Introduction To Wastewater Treatment

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.
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• 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-in-
time’ 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.
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-to-
day 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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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
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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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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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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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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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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
(£ 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
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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
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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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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 super-
visors' 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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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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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 = $10000
Markup = 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. $5000-
Firms 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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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 = $60,000-
Variable 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-
15
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
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.
17
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.
18
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
19
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. £ 70 m
Current assets. £ 53 m
Current liabilities £ 23 m
Net current assets. £ 30 m
Long-term liabilities. £ 40 m
Net assets. £ 60 m
Shareholder’s funds. £ 60 m
Horizontal Format
Liabilities Assets
Shareholder’s funds £ 60 m Fixed assets. £ 70

m
Long-term liabilities. £ 40 m Current assets £53
m
Current liabilities. £ 23 m
Total liabilities £123m Total assets £

123m
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
• 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 1200
Fixtures & fittings 1100
Equipment 700 3000
Current Assets
Stocks 800
Debtors 500
Cash at bank 400
1700
Current liabilities
Trade creditors 200
Taxation 300
Dividends 200
700
_____
Net Current Assets 1000
Working capital (current asset – current liabilities)
Total assets less current liabilities 4000
Creditors: amount (long-term liabilities)
Falling due after one year

Mortgage 1100
Bank loan 200 1300
Net Assets
21
(Total assets less current liabilities – long tern liabilities) 2700
Capital and reserves

Ordinary Share Capital
(2000,000 shares at £ 1 each) 2000
Retained Profit 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.
22
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)
Turn over 800
Less Cost of sales 350
Gross profit 450
Less Expenses (all indirect) 340
Operating profit 110
Plus Non-operating income 10
Profit on ordinary activities before interest 120

(The profit & loss account)
Less Interest 20
Profit on ordinary activities before taxation (net profit)

100
Less Taxation 33
(The appropriation account)

Profit on ordinary activities after taxations 67
Less Dividends
32
Retained Profit 35
==
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.
23
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
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
Capital grants received 73 63

Net cash flow from financing 430 2
(Decrease)/Increase in cash (5) 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.
26
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 Sales Net

profit turnover profit margin
$m $m
Nairobi press 50 250 50/250 × 100 = 20%
Kingston press 500 3200 500/3200 × 100 = 15.6%
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.
27
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 2002 Gross

gross sales profit margin
profit turnover
$m $m
Nairobi press 125 250 125/250 × 100 = 50%
Kingston press 800 3200 800/3200 × 100 = 25%
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 Sales Net

profit turnover profit margin
$m $m
Nairobi press 50 250 50/250 × 100 = 20%
Kingston press 500 3200 500/3200 × 100 = 15.6%
Points to note:
28
• 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 Current Current ratio

assets liabilities
$m $m
29
Nairobi press 60 30 2.1

Kingston press 500 3200 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 Current Acid test

assets liabilities ratio
$m $m
Nairobi press 30 30 1
Kingston press 180 240 0.75
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.
30
• 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.
31
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 =200000/500000 ×100
=40%
Contribution to total direct cost B =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 =300000×40%

=£120000
60% of indirect cost of B =300000×60%
=£180000
Therefore, total cost of A =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.
32
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 Fuel Total direct cost Factory time (hrs)
A 2 3 1 6 1
B 2 4 2 8 3
C 4 4 2 10 2
Total 8 11 5 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
=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:
Description Standard cost Actual cost
Material 90 90
Components 120 120
Labour 350 400 (variance of £50 more)
Indirect costs 140 140
Total 700 750 (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 Product B
Direct material 30,000 25,000
Direct labour 5,000 3,500
Other direct costs 5,000 3,000
Marginal cost 20,000 11,000
Contribution 10,000 14,000
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
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.
35
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
• 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
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?
38
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 See 5AS.5 Accounting fundamentals

Balance sheet
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 97900
Opening stock 12300
Cost of sales 56400
68700
Less closing stock 11300
57400
Gross profit _40500_
(b)
Turnover 97900
39
Opening stock 12300

Cost of sales 56400
68700
Less closing stock 14100
54600
Gross profit _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 Stock Stock issued Stock valuation

received and and price Goods in stock Total
price
01.06.2003 100 @ $5 (100 @ $5 = $500) $500
04.06.2003 200 @ $6 (100 @ $5 = $500)
(200 @ $6 = $1200) $1700
25.06.2003 100 @ $ 5 (200 @ $6 = $1200) $1200
02.07.2003 100 @ $ 6 (100 @ $6 = $600) $600
12.07.2003 200 @ $ 6.50 (100 @ $6 = $600)
(200 @ $6.5 = $1300) $1900
23.07.2003 100 @ $ 6 (200 @ $6.5 = $1300) $1300
24.07.2003 100 @ $ 6.50 (100 @ $6.5 = $650) $650
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.
40
If the value of stock is rising, the LIFO method gives a lower finishing stock then
FIFO method.
Stock Stock issued Stock valuation

Date received and and price Goods in stock Total
price
01.06.2003 100 @ $5 (100 @ $5 = $500) $500
04.06.2003 200 @ $6 (100 @ $5 = $500)
(200 @ $6 = $1200) $1700
25.06.2003 100 @ $ 6 (100 @ $5 = $500)
(100 @ $6 = $600) $1100
02.07.2003 100 @ $ 6 (100 @ $5 = $500) $500
12.07.2003 200 @ $ 6.50 (100 @ $5 = $500)
(200 @ $6.50 = $1300) $1800
23.07.2003 100 @ $ 6.50 (100 @ $5 = $500)
(100 @ $6.50 = $650) $1150
24.07.2003 100 @ $ 6.50 (100 @ $5 = $500) $500
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 Weighted Stock valuation

Date received and Issues average Goods in stock Total
price cost
01.06.2003 100 @ $5 $5.00 (100 @ $5 = $500) $500
04.06.2003 200 @ $6 (500+1200)
(100+200)
= $5.67 (300 @ $5.67 = $1701) $1701
25.06.2003 100 $5.67 (200 @ $5.67 = $1134) $1134
02.07.2003 100 $5.67 (100 @ $5.67 = $567) $567
12.07.2003 200 @ $ 6.5 (1300+567)
(200+100)
= $6.22 (300 @ $6.22 = $1866) $1866
23.07.2003 100 $6.22 (200 @ $6.22 = $1244) $1244
41
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. Depreciation allowance Net value £

(each year) £
1 6000 (28000 – 6000) 22000
2 6000 (22000 – 6000) 16000
3 6000 (16000 – 6000) 10000
4 6000 (28000 – 6000) 4000
Using graph base value over its lifetime is given:
42
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 Depreciation allowance Book value
(each year)
1 (28,000 x 40%) 11200 (28000 - 11200) 16800
2 (28,000 x 40%) 6720 (16800 - 6720) 10080
3 (28,000 x 40%) 4032 (10080 - 4032) 6048
4 (28,000 x 40%) 2419 (6048 - 2419) 3629
b)
Where n = estimated life of the asset
= 38.052%
Graphical illustration
43
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 2002 Stock

cost of Average turnover ratio
goods stock
sold $m level $m
Nairobi press 125 25 125/25 = 5
Kingston press 2400 600 2400/600 = 4
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.
44
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 2002 Debtors days

Debtors sales (days)
$m turnover
$m
Nairobi press 5 250 75/250 × 365 = 109.5
Kingston press 600 3200 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
Long-term Capital Gearing ratio

loans employed
$m $m
Nairobi press 40 40 40/400 × 100 = 10%
Kingston press 2000 5000 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
46
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)
47
Profit after tax Share- Return on equity ratio

and interest holder’s
(there were no funds
preference
dividends) $m
Nairobi press 30 360 30/360 × 100 = 8.3%
Kingston press 200 3000 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 Dividend yield ratio

per share share
price
Nairobi press 15c $3 15/300 × 100 = 5%
Kingston press 70c $10 70/1000 × 100 = 7%
48
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.
49
• 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
50
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.
Amount in £
Project X Project Y Project Z
Cost 50,000 40,000 90,000
Return year 1 10,000 10,000 20,000
Year 2 10,000 10,000 20,000
Year 3 15,000 10,000 30,000
Year 4 15,000 15,000 30,000
Year 5 20,000 15,000 30,000
Total 70,000 60,000 130,000
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%
51
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 5% 10%

0 1.00 1.00
1 0.95 (1.00-1.00×5%) 0.91
2 0.90 (0.95-0.95×5%) 0.83
3 0.86 (0.90-0.90×5%) 0.75
4 0.82 (0.86-0.86×5%) 0.68
5 0.78 (0.82-0.82×5%) 0.62
The future cash flow is then multiplied by the appropriate discount factor to find the
present value.
52
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):
53
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.
Present value of income/return at

Year Income/return 10% 7.5% 5%
1 5,000 4,545 4,651 4,762
2 5,000 4,132 4,325 4,555
3 10,000 7,513 8,045 8,643
4 20,000 13,661 14,970 16,447
5 20,000 12,442 13,828 15,661
Total 60,000 42,273 45,919 50,048
NPV - 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.
54
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.
55
Summery for ratios
Ratio Definition Interested Formula Favorable

stakehol- position
ders
Profitability Helps to show how Managers,
or well a business is employees
performance doing and
ratios potential
investors
Gross profit Shows gross profit Gross profit × 100 High vale is
margin (%) made on sales Sales turnover preferred
turnover
Net profit Helps to measure Net profit × 100 High vale is
margin (%) how well a Sales turnover preferred
business controls
its overheads
Return on Measures the return Net profit × 100 High vale is
capital on the capital Capital employed preferred
employed invested in business
(RoCE) (%)
Liquidity Illustrates the Lenders,
ratios solvency of a suppliers
business – whether and
it is in position to potential
repay its debts. investors
Current ratio Shows relationship Current assets Between 1.5:1 and
between current Current liabilities 2:1
assets and liabilities Above 1.5:1 shows
working capital
problem, below
2:1 shows
unproductive
capital
Acid test or Shows company’s Liquid assets Ratio of 1:1 is
quick ratio adequate liquid Current liabilities desirable
resources
Efficiency / Allow a business to Businesses
activity / measure how
asset usage effectively it uses
ratio some of its
resources
Asset Measure Turnover High ratio is
turnover ratio productivity of a Net assets favourable
business
Stock Shows number of Cost of goods sold High stock
turnover ratio times during the Average stock holding turnover or low
year a business or figures in days are
sells the value if its Stocks × 365 preferred
56
stock or number of Cost of goods sold

days it takes to sell
stock
Debtor days Measures the Debtors × 365 Short debt
ratio number of days a Sales turnover collection period
business takes to
collect debts on
average
Shareholder Helps to measure Owners of
or return on share limited
investment holding companies
ratios , investors,
media
Earning per How much each Profit accruing to High ratio is

share share is earning ordinary shareholders desirable
(net profit after tax –
payment on fixed
interest bearing capital)
× 100
Number of (ordinary)
shares
Price or Shows how many Market price per share High ratio is
earning ratio years, at current Earning per share desirable
earning, it will take (amount of capital
an investor to cover recovered by
the cost of share shareholders per year)
Dividend per Shows how much Dividend on ordinary High ratio is
share money is actually shares desirable
paid to (dividend – preference
shareholders shareholder’s dividend)
Number of ordinary
shares
Dividend It measures the Dividend per High ratio is
yield ratio value of the return share×100 desirable
(%) on the share Market share price
for an investor
Dividend How many times Profit accruing to High value shows
cover ratio the dividend could ordinary shareholders profits are high.
(times) have been paid out (net profit after tax – Shareholders
of current earnings payment on fixed demand high
interest bearing capital) dividends
× 100
Dividends (paid &
proposed)
Return on It measures return Profit accruing to High ratio is
equity (%) on investment ordinary shareholders desirable
(net profit after tax –
payment on fixed
57

× 100
Equity or net assets –
fixed interest bearing
(preference share)
capital
Gearing or Show long term Creditors Long term loans×100 Less than 50% is
leverage financial position Capital employed low geared i.e.
ratio of the business (equity) majority of capital
is raised from
shareholders.
Above 50% means
most of the capital
is borrowed
Or Long term debts×100
Shareholder’s funds
Total capital (total
assets less current
liabilities)
Interest cover Assesses the Operating profit Interest cover of 5
ratio business’s ability to Interest paid or 6 is said to be
pay interest by adequate. A figure
comparing profit of 1 means that a
and interest business would
payments need to use all its
profit to pay
interest
58
Ratios question with solution
TOYOTA plc PROFIT AND LOSS TOYOTA plc BALANCE SHEET

ACCOUNT 31st July 2006
Year ended 31st July 2005 2005 2006
2005 2006 $000 $000
$000 $000 Fixed assets
Turnover 69618 6371 Tangible assets 10092 9811
8 Investments 59 44
Cost of sales 45272 3994 10151 9855
5 Current assets
Gross profit 24346 2377 Stocks 18162 16981
3 Debtors 11488 10674
Operating expenses 19476 1816 Cash in bank and in 7219 3516
0 hand
Operating profit 4870 5613 36869 31171
Creditors: amounts
Income from -------- 35 falling due within 20203 14148
investments - one year
(current liabilities)
Profit on ordinary 4870 5648 Net current assets 16666 17023
activities before Total assets less
interest and tax current liabilities 26817 26878
Creditors: amounts
Interest receivable 351 218 falling due after more (2514 (2834)
5221 5866 than one year )
Interest payable 1058 568 Provisions for
profit on ordinary 4163 5298 liabilities and (997) (1010)
activities charges
before taxation (net Minority interests ------ (75)
profit) Deferred income (279) (485)
Tax on profit on 1494 1987 (long term liabilities) (3790 (4404)
ordinary activities )
Profit on ordinary 2669 3311 Net assets 23027 22474
activities Capital and
After taxation reserves
Extraordinary items 1224 ------ Called up share 1856 1856
- capital
Profit for the financial 1445 3311 Share premium 169 169
year account
Dividends 761 712 Revaluation reserves 893 893
Retained profit for 684 2599 Other reserves 147 278
the period Profit and loss 19962 19278
Earnings per share 41.42 51.4 account
p 1p Shareholder’s funds 23027 22474
Additional information for the account of
TOYOTA plc
2005 2006
59
$000 $000
(i) Long term capital 2454 2589
(ii) fixed interest
preference share capital 250 250
(iii) Preference
shareholder’s dividend 9 9
(iv) Number of ordinary 6423 6423
shares
(v) Share price 31st July 1950 1845p
p
Solution:
Ratio Formula Solution for 2005 Solution for 2006

Profitability
or
performance
ratios
Gross profit Gross profit × 100 24346000 × 100 23773000 × 100
margin (%) Sales turnover 69618000 63718000
=34.9% =37.3%
Net profit Net profit × 100 4163000 × 100 5298000 × 100
margin (%) Sales turnover 69618000 63718000
=5.98% =8.3%
Return on Net profit × 100 4870000 × 100 564800× 100
capital Capital employed 1015100 + 3686900 9855000 +31171000
employed (fixed assets + current =10.4% =13.8%
(RoCE) (%) assets)
Liquidity
ratios
Current ratio Current assets 36869000 31171000
Current liabilities 20203000 14148000
=1.82 =2.2
Acid test or Liquid assets 36869000 – 18162000 31171000 – 16981000
quick ratio (current assets - stocks) 20203000 14148000
Current liabilities =0.93 =1.00
Efficiency /
activity /
asset usage
ratio
Asset Turnover 69618000 63718000
60
turnover ratio Net assets 23027000 22474000

=3.02 =2.84
Stock Cost of goods sold 45272000 39945000
turnover ratio Average stock 18162000 16981000
holding/stock =2.49 times =2.35 times
Debtor days Debtors × 365 11488000 × 365 10674000 × 365
ratio Sales turnover 69618000 63718000
=60 days =61 days
Shareholder
or
investment
ratios
Earning per Profit accruing to (2669000 – 9000) × (3311000 – 9000) × 100
share ordinary shareholders 100 6423000
(net profit after tax – 6423000 =51.41p
payment on fixed =41.42p
× 100
Number of (ordinary)
shares
Price or Market price per share 1950 1845
earning ratio Earning per share 41.42 51.41
(amount of capital =47.08 =35.89
recovered by
shareholders per year)
Dividend Dividend per 11.7 × 100 10.9 × 100
yield ratio share×100 1950 1845
(%) Market share price =0.6% =0.59%
Dividend Profit accruing to 2669000 – 9000 3311000 – 9000

cover ratio ordinary shareholders 761000 – 9000 712000 – 9000
(times) (net profit after tax – =3.5 Times =4.7 Times
payment on fixed
× 100
Dividends (paid &
proposed)
Return on Profit accruing to 2669000 – 9000 3311000 – 9000
equity (%) ordinary shareholders 23027000 – 250000 22474000 – 250000
(net profit after tax – =11.7% =14.85%
payment on fixed
× 100
Equity or net assets –
fixed interest bearing
(preference share)
capital
Gearing or Long term loans×100 2454000 × 100 2589000 × 100
leverage Capital employed 23027000 22474000
ratio (equity) or net assets =10.66% =11.52%
61

Shareholder’s funds
Total capital (total
assets less current
liabilities)
Interest cover Operating profit 4870000 5648000
ratio (before tax and interest) 1058000 568000
Interest paid =4.6 Times =9.9 Times
62

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Business

Sa’adat Ali Mughal

5AS.1 The need for business finance

THE NEED FOR BUSINESS FINANCE

The items of expenditure method above fall in to two categories.

Control of Working capital

WHY BUSINESS ACTIVITY REQUIRES FINANCE

5AS.2 Sources of finance

Sources of finance basically divided into two categories

1 Internal sources of finance

Internal sources of finance – an evaluation

2 External source of finance

External short-term finance

External long-term finance

Government assistance- government provide amount for those starting new

Capital and money markets

Other sources of long-term finance

Factors affecting sources of finance

Objective of business- businesses carefully calculate involved risks, heavy capital

5AS.3 forecasting cash flow and managing working capital

Cash Flow Statement

Method of Improving Cash flow

Creditors- increasing the time it takes to pay creditors requires understanding

Why do businesses prepare cash flow forecast statement

Problems with cash flow forecast statement

DIFFERENT WAYS TO CATEGORIZE COSTS

FIXED AND VARIABLE COSTS

DIRECT AND INDIRECT COSTS

Marginal Cost (MC)

Problems of classifying costs

How cost can be used for pricing decision?

2 Using total revenue and total cost

Total cost = Fixed cost + Variable cost

Total revenue = Selling price × Quantity sold

3 Profit and loss

Profit = Total revenue – Total cost (fixed + variable)

The break-even chart shows the following points

The margin of safety (M.O.S.)

Margin of Safety = Current Output – Break even output

Advantages of break-even point

Limitations to break-even analysis

5AS.5 Accounting fundamentals

The main users of published company accounts

Internal users of accounting information

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

Management accounting- though financial accounting is important; it deals with the

What that published accounts contain

The Structure of Balance Sheet

Stock- this includes new materials work-in-progress and finished goods.

d) Net Current Assets/Working Capital

Working capital = Current assets - Current liabilities

e) Long Term liabilities

0 = (total assets - current liabilities) - log term liabilities

f) Capital and Reserves/Capital Employed/Share Holder’s Fund

Format of Balance Sheet

Shareholder’s funds £ 60 m Fixed assets. £ 70

Total liabilities £123m Total assets £

The use of balance sheet

Limitations of Balance Sheet

Total assets less current liabilities 4000

Creditors: amount (long-term liabilities)