase (50% X 360,000)180,000

(50% X 360,000) - 180,000

August purchase (50% X 280,000) 140,000

(50% X 280,000) 140,000

September purchase (50% X 304,000) 152,000

--------- -------- -----------

300,000 320,000 292,000

Note: depreciation is non-cash flow item hence not treated in the cash budget.

QUESTION 2:

The managing director of MORE LTD, has asked you to prepare his cashbudget for the coming period. He provide you with the following informationto enable you do the job for him

i. EXAMPLE 3 (JUNE 2006) Q 6

Mirzer Ltd. intends to commence business on 1 July 2006 with sharecapital of £180,000. On 1 July 2006 Mirzer Ltd. will also receive





£30,000 in various grants from government and EU sources.OtherInformation:

• Mirzer Ltd. will spend £90,000 on fixed assets on 1 July 2006.

• The following are the costs per unit:£

Direct material 8Direct wages 6Variable overhead 4

18

• The selling price will be £25 per unit.

• Mirzer Ltd. have agreed to pay rent of £40,000 per year – payablequarterly in advance.

• Other fixed overheads are estimated to be £14,000 per monthpayable in arrears.

• Budgeted production will be 10,000 units per month for the first

three months, increasing to 12,000 units per month thereafter.• Budgeted sales are estimated to be 9,000 units per month for the

first three months, increasing to 12,000 per month thereafter.

• All sales are to be on credit. Mirzer Ltd. will allow one month’scredit.

• The suppliers of direct material will allow one month’s credit.

• Direct wages costs will be paid in the month of production.

• Variable overheads will be paid for in the month followingproduction.

TASKSa) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31December 2006, clearly showing the budgeted cash balance at theend of each month.

b) Comment on the budgeted cash flow position of Mirzer Ltd.c) Outline the potential sources of short-term finance available to MirzerLtd.

QUESTION 4:Mr. Timore has just decided to enter into the production and sale of A4Rimes starting on 1st July 2008. He has a personal savings amounting to£15,000 of which he wants to start the business with. This amount will be

paid into the companies account non 1

st

July 2008. The forecasted cash flowfor the first six (6) month is as follows:





1) Production: He plans to produce 1,500 Rims per month for the first 6months for the printing industry.

2) Sales: The selling price of each Rim will be £37.5. The sales for the sixmonth will be as follows:

July August September October NovemberDecember

1200 1440 1440 1680 19201200

3) Variable overheads: Variable Overheads per Rim (based on output)will be £4.5. This will be payable in the month of production.

4) Fixed cost: A fixed cost of £3,000 will be incurred per month, payableafter the month of production.

5) Wages: Wages of production staff will be £9 per Rim, payable in themonth of production.

6) Salaries: Salaries of £1,500 per month will be paid until October whensalaries are expected to increase by 10% for the rest of the months.

7) £24,000 will be used to purchase a new plant in September. The sellerof the plant has agreed to accept a deposit of 25% and the balancepaid in equal installment in October and November.

8) Raw materials: cost per Rim of raw material will be £6. The supplierof the material will allow one month credit period.

9) Debtors: Sales are basically on credit. Debtors are expected to pay inone month following their purchases.

You are required to prepare the cash budget for the six month periodending 31st December 2008

SOLUTION:CASH BUDGET FOR 6 MONTH ENDING 31 DECEMBER 2008

Jul. Aug. Sept. Oct.Nov. Dec.

£ £ £ ££ £Bal. b/d -ReceiptsCapital 15,000

Debtors - 45,000 54,000 63,00072,000 45,000 Total receipts 15,000

PaymentsOverhead (£4.5X1500) 6,750 6,750 6,750 6,7506,750 6,750wages

TRY QUESTIONS





• The sale of old equipment will bring income of £5,000 in March.• The bank balance is predicted to be £30,000 on 1 January, 2006.

TASKSa) Prepare cash budget for the period January – March 2006.

b) Comment on the budgeted cash position of the company.

c) Explain the principal benefits of preparing and monitoring a cashbudget.

Question 3 (cash budget): The following projections were obtained from SUANAD Ltd, Retail Companyfor the years 2008 and 2009.

NOV. DEC. JAN. FEB. MAR. APR.2008 2008 2009 2009 2009 2009£’000 £’000 £’000 £’000 £’000 £’000

Bills issued 940 1,020 1,280 1,420 1,080 1,800Rights issue ---- ----- 50 120 20

---Interest receivable 25 23.50 32.50 30 28.50

25Loan payable 120 110 98 95 92

89New equipment 1,800

Additional information:1) Recurrent expenditure is estimated at 40% of bills issued and is paid

every month.

2) 60% of bills issued is collected in the month after issue and 30% in thenext month.

3) The new equipment will be paid for in two equal installments startingfrom the month of purchase.

4) All the other receivables and payables are settled in the month inwhich they occur.

5) Any shortfall will be financed by an overdraft which is obtained inmultiples of £50,000 at 5% interest per month payable in the nextmonth.

6) The opening balance will be an overdraft of £50,000. You are required to prepare a cash budget for Suanad Ltd for the first four

months of the year 2009.

CHAPTER SIX

BREAK-EVEN ANALYSIS

Introduction

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"

(costs that change when the production output changes) and those that are "fixed" (costs not

directly related to the volume of production).





It is a term used to describe the study of the relationship between costs, volume and profit at

different levels of activities. It shows the relationship that exists between cost, revenue, level

of output and profit. Another term for Break-even analysis is Cost-Volume-Profit analysis.

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a

loss (the "break-even point").

An important factor in break-even analysis is the ability to distinguish total cost into fixed costs

and variable cost.

FIXED COST AND VARIABLE COST

FIXED COST: Fixed costs are those business costs that are not directly related to the level of

production or output. It is defined by CIMA as “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 level of activity (output or turnover” In other words, even if the business has

a zero output or high output, the level of fixed costs will remain broadly the same. In the long

term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding

a new factory unit) or through the growth in overheads required to support a larger, more

complex business. Examples of fixed costs include: Rent and rates, depreciation, research and

development, marketing cost (I .e. none-revenue related cost)

VARIABLE COST:

Variable costs are those costs which vary directly with the level of output. It is defined as “ a

cost which varies with a measure of activity” They represent payment output-related inputs

such as raw materials, direct labour, fuel and revenue-related costs such as commission.

A distinction is often made between the following:

"DIRECT" VARIABLE COSTS: Direct variable costs are those which can be directly

attributable to the production of a particular product or service and allocated to a particular cost

centre. Raw materials and the wages those working on the production line are good examples.

INDIRECT VARIABLE COSTS cannot be directly attributable to production but they do vary

with output. These include depreciation (where it is calculated related to output - e.g. machinehours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorizing

business costs, in reality there are some costs which are fixed in nature but which increase when

output reaches certain levels. These are called semi-variable costs.

ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The main assumptions behind C-V-P/Break-even Analysis includes





1) All costs can be classified into fixed and variable costs

2) Fixed costs will remain constant over relevant range

3) Costs and revenues behave in a linear fashion.

4) Volume or output is the only factor which affects costs and revenue.

5) Technology, production methods and efficiency remain unchanged.

6) All quantities produced are sold.7) There are no stock level changes and stocks are valued at marginal costs only.

BREAKEVEN ANALYSIS – MATHEMATICAL METHOD

C.V. P analysis can be done using simple formulae

1. Break-even point (in units) = fixed costs

Contribution per unit

2. Break-even point (£ sales) = fixed cost X selling priceContribution per unit

OR

Fixed costs

Contribution to sales ratio(C/S ratio)

3. (C/S Ratio) = contribution per unit X 100

Selling price

4. Level of sales to achieve a target profit (in units)

= Fixed cost +Target profit

Contribution per unit

Level of sales to achieve a target profit (£ sales)

= fixed cost + target profit X selling price

The Break-Even Chart

THE BREAK EVEN CHART

In its simplest form, the break-even chart is a graphical representation of costs at various levels

of activity shown on the same chart as the variation of income (or sales, revenue) with the same

variation in activity. The point at which neither profit nor loss is made is known as the "break-

even point" and is represented on the chart below by the intersection of the two lines:





In the diagram above, the line OA represents the variation of income at varying levels of

production activity ("output"). OB represents the total fixed costs in the business. As output

increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At

low levels of output, Costs are greater than Income. At the point of intersection, P, costs are

exactly equal to income, and hence neither profit nor loss is made.

QUESTION 1A company is about to bring a new product to the market. The following

budgeted data has been gathered:

Direct material cost per unit 30Direct labour cost per unit 30Variable overhead cost per unit 50Selling price per unit 200Fixed overhead cost 420,000Planned production and sales 12,000 units. Maximum possible output 16,000units. TASKS:a) Calculate the original budgeted profit.

b) Calculate the original budgeted break-even point.c) The sales manager thinks that if he was allowed to spend an extra£100,000 on marketing, the company would be able to sell 14,000 units at aprice of £210 per unit. Calculate the profit.d) The production manager thinks that if he implemented a cost reductionprogramme he could reduce direct materials by 10%, direct labour by 5%and variable overheads by 5%. He also thinks that he could achieve savingof £30,000 on fixed overheads.Calculate the profit based on selling 12,000 units at £200 each.e) Explain which option you would recommend.

SOLUTION: QUESTION 1





1,164,000Fixed overhead cost (420,000-30,000)(390,000)Budgeted profit774,000

e) From the above calculations, I will recommend option (c) since it

produces the highest profit.Tutorial:

i. The extra £100,000 on marketing is a fixed cost hence it isadded to the fixed overheads

ii. The (d) part of the question requires the following calculations:Direct material (£30x10%= 3; it is to be reduced by 10% =£30 -£3=£27. it can be calculated as 90% x 30= ₤27 (i.e 100% -10% = 90%)Direct Labour (95%x £30= £28.50)Variable overheads (£50x95%) =£ 47.50

Q2 . Cost accounting (September 2005)

A company is about to bring a new product to the market. The followingbudgeted data has been collected:

£Direct material cost per unit 30Direct labour cost per unit 40Variable overhead cost per unit 50

Selling price per unit 230Fixed overhead cost 1,000,000Planned production and sales 18,000 units. Maximum possible output 22,000

units. TASKS:a) Calculate the original budgeted profit.b) Calculate the original budgeted break even point.c) It is thought that if an extra £80,000 was spent on marketing it would

be possible to sell 19,500 units at the original budgeted sellingprice. Calculate the profit.

d) It is thought that if the price was increased to £260 per unit it would

only be possible to sell 15,000 units. Calculate the profit.e) It is thought that by improving the product, at a cost of £10 extra per

unit, and increasing the selling price to £270 per unit it would bepossible to sell 18,500 units. Calculate the profit

f) Explain the term margin of safety.

SOLUTION: QUESTION 1a)

£ £

Sales (£230 X 18,000)4,140,000





Budgeted profit1,100,000

e)Sales (£270 X 18,500)

4,995,000Variable costs:

Direct material (£30 X 18,500) 555,000Direct labour (£40 X18, 500) 740,000Improvement (10 x 18,500) 185,000Variable overheads (£50 X18, 500) 925,000

(2,405,000) Total contribution2,590,000Fixed overhead cost (1,000,000 +80,000)(1,000,000)Budgeted profit1,590,000

f) From the above calculations, I will recommend option (c) since itproduces the highest profit.

Tutorial:i. The extra £100,000 on marketing is a fixed cost hence it is

added to the fixed overheads

ii. The (d) part of the question requires the following calculations:Direct material (£30x10%= 3; it is to be reduced by 10% =£30 -£3=£27. it can be calculated as 90% x 30= ₤27(i.e 100% -10% = 90%)Direct Labour (95%x £30= £28.50)Variable overheads:(£50x95%) =£ 47.50





ADVANTAGES OF RIGHT ISSUES AS A SOURCE OF FINANCEi. A right issue is the simple and cheapest way by which a company

can get fundsii. It has a greater chance of success since the buyers are the existing

known shareholders of the company.

iii. Shareholders of the company have the choice either to accept theoffer or sell their right to other shareholders for money.

iv. A right issue enables the company to at least maintain itsdividends.

v. A right issue automatically lowers the gearing ratio of the companyvi. The finance is fully guaranteed if the issue is underwritten.vii. It might give the impression that the company is expanding.

viii. Investors see a right issue as a healthy sign of future growthprospect of the company.

DISADVANTAGES OF RIGHT ISSUEi. The amount of money required may not be able to obtain.ii. Right issues are normally made at a discount, which usually

involves diluting the Earnings Per Share of the company.iii. Underwriter’s fees and other administrative expenses of the issue

may be costly.iv. The market is often skeptical about the reason for the right issue,

tending to assume that the company needs cash seriously.v. A right issue usually forces shareholders to either buy the shares or

sell their right.

2. RETAINED EARNINGS (Plough-back profit)

Simply retaining profits, instead of paying them out in the form of dividends, offers an

important, simple low-cost source of finance, although this method may not provide enough

funds, for example, if the firm is seeking to grow.

This is where earnings from operations are ploughed.

For any company, the amount of earnings retained within the business has a directimpact on the amount of dividends. Profit re-invested as retained earnings is profit

that could have been paid as a dividend. The major reasons for using retainedearnings to finance new investments, rather than to pay higher dividends and thenraise new equity for the new investments, are as follows:

a) The use of retained earnings as a source of funds does not lead to a payment of cash. Retained earnings are an attractive source of finance because investmentprojects can be undertaken without involving either the shareholders or anyoutsiders.

c) The use of retained earnings as opposed to new shares or debentures avoidsissue costs.

d) The use of retained earnings avoids the possibility of a change in controlresulting from an issue of new shares.





Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations,they would rather make a capital profit (which will only be taxed when shares aresold) than receive current income, then finance through retained earnings would bepreferred to other methods.

A company must restrict its self-financing through retained profits becauseshareholders should be paid a reasonable dividend, in line with realisticexpectations, even if the directors would rather keep the funds for re-investing. Atthe same time, a company that is looking for extra funds will not be expected byinvestors (such as banks) to pay generous dividends, nor over-generous salaries toowner-directors.

back into the firm, i.e. they are used for investment in other potentialprofitable projects. The use of retained earnings is the most common source of finance inpractice.

ADVANTAGES:

1. Flexible, particularly for small amounts2. No cost involved in raising the finance3. No new shareholders are involved hence all gains from any investmentwill go to the existing shareholders

3. BANK LOAN

Loan stock is long-term debt capital raised by a company for which interest is paid,

usually half yearly and at a fixed rate. Holders of loan stock are therefore long-termcreditors of the company.

ADVANTAGES OF BANK LOAN

4. DEBENTURES

Debentures are a form of loan stock, legally defined as the writtenacknowledgement of a debt incurred by a company, normally containing provisionsabout the payment of interest and the eventual repayment of capital.

Debentures will often be secured. Security may take the form of either a fixedcharge or a floating charge.

a) Fixed charge: Security would be related to a specific asset or group of assets,typically land and buildings. The company would be unable to dispose of the assetwithout providing a substitute asset for security, or without the lender's consent.





a) The lessee is responsible for the upkeep, servicing and maintenance of theasset. The lessor is not involved in this.

b) The lease has a primary period, which covers all or most of the economiclife of the asset. At the end of the lease, the lessor would not be able to lease

the asset to someone else, as the asset would be worn out. The lessor must,therefore, ensure that the lease payments during the primary period pay forthe full cost of the asset as well as providing the lessor with a suitable returnon his investment.

c) It is usual at the end of the primary lease period to allow the lessee tocontinue to lease the asset for an indefinite secondary period, in return for avery low nominal rent or the lessee might be allowed to sell the asset on thelessor's behalf (since the lessor is the owner) .

Why might leasing be popular

The attractions of leases to the supplier of the equipment, the lessee and the lessorare as follows:

5. The supplier of the equipment is paid in full at the beginning. The equipment issold to the lessor, and apart from obligations under guarantees or warranties,the supplier has no further financial concern about the asset.

6. The lessor invests finance by purchasing assets from suppliers and makes areturn out of the lease payments from the lessee. Provided that a lessor canfind lessees willing to pay the amounts he wants to make his return, the lessorcan make good profits. He will also get capital allowances on his purchase of the equipment.

7. Leasing might be attractive to the lessee:i) if the lessee does not have enough cash to pay for the asset, and wouldhave difficulty obtaining a bank loan to buy it, and so has to rent it in oneway or another if he is to have the use of it at all; or

ii) Finance leasing is cheaper than a bank loan. The cost of payments undera loan might exceed the cost of a lease.

Operating leases have further advantages:

i. The leased equipment does not need to be shown in the lessee's publishedbalance sheet, and so the lessee's balance sheet shows no increase in itsgearing ratio.

j. The equipment is leased for a shorter period than its expected useful life. Inthe case of high-technology equipment, if the equipment becomes out-of-date before the end of its expected life, the lessee does not have to keepon using it, and it is the lessor who must bear the risk of having to sellobsolete equipment secondhand.

6. HIRE PURCHASE

Hire purchase is a form of installment credit. Hire purchase is similar to leasing,with the exception that ownership of the goods passes to the hire purchase

customer on payment of the final credit installment, whereas a lessee neverbecomes the owner of the goods.





Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.ii) The supplier delivers the goods to the customer who will eventually purchasethem.

iii) The hire purchase arrangement exists between the finance house and thecustomer.

The finance house will always insist that the hirer should pay a deposit towards thepurchase price. The size of the deposit will depend on the finance company's policyand its assessment of the hirer. This is in contrast to a finance lease, where thelessee might not be required to make any large initial payment.

An industrial or commercial business can use hire purchase as a source of finance.With industrial hire purchase, a business customer obtains hire purchase financefrom a finance house in order to purchase the fixed asset. Goods bought bybusinesses on hire purchase include company vehicles, plant and machinery, office

equipment and farming machinery.

Government assistance

The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy,especially in high technology industries and in areas of high unemployment.

Venture capital

The term 'venture capital' is more specifically associated with putting money,usually in return for an equity stake, into a new business, a management buy-out ora major expansion scheme.

Venture capital is money put into an enterprise which may all be lost if theenterprise fails. The institution that puts in the money recognises the gambleinherent in the funding. There is a serious risk of losing the entire investment, andit might take a long time before any profits and returns materialise. But there isalso the prospect of very high profits and a substantial return on the investment. Aventure capitalist will require a high expected rate of return on investments, tocompensate for the high risk.

A venture capital organisation will not want to retain its investment in a businessindefinitely, and when it considers putting money into a business venture, it willalso consider its "exit", that is, how it will be able to pull out of the businesseventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and AngloAmerican Corporation Services Ltd.

The directors of the company must then contact venture capital organisations, totry and find one or more which would be willing to offer finance. A venture capitalorganisation will only give funds to a company that it believes can succeed, andbefore it will make any definite offer, it will want from the company management:

a) a business plan





DISADVANTAGES The major problems of overdraft interest arei. Technically overdrafts are payable on demandii. Interests rates may increase due to inflation

4. FACTORING & INVOICE DISCOUNTINGFactoring involves the outright sale (at a discount) of debts owed to thecompany to an outside body in exchange for cash. Thus companies can usefactoring to raise immediate cash on the security of the companies debt. Acompany anxious to restore liquidity can be helped by a factor. Factorsare specialist financial institutions, usually a subsidiary of major banks) The factor takes over the administration of the client company’s invoices,collects the money and also assumes the risk of customer default. How

much is paid for the invoice is subject to negotiation but usually depends onthe volume of debt involve, degree of customer default and the extent of paperwork involve.A typical factoring arrangement include the following

a. The company sells and invoices goods to customersb. The company (supplier) sells the debt/ the invoice amount to the

factorc. The factor then releases a loan of about 80% of the invoice amount

to the supplierd. At the agreed payment date by the customer, the customer pays the

amount to the factor

e. The factor then releases the remaining 20% to the company afterdeducting interest charges and commission.

A typical factor’s cost can be divided into the following:i. A service charge ( usually 1% or 2% of the sales value) to cover the

cost of administering the invoicesii. A finance charge (i.e. loan interest) on the amount paid by the factor

to the company, usually between 3% - 4%. The interest is calculatedup the time that debtors settle their bills.

iii. A premium ( about 1% ) to cover bad debtsiv. Extra charges for legal fees incurred by the factor during the debt

collection

5. INVOICE DISCOUNTING

This involves the buying of invoices issued to customers by the discounter. The discounter then issues immediate cash to the supplier up to say 80% of the invoice values. That is with invoice discounting, the company receives acash payment (thus a loan) from the invoice discounter against the value of the invoices issued to customers but the company retains the responsibilityfor the debts collection but not the discounter who collects the debt as in

factoring. Charges in invoice discounting are usually higher than factoring.





One advantage of invoice discounting is that, customer goodwill ismaintained

ADVANTAGES OF FACTORING & INVOICE DISCOUNTING1. Factors are experts in debt collection and may be able to

persuade debtors to settle their outstanding debts moreconveniently than the company’s own accounting staff.

2. Factoring speeds up cash flows of a company thereby preventingcash flow difficulties.

DISADVANTAGES OF FACTORING & INVOICE DISCOUNTING1. One of the problems with factoring is that, the client company looses

contact with its customers. The factor may collect the debts in its ownname or under the letter head of the come. Some times the customeris irritated during the process.

2. Factors are not always interested to deal with small companies wherethe debt is small.

3. The interest charged by these factors are usually costly4. Factoring can be applied to few customers with huge debt.

6. DEFERED TAX PAYMENTAnother source of short-term funds similar character to trade credit is thecredit supplied by the tax authority. This is created by the interval that

elapses between the earnings of the profits by the company and thepayment of the taxes due on them. As long as the company continues toearn stable or expanding profit, tax payment deferred in this way comprisesa virtually permanent source of finance. Provisional assessments andpayment of deposit on account by Ghana tax authorities has render thissource of finance non-effective.

CHAPTER EIGHT

MERGERS AND TAKEOVERS





A merger is a combination of two companies into one larger company.MERGER means the combination of two or more firms to form a singlecompany.Thus a merger is the joining of two separate companies to form asingle company It is a tool used by companies for the purpose of expandingtheir operations often aiming at an increase of their long term profitability.

Corporate mergers may be aimed at reducing market competition, cuttingcosts (for example, laying off employees, operating at a moretechnologically efficient scale, etc.), reducing taxes, removing management,"empire building" by the acquiring managers, or other purposes which mayor may not be consistent with public policy or public welfare. .

A merger can resemble a takeover but result in a new company name(often combining the names of the original companies) and in new branding;in some cases, terming the combination a "merger" rather than anacquisition is done purely for political or marketing reasons.

Acquisition on the other hand is the purchase of a controlling interest inanother company.

TYPES OF MERGER:Mergers can be classified into four groups:

1. horizontal merger2. vertical merger3. concentric/ congeneric merger4. conglomerate merger

1) HORIZONTAL MERGER: This is a combination of two or morecompanies that produce the same type of goods and services.Horizontal mergers take place where the two merging companiesproduce similar product in the same industry. That is when one firmcombines with another in its same line of business. eg MTN & TIGO

2) VERTICAL MERGER: A merger between a firm and one of its suppliersor customers e.g. a steel company acquiring a coal mining firm.Vertical mergers occur when two firms, each working at differentstages in the production of the same good, combine.

3) COMGLOMERATE MERGER: A merger of companies in totally

different industries. Conglomerate mergers take place when the twofirms operate in different industries.

Hostile Merger: A form of merger where the target firm’s managementresists or opposes the acquisition.Friendly Merger: A merger whose which is supported and whose terms areapproved by the management of the two companies.


http://en.wikipedia.org/wiki/Corporation

http://en.wikipedia.org/wiki/Business_operations

http://en.wikipedia.org/wiki/Competition#Economics_and_business_competition

http://en.wikipedia.org/wiki/Taxes

http://en.wikipedia.org/wiki/Management

http://en.wikipedia.org/wiki/Takeover

http://en.wikipedia.org/wiki/Brand

http://en.wikipedia.org/wiki/Horizontal_integration

http://en.wikipedia.org/wiki/Industry

http://en.wikipedia.org/wiki/Vertical_integration

http://en.wikipedia.org/wiki/Conglomerate_(company)

http://en.wikipedia.org/wiki/Corporation

http://en.wikipedia.org/wiki/Business_operations

http://en.wikipedia.org/wiki/Competition#Economics_and_business_competition

http://en.wikipedia.org/wiki/Taxes

http://en.wikipedia.org/wiki/Management

http://en.wikipedia.org/wiki/Takeover

http://en.wikipedia.org/wiki/Brand

http://en.wikipedia.org/wiki/Horizontal_integration

http://en.wikipedia.org/wiki/Industry

http://en.wikipedia.org/wiki/Vertical_integration

http://en.wikipedia.org/wiki/Conglomerate_(company)




Proceeds from share issue 480Repayment of long-term loans 240

Interest paid 25Interest received 5

Cash inflow from operating activities 290 b) Comment on the cashflow position of Venasius plc during the year ended 28 February 2009.

c) Explain the sources of long-term capital available to a major company.

5. The following information relates to Shabalal Ltd and has been taken from their books as at 28 February2009:

£Turnover 2,100,000

Administration expenses 360,000

Cost of sales 550,000Taxation for the year 140,000

Interest paid 40,000

Distribution costs 290,000Proposed dividends 220,000

OTHER INFORMATION:

• There are 1,500,000 £1 ordinary shares in issue.• The market price of an ordinary share on 28 February 2009 was £5.80 per share.TASKS

a) Prepare the profit and loss account of Shabalal Ltd for the year ended 28 February 2009. b) Calculate the following:

i the EPS

ii the PE ratioiii the dividend per share

iv the interest cover

c) The following are the simplified individual balance sheets of two companies P (the parent company)and S (the subsidiary company) immediately after acquisition:

£m £mP S

Fixed AssetsInvestments in S (60% of the shares) 20 –

Tangible assets 28 10---- ----

48 10---- ----

Current Assets

Stock 20 6Debtors 12 6

Bank 3 1---- ----

35 13---- --

Current Liabilities

---- ----Creditors (12) (2)

---- ----

71 21=== ===

Capital and reservesOrdinary share capital 60 15

Profit and loss account balance 11 6

=== ===

TASK Construct the group balance sheet immediately after acquisition.OR





Credit sales 2,900Opening stock 240

Purchases 1,290TASKS

a) Prepare the balance sheet of Rovfort Ltd as at 30 November 2008.[8] b) Calculate the following ratios:


iii the debtor collection period in daysiv the rate of stock turnover[2 each]

c) Comment briefly on the liquidity position of Rovfort Ltd as at 30 November 2008.[4]

7. Write notes on FOUR of the following:

a) the purposes of a cash budget b) accounting standards

c) a cash flow statement (FRS 1)

d) financial gearing (leverage)e) efficiency ratios

f) IRR

g) a rights issue[5 each]

SEPTEMBER 2008

FINANCIAL MANAGEMENT

1. Explain the following terms:a) cash budget

b) stock exchangec) a share prospectus

d) marginal costing[5 each]

2. The following information relates to LEN Ltd and has been taken from their books as at 31 August 2008:£

Turnover 1,960,000

Administration expenses 280,000Cost of sales 530,000

Taxation for the year 270,000

Interest paid 25,000Interest received 10,000


OTHER INFORMATION:

• There are 1,000,000 £1 ordinary shares in issue.

• The market price of an ordinary share on 31 August 2008 was £9.40 per share.

• The total capital employed in the business on 31 August 2008 was £1,850,000.TASKS

a) Prepare the profit and loss account of LEN Ltd for the year ended 31 August 2008. [5] b) Calculate the following:

i the EPSii the PE ratio

iii the dividend per shareiv the dividend cover

v the profit before tax to total capital employed percentage[2 each]

Note. The following ratios on 31 08 07 were:EPS 52 pence per share

PE ratio 12 timesc) Give an opinion as regards the performance of LEN Ltd from the view of an existing shareholder. [5]





The following information has also been gathered:


Purchases 1,400

TASKS

a) Prepare the balance sheet of Lucas Ltd as at 31 August 2008.[8] b) Calculate the following ratios:


iii the debtor collection period in days

iv the gearing percentage[2 each]c) Comment briefly on the liquidity position of Lucas Ltd as at 31 August 2008.[4]

7. Write notes on FOUR of the following:a) accounting standards (or international accounting standards)

b) group accounts

c) short-term sources of financed) the role of an external auditor e) a rights issue

f) the role of a management accountantg) IRR [5 each]

JUNE 2008


1. The summarised financial statements of Barista Ltd for 2006 and 2007 were as follows:

Barista Ltd balance sheets as at 31 December 2006 2007£000 £000 £000 £000

Fixed assets at cost 19,000 35,000Depreciation (9,000) 10,000 (13,000) 22,000

Current assets

Stock 10,000 8,000Debtors 15,000 17,000

Bank 8,000 1,000-------- --------

33,000 26,000-------- --------

Current liabilitiesCreditors 6,000 2,000Taxation 5,000 3,000

Dividends 2,000 3,000

-------- --------13,000 8,000

-------- --------Working capital 20,000 18,000

Long-term loans (5,000) (10,000)

-------- --------25,000 30,000

-------- --------

Capital and reserves:Ordinary shares (£1) 10,000 14,000





Profit and loss account 15,000 16,000-------- --------

25,000 30,000-------- --------

Barista Ltd profit and loss account for the year ended 31 December 2007:£000

Operating profit 8,000Interest paid (1,000)

---------Profit before tax 7,000

Taxation (3,000)--------

Profit after tax 4,000

Dividend (3,000)--------

Retained profit 1,000

--------

TASKS

a) Prepare a cash flow statement for Barista Ltd for the year ended 31 December 2007.[10] b) Calculate the following:

i the dividend per share for BOTH years[3]

ii the EPS for year ended 31 December 2007[2]c) Comment briefly on the major inflows and outflows of cash during the year ended 31 December

2007.[5]

2. A company is about to bring a new product to the market. The following budgeted data has beenassembled:

£Direct material cost per unit 40

Direct labour cost per unit 20Variable overhead cost per unit 50

Selling price per unit 170Fixed overheads allotted to the product 320,000The first draft budgeted production and sales is 12,000 units.

The maximum possible output is 20,000 units.

TASKSa) Calculate the first draft budgeted profit.[3]

b) Calculate the first draft budgeted break-even point.[2]c) The marketing department have carried out some market research and are convinced

that if an extra £50,000 was spent on marketing sales would rise to 15,000 units.Calculate the profit.[3]

d) It is thought that if the selling price is increased to £180 per unit it would only be possible to sell11,000 units. Calculate the profit. [3]

e) The production department thinks that by improving the quality and packaging of the product by

spending an extra £4 per unit making the product, sales would rise to 14,500 units. The selling price would be kept at £170. Calculate the profit.[3]f) Fully evaluate the above options.[6]

3. The following information relates to Karos Ltd and has been extracted from their books as at 31 May 2008:

£Turnover (all credit sales) 2,200,000

Selling and distribution costs 220,000Taxation for the year 140,000

Stock at 01 06 07 300,000

Purchases 970,000Stock at 31 05 08 280,000

Administration expenses 230,000

Interest paid 90,000Proposed ordinary dividend 100,000





-------------Issued ordinary share capital 1,000,000

Current market price per ordinary share 15Total closing debtors 190,000

TASKSa) Prepare the profit and loss account for the year ended 31 May 2008.[5]

b) Calculate the following:i the gross profit to sales percentage

ii the operating profit (PBIT) to sales percentageiii the earnings per share (EPS)

iv the PE ratiov the debtor collection period in days[10]

c) Comment on the financial performance of Karos Ltd.[5]

4. Domone plc is considering investing in a project that has the following cash flows:

£000Initial investment 2,700

Cash flows:

Year one 700Year two 1,000Year three 1,100

Year four 600Year five 300


Rate of discount 8% 9% 10%Year one .926 .917 .909

Year two .857 .842 .826Year three .794 .772 .751

Year four .735 .708 .683Year five .681 .650 .621

Year six .630 .596 .564TASKSa) Calculate the payback period.[2]

b) Calculate the ARR (accounting rate of return).[2]

c) Calculate the NPV (net present value).[4]d) Explain briefly if you think that the project is viable.[4]

e) Explain the long-term sources of finance available to Domone plc.[8]

5. a) Explain why budgetary control is used by most successful companies.[12] b) Explain the importance of controlling inventory (stock) levels.[8]

6. Explain why the international trend is for growth via mergers or takeovers.[20]

7. Explain FOUR of the following:a) share issues b) cash budgets

c) accounting standardsd) gilt edged securities

e) liquidity ratiosf) the potential dangers of high gearing

g) the role of a central bank[5 each]

MAY 2008






Cost of sales 650,000Taxation for the year 110,000

Interest paid 30,000Distribution costs 340,000

Proposed dividends 190,000OTHER INFORMATION:

• There are 500,000 £1 ordinary shares in issue.• The market price of an ordinary share on 29 February 2008 was £11.40 per share.

• The total revenue reserves at 1 March 2007 was £1,420,000.

• Diamonte Ltd do NOT have any form of long-term loan finance.

TASKSa) Prepare the summarised published profit and loss account of Diamonte Ltd for the year ended 29

February 2008. [4] b) Calculate the following:

i the EPSii the PE ratio

iii the dividend per share

iv the dividend cover v the operating profit as a percentage of total capital employed[2 each]

c) The following are the simplified individual balance sheets of two companies P (the parent company)

and S (the subsidiary company) immediately after acquisition:£m £m

P SFixed Assets

Investments in S (75% of the shares) 34 – Tangible assets 41 19

75 19Current Assets

Stock 19 12Debtors 15 9

Bank 7 441 25

Current LiabilitiesCreditors (12) (6)

104 38=== ===

Capital and reservesOrdinary share capital 80 20

Profit and loss account balance 24 18

=== ===

TASK Construct the group balance sheet immediately after acquisition.[6]

3. a) Explain the importance of budgetary control.[15] b) A company is about to introduce a new product to the market. The cost data is as follows:

£Selling price per unit 95

Direct material cost per unit 24Direct wages cost per unit 22

Variable overhead cost per unit 24Associated total fixed costs 200,000

The company thinks that it can make and sell 20,000 units.TASKS

i Calculate the budgeted profit.[3]ii Calculate the break-even point in units.[2]

4. a) Prepare a cashflow statement of a company called RSP plc for the year ended 29 February 2008 fromthe following data:

£000





Interest paid 30,000Distribution costs 270,000

Proposed dividends 90,000Other Information:

• There are 400,000 £1 ordinary shares in issue.

• The market price of an ordinary share on 30 November 2007 was £22.00 per share.

TASKSa) Prepare the profit and loss account of Yasmin Ltd for the year ended 30 November 2007[5]

b) Calculate the following:i the EPS


iv the profit before tax as a percentage of sales[2 each]

c) The following are the simplified individual balance sheets of two companies P (the parent company) and S(the subsidiary company) immediately after acquisition:

£m £mP S

Fixed Assets

Investments in S (80% of the shares) 22 -Tangible assets 25 12

47 12

Current AssetsStock 18 8

Debtors 11 7

Bank 2 131 16

Current Liabilities

Creditors (10) (4)68 24

=== ===Capital and reserves

Ordinary share capital 50 20Profit and loss account balance 18 4

=== ===TASK

Construct the group balance sheet immediately after acquisition.[7]OR

Explain the following terms:i Minority interest[4]

ii An associated company[3]

2. Explain the following terms:a) Underwriting fees

b) A subsidiary companyc) Gilt edged securities

d) Contribution[5 each]

3. a) Explain the principal purposes of using a budgetary control system.[12]

b) Explain the sources of finance available to a multinational company. [8]

4. a) Prepare a cashflow statement of a company called VFR plc. for the year ended 30 November 2007

from the following data:£000

Purchase of new equipment 210Purchase of new computers 90

Tax paid 130

Equity dividends paid 80Proceeds from share issue 540Repayment of long-term loans 350





Interest paid 30Interest received 5

Investment income 10Cash inflow from operating activities 220[5]

b) Comment on the cashflow position of VFR plc. during the year ended 30 November 2007.[5]c) Explain the purpose of accounting standards.[5]

d) Explain the difference between fixed and variable costs.[5]

5. The following figures have been extracted from Gleeson Ltd.’s accounts for the two years to 30 November 2007:

2007 2006BALANCE SHEET CLOSING BALANCES:

Stock £190,000 £120,000

Debtors £320,000 £190,000Cash in bank - £30,000


Long-term loans £550,000 £250,000

Issued share capital £600,000 £600,000

Retained profit £240,000 £180,000TASKS

a) For both years calculate the following:i the current ratio[3]

ii the acid test ratio[3]iii the gearing percentage[3]

b) Comment on the liquidity position of Gleeson Ltd.[5]c) Explain the importance of monitoring the cash flow position of a business.[6]

6. a) Explain why a company will use investment appraisal techniques in the choice of allocating finance

to potential investment projects.[10] b) Explain the potential sources of short-term finance available to a large company.[10]


a) the principal role of a central bank b) VAT

c) a rights issued) intangible fixed assets

e) goodwillf) currency hedging

g) venture capitalists[5 each]

SEPTEMBER 2007


1. The following information relates to Steric Ltd and has been taken from their books as at 31 August 2007:

£000Taxation for the year 15,000

Turnover (all credit sales) 290,000

Distribution costs 28,000Stock at 01/09/06 42,000

Purchases 142,000

Administration expenses 36,000Stock at 31/08/07 44,000





Taxation for the year 160,000Stock at 01 03 06 360,000

Purchases 1,200,000Stock at 28 02 07 380,000

Administration expenses 240,000Interest paid 110,000

Proposed ordinary dividend 100,000Issued ordinary share capital 1,000,000

Current market price per ordinary share 16

TASKSa) Prepare the profit and loss account for the year ended 28 February 2007 [5]

b) Calculate the following:

i the gross profit to sales percentageii the profit after tax to sales percentage

iii the earnings per share (EPS)

iv the PE ratiov the stock turnover period in days [10]

c) Comment on the financial performance via the use of ratios. [5]

4. Boris Ltd is considering investing in a project that has the following cash flows:£000


Year one 800Year two 1,200

Year three 1,400Year four 700

Year five 400The cost of capital is 8%.

Extracts from NPV (DCF) tables:Rate of discount 8% 9% 10%

Year one .926 .917 .909Year two .857 .842 .826Year three .794 .772 .751

Year four .735 .708 .683

Year five .681 .650 .621Year six .630 .596 .564

TASKSa) Calculate the payback period [2]

b) Calculate the ARR (accounting rate of return). [2]c) Calculate the NPV (net present value). [4]

d) Explain briefly if you think that the project is viable. [4]e) Explain why large firms often seek to grow larger by taking

over or merging with a similar business. [8]

5. Explain the following terms:a) Purchased goodwill

b) Share capitalc) Sale and leaseback

d) Group accounts [5 each]

6. Capers Ltd. intends to commence business on 1 April 2007 with share capitalof £250,000. On 1 April 2007 Capers Ltd. will also receive £40,000 in various grants from government and EU

sources.

Other Information:

• Capers Ltd. will spend £80,000 on machinery and office equipment on 1

April 2007.• The following are the costs per unit: £

Direct material 7





Taxation for the year 100,000Interest paid 20,000


OTHER INFORMATION:


• The market price of an ordinary share on 30 November 2006 was £6.20 per share.TASKS

a) Prepare the profit and loss account of Sirus Ltd. for the year ended 30 November 2006.[5]



iv the dividend cover [2 each]

c) The following are the simplified individual balance sheets of two companies P (the parent company) and S(the subsidiary company) immediately after acquisition:

£m £m

P SFixed Assets

Investments in S (80% of the shares) 22 -

Tangible assets 25 1247 12

Current Assets

Stock 12 8

Debtors 6 7

Bank 4 222 17

Current Liabilities Creditors (9) (5)

60 24

=== ===Capital and reserves

Ordinary share capital 50 10

Profit and loss account balance 10 14=== ===

TASK Construct the group balance sheet immediately after acquisition [7]

OR Explain the following terms:

i Minority interest [4]

ii An associated company [3]

3.a) Explain the principal purposes of using a budgetary control system. [12]

b) Explain the process of raising finance via a new issue of shares. [8]

4.a) Prepare a cashflow statement of a company called CRE plc for the year ended

30 November 2006 from the following data:£000

Purchase of new machinery 200Purchase of new vehicles 90

Tax paid 130

Equity dividends paid 100

Proceeds from share issue 580Repayment of long-term loans 250

Interest paid 30





Bank overdraft 160Creditors 170

Goodwill 204Debtors 400

Vehicles (net) 152Ordinary share capital 600

Preference share capital 200Share premium 140

Tax owing 90Dividends owing 100

Equipment 380Closing stock 250

Profit and loss account balance 416

Long-term loans 260

The following information has also been gathered:


Purchases 1,240

TASKSa) Prepare the balance sheet of EtNat Ltd. as at 31 August 2006. [8] b) Calculate the following:

i current ratio

ii acid test ratioiii the debtor collection period in days

iv the rate of stock turnover [2 each]

c) Comment briefly on the liquidity position of EtNat Ltd. as at 31 August2006. [4]


a) horizontal integration b) the importance of monitoring working capitalc) a cash flow statement (FRS 1)

d) limiting factors

e) efficiency ratiosf) the role of a management accountant

g) IRR [5 each]

JUNE 2006


1. The summarised financial statements of Gucki Ltd. for 2004 and 2005 were as follows:Gucki Ltd. balance sheets as at 31 December

2004 2005

£000 £000 £000 £000Fixed assets at cost 12,000 17,000

Depreciation (6,000) 6,000 (8,000) 9,000

Current assetsStock 8,000 11,000

Debtors 10,000 9,000Bank 4,000 7,000

-------- --------

22,000 27,000-------- --------





Current liabilitiesCreditors 6,000 4,000

Taxation 5,000 7,000Dividends 4,000 6,000

-------- --------15,000 17,000

-------- --------Working capital 7,000 10,000

Long-term loans (2,000) (4,000)

-------- --------11,000 15,000

-------- --------

Capital and reserves:Ordinary shares (£1) 8,000 9,000

Profit and loss account 3,000 6,000

-------- --------11,000 15,000

-------- --------

Gucki Ltd. profit and loss account for the year ended 31 December 2005:£000

Operating profit 16,500Interest paid (500)

---------Profit before tax 16,000

Taxation (7,000)--------

Profit after tax 9,000Dividend (6,000)

--------Retained profit 3,000

--------TASKSa) Prepare a cash flow statement for Gucki Ltd. for the year ended 31 December 2005.[10]

b) Calculate the following for BOTH years:

i the current ratioii the acid test ratio[6]

c) Comment briefly on the financial performance during 2005.[4]

2. A company is about to bring a new product to the market. The following budgeted data has been

assembled:£

Direct material cost per unit 40

Direct labour cost per unit 25Variable overhead cost per unit 50Selling price per unit 200

Fixed overheads allotted to the product 600,000

The first draft budgeted production and sales is 11,000 units.The maximum possible output is 15,000 units.

TASKSa) Calculate the first draft budgeted profit.[3]

b) Calculate the first draft budgeted break even point.[2]

c) The marketing department are convinced that if an extra £40,000 was spent on marketing, saleswould

rise to 14,000 units. Calculate the profit.[3]

d) It is thought that if the selling price is increased to £220 per unit it would be possible to sell 10,000units. Calculate the profit. [3]





b) Vertical integrationc) Master budget

d) Group accounts [5 each]

6. Mirzer Ltd. intends to commence business on 1 July 2006 with share capital of £180,000. On 1 July 2006Mirzer Ltd. will also receive £30,000 in various grants from government and EU sources.

Other Information:• Mirzer Ltd. will spend £90,000 on fixed assets on 1 July 2006.

• The following are the costs per unit:£

Direct material 8Direct wages 6

Variable overhead 4---

18---

• The selling price will be £25 per unit.

• Mirzer Ltd. have agreed to pay rent of £40,000 per year – payable quarterly in advance.

• Other fixed overheads are estimated to be £14,000 per month payable in arrears.

• Budgeted production will be 10,000 units per month for the first three months, increasing to 12,000

units per month thereafter.

• Budgeted sales are estimated to be 9,000 units per month for the first three months, increasing to12,000 per month thereafter.

• All sales are to be on credit. Mirzer Ltd. will allow one month’s credit.

• The suppliers of direct material will allow one month’s credit.

• Direct wages costs will be paid in the month of production.

• Variable overheads will be paid for in the month following production.

TASKSa) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31 December 2006, clearly showing

the budgeted cash balance at the end of each month.[10] b) Comment on the budgeted cash flow position of Mirzer Ltd. [5]

c) Outline the potential sources of short-term finance available to Mirzer Ltd.[5]

7. Write notes on FOUR of the following:a) international accounting standards

b) an offer of shares to the general publicc) a bonus issue of shares

d) the functions of a stock exchangee) the principal contents of a balance sheet

f) efficiency ratios

g) minority interest[5 each]

MARCH 2006


1. a) The trend of international acquisitions and mergers continues. Explain the reasons for such

takeovers/mergers.[12] b) Explain the following terms:

i a rights issue

ii underwriting fees[4 each]

2. a) Prepare a cashflow statement of a company called LED plc for the year ended 31 March 2006 from

the following data:

£000Purchase of new machinery 180





Tangible assets 20 938 9

Current AssetsStock 12 7

Debtors 9 6Bank 2 1

23 14

Current Liabilities

Creditors (8) (3)53 20

=== ==Capital and reserves

Ordinary share capital 40 10Profit & Loss account balance 13 10

53 20=== ===

TASK Construct the group balance sheet immediately after acquisition.[7]

OR Explain the following terms:

i Minority interest[4]

ii An associated company[3]

5. a) Explain the principal purposes of using a budgetary control system.[12]

b) Explain the sources of short-term finance available to a large company. [8]

6. a) Explain why a company will use investment appraisal techniques in the choice of allocating financeto potential investment projects.[10]

b) Explain the potential sources of long-term finance available to a large company.[10]

7. Write notes on FOUR of the following:a) the principal role of a central bank

b) company taxationc) gilt edged securities

d) intangible fixed assetse) goodwill

f) currency hedgingg) venture capitalists[5 each]

DECEMBER 2005

FINANCIAL MANAGEMENT1. a) Explain the principal sources of long-term finance available to a large PLC.[10]

b) A company is facing short-term cash flow difficulties. The company is making good profits, has agood ‘track record’ and has excellent long-term financing in place.

Explain how the company might solve the short-term cash flow problems.[10]

2. The following information relates to REB Ltd. and has been taken from their books as at 30 November 2005:

£

Turnover 980,000Administration expenses 160,000

Cost of sales 340,000

Taxation for the year 70,000

Interest paid 20,000Distribution costs 155,000Proposed dividends 40,000





Vehicles (net) 140Ordinary share capital 500

Preference share capital 200Share premium 120

Tax owing 90Dividends owing 100

Premises 700Closing stock 224

Profit & Loss account balance 390Long-term loans 280

TASKSa) Prepare the balance sheet of RebEt as at 30 November 2005.[8]

b) Calculate the following ratios:

i current

ii acid test[2 each]

c) Comment briefly on the liquidity position of RebEt as at 30 November 2005.[4]d) Explain briefly the reasons for accounting standards.[4]

7. Write notes on FOUR of the following:a) gearing b) the importance of monitoring working capital

c) a cash flow statement (FRS 1)d) fixed assets

e) efficiency ratiosf) the function of a stock market

g) IRR [5 each]

SEPTEMBER 2005


1. a) Explain the typical synergetic benefits gained by a company thatacquires a major competitor. [12]

b) Explain the following terms:

i arbitrageii the average cost of capital [4 each]

2. The following information relates to AVCE Ltd. and has been taken from their books as at 31 August

2005:£

Turnover 1,120,000Administration expenses 170,000

Cost of sales 460,000

Taxation for the year 90,000Interest paid 25,000Distribution costs 210,000



• The market price of an ordinary share on 31 August 2005 was £4.90 per share.

TASKSa) Prepare the Profit & Loss account of AVCE Ltd. for the year ended

31 August 2005. [5]


ii the PE ratio

iii the dividend per shareiv the interest cover





v the profit after tax to sales percentage [2 each]c) Explain the term floatation costs. [5]

3. REM Ltd is considering investing in a project, which has the following cash flows:£000


Year 1700Year 2900

Year 3 1,100Year 4800

Year 5400


Rate of discount 8% 9% 10%

Year 0 1.000 1.000 1.000Year 1 .926 .917 .909

Year 2 .857 .842 .826

Year 3 .794 .772 .751Year 4 .735 .708 .683Year 5 .681 .650 .621

Year 6 .630 .596 .564

TASKS

a) Calculate the payback period (in years and months). [2] b) Calculate the ARR (accounting rate of return). [2]

c) Calculate the NPV (net present value). [4]d) Explain briefly whether you think that the project is viable. [4]

e) Explain why firms increasingly look at ‘non-financial’ factors during thedecision-making process. [4]

f) Explain the IRR investment appraisal method/technique. [4]

4 .a) Explain the principal sources of long-term capital available to a verylarge international company. [10]

b) Explain the importance of Modigliani and Miller as regards capitalstructure and valuation. [10]

5. a) Prepare a cashflow statement of a company called HUG plc for the year ended 31 August 2005 fromthe following data:

£000Purchase of new computers 120

Purchase of new vehicles 90

Tax paid 100

Equity dividends paid 80Proceeds from share issue 420

Repayment of long-term loans 330Interest paid 30

Interest received 5Investment income 10

Cash inflow from operating activities 180 [5]

b) Comment on the cashflow position of HUG plc during the year ended31 August 2005 [5]

c) Explain the purpose of a cashflow statement. [5]d) Cashflow is more important than profitability. Discuss. [5]





6. The following figures have been extracted from VROOM Ltd.’s accounts for the two years to 31 August2005:

2005 2004BALANCE SHEET CLOSING BALANCES:

Stock £140,000 £100,000Debtors £350,000 £190,000

Cash in bank - £50,000


Long-term loans £500,000 £350,000

Issued share capital £500,000 £500,000Retained profit £300,000 £250,000

TASKS

a) For BOTH years calculate the following:i the current ratio [3]

ii the acid test ratio [3]

iii the gearing percentage [3] b) Comment on the liquidity position of VROOM Ltd. [5]c) Explain briefly why new businesses will often prefer to lease

fixed assets rather than buy them. [6]

7. Write notes on FOUR of the following:a) the principal role of a central bank

b) the importance of monitoring working capitalc) gilt edged securities

d) intangible fixed assetse) international accounting standards

f) currency hedgingg) venture capitalists [5 each]

JUNE 2005


1. a) Explain the principal sources of finance available to a large plc company.

[9] b) Explain briefly the principal role of a stock exchange. [5]

c) Explain briefly the following:

i a rights issueii a bonus issue [3 each]

2. The following information relates to TLC Ltd. and has been taken from their books as at 31 May 2005:

£Turnover 990,000

Administration expenses 140,000Cost of sales 370,000

Taxation for the year 40,000Interest paid 20,000

Distribution costs 190,000



• The market price of an ordinary share on 31 May 2005 was £6.00 per share.TASKS





Issued share capital 800 800

Reserves 480 679Shareholder’s funds 1280 1479

TASK:

a) Calculate for both yearsi. Three profit ratios

ii. Two liquidity ratiosiii. Two efficiency ratios

b) Comment on the financial progress of Trusso Ltd during the year ended 31/12/01.

2. The following are the capital structures of two companies and their operating profits their first year of trading.

COMPANY X Y

£’000 £’000£1 ordinary shares 300 600

£1 preference shares 100 -

Debenture stock (10%) 400 200Operating profit 120 120Ordinary share price at year end £2 £1.6

TASK :a) Calculate the commencing gearing ratio of each company

b) Prepare Vertical schedules which show the interest payable, tax charge and preference dividends. Note: corporation tax is 20% of taxable profit.

c) Calculate for both companies the EPSd) Calculate for both companies the PE ratio

e) Comment briefly on the financial position of both companies from the standpoint of an ordinary shareholder.

3. Module Ltd is considering investing in a project which has the following budgeted cash flows:

£’000Initial investment (1,200)Cash flows:

Year 1 300

Year 2 500Year 3 700

Year 4 600Year 5 200

The cost of capital is 8%.

DCF tables:Rate of discount 8% 9% 10%

Year 1 .926 .917 .909

Year 2 .857 .842 .826Year 3 .794 .772 .751Year 4 .735 .708 .683

Year 5 .681 .650 .621Year 6 .630 .596 .564

TASKSa) Calculate the payback period

b) Calculate the Accounting rate of returnc) Calculate the NPV

d) Explain whether or not your would advise Module Ltd to invest in e project

e) Explain the following terms:i. Risk free rate of interest

ii. Risk adverse investor

4. a) Prepare a cash flow statement from the following data:


37536570 finanacial management for icm

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