Finance and Accounting

Business accounting
Sa’adat Ali Mughal
9/18/2011

Business Accounting_________________________________________

5AS.1 The need for business finance THE NEED FOR BUSINESS FINANCE Firms need money to get started, i.e. to buy equipment, raw material and obtain premises. Similarly finance is required to expand the business in terms of larger premises, more equipments and extra workers. The items of expenditure method above fall in to two categories. Revenue expenditure- refers to payments for goods and services which have either already been consumed or will be very soon. Wages, raw materials and fuel are all examples. Revenue expenditures are shown in a firms profit and loss account because it represents business costs or expenses. Capital expenditures- is spending on items, which may be used over, and over again. A company’s vehicle, machines and a new factory all fall into this category. Capital expenditure is shown in a firm’s balance sheet because it includes the purchase of fixed assets. WORKING CAPITAL Working capital is the difference between current assets and current liabilities. Current assets are either in the form of cash or that can soon lead to cash, and current liabilities will soon have to be paid for with cash. Working capital is often considered to be the portion of capital that ‘oils the wheel’ of business. Funds employed in fixed assets are concerned with producing goods and services. Working capital provides stocks from which the fixed assets may produce. It allows the sales force to offer trade credit and create debtors. Firms with insufficient working capital are in a financial straitjacket. They lack the funds to buy stocks, and to produce and create debtors. In these circumstances providers of finance may well call a meeting of creditors and appoint a liquidator. Clearly, a business must always have adequate short-term funds to ensure a continuation of its activities. Control of Working capital • Reducing the period between the time cash is paid out for raw materials and the time cash is received from sales will provide funds for regeneration. Although the improved efficiency of the cash cycle will help working capital, however, it might be unpopular with creditors. • Fixed assets such as land and buildings might not be fully utilized, or space might be used for unprofitable purposes. Space could be rented, sold or allowed to house a more profitable operation so that cash flow could be improved. A business’s cash flow might be improved by selling assets and leasing them back, although, this can commit the firm to heavy leasing fees. 2

Sa’adat Ali Mughal • A company could review its stock level to see if these could be the subjects of economy measures. If the stock of raw materials is divided by the average weekly issue, the number of week’s raw materials held in stock can be calculated. Some companies attempt to maximize liquidity by using ‘just-intime’ approach so as to hold the maximum stocks possible. Many businesses employ a credit controller to economies on debtors. A credit controller will yet new customers and set them a credit limit, ensure that credit limits are not exceeded and encourage debtors to pay on time. Cash budgeting can also be used as an important control mechanism to predict the effects of future transactions on the cash balance of a company. Cash budgeting can help a company to take actions to ensure that cash is available when required. A number of short-term solutions are available to increase working capital. Companies might extend their overdraft or bring in a factoring company. It might be possible to delay the payments of bills, although this obviously displeases creditors.

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WHY BUSINESS ACTIVITY REQUIRES FINANCE Finance is required for many business activities. Here is a list of just some of the main circumstances in which business will require finance: • Setting up a business will require cash injections from the owner to purchase essential capital equipment and, possibly, premises. This is called start up capital. • All businesses will have a need to finance their working capital –the day-today finance needed to pay bills and expenses and to build up stocks. • When business expand, further finance will be needed to increase the capital assets held by the firm – and, often, expansion will involve higher working capital needs. • Expansion can be achieved by taking over other businesses. Finance is then needed to buy out the owners of the other firm. • Special situation will often lead to need for greater finance. For example, a decline in sales, possibly as a result of economic recession, could lead to cash needs to keep the business stable; or a large customer could fail to pay for goods, and finance is quickly needed to pay for essential expanses. • Apart from purchasing fixed assets, finance is often used to pay for research and development into new products or to invest in new marketing strategies, such as opening up overseas markets. Some of these situations will need investment in the business for many years – or even permanently. Other cases will need only short-term funding – this is usually defined as being for around one year or less. Some finance requirements of the business are for between one and five years and this is referred to as medium-term finance.

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Business Accounting_________________________________________ 5AS.2 Sources of finance SOURCES OF FINANCE

Sources of finance basically divided into two categories 1 Internal sources of finance Profit- a firm’s profit after tax is an important and inexpensive source of finance from profit. Depreciation- this is financial provision for the replacement of worn out machinery and equipment. All businesses use depreciation as a source of finance. Further methods for depreciation are explained in business accounting. Sale of assets- sometimes businesses sell off assets to raise money. Occasionally a company may be forced to sell assets because it is not able to raise finance from other sources. The sale of business assets such as an associated company or a subsidiary of a business is called divestment. Reduction in working capital- when businesses increase stock levels or sell goods on credit to customers (debtors) they use a source of finance. When companies reduce these assets – by reducing their working capital – capital is released, which act as a source of finance for other uses. There are risks on cutting down on working capital, however. Cutting back on current assets by selling stocks or reducing debts owed to the business may reduce the firm’s liquidity – its ability to pay short-term debts – to risky levels. Internal sources of finance – an evaluation This type of capital has no direct cost to the business, although, if assets are leased back once sold, there will be leasing charges. Internal finance does not increase the liabilities or debts of the business. However, it is not available for all companies, for example newly formed ones or unprofitable ones with few ‘spare’ assets. Solely depending on internal source of finance for expansion can slow down business growth as 4

Sa’adat Ali Mughal the pace of development will be limited by the annual profits or the value of assets to be sold. Thus, rapidly expanding companies are often dependent on external sources for much of their finance. 2 External source of finance The finance is raised form outside the business. External source of finance is further divided into two categories External short-term finance Bank overdraft- this probably most commonly used form of finance, a business takes out more from the bank than it has invested there. The bank set a limit for the overdraft facility, allowing the business to draw on its current account up to a set limit. Interest is paid on the actual amount that is overdrawn at any given time, calculated on a daily basis. The overdraft is used to allow the business to operate during time when cash flow is negative and can act as a lifeline when business facing cash flow problems. Hire purchase- this is often used by small businesses to buy plant and machinery. The borrowers give a down payment and repay the remaining in small installments over a period of time. Once payment is complete, the business owns the asset. Finance houses specialize in providing funds. If the buyer falls behind with the repayments the finance house legally reposes the item. Trade credit- it is common for businesses to buy new materials, components and fuel and pay for them at a later date. It is an interest free way of raising finance. Many companies encourage early payments by offering discounts. Delay in the payment of bill can result in poor business relations with suppliers. Leasing- it allows the business to buy plant, machinery and equipment without having to payout large amounts of money. An operating lease means that the leasing company simply hires out equipment for on agreed periods of time. They never own the equipment, but it is given the option to purchase the equipment out right if it is leased with a finance lease. No large sums of money are needed to buy the use of equipment. Repair and maintenance costs are usually not the responsibility of the user. Most up to date equipments can be offered by Hire purchase. Leasing is useful when equipment is only required occasionally. Leasing payment can be offset by tax. However, over a long period of time leasing is more expensive than the out right purchase of plant or machinery. Loan cannot be secured on assets, which are leased. Debt factoring- when a business sells their products they send invoices stating the amount due. Debt factoring involves a specialist company (the factor) providing finance against these unpaid invoices. A common arrangement is for a factor to pay 80% of the value of the invoices when they are issued. The balance of 20% is paid by the factor when the customer settles the bill. An administrative and service fee will be charged. Trade bills- it is particularly used in overseas trade. The purchase of traded goods may sign a bill of exchange agreeing to pay for the goods at a specified later date. The

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Business Accounting_________________________________________ seller of the goods holds the bill until payment is due. However, the holder can sell it at a discount before the maturity date to a specialist financial institution. Credit cards- these are used to meet small expenses for example hotel bills, petrol, and meals. They may also be used to purchase materials from suppliers who accept credit cards. Credit cards are popular because they are convenient, flexible, secure and avoid interest charges if monthly accounts are settled within the credit period. External long-term finance Share capital It is also known as debit or equity capital. Being a limited company this is likely to be the most important source of finance. A very large amount of money can be raised through sale of shares. Share capital often referred to as permanent capital because it is not repaid by the business (not redeemed). Once the shares have been sold the buyer is entitled to a share in the profit of the company in the forms of ‘dividend’. Dividends are not always declared. Sometimes a business makes a loss or need to retain profit to help fund future business activities. A shareholder can gain capital by selling the share at a higher price than it was originally bought for (or at the current market rate). Shares are not normally sold back to the business. The shares of public limited companies are only sold in ‘stock exchange’. Shares in private limited company are transferred privately. Shareholders are entitled to a vote and select board of directors or participate in company’s major decisions. Here are different types of shares. Ordinary shares- these are also known as equities and the most common types of share issued by a business. They are also the riskiest type of share because there is no guaranteed dividend. Dividend depends on how much profit is made and how much the directors decide to retain in the business. All ordinary shareholders have voting rights. When a share is first sold it has a nominal value shown on it, which is also known as its original value. Share prices change as they are bought and sold again and again. Preference shares- the owners of these shares receive a fixed rate of return when a dividend is declared. They carry less risk because shareholders are entitled to their dividend before the holders of ordinary shares. Preference shareholders are not strictly owners of the company. If the company is sold, their right to dividends and capital requirement is limited to fixed amounts. Some preference shares are cumulative, entitling the holder to dividend arrears from years when dividends were not declared. Participating preference shareholder also receives more than agreed rate of return if a business earns abnormal profit. Deferred share- these are not used often. Founders of the company usually hold them. Deferred share only receive a dividend after the ordinary shareholder have been paid a minimum amount. Loan capital Any money, which is borrowed for a lengthy period of time by the business, is called loan capital. Loan capital may come from four sources,

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Sa’adat Ali Mughal Debentures- holders are entitled to an agreed fixed rate of return, but have not voting right. The holder of a debenture will have a certificate stating when the loan is to be repaid, known as the maturity date. Mortgage- this is a form of borrowing which is used when a business buy property and secures the loan against the property. Industrial loan specialist- this specialist tends to cater for businesses, which have difficulty in raising funds from convenient sources. These venture specialists provide fund to small and medium size companies that appear to have some potential, but are considered too risky by other investors. Government assistance- government provide amount for those starting new businesses or to control regional unemployment. Capital and money markets Business has to look to external sources for their funds. Financial intermediates are the institutions responsible for matching the needs of sources, which want to loan funds, with those of investors, who need funds. These groups do not naturally communicate with each other. Intermediaries provide the link between them. Stock market- it deals in second hand shares. The main function of stock exchange is to provide a market where the owners of the share can sell them. If this market does not exist, selling shares would be difficult because buyers and sellers could not easily communicate with each other. A stock exchange enables mergers and takeovers to take place smoothly. It also provides a means of protection for shareholders. Companies, which are stock exchange listed, have to obey a number of stock exchange rules and regulations, which are designed to safeguard shareholders from fraud. General movements in share price reflect the health of economy. Insurance companies, pension funds, investment trusts, unit trusts and issuing houses (merchant banks) are some of the institutions, which trade in shares. Banks- the money market is dominated by commercial banks. They allow payments to be made through the cheque system and deal in short term loans. Saving banks, financial corporations and building societies also provide a source of finance. Central bank also tends to play an important role in controlling the amount of money, loan and interest rate. IMF and World Bank- IBRD or World Bank is a sister institution of the IMF. While the purpose of IMF is to provide short-term assistance to nations in balance of payments difficulties, that of the World Bank is to provide long-term assistance for reconstruction and development purposes. It has 148 members and is considered as the World’s largest multinational source of development finance. Member nations are required to subscribe to the capital stock of the Bank, each being given a quota, which is related to the member’s national income and position in world trade. The IBRD tends to set fairly stringent conditions on its lending. Interest is charged on the loans, but the interest is set as how as compatible with the Bank’s ability to borrow.

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Business Accounting_________________________________________ In early years the major part of the loan was given to European countries but in recent years loans have gone increasingly to the developing nations. The loans are given for infrastructure projects such as road system, electric plants, railways, irrigations, water supply and industrial undertakings. Education and health care are at their top priorities. The borrowers application for a loan is care fully examined by World Bank experts who must be satisfied that the project is designed to strengthen the economy. Other sources of long-term finance Grants- there are many agencies that are prepared, under certain circumstances, to grant funds to businesses. The two major sources in European countries are the central government and the European Union. Usually, grants from these two bodies are given to small businesses or those expanding in developing regions of the country. Grants often come with ‘string attached’, such as location and number of jobs to be created, but if these conditions are met grants do not have to be repaid. Venture capital- small companies that are not listed on the Stock Exchange – ‘unquoted companies’ – can gain long-term investment funds from venture capitalists. These are specialist organizations, or sometimes wealth individuals, who are prepared to lean risk capital to, or purchase shares in, small to medium-sized businesses that might find it difficult to raise capital from other sources. This could be because of the new technology that the company is dealing in , with which other providers of finance are not prepared to get involved. Venture capitalists take great risks and could lose all of their money – but the reward can be great. The value of certain ‘high tech’ business has grown rapidly and many were financed, at least in part, by venture capitalists. Factors affecting sources of finance Costs- businesses obviously prefer sources, which are less expensive, both in terms of interest payments and administrative costs. Objective of business- businesses carefully calculate involved risks, heavy capital expenditures and revenue expenditures etc. these objectives helps to select best suitable source of finance to the business. Time- how long the finance is required for, will greatly influence the type used. Legal status of the business- sole trader is limited in their source of finance as compare to private and limited companies. Financial situation of the business- the health of the business is an important factor. Lenders are more willing to lend to a business that is well established and with a known ‘trade record’. Interest rate- as interest rate falls; the stock market usually raises as investor invest more money from bank to the stock market. Economic climate- when the economy is growing, profit grows due to growth in demand, which intern leads to greater investment and growth. 5AS.3 forecasting cash flow and managing working capital

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Sa’adat Ali Mughal CASH FLOW Cash is the most liquid of all business assets. A business’ cash is the notes and coins it keeps on the premises and any money it has in the bank. The role of cash in the business is very important and can be shown through the cash flow cycle. Cash Flow Statement It is a prediction of all expected receipts and expenses of a business over a future time period which shows the expected cash balance at the end of each month. Business draw up cash flow forecast statement to help, control and monitor cash flow in business. A statement can help to identify in advance when a business might wish to borrow cash. When trying to raise finance, lender often insists that business support their application with documents showing business performance and outlook. A cash flow forecast statement would help to indicate the future outlook for the business. It helps to classify aims and improve performance. During the end of the financial year a business should make comparisons between the predicted figures in the cash flow forecast statement and those which actually occur. By doing this it can find out where problems have occurred. Example: Cash flow forecast statement for ABC pvt. Ltd. for a 6 month period Jul Receipts Cash sales Capital introduced Total receipts Payments Goods for resale Leasing charges Motor expenses Wages VAT Loan payment Telephone Miscellaneous Total payments Net cash flow Opening balance Closing balance 452 452 150 20 40 100 35 20 365 87 (33) 54 Aug 340 340 180 20 40 105 35 12 20 412 (72) 54 (18) Sep 450 300 750 150 20 40 105 187 35 20 557 193 (18) 175 Oct 390 390 180 20 40 105 35 20 400 (10) 175 165 Nov 480 480 220 20 40 125 35 14 20 474 6 165 171 (£ 000) Dec 680 680 250 20 40 125 198 35 20 688 (8) 171 163

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Business Accounting_________________________________________ Method of Improving Cash flow Stock- the longer a product stays in shortage, the longer the debtors take to pay, the less able the company is to reinvest the cash. Debtors- a business must use careful credit to customers. They should reduce, at least, credit periods given to customers. Creditors- increasing the time it takes to pay creditors requires understanding suppliers and the business may well lose out on a discount which has been offered by the supplier for prompt payment. Dropping Prices- this ought to generate grater revenue, although the credit terms will also be significant in this respect. Leasing as opposed to buying- when a business wants to keep cash within the business, it may chose to lease assets, thereby not needing to find the principal sum for outright purchase. Subcontracting- instead paying the workforce regularly wages, the business may decide to contract out work to a company, which will allow a generous credit period. Selling fixed or idle assets- only those, which are earning for a business, should be kept. Sometimes a business will sell its headquarters and move into rented accommodation in order to improve cash flow. Control of working capital- it is the amount of money needed to pay for day-to-day trading of a business (wages, utility charges, components to make product). The managers should produce production time, shortage time of finished goods and stock holding (JIT), the time it takes for customers to settle their bills. Why do businesses prepare cash flow forecast statement A statement can help to identify in advance when a business mighty wishes to borrow cash. At the bottom of the statement the monthly closing balance are shown clearly. This will help to identify when extra funds will be needed. • When trying to raise finance, lenders often insist that businesses support their applications with documents showing business performance, outlook and solvency. A cash flow forecast statement helps to indicate the future outlook for the business. It is also common practice to produce a cash flow forecast statement in the planning stages of setting up a business. • Careful planning helps to clarify aims and improve performance. It is a key part of planning process. • By comparing predicted figures with actual one a business can find out where problems have occurred. It also identify possible reasons of these differences. Problems with cash flow forecast statement • In practice, little new information is shown in the statements. The law encourages disclosure but does not enforce it. • Small limited companies are not bound to publish a cash flow statement because they are owner managed. However, medium sized firms are bound to 10

Sa’adat Ali Mughal publish. This seems to lack a little logic since most medium sized firms are also owner managed. Cash flow statements, like funds flow statements, are based on historical information. It is argued that cash flow statements based on future predictions are more useful. A profitable business may run out of cash which a business recording a loss may have a cash surplus for that period. How is this possible? Explain. Ans. The answer to such situations ties in the fact that cash flow of a business is not the same as profit. The profit or loss of a business takes into account all expenses incurred or incomes received during a financial year only, whether they are on credit or even if they are totally unrelated to cash. Cash on the other hand is the inflow and outflow of money from banks or that within the premises of the business, regardless of it being received for past years’ sales or being paid for the next year’s expenses. Therefore, this leaves a gap between the cash of the business and its profit or loss. Some of the reasons will be illustrated blow. Firstly, the business may give credit period to its customers. This means that not all sales are on cash. E.g. a business selling goods worth $500,000 and incurring costs of $250,000, would make a profit of $250,000. However, if it only receives cash for $200,000 worth of goods, then this means that it has run out of cash. Then during the year a business may receive cash for sales of previous years. This would increase the cash of the business but have no affect on the profitability of the business. If in the current year the sales of business are less than its costs, then a loss is made while because of cash inflow of from debtors, the business is in possession on excess amounts of cash. Also if the owners of the business introduce more cash into their loss-making business, then this would increase the capital of the business but would have no effect on the profit or loss of the business. Again the liquidity of the business could be good while profitability is poor. Then the purchase and sale of fixed asset also has no effect whatsoever on the profit or loss of a business. A loss making business may sell its fixed asset which could considerably increase its cash balance depending on value of asset. On the other hand, a very profitable business may invest too much of its cash into the purchase of a fixed asset, causing it to run out of cash i.e. becoming illiquid. The sale of fixed asset an only have a very limited affect on profit or loss which is if its sale incurs a loss or profit depending on how much above or below net book value it was sold. Depreciation is another aspect which affects the profit of a business as it is an expense depicting fall in value of asset. If a very large amount of depreciation is incurred then this could cause the profit to drop considerably. However, the ash balance won’t be affected and so a large surplus of cash remains. A business can also pay its expenses like rent or advertising or interest in advance. These are prepayments for the upcoming year. They would lower the amount of cash available to business but such prepayments are not included in profit and loss account as these expenses haven’t been faced by the business. The business may also make credit purchases i.e. not pay the cash right away but after some time. These purchases would be recorded as costs in the profit and loss account

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Business Accounting_________________________________________ and would lower the profit figure. However, as business hasn’t paid yet so the cash would remain within the business. The same is true for accruals. They are expenses incurred during a financial year but not yet paid for like the wages and salaries of workers. These would be included in profit and loss account and if a large amount of such expansion are incurred then the business may make loss. However, it could have a strong liquidity position as it still has a lot of cash left which wasn’t paid yet for expenses. 5AS.4 Costs DIFFERENT WAYS TO CATEGORIZE COSTS Costs can have different relationships to output. Costs also are used in different business applications, such as financial accounting, cost accounting, budgeting, capital budgeting, and valuation. Consequently, there are different ways of categorizing costs according to their relationship to output as well as according to the context in which they are used. Following this summary of the different types of costs are some examples of how costs are used in different business applications. FIXED AND VARIABLE COSTS The two basic types of costs incurred by businesses are fixed and variable. Fixed costs do not vary with output, while variable costs do. Fixed costs are sometimes called overhead costs. They are incurred whether a firm manufactures 100 widgets or 1,000 widgets. In preparing a budget, fixed costs may include rent, depreciation, and supervisors' salaries. Manufacturing overhead may include such items as property taxes and insurance. These fixed costs remain constant in spite of changes in output. Variable costs, on the other hand, fluctuate in direct proportion to changes in output. Labor and material costs are typical variable costs that increase as the volume of production increases. It takes more labor and material to produce more output, so the cost of labor and material varies in direct proportion to the volume of output. The direct proportionality of variable costs to level of output may break down with very small and very large production runs. In addition, some costs are considered mixed costs. That is, they contain elements of fixed and variable costs. In some cases the cost of supervision and inspection are considered mixed costs. DIRECT AND INDIRECT COSTS Direct costs are similar to variable costs. They can be directly attributed to the production of output. The system of valuing inventories called direct costing is also known as variable costing. Under this accounting system only those costs that vary directly with the volume of production are charged to products as they are

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Sa’adat Ali Mughal manufactured. The value of inventory is the sum of direct material, direct labor, and all variable manufacturing costs. Indirect costs, on the other hand, are similar to fixed costs. They are not directly related to the volume of output. Indirect costs in a manufacturing plant may include supervisors' salaries, indirect labor, factory supplies used, taxes, utilities, depreciation on building and equipment, factory rent, tools expense, and patent expense. These indirect costs are sometimes referred to as manufacturing overhead. Under the accounting system known as full costing or absorption costing, all of the indirect costs in manufacturing overhead as well as direct costs are included in determining the cost of inventory. They are considered part of the cost of the products being manufactured. Total cost total cost (TC) describes the total economic cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labor and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term, such as buildings and machinery. Total cost in economics includes the total opportunity cost of each factor of production in addition to fixed and variable costs. The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known as the marginal unit variable cost. Average cost Average cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period considered (increasing production may be expensive or impossible in the short term, for example). Marginal Cost (MC) The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Marginal cost and average cost can differ greatly. For example, suppose it costs $1000 to produce 100 units and $1020 to produce 101 units. The average cost per unit is $10, but the marginal cost of the 101st unit is $20 Problems of classifying costs The classification of costs is not always straightforward. In some case the same business cost can be classified in several ways. For example, the earning of a full time

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Business Accounting_________________________________________ administrative assistant may be classified as a fixed cost, if they do not vary with out put, and indirect cost, if they are not associated with a particular product. The cost of a worker earning piece rates might be a direct cost if they can be associated with a particular product and a variable cost if they rise as the out put of the worker increases. Another problem relating to the costs concerns the allocation of indirect costs. When calculating the cost of producing particular product it is necessary to allocate indirect costs to each of the different products a business manufactures. The way in which costs are classified will depend on the purposes for which the classification is being undertaken and the views of the management team. How cost can be used for pricing decision? The roll of costs in price setting varies widely among individuals. In some industries prices are determined almost entirely by market forces. An example is agricultural industry, where grain and meat prices are market driven. To make profit formers must produce at a cost below market price. In other industries managers set price at least partially on the basis of production cost. For example, cost based pricing is used in aircraft, household appliance and gasoline industries. Prices are set by adding mark up to production cost. For example if $10000 incurred to produce one aircraft and the manufacturer wants a 40% markup on aircraft, then its price will be Cost Markup $10000 40% 10000*40% 4000 Sales price = 10000+4000 14000 How analysis of costs can help in the calculation of payment for resources Cash flow statement is prepared on the basis of projected or forecasted data. This all information is gathered from cost data.e.g. Production and sales staff say that during next year 10000 units will be produced and sold. These 10000 units will describe how much material will be required and when and how much labor and other overheads required. This is helpful for payment of resources against material, labor and other overheads BREAK-EVEN ANALYSIS The level of sales or output where total costs are exactly the same as total revenue is called the break-even point. For example, if a business is producing 100 units at total cost of $5000- and sell them @ $50 each total revenue will be equal to total cost i.e. $5000Firms use break-even analysis to • Calculate in advance the level of sales needed to break-even. • See how changes in output affect profit. • See how changes in price affect the break-even point and profit. • See how changes in cost affect break-even and profit. = = =

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Sa’adat Ali Mughal Calculating break-even 1 Using contribution It is simplest way to calculate break-even point. Contribution is the amount of money left over after the variable cost per unit is taken away from selling price. This method is possible only if firm exactly knows the value of its fixed cost, variable cost and prices it will take. For example, a company is producing chairs and has Fixed cost = $60,000Variable cost = $40- per chair Selling price @ $100- each Solution: Contribution = Selling price – Variable cost = 100 – 40 = $60 Break-even = fixed cost / contribution =60,000 / 60 = 1,000 chairs Therefore the company will be at break-even point when 1000 chairs are sold. 2 Using total revenue and total cost By using data from previous example Total cost = Fixed cost + Variable cost = 60,000 + 40 × Q (where Q is the quantity sold) Total revenue = Selling price × Quantity sold = 100 × Q Total cost = Total revenue (according to the definition of B.E.P) 60,000 + 40 × Q = 100 × Q 100 × Q – 40 × Q = 60,000 60 × Q = 60,000 Q = 60,000 / 60 = 1000 Therefore the company will be at break-even point when 1000 chairs are sold. The quantity is same in both methods, therefore break-even quantity is correct. 3 Profit and loss Total cost and total revenue equation can be used to calculate the amount of profit or loss the firm will make at particular level of output. At any level of output below the break-even point the firm will make the loss. Output above the break-even point will definitely produce profit. Therefore if the same company is producing 1300 chairs then: Profit = Total revenue – Total cost (fixed + variable) = (100 × 1300) – [60,000 + (40 × 1300)] = 130,000 – 112,000 = $18,000-

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Business Accounting_________________________________________ 4 Break-even chart Graphs are quite useful to calculate break-even point. It can be calculated by plotting total revenue and total cost equations at same graph. This is also known as break-even charts.

The break-even chart shows the following points • Value of total revenue over a range of output. • Value of total cost over a range of output. • Some break-even charts show the level of fixed cost over a range of output. • On the graph where total revenue curve cuts the total cost curve is called break-even point. • At the same level of output below the break-even point losses are made. This is because total cost is greater than total revenue. • At the same level of output above the break-even point profit is made. The profit will be increased with output. • At low level of output fixed cost represent large proportion of total cost. As output rises, fixed cost becomes a smaller portion of total cost. • The profit at a particular level of output is shown by the vertical graph between total cost and total revenue equation. The margin of safety (M.O.S.) It is important to know that by how much sales could fall before a loss is made. This is known as M.O.S. It refers to the range of output over which a profit can be made. The MOS can be identified on the break-even chart by measuring the distance between break-even level of output and the current (profitable) level of output. From figure if the company is producing 1200 chairs and the break-even point is 1000 chairs, the margin of safety is 200 chairs. This means that output can fall by 200 chairs before a loss is made. Businesses prefer to operate with a large margin of safety. This means that if sales drop they still might make some profit. With a small MOS there is a risk that the business is more likely to make loss if sales fall. Margin of Safety = Current Output – Break even output Advantages of break-even point With the evaluation of break-even analysis a firm can set his pricing strategy i.e. skimming or penetrating etc. higher the prices means business will break-even at a lower level of output. A rise in fixed costs causes total cost to increase by the same amount at every level of output. As a result the break-even level of output rises. 16

Sa’adat Ali Mughal An increase in variable costs will increase the gradient of the total cost function and therefore the break-even level of output will also rise. Limitations to break-even analysis Break-even analysis has some limitations while taking business decisions, because most of the values are based on assumptions. For example, • It assumes that all output is sold and no stock is held. • The break-even chart is drawn for a given set of conditions. It cannot cope with sudden fluctuations. • Break-even analysis will be effective with the reality and accuracy of data. 5AS.5 Accounting fundamentals PUBLISHED ACCOUNTS Public limited companies must publish their accounts by law. The main users of published company accounts The accounting has a key role as a communicator of information, presenting it to the rest of the management team. There are various internal and external groups of people who are interested in its financial information. Internal users of accounting information Business managers – to take decisions on daily business and to arrange finance Workforce – to check profitability as wages and house are associated with it Owners – calculate profitability and status of business of the business included assets and liabilities. External users Government – for employment and wage rates Tax collectors – to access profile of the business and calculate tax Lending Institutions – Banks – growing ratio Suppliers – for performance of the business, doubtful debts, ability to pay etc Investors – profitability so that dividend and liquidity could be accessed Communities as a whole Competitors – status of business The annual report and accounts documents published by a plc contain not only its final accounts, but also a lot of other information. This includes: • A financial highlights summary. • The chairman’s statement and statement by chief executive running a broad outline of the companies achievements in the year. • The detailed financial or operating (trading) revenue. • The director’s report on the company’s performance. • The actual final accounts (Profit and loss account, and balance sheet, plus a cash flow statement), together with notes that explain these accounts. • The auditors report confirming that the accounts are fair. • A summary of the last five year’s financial performance.

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Business Accounting_________________________________________ Financial & Management accounting The process of accounting can be divided into two board areas. Financial Accounting- this is concerned primarily accuracy of the record-keeping process. A financial accountant will assure that an organization’s accounts bear a true and fair view of businesses activities and those they comply with the precision of the company’s acts. Final accounts provide statements called final accounts, which are handed to shareholders who will then know how well the directors, or ‘stewards’ have performed on their behalf. From final accounts, ratios and other figures can be extracted which can provide fairly precise indicators of an organization’s performance. Such knowledge will help to influence the decision that has to be made. Management accounting- though financial accounting is important; it deals with the past and views the organization as a whole. Management accounting is concerned with providing information for managers so that they can plan, control and make decisions about future activities. It involves guiding an organization in a particular direction so that it can achieve its objectives. Business operation can be closely monitored to ensure that processes, products, deportment and operations are managed efficiently.

What that published accounts contain 1 Balance sheet

The balance sheet represents a valuation of what the business owns (assets) and owes (liabilities) at any one time. In effect, it is a snapshot of the business’s wealth, reported at the end o its financial year. It keeps information about the assets, liabilities and capital of business. The Structure of Balance Sheet At the start of every balance sheet there will be reference to a date, which will immediately distinguish it from the profit and loss account. The title will state Balance Sheet for ABC plc as at 31/12/00, meaning that this balance was accurate on that particular date. The profit and loss, by contrast, refers to the entire year. In balance sheet, assets will then be grouped separately from liabilities.

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Sa’adat Ali Mughal a) Fixed assets They are assets with a life span of more than one year. Tangible Fixed Assets- it includes all visible equipments/things, e.g. land, building, plant and machinery. Intangible Fixed Assets- patents are bought by the business on a means of protecting its investment in a new product. Good will- when one company buys another, it may pay more then the value of its assets. It appears only when one business takes over another. b) Current Assets These are assets that are likely to be changed into as quickly as possible. It allows the business to operate on day-to-day basis and is short-term assets. It includes Stock- this includes new materials work-in-progress and finished goods. Debtors- these represent the `customers who owe the business money. As with stock, the business will always encourage debtors to pay because debtors are effectively holding the company’s money in their bank account. Cash- the most liquid of assets; a business will need to keep cash flowing through the business. c) Current Liabilities These are debts that have to be repaired within 12 months. It includes money owed to Suppliers, utility bills, Corporation tax, dividends and Bank overdraft etc. d) Net Current Assets/Working Capital It can be found by subtracting current assets from current liabilities. Working capital = Current assets - Current liabilities Total Assets less Current liabilities = (fixed assets + current assets) - current liabilities e) Long Term liabilities They represent money, which the business owes, but does not need to repay within the next 12 months. Mortgage- normally used to purchase property, using the property as security in case the business cannot repay either the interest or the original (principal) sum. Debenture- a private investor lends money to the business and receives interest on a long-term basis. It is issued by plc. Net Assets =fixed asset + net current asset - long term liabilities

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Business Accounting_________________________________________ 0 = (total assets - current liabilities) - log term liabilities f) Capital and Reserves/Capital Employed/Share Holder’s Fund The value of this figure is equal to the value of net assets. These are liabilities for a business-money that it owes. Shareholder’s funds include the money that is put into the business by people purchasing shares. It is the value of shares when first sold rather than the current market value. Retained profit is profit that the business has made in previous years. It is money, which is owed by owners. However, it has been retained in the business to buy equipment or to help cash flow rather then distributing it as a dividend. Format of Balance Sheet Vertical format- Plc must produce balance sheet in vertical format, with assets at the top and liabilities at the bottom. Horizontal format- the liabilities are mentioned at left and assets on the right. Now a day this format is not in practice. Vertical Format Fixed assets. Current assets. Current liabilities Net current assets. Long-term liabilities. Net assets. Shareholder’s funds. Liabilities Shareholder’s funds m Long-term liabilities. m Current liabilities. Total liabilities 123m £ 60 m £ 40 m £ 23 m £123m Total assets £ £ 70 m £ 53 m £ 23 m £ 30 m £ 40 m £ 60 m £ 60 m Horizontal Format Assets Fixed assets. Current assets £ 70 £53

The use of balance sheet The balance sheet has a number of users for a business. • In general, it provides a summary and valuation of all business assets, capital and liabilities. • The balance sheet can be used to analyze the asset structure of a business. The business has been spent on different types of assets. • The balance sheet can also be used to analyze the capital structure of the business. • Looking at, the value of working capital can indicate whether a firm is able to pay its everyday expenses or is likely to have problems. 20

Sa’adat Ali Mughal • A balance sheet may provide a guide to a firm’s value. Generally, the value of the business is represented by the value of all assets less any money owed to outride agents such as banks or suppliers.

Limitations of Balance Sheet • The value of money assets listed in the balance sheet may not reflect the amount of money the business would receive if it were sold. • Many balance sheets do not include intangible assets. Assets such as goodwill, brand name and the skills of the workforce may be excluded because they are difficult to value or could change suddenly. If such assets are excluded, the value of the business may be understated. • A balance sheet is a static statement. Many of the values for assets, capital and liabilities listed in the statement are only valid for the day the balance sheet was published. After another day’s trading, many of the figures will have changed. This can restrict its usefulness. • It can be argued that a balance sheet lacks detail. Many of the figures are totals (e.g. tangible assets) and are not broken down. Example (sample) ABC Ltd. Balance Sheet as at 31 August 2004. (Amount in £ 000) Fixed Assets Premises Fixtures & fittings Equipment Current Assets Stocks Debtors Cash at bank Current liabilities Trade creditors Taxation Dividends 1200 1100 700 800 500 400 1700 200 300 200 700 _____ 1000 4000

3000

Net Current Assets Working capital (current asset – current liabilities) Total assets less current liabilities Creditors: amount (long-term liabilities) Falling due after one year Mortgage Bank loan Net Assets 1100 200

1300

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Business Accounting_________________________________________ (Total assets less current liabilities – long tern liabilities) Capital and reserves Ordinary Share Capital (2000,000 shares at £ 1 each) Retained Profit 2700

2000 700

_____ 2700

2. Profit and Loss Accounts It is a financial statement that sets out and summarizes the revenues and expenses of a business for a fixed period of time. It shows the profit or loss that the business has made. This is a summery of all the business Transactions and shows the flow of expenditures to commit time and money to a business; it also helps in the allocation of resources. The profit and loss account is split into three different accounts. a) The trading account Shows the revenues earned from selling products (Turnover) and the cost of those sales. Subtracting cost of sales from turnover gives gross profit. In turnover, goods, which have been manufactured but not sold to customers, are excluded and goods, which have been sold and payment not received are included. The turnover figure should not include VAT. Cost of sales includes all direct costs: wages, materials and production overheads. Since stock exchange levels change over the year, the cost of materials sold is found by taking: Opening Stock. Plus Purchases. = Stock available. Less Closing Stock = Cost of goods sold. Expenses generally include all the indirect costs such as selling expenses, marketing, depreciation, advertising and promotion etc. b) The profit & loss account The profit and loss account is an extension of the trading account. In practice, there is no indication where the trading account ends and the profit and loss account begins. However, over a business has calculated its gross profit it can then calculate how much profit (or loss) it has made by adding any extra income it has earned and subtracting its expenses and tax. Then non-operating income is added. It is income, which is not earned from the direct trading of company. This could include dividends from shares held in other companies, interest from deposit in financial institutions or rent from property that is let out. After subtracting interest the company gets profit on ordinary activities before tax (Net profit). c) The profit and loss appropriation account The appropriation account shows how the profit after tax is distributed. This includes dividend paid to shareholders, retained for internal use in future periods and for corporation tax.

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Sa’adat Ali Mughal Limitations of profit and loss accounts • The account shows what has happened in past. However, it may be possible to identify future trends by looking at the accounts for a longer time period. The casts flow forecast statement and other budgets may be helpful in predicting future business performance. • It is possible to disguise or manipulate financial information in the accounts. Example (sample) ABC Ltd. Profit and loss account for the year ended 31.5.2002. £ ‘000 (The trading account) Less Less Plus Turn over Cost of sales Gross profit Expenses (all indirect) Operating profit Non-operating income 800 350 450 340 110 10 120 20

Profit on ordinary activities before interest (The profit & loss account) Less Interest Profit on ordinary activities before taxation (net profit) 100 Less Taxation

33 67 35 ==

(The appropriation account) Profit on ordinary activities after taxations Less Dividends 32 Retained Profit 3. Cash Flow Statement

Cash flow forecast statement It is a prediction of all expected receipts and expenses of a business over a future time period which shows the expected cash balance at the end of each month. Business draw up cash flow forecast statement to help, control and monitor cash flow in business. A statement can help to identify in advance when a business might wish to borrow cash. When trying to raise finance, lender often insists that business support their application with documents showing business performance and outlook. A cash flow forecast statement would help to indicate the future outlook for the business. It helps to classify aims and improve performance.

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Business Accounting_________________________________________ During the end of the financial year a business should make comparisons between the predicted figures in the cash flow forecast statement and those which actually occur. By doing this it can find out where problems have occurred. Example: Cash flow forecast statement for ABC pvt. Ltd. for a 6 month period (£ 000) Jul Aug Sep Oct Nov Dec Receipts Cash sales 452 340 450 390 480 680 Capital introduced 300 Total receipts 452 340 750 390 480 680 Payments Goods for resale 150 180 150 180 220 250 Leasing charges 20 20 20 20 20 20 Motor expenses 40 40 40 40 40 40 Wages 100 105 105 105 125 125 VAT 187 198 Loan payment 35 35 35 35 35 35 Telephone 12 14 Miscellaneous 20 20 20 20 20 20 Total payments 365 412 557 400 474 688 Net cash flow 87 (72) 193 (10) 6 (8) Opening balance (33) 54 (18) 175 165 171 Closing balance 54 (18) 175 165 171 163 Method of Improving Cash flow Stock- the longer a product stays in shortage, the longer the debtors take to pay, the less able the company is to reinvest the cash. Debtors- a business must use careful credit to customers. They should reduce, at least, credit periods given to customers. Creditors- increasing the time it takes to pay creditors requires understanding suppliers and the business may well lose out on a discount which has been offered by the supplier for prompt payment. Dropping Prices- this ought to generate grater revenue, although the credit terms will also be significant in this respect. Leasing as opposed to buying- when a business wants to keep cash within the business, it may chose to lease assets, thereby not needing to find the principal sum for outright purchase. Subcontracting- instead paying the workforce regularly wages, the business may decide to contract out work to a company, which will allow a generous credit period. Selling fixed or idle assets- only those, which are earning for a business, should be kept. Sometimes a business will sell its headquarters and move into rented accommodation in order to improve cash flow. 24

Sa’adat Ali Mughal

Control of working capital- it is the amount of money needed to pay for day-to-day trading of a business (wages, utility charges, components to make product). The managers should produce production time, shortage time of finished goods and stock holding (JIT), the time it takes for customers to settle their bills. Why do businesses prepare cash flow forecast statement A statement can help to identify in advance when a business mighty wishes to borrow cash. At the bottom of the statement the monthly closing balance are shown clearly. This will help to identify when extra funds will be needed. • When trying to raise finance, lenders often insist that businesses support their applications with documents showing business performance, outlook and solvency. A cash flow forecast statement helps to indicate the future outlook for the business. It is also common practice to produce a cash flow forecast statement in the planning stages of setting up a business. • Careful planning helps to clarify aims and improve performance. It is a key part of planning process. • By comparing predicted figures with actual one a business can find out where problems have occurred. It also identify possible reasons of these differences. Cash Flow Statement This is required in the published financial accounts of public limited companies only. It shows where cash has come from and where cash has been used over the course of the past year. A cash flow statement must be shown in a standardized presentation. Note that this is not the same as cash flow forecast statement. Cash flow statement may include receipts and payments from the previous two years. Example: ABC, cash flow statement 1998 1997 £m £m Net cash inflow from operating activities 362 608 Returns on investments and servicing of finance Interest received 13 10 Interest paid (40) (39) Net cash outflow from returns on investments and servicing of finance (27) (29) Taxation paid (109) (17) Capital expenditure Purchase of tangible fixed assets (620) (462) Sale of tangible fixed assets 47 39 Net cash outflow from capital expenditure (573) (423) Equity dividends paid (80) (106) Management of liquid resources Purchase of short term investments (8) (15) Financing New loans 565 283 Payment of discount and fees on new loans (5) Repayment of loans (218) (350) Capital element of finance lease rental payment (6) Capital element of finance lease receipts 15 12 25

Business Accounting_________________________________________ Capital grants received Net cash flow from financing (Decrease)/Increase in cash 73 430 (5) 63 2 20

Problems with cash flow forecast statement • In practice, little new information is shown in the statements. The law encourages disclosure but does not enforce it. • Small limited companies are not bound to publish a cash flow statement because they are owner managed. However, medium sized firms are bound to publish. This seems to lack a little logic since most medium sized firms are also owner managed. Cash flow statements, like funds flow statements, are based on historical information. It is argued that cash flow statements based on future predictions are more useful. ANALYSIS OF PUBLISHED ACCOUNTS – RATIO ANALYSIS Under the companies’ acts, all limited liability companies are required to file copies of their accounts with their annual return to the registrar of companies. The Act specify the information that should be contained in the balance sheet and profit and loss accounts and indicate that these accounts must provide a true and fair view of the affairs of the company for the period concerned. Additional information required with the accounts includes: • Details of subsidies • Group accounts if there is a group of companies • A director’s report, which has to contain certain information • An auditors report Shareholders and debenture holders receive copies of these accounts and notice of the company’s annual general meetings. A company’s account is useful source of information about the condition of that business. Final accounts can be carefully analyzed, often by using ratios, to make comparison between one year and another. The accounts can be analyzed to look at: • Profitability/Shareholder’s ratio • Liquidity ratio • Asset usage/Financial efficiency ratio • Capital structure/Gearing ratio Why ratios are important Financial ratios can be calculated by comparing two figures in the accounts, which are related in some way. It may be one number expressed as a percentage of another. Ratios on their own are not particularly useful. They need to be compared with other ratios. There is a number of ways in which ratios can be compared. Overtime- the same ratio can be compared in two time periods for example, the current financial year and the previous one. Comparisons over time also show trends. This allows a business to decode whether or not certain aspects are improving. Interfirm comparison- businesses compare their results with others in same industries. By his they can find their strengths and weaknesses easily.

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Sa’adat Ali Mughal Interfirm comparison over time- using the two standards above we can make information comparisons overtime. This shows trends that may exist. Such comparisons are quite popular and could analyses the behavior of whole of industry, over a lengthy time period. Results and forecasts- management also wants to compare actual results with predicted results. They prepare budgets and make forecasts about the future. Decision makers also try to account for differences, which exist between the actual results and their estimates. This is called variance analysis. Types of ratios and their uses Performance/profitability ratios Performance ratio help to show how well a business is doing. They tend to focus on profit, capital employed and turnover. Stakeholders such as owners, managers, employees and potential investors are all likely to be interested in the profitability and efficiency of a business. However, when measuring performance a business must take into account its objectives. For example, a performance ratio using profit may not be appropriate if the business is pursuing another objective, such as survival. Competitors might also use performance ratios to make comparisons of performance. Return on capital employed (ROCE)- measures the return on the capital invested in the business. It expresses profit before tax and interest are taken into account as a percentage of capital employed. The advantage of this ratio is that it relates profit to the size of the business. It can be calculated by Return on capital employed = Net profit × 100 Capital employed A business having high percentage is said to be in favourable position. Net profit $m 50 500 Sales turnover $m 250 3200 Net profit margin 50/250 × 100 = 20% 500/3200 × 100 = 15.6%

Nairobi press Kingston press

Points to note: • The profitability gap between these two businesses has narrowed. Whereas the difference in gross profit margins was substantial, the net profit margins are much more similar. This suggests that Nairobi has relatively high overheads compared to sales, when contrasted with Kingston. • Kingston could narrow the gap further by reducing expenses whilst maintaining sales or by increasing sales without an increase in overhead expenses. • As with all ratios, a comparison of results with those of previous years would indicate whether the performance and profitability of a company were improving or worsening. Gross profit Margin- this shows the gross profit made on sales turnover.

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Business Accounting_________________________________________ Gross profit Margin = Gross profit × 100 Sales turnover An improved gross profit margin may result of an increase in turnover relative to costs of sales or a fall in costs of sales as a percentage of turnovers. High gross profit margins are preferable to lower ones. However, they vary significantly according to industry type. As a rule, the quicker the turnover, the lower the gross profit margin. A car retailer with a slow turnover is likely to have a higher gross profit margin than a super market with a higher turnover. 2002 gross profit $m 125 800 2002 sales turnover $m 250 3200 Gross profit margin 125/250 × 100 = 50% 800/3200 × 100 = 25%

Nairobi press Kingston press

Points to note: • Kingston’s gross profit margin could be lower because it is adopting a low pricing strategy to increase sales. • Kingston could increase its ratio by reducing the cost of sales while maintaining revenue – say, by using a cheaper supplier or by increasing revenue without increasing cost of sales – say, by raising prices but offering a better service. • The gross profit margin is a good indicator of how effectively managers have ‘added value’ to the cost of sales. It is difficult to compare the ratios of firms in different industries because the level of risk Net Profit Margin- this ratio helps to measure how well a business control its overheads. If overheads are low then there will be less of difference between the gross and net profit margins. This is because net profit is gross profit minus overheads. The net profit ratio can be calculated by: Net Profit Margin = Net profit × 100 Turnover Again, higher profit margins are better than lower ones. The net profit margin is only suitable for comparisons over time. Interfirm comparison could be misleading because different businesses have different patterns of spending, which affect this ratio. Net profit $m 50 500 Sales turnover $m 250 3200 Net profit margin 50/250 × 100 = 20% 500/3200 × 100 = 15.6%

Nairobi press Kingston press Points to note:

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Sa’adat Ali Mughal • The profitability gap between these two businesses has narrowed. Whereas the difference in gross profit margins was substantial, the net profit margins are much more similar. This suggests that Nairobi has relatively high overheads compared to sales, when contrasted with Kingston. Kingston could narrow the gap further by reducing expenses whilst maintaining sales or by increasing sales without an increase in overhead expenses. As with all ratios, a comparison of results with those of previous years would indicate whether the performance and profitability of a company were improving or worsening.

• •

Liquidity This refers to the ability of a firm to convert its long-term or current assets into cash to cover payments as and where they arise. Stocks are the last liquid of the current assets because they must first be sold (probably on credit) and the customer provided with a credit period. As a result, there is a time laps before stocks are converted to cash. It is the responsibility of the company to ensure that it can meet debts likely to arise in the near future. Current liabilities are items that have to be paid for in the short period. Liquidity ratios This illustrates the solvency of a business- whether it is in a position to repay its debts. They focus on short-term assets and liabilities. Creditors are likely to be interested in liquidity ratios to asses whether they will receive money that they are owed. Moneylenders and suppliers, for examples, will be interested in how easily a business can repay its debts. Potential investors might also have an interest in liquidity ratios for the same reason. In addition, managers might use them to aid financial control, i.e. to ensure that they have enough liquid resources to meet debts. Effective cash management is essential for business survival. Companies must have access to liquid assets- assets that can be turned easily into cash, to meet day-to-day payments. Liquidity ratios are concerned with a business’s ability to convert its assets into cash. Two of the ratios already considered, stock turnover and the debt collection period, give some indication of a firm’s liquidity. If these ratios are poor then it means that money is tied up in stock and debtors. It is, therefore, not immediately available to make payments. Two other ratios can be used to asses liquidity. Current Ratio- The current ratio shows the relationship between the current assets and the current liabilities. Current ratio = Current assets Current liabilities It is suggested that a business should aim for a current ratio of between 1.5:1 and 2:1. A business operating below 1.5:1 may face working capital problems. For example, a business may be overtrading or over borrowing, which could result in difficulties when paying immediate bills. Operating above 2:1 may suggest that too much money is tied up unproductively. Current assets $m 29 Current Current ratio liabilities $m

Business Accounting_________________________________________ Nairobi press Kingston press 60 500 30 3200 2.1 1.0

Points to note: • From these results it is clear that Nairobi press is in a more liquid position than Kingston press. The former company has twice as many current assets as current liabilities. For every $1 of short-term debts it has $2 of current assets to pay for them. This is relatively ‘safe’ position – indeed, many accountants advise firms to aim for current ratios between 1.5 and 2.0. • The current ratio of Kingston press is more worrying. It only has $1 of current assets to pay for each $1 of short-term debts. It could be in trouble in the (unlikely) event that all of its short-term creditors demanded repayment at the same time, especially if some of its current assets could not be converted into cash quickly. For this reason, the next ratio, the acid test, is often more widely used. • Very low current ratios might not be unusual for businesses, such as food retailers, that have regular inflow of cash, such as cash sales, that they can rely on to pay short term debts. • A low current ratio might lead to corrective management action to increase cash held by the business. Such measures might include: sale of redundant assets, canceling capital spending plans, share issue, or taking out long-term loans. Acid test/quick ratio- the acid test or quick ratio is a more severe test of liquidity. This is because it does not treat stocks as a liquid asset. Stocks are not guaranteed to be sold; they may become obsolete or deteriorate. They are therefore excluded from current assets in the calculation. Acid test ratio = Liquid assets (current assets – stocks) Current liabilities A quick ratio of 1:1 is desirable. This suggests that the company has adequate liquid resources according to this measure. Liquid assets $m 30 180 Current liabilities $m 30 240 Acid test ratio 1 0.75

Nairobi press Kingston press

Points to note: • Results below 1 are often viewed with caution by accountants as they mean that the business has less than $1 of liquid assets to pay each $1 of short-term debts. Therefore, Kingston press may well have a liquidity problem. • The full picture needs to be gained by looking at previous year’s results – for example, last year, Kingston press had an acid test of 0.5. This means that over the last 12 months its liquidity has actually improved and this is more favorable than of its results last year had been 1, showing a decline in liquidity in the current year.

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Sa’adat Ali Mughal • Firms with very high stock levels will record very different current and acid test ratios. This is not a problem if stock levels are always high for this type of business, such as furniture retailer. It would be a cause for concern for other types of businesses, such as computer manufacturer where stocks lose value rapidly due to technical changes. Whereas selling stocks for cash will not improve the current ratio – both items are included in current assets – this policy will improve the acid test ratio as cash is a liquid asset but stocks are not.

•

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Business Accounting_________________________________________

5AL.4 Costs The use of cost information (approaching to costing) 1 Contribution or full costing It can help to calculate indirect cost of individual product from a range of products’ as direct cost is same and indirect cost varies from product to product. For example, for products A and B Total number of units =100000 Indirect cost =£300000 Direct cost =£500000 (200000 for A and 300000 for B) Solution: Contribution to total direct cost A Contribution to total direct cost B =200000/500000 ×100 =40%

=300000/500000 ×100 =60% (This method implies that to calculate indirect cost same percentage ratios will be applicable) Therefore. 40% of indirect cost of A 60% of indirect cost of B Therefore, total cost of A =300000×40% =£120000 =300000×60% =£180000

=total indirect cost of A + total direct cost of A =120000 + 200000 =£320000

Similarly, total cost of B

=Total indirect cost of B + Total direct cost of B =180000 + 300000 =£480000 It could result in misleading costing because the allocation of indirect cost is not based on any actual indirect costs incurred. 2 Absorption costing This includes all direct and indirect costs. This apportions (divide) all indirect costs more accurately and covers all errors involved in full costing method. For example, Costs like rent, heating lighting is dividing according to area, volume or time in a building, that a particular operation occupies. Personnel (labour) expenses are also divided according to the number of people employed in a particular operation. Depreciation and insurance costs are also divided according to book value. For example: A factory is producing three units A B C in a product range.

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Sa’adat Ali Mughal Indirect costs (amount in £) Rent =12000 Selling =18000 Overheads =24000 Administration=4000 Number of each unit produced = 1000 units. Direct costs (amount in £) Labour Material A 2 3 B 2 4 C 4 4 Total 8 11 Fuel 1 2 2 5 Total direct cost 6 8 10 Factory time (hrs) 1 3 2 6

Solution: Rent divided to A = 12000 × 1/6 × 1/1000 = £2. (Rent is divided to the production of one unit of A) Similarly, selling cost of A = 18000 ×1/3 × 1/1000 =£6. Overheads =24000 × 1/3 × 1/1000 = £8. Administration cost for A =4000 × 2/8 × 1/1000 =£1. (Administration cost is divided according to amount of labour used to make each unit) Total cost for the production of A=direct+rent+selling+overheads+admin. =6 + 2 + 6 + 8 + 1 =£23. Total costs for B and C will be calculated in the same way. 3 Special order decision This method is used if a firm receives an order with different quantities and selling prices. By using this method the company evaluates the feasibility of the order and takes decision whether to accept the order or not. Example: A firm is producing boats and its costs are as follows Fixed cost =500,000/p.a. Variable cost =18,000/boat Price of each boat =23,000/boat Last year’s sale =120boats Unexpectedly, the business receives an order from a new customer for 10 boats and he is willing to pay £19,000 each. Solution: Generated profit in last year = revenue – cost (fixed + variable) =120×23000 – (500,000 + 120×18,000) =£100,000. The contribution for new order = revenue – variable cost 33

Business Accounting_________________________________________ =10 × 19,000 - 10 × 18,000 =£10,000. Which is feasible (revenue is greater then cost). Note that only variable cost will be considered only because the fixed costs have been covered by production of original 120 boats. Sale of extra 10 boats @ 19000, each will help to rise profit to £110,000 (previous plus present profit). If company sale all 130 boats @ £19,000 each it would make a loss of £370,000. [130×19,000 – (500,000 + 130 × 18,000)]. A number of non-financial factors might also be considered before accepting the order i.e. capacity, customer response, future orders, current utilization and retaining customer’s loyalty. 4 Standard costing Standard costs are those costs, which a business expects to incur for particular activity when they are carried out efficiently. They are known in advance. Standard costing involve calculating the expected costs of an activity and comparing these with the actual costs incurred. The difference between the standard cost and the actual cost is called variance. It is used to monitor and control costs. Such a variance is likely to result in the business carrying out investigations to determine why the actual cost of manufacturing the product is higher than expected cost. By variance a business can quickly identify poor performance or inconsistencies, which might be indicated by large variances. Example: Material Components Labour Indirect costs Total Description Standard cost 90 120 350 140 700 Actual cost 90 120 400 (variance of £50 more) 140 750 (variance of £50 more)

5 Marginal costing This is the cost of increasing the output by one more unit. In marginal costing, decisions are based upon the value of the contribution that a product or process makes to the indirect costs (likely fixed costs) and profit (i.e. it allocate direct cost only). Because contribution cost is the marginal/direct cost less selling price.

For example: Product A Direct material Direct labour Other direct costs Marginal cost Contribution 30,000 5,000 5,000 20,000 10,000 3,500 3,000 11,000 14,000 Product B 25,000

It shows product A contributes 10,000 and product B 14,000 to fixed cost. If total indirect (fixed) cost were £12,000 then profit would be: Total contribution =24,000 Less indirect (fixed) cost =12,000 34

Sa’adat Ali Mughal Profit =£12,000.

6 The closing-down point When revenue is incapable of covering variable cost the firm should close down. For example, Open Closed Fixed cost 1,000 1,000 Variable cost 500 n.a. Total cost 1,500 1,000 Revenue 700 no Loss (800) (1,000) For short run if shop is remained open some revenue is generated which minimize loss but by closing down, revenue becomes zero. 7 Profit centers It is part of a business where costs and revenues can be clearly defined. Profit centers can be used when a business consists of several clearly identified operations. For example, Shop A B C D and E is operating/running by one owner. A B C D E Total Total revenue 32,000 21,000 12,000 31,000 37,000 133,000 Total cost 21,000 16,000 14,000 24,000 23,000 98,000 Profit/loss 11,000 5,000 (2,000) 7,000 14,000 35,000 Therefore, the business is in profit overall. • • • • Advantages of profit centers Performance of specific operations can be monitored. Competition is generated between each center. Staff is equally motivated. Loss making operations can be clearly identified and action taken.

5AL.5 Accounting fundamentals No topic beyond AS level 5AL 5AL.6 Budgets BUDGETS AND BUDGETING A budget is a quantitative economic plain prepared and agreed in advance. Budget can be divided into different categories due to different methods of setting budget. These methods are given as under. Incremental budgeting- also known as the ‘last year plus a bit’. This is the most common method. It is easy to understand. The problem is that it is inflexible and does not allow for unexpected events.

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Business Accounting_________________________________________ Sales-related budgeting- expenditure is allocated in proportion to sales. This is often used to determine promotional expenditures. Task-base budgeting- is based on finding the best way of achieving particular objective. The activities are coasted and the amount agreed becomes the budget. Competitor’s parity budgeting- expenditure is allocated in line with competitor’s spending. Flexible budgets- is designed to change as business changes. For example, the sales budget may be altered if there is sudden increase in demand resulting in much higher sales level. Operating budgets- plain the day-to-day use of resources. Capital budgets- plain the capital structure and the liquidity of the business over a long period of time. Budget allocation/level of expenditures On of the most difficult question facing the marketing manager is how to spend the available resources. The level of expenditure will depend on many factors. These include • The amount available • The likely return from the expenditure type of product • Product life cycle • Type of customer Process of setting budgets

The benefits of budgets • Budgets provide a means of controlling income and expenditures. They regulate the spending of money and draw attention to losses, waste and inefficiency. • They act as a ‘review’ for a business, allowing time for corrective action. • Budget can emphasise and clarify the responsibilities of executives.

36

Sa’adat Ali Mughal • • • They help the coordination of business and improve communication between departments. Budgets provide clear targets. Budget help to ensure that capital is usefully employed by checking that the capital employed is consistent with the planned level of activity.

The drawbacks of budgets • If the actual business results are very different from the budgeted ones then the budget can loose its importance. • If budgets are too inflexible then it is possible that the business could suffer. • This could result in poor motivation and targets may be missed. VARIANCE ANALYSIS It is vital that a business regularly reviews and revises its budgets. Any discrepancies that exist between the budgeted figures (i.e. for sales, costs, etc) and the actual results are known as variances. The business needs to investigate these variances and attempt to establish the reasons for their existence - this is known as budgetary control. Variances can be either positive or negative. Positive (i.e. favourable) variances occur where the actual amount of money flowing into the business is more than the budgeted figure, or where the actual amount of money flowing out of the business is less than the budgeted figure. This could be due to a variety of reasons, including an increase in the demand for the products of the business, a reduction in the labour costs, or competitors ceasing to trade. Negative or adverse (i.e. unfavourable) variances occur where the actual amount of money flowing into the business is less than the budgeted figure, or where the actual amount of money flowing out of the business is more than the budgeted figure. This could be due to a variety of reasons, including price discounts on the products of the business, an economic recession or a rise in labour costs. For example, consider the following data which has been extracted from the budgeted figures and the actual results for a business: Budget Actual Variance £ 000 £ 000 £ 000 % Sales revenue 500 605 105 F 21 F Raw materials 200 220 20 A 10 A Labour costs 100 110 10 A 10 A Advertising 50 45 5F 10 F Delivery 20 20 0 0 Utility bills 15 16 1A 7A The business has six budget-heads listed. It budgeted to have sales revenue of £ 500,000 for the year, but actually managed to sell £ 605,000 of products. This leaves a variance (the difference between the budgeted sales revenue and the actual sales revenue) of £ 105,000 (or 21% of the budgeted figure). This is a favourable variance (F), because it results in the business receiving more revenue than it budgeted for. 37

Business Accounting_________________________________________ The business budgeted to purchase £ 200,000 of raw materials. It actually spent £ 220,000 on raw materials. This is a variance of £ 20,000 (or 10% of the budgeted figure). This is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for. Similarly, the business budgeted to spend £ 100,000 on its labour costs (wages and salaries). It actually spent £ 110,000 on its labour costs. This is a variance of £ 10,000 (or 10% of the budgeted figure). Again, this is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for. The business budgeted to spend £ 50,000 on its advertising for the year, but it actually spent only £ 45,000. This is a favourable variance (F) of £ 5,000 (or 10% of the budgeted figure), since it results in the business spending less money than it budgeted for. The distribution budget was £ 20,000 and the actual cost of distributing the products was £ 20,000. Therefore there is no variance, since the actual figure was the same as the budgeted figure. The budgeted figure for the utility bills was £ 15,000. However, the utility bills actually cost £ 16,000. This is an adverse (A) variance of £ 1,000 (or 7% of the budgeted figure), since it results in the business spending more money than it budgeted for. When investigating and analysing the variances, it is common for managers to concentrate on the large positive and large negative variances and ignore the smaller variances. This is known as management by exception and involves the managers focussing their attention on those areas which have resulted in large overspending or underspending, and attempting to discover the reasons behind it. Incremental Budgeting Previous year’s budget is used as basis and only adjustments are made to the budget. E.g. in a competitive market, cost budgets are reduced while sales budgets increased as compared to last year. Departments only have to justify changes or increments for the coming year. This type of budgeting doesn’t allow for unforeseen events. But it is comparatively easy to prepare and is therefore less time – consuming. Zero Budgeting This is where a budget is set to zero for a given time-period, and the manager of the particular division or department then has to justify any expenditure which they wish to make. It is often used in an economic recession or a downturn in the industry, when money is not as readily available and the business wishes to make cutbacks in its expenditure. Zero budgeting helps the business to identify those departments which require large amounts of essential capital and day-to-day expenditure, as well as identifying those departments which require minimal expenditure. However, zero budgeting can result in managers spending far more of their valuable time on the budgeting process than would be the case if budgets were set more traditionally. Q. Explain the difference between fixed & flexible budgets. Which of the two provides a better basis for variance analysis?

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Sa’adat Ali Mughal Fixed Budgeting is bases on the assumption that the level of output remains at the predicted or budgeted level. So in case of an increase or fall in output, there would be a variance is the difference between budgeted and actual figures. E.g. Budgeted outputs as 2000 units and actual output is 1500 units while sales revenue budgeted is $100000 but actual is $90000. In case of fixed budgeting this variance of $10000 is adverse because sales revenue is lower than budget and this would reduce profits. However, this ignores the fact that out put has fallen by 25%. Flexible Budgeting on the other hand sets new budgets depending on the actual output level achieved which adjusts the figures according to a rise or fall in output levels. E.g. In the above example to reflect the decrease in actual output, a new flexible budget is produced. According to this the sales revenue should be $75000. Now we look at the variance which is $15000 favourable as the actual revenue is greater than budgeted according to actual output produced. Flexible budgets are more motivating for lower and middle management as they would be held responsible for adverse variances just because output has fallen. Flexible budgets give a more realistic target. It is the flexible budgets which provide a better basis for variance analysis as they highlight the change sin efficiency and not just in out put like fixed budgets. It is the flexible budgets which give a more valid and accurate variance which helps to decide the true productivity of labour and capital and allow performance to be seen as weaknesses of each department to be identified. 5AL.7 Contents of published accounts Income statement Balance sheet See 5AS.5 Accounting fundamentals

INVENTORY/STOCK VALUATION When accounts are produced, a firm must calculate the quantity and value of the stocks, which it is holding. The value of the stock at the beginning (opening stock) and end of the year (closing stock) will affect the gross profit for the year because in trading account (balance sheet) if closing stock is overvalued then gross profit will be higher and vise versa. Example: (a) Turnover Opening stock Cost of sales Less closing stock Gross profit (b) Turnover 39

97900 12300 56400 68700 11300 57400 _40500_ 97900

Business Accounting_________________________________________ Opening stock Cost of sales Less closing stock Gross profit 12300 56400 68700 14100 54600 _43300_

Finding: by valuing closing stock higher, cost of sales (adjusted for stock) becomes lower and increases the value of gross profit. A stock take can be used to find out how much stock is held. This involves making a list of all new materials, finished goods and work in progress. Stock valuation is more difficult. Some times the cost of stock changes over time to overcome this problem there are three methods for stock valuation. Methods for stock valuation 1. FIFO (first in first out) FIFO method assumes that stock for production is issued in the order in which it was delivered. Thus, stocks, which are bought, first are used up first. This insures that stocks issued for production are priced at the cost of earlier stocks, which any remaining stock is valued much closer to the replacement cost. Assuming that the opening stock is zero, consider the following stock transaction in following table. On 01.06.2003 a business receives 100 units of stock @5, which mean it has $500 of goods in stock. On 04.06.2003 an extra 200 units at $6 ($1200) are added, making a total of $1700. On 25.06.2003 100 units are issued from stock for production. As it is first in first out, the goods are taken from the 01.06.2003 stock, priced at $5 – the first stock to be received. This means $500 is removed from stock leaving 200 units valued at $6 ($1200) left in stock. By using the FIFO method, the value of stocks after all the transactions is $650. Date 01.06.2003 04.06.2003 25.06.2003 02.07.2003 12.07.2003 23.07.2003 24.07.2003 Stock received and price 100 @ $5 200 @ $6 Stock issued and price Stock valuation Goods in stock Total (100 @ $5 = $500) (100 @ $5 = $500) (200 @ $6 = $1200) (200 @ $6 = $1200) (100 @ $6 = $600) (100 @ $6 = $600) (200 @ $6.5 = $1300) (200 @ $6.5 = $1300) (100 @ $6.5 = $650) $500 $1700 $1200 $600 $1900 $1300 $650

100 @ $ 5 100 @ $ 6 200 @ $ 6.50 100 @ $ 6 100 @ $ 6.50

2. LIFO (last in first out) LIFO method assumes that the most recent deliveries are issued before existing stock. In this case any unused stocks are valued at the older and probably lower purchase price.

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Sa’adat Ali Mughal If the value of stock is rising, the LIFO method gives a lower finishing stock then FIFO method. Stock received and price 100 @ $5 200 @ $6 Stock issued and price Stock valuation Goods in stock Total (100 @ $5 = $500) (100 @ $5 = $500) (200 @ $6 = $1200) (100 @ $5 = $500) (100 @ $6 = $600) (100 @ $5 = $500) (100 @ $5 = $500) (200 @ $6.50 = $1300) (100 @ $5 = $500) (100 @ $6.50 = $650) (100 @ $5 = $500) $500 $1700 $1100 $500 $1800 $1150 $500

Date 01.06.2003 04.06.2003 25.06.2003 02.07.2003 12.07.2003 23.07.2003 24.07.2003

100 @ $ 6 100 @ $ 6 200 @ $ 6.50 100 @ $ 6.50 100 @ $ 6.50

3. Average cost This method involves recalculating the average cost of stock every time a new delivery arises only and all issued materials will be valued at same previous value/price. Each unit is assumed to have been purchased at the average price of all components. In practice the average cost of each unit is weighted average and is calculated using the following formula: Average cost = Existing stock value + Value of latest purchase Number of unit then in stock Using the same stock transactions as before we can find the closing stock by drawing up following table. When the average cost method is used the value of stock following the transactions is $622. this stock figure lies closer to the FIFO method of stock evaluation. It is often used when stock prices do not change a great deal. In practice it is the FIFO and average cost methods which are most commonly used by the firms. Once a method has been chosen it should conform with the ‘consistency’ convention and not change. Stock received and price 100 @ $5 200 @ $6 Weighted average cost $5.00 (500+1200) (100+200) = $5.67 $5.67 $5.67 (1300+567) (200+100) = $6.22 $6.22 41 Stock valuation Goods in stock Total (100 @ $5 = $500) (300 @ $5.67 = $1701) (200 @ $5.67 = $1134) (100 @ $5.67 = $567) (300 @ $6.22 = $1866) (200 @ $6.22 = $1244) $500 $1701 $1134 $567 $1866 $1244

Date 01.06.2003 04.06.2003 25.06.2003 02.07.2003 12.07.2003 23.07.2003

Issues

100 100 200 @ $ 6.5 100

Business Accounting_________________________________________ 24.07.2003 100 $6.22 (100 @ $6.22 = $622) $622

DEPRICIATION Fixed assets are used again and again over a longer period of time. During this time the value of money assets falls, this is known as depreciation. The value of assets falls because of wear and tear (use of items). Due to change in technology assets obsolete, capital goods, which are hardly used or poorly maintained, may loose value quickly. The passing of time can also reduce the value of assets Calculating depreciation 1. The straight line method It is the most common method used by business to work out depreciation. It assumes that the net cost of an asset should be written off in equal amounts over its life. The accountant needs to know the cost of the assets; its estimated residual value and scrap value after the business has finished with it and its expected life in years. Example: A delivery van costs £28,000 to buy and has an expected life of 4 years. The residual value is estimated at £4000. Solution: Depreciation allowance = Original cost – residual value Expected life (years) = 28000 – 4000 4 = £ 6,000. Therefore the annual depreciation allowance and book value of the van will be: Years. 1 2 3 4 Depreciation allowance (each year) £ 6000 6000 6000 6000 Net value £ (28000 – 6000) 22000 (22000 – 6000) 16000 (16000 – 6000) 10000 (28000 – 6000) 4000

Using graph base value over its lifetime is given:

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Sa’adat Ali Mughal When calculating depreciation it is helpful to draw up a table to show how an asset is written off over its lifetime. It is a simple method and useful for assets like lease, where the life of the asset and the residual value is known precisely. 2. Diminishing/Reducing balance Method The reducing method assumes that the depreciation change in the early years in an asset’s life should be higher then in the last years to do this, the assets must be written off by the same percentage rate each year. This means the annual change falls. Example: Assume a vehicle is bought for £28,000 and has a life of four years. A 40% charge will be made each year and the firm expects a residual value of £3629. a) Calculate depreciation allowance in the profit and loss account (or book value listed in balance sheet) in each of four years. b) Calculate depreciation rate/charge if the business expected the residual value to be £4,000. Solution: a) Years 1 2 3 4 b)

Depreciation allowance (each year) (28,000 x 40%) 11200 (28,000 x 40%) 6720 (28,000 x 40%) 4032 (28,000 x 40%) 2419

Book value (28000 - 11200) 16800 (16800 - 6720) 10080 (10080 - 4032) 6048 (6048 - 2419) 3629

Where n = estimated life of the asset

= 38.052% Graphical illustration

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Business Accounting_________________________________________ 5AL.8 analysis of published accounts RATIO ANALYSIS Profitability ratio See 5AS.5

Activity/asset usage/efficiency ratio It allows a business to measure how effectively it uses some of its resources. Businesses use the ratio to check their efficiency. Mostly used ratios are given below. Asset turnover- this ratio measure the productivity of assets. It shows the value of sales generated by every $1 of net asset. Higher ratio shows that assets are more productive and are being used more effectively. Asset turnover = Turnover Net sales Stock turnover- this ratio measures the number of times during the year that a business sells the value of its stocks. Stock turnover = Cost of goods sold Average stock holding Stock turnover can also be expressed in terms of the number of days it takes to sell stocks. This is calculated by Stock turnover = Stocks × 365 Cost of sales 2002 cost of goods sold $m 125 2400 2002 Average stock level $m 25 600 Stock turnover ratio 125/25 = 5 2400/600 = 4

Nairobi press Kingston press

Points to note: • The result is not a percentage but the number of times stock turns over in the time period – usually one year. • High stock turnovers are preferred (or lower figures in days). A higher stock turnover ratio means that profit on sale of the stock is earned more quickly. Thus, businesses with high stock turnovers can operate on lower margins. • A declining stock turnover ratio might indicate higher stock levels, a large amount of slow moving or obsolete stock, a wider range of products being stocked or a lack of control over purchasing. • The ‘normal’ result for a business depends very much on the industry it operates in – for instance, a fresh fish retailer would (hopefully) have a much higher stock turnover ratio than a car dealer. • For service sector firms, such as insurance companies, this ratio has little relevance as they are not selling ‘products’ held in stocks.

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Sa’adat Ali Mughal

Debtor days/debt collection period- it is also known as debtor days ratio. This measure the number of days it takes to collect debts on average. Businesses always try to short debt collection period. Debt collection period = Debtors × 365 Sales turnover

A debt collection period of over 60 days could be a problem for a small business. Even for a large business it may indicate a need to improve the credit control. The point at which the debt collection period becomes a problem may also depend on the industry in which the business operates. 2002 Debtors $m Nairobi press Kingston press 5 600 2002 sales turnover $m 250 3200 Debtors days (days) 75/250 × 365 = 109.5 600/3200 × 365 = 87.5

Points to note: • There is no ‘right’ or ‘wrong’ result – it will vary from business to business and industry to industry. A business selling almost exclusively for cash will have a very low ratio result. • A long debtor days ratio may be deliberate management strategy – customers will be attracted to business that give extended credit. Despite this, the results shown above are higher than average for most businesses and could result from poor control of debtors and repayment periods. • The number of debtor days could be reduced by giving shorter credit terms – say, 30 days instead of 60 days – or by improving credit control. This could involve refusing to offer credit terms to frequent late payers. The impact on sales revenue of such policies must always be borne in mind. Gearing/leverage Ratios It shows the long-term financial position of the business. They can be used to show the relationship between loans, on which interest is paid, and shareholder’ funds, on which dividend might be paid. Creditors are likely to be concerned about a firms gearing. Loans, for example have interest charges, which must be paid. Dividends don’t have to be paid to ordinary shareholders. As the business becomes more highly geared (loan are high relative to share capital), It is considered more risky by the creditors. The owners of the business might prefer to raise extra funds by borrowing rather than from shareholders, so they retain control of the business. Gearing ratio can also show the relationship between fixed interest bearing debts and the long-term capital of the business. There are several ways in which gearing ratios can be expressed. One simple method is to look at the relationship between loans and equity. Many company accounts express equity as capital plus reserves. Therefore, gearing can be calculated by Gearing ratio = Long-term loans × 100 Capital employed (Equity) 45

Business Accounting_________________________________________

Nairobi press Kingston press

Long-term loans $m 40 2000

Capital employed $m 40 5000

Gearing ratio 40/400 × 100 = 10% 2000/5000 × 100 = 40%

Points to note: • If the ratio is less than 50 % then the company is said to be low geared. This means that the majority of the capital of the business is likely to be raised from the shareholders. Creditors prefer lending to low geared companies, as there is less risk. • Conversely, if the ratio is greater than 50 % the company is said to be high geared. This means that most of the capital is borrowed. High-geared businesses, therefore, are likely to be in a weaker position as they are committed to greater interest payments. This risk arises for two main reasons: o The higher the borrowing of the business, the more interest must be paid and this will affect the ability of the company to pay dividends. This is particularly the case when interest rates are high and company profits are low – such as during economic downturn. o If the company does not have the cash to repay the loans then the shareholders may not receive back their investment if the company goes into liquidation. • A gearing ratio is important because it has to pay interest on some long-term debts, such as loans, debentures and certain preference shares. Raising a large amount in this way is likely to commit the business to fix interest payments, which it has to pay. Even in difficult trading periods. However if it raises money from ordinary shares it has the option not to pay a dividend to ordinary shareholders if it does not have sufficient profits. • Shareholders may prefer businesses to raise money from methods other than increasing shareholders funds. Raising extra capital from loans, rather than issuing shares, means that they retain greater control of the business. They would not however, want the business to be so highly geared that it faced problems. Interest cover- the gearing ratio is a balance sheet measure of financial risk. Interest cover is a profit and loss account measure. This ratio assesses the business’s ability to pay interest by comparing profit and interest payments. Interest cover = Operating profit (profit before tax and interest) Interest paid A figure of 1 means that a business would need to use all its profit to pay interest. This is obviously not a good position to be in. a figure of 1-2 is also likely to cause problems. An interest cover of about 5-6 is said to be adequate. Shareholder’s/investment ratios The owners of limited companies will take an interest in ratios, which helps to measure the return on their shareholding. Such ratios focus on factors such as earnings

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Sa’adat Ali Mughal and dividends from shares in relation to their price. Potential investors will also show an interest in shareholder’s ratios. Investors are interested in the returns or dividends they may get from holding shares. A number of ratios can be used to measure these returns. Shareholder’s ratios focus on shares where dividend can vary from one year to another. These are mainly ordinary shares, although there are other shares with variable returns. Debentures and certain preference shares tend to have fixed returns. This means that the business has to pay a fixed dividend or interest payment. Earnings per share- the earnings per share (EPS) measure how much each share is earning. It does not show how much money is actually paid to share holders, but how much is available to be paid to shareholders. Shareholders may not be paid all of the money because the business will wish to hold back an amount for other purposes. The EPS is always shown in the accounts at the bottom of the profit and loss account.

Price/Earning ratio- The P/E ratio is said to reflect the confidence shown in the company. It shows how many years, at current earnings, it will take an investor to recover the cost of the share. The market prices of shares are not shown in the annual reports. However, they are listed in many newspapers everyday. Price/Earnings ratio = Market price per share Earnings per share The higher the ratio, the more confidence investors have in the future of the company. Acceptable price / earnings ratio will tend to vary from industry to industry. Generally, price / earning ratio of between 10 and 15 are said to be acceptable. However P/E ratios can be considerable higher than the normal due to: • The higher status of the company. • The share price being overvalued. • Investors expecting future profits to grow significantly Return on equity- this ratio measures the return on investment. It shows the profit to the shareholder as a percentage of the shareholders equity. The higher the return is, the better. Shareholders may decide that the return on equity is adequate. As with the EPS this ratio does not illustrate how much money is actually paid to shareholders but how much is available to be paid to shareholders. It can be calculated as: Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Equity or net assets – fixed interest bearing (preference share) capital or = profit after tax and interest and preference dividend × 100 Shareholder’s funds (share capital and reserves)

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Business Accounting_________________________________________ Profit after tax and interest (there were no preference dividends) $m 30 200 Shareholder’s funds 360 3000 Return on equity ratio

Nairobi press Kingston press

30/360 × 100 = 8.3% 200/3000 × 100 = 6.6%

Points to note: • Kingston is earning a low rate of return on shareholder’s equity than Nairobi is. This might come as no surprise given that the net profit margin is lower and the gearing ratio is higher for Kingston – making interest payments more of a burden than for Nairobi. • This ratio does not measure the amount actually received by shareholders as most companies will retain some of the profit after tax for reinvestment. • If this ratio is declining over time then it suggests that the business is less efficient in the application of funds providing by shareholders – this could lead to lower dividends and share price. It could be time to sell the shares! Dividend per share- this ratio does show how much money is actually paid to shareholders. Dividends per share = Dividends (on ordinary shares) Number of (ordinary) shares This ratio is quite important to shareholders. It enables them to calculate their total dividend payment by multiplying dividends per share by the number of shares they hold. Dividend yield- this ratio helps to measure the value of the returns on the share for an investor. It shows the dividend per share as the percentage of market price. Dividend yield = Dividends per share × 100 Market share price A higher dividend yield is preferred. Comparison with other firms could tell whether a dividend yield of 0.6 percent is satisfactory for shareholders. The level of interest rate at any given time will also influence the value of dividend yield. Any unusually high dividend yield might suggest to investor that the company has problems. This is because a falling share price will raise the dividend yield and the falling share price might be a result of a loss of confidence of the company. Dividend Market per share share price 15c $3 70c $10 Dividend yield ratio 15/300 × 100 = 5% 70/1000 × 100 = 7%

Nairobi press Kingston press

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Sa’adat Ali Mughal Point to note: • A high dividend yield may not indicate a wise investment – the yield could be high because the share price has recently fallen, possibly because the stock market is concerned about the long-term prospects of the company. • The results need to be compared with previous years and with other companies in a similar industry to allow effective analysis. Dividend cover- this ratio takes into account the chance of capital growth. This ratio shows how many times the dividend could have been paid out of current earnings. There are two financial motives of holding shares – to earn dividend and to make a capital gain. If a company’s share price rises over time and investor can make a capital gain then the share are sold. Dividend cover links profit after tax with the dividend payment.

or

= Profit after tax and interest Dividends (paid and proposed)

A dividend cover of 2 times suggests that the dividend could have been paid 50% of its distributable profit as dividend and retained 50% in the business to help to finance future operations.. If the cover is too high it may mean that profits are low for the year or that the company is not retaining enough profit for new investment. Limitations to ratio analysis • Ratio analysis does not provide a complete means of assessing a company’s financial position. There are also problems when using ratios. • When making comparisons over time, it is necessary to take into account the following: o Inflation o Any changes in accounting procedures o Changes in the business activities of a firm o Changes in general business conditions and economic environment • It is also important that firm’s compare ‘like with like’ when using ratios, especially when making comparisons between businesses. Even firms in the same industry may be different. Their size of product mix or objectives might differ. Different accounting techniques might be used. The financial year ending may not be same. We also need to account for differences in human judgment. Some information is estimated. Firms may window dress their final accounts to show they are in better position. • Ratio analysis is based on historic information and does not include other useful information, such as chairperson’s and director’s report. It does not include some of the positive factors with in the business such as the quality of the staff or location. • As noted above, some ratios can be calculated using slightly different formulae, and care must be taken to only make comparisons with results calculated using the same ratio formula.

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Business Accounting_________________________________________ • • Companies can value their assets in rather different ways, and different depreciation methods can lead to different capital employed totals which will affect certain ratio results. Ratios are only concerned with accounting items to which a numerical value can be given. Increasingly, observers of company performance and strategy are becoming more concerned with non-numerical aspect of business performance, such as environmental policies and approaches to human rights in developing countries that the firms may operate in. indicators other than ratios must be used for these assessments.

5AL.9 Investment appraisal INVESTMENT APPRAISAL Investment can be placed into various categories. For example, capital goods, constructions, stocks, public sector, redundancies (when becoming more capital intensive), marketing etc. Methods of payback period 1 Payback Period It referrers to the amount of time it takes for a project to recover or payback. The quicker the payback period, the better. When using this method to choose between projects, the project with the shortest payback will be chosen. Assume a business is appraising three investment projects A B and C, all of which cost £70,000. The flow of income expected from each project is shown in table. Amount in ($’000) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total A 10 10 20 20 30 40 130 B 20 20 20 20 20 20 120 C 30 30 20 10 10 10 110 Solution: For project A In four years company is earning profit of $60000 (10000 +10000 + 20000 + 20000) remaining $10000 will be collected in year five = Amount remaining/total profit of the year × 12 = 10000/30000 × 12 = 4 months Therefore payback period for project A will be 4 years and 4 months For project B Pay back period = 3 yr and 6 months (20 + 20 + 20 Years and 10/20 × 12) For project C Payback period = 2Years and 6 months (30 + 30 years and 10/20 × 12) In this example project C would be chosen because it has shortest payback time i.e. two and half years (add with each consecutive years and match with investment and

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Sa’adat Ali Mughal find at which year figures are equal i.e. 30 for year 1, 30 for year 2 and from some where in year 3 project will recover its 70000 investment). Note that total income is note taken into account in this method. Infect project C has the lowest total return over the six years. Advantages • This method is useful when technology changes rapidly. • It is simple to use. • It is useful as initial test to check the validity of an investment. • Firms might adopt this method if they have cash flow problems. This is because the projects chosen will payback the investment more quickly than others. Disadvantages • Cash earned after the payback is not taken into account in the decision to invest. • The method ignores the profitability of the project, since the criterion used is the speed of payment. • It takes no account of the value of money over time. 2 Average Rate of Return (ARR)

This method measures the net return each year as the percentage of the initial cost of the investment. ARR (%) = Net return (profit) per annum × 100 Capital outlay (cost) For example, the cost and expected income from three investment projects are shown in table below. Project X 50,000 10,000 10,000 15,000 15,000 20,000 70,000 Project Y 40,000 10,000 10,000 10,000 15,000 15,000 60,000 Amount in £ Project Z 90,000 20,000 20,000 30,000 30,000 30,000 130,000

Cost Return year 1 Year 2 Year 3 Year 4 Year 5 Total

First calculate the total net profit from each project by subtracting the total return of the project from its cost i.e. 70,000 – 50,000 = 20,000 fro project X. Secondly calculate the net profit per annum by dividing the total net profit by the number of years the pro9ject returns for i.e. 20,000 / 5 = 4,000. Finally, the ARR is calculated by putting values in the formula. ARR (project X) = 4000 × 100 50,000 = 8%

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Business Accounting_________________________________________ Similarly ARR for project Y and Z will be 10% and 8.9 % respectively. Comparing ARR of X Y and Z will choose project Y chosen because of its highest ARR. Advantages • It shows clearly the profitability of an investment project. • Overall rate of return of all projects can be compared. • It is easier to identify the opportunity cost of investment. • It gives an indication of both the cash flows and the profitability of investment. Disadvantages • It does not take into account the effects of time on the value of money. • It takes no account of when the cash flows occur. 3 Discounted Cash Flow (DCF) When considering predicted cash flows in the future, it is worth remembering that money has a ‘time value’. This means that having money in the hand now is worth more to a business than a same quantity of money in the future. In a same way, asking a student if they would prefer to receive £100 now or £100 in five years time will almost always be answered by taking the money now. The reason for this is clear: • Future cash flows are subject to risk. There can be no guarantee that a promise of money in five years, however sincerely made, will be fulfilled. Bankruptcy, death or forgetfulness may prevent the promise being carried out. • Opportunity costs come into play. The money, if received now, could be used profitable, whether invested in a business venture or put into a bank or building society account. £100 put into a saving account today could earn a lot of interest in five years. When considering potential capital investment on the basis of predicted future cash flows, it makes sense to ask: what will the money we receive in the future really be worth in today’s terms? The present value is calculated using a method called discounting. To discount a future cash flow, it is necessary to know: • How many years into the future we are looking, since the greater the length of time involved, the smaller the present or discounted value of money will be. • What the prevailing rate of interest will be. Once these have been determined, the relevant discount factor can be found. This can be done by calculating or looked up in discount tables, which is given below (values are rounded off to two decimal places): Years ahead 0 1 2 3 4 5 5% 1.00 0.95 (1.00-1.00×5%) 0.90 (0.95-0.95×5%) 0.86 (0.90-0.90×5%) 0.82 (0.86-0.86×5%) 0.78 (0.82-0.82×5%) 10% 1.00 0.91 0.83 0.75 0.68 0.62

The future cash flow is then multiplied by the appropriate discount factor to find the present value.

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Sa’adat Ali Mughal For example, the present value of £100 received in five years time, if the expected rate of interest is 10%, would be: £100 × 0.62 = £62.10 The higher the rate of interest expected, and the longer the time to wait for the money to come in, the less the money is actually worth in today’s terms. So how does a firm decide which discount factor to choose? There are two main ways: The discount factor can be based on the current rate of interest, or the rate expected over the coming years. A firm can base the factor on its own criteria, such as that it wants every investment to make at least 15%; therefore it expects future returns to be positive even with a 15% discount rate. Example: An investment project costing £100,000 yield an expected income stream over a three year period of £30,000 (year 1), £40,000 (year 2) and £50,000 (year 3). The present value of income stream will be: Year 1 = 30,000 × 0.95 = £28,500 Year 2 = 40,000 × 0.90 = £36,000 Year 3 = 50,000 × 0.86 = £ 43,000 Total present value of all income = £107,500. This investment project is viable because present value of return (£107,500) is greater than the cost (£100,000). The Net Present Value is 107,500 – 100,000 = £7,500. Advantages • It takes into account the value of money over time. • All cash flows are taken into consideration, until payback. • It is more scientific than the other techniques. Disadvantages • It is more difficult to calculate • The selection of the discount factor is crucial for the net present value, but it is to some extent guesswork what percentage is used. Note: - Payback, net present value and annual average rate of return all together can be used to decide which investment option ought to be undertaken. Using just one appraisal technique could be misleading. 4 Internal Rate of Return (IRR) A firm must find the rate of return (x) where the net present value is zero. This IRR is than compared with the marker rate of interest to determine whether the investment should take place. IRR is based on opportunity cost. Assume an investment project costs £10,000 and yields a one-year return only of £13,000. The market rate of interest is 14%. To calculate IRR (x):

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Business Accounting_________________________________________

X = 0.3 or 30% Since IRR of 30% is greater than the market rate of interest (14%) the firm should invest in the project. Alternative approach This means choosing a discount rate (rate at which value of money is changed), calculate the net present value (NPV) and seeing whether it equals to zero. If it does not than another rate is chosen. This process is continued until the correct rate is found. Example: Assume that an investment project costs £50,000 and earns a five-year return. Table shows the actual return and the present value of the return over the five-year period at different discount rates. Year 1 2 3 4 5 Total NPV Income/return 5,000 5,000 10,000 20,000 20,000 60,000 Present value of income/return at 10% 7.5% 5% 4,545 4,651 4,762 4,132 4,325 4,555 7,513 8,045 8,643 13,661 14,970 16,447 12,442 13,828 15,661 42,273 45,919 50,048 - 7,727 - 4,081 48

From table only at 5% rate of NPV is, as near to zero as it needed i.e. just £48. Thus 5% is the internal rate of return. Following figure shows the relationship between the discount rate and the NPV. As the discount rate increases the NPV falls. The IRR is shown on the discount rate axis where NPV is zero.

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Sa’adat Ali Mughal

Note: - the value of discount rate (i.e. at year 1,2,3,4,5… is 0.909, 0.826, 0.751, respectively) will be given with question. The factors that should be taken into consideration when deciding to proceed with the investment are: 1. The prevailing interest rate in the country. this would show whether it would be better to leave the capital in the bank to earn interest or to invest it E.g. if the interest rate was 10% while the ARR or the IRR earned was just 7%, then it would have been more profitable to leave the capital in bank. 2. The economic situation of the country. This means whether the country is in a boom or a recession. If the country is in a boom than risks can be taken i.e. longer investments spread over several years could be chosen. However, if the country is going into recession then it would not be good to invest in risky projects or equipment. E.g. the ones that generate revenue within a span of three to five years should be selected even if they are apparently less profitable than that of 10 years project. As in short – term projects the revenue is more guaranteed and higher chances are there for its earning. 3. Legal considerations also need to be taken into account. This include government policies on different industries e.g. a firm may have a choice of investments including a foreign project. However, if there is a policy preventing investment in foreign project may have to be rejected despite its greater returns and favourable terms. 4. Social, environmental and ethical considerations. Certain projects despite their profitablility may be unethical or socially unacceptable E.g. a project may involve smuggling goods such as drugs approached animals and may thus be very profitable. However, it is socially wrong. 5. Leadership attitude. If the leadership likes taking risks then it would take risky investments and invest in projects that give higher returns but after several years. If the leadership attitude is risk averse then the projects selected would be only moderately profitable and generating returns in a shorter time period.

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Business Accounting_________________________________________ Summery for ratios Ratio Definition Interested stakeholders Managers, employees and potential investors Formula Favorable position

Profitability Helps to show how or well a business is performance doing ratios Gross profit margin (%) Net profit margin (%) Return on capital employed (RoCE) (%) Liquidity ratios Shows gross profit made on sales turnover Helps to measure how well a business controls its overheads Measures the return on the capital invested in business Illustrates the solvency of a business – whether it is in position to repay its debts. Shows relationship between current assets and liabilities

Gross profit × 100 Sales turnover Net profit × 100 Sales turnover Net profit × 100 Capital employed Lenders, suppliers and potential investors Current assets Current liabilities

High vale is preferred High vale is preferred High vale is preferred

Current ratio

Acid test or quick ratio

Shows company’s adequate liquid resources Efficiency / Allow a business to activity / measure how asset usage effectively it uses ratio some of its resources Asset Measure turnover ratio productivity of a business Stock Shows number of turnover ratio times during the year a business sells the value if its

Liquid assets Current liabilities Businesses

Between 1.5:1 and 2:1 Above 1.5:1 shows working capital problem, below 2:1 shows unproductive capital Ratio of 1:1 is desirable

Turnover Net assets Cost of goods sold Average stock holding or Stocks × 365

High ratio is favourable High stock turnover or low figures in days are preferred

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Sa’adat Ali Mughal stock or number of days it takes to sell stock Measures the number of days a business takes to collect debts on average Helps to measure return on share holding Cost of goods sold Debtors × 365 Sales turnover Short debt collection period

Debtor days ratio

Shareholder or investment ratios Earning per share

Owners of limited companies , investors, media Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Number of (ordinary) shares Market price per share Earning per share (amount of capital recovered by shareholders per year) Dividend on ordinary shares (dividend – preference shareholder’s dividend) Number of ordinary shares Dividend per share×100 Market share price Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Dividends (paid & proposed) Profit accruing to ordinary shareholders (net profit after tax – payment on fixed High ratio is desirable

How much each share is earning

Price or earning ratio

Dividend per share

Shows how many years, at current earning, it will take an investor to cover the cost of share Shows how much money is actually paid to shareholders It measures the value of the return on the share for an investor How many times the dividend could have been paid out of current earnings

High ratio is desirable

High ratio is desirable

Dividend yield ratio (%) Dividend cover ratio (times)

High ratio is desirable High value shows profits are high. Shareholders demand high dividends

Return on equity (%)

It measures return on investment

High ratio is desirable

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Business Accounting_________________________________________ interest bearing capital) × 100 Equity or net assets – fixed interest bearing (preference share) capital Long term loans×100 Capital employed (equity)

Gearing or leverage ratio

Show long term financial position of the business

Creditors

Less than 50% is low geared i.e. majority of capital is raised from shareholders. Above 50% means most of the capital is borrowed

Or Or

Interest cover Assesses the ratio business’s ability to pay interest by comparing profit and interest payments

Long term debts×100 Shareholder’s funds Long term debts×100 Total capital (total assets less current liabilities) Operating profit Interest paid

Interest cover of 5 or 6 is said to be adequate. A figure of 1 means that a business would need to use all its profit to pay interest

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Sa’adat Ali Mughal

Ratios question with solution TOYOTA plc PROFIT AND LOSS ACCOUNT Year ended 31st July 2005 2005 2006 $000 $000 Turnover 69618 6371 8 Cost of sales 45272 3994 5 Gross profit 24346 2377 3 Operating expenses 19476 1816 0 Operating profit 4870 5613 Income from investments Profit on ordinary activities before interest and tax Interest receivable Interest payable profit on ordinary activities before taxation (net profit) Tax on profit on ordinary activities Profit on ordinary activities After taxation Extraordinary items Profit for the financial year Dividends Retained profit for the period Earnings per share -------- 35 4870 5648 TOYOTA plc BALANCE SHEET 31st July 2006 2005 2006 $000 $000 Fixed assets Tangible assets 10092 9811 Investments 59 44 10151 9855 Current assets Stocks 18162 16981 Debtors 11488 10674 Cash in bank and in 7219 3516 hand 36869 31171 Creditors: amounts falling due within 20203 14148 one year (current liabilities) Net current assets 16666 17023 Total assets less current liabilities 26817 26878 Creditors: amounts falling due after more (2514 (2834) than one year ) Provisions for liabilities and (997) (1010) charges Minority interests -----(75) Deferred income (279) (485) (long term liabilities) (3790 (4404) ) Net assets 23027 22474 Capital and reserves Called up share 1856 1856 capital Share premium 169 169 account Revaluation reserves 893 893 Other reserves 147 278 Profit and loss 19962 19278 account Shareholder’s funds 23027 22474

351 5221 1058 4163

218 5866 568 5298

1494 2669 1224 1445 761 684 41.42 p

1987 3311 -----3311 712 2599 51.4 1p

Additional information for the account of TOYOTA plc 2005 2006

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Business Accounting_________________________________________ $000 2454 250 9 6423 1950 p $000 2589 250 9 6423 1845p

(i) Long term capital (ii) fixed interest preference share capital (iii) Preference shareholder’s dividend (iv) Number of ordinary shares (v) Share price 31st July

Solution: Ratio Formula Profitability or performance ratios Gross profit Gross profit × 100 margin (%) Sales turnover Net profit margin (%) Return on capital employed (RoCE) (%) Liquidity ratios Current ratio Acid test or quick ratio Efficiency / activity / asset usage ratio Asset Net profit × 100 Sales turnover Net profit × 100 Capital employed (fixed assets + current assets) Current assets Current liabilities Liquid assets (current assets - stocks) Current liabilities Solution for 2005 Solution for 2006

24346000 × 100 69618000 =34.9% 4163000 × 100 69618000 =5.98% 4870000 × 100 1015100 + 3686900 =10.4%

23773000 × 100 63718000 =37.3% 5298000 × 100 63718000 =8.3% 564800× 100 9855000 +31171000 =13.8%

36869000 20203000 =1.82 36869000 – 18162000 20203000 =0.93

31171000 14148000 =2.2 31171000 – 16981000 14148000 =1.00

Turnover

69618000

63718000

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Sa’adat Ali Mughal turnover ratio Net assets Stock Cost of goods sold turnover ratio Average stock holding/stock Debtor days Debtors × 365 ratio Sales turnover Shareholder or investment ratios Earning per share 23027000 =3.02 45272000 18162000 =2.49 times 11488000 × 365 69618000 =60 days 22474000 =2.84 39945000 16981000 =2.35 times 10674000 × 365 63718000 =61 days

Price or earning ratio

Dividend yield ratio (%) Dividend cover ratio (times)

Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Number of (ordinary) shares Market price per share Earning per share (amount of capital recovered by shareholders per year) Dividend per share×100 Market share price Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Dividends (paid & proposed) Profit accruing to ordinary shareholders (net profit after tax – payment on fixed interest bearing capital) × 100 Equity or net assets – fixed interest bearing (preference share) capital Long term loans×100 Capital employed (equity) or net assets

(2669000 – 9000) × 100 6423000 =41.42p

(3311000 – 9000) × 100 6423000 =51.41p

1950 41.42 =47.08 11.7 × 100 1950 =0.6% 2669000 – 9000 761000 – 9000 =3.5 Times

1845 51.41 =35.89 10.9 × 100 1845 =0.59% 3311000 – 9000 712000 – 9000 =4.7 Times

Return on equity (%)

2669000 – 9000 23027000 – 250000 =11.7%

3311000 – 9000 22474000 – 250000 =14.85%

Gearing or leverage ratio

2454000 × 100 23027000 =10.66% 61

2589000 × 100 22474000 =11.52%

Business Accounting_________________________________________ Or Long term debts×100 Shareholder’s funds Or Long term debts×100 Total capital (total assets less current liabilities) Interest cover Operating profit 4870000 ratio (before tax and interest) 1058000 Interest paid =4.6 Times

5648000 568000 =9.9 Times

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