Finanacial Management For Icm

NOTES & EXERCISES ON Financial Management -For ICM
Students
CHAPTER ONE
COMPANY ACCOUNTS
INTRODUCTION
A company is an association of people who have contributed money for
the purpose of carrying on business to make a profit. A company is
formed using contributions from many people each putting in a share of
the total money required to operate the business. All companies are
regulated by the Companies Act 1985 (as Amended by 1989). The
companies Act of 1985 & 1989 therefore sets out the basic format and
content of a published accounts.
The people who contribute the money in forming the company are called
the shareholders. They own the company but usually do not participate
in the management of the company. The shareholders therefore appoint
Directors to management the company on their behalf.
FORMATION OF A COMPANY
A company cannot form itself. Companies are formed by promoters. A
promoter is a person who sees to the formation of a company. In small
companies, they are usually the owners who act as the promoters of the
company. The formation of a company requires only a minimum of two
founders who are willing to subscribe (buy) the share capital. There is no
maximum limit. The procedure involved in forming a limited company is a
little more complex than the procedures involved in other business units.
A company is formed by the issue of certificate of registration by the
Registrar of Companies. To obtain a certificate of incorporation two
important documents are required to be sent to the Registrar at
Company House. These documents are Memorandum of Association
and Article of Association.
MEMORANDUM OF ASSOCIATION AND ARTICLE OF ASSOCIATION

A limited company must prepare two important documents that will be
sent to the Registrar of Companies, at Company House for the
company to obtain approval before it can start business. There documents
govern the company. The documents are:
1. MEMORANDUM OF ASSOCIATION: The memorandum of association

is a document which contains information concerning a company’s
relation with the external world/outsiders. The document gives the
external view of the company to the public, including details of its name,
addresses, registered office, share capital, a statement indicating
whether it is a Limited company or not and the objectives or purposes of
the company.
2. ARTICLE OF ASSOCIATION: This document gives the internal view
of the company and relates to the rules and regulations governing the
internal organization of the company such as voting rights, powers of
directors and conduct of meetings.
More Lecture Series – by TIMORE B. F

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The purpose of the Memorandum of Association and the Article of
Association is to define what the company is and how its business and
affaires are to be conducted.
The memorandum sets out the basic elements and the articles are mainly
internal rules.
THE CORPORATE CONSTITUTION (The Contents of the Article &

Memorandum of Association)
The constitution of a company consists of its memorandum of association

and its articles of association.
1. The Memorandum of Association
For a company limited by shares, the memorandum must contain the

following:
(a) Name Clause
CA 1985, s.25 - the name of a public limited company must end with the
words "public limited company", (PLC), the name of a private limited
company must end with the word "Limited". Abbreviations may be used
instead: "plc" or "Ltd". A company cannot be registered under a name
which is identical to a name already registered.
A company must have its name printed on all business documents and it
must be displayed at the registered office and all business premises.
A company can change its name by special resolution.
(b) Registered Office Clause
This establishes company’s nationality and its domicile, but not its
residence.
(c) Objects Clause
Company’s memorandum must contain an objects clause - a clause which

states the purpose or purposes for which the company was incorporated
or established.
The Ultra Vires Rule
If the company does something beyond the scope of its objects clause,
this is said to be ultra vires (beyond the powers of the company).
A director may be liable to the company for any costs incurred by the
company on an ultra vires transaction.

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Problems from this rule can be avoided by stating in the memorandum
that, the object is to carry on as a general commercial company.
(ii) Change of Objects Clause
A company can change its objects clause by special resolution.
(d) Limitation of Liability Clause
If members’ liability is to be limited, this must be stated in the

memorandum.
(e) Capital Clause
Limited companies with share capital must have a clause stating the total
amount of share capital with which it proposes to be registered and the
division of that capital into shares of a fixed amount.
(f) Alteration of Memorandum
A company cannot change its memorandum except in the circumstances

and manner expressly provided for in the Act. Memorandum can be
altered to change company from public to private and vice versa.
However this requires special resolution of shareholders. Company can be
changed from unlimited company to limited by special resolution - change
from limited to unlimited requires written consent of all the members.
Reduction of share capital requires special resolution
When company resolves to alter its memorandum, a copy of the

resolution, and the amended memorandum, must be sent to the Registrar
within 15 days - failure to do this is a criminal offence punishable by a
fine.
2. Articles of Association
(a) Articles Generally
The articles govern the internal management and organization of the

company. The articles are secondary to the memorandum - if there is
conflict between the articles and the memorandum, the memorandum
prevails.
3. Legal Effect of Memorandum and Articles
The memorandum and articles operate as a contract between the

company and its members, which both parties are bound to honour. The
effect of this is:

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(a) Each member, in his capacity as a member, is bound to the company
as if he personally had signed the memorandum and articles.
(b)The company is bound to each member in his capacity as a member.
(c)The memorandum and articles do not constitute a contract binding the

company or any member to an outsider - or to a shareholder in any other
capacity than as a member.
(d) A member has a right to compel the company to act according to the
articles even if not enforcing a right which is personal to himself as a
member.
(e) The memorandum and articles constitute a contract between each

member and every other member.
MEETINGS AND RESOLUTIONS
1. Shareholders and Shares
It must be noted that the day to day management of a company is in the

hands of the directors, not the shareholders - but the shareholders retain
some important powers - many decisions require a resolution of the
shareholders and cannot be decided by the directors alone.
(a) Who is a "Member?" A member is:
(i) Anyone who subscribes the memorandum.
(ii)Any other person who agrees to become a member and whose name is
entered on the register of members.
(b) Register of Members
CA 1985 requires every company to keep a register of its members. The

register must show:
- Name and address of each member.
- Date each person became a member and, where applicable, the date he
ceased to be a member.
- The number of shares held by each member and the amount paid on
them.
2. MEETINGS
Kinds of Meetings

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(a) Annual General Meeting
Most companies must hold an AGM.
An AGM must be held every calendar year with not more than 15 months
between meetings. A newly incorporated company must hold its first AGM
within 18 months of incorporation. If a company does not hold an AGM as
required, any member can apply to the Secretary of State to call or to
direct the calling of the meeting.
Members of a private company can choose to dispense with the holding of

an AGM by elective resolution - but any member of such a company can
require that an AGM be held in a particular year by giving notice at least 3
months before the end of the year.
(b) Usual Business of an AGM
Directors lay before the company annual accounts and reports for the
most recent financial period.
Auditor's term of office ends at AGM, so they must be re-appointed or new

auditors must be appointed. Director's recommendation for the dividend
to be paid to shareholders will be voted on.
The Articles may provide that directors are to retire in rotation. Some
directors will retire at the AGM and must be re-appointed or replaced.
Resolutions may be required to pay directors’ and auditors’ fees. (Now

normally fixed by contract).
Shareholders may have their own resolutions placed on the agenda.
(c) Extraordinary General Meetings
This is any meeting which is not an AGM. Table A provides that only
directors can call an EGM, unless there are too few directors in the UK to
make up a quorum - then any member can call one.
Public company must hold an EGM if the company’s net assets have fallen
to less than half of its called up capital. Meeting must be called within 28
days of the directors becoming aware of the loss of capital, and must be
held within 56 days of that date.
Where auditor has resigned and has made a statement of circumstances

he thinks should be brought to the attention of creditors and shareholders
- the auditor can requisition the directors to hold an EGM so that he can
explain the circumstances of his resignation.
TYPES/ CLASSIFICATION OF COMPANIES

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Companies are usually classifies as
a) Limited Companies or Unlimited Companies
b) Private Companies or Public Companies
NOTE: The word limited liability means that shareholders liability is
“limited” to the unpaid nominal capital for which they have subscribed for.
A) LIMITED COMPANIES AND UNLIMITED COMPANIES.

LIMITED COMPANIES
These are companies that have the liability of its members limited. The
liability of the members in these types of companies depends on whether
the company is any of the following
i. A Company Limited by Shares: This is the type of company in
which the liability of the members is limited to the amount of money
they owe in respect of the shares they subscribes (applied). The
members liability to contribute towards the debt of the company
(e.g. if the company is owing and about to be wound up and
therefore cannot pay its debts) is limited to the shares for which
they have subscribed and once the shares have been paid up, they
are not under any further liability.
ii. Companies Limited by Guarantee
There are no shares in this type of company. Any person who is accepted
as a member of the company is made to make a promise or guarantee of
an amount that he will contribute upon the liquidation of the company.
The members’ liability is limited to the amount they guarantee. That is,
the amount each member has pledged to contribute in the event of the
company being wound up. Such companies are non-profit organizations
such as charities and Trade Association.
UNLIMITED COMPANIES
In this type of company, the liability of the members is unlimited,
meaning that, shareholders can be made personally liable for the debts of
the company even if they have finished paying for their shares
subscribed. It is the direct opposite of limited companies. The position of
the members is like that of partners in a partnership firm.
B: PRIVATE OR PUBLIC COMPANIES
PRIVATE COMPANY: A private company is any company that is not

registered as a public company. Private companies can not invite the
public to subscribe (buy) their shares. That is they cannot sell their shares
to the public.
PUBLIC COMPANIES
A public company is the one which
i. Is limited by shares or guarantee and has a share capital
ii. Is registered as a public company; and
iii. Whose memorandum states that it is a public company.
iv. Its name must have the words “ Public Ltd Company or PLC”

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ADVANTAGES OF COMPANIES
The advantages of forming a company are as follows:
a) It has a separate legal entity from the shareholders.
b) There is limited liability. The liability of its members is limited to the
amount (if any) which remains unpaid on their shares.
c) Ownership and management of the business is separate so that
investors can put money into shares without taking part in running
the company.
d) Large amount of capital can be raised from many investors.
e) There is perpetual succession. That is the continuation and legal
standing of a company is not affected by the death of a director or
withdrawal of a director of the company. This is not so in sole
proprietorship businesses.
DISADVANTAGES OF COMPANIES
a) The procedure for forming a company is costly and complicated as
compared to other forms of business ownership.
b) Public companies are more venerable to takeovers.
c) Mangers are not likely to put in much of their efforts as in the case
of sole proprietorship.
d) Shareholders (i.e. the owners of the company) may have little
control and involvement in the management of the company
especially with PLCs.
FINAL ACCOUNTS OF LIMITED COMPANIES
THE CAPITAL OF A COMPANY
Nature of Shares and Share Capital
A company raises capital by the issue of shares. Shareholders are then

issued a share certificate which shows their ownership in the company. A
shareholder is therefore a part-owner of a company.
What is a Share?
A share is the unit of a capital structure of a company. That is the unit of

measure for determining a member’s interest in the company.
TYPES OF SHARES
There are two main types of share;
1) Ordinary shares / Equity shares

2) Preference share

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

of dividend. The dividend is paid first before any dividend is paid to
ordinary shareholders. Preference shares usually give a preferential right
to repayment of capital on a winding up. Preference shareholders
normally have restrictions placed on their power to vote at general
meetings.
TYPES OF PREFERENCE SHARES

1. Cumulative preference shares: This is the type of preference
shares in which unpaid dividends are accumulated and carried
forward. That is if the company is not able to pay for dividends due
to losses or low profit, the unpaid dividend is carried forward to the
following year and paid in the following year(in addition to the
dividend payable in the current year).
2. Participating preference shares: Theses shareholders have the
right to participate in the sharing of profit after the entire capital has
been paid during the winding up of a company.
3. Non-participating preference shares: These shareholders do
not have such right to participate in the sharing of profit after the
entire capital has been paid during the winding up of a company.
4. Redeemable preference shares: These are the shares which
allows the company to buy back (redeem) the shares from the
shareholders after sometime.
5. Irredeemable preference shares: These shares cannot be
bought back by a company.
THE SHARE CAPITAL OF A COMPANY
We shall now look at some terms which are used in company accounts.
1. STATED CAPITAL
This is the capital of the company that has been provided by the
members or owners of the company. This amount may include the
following:
i. The total amount (proceeds) received from the sale of the issue of
shares.
ii. Any other value received apart from cash.
iii. Any other transfer to reserves.

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2. AUTHORIZED SHARE CAPITAL
This represents the maximum amount of shares that the company is

allowed to allot or issue to the public. It is also known as nominal or
registered capital.
3. ISSUED SHARE CAPITAL/ ALLOTTED SHARE CAPITAL: This is that

part of the authorized shares that the company has actually allotted or
issued to the public for subscription.
4. PAID-UP SHARE CAPITAL: This is the amount that members have

paid on their shares, excluding any premium. That is, the amount of called
–up capital that has actually been paid by shareholders.
5. CALLED-UP SHARE CAPITAL: This is the part of issued share capital

which has been demanded by the company from shareholders. This
happens because sometimes a company may not need the full amount of
shares from the shareholders at once. Therefore the company calls for
such money when it needs it.
6. UNCALLED CAPITAL AND RESERVE CAPITAL: Uncalled capital is the

amount owing on partly paid shares which members have not yet been
called on to pay. Reserve capital is uncalled capital the company has
resolved not to call unless the company is wound up.
7. UNISSUED CAPITAL: This is the part of the authorized capital which

has not yet been issued to the public.
DIVIDEND: This is the interest payable on the shares to the shareholders.

Dividend is charged against the appropriation accounts. Dividend can be
either interim or final.
I Interim dividend: This is the dividend which is declared and paid

during the year by the board of directors.
Final Dividend: This is dividend which is paid at the end of the

year. It is proposed by the Directors and approved by management.
RIGHT ISSUE
A right issue is a situation where a company issues its shares to the

existing shareholders in proportion to their existing shareholding at a
favorable price. To do this the company contacts the existing shareholders
and informs them of the number of shares which each one of them is
entitled to buy of the new issue. It is one way through which to reduce the cost of
raising new shares. It is a device used by companies whose shares are listed
on the stock to raise additional capital. Existing ordinary shareholders are

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given a right certificate which entitles them to take up a specified number
of shares at a specified price. The right issue price is sufficiently below
listed price to make the offer attractive.
Shareholders who do not wish to exercise any or all of their rights may sell
them to third parties who then apply for the shares or he may renounce
his right.
DEBENTURES
A debenture is defined as a written acknowledgement of debt by a company, containing
provisions as to the payment of interest and the repayment of the principal.
FORMS/ TYPES OF DEBENTURES

Debentures can take any of the following forms.
1. Naked (unsecured) debenture: They are debentures which have not been guaranteed
with any collateral. It is not secured against any property. It does not carry any fixed
charge against the assets of the company.
2. Secured/ mortgage debenture: This debentures are secured and carry a fixed charge
on the assets to the company.
3. Redeemable debentures: These are debentures which the company aggress to repay at
a fixed determinable future date.
4. Irredeemable debentures: These are debentures which the company cannot redeem
or payback.
THE PROFIT AND LOSS ACCOUNT AND THE

BALANCE SHEET
THE TRADING ACCOUNT
It shows the total sales revenue less the cost of goods sold. It is the first to be prepared and
therefore comes before the profit and loss account. The difference between the sales
revenue and the cost of goods sold is termed GROSS PROFIT.
FORMAT FOR INTERNAL USE

MORE LTD
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 31ST DECEMBER 2006
£ £
£
Sales XXX
Less: Returns inwards XX
Net sales XXX
Less Cost of Sales:
Opening stock XX

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Add: purchases XX
Carriage inwards XX
Less returns outwards XX
Goods available for sale XX
Less closing stock XX
Cost of sales
XXX
Gross profit
XXX
Add other income:
Rent received XX
Discount received XX
Decrease in provision for bad debt XX
Profit on sale of assts XX
Investment income XX
XXX
XXX
Less expense:
Rent and rates XX
Selling and distribution expenses XX
Wages and salaries XX
Light and heating XX
Postage and stationary XX
Discount allowed XX
Interest XX
Insurance XX
Increase in provision for bad debt XX
Bad debt written off XX
Loss on disposal/ sale of asset XX
Vehicle expenses XX
Auditors fees XX
General expenses XX
Depreciation XX
Other expenses XX
XXX
Net profit before tax
XXX
Taxation
(XX)
Net profit after tax
XXX
Dividends: Interim dividends paid XX

Proposed dividends XX
(XX)
X
X
Transfer to capital reserves
(XX)
Profit and loss c/d
XXX

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BALANCE SHEET AS AT 31 AUGUST 2005
FIXES ASSETS COST DEP. NBV

£ £ £
Intangible (e.g. Goodwill) XXX XX XXX
Premises/ Land& buildings XXX XX XXX
Furniture and fittings XXX XX XXX
Motor vehicles XXX XX
XXX
Other assets XXX XX
XXX
Equipment XXX XX
XXX
XXX XX
XXX
CURRENT ASSETS:
Stocks XXX
Trade debtors XXX
Less provision for bad debt (XX) XXX
Prepayment XXX
Other receivables XXX
Cash & Bank XXX
XXX
CURRENT LIABILITIES:
Trade creditors XXX
Debenture interest unpaid XXX
Other owing XXX
Provision for taxation XXX
Proposed dividends XXX (XXX)
Working capital
XXX
Net assets
XXX
Financed by:
£1 ordinary share capital
XXX
Profit and Loss account
XXX
Debentures
XXX
Long term Loan
XXX
Net Worth
XXXX

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FOR PUBLICATION
This section concentrates on the syllabus of financial management. However,
students who have difficulty or whose first time in accounting is at this level
should refer to page (xxx) for brief introduction before reading this section.
If the final account is for publication or for presentation to members

(shareholders), the Profit and Loss Account and the Balance Sheet are
prepared in a summarized form and the details are then presented in the
form of a “note to the accounts”. The format for accounts for publication
is provided by the companies Act 1985. The format may be different from
business to business and a particular format to use in an examination
depends on the question given. (For details of the format, refer to Frank
Wood Business Accounting 2)
The format is presented below. Once again students must remember that,
for our examination purpose, the format has been limited the questions
set in our examination for easy understanding.
Notes to the accounts are not required by the syllables and therefore it is
excluded from this manual.
A specimen format is presented below:
THE PROFIT AND LOSS ACCOUNT

ABC LTD
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST DECEMBER 2006
£ £
Turnover XXX
Cost of sales (XX)
Gross operating profit/ (loss) XX
Distribution cost XX
Administrative Expenses XX XX
Net profit before interest and tax XX
Interest (XX)
Net profit before taxation XX
Taxation for the year (XX)
Net profit after tax XX
Dividends (proposed and paid) (XX)
Transfer to capital surplus (XX)

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Net profit c/d XXX
THE BALANCE SHEET

ABC LTD
BALANCE SHEET AS AT 31ST DECEMBER 2006
££ £
Fixed Assets
Intangible assets (e.g. Goodwill) XXX
Tangible assets XXX
Long term investment XXX
XXX
Current Assets
Stocks XXX
Debtors XXX
Cash XXX
Bank XXX
Prepayment XXX
Other receivables XXX
XXX
Current liabilities
Trade creditors XXX
Bank overdraft XXX
Taxation XXX
Proposed dividends XXX
Accrued expenses (owing) XXX
Other payables XXX (XXX)
Working capital XXX
XXX
Debentures XXX
Other Long term liabilities XXX (XXX)
Net assets XXXX
CAPITAL AND RESERVES:
Ordinary share capital XXX
Preference share capital XXX
Share premium XXX
Profit and loss account/Revenue reserves XXX
Capital reserves XXX
Shareholder’s fund/Net worth XXX

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Tutorial:
i. The format provided above does not contain all items in the
format as contained in the companies Act 1985. The standard
format can be obtained from Frank Wood Accounting 2.
ii. Debentures and other long term loans: These can be deducted
from the assets or added to capital and reserves.
iii. Debtors are stated after deducting provision for bad debt.
Example1.
The following information has been extracted from the mores of Fordham
Ltd as at 31st December 2007
Dr Cr
Bank 2,000
Capital: 100,000 ordinary shares fully paid (£1 each)
100,000
8%50,000 preference shares fully paid (£1 each)
50,000
Debenture loan stock (10%-repayable 2009)
30,000
Debenture loan interest 3,000
Discount allowed 2,000
Discount received 5,000
Dividend received 700
Dividend paid: ordinary interim 5,000
Preference 4,000
Freehold land (at cost) 200,000
Investments (listed: market value at 31/12/2007- £11,000) 10,000
Office expenses 15,000
Office salaries 35,000
Motor van (at cost) 15,000
Motor van: accumulated depreciation (1/1/2007)
6,000
Motor van expenses 2,700
Purchases 220,000
Sales 300,000
Retained profit (1/1/2007) 9,000
Share premium account
10,000
Stocks (1/1/2007) 20,000
Trade creditors 50,000
Trade debtors 27,000
560,700 560,700

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Additional information
1. The stocks as at 31st December 2007 were valued at cost at £40,000
2. Depreciation is to be charged on the motor van at a rate of 20% per
annum on cost. No depreciation is to be charged on the freehold
land.
3. Corporation tax (based on profits for the year at the rate of 35%)
has been estimated at £ 10,000
4. The directors proposed a final ordinary dividend of 10p per share.
5. The authorized share capital of the company is as follows:
a) 150,000 ordinary shares of £1 each and
b) 75,000 preference shares of £1 each
REQUIRED:
a) Prepare Fordham Ltd’s trading, profit and loss account for
the year end 31st December 2007
b) The balance sheet as at that date
Solution
QUESTION 2
You have obtained the following information in respect of BOB Ltd. For the
year ended
30 June 2007
th
£000
Sales (all credit) 1,800
Cost of sales 700
Administration expenses 400
Distribution costs 250
Interest paid 10
Provision for taxation 50
Proposed dividend 80
TASKS
Prepare a summarised Profit & Loss account for the year 30 June
2007.
Solution:
a) BOB LTD
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007
£ £
Turnover 1,800,000

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Less cost of sales 700,000
Gross Profit 1,100,000
Less Expense:
Administrative Expenses 400,000
Distribution cost 250,000 (650,000)
Net profit before interest and Tax 450,000
Less Interest paid 10,000
Net profit before Tax 440,000
Less Provision for taxation 50,000
Net profit after tax 390,000
Less Proposed Dividends 80,000
Net profit c/d 310,000
QUESTION 3 (JUNE 2005) Q.2
The following information relates to TLC Ltd. and has been taken from
their books as at 31 May 2005:
£
Turnover 990,000
Administration expenses 140,000
Cost of sales 370,000
Taxation for the year 40,000
Interest paid 20,000
Distribution costs 190,000
Proposed dividends 40,000
OTHER INFORMATION:
• There are 500,000 £1 ordinary shares in issue.
• The market price of an ordinary share on 31 May 2005 was £6.00
per share.
TASKS
a) Prepare the Profit & Loss account of TLC Ltd. for the year ended 31 May
2005.
b) Calculate the following
i. The EPS
ii. The PE ratio
iii. The dividend per share
iv. The interest cover
v. The profit after tax to sales percentage
SOLUTION TO QUESTION 2:
a)
TLC Ltd
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005
£ £
Turnover 990,000
Cost of sales (370,000)
Gross profit 620,000

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Less Expenses:
Distribution costs 190,000 (330,000)
Net profit before Interest & Tax
290,000
Interest Paid (20,000)
Taxation for the year (40,000)
230,000
Proposed dividends (40,000)
Profit & Loss Account c/d 190,000
b)
i. Earnings Per Share (EPS) = Net profit after tax – Preference share
dividend
No. of ordinary shares
Note: there are no preference shares. We only have ordinary shares of
500,000 shares in the question.
= £230,000 X100= 46p per share (or £0.46 per share)

500,000 shares
ii. Price Earnings (P E ) ratio = Market Price per share

EPS
= £6.0 = 13.04 times

£0.46
iii. Dividend per share = dividend paid/proposed

No. of shares
= £40,000 X 100 = £0.08 or 8% per

share = 8P per share
500,000
iv. Interest cover = Net profit before Interest and Tax
Interest
= £290,000 = 14.5 times
£20,000
v. Profit after tax to sales percentage = Net profit after tax X 100
Sales
= £230,000 X 100
£ 990,000
= 23.23%
QUESTION 3 (September 2005 Q.2)

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

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31 August 2005
£
Turnover 1,120,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 August 2005 was
£4.90 per share.
TASKS
a) Prepare the Profit & Loss account of AVCE Ltd. for the year ended 31
August 2005
b) Calculate the following
i. The EPS
ii. The PE ratio
iii. The dividend per share
iv. The interest cover
v. The profit after tax to sales percentage
a)
AVCE Ltd
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST AUGUST
2005
£ £
Turnover 1,120,000
Cost of sales (460,000)
Distribution costs 210,000 (380,000)
Net profit before Interest & Tax 280,000
Taxation for the year (90,000)
Profit & Loss Account c/d 75,000
b)
i. Earnings Per Share (EPS) = Net profit after tax – Preference share
dividend

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Note: There is no preference share dividend in the question and so
nothing was deducted
= £165,000 = 33p per share (or £0.33 per share)
500,000 shares
ii. Price Earnings (P E ) ratio = Market Price per share

EPS
= £4.90 = 14.84 times
£.0.33
iii. Dividend per share = dividend

No. of shares
= £90,000 = 18P per share or 18% per
share
500,000
iv. Interest cover = Net profit before Interest and Tax
Interest
= £280,000 = 11.2 times
£25,000
v. Profit after tax to sales percentage = Net profit after tax X 100
Sales
= £165,000 X 100
£ 1,120,000
= 14.73%
QUESTION 4
You have obtained the following information/data of Slingsbury Ltd. as at
31 May 2005:
£
Stock 130,000
Creditors 210,000
Fixed assets at cost 350,000
Cumulative depreciation of fixed assets 65,000
£1 Ordinary share capital 100,000
Debtors 140,000
Proposed dividend 30,000
Provision for company tax 20,000
Bank overdraft 13,000
Long-term loans outstanding 40,000
Share premium account 20,000
Revenue reserves 122,000
TASKS
a) Prepare the balance sheet of Slingsbury Ltd. as at 31 May 2005.
b) Calculate TWO liquidity ratios.

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Students
SOLUTION
QUESTION 4(a)
SLINGSBURY LTD
BALANCE SHEET AS AT 31 MAY 2005
ASSETS: COST DEP.

NBV
£ £ £
Fixed Assets 350,000 65,000
285,000
350,000 65,000
285,000
CURRENT ASSETS:
Stocks 130,000
Debtors 140,000
270,000
Creditors 210,000
Provision for taxation 20,000
Proposed dividends 30,000 (273,000)
Working capital
(3,000)
Net assets
282,000
Financed by:
100,000
Revenue reserves (P&L)
122,000
Share Premium Account
20,000
Long term Loan
40,000
Net Worth
282,000
b) TWO LIQUIDITY RATIOS
i. Current Ratio = Current Assets : 1 = 270,000 : 1 = 0.99:1
Current Liabilities 273,000
ii. Quick/Acid Test Ratio = Current Assets – Stocks: 1

Current liabilities
= 270,000-130,000 :1 =140,000 :1
273,000 273,000

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Students
= 0.51:1
QUESTION 5
The following list of balances as at 31 August 2005 of GHB Ltd. has been
taken from the books
AFTER the trading account has been completed:
£000 £000
Dr Cr
Gross profit for the year 270
Equipment at cost 280
Equipment depreciation (01 09 04) 112
Ordinary share capital 200
Interim dividend paid 10
Stock at 31 08 05 240
Trade debtors 190
Trade creditors 70
Cash and Bank 20
6% Debentures (redeemable 2009) 200
Profit & Loss account (01 09 04)
88
940 940
Notes:
• Equipment is to be depreciated at 10% on cost.
• Interest on debentures is still unpaid.
• The provision for tax is estimated at £12,000.
• A final dividend of 10 pence per share is proposed.
TASKS
a) Prepare the Profit & Loss and appropriation account for the year
ended 31 August 2005.
b) Prepare the balance sheet as at 31 August 2005.
c) Calculate the EPS.
d) Calculate the dividend cover.
SOLUTION: question 5
a)
GHB LTD
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST 2005
£ £
Gross profit
270,000
Distribution cost 110,000
Administrative expenses 90,000
Depreciation (280,000 X10%) 28,000 (228,000)
Net profit before interest and tax 42,000

22
Students
Debenture interest unpaid (6% X 200,000) (12,000)
Net profit before tax 30,000
Taxation (12,000)
Profit and Loss account balance b/d 88,000
106,000
Dividends: paid 10,000
Proposed (10% 200,000) 20,000 (30,000)
Profit and Loss c/d 76,000
b)
GHB LTD
FIXES ASSETS : COST DEP. NBV

£ £ £
Equipment 280,000 140,000
140,000
280,000 140,000
140,000
CURRENT ASSETS:
Stocks 240,000
Cash & Bank 20,000
450,000
Debenture interest unpaid 12,000
336,000
Net assets
476,000
Financed by:
200,000
76,000
Long term Loan
200,000
Net Worth
476,000
c) The EPS.
Earnings Per Share (EPS) = Net profit after tax – preference shares
dividend

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Students
= £18,000 = 9 pence per share (or £0.09 per share)
£200,000
d) The dividend cover = Net profit after tax = £18,000

Dividend £30,000
= £0.6 per share (or 60 pence per share)
QUESTION 6
The following trial balance has been extracted from the books of
Dessorch plc. for the year ended 28 February 2007:
£dr £cr
Land and Buildings at cost400,000
Plant and Machinery at cost150,000
Office equipment at cost60,000
Vehicles at cost 50,000
Depreciation accounts (01 03 06):
Plant and machinery 50,000
Office equipment 20,000
Vehicles 25,000
Cash 3,000
Long-term loan 80,000
Sales (all on credit) 2,230,000
Purchases 1,300,000
Stock (01 03 06) 200,000
Wages and salaries 450,000
Business rates and insurance60,000
Heating and lighting 30,000
Vehicle expenses 31,000
Interest paid 6,000
Profit and loss account (01 03 06) 205,000
£1 Ordinary shares 200,000
---------- ----------
2,940,000 2,940,000
NOTES at 28 February 2007:
• Stock in hand was valued at £105,000.
• Wages owing amounted to £5,000.
• Business rates prepaid amounted to £1,000.
• Plant and machinery is to be depreciated at 25% on cost.
• Office equipment is to be depreciated at 20% on cost.
• Vehicles are to be depreciated at 25% of net book value.
• It has been established that included in the £155,000 of trade
debtors is an amount of £5,000 owing from a company which
has ceased to trade, and has large debts. Consequently it is felt
that the whole amount should be written off.

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Students
• It has been decided to create a provision for doubtful debts
equal to 5% of the final end of year trade debtor figure.
• The directors estimate the tax liability to be £30,000.
• The directors have declared a final dividend of 9p.
TASKS
a) Prepare the trading and profit and loss account for the year ended
28 February 2007.
b) Prepare the balance sheet as at 28 February 2007.
SOLUTION
Q6. (a)
DESSORCH PLC
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED
28 FEBRUARY 2005
£ £
Sales 2,230,000
Cost of sales (1,395,000)
Administrative expenses 643,500 (688,250)
Net profit before interest and tax 146,750
Interest paid (6,000)
Taxation (30,000)
Dividends: Proposed (9% x 200,000) (18,000)

92,750
Profit and Loss account balance b/d 205,000
Profit and Loss c/d 297,750
(b)
DESSORCH PLC
BALANCE SHEET AS AT 28 FEBRUARY 2005
FIXES ASSETS : COST DEP.

NBV
£ £
£
Land & Buildings 400,000 -
400,000
Plant & Machinery 150,000 87,500
62,500

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Students
Motor Vehicle 50,000 31,250
18,750
Office Equipment 60,000 32,000
28,000
660,000 150,750
509,250
CURRENT ASSETS:
Stocks 105,000
Trade debtors (155,000 – 5,000 -7,500) 142,000
Rent prepaid 1,000
Cash & Bank 3,000
251,500
Wages owing 5,000
68,500
Net assets
577,750
Capital & Reserves
200,000
297,750
Long term Loan
80,000
Net Worth
577,750
Workings:
1. COST OF SALES: £
Opening stock 200,000
Purchases 1,300,000
1,500,000
Closing stock (105,000)
Cost of sales 1,395,000
2. ADMINISTRATIVE EXPENSES
£ £

Add wages owing 5,000 455,000
Business rates 60,000
Less prepaid 1,000 59,000

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Students
Bad debt written off 5,000
Provision for bad debt (155,000-5,000) x 5% 7,500
Depreciation:
Plant and machinery (150,000x25%) 37,500
Office equipment (60,000x20%) 12,000
Vehicles (50,000-25,000) x 25%) 6,250
643,250
QUESTION 7
You are the account officer of MORE LTD which has a registered capital of
£1,500,000 divided into 2,400,000 ordinary share of 50p each and
600,000 8% preference shares of 50p each. The following balances have
been extracted from the books of the company after preparing the trading
profit and Loss Accounts for the year ended 30 June 2007.
Dr Cr
£ £
Ordinary share capital 300,000
8% preference shares 90,000
General Reserve 15,000
Premises (cost) 420,000
Bank 24,600
Light & heating owing 2,640
Profit & Loss A/c bal (1July 2006) 57,600
Debtors & Creditors 17,400 3,360
Stocks 115,020
Cash 120
Plant & Machinery (at cost) 150,000
Net profit for the year ended (30 June 2007)
121,800
Insurance prepaid 2,460
Provision for depreciation:
Plant & Machinery
90,000
705000
705,000
Additional information:
The directors of MORE LTD have made the following Recommendations.
1. Corporate tax provision of £25,200
2. The payment of preference share dividend
3. A maximum dividend on ordinary shares which would maintain a
working capital ratio of 1:5:1, the balance remaining from profits to
be transferred to general reserves.
Required:
a) Prepare the profit and loss A/c for the year ended 30 June 2007
b) Prepare the balance sheet as at 30 June 2006.
SOLUTION: Q7
Note: The additional information on ordinary share dividends requires the
preparation of the balance sheet first

27
Students
MORE LTD
Profit and Loss Account for the Year ended 30th June 2007
£ £
Net profit for the year 121,800
Taxation provision (25,200)
Dividend: Preference shares (8% x 90,000) 7,200
Ordinary shares (w1) 27,000 34,200
General reserve (Balance remaining) (62,400)
P & L Bal b/d 57,600
57,600
MORE LTD
BALANCE SHEET AS AT 30TH JUNE 2007

NBV
£ £
£
Premises 420,000 -
420,000
Plant & Machinery 150,000 90,000
60,000
570,000 90,000
480,000
CURRENT ASSETS:
Stocks 115,020
Insurance prepaid 2,460
Cash 120
135,000
Light & heating owing 2,640
Proposed dividends: ordinary shares 27,000
Preference shares 7,200
Provision for taxation 25,200 (90,000)
45,000
Net assets
525,000
Capital & Reserves

300,000
Preference shares
90,000

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Students
297,750
General reserves (15,000 +62,400)
77,400
Net Worth
525,000
WORKINGS: DIVIDENDS
Preference share dividends: (90,000x 8%) 7,200
Ordinary shares dividend:
After paying the ordinary shares the working capital ratio (current
assets divided by current liabilities) must give a ratio of 1.5:1(i.e.
should be 50% more than the current liabilities).
The total current asset was £135,000. This means that to get a current
ratio of 1.5:1 and the total current liabilities must be £90,000. Total
liabilities before ordinary shares were £63,000. Therefore 27,000 must
be paid as dividends on ordinary shares to make total liabilities equal
£90,000 (£63,000 +£27,000) which will give a working capital ratio of
1.5:1 (135,000 ÷ 90,000). The remainder of the profit for the year
£62,400 is transferred to the general reserve in the balance sheet.
QUESTION 8(MARCH 2007)

The following information relates to Rollo Ltd and has been extracted from
their books as at 28 February 2007:
£
Turnover 2,900,000
Selling and distribution costs250,000
Stock at 01 03 06 360,000
Purchases 1,200,000
Stock at 28 02 07 380,000
Proposed ordinary dividend100,000
Issued ordinary share capital 1,000,000

Current market price per ordinary share 16
TASKS
a) Prepare the profit and loss account for the year ended 28
February 2007.
b) Calculate the following:
i the gross profit to sales percentage
ii the profit after tax to sales percentage
iii the earnings per share (EPS)
iv the PE ratio
v the stock turnover period in days
c) Comment on the financial performance via the use of ratios.

29
Students
SOLUTION: a)
ROLLO LTD
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 28TH FEBRUARY 2007
£ £
Turnover 2,900,000
Cost of sales (1,180,000)
Gross profit 1,720,000
Selling and distribution expenses 250,000 (490,000)
Net profit before interest and tax 1,230,000
Net profit before Tax 1,120,000
Taxation (160,000)
Profit and loss c/d 860,000
b)
i. Gross profit percentage = Gross profit X 100 = £1,720,000 X 100
Sale £2,900,000
=59.3%
ii. Profit after tax to sales percentage = Net profit after tax X 100
Sales
= 960,000 X 100
2,900,000
= 33.1%
iii. EPS = Net profit after tax = £960,000 = 96p per share
No. of shares 1,000,000
iv. PE ratio = Market price per share = £16 = 16.67

times
EPS £ 0.96
v. Stock turnover (in days) = Average stock X 365 days

Cost of sales
Average Stock = opening stock + closing stock= £360,000
+380,000 = £370,000
2 2
Stock turnover = £370,000 X 365 days
£ 1,180,000
= 114 days

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Students
c) Comment of the financial performance of Rollo Ltd:
The gross profit of 59.3% seems fairly good even though previous year’s
performance is not available for comparison. The EPS seems high
compared with the 1,000,000 shares in issue. However, the company is
not able to sell its stock quickly enough. This may suggest lack of demand
for the goods otherwise management are taking advantage of bulk
purchase as the stock turnover stood at 114days.
QUESTION 10(MARCH 2008-ACCOUNTING III)

The following trial balance has been extracted from the books of Yousef plc for the year
ended 29 February 2008:
£dr £cr
Premises 400,000
Machinery 150,000
Vehicles 60,000
VAT refund due 10,000
Prepayments 4,000
Bank 6,000
Cash 1,000
Hire purchase account 90,000
Purchases 990,000
Stock (01 03 07) 59,000
Energy costs 65,000
Interest paid 8,000
Vehicle running expenses 36,000
Advertising expenses 65,000
Communication expenses 70,000
Profit and loss account (01 03 07) 237,500
Machinery depn. a/c (01 03 07) 37,500
Vehicle depn. a/c (01 03 07) 15,000
---------- ----------
2,806,000 2,806,000
======== ========
Notes at 29 February 2008:
• Stock was valued at £64,000
• The analysis of the hire purchase account revealed that £20,000 falls due for
payment by 30 June 2008 and that the rest falls due for payment in the year 2012.
• Machinery AND vehicles are to be depreciated at 25% on cost.
• The directors have decided to provide the following provisions:
o Corporation tax of £56,000
o An ordinary dividend of 80 pence per share

31
Students
TASKS
a) Prepare the trading and profit and loss account for the year ended 29 February2008.
[9]
b) Prepare the balance sheet as at 29 February 2008.[8]
c) Calculate the following accounting ratios:
i gross profit percentage
ii the profit before tax percentage of sales
iii the current ratio
iv the acid test
SOLUTION: Q 8 (a)
YOURSEF PLC
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 29TH
FEBRUARY 2008
₤ ₤
Sales
2,076,000
Purchases 990,000
1,049,000
Closing stock (64,000) (985,000)
Gross profit 1,091,000
EXPENSES:
Wages & salaries 410,000
Business Rates 70,000
Energy costs 65,000
Interest paid 8,000
Vehicles running expenses 36,000
Advertising 65,000
Depreciation:
Machinery (25% X 150,000) 37,500
Vehicle (25% X 60,000) 15,000 (818,500)
Corporation tax (56,000)
Dividends (0.8 X 100,000) (8,000)
Retained profit for the year 208,500
Net profit b/d 237,500

32
Students
(b)
YOUSEF PLC
BALANCE SHEET AS AT 29TH FEBRUARY 2008

NBV
£ £
£
Premises 400,000 -
400,000
Vehicles 60,000 30,000 30,000
Machinery 150,000 75,000
75,000
610,000 105,000
505,000
CURRENT ASSETS:
Stocks 64,000
Vat refund 10,000
Bank 6,000
Cash 1,000
Prepayments 4,000
445,000
Hire purchase 20,000
Corporate tax 56,000
Dividends 8,000 (224,000)
221,000
Hire purchase account (90,000-20,000) (70,000)

Long term loan (110,000)
Net assets
546,000
Capital & Reserves

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Students
100,000
Net profit 446,000
Net Worth
546,000
(c)
i. Gross profit percentage = Gross profit X 100 = £1,091,000 X
100 = 52.55%
Sale £2,076,000
ii. Profit before tax to sales percentage = Net profit before tax X
100
Sales
= 272,500 X 100
= 13.1%
2,076,000
iii. Current Ratio = Current Assets = 445,000 = 1.98:1

iv. Quick/Acid Test Ratio = Current Assets – Stock = 455,000 –

64,000 = 381,000 = 1.7:1
224,000
QUESTION 9 ( past Question)

The following trial balance has been taken from the books of RAB Ltd. as
at 30 April 2007:
£ £
Turnover 1,960,000
Purchases 1,120,000
Stock (01 05 06) 76,000
Communication expenses28,000
Rent, rates and insurance 53,000
Marketing expenses 95,000
Auditor’s fee 7,000
Salaries 168,000
Debenture interest 3,000
Wages 210,000
Creditors 55,000
Provision for doubtful debts 2,000
Equipment at cost 530,000
Depreciation of equip. (01 05 06) 90,000
Debentures (6%) 50,000
Ordinary share capital (£1) 200,000
Profit and loss a/c bal (01 05 06) 102,000
Debtors 130,000

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Students
Bank balance 10,000 -------
2,459,000 2,459,000
Notes at 30 April 2007:

• Stock is valued at £74,000.
• Salaries owing amounted to £6,000.
• Marketing expenses prepaid amounted to £8,000.
• The provision for doubtful debts is to be increased to £4,000.
• The equipment is to be depreciated by 25% pa on cost.
• The directors wish to provide £38,000 for corporation tax.
• The directors have declared an ordinary dividend of 12p per
share.
TASKS
a) Prepare the profit and loss account for the year ended 30 April
2007.
b) Prepare the balance sheet as at 30 April 2007
Solution: Q9(b)
RAB LTD
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30TH APRIL 2007
£ £ £
Turnover
1,960,000
Cost of sales:
Purchases 1,120,000
Cost of goods available for sale 1,196,000
Cost of sales
(1,122,000)
Gross profit
838,000
EXPENSES:
Rent, rates & Insurance 53,000
Marketing expenses 95,000
Less prepaid (8,000) 87,000
Auditor’s fees 7,000
Salaries 168,000,
Add owing 6,000 174,000
Wages 210,000
Increase in prov. for bad debts (4,000 -2,000) 2,000
Debenture interest 3,000

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Students
Depreciation: equipment (25%x 530,000) 132,500
(722,500)
115,500
Taxation
(38,000)
74,500
Proposed dividends (12% x 200,000)
(24,000)
Retained profit for the year
50,500
P & L Account Bal. b/d
102,000
P&L Account c/d
152,500
RAB LTD
BALANCE SHEET AS AT 30 APRIL 2007

NBV
£ £
£
Equipment 530,000 222,500
307,500
530,000 222,500
307,500
CURRENT ASSETS:
Stocks 74,000
Debtors 130,000
Less provision for bad debt 4,000 126,000
Marketing expense prepaid 8,000
Bank balance 10,000
218,000
Salaries owing 6,000
95,000
402,500
6% Debentures
(50,000)
Net assets
352,500
Capital & Reserves

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Students
200,000
152,500
Net Worth
352,500
TRY QUESTIONS:
1. You work as the accountant for a client named Dusty, and have just
taken out the trial balance as at 30 April 2007:
£ dr £ cr
Capital as at 01 05 06 219,000
Sales 1,879,000
Purchases 1,210,000
Stock as at 01 05 06 74,000
Debtors 82,000
Prov. for doubtful debts 1,000
Creditors 67,000
Insurances 45,000
Light and heat 42,000
Motor expenses 18,000
Staff salaries 82,000
Loan interest 2,000
Buildings at cost 400,000
Vehicle depreciation 01 05 06 20,000
Wages 155,000
Bank 6,000
Cash 1,000
Drawings 21,000
2,226,000 2,226,000
======== ========
Notes at 30 April 2007:
• Stock was valued at £71,000.
• Insurance prepaid amounted to £2,000.
• Wages owing amounted to £5,000.
• The accountant’s fee outstanding is estimated to be £4,000.
• The accountant has reviewed the debtors outstanding and
advises Dusty to write off £2,000.
• After writing off the bad debt you suggest that the provision for
doubtful debts should be increased to £3,000.
• The vehicles are to be depreciated by 20% on cost.
TASKS
a) Prepare Dusty’s trading and profit and loss account for the year
ended 30 April 2007.
b) Prepare Dusty’s balance sheet as at 30 April 2007.
Question 2.

37
Students
The following information relates to Status Ltd. and has been taken from
their books as at 31 March 2006:
£
Turnover 1,400,000
Administration expenses210,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 March 2006 was
£11.20 per share.
TASKS
Prepare the Profit & Loss account of Status Ltd. for the year ended 31
March 2006.
Question 3
The following are the assets and liabilities of Chantal Ltd. as at 30
April 2007:
£000
Premises 800
Bank overdraft 130
Creditors 110
Goodwill 150
Debtors 400
Vehicles (net) 190
Preference share capital 300
Share premium 140
Tax owing 110
Dividends owing 80
Equipment 460
Closing stock 300
Profit and loss account balance 400
Long-term loans 330
The following information has also been gathered:

Credit sales 3,400
Opening stock 260
Purchases 1,500
TASKS
a) Prepare the balance sheet of Chantal Ltd. as at 30 April 2007.
b) Calculate the following ratios:
i current
ii acid test
iii the debtor collection period in days
iv the rate of stock turnover

38
Students
c) Comment briefly on the liquidity position of Chantal Ltd. as at 30 April
2007.
Question 4
The following are the assets and liabilities of RebEt Ltd. as at 30
November 2005:
£000
Equipment (net) 280
Bank overdraft 110
Creditors 156
Goodwill 190
Debtors 412
Vehicles (net) 140
Share premium 120
Tax owing 90
Dividends owing 100
Premises 700
Closing stock 224
Profit & Loss account balance 390
Long-term loans 280
TASKS
a) Prepare the balance sheet of RebEt as at 30 November 2005.
i current
ii acid test
c) Comment briefly on the liquidity position of RebEt as at 30 November
20
CHAPTER THREE
ACCOUNTING RATIOS
INTRODUCTION
An accounting ratio is a mathematical relationship between two

accounting figures which can be presented in the form of numerals,
percentage, a fraction or a decimal. Each expression attracts a
special care.
Financial ratios or Accounting ratios are useful indicators of a firm's

performance and financial situation. Ratios can be used to analyze trends

39
Students
and to compare the firm's financials position to those of other firms. In
some cases, ratio analysis can predict future bankruptcy.
USERS OF ACCOUNTING RATIOS

1. Trade Creditors: These groups of people are interested in the
company’s ability to pay its short term debts as and when they fall
due. Their analysis will usually concentrate on the evaluation of the
company’s liquidity position (i.e. Liquidity ratios).
2. Lenders of long term loan (e.g. debenture holders): They are
concerned with the company’s long term solvency and its survival in
the future. Their analysis will concentrate on the firm’s profitability
over time, its ability to generate cash to pay them (i.e. the lenders)
their interest when due and the payment of the principal money.
Their focus will be on the company’s capital structure (i.e. the
relationship between the various sources of funds- equity and debt
capital)
3. Investors: These people are mostly concerned with the company’s
earnings. Investors have more confidence in companies that shows
a steady growth in earnings. Their analysis concerns an evaluation
of the company’s present and future profitability. They are also
interested in the capital structure of the company to prevent greater
risks and any structure which can influence the earrings ability of
the firm.
4. Management: Management/Directors of the company are the
stewards of the company. They are therefore interested in every
aspect of the analysis.
CATEGORIES /TYPES OF ACCOUNTING RATIO

Financial ratios can be classified according to the information they
provide. They can be classified in to five main groups.
1. PROFITABILITY RATIOS
2. LIQUIDITY RATIOS
3. ACTIVITY RATIOS OR EFFICIENCY RATIOS
4. LONG-TERM SOLVENVY/GEARING OR LEVERAGE RATIOS
5. INVESTMENT/ STOCK MARKET RATIOS.
In general, Profitability ratios measures the overall performance of the
company, Liquidity ratios measures the firms ability to meet current
debts as they become due for payment, Activity/ efficiency ratios
reflects the firms efficiency in utilizing its assets, Gearing/Leverage
ratios measures the proportion of debt and equity in financing the assets
of the company and Stock market ratios evaluate the firms growth
earnings.
These categories have a number of ratios under each type. These are
discussed in details below.

40
Students
1) PROFITABILITY RATIOS
These ratios measure the business’s potential to make profit in excess of

its operating cost. It is one of the most important measures of a
company’s success. These ratios are used to measure the trading
performance of the business in terms of profit to sales or capital.
They compare profits at different levels with other figures and are often
presented as percentages. The main purpose of these ratios is to
measure the profit made by a business within one year.
Profitability is a primary measure of the overall success of a
company. Indeed, it is necessary for a company’s survival.
The main profitability ratios are:
a) Gross Profit (Margin) percentage/ratios
b) Net profit percentage/ ratio
c) Return On Capital Employed (ROCE)
d) Return on Total Assets
e) Return on Net Worth
f) Expenses to Net profit ratio (percentage.)
g) Expenses to sales percentage
A) GROSS PROFIT PERCENTAGE:

This is Gross Profit divided be Sales. This ratio measures the average
gross profit/margin on sales of goods. It expresses the proportion of the
selling price which represents gross profit.
It is calculate by the formulae below:
Gross profit percentage = Gross Profit X 100
Sales
The answer you get represents the amount of gross profit for every
₤100 of sales revenue. For instance, if the answer is 20%, this would
mean that for every ₤100 of sale you make, ₤20 gross profit is made
before any expense is paid.
Interpreting the gross profit percentage

Normally this ratio is expected to remain reasonably constant
overtime. Manufacturing industries with high operating cost/overheads
would usually have higher margins whilst industries with high volumes
of sales like food retailing have low margins.
 Low margins usually suggest poor performance.
 But sometimes it may be due to expansion cost undertaken by
the company such as launching a new product, trying to increase
market share etc.
 Above average margins are usually a sign of good management.
 However, too high margins may make competitors enter the
market to compete with the business.
 High profit margins could also mean the effectiveness of the
sales team, pricing policies, purchasing methods, and the
production process.

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The ratio is expected to remain constant over time. Therefore if there is
a change in this ratio over various accounting periods, the change may
be traced to a change in any of the following:
a) Selling price- increase or decrease in selling price over the
periods, which is sometimes deliberate; perhaps in order to
increase sales.
b) Stocks- wrong valuation of stocks or errors in accounting for
stocks etc.
c) Production cost- increase or decrease in the production cost over
the period e.g. Increase in raw materials which has not been
possible to pass on to customers in the form of higher prices.
d) Sales mix- a change in sales mixed; if several different products
are been sold they will not all be equally profitable; it is possible
that in the current year, the company sold a higher proportion of
less profitable products.
Assuming you calculate the ratio and there is a decline or reduction,
how do you interpret this? Possible factors for interpreting this may
include
• Sales revenue declined
• Sales revenue remained the same, but costs increased over
the year
• Sales increased, but costs increased in greater proportion
• Suppliers increased their prices or the business lost trade
discount
• There was a change in the sales mix; more of less profitable
goods were sold this year.
B) NET PROFIT RATIO (PERCENTAGE)

The net profit percentage expresses an organization’s net profit as a
percentage of total sales.
It is calculated as:
Net profit percentage = Net profit x100
Sales
The factors that affect the gross profit as stated above affects the net
profit percentage in the same way. Other factors affecting the Net
profit which will cause the percentage to change over accounting
period or between companies more importantly includes the following:
i. Depreciation policy adopted
ii. Change in selling and administrative expenses.
C) RETURN ON CAPITAL EMPLOYED (ROCE)

It is the net profit before interest and tax divided by capital employed.
ROCE is the most important profitability ratio and is probably the most
important of all the other ratios. It states the profit as a percentage
of the amount of capital employed. It is often referred to as the
primary ratio. In its simplest form, it attempts to measure the
performance of the business by comparing profit with the funds used to
generate them. It is considered the most important because, growth of

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profit can only be assessed properly when the profit is related to the
capital used or employed in generating the profits.
ROCE = Profit before Interest & Tax X 100

Capital Employed
Unfortunately, the term capital employed has more than one meaning.
The most common meanings are: Capital Employed= TOTAL ASSETS -
CURRENT LIABILITIES (i.e. Fixed Assets +Current Assets – Current
Liabilities)
OR
Capital employed = shareholder’s fund + Long term creditors
(amount falling due after more than one year) + any long term
provision for liabilities and charges.
D) RETURN ON NET WORTH

This ratio expresses the net profit as a percentage of owner’s equity.
It is calculated as: Net profit X 100
Net worth (owner’s equity)
E) RETURN ON TOTAL ASSETS

This is the net profit expressed as a percentage of total assets. It is
calculated as:
= Net profit X 100
Total Assets
F) EXPENSES TO NET PROFIT PERCENTAGE:

This is the total expenses expressed as a percentage of Net profit. It is
calculated by the following formulae:
Total expenses to Net profit percentage = Total expenses X 100
Net profit
This ratio shows how net profit can pay off expenses.
The usefulness of this ratio is that, it helps management to take steps to
control expenses when the ratio is getting high. For example if the total
expenses amount to ₤5,000 and the net profit is ₤10,000, this means that,
expenses is 50% of net profit.
Thus net profit can pay off expenses twice over. A low rate means good
expenditure control.
Thus Expenses to Net profit percentage = ₤5,000 X 100 = 50%

₤10,000
If in the subsequent period, expenses to net profit percentage is 75%,
thus if expenses has increased to ₤7,500, then this is an indication to
management to take steps to control the level of expenditure in the
business.
NOTE: The individual expenses ratios can also be calculated in the same
way. For example, Distribution cost to net profit ratio, administrative
expenses to net profit ratio etc.

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G) Expense to Sales Ratio

This is the total expenses expressed as a percentage of sale revenue or
turnover. It is calculated by the following formulae:
Expenses to sales percentage= Total expenses X100
Sales
EXAMPLE 1:
year ended
30 June 2007
th
£000
Cost of sales 700
Interest paid 10
Closing value of fixed assets 700
Closing stock 90
Closing debtors 100
Closing cash/bank balance 30
Closing creditors 40
Issued ordinary share capital (£) 500
TASKS
a) Prepare a summarised Profit & Loss account for the year 30 June
2007
ii the net profit before tax as a percentage of sales
iii the operating profit as a percentage of sales
iv the total expenses as a percentage of sales
Solution:
a) BOB LTD
£ £
Sales 1,800,000
Less cost of sales
700,000
Less Expense:
Interest paid 10,000 660,000

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390,000
b)
i) The gross profit percentage = Gross Profit X 100 = 1,100,000 X 100 =
61.1%
Sales 1,800,000
ii) Net profit before tax as a percentage of sales
=Net profit before tax X100 = 440,000 X 100 = 24.4%
Sales 1,800,000
iii) The operating profit as a percentage of sales
= Net profit after tax X 100 = 390,000 X100 =21.67%
Sales 1,800,000
iv) The total expenses as a percentage of sales = Total expenses X 100 =
660,000 X 100 = 36.67%
Sales 1,800,000
Example 2
Study the following information regarding Companies A and B for the
year ended 30 June 2007
Profit and Loss account Company A Company B
£ £
Turnover 9,000 24,000
Cost of goods 5,000 10,500
Other expenses:
Selling 500 4,750
Administration 750 2,250
Financial 300 500
TASKS:
a) Prepare the Profit and Loss Accounts for the year ended 30th
June 2007
i. Gross profit percentage
ii. Net profit percentage
Solution:
a) Profit and Loss account for the year ended 30th June 2007
Company A B
Turnover 9,000 24,000
Cost of sales (5,000) (10,500)
Gross profit 4,000 13,500
Selling expenses (500) (4,750)
Administrative expenses (750) (2,250)

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Financial expenses (300) (500)
Net profit 2,450 6,000
b) i) Gross profit percentage:

Gross profit X 100 4,000 X100
13,500 X100
Turnover 9,000
24,000
= 44.44%
= 56.25%
ii) Net profit Percentage
= Net profit X100 = 2,450 X100
= 6,000 X100
Sales 9,000
24,000
= 27.22%
= 25%
LIQUIDITY RATIOS
These ratios measure the ability of a business to pay its current
liabilities as and when they fall due. It is also known as short-term
solvency ratios.
A liquidity ratio measures the extent to which current assets can be

quickly turned into cash. In other words they show how much cash the
entity has available in the short term. Liquidity ratios are probably the
most commonly used of all the business ratios. A company’s creditors
may often be particularly interested in this because they show the ability
of the business to quickly generate the cash needed to pay its bills.
Liquidity is the amount of cash a company can put its hands on quickly to
settle its debts. Liquidity ratios are sometimes called working capital
ratios because that, in essence, is what they measure.
Liquidity ratios provide information about a firm's ability to meet its short-
term financial obligations. They are of particular interest to those
extending short-term credit to the firm.
TYPES OF LIQUIDITY RATIOS
Two frequently-used liquidity ratios are
A. THE CURRENT RATIO (OR WORKING CAPITAL RATIO)

B. THE QUICK RATIO/ ACID TEST RATIO
A. CURRENT RATIO: It is current assets divided by current liabilities.
The current ratio is used to evaluate the liquidity or the ability to
meet short term debts. The standard test of liquidity is the Current
Ratio. The current ratio measures the adequacy of current assets to
meet short term liabilities. The current ratio is the ratio of current

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assets to current liabilities. It is calculated by the following
formulae:
Current ratio = Current assets
Current liabilities
The answer is expressed as a factor, e.g. 2 to 1 or 2:1, 3:1, 1.6:1 etc.

The idea behind this is that the company should have enough current
assets to pay off its current liabilities. Obviously, a ratio in excess of 1.0
should be expected. Otherwise there would be the prospect that the
company might be unable to pay its debts on time.
Traditionally, a current ratio of 2 or higher was regarded as appropriate
for most businesses to maintain credit worthiness.
However, in recent times a ratio of 1.5 may be regarded as the norm.
Short-term creditors prefer a high current ratio since it reduces their risk.
Shareholders may prefer a lower current ratio so that more of the firm's
assets are working to grow the business. Typical values for the current
ratio vary by firm and industry. For example, firms in cyclical industries
may maintain a higher current ratio in order to remain solvent during
downturns.
One drawback/disadvantage of the current ratio is that inventory may

include many items that are difficult to liquidate quickly and that have
uncertain liquidation values.
Interpretation
A reducing current ratio might mean a sign of deteriorating financial

condition. It might also be the result of eliminating obsolete stock.
An increasing current ration may mean a good financial situation. But it

can also mean an unnecessary piling of stock which may have other
negative effects like increase in stockholding cost.
A low current ratio has any of the following consequences:
i. Delays in payment to creditors. This will lead to loss of discount

ii. Creditors will withhold supplies because of late payments
iii. There will be constant problem as to how to find cash to pay weekly
bills
iv. Investment plans will have to be postponed
Too high ratios on the other hand may have the following
consequences:
NB: The current ratio is very useful in assessing the performance of a

business but very tricky to interpret the answer. Therefore it is useful that
the analyst take a careful look at the individual assets and liabilities when

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interpreting the ratio. Consider the individual assets and liabilities and
note any changes too much stock, higher bad debt provision etc.
B. QUICK RATIO/ACID TEST RATIO
This is the current assets less closing stock divided by current liabilities.
The quick ratio is an alternative measure of liquidity that does not include
inventory in the current assets. Most companies are not able to convert all
their current assets into cash very quickly. Manufacturing companies in
particular may hold large quantities of raw materials stock, finished
goods, WIP. For this reason we calculate an additional liquidity ratio
known as the Quick / Acid test ratio.
The quick ratio is defined as follows:

Quick or Acid test ratio = Current Assets - stock
Current Liabilities
This ratio should ideally be at least 1.0 for companies with a slow stock
turnover, for companies with a fast stock turnover; a quick ratio can be
comfortably less than 1.0 without suggesting that the company should
be in cash flow trouble.
Example 3:
The following information relates to MORE LTD at the end of three
consecutives years ending 31 December 2006.
Year 2004 2005

2006
£ £
£
Creditors 6,480 9,740
12,565
Bank - -
1,500
Loan (long –term) 12,500 10,500
10,000
Capital 24,100 24,180
26,220
43,080 44,420
50,285
Cash in hand 100 100

250
Bank 1,450 1,750
-
Debtors 8,455 7,940
9,165
Stocks 4,575 6,230
10,120

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Shop fittings 3,500 3,400
5,750
Premises 25,000 25,000
25,000
43,080 44,420
50,285
TASKS:
a) Calculate the amount of the working capital at the end of each year
b) Calculate the ratio of current assets to current liabilities to one
decimal place at the end of each year
c) Calculate the acid test correct to one decimal place at the end of
each year
d) Which year do you consider has been the safest as far as MORE
LTD’s debt paying ability is concern?
Solution:
MORE LTD
BALANCE SHEET AS AT
2004 2005
2006
£ £ £ £ £ £ £ £
£
Fixed assets
Premises 25,000 25,000
25,000
Shop fittings 3,500 3,400
5,750
28,500 28,400
30,750
Current Assets
Cash in hand 100 100
250
Bank 1,450 1,750 -
Stocks 4,575 6,230
10,120
Debtors 8,455 7,940
9,165
14,580 16,020
19,535
Current Liabilities
Creditors 6,480 9,740 12,565
Bank Overdraft -- (6,480) -- (9,740) 1,500
(14,065)
Working capital 8,100 6,280
5,470
Net Assets 36,600 34,680
36,220
Financed by:
Capital 24,100 24,180
26,220
Long –term Loan 12,500 10,500
10,000
36,600 34,680
36,220

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a) Working capital at the
end of each period =£ 8,100 £6,280
£5,470
b) Current ratio = Current Assets

Current Liabilities
Years 2004 2005 2006

Current Ratio = 14,580 16,020 19,535
6,480 9,740 14,065
= 2.3:1 =1.6:1 = 1.4:1
c) Acid test ratio = Current Assets – stocks

Current Liabilities
Years 2004 2005 2006
Acid Test ratio = 14,580 – 4575 = 16,020 – 6,230 = 19,535 –

10,120
6,480 9,740 14,065
= 1.5:1 =1:1 =
0.7:1
EXAMPLE 4:
The following trial balance has been extracted from the books of Tourist
PLC. for the year ended 31 August 2005:
£dr £cr
Property (31 08 05) 340,000
Plant and Machinery (31 08 05) 36,000
Office equipment (31 08 05)40,000
Vehicles (31 08 05) 30,000
VAT refund due 46,000
Prepayments 4,200
Cash 2,000
Purchases 1,200,000
Stock (01 09 04) 100,000

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Depreciation for the year20,000
Profit & Loss account (01 09 04) 190,000
2,928,000 2,928,000
NOTES at 31 August 2005:

• Stock was valued at £108,000.
• The analysis of the hire purchase account revealed that £8,000
falls due for payment by 31 March 2006, and that the rest falls due
for payment after 1 September 2006.
• The directors have decided to provide the following provisions:
Corporation tax of £65,000
An ordinary dividend of 10 pence per share
TASKS
a) Prepare the Trading and Profit & Loss account for the year ended 31
August 2005.
b) Prepare the balance sheet as at 31 August 2005.
c) Calculate the following accounting ratios for the two years:
i gross profit percentage
ii the profit after tax percentage
iii the acid test
iv the current ratio
TOURIST PLC.
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST
2000
£ £
£
Sales
1,980,000
Cost of sales:
Stock 100,000
Purchases 1,200,000
1,300,000
(1,192,000)
Gross profit
788,000
Wages 420,000
Depreciation for the year 20,000
(596,000)

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192,000
Taxation
(65,000)
127,000
Dividend (200,000X10%)
(20,000)
10
7,000
Profit and Loss Account bal. b/d
190,000
Profit and Loss Account bal. c/d
297,000
TOURIST PLC.
FIXES ASSETS :
NBV
£ £
£
Property
340,000
Plant & Machinery
36,000
Vehicle
30,000
Office Equipment
40,000
446,000
CURRENT ASSETS:
Stocks 108,000
Vat refund due 46,000
Prepayment 4,200
Cash 2,000
694,000
171,000

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617,000
Long term liabilities:
Long term loan 80,000
Hire purchase account (48,000 - 8,000) 40,000
(120,000)
Net assets
497,000
Capital & Reserves

200,000
297,000
Shareholders fund
497,000
c)
i. Gross profit percentage = Gross profit X100 = 788,000 X 100
Sales
1,980,000
= 39.79%
ii. Profit after tax percentage = Net profit after tax X100
Sales
= 127,000 X 100
1,980,000
= 6.4%
iii. Acid Test ratio = Current Assets – Stock = 694,000 –

108,000
= 1.04: 1
iv. Current Ratio = Current Assets = 694,000

Current liabilities 563,000
= 1.2: 1
2) EFFICIENCY RATIO/ACTIVITY RATIOS

These ratios show how effective the resources of the business have
been utilized to generate income. They measure the efficiency of the
management of assets (both fixed assets and current assets). Thus
activity ratios measure how well the assets of the organization have
been used to attain the objectives of the organization.
The following are the major activity or efficiency ratios.
A). STOCK TURNOVER RATIO

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Stock turnover refers to the number of times/days that stocks are sold
and replenished during a year. It is an indication of a business selling
efficiency.
The stock turnover can be measured in two ways.
The stock turnover ratio is calculated as follows:
1. Stock turnover ratio (in days) = Average stock x 365
days
Cost of sales
2. Stock turnover (No. of times) = cost of sales
Average stock
Average Stock = opening stock + closing stock

2
Note that, one is the opposite of the other.
The greater the stock turnover, the more efficient the entity would appear
to be in purchasing and selling goods. A stock turnover of say 2
times would suggest that the company has about six month of
sales in stock.
Interpretation:
When interpreting the stock turnover, it is important to compare or relate
the answer with the previous years’ stock turnover.
If the rate of turnover is slowing down (i.e. reduction in the stock turnover)
it might mean that, the business is holding or keeping too much stock- i.e.
waste of resources.
It can also mean that business is slowing down and that customers are not
buying the product anymore. (e.g. Stocks may be pilling up and not being
sold and this could lead to liquidity problems).
however, the increases in stock may be deliberates (management may
intentionally increase stock to take advantage of discounts on large
purchase or management may anticipate shortage in stock in the near
future and therefore may decide to keep stock levels high to meet long
term demand). A slow rate will affect the cash position of the business-
cash used in buying the stocks are not realised early.
Increase in stock turnover may indicate greater efficiency.
The rate of stock turnover depends on the type of goods sold. For
example supermarkets may have high stock turnover because it sells
daily. Goods like cars may have a low turnover rate.
The stock turnover should be compared with the gross profit percentage
to see the effect of selling price on turnover. If say stock turnover
increases, it may mean that the company has reduced its selling price in
order to increase sales.
B). Debtors Collection Period (Average Collection Period)

This is the average length of time taken by customers to settle their
accounts. Thus the number of days it takes the company to collect its
debts.
It is calculated by the following formula:

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Debtors Collection Period (in days) = Debtors (Closing Balance) X
365 days
Sales
Interpretation:
The result (answer) you get should be compared with the credit
policy (the number of days’ credit normally allowed by the
business to its customers.
The ideal collection period should by some what 30 days. This is because
sales are usually made in terms of payment within 30 days or at the end
of the month following the month in which the invoice is sent out.
Therefore debtors’ collection period which is too much in excess of 30
days might indicate poor management of funds. Thus a long average
collection period indicates a poor credit control. However, some
companies may also give long credit period in order to attract customers.
The answer you get depends on the type of organisation and the industry
of that business.
ASSET TURNOVER RATIO
It is a measure of how effectively the assets of the company are being

used to generate income. They sometimes are referred to as asset
utilization ratios, or asset management ratios. It is calculated by
the following formulae:
Asset Turnover Ratio = net profit
Total Assets
Note that Total assets – current liabilities = Capital Employed
Interpretation: Low Assets turnover: Where the Asset Turnover Ratio

is lower than that of competitors; it might mean over- investment in
assets. However it may also mean that the assets are new (hence they
have high values) than that of competitors. Again it could mean that
depreciation charges are lower that that of competitors.
High Asset Turnover: A high Asset turnover ratio suggests that selling
prices have been reduced or suppressed in order to increase sales
volume.
CASH OPERATING CYCLE/(WORKING CAPITAL CYCLE)
This is the period of time that elapse between the payment for the goods
supplied and the receipts of cash from customers in respect of the sales
made.

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That is the length of time between when the business makes payment to
its suppliers for the materials and stock and when the business receives
payment for the resources from its customer.
The number of days in the cash operating cycle equal to:
Debtors collection period XX
Add stock turnover (in days) XXX
Less creditors payment period (days) XXX
CASH OPERATING CYCLE XXX
THE CONCEPT OF OVERTRADING
Overtrading occurs when a firm has inadequate finance to support its

level of trading activities. This is when a firm tries to undertake more
business than is financial resources permit.
Overtrading is a common source of a business’s insolvency and explains

why a firm which makes high profit can fail to pay its short term debts as
and when they fall due.
COMMON SIGNS OR SYMPTONS OF OVERTRADING
The following, when seen in the business operation van indicate that the
business is overtrading.
1. rapid growth in sales

2. static long term finance
3. a sharp increase in debtors and debtors collection period
4. a sharp increase in creditors and creditors payment period
5. a sharp fall in cash balances and increase in overdraft
6. A sharp change in stocks. An increase in stock means that excess
production or lack of demand for the product. A decrease means
that the company is not able to produce to meet demand.
7. a sharp decrease in profit margin
8. A sharp increase in asset turnover ratio.
INVESTORS RATIO/STOCK MARKET RATIO

These ratios focus more on the investor’s viewpoint. Investment ratios
provide information to investors to enable them judge the profitability of
the investment.
It tells whether current investors should continue to hold their investment
in the company or they should sell their investment.
Potential investors also use these ratios to decide which company they
should invest. These ratios cornered mostly ordinary shareholders.

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The major ratios under these sets are:
1. Price Earnings Ratio (P/E)
2. Earnings Per Share (EPS)
3. Dividend Per Share
4. Dividend Cover
5. Dividend Yield
6. Earnings Yield
1) PRICE/ EARNINGS RATIO(P/E RATIO)

This ratio expresses the current market price (market value) as a multiple
of the Earnigns Per Share (EPS). It indicates the number of years it would
take to recover the share price (cost of the investment in shares) out of
the current earnings of the company. The P/E ratio is simply a measure of
the relationship between the market value of a company’s share and the
earnings from those shares. It is the most important yardstick for
assessing the relative worth of a share.
P/E Ratio = Market Price per share
Earnings per share (EPS)
For example a P/E ratio of 12.5 (i.e. £2÷£0.16), this means that, it will
take about 12 and half years to repay the cost of investment in the
shares. The higher the P/E, the longer the payback. The lower the P/E
ratio, the better the investment.
The value of the P/E ratio reflects the market’s appraisal of the share’s
future prospects. In other words if one company has a higher P/E ratio
than another, it is because investors either expect its earnings to increase
faster than the other’s or investors consider that, it is less risky company
or it is in a more secure industry
The P/E ratio is expected not to vary much over time. If there is a change
in the P/E ratios of companies overtime, it may be due to several factors:
I. If interest rate goes up, investors will be attracted away from shares
and into debt capital will generate high interest. Share price will fall
and so P/E ratio will fall. The opposite happens when interest rates
goes down.
II. If the future prospects of the company’s profit improves, share
prices will go up and P/E ratios will rise. Share prices depend on
expectations of future earnings, and so a change in prospects,
perhaps caused by a substantial rise in international trade or
economic recession will affect prices and P/E ratios
Earnings Per Share (EPS) : The earnings per share looks at the profit
which could be in theory be paid to each ordibnary shareholder. It is
usually looked at from the ordinary shareholder
It is calculated by the following formular
EPS = Net profit after tax – Preference Share Dividends
No. Of ordianry shares in issue
DIVIDEND COVER (DIVIDEND PAYOUT):

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This measures the ability of the firm to pay current dividend level in the
future. It indicated the proportion of the Net profit which is retained for by
management for future investment.
The dividend cover is calculated as follows:
Dividend cover = Net profit after tax& preference share dividends
Ordinary share dividend
LONG-TERM SOLVENCY /GEARING /LEVERAGE RATIOS

These ratios are used to help predict the long term solvency of a firm.
These ratios indicates the relationship between funds provided by the
actual owners of the company and the funds provided by outsiders/ long
term creditors such as debenture holders. They emphasizes on the capital
structure of the firm and how the company is financed by debt capital or
long term loan. Solvency refers to the ability of a company to pay its long
term debts.
The following ratios are mostly used to measure solvency ratios.
i. Debt- equity ratio
ii. Interest cover
iii. Fixed dividend cover
iv.
It is measured as:
Prior charge capital
Total capital
*prior charge capital is capital carrying a right to a fixed return. It will
include preference share and debentures.
Total capital = ordinary shares capital and reserves +prior capital plus
any long term liabilities and provisions. OR TOTAL ASSETS- CURRENT
LIABILITIESrovide an indication of the long-term solvency of the firm.
Unlike liquidity ratios that are concerned with short-term assets and
liabilities, financial leverage ratios measure the extent to which the firm is
using long term debt.
The debt ratio is defined as total debt divided by total assets:
INTEREST COVER
This ration indicates whether a company is earning enough profit to meet

interest payment. That is whether net profit before interest and tax is able
to pay for the interest. Thus how well the firm's earnings can cover the
interest payments on its debt. This ratio is calculated as follows:
Interest Cover = Net profit before interest and tax

Interest
ADVANTAGES OF ACCOUNTING RATIOS
Ratios are the most powerful tools for analysing financial statement. The
following are the advantages of ratio analysis.
1. ratios helps to know the ability of the company to pay its short
term debts

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2. it also helps us know the extent to which the company has used its
assets effectively and efficiently
3. it helps to assess the overall operating efficiency and effective
performance of the organisation
4. ratios provide a simple and convenient way of comparing
companies
5. the pattern of performance over several years can be clearly
identified
LIMITATIONS/DISADVANTAGES OF RATIO ANALYSIS

1. Ratios are normally calculated from past historical accounting
figure and therefore might not be indications of current/ future
events
2. inflation/price level changes can render the interpretation of ratios
risky
3. Accounting policies of companies can influence ratios. Example,
the type of depreciation policy adopted and the rates used can
affect the net profit ratio greatly. This can make comparison very
difficult.
4. Management of a company can influence the ratios by engaging in
window dressing actions prior to the preparation of financial
statement to make them look better.
5. There is more than one definition for some of the ratios, making
them difficult to compare with other companies in the same
industry.
QUESTIONS AND ANSWERS

QUESTION 1. (Past question)
You have obtained the following information/data in respect of three

companies for the year ended 31 May 2005:
Company X Y Z
£000 £000 £000
Sales (all on credit) 750 950 1,200
Cost of sales 310 390 510
Administration expenses 160 190 210
Distribution costs 100 130 160
Interest paid 5 5 5
Provision for taxation 20 50 70
Proposed ordinary dividend 15 30 90
Issued share capital (£1 ordinary)200 200 400
Long-term loans outstanding 100 100 100
Retained profit (01 06 04) 130 210 300
TASKS
a) Prepare summarised Profit & Loss accounts (for EACH company) for
the year ended 31 05 05. [
b) Calculate the following ratios (for EACH company):
i the gross profit as a percentage of sales
ii the operating profit as a percentage of sales

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iv the dividend cover
v the gearing percentage
c) Explain the significance of a company’s Price Earnings Ratio
(PE ratio).
SOLUTION TO QUESTION 1
a)
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005
Company X Y
Z
£ £
£
Sales 750,000 950,000
1,200,000
Cost of sales (310,000) (390,000)
(510,000)
Gross profit 440,000 560,000
690,000
Administrative expenses (160,000) (190,000)
(210,000)
Distribution costs (100,000) (130,000)
(160,000)
Net profit before interest and tax 180,000 240,000
320,000
Interest paid (5,000) (5,000)
(5,000)
Net profit before tax 175,000 235,000
315,000
Taxation provision (20,000) (50,000)
(70,000)
Net profit after tax 155,000 185,000
245,000
Proposed dividend (15,000) (30,000)
(90,000)
Net profit for the year 140,000 155,000
155,000
Net profit b/d 130,000 210,000
300,000
Net profit c/d 270,000 365,000
455,000
b)
COMPANY X
Y X
i) The gross profit as a percentage
of sales:

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= Gross Profit X 100 440,000 X100 560,000
X100 690,000 X100
Sales 750,000 950,000
1,200,000
= 58.67%
58.95% 57.5%
ii) Operating profit as a percentage of sales:
= Net Profit before Interest &Tax X 100 180,000 X 100
240,000 X100 320,000 X100
Sales 750,000
950,000 1200,000
= 24% =
25.26% = 26.67%
iii) The earnings per share (EPS)

= Net profit after tax = 155,000 =
185,000 245,000
No. of shares 200,000
200,000 400,000
= £0.775 =£0.925
£0.0.62
iv) The dividend cover

= dividend = 15,000 30,000
90,000 =
185,000 245,000
= 0.097 times = 0.162 times
=0.37 times
v) The gearing percentage

= long term debt = 100,000 X100 =
100,000 X100 = 100,000 X 100
Capital employed 300,000
300,000 400,000
= 33.33%
33.33% 25%
QUESTION 2
Barclays Bank Ltd and Standard Chartered Bank Ltd are two independent
companies in the banking industry. The following information has been
extracted from the books of the two companies for the year ended 31 st
July 2007.
Stanbic Bank
Stanchat Bank
£ £ £ £
Net Fixed assets 58,500 6,000
Intangibles 6,000 -

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Investments (Long term) 3,000 67,500 13,500
19,500
Stocks 40,500
Debtors 37,500
Advances 31,500
Cash & liquid assets - 88,500
Investments 4,500 82,500 10,500
130,500,
150,000
150,000
Taxation 1,500 1,500

Creditors 72,000
Current and deposits accounts
136,500
Bank 10,500 84,000 ---
138,000
10% debenture stock 49,500
750
Shareholders’ funds
£1 ordinary shares 15,000 3,000
Reserves 1,500 16,500 8,250
11,250
150,000
150,000
1. The Net Profit before tax for the companies are:
Stanbic Bank Ltd £3,750
Stanchat Bank Ltd £ 3,900
2. proposed dividends for the year are:
Stanbic Bank Ltd £1,050
Stanchat Bank Ltd £ 600
REQUIRED:
As a young financial adviser, you have been asked to assess the situation
of both companies. Choose the appropriate ratios that you consider will
reveal the differences between the two companies. Discuss your
calculations from the point of view of profitability and financial stability.
SOLUTION:
Note:
 Profitability measures the relationship between the profit and the
assets or resources used in generating the profit.
 Financial stability measures the ability of a firm to pay its debts
when due to prevent it from collapse.
STANBIC
STANCHAT

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Current ratio =Current assets = 82,500 =
130,500
138,000
= 0.98:1
= 0.96:1
Acid test ratio=Current Assets- stocks = 82,500 – 40,500 =

130,500
138,000
= 0.5:1
= 0.96:1
Earnings per share=Net profit after tax = 3,750 -1,500 =

3,900 -1,500
3,000
= 15p per share =

80p per share
Dividend per share = dividend = 1,050 =

600
3,000
= 7p per share
= 20p per share
Dividend cover = net profit = 3,750 -1,500 =

3,900 – 1,500
Dividend paid 1,050 600
= 2.1 times =4
times
Gearing Ratio = long term debt = 49,500 X100 =

750 X100
12,000
= 75% =
6.25%
QUESTION 3
year ended 30 June 2008
£000
Cost of sales 700

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Interest paid 10
Closing value of fixed assets 700
Closing stock 90
Closing debtors 100
Closing cash/bank balance 30
Closing creditors 40
Issued ordinary share capital (£) 500
TASKS
a) Prepare a summarised Profit & Loss account for the year.

ii the net profit before tax as a percentage of sales
iii the operating profit as a percentage of sales
iv the earnings per share (EPS)
v the debtor collection period in days
vi the total expenses as a percentage of sales
vii the current ratio
viii the acid test
SOLUTION: QUESTION 3
a) BOB LTD
£ £
Sales 1,800,000
Less cost of sales
700,000
Less Expense:
Interest paid 10,000 660,000
390,000
b)
i) The gross profit percentage = Gross Profit X 100
Sales
= 1,100,000 X 100 = 61.1%

1,800,000

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ii) Net profit before tax as a percentage of sales

=Net profit before tax X100 = 440,000 X 100 = 24.4%
Sales 1,800,000
iii) The operating profit as a percentage of sales

= Net profit after tax X 100 = 390,000 X100 =21.67%
Sales 1,800,000
iv) The earnings per share (EPS) = Net profit after tax = 390,000 =
₤0.78 per share
v) The debtor collection period in days = Trade debtors X 365 days =

100,000 X 365days = 21 days
Sales
1,800,000
vi) The total expenses as a percentage of sales = Total expenses X 100

Sales
660,000 X 100 = 36.67%
1,800,000
vii) Current ratio =Current assets = 220,000

= 1.29:1
viii) Acid test ratio=Current Assets- stocks = 220,000 – 90,000
= 0.76:1
Workings:
Current assets:
Closing stock 90,000
Closing debtors 100,000
Closing cash/bank balance 30,000
Total current assets 220,000
Current liabilities
Proposed dividend 80,000
Closing creditors 40,000
Total current liabilities 170,000
QUESTION 4(COMPREHENSIVE QUESTION)

You are provided with the following information relating to KASAPA LTD.
KASAPA LTD.
Trading Profit and Loss Account for the year ended 31st December
2007
2006 2007

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₤’000 ₤’000 ₤’000 ₤’000
Sales 240 270
Less cost of sales:
Opening stock 15 21
Purchases 150 195
165 216
Closing stock (21) (144) (56)
(180)
Gross profit 96 90
EXPENSES:
Administrative expenses 27 36
Loan Interest 1.5 1.5
Selling &Distribution expenses 18 (46.5) 24
(61.50)
Net profit before tax 49.50
28.50
Taxation (22.50)
(9.00)
Net profit after tax 27
19.50
Dividends: Preference shares (paid)3 3
Ordinary shares (Proposed) 12 (15) 7.5
(10.50)
Retained profit 12 9
Net profit b/d 6 18
Profit and Loss account c/d 18
27
KASAPA LTD
BALANCE SHEET
2006 2007
FIXES ASSETS COST DEP. NBV COST DEP NBV
₤’000 ₤’000 ₤’000 ₤’000 ₤’000 ₤’000
Freehold property90 - 90 90 - 90
Vehicles 63 21 42 72 33 39
153 21 132 162 33 129
CURRENT ASSETS
Stocks 21 36
Bank 4.5 90
Debtors 30 1.5
55.55 277.50
CURRENT LIABILITIES
Creditors 15 93
Tax 22.50 9
Proposed dividends 12 (46.50) 6 7.5 (109.50)
18
138 147
Financed by:
Ordinary share capital ₤1.00 60 60

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10% preference shares 30 30
Profit and loss account 18 27
Shareholder’s fund 108
117
5% debenture loan 30 30
138 147
1. Purchases and sales were made evenly throughout the year.
2. all purchases and sales were made on credit
3. assume the prices were stable throughout the year
4. The company sells only one product. In 2006 60,000 mobile phones
were sold and in 2007, 90,000 were sold.
5. no fixed asset was sold during the year
6. the market value of the ordinary shares are estimated to be ₤3.45
per share at 31 December 2006 and ₤2.70 per share at 31
December 2007.
REQUIRED: CALCULATE the following ratios

a) PROFITABILITY RATIO
i. Return On Capital Employed\
ii. Gross profit percentage
iii. Net profit Percentage
b) LIQUIDITY RATIO
i. Current Ratio
ii. Acid test ratio
c) EFFECIENCY RATIO
i. Stock turnover (rate & in days)
ii. Fixed assets turnover
iii. Debtors collection period
iv. Creditors payment period
d) INVESTMENT RATIO
i. P/E ratio
ii. EPS
iii. Dividend cover
iv. Capital Gearing
v. Dividend per share
vi. Dividend yield
e) Comment on the results of KASSAPA LTD for the year to 31
December 2007
SOLUTION: Q4
2006 2007
a) PROFITABILY RATIO
Gross profit percentage:
Gross profit X 100 4,000 X100

13,500 X100

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Sales 9,000 24,000
= 44.44%
= 52.25%
ii) Net profit Percentage
= Net profit X100 = 2,450 X100 =

6,000 X100
Sales 9,000
24,000
=27.22%
= 25%
Current ratio =Current assets = 82,500 =

130,500
138,000
= 0.98:1
= 0.96:1
Acid test ratio=Current Assets- stocks = 82,500 – 40,500 =

130,500
138,000
= 0.5:1
= 0.96:1
Earnings per share=Net profit after tax = 3,750 -1,500 =

3,900 -1,500
3,000
= 15p per share =

80p per share
Dividend per share = dividend = 1,050 =

600
3,000
= 7p per share
= 20p per share
Dividend cover = Dividend = 3,750 -1,500 =

3,900 – 1,500
600
= 2.1 times =4
times

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

750 X100
12,000
= 75% =
6.25%
QUESTION 5: (September 2005 ACCOUNTING 2)

The following details have been obtained from the final accounts of REM
plc for the last three years:
2002 2003 2004
£m £m £m
Sales all on credit110 140 210
Total expenses 30 40 50
Closing debtors 21 22 24
Average stock 11 12 13
TASKS
a) Calculate for EACH of the three years:
i the gross profit percentage
ii the net profit percentage
iii the expenses to sales percentage
iv the debtor collection period in days
v the stock turnover in days
b) Comment on the trends as revealed by your answer to a) above.
SOLUTION:
REM PLC
PROFIT AND LOSS ACCOUNT
2002 2003
2004
£’m £’m
£’m
Sales (all on credit) 110 140
210
Cost of sales (70) (80)
(90)
Gross profit 40 60
120
Total expenses (30) (40)
(50)
Net profit 10 20
70
i) Gross profit percentage:

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

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Sales 110 140
210
=36.36% = 42.87%
= 57.14%
ii) Net profit percentage:

Net profit X100 =10X100 = 20 X100
= 70 X100
Sales 110 140
210
= 9.09 14.28%
=33.33%
iii) Expenses to sales percentage:
= Total expenses X 100 = 30 X100 = 40 X100

= 50 X100
Sales 110 140
210
= 27.27%
=28.57% =23.8%
iv) Debtors collection period:
= Debtors X 365 days = 21 X 365 =22 X 365

= 24 X365
Sales 110 140
210
= 70days =
57days =42days
v) Stock Turnover (in days):
= average Stock X 365days = 11X 365 =12 X 365

= 13 X365
Cost of sales 70 80
90
= 57days 55days
53days
b) Comment of the financial performance of the company:
QUESTION 6: (MARCH 207 ACCOUNTING 3)

The following summarised information has been extracted from the
accounts of three companies:
Profit and loss extracts for year ended 28 February 2007:
D E F
£ £ £
Profit before tax 13,000 9,000 5,000

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Taxation (3,000) (2,100) (1,800)
Profit after tax 10,000 6,900 3,200

Dividends (4,000) (2,000) (1,000)
Retained profit for the year 6,000 4,900 2,200
Balance sheet extracts as at 28 February 2007:
Ordinary share capital (£1) 5,000 3,000 1,000

Long-term loans nil 2,000 5,000
Cumulative retained profit 8,000 4,000 2,000
On 28 February 2007 the market price of an ordinary share was:

Company D £15
Company E £24
Company F £35
TASKS
a) Calculate the following for EACH of the three companies:
i the profit after tax as a percentage of shareholders’ funds
ii the earnings per share (EPS)
iii the PE ratio
b) From the standpoint of a potential investor comment on the
performance of the three companies.
Solution:
The shareholder’s fund is calculated as follows:
SHARESHOLDERS FUND: D E F
£ £ £
Ordinary shares 5,000 3,000
1,000
Cumulative retained profit 8,000 4,000
2,000
Shareholders fund 13,000 7,000
3,000
Company D E
F
a)
i) Profit after tax as a percentage of
Shareholder’s fund:
= Net profit after tax X 100 = 10,000 X100 = 6,900 X100
= 3,200 X100
Shareholder’s fund 13,000 7,000
3,000
= 76.9% = 98.6%
= 106%

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ii) EPS = Net profit after tax = 10,000 = 6,900
= 3,200
No. of shares 5,000 3,000
1,000
= £ 2 per share =£2.3 per share
= £3.2 per share
iii) P/E ratio:
=Market price per share = £15 = £24

= £35
EPS £2 £2.3
£3.2
= 7.5 times =10.4 times
= 10.9 times
iii) Dividend Cover:
= Net profit after tax = 10,000 = 6,900
= 3,200
Dividend 4,000 2,000
1,000
= 2.5 times = 3.45 times
= 3.2 times
vi. Gearing Percentage

= Long term debt X 100 0 x, 100 2000X100
5,000 X 100
Capital employed 13,000 9,000
8,000
= 0% = 22.22%
= 62.5%
b) Comment on the performance of the three companies

Question 7:
Study the following information regarding Companies A and B
Profit and Loss account Company A Company B
£ £
Turnover 9,000 24,000
Cost of goods 5,000 10,500
Other expenses:
Selling 500 4,750
Administration 750 2,250
Financial 300 500
Balance Sheet
Fixed assets 7,000 10,000

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Current assets 4,275 6,750
Current Liabilities 2,000 3,500
TASKS:
a) Prepare the Profit and Loss Accounts for the year ended 30th June
2007 and the Balance sheet as at that date
iii. Gross profit percentage
iv. Net profit percentage
v. Return on capital
c) The working capital and working capital ratio
d) A brief comment on the results comparing the two firms.
SOLUTION: Q7
a) PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007
COMPANY A
B
£ £
£ £
Turnover 9,000
24,000
Cost of goods 5,000
10,500
Gross profit 4,000
13,500
Less: expenses
Selling expenses 500
4,750
Administrative expenses 750
2,250
Financial charges 300 (1,550)
500 (7,500)
Net Profit 2,450
6,000
BALANCE SHEET AS AT 30TH JUNE 2007

COMPANY A
B
£ £ £ £
Fixed Assets 7,000
10,000
Current Assets 4,275
6,750
Current liability (2,000) 2,275
(3,500) 3,250
9,275
13,250
TRY QUESTIONS
QUESTION 1
You have obtained the following data in respect of two firms:

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X Y
£000 £000
Sales (all on credit) 400 820
Cost of sales 190 330
Total expenses 130 190
Closing debtors 35 45
Average value of stock 17 21
TASKS
a) For both companies calculate the following:
i the gross profit percentage.
iii the expenses percentage
iv the stock turnover
v the debtor collection period
b) Compare the financial performance of BOTH firms.
QUESTION 2:
The following summarised information has been extracted from the

accounts of three companies:
Profit and loss extracts for year ended 28 February 2007:
D E F
£ £ £
Profit before tax 13,000 9,000 5,000
Taxation (3,000) (2,100) (1,800)
Profit after tax 10,000 6,900 3,200

Dividends (4,000) (2,000) (1,000)
Retained profit for the year 6,000 4,900 2,200
Balance sheet extracts as at 28 February 2007:

Ordinary share capital (£1) 5,000 3,000 1,000
Long-term loans nil 2,000 5,000
Cumulative retained profit 8,000 4,000 2,000
On 28 February 2007 the market price of an ordinary share was:

Company D £15
Company E £24
Company F £35
TASKS
a) Calculate the following for EACH of the three companies:
i the profit after tax as a percentage of shareholders’ funds
ii the earnings per share (EPS)
iii the PE ratio
b) From the standpoint of a potential investor comment on the
performance of the three companies.

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QUESTION 3
The following details have been obtained from the final accounts of Kulio
plc for the last three years:
2003 2004 2005
£m £m £m
Sales all on credit 140 190 290
Total expenses 40 50 65
Closing debtors 20 23 26
Average stock 12 14 14
Closing creditors 8 10 12
TASKS
a) Calculate for EACH of the three years:
i the gross profit percentage
iii the creditor payment period in days
iv the debtor collection period in days
v the stock turnover in days
b) Comment on the trends as revealed by your answer to a) above.
QUESTION 4:
Explain the purpose of the following rations:
i. Current ratio
ii. Assets turnover
iii. Interest cover
iv. Dividend per share
v. Net profit ratio
QUESTION 5
The following figures have been extracted from Horace Ltd.’s accounts for
the two years to 30 November 2006:
2006 2005
BALANCE SHEET CLOSING BALANCES:
Stock £170,000 £120,000
Debtors £350,000 £190,000
Cash in bank - £40,000
Creditors £230,000 £210,000

Bank overdraft £50,000 -
Long-term loans £600,000 £300,000
Issued share capital £500,000 £500,000

Retained profit £260,000 £210,000
TASKS
a) For BOTH years calculate the following:
i the current ratio[3]
ii the acid test ratio[3]
iii the gearing percentage[3]

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b) Comment on the liquidity position of Horace Ltd.[5]
c) Explain the importance of preparing and monitoring a cash
budget.[6]
SUMMARY OF RATIOS
i. Gross profit ratio = Gross profit X100

Sales
ii. Net profit ratio = Net profit before tax x100

Sales
iii. ROCE = Net profit after tax X 100

Share holder fund
OR
ROCE = Net profit before tax and interest X 100
Share holder’s fund +long term loan
OR
ROCE = Net profit before tax X 100
Share holder’s funds
iv. Expenses to Net profit percentage = Expenses x100

Net profit
v. Expenses to sales percentage = Expenses X 100

Sales
LIQUIDITY RATIO:
i. Current ratio= Current Assets
Current Liabilities
ii. Acid Test ratio = Current Assets - Stocks

Current Liability
EFFICIENCY RATIOS /ACTIVITY RATIOS
i. Stock Turnover ( in days) = Average Stock X 365 days

Cost of sales

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ii. Rate of stock Turnover = Cost of sales
Average Stock
iii. Debtors Collection Period = Trade Debtors X 365 days
Credit Sales
iv. Creditors Payment Period = Creditors X 365 days

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

Fixed Assets
INVESTORS RATIOS/ STOCK MARKET RATIO
i. Earnings Per Share (EPS) =Net profit after tax & preference
share dividend
No. of ordinary shares in
issue
ii. Price Earnings(P/E) Ratio = Market price per share

EPS
iii. Dividend Per Share = Dividend

No. of shares
iv. Dividend Cover = Net profit after tax & preference share
dividends
Dividend
v. Dividend Yield = Dividend per share

Market price per share
LONG-TERM SOLVENCY RATIO:

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CHAPTER THREE
CASH FLOW STATEMENT
Introduction
Historically the financial statements of a business have been two;
a) The Profit and Loss Account, showing increase or decrease in
the wealth of the business for a given period.
b) The Balance Sheet, showing the position of the business at
one point in time.
However, during the late 1960’s and the early 1970’s, the Accounting
Standards Committee (ASC) considered it necessary to have a third
type of statement which will focus on the flow of resources through a
business between two balance sheet dates. The aim of the statement was
to show the sources and application of funds. The statement was also
aimed at highlighting a business’s cash flow position for a particular
accounting period. The concept of Fund Flow Statement was then
introduced into UK accounting standards.
In 1975, the ASC produced a standard, SSAP 10 (The Statement for

Sources and Application of Funds) to deal with this issue. It was
named Funds Flow Statement.
Note that, Standards produced by ASC were called SSAPs.

SSAPs = Statement of Standard Accounting Practices.
In August 1990, a new independent body called the Accounting

Standard Board (ASB) was formed to takeover the responsibilities of
the ASC. Standards Produces by ASB were called Financial Reporting
Standards.
In September 1991, the ASB issued its first standards, known as the
Financial Reporting Standards No.1 (FRS 1): The Cash Flow Statement.
FRS 1 came to replace SSAP 10, hence SSAP 10 ceased to apply.
FRS 1 basically has the same purpose as the old SSAP 10 (Funds Flow
Statement). That is, they all emphasize on a business’s cash inflow and
outflow of cash during the financial year.
In 1996, FRS1 was revised to include a statement which reconciles cash
flow to movement in net debt.

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FRS 1 requires large companies/organizations preparing “true and fair”
accounts to prepare CASH FLOW STATEMENT. Smaller companies are
also encouraged to do so, though some Small & Medium Enterprises use
FRSSE.
ADVANTAGES OF CASH FLOW STATEMENT

Cash flow statements help users understand performance and position of
the company better by explaining the difference cash inflows/outflows and
profit & Loss. The main advantages of cash flow statements include:
1. The cash flow statement helps in assessing the current liquidity
position of the business.
2. It also provides additional information on business activities
3. It provides a mechanism for estimating the future cash flow of the
business
4. It helps in determining cash flows generated from trading as
opposed to other sources of finance.
5. The statement also allows the user to see the major types of cash
inflows and outflows of the business
6. It helps the user to estimate the future cash flows of the business
7. It helps in comparing the performance of different enterprises
because it eliminates the effect of different treatments of the same
transaction by these companies.
8. It helps evaluate management performance
9. It commits management to consider the going concern of the
organization
10. Creditors can assess the companies ability to pay amount owed
them.
DISADVANTAGES OF CASH FLOW STATEMENT

Cash flows statements have some limitations. They include the following
a. They place undue reliance on cash flow. Although cash flow is
important, it is not enough in assessing the performance of the
company.
b. Too much cash in the short term will prevent future growth.
WHY DOES PROFIT NOT EQUAL TO CASH?

If a company makes higher profit, it does not necessarily mean the
company has more cash. In the short term, profits and cash/bank need
not be equal and a high profit does not necessary mean the company has
generated large cash surplus.
The following are some of the reasons why profit may not be equal to
cash.
1) Profit is calculated on accrual basis. Thus revenue is recognized
(recorded) when it is earned, not when it is received and expenses
are recorded when it is incurred, not when it is paid. On the other
hand, cash/bank will change only when money is paid or money
received. Therefore cash and profit will differ due to certain items
such as accruals, prepayment, unpaid debtors etc.

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2) The calculation of profit is affected by certain items which do not
affect cash or affects it differently. For example, depreciation affects
profit but do not affect cash, because depreciation does not involve
the payment (movement) of cash. Also provision for doubtful debts
affects profit but do not affect cash. Other items include taxation in
the current year, proposed dividends, profit or loss on disposal of
fixed assets etc. These items affect cash differently.
3) Cash is affected by transaction such as purchase of fixed assets
which do not affect profit. Profit is only affected by the depreciation
of the fixed asset. Items such as repayment of loan, issue of shares
etc do not affect profit but does affect cash.
In the long term, profits will be equal to cash. For instance, debtors will be
realized (i.e. collected), the depreciation charged will be equal to the total
cash expended and provisions will either be written back and accrued
income received.
However, since short term position of the business is relevance to
shareholders, there should be proper cash management for the
company’s survival. Many businesses fail and are wound up because of
cash shortages, despite adequate profit made.
Cash flow statements help to notify the possibility of cash shortage
FRS 1: STANDARD HEADINGS OF CASH FLOW STATEMENT

In 1996, the ASB (Accounting Standards Board) revised FRS1, extending
the analysis to eight (8) key headings. The standard headings include the
following:
1. Operating activities: These are cash flows relating to operating or
trading activities. They are cash flows generated from the
main/principal revenue generating activities of the business.
2. Dividends from joint ventures and associates (not examinable
at ICM level):
3. Returns on investment and servicing of finance: These are
receipts resulting from investment in other companies and
payments made for the providers of finance to the company (those
who have invested in the company). Cash inflows under this
heading may include interest received, dividend received. Cash
outflows include interest paid, dividend paid on non-equity share
(Preference shares).
4. Taxation: This heading covers the cash outflows (and sometimes
inflows) to tax authorities (IRS) relating to profits and capital gains.
It does not include VAT.
5. Capital expenditure and Financial Investment: This covers all
purchase and sale of fixed assets. Cash inflows include sale
(disposal of fixed assets and cash outflows are the purchase of fixed
assets.
6. Acquisition & Disposals: This relates to cash flows arising from
acquisitions or disposals of a trade or business or an investment in a
subsidiary, associate or joint venture. (This is not examinable at ICM
level).

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7. Equity dividend paid: This relates to cash outflows relating to
equity dividend paid. (That is dividend on ordinary shares)
8. Management of liquid resource: These are cash flows relating to
withdrawal from short-term deposits (not examinable)
9. Financing Activities: These are receipts or payments of principal
for or to external providers of finance. Cash Inflows include cash
received from shares issued and debentures (long term loans).
Outflows include payment of Loans/debentures the capital element
of finance lease (though not examinable at ICM level), payment of
expense on share issues etc.
The individual items under the above standard headings are as follows.
a. operating activities:
a) Net profit before taxation
b) Adjustments for non-cash flow expenses like deprecation, loss
on disposal of asset, profit on sale of asset etc.
c) Adjustments to the movement in working capital (stock,
debtors and creditors)
b. Returns on investment and servicing of finance:
a) Interest received/ investment income received
b) Dividend received
c) Interest paid
c. Taxation
d. Capital expenditure and financial investment:
a) Purchase of fixed assets
b) Sale/disposal of fixed assets
e. Acquisitions and disposals:
a) Cash flow from the acquisition of business
b) Cash flow from the disposal of business
f. Equity dividend paid
g. Management of financial resources
a) Cash flow from the acquisition or disposal of short-term
investment
h. Financing:
a) Issue of shares or debentures
b) Payment of shares or debentures
c) Payment of other long term loan.
This is summarized in the table below
PREPARING THE CASH FLOW STAMENT

We have explained the standard headings under which cash flow
statements are prepared as required by FRS1. Students must note the
sequence of the headings when preparing the cash flow statement. The
standard format in which cash flow statement should be prepared is given
in this chapter but for the purpose of our exams, some of the items are
not applicable at our level.

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Students
For the purpose of our study, the following sequence should be noted
when preparing the cash flow statement.
1. Net cash flow from operating Activities: These are flows which
resulted from trading (operation) activities. They are primarily
derived from the principal revenue generating activities of the
business.
2. Returns on investment and servicing of finance: These are
items such as interest paid, interest received, dividend received,
preference share dividend paid etc.
3. Taxation: These are cash flows resulting from tax paid during the
year to the Inland Revenue.
4. Investing activity/ capital expenditure/financial Activities:
These cash flows arise from the purchase or sale of fixed assets.
5. Equity dividend paid: this is sometimes classified under returns
on investment and servicing of finance but can also be classified
separately. These cash flows relate to payments of dividends to
ordinary shareholders.
6. Financing Activities: These are cash flows resulting from the
capital structure of the business. Cash inflows items under this
heading include issues of shares (both preference and ordinary
shares), additional long term loans obtained, and debenture loans.
Cash outflows include repayment of loan and debentures and
expenses relating to issue of shares.
Students should note that depending on the question given, some of the
items listed under the various headings may not be available. Where
some of the items are not given in the question, proceed to the next.
Remember also that the starting point of the preparation of the cash flow
is the calculation of the Net cash flow from operating activities. The
format for preparing cash flow statement is discussed below. Two formats
are provided; the standard format which is provided be FRS1 (CASH
FLOW STATEMENT)
The second format is a summarized form of the standard as a result of the
nature of ICM questions. Students should therefore not get confused
about the formats. What is important is to grasp the principles behind the
cash flow statement and you can solve
any question given in the exams.
FORMAT OF CASH FLOW STATEMENT
FORMAT A- For the purpose of exams:

Note that, this is provided based on the nature of ICM questions. It may
not be the same for all questions.
MORE LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006
₤
₤
Net cash inflow/ (outflow) from operating activities (note1)
xx

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Students
Returns on investment &serving of finance:
Interest received xx
Interest paid (xx)
Preference dividend paid (xx)
Net cash inflow/ (outflow) from return on investment &serving of finance
xx
Taxation paid xx
Capital expenditure & financial investment:
Payment to acquire tangible fixed assets (xx)
Receipts from sale of fixed assets xx
Net cash inflow/ (outflow) from capital expenditure/financial activities
xx
Equity dividend paid
xx
Financing Activities:
Issue of ordinary share capital xx
Repurchase of debenture (xx)
Issue of loan and debentures xx
Net cash inflow/ (outflow) from financing activities
xx
Increase/ (decrease) in cash
xxx
FORMAT B- STANDARD FORMAT
MORE LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006
₤
₤
Net cash inflow/ (outflow) from operating activities (note1)
xx
Dividends from joint venture xx
Returns on investment &serving of finance:
Interest received xx
Interest paid (xx)
Preference dividend paid (xx)
Net cash inflow/ (outflow) from return on investment &serving of finance
xx
Taxation paid xx
Capital expenditure & financial investment:
Payment to acquire intangible fixed assets (xx)
Payment to acquire tangible fixed assets (xx)
Receipts from sale of fixed assets xx
Net cash inflow/ (outflow) from capital expenditure/financial activities
xx
Acquisition and disposals:
Purchase of subsidiary (xx)
Sale of business xx
Net cash inflow/ (outflow) from acquisitions and disposal
xx
xx
Management of liquid resources:

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Cash withdrawn from deposit xx
Purchase of government securities (xx)
Sale of corporate bond xx
Net cash inflow/ (outflow) from management of liquid resources xx
Issue of ordinary share capital xx
Repurchase of debenture loan (xx)
Issue of loan and debentures xx
Expenses paid in connection with share issue (xx)
Net cash inflow/ (outflow) from financing activities
xx
Increase/ (decrease) in cash
xxx
THE CASH FLOW FROM OPERATING ACTIVITIES:

The starting point for cash flow statement is the Net cash flow from
operating activities. There are two alternatives ways in which FRS1 allows
cash flows from operating statement may be calculated.
1) The Indirect Method (Net method)
2) The Direct method (Gross Method).
Both methods give the same value for Net cash flows from operating
activities.
THE INDIRECT METHOD (exam approach)
This method starts with the operating profit and makes adjustment to
non-cash flow items (such as depreciation) and changes in working capital
(i.e. changes in stock, debtors and creditors) so that one figure of
operating cash flow is shown. Thus we reconcile the operating profit to the
net cash inflows or outflows so that we show only one figure in the cash
flow statement.
Using the indirect method, the Net cash flow is calculated as follows:
The indirect method is one often used and this book focuses the indirect
method
USING THE INDIRECT METHOD

RECONCIALIATION OF OPERATING PROFIT TO NET CASH INFLOWS/
(OUTFLOWS) FROM OPERATING ACTIVITIES
£’000
Operating profit xxx
Add: Depreciation charges for the year xx
Loss on sale of assets xx
Less: Profit on sale of asset xx
(Increase)/Decrease in stock xx
(Increase)/Decrease in Debtors xx
Net cash inflows/outflows from operating activities xxx
Note: readers must note that, the reconciliation of operating profit to net
cash flow does not form part of the statement. It is shown as a note to the
statement.
EXPLANATION:

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Students
1. Operating profit: This is given in the exams and it is the net profit
before interest and tax but after depreciation has been deducted.
Profit increase cash but a loss reduces cash – i.e. takes away cash
from the business.
2. Depreciation: The purpose of charging depreciation in the profit
and loss account is that sales during the year benefited from the
use of the assets on which depreciation is charged. Depreciation
therefore reduces profit made but depreciation does not involve
current cash outflow. Therefore add back depreciation charged
for the current year to the operating profit. Note that were the profit
is given as ‘profit before depreciation’ it means that depreciation
has not been deducted from the profit and therefore no need to add
back depreciation again.
3. stocks:
a) Decrease in stock: Compare the stocks of the previous year
to the stocks for the current year in the balance sheet. If there
is a decrease in stock (i.e. if last years stock is lower that this
years’ stock), the business has been able to sell more of its
goods to customers (hence the reduction in stock). If more
stocks are sold during the year, then more cash has come into
the business (cash inflows). Therefore add decrease in
stocks.
b) Increase in stock: Again compare the stocks figure in the
balance sheet. If there is an increase, it means that more
money has been used to purchase stocks during the year. This
represents a cash outflow (cash gone out of the business).
Therefore deduct all increases in stock during the year.
4. Debtors:
a) Decrease in debtor: When the amount of debtors
reduces during the year, it means that, debtors (people who owe
us) have paid us their debts, so we have received cash/cheque.
This increases our cash balance in the business, hence increase in
debtors represents cash inflows
b) Increase in debtors: An increase in debtors means
that, goods/services are sold without collecting the cash.
Customers are allowed more credit terms and are required to pay
later. Thus allowing the debtors balance to increase means
stopping cash from coming in.
5. Creditors:
a) Increase in Creditors: When there is an increase, it means
we have taken more credit from our suppliers and did not pay
cash for the goods. More we have therefore saved cash in the
business which are supposed to be paid to suppliers/creditors
b) Decrease in creditors: A decrease in creditors means we
have paid our creditors.
THE DIRECT METHOD:
This method calculates the cash flow by comparing the cash received
from customers (cash inflows) with the cash out for goods and services
paid to suppliers and employees.

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Students
Thus it involves showing all the individual operating cash receipts and
payments such as cash receipts from customers, cash payment to
suppliers and cash payment to employees.
Using the Direct method the Net cash flows from operating
activities is calculates as follows:
DIRECT METHOD
£ £
Sale (Receipts from Customers) XXX
Cash paid for:
Purchases (suppliers) XXX
Payment to employees XXX
Other cash payment XXX XXX
Net cash flow from operating activities XXX
The purchases and sales must be calculated as follows:
SALE PURCHASES
£ £
Bal. in P&L account xxx xxx
Add: opening debtors & creditors BAL. xxx xxx
Less: Closing debtors & Creditors xxx xxx
Cash from sales & purchases xxx xxx
NOTE: The opening balances of debtors (customers) and creditors

(suppliers) are added to sales and purchases respectively. This is because
they represent cash flow transactions which took place the previous but
are received in the current year. The closing balances are deducted
because those cash are going to be received next year hence they are not
cash inflows and outflows for the current year.
QUESTION 1: (ICM-Financial Management- March 2007)

The summarised financial statements of Carla Ltd. for 2005 and 2006
were as follows:
Carla Ltd. balance sheets as at 31 December
2005 2006
£000 £000 £000 £000
Fixed assets at cost15,000 18,000
Depreciation (7,000) 8,000 (9,000) 9,000
Current assets
Stock 7,000 9,000
Debtors 11,000 10,000
Bank 3,000 4,000
-------- --------
21,000 23,000
-------- --------
Current liabilities

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Students
Dividends 3,000 4,000
-------- --------
13,000 12,000
-------- --------
Long-term loans (3,000) (4,000)

-------- --------
13,000 16,000
-------- --------
Capital and reserves:

Ordinary shares (£1) 9,000 11,000
Profit and loss account 4,000 5,000
13,000 16,000
Carla Ltd. profit and loss account for the year ended 31 December 2006:
£000
Operating profit 11,000
Profit before tax 10,000

Taxation (5,000)
Profit after tax 5,000
Dividend (4,000)
--------
Retained profit 1,000
TASKS
a) Prepare a cash flow statement for Carla Ltd. for the year ended
31 December 2006.
i the dividend per share for BOTH years
ii the EPS for year ended 31 December 2006

c) Comment briefly on the financial performance during year ended
31 December 2006.
QUESTION 1: SOLUTION
CARLA LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER
2006
£’000 £’000
Net cash inflows from operating activities (note 1)
9,000

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Students
Returns on investment and servicing of Finance:
Interest paid (1000)
Net cash outflows from returns on investment & servicing of finance
(1000)
Tax paid (4,000)
Capital Expenditure/financial investment:
Purchase of Fixed asset (18,000 -15,000) w2
(3,000)
Net cash outflows from capital expenditure/financial investment
(3,000)
Equity dividend paid (w3)
(3,000)
Long term loan (4,000 -3,000)
1,000
Issue of ordinary Shares (11,000 -9,000) 2,000
Net cash inflows from financing Activities
3,000
Increase in cash & cash equivalents/net cash inflows
1000
NOTE 1:
NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH
INFLOWS
£
Operating Profit
11,000
Add: depreciation (9,000 – 7,000)
2,000
Increase in stock (9,000 – 7,000)
(2,000)
Decrease in Debtors (11,000 – 10,000)
1,000
Creditors (Decrease) 6,000 -3,000
(3,000)
Net cash Inflows from operating Activities
9,000
WORKINGS:
(W1)
TAXATION ACCOUNT
£ £
Bank (bal. figure) 4,000 Balance. b/d
4,000
Balance c/d 5,000 P& L
5,000
9,000
9,000

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Students
W3
EQUITY DIVIDEND ACCOUNT
£
£
Bank (bal. figure) 3,000 Bal. b/d
3,000
Bal. c/d 4,000 P&L
4,000
7,000
7,000
W2
FIXED ASSETS ACCOUNT
£
£
Bal. b/d 15,000
Purchase (bal. figure) 3,000 Bal. c/d
18,000
18,000
18,000
ANALYSIS OF MOVEMENT IN CASH

2005 2006 Changes during the Year
Bank balance 10,880 - (10,880)
Bank overdraft - (2,320) (2,320)
(13,200)
NOTE:
i. Net cash inflows form operating activity: the first figure we need for
the cash flow statement is the cash flow from operating activity.
This is usually done in a reconciliation statement by adjusting the
operation profit before interest and tax with the changes in stocks,
debtors and prepayments (if any) and creditors and accruals
ii. Deprecation: the deprecation charge for the year (which is the
difference between the two depreciation amounts is always added.
This is not a cash flow item and therefore should not be deducted
from profit
b)
i) Dividend Per Share 2005
2006
= Dividend = 3,000
4,000
No. of shares 9,000
11,000

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Students
= ₤0.33 Per share
= ₤0.36 Per share
ii) EPS = Net profit after tax

= 5,000
No. of shares
11,000
=₤0.45 Per share
QUESTION 2: (I C M)
You work for a small limited company and are assisting in the preparation
of the annual accounts for the year ending 30th may 2007
ASPEN LIMITED
BALANCE SHEET AS AT 30TH MAY
2005
2006
£ £ £ £
£ £
Fixed assets (at cost) 173,000
243,400
Less depreciation 57,800 115,200
78100 165,300
Current assets:
Stock 74,400
72,080
Debtors 97,920
100,020
Bank 10,880
-
183,200
172,100
Current Liabilities:
Creditors 41,440
37,080
Overdraft - 2,320
Provision for tax 17,120 12,400
Proposed dividends 10,000 (68,560) 114,640 12,000
(63,800) 108,300
229,840
273,600
Financed by:
£1 ordinary shares 200,000
220,000
Reserves 29,840
53,600

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Students
229,840
273,600
ASPEN LTD
Profit and Loss account for the year ended 30th May 2007
£
Operating profit for the year 49,160
Interest payable (1,000)
Profit after interest 48,160
Provision for tax (12,400)
Proposed dividend (12,000)
23,760
Profit & Loss balance b/f 29,840
Profit & Loss balance c/f 53,600
Requires:
a) Prepare a cash flow statement of MORE LTD for the year ended 30 May
2007
b) Compute the current ratios for both years
ASPEN LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 30TH MAY 2007
£
£
65,320
Interest paid
(1,000)
Taxation
(17,120)
Purchase of Fixed asset
(70,400)
(70,400)
Equity dividend paid (W2)
(10,000)
Issue of Shares (220,000-200,000) – W3
20,000
20,000
Decrease in cash
(13,200)

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Students
INFLOWS
£ £
Operating Profit
49,160
Add: depreciation (78,100-57,800) *
20,300
Decrease in Stocks (44,400-72,080)
2,320
Increase in Debtors (100,020-97,920)
(2,100)
Creditors (Decrease) (41,400-37,080)
(4,360)
65,320
WORKINGS:
W1
TAXATION ACCOUNT
£ £
17,120
12,400
29,520
29,520
W2
EQUITY DIVIDEND ACCOUNT
£
£
10,000
Bal. c/d 12,000 P&L
12,000
27,000
27,000
W3
£
£
Bal. b/d 173,000
243,400
243,400
243,000

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Students
Bank balance 10,880 - (10,880)
Bank overdraft - (2,320) (2,320)
(13,200)
Note: The depreciation calculation can also be controlled in a “T”

Account as follows
DEPRECIATION ACCOUNT
£ £
Balance. b/d
57,800
Balance c/d 78,100 P& L (balancing fig.)
20,300
78,100
78,100
QUESTION 3 (I C M)
You work in the accounts office of XYZ Ltd and the accountant has
provided you with the following information at the end of the financial
period, 2007
BALANCE SHEET OF XYZ AS AT 31 December 2007
2006 2007 2006
2007
£ £ £ £
Freehold property (cost) 25,000 25,000 Issued share capital 30,000
30,000
Equipment (note 1) 18,000 22,200 Profit and Loss A/c 27,000
33,000
Stock in trade 16,400 17,800 Corporation Tax due:
Debtors 13,600 14,000 1 January 6,000
-
Bank 2,000 1,000 1 January -
4,000
Creditor 12,000
13,000
75,000 80,000 75,000
80,000
The company’s summarized profit calculation for the ended 31 March 2007
revealed:
2006 2007
£ £
Sales 95,000 100,000
Profit on sale of equipment 2,500

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Students
95,000 102,500
LESS:
Cost of sales and other expenses 84,800 92,500
Net profit before tax 10,200 10,000
Corporate tax on profit of the year 6,000 4,000
Retained profit of the year after tax 4,200 4,000
NOTE 1: Equipment movements during the year ended 31 March 2007.
Cost Deprecation Net
£ £ £
Balance at March 2006 30,000 12,000 18,000
Additions during the year 9,000 - -
Depreciation provided during the year - 3,800 -
39,000 15,800 -
Disposals during the year (4,000) (3,000) -
Balance at 31 March 35,000 12,800 22,200
Required: Prepare a cash flow statement for the year ended 31 March 2007.
QUESTION 3:SOLUTION
ABC LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST MARCH 2007
£
£
57,275
Preference shares dividend paid
(2,000)
(2000)
Taxation: tax paid
(12,500)
(63,000)
(63,000)
(6000)
Debenture loan (50,000 -35,000)
15,000
Preference Shares (25,000 -15,000)
10,000
25,000
Decrease in cash
(1,225)

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Students
INFLOWS
£
Operating Profit 44,150
Add: depreciation 8,000
Stocks (decrease) 1950
Debtors (Increase) (3725)
Creditors (Increase) 6900
57,275
WORKINGS
TAXATION ACCOUNT
£ £
12,500
15,000
27,500
27,500
ORDINARY DIVIDEND ACCOUNT

£
£
Bank (bal. figure) 6000 Bal. b/d (y1)
6,000
Bal. c/d 6,500 P&L 6,500
12,500
12,500
£
£
Bal. b/d 140,000 Depreciation
8,000
195,000
203,000
203,000

Year 1 Year 2 Changes during the Year
Cash balance 500 500 -
Bank 4,150 2925 (1225)
4,650 3425 (1225)

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Students
INTERNATIONAL ACCOUNTING STANDARDS 7 (IAS 7): CASH FLOW
STATEMENT
Apart from FRS 1, there is IAS 7(International Accounting Standard- 7)
which also requires companies to prepare a cash flow statement. The two
standards are similar; the only difference is that IAS 7 is less detailed than
FRS 1.
Under IAS 7, the Cash flow statement is prepared under three (3) major
headings. The headings under IAS7 are:
i. OPERATING ACTIVITIES ( i.e. cash flow from operation
activities)
ii. INVESTING ACTIVITIES (i. e. cash flows from investing
Activities)
iii. FINANCING ACTIVITIES (i.e. Cash flows from financing
activities)
CHAPTER QUESTIONS AND SUGGESTED SOLUTION
QUESTION 1
You have just been employed as the accountant of Timore Ltd and your
first assignment is to prepare the cash flow statement to be included in
the annual report for the year ended 2007. The following information is
made available to you by the managing director.
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31

DECEMBER 2007
£ £
Sales 1,500,000
Less cost of sales:
Purchases 1,050,000
1,350,000
Less closing stock 450,000 900,000
Operating expenses (375,000)
Net profit 225,000
Taxation 75,000
Dividends 90,000
Retained profit for the year 60,000
TIMORE LTD
BALANCE SHEET AS AT 31 DECEMBER 2007
2006 2007
£ £ £ £
Fixed assets (at cost) 1,350,000 1,575,000
Less accum. Dep. 225,000 1,125,000 382,500
1,192,500
Current asset:
Stock 300,000 450,000

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Students
Trade debtors 180,000 225,000
Cash 30,000 67,500
510,000 742,000
Current liabilities:
Trade creditors 105,000 135,000
Taxation 60,000 75,000
Proposed dividends 45,000 90,000
210,000 300,000 300,000
442,500
1,425,000
1,635,000
Capital & Reserves:

Ordinary share capital (£1) 1,125,000
1,125,000
Profit and Loss Account 300,000
360,000
1,425,000 1,485,000
Loans:
10% debenture stock -- - -
150,000
1,425,000 1,635,000
REQUIRED:
Prepare the cash flow statement for the year ended 31 December 2007
NB: Show all workings.
SUGGESTED SOLUTION: QUESTION 1

TIMORE LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2007
£
£
232,500
Interest Paid(10% debentures)
(15,000)
(15,000)
Taxation: Tax paid
(60,000)
Capital Expenditure
(225,000)
(225,000)

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Students
(45,000)
Debenture loan
150,000
150,000
Increase in cash
37,500

INFLOWS
£
Operating Profit (225,000 +15,000) (10% interest on debentures)
240,000
Add: depreciation (382,500-225,000)
157,500
Increase in stocks (450,000 – 300,000)
(150,000)
Increase in debtors (225,000-180,000)
(45,000)
Increase in creditors (135,000 – 105,000)
30,000
232,500
TAXATION ACCOUNT
£ £
60,000
75,000
135,000
135,000
ORDINARY DIVIDEND ACCOUNT

£
£
Bank (bal. figure) 45,000 Bal. b/d (y1)
45,000
Bal. c/d 90,000 P&L
90,000
135,000
135,000
FIXED ASSETS
Opening balance 1,350,000
Closing balance 1,575,000

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Students
Additional purchase 225,000
Cash balance 30,000 67,500 37,500
Increase in cash 37,500
Question 2
You are presented with the following information:
MORE LTD
BALANCE SHEET AS AT 31 DECEMBER 2006
31/12/2005
31/12/2006
£ £ £
£
Fixed Assets:
Land & Buildings at cost 900,000
1,050,000
Current Assets:
Stocks 150,000
180,000
Debtors 300,000
375,000
Cash 9,000 15,000
459,000
570,000
Creditors (270,000) 189,000
(330,000) 240,000
1,089,000
1,290,000
Capital & Reserves:
£1 ordinary share capital 1,050,000
1,200,000
Profit & Loss Account 39,000
90,000
1,089,000
1,290,000
Task: prepare the cash flow statement for MORE LTD for the year ended
31 December 2006.
SUGGESTED SOLUTION: QUESTION 2

MORE LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2006
£ £
Net cash inflows from operating activities 6,000

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Capital expenditure/investing activities:
Purchase of fixes assts
(150,000)
Financing activities:
Issues of ordinary share capital
150,000
Increase in cash
6,000
Reconciliation of operating profit to net cash inflows from

operating activities
£
Operating profit (90,000 - 39,000)
51,000
Increase in stock (180,000 – 150,000)
(30,000)
Increase in debtors (370,000 - 300,000)
(75,000)
Increase in creditors (330 - 270)
60,000
Net cash inflows from operating activities
6,000
Analysis of movement /changes in cash:

2005 2006 change
during the year
£ £ £
Cash balance 9,000 15,000
6,000
Increase in cash
6,000
QUESTION: 3
The following information relates to CAR Ltd for the year ended 30 June
2007
Profit and Loss account for the year ended 30
June 2007
£
£
Gross profit
322,000
Loss on sale of vehicle 4,200
Increase in provision for bad debt 1,400
Depreciation (vehicles) 49,000
(161,000)

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Students
161,000
Taxation
(91,000)
70,000
Dividends
(35,000)
Retained profit for the year
35,000
BALANCE SHEET AS AT 30 JUNE 2007

2006
2007
Fixed assets: £ £ £ £ £
£
280,000
Less depreciation (105,000)
(140,000)
105,000
140,000
Current Assets:
Stocks 84,000
70,000
Debtors 112,000 140,000
provision (5,600) 106,400 (7,000)
133,000
Cash 8,400
11,200
198,800
214,200
Trade creditors 84,000 74,200
Taxation 72,800 91,000
Proposed dividends 28,000 (184,800) 14,000 35,000
(200,200) 14200
119,000
154,000
Capitals & Reserves:

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Students
Ordinary share 105,000
105,000
Profit and Loss account 14,000
49,000
119,000
154,000
i. During the year, the company sold a vehicle for £16,800 in cash.
The vehicle had originally cost £35,000 and a depreciation charges
amounted to £14,000
ii. A new vehicle costing £105,000 was purchased during the year.
Required: You are required to prepare the Cash Flow statement for the
year ended 30 June 2007.
QUESTION 7: (SEPTEMBER 2005 ACCOUNTING II)

The summarised financial statements of Axenby Ltd. for 2003 and 2004
were as follows
Axenby Ltd. balance sheets as at 31 December:
2003 2004
£000 £000 £000 £000
Fixed assets at cost 13,000 28,000
Depreciation (6,000) 7,000 (8,000) 20,000
Current assets:
Stock 8,000 16,000
Debtors 6,000 8,000
Bank 1,000 2,000
15,000 26,000
Current liabilities:
6,000 11,000

11,000 26,000
Capital and reserves

Profit & Loss account 6,000 16,000
11,000 26,000
Axenby Ltd. Profit & Loss account for the year ended 31 December
2004:
£000

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Taxation (2,000)
Dividend (3,000)
TASKS
a) Prepare a cash flow statement for Axenby Ltd. for the year
ended 31 December 2004.
b) Calculate the following for BOTH years:
i the current ratio
ii the acid test
c) Comment briefly on the financial performance during 2004.
AXENBY LTD
CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2004
£ £
11,000
Interest Payable (1,000)
(1,000)
Taxation
(1,000)
Purchase of Fixed asset (15,000)
(15,000)
(2,000)
Debenture loan (9,000 - 5,000) 4,000
Ordinary Shares (10,000 - 5,000) 5,000
9,000
Increase in cash
(1,000)

INFLOWS
£
Operating Profit 16,000
Add: depreciation (8,000- 6,000) 2,000
Increase in stocks (16,000 – 8,000) (8,000)
Increase in Debtors (8,000 – 6,000) (2,000)

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Increase Creditors (6,000 -3,000) 3,000
11,000
TAXATION ACCOUNT
£ £
1,000
2,000
3,000
3,000
NB: the tax paid during the year is sometimes (but not always) equal to
the tax figure for the previous year in the question given you.
DIVIDEND ACCOUNT
£
£
2,000
Bal. c/d 3,000 P&L 3,000
5,000 5,000
FIXED ASSETS
£
Opening balance at cost (2003) 13,000
Closing balance at cost (2004) 28,000
Purchased during the year 15,000

Bank 1,000 2,000 1,000
Increase in cash (1000)
b) Year 2003 2004
i) Current ratio= Current Assets = 15,000 X100 =

26,000 X100
11,000
= 2.5:1
= 2.36:1
ii) Acid Test Ratio =Current Assets- stocks = 15,000 - 8,000

26,000 -16,000
11,000

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= 1.16:1
= 0.9:1
QUESTION 7 :( MARCH 2006 FINANIAL MANAGEMENT)

a) Prepare a cash flow statement of a company called LED plc for the year
ended 31 March 2006 from the following data:
£000
Purchase of new machinery 180
Purchase of new vehicles 80
Tax paid 110
Equity dividends paid 90
Proceeds from share issue 510
Repayment of long-term loans370
Interest paid 40
Interest received 5
Investment income 15
Cash inflow from operating activities 190
b) Comment on the cash flow position of LED plc during year ended 31
March 2006.
LED PLC
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 2006
£
£
Net cash inflows from operating activities
190,000
Interest Received 5,000
Investment income 15,000
(20,000)
Taxation
(110,000)
Purchase of new machinery
(180,000)
Purchase of Vehicle
(80,000)
(260,000)
(90,000)
Financing Activities:0
Proceeds for issue of shares 510,000

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Repayment of long term loan
(370,000)
140,000
Decrease in cash
(150,000)
CHAPTER FOUR
CAPITAL INVESTMENT APPRAISAL
Introduction
Capital investment decisions are those decisions that involve current outlays
(cash outflow) in return for future benefits (cash inflows). In other words,
when a company makes a capital investment, it makes an initial cash outlay
(outflow) for benefits to be received or realized in the future.
Such investments are made in the long-term assets of the firm. The general
idea is that the capital, or long-term funds, raised by the firm is used to invest
in assets that will enable the firm to generate revenues several years into the
future. Normally the funds raised to invest in such assets are not available.

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Therefore the firm must budget/plan correctly, how these funds will be
invested.
DEFINITION: CIMA defines Capital Investment Appraisal as follows:

‘An evaluation of the costs and benefits of a proposed
investment in operating assets’
Capital Investment Appraisal (sometimes called capital budgeting) is
therefore the process of planning capital investment and evaluating and
selecting from a range of possible choices /alternatives.
Because capital budgeting decisions have a major impact on the firm for
several years, they must be carefully planned. A bad decision can have a
significant effect on the firm’s future operations. Again, the timing of the
decisions is important. Many capital budgeting projects take years to
implement. If managers do not plan accordingly, they might find that the
timing of the capital budgeting decision is too late (i. e costly with respect to
competition.
Decisions that are made too early can also be problematic because capital
budgeting projects generally are very large investments, thus early decisions
might generate unnecessary costs for the firm.
A proposed investment is judged by a number of appraisal techniques

before they are undertaken and therefore Capital budgeting is a required
managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a
finance manager must be able to decide whether an investment is worth
undertaking and be able to choose intelligently between two or more
alternative projects/investments. A sound procedure to evaluate,
compare, and select projects is needed by the finance manager.
REASONS WHY COMPANIES USE APPRAISAL TECHNIQUES

The following are some reasons why companies evaluate potential
investment projects before beginning such projects
1. It involves substantial expenditure. The sum (cash) involved
is relatively large hence a bad decision and choice may have
very serious consequence on the company.
2. The benefits may be spread over many years. The time
scale over which the benefits (cash inflows) will be received is
relatively large and cover a series of years hence proper
assessment of the project must be made.
3. Capital investment, when undertaken, are irreversible
decisions, hence they require proper analysis.
4. Uncertainty: The expected cash flows are computed based on
future expectations. Since the future is uncertain, correct
decisions may sometimes prevent disastrous consequences.

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CHARACTERISTICS/ FEATURES OF CAPITAL INVESTMENT
DECICIONS
Capital investment decisions have certain characteristics which are not
always present in other management decisions, and as a result, special
techniques are required to ensure that only the best information is
available to the decision maker.
These characteristics are:
1. A significant outlay of cash;

2. Long term involvement with greater risks and uncertainty
(because forecasts of the future are less reliable)
3. Irreversibility of some projects due to the specialised nature
of, for example, plant which having been bought with a specific
project in mind may have little or no scrap value;
4. A significant time lag between commitment of resources and
the receipt of benefits;
5. Project completion time requires adequate continuous control
information as costs can be exceeded by a significant amount.
INVESTMENT APPRAISAL TECHNIQUES/METHODS

There are several methods for evaluating capital expenditure projects but
no matter what method is used it is important to realize that the
information used for the evaluation has to be properly screened as it can
materially affect the evaluation.
The most commonly used techniques can be classified into two main
groups.
A) NON-DISCOUNTED CASH FLOW TECHNIQUES

These are sometimes referred to as the traditional appraisal techniques
The two popular traditional methods of comparing the attractiveness of
competing projects are:
1) The Accounting Rate of Return (ARR)
2) The Payback period
B) DISCOUNTED CASH FLOW TECHNIQUES

3) Net Present Value (NPV)
4) Internal Rate of Return (IRR)
5) Profitability Index (P I)
Each of these methods will be described and an example given of the
calculations involved.
Then the acceptance criterion for each will be stated. We share consider
investment projects in circumstances
1. ACCOUNTING RATE OF RETURN (ARR)
It is defined as the ratio of average profit, after depreciation, to
the capital invested. That is, the average earnings/profit of a project
expressed as a percentage of the average or initial capital invested in the
project. This is sometimes known as the Return On Capital Employed
(ROCE).

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It is calculated by the formulae:

ARR= Average annual profit after depreciation X 100
Initial Investment
Average Annual profit=Total annual profit (cash inflows minus

depreciation) x100
No. of years
Note that Capital invested is the cost of the project. In the calculation
the initial investment or Average investment can be used i.e. ARR
can be calculated using either the total initial investment (total
cost of the project) or on the Average initial investment (half of
the cost of the project)
Where ARR is calculated using average investment, the formula
becomes
ARR= Average annual profit after depreciation X 100
Average Investment
Note that, AVERAGE INVESTMENT= TOTAL INVESTMENT

2
DEPRECIATION:
From our previous discursion on company accounts, we learnt that, when
we buy assets, its value reduces every year. In project appraisal, the
general assumption still holds that, when a project is undertaken, the
value of the project losses its value every year.
The ARR method of investment appraisal uses Accounting profit but not
the cash flow in the assessment of the project’s worthiness. Remember
that profit is not necessarily the same as cash.
Since Net profit is different from cash flow, we must calculate the
depreciation and deduct from the cash flow from the project to get the
profit. We can then use the profit in the calculation of the ARR.
There are a number of methods that can be used to calculate the

depreciation of a fixed asset. The most commonly used ones are the
Reducing Balance method and the Straight Line method. In this
chapter, we shall assume that only the straight line method is used in
calculation of the project’s depreciation.
The formula for the depreciation using the straight line method is:
Depreciation = cost –residual value

No. of years
In the project appraisal, it is usually assumed that the residual value or
scrap value will be zero but this is not true for all cases. In some cases
there could be residual value at the end of the projects life.
Let us consider the following examples and see how the ARR is calculated

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Example 1
Etienne Ltd is considering investing in a project which has the following
cash flows:
£000
Initial investment 2,100
Cash flows:
Year 1 500
Year 2 900
Year 3 1,000
Year 4 800
Year 5 500
TASKS: Calculate the ARR (accounting rate of return)
Solution :( with explanation) example one
ARR= Average annual profit (after depreciation) X 100

Initial investment
Average Annual Profit= Total annual Profit (after depreciation)

No. of years
Note: in the example, we are given the case flows for the project over 5
years. These case flows are not profit. It means that we need to
subtract the depreciation of the project to get the profit.
Annual depreciation = cost- residual value = £ 2,100,000 = £420,000

No. of years 5 years
That is, the depreciation for every year is £420,000. Therefore we have
to deduct this depreciation from each year’s cash flow to get the profit.
Cash flows Depreciation Annual

profit
Year 1 500,000 420,000 80,000
Year 2 900,000 420,000 480,000
Year 3 1,000,000 420,000 580,000
Year 4 800,000 420,000 380,000
Year 5 500,000 420,000 80,000
3,700,000 2,100,000
1,600,000 now since the profit has been calculated,
ARR can now be calculated
ARR= Average annual profit X 100
Initial investment
Average Annual Profit= Total annual Profit = 1,600,000 = £320,000

Therefore ARR = £320,000 X 100 = 15.23%

2,100,000

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Tutorial
The solution appears to be too long. This is due to the explanation. The explanations
is not necessary in exams. Let us now take a look at some few points in the above
solution.
a. The general assumption is that the straight line method will be used in
the calculation of the depreciation. Therefore remember to use it when
no other method is given to you.
b. From example one, the annual depreciation was £420,000. You can see
that the total depreciation for the years is equal to the cost of the
project which is £ 2,100,000. The reason is that, there is no scrap or
residual value at the end of the project’s life. Therefore we can assume
that the total annual depreciation is equal to the cost of the project. This cost
of the project can therefore be used as the total depreciation when
the straight line method is used and there is no residual value
c. Unless you are told to use the average investment, always use the initial
investment
Let us look at the example below. This time no explanation is provided.
EXAMPLE 2
Mars Ltd is considering investing in a project which has the following cash
flows:
£000
Cash flows:
Year 1 600
Year 2 1,000
Year 3 1,100
Year 4 700
Year 5 300
Calculate the ARR (accounting rate of return).
SOLUTION: EXAMPLE 2
ARR= Average annual profit X 100
Initial investment
Annual Profit = Total cash inflows – Total depreciation
Total cash inflows (£’000) = 600+1,000+1,100+700+300 = £3,700
Annual depreciation = cost- residual value = £ 2,500 - £ 0= £500,000

Total depreciation for years = 500,000X 5 = £2,500,000
Note: Total depreciation = cost of project = 2,500,000
Average Annual profit = 3,700,000 – 2,500,000 = 1,200,000 = £240,000

5 years 5

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There fore ARR = 240,000 X 100 = 9.6%

2,500,000
Example 3: GATO Ltd is considering investing in a new project. The details

of the projects are as follows.
Cost of project
£10,000
Estimated life 10 years
Estimated net profit:
Year £
1 24,000
2 36,000
3 60,000
4 50,000
5 10,000
Total net profit 180,000
Note: the estimated residual value of the project at the end of the 10
years is £20,000
REQUIRED: calculate the Accounting Rate of Return (ARR) using

b)The initial capital invested
c) The average capital invested
ADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR)

1) It is simple to calculate
2) It is easy to understand
3) It is consistent with the short-term profit maximizing objectives
4) It is consistent with Return-on Investment (ROI); a measure which is
used in most companies to compare divisional performance.
5) The Data for its calculation is readily available to calculate it.
DISADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR)

1) It does not allow for the timing of outflows and inflows. That is, since
it is an average, it takes no account of the timing of the profit
2) It does not take account of the size of the investment
3) It uses accounting profit as a measure. Accounting profit is affected
by accounting concepts and conventions such as the method of
depreciation of assets. These are subjective, hence not appropriate
for investment decisions.
4) There is no universally accepted method of calculating Accounting
Rate of Return
THE PAYBACK (PB) METHOD

Payback period is defined as the ‘the time required for the cash
inflows from a capital investment project to equal the cash
outflow ‘. Thus the period of time required for the return on an investment to "repay" the

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sum of the original investment. This period is the number of years it takes to recoup the
original investment.
It is the length of time it takes a project to recoup its initial cost out of the
cash receipts that it generates. This period is referred to as ‘the period
that it takes the project to pay for itself’. It is intuitively the measure that
describes how long something takes to "pay for itself"; shorter payback periods are obviously
preferable to longer payback periods.
Note: this is a cash measure and therefore measures the number of years taken to recoup the
investment in cash.
PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOW

Where the cash flow is constant over the period, (i.e. where there is even
cash inflow) the pay back is calculated as follows:
Payback = Initial Investment

Annual Cash inflows
PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOW

Where the cash flow is constant over the period, (i.e. where there is even
cash inflow) the pay back is calculated as follows:
Payback = Initial Investment

Annual Cash inflows
Example1: PROJECTS WITH EQUAL (EVEN CASH FLOW)

MORE LTD is considering an investment in a new plant. The following
information has been provided on the project:
Cost of plant (Initial Investment) £
50,000
Yearly Cash inflows: £
Year 1 12500
Year 2 12500
Year 3 12500
Year 4 12500
Year 5 12500
Year 6 12500
Required: Calculate the payback period for the project
SOLUTION: EXAMPLE 3
NB: the yearly cash inflows are constant (i.e. £12,500 for each year)
Payback Period = Initial Investment

Total Net cash inflows
= £50,000 = 4yrs
£12,500

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Therefore it will take 4 years to get the amount invested in the
project (i.e. £50,000)
**Check: 12,500 X4 years =£50,000
Note: projects with equal cash flow hardly appear in our exams.
So we will concentrate more on projects with unequal cash flow
as this is the usual way of the questions.
PROJECTS WITH UNEQUAL CASH FLOWS
Where there are uneven cash flows, the payback period is calculated as
follows
Payback period = year(s) before full recovery + unrecovered cost
at beginning of the year
Cash flows during the year
Example 1
More Investments Ltd is considering an investment in a machine. The

machine would cost $50,000 and would generate net cash receipts as
follows:
1st year 15,000
2nd year 30,000
3rd year 10,000
4th year 5,000
5th year 2,000
It is expected that, the machine will last for five years

Required:
Calculate the payback period of the machine.
Solution:
Payback period = 2yrs + 5,000 X 12 months
10,000
= 2years 6 months.
Tutorial:
1. after one year we would have recouped $15,000
2. after the 2rnd year the total would be (15,000 + 30,000) =
45,000
3. we will be left with $5,000 to achieve the total of $50,000, i.e.
the initial investment but the 3rd years cash inflows is $10,000,
which is more than the $5,000 we need.
4. This means that, when we enter year 3, we will need about 6
months (half of the year) to get the $5,000.

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5. The remaining balance is therefore divided by the cash inflows
during that year (5,000 ÷ 10,000). Since it is less than a
year, we will express it in months by multiplying it by 12
months.
QUESTION 2
You are working on the evaluation of a number of potential projects, one
of which involves the opening of a training centre for your firm’s staff. It
would cost £120,000 to renovate and refurbish a building ready for
training purposes. Your company expects to save the following net cash
costs on external training fees over the next five years at present day
prices:
Year 1 £42,000
Year 2 £53,000
Year 3 £59,000
Year 4 £61,000
Year 5 £65,000
TASKS
a) Calculate the payback period.
SOLUTION:
Payback period = 2 yrs + (120,000 – 95,000) X 12 months
59,000
= 2 yrs + 25,000 X 12 months
59,000
= 2yrs + 5.08 months
Therefore the payback period of the project is 2years 5 months.
Tutorials
6. At the end of year 2, only £95,000 (i.e. 42,000 + 53,000) have
been recouped or realised from the project. Since the cost of
the project is £ 120,000, we need about £25,000
(£120,000 -£95,000) before the cost is fully recouped.
7. If we add year 3 cash flows, the total will be more than £120,000
(£95,000 +59,000)
8. So we need only £25,000 from the £59,000 to top up.
9. Note how the payback is expressed. That is in years and in
month.
Example 3.
MORE LTD has an investment projects. The estimated costs and returns
are as follows:
Project A
£
Cost 215,000
Year 1 Cash inflows 44,000

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Tasks:
Calculate the payback period of project A (in years and months)
SOLUTION
a) Payback period: PROJECT A

£’000
Year 1 Cash inflow 44,000

140,000
Payback period = 2years + (215,000 -140,000) X 12 months

90,000
= 2yr + 75,000 X 12 months

90,000
= 2yrs 9.99 months
= 2yrs 10 months
ADVANTAGES OF PAYBACK METHOD

1. It is simple to calculate and understand
2. It is more objectively based because it uses the projects cash flows
instead of the accounting profit which is very subjective and can be
manipulated
3.
DISADVANTAGES OF PAY BACK PERIOD
• simple payback does not take into account the time value of money
• it ignores cash flows received after the end of the payback period
• it does not take into account the overall profitability of the project
Net Present Value (NPV)
DISCOUNTED CASH FLOW TECHNIQUES
The discounted cash flow (or DCF) approach describes a method to

value a project using the concepts of the time value of money. All future
cash flows are estimated and discounted to give them a present value.
The discount rate used is generally the appropriate cost of capital.
The main methods under this approach are:
1) Net Present Value (NPV)

2) Internal Rate of Return (IRR)

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3) Profitability Index (PI)
Discount factor
The discount factor, P (T), is the number by which a future cash flow to
be received at time T must be multiplied in order to obtain the current
present value. Thus for a fixed annually compounded discount rate r we
have
The discount Factor is usually provided in an exams in the form of

a discount factor table. However, let us see how this is calculated
using our own calculators
Question
Calculate the discount factor for the following discount rates
a) 8%
b) 9%
c) 10%
d) 15%
e) 20%
THE NET PRESENT VALUE (NPV)
NPV is concerned with cash flows (based on relevant costs and benefits)
rather than profits. The net present value method of project appraisal is a
more sophisticated technique than payback since it takes into account the
time value of money while considering relevant cash flows over the entire
life of the project.
By identifying an appropriate cost of capital and utilizing discount tables,

this enables us to calculate the present values of cash flows over the life
of a project. The total of the discounted cash flows is known as the net
present value (NPV).
Using this technique, so long as a project yields a positive NPV (at the
relevant cost of capital) it will be recommended on financial grounds. A
negative NPV will result in the project being rejected. The higher the NPV,
the more desirable a project is on financial grounds. With mutually
exclusive projects the project with the highest NPV would be preferred.
By taking into account the time value of money and discounting cash
flows according to when monies are paid out or received, projects can be
appraised before the investment decision is made. It is important to note
that it is the cash flows of the project that are discounted, not the profits.

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When performing NPV calculations, the following approach should be
taken:
• identify the relevant cash inflows and outflows of the project, not
forgetting the initial investment
• set up a table and discount each of the cash flows to its present
value, using the company's required rate of return - discount tables
will be provided on the day to facilitate calculations
• calculate the net present value of the project by taking the outflows
away from the inflows
• decide whether or not the project should be accepted on the basis
of whether or not it has a positive NPV.
The advantages and disadvantages of NPV as a method of project

appraisal are set out below:
Advantages
shareholder wealth is maximised
• it takes into account the time value of money

• it is based on cash flows, which are less subjective than profits.
Disadvantages
• it can be difficult to identify an appropriate discount rate

• Cash flows are usually assumed to occur at the end of a year, but in
practice this is over simplistic.
INTERNAL RATE OF RETURN (IRR)
IRR can be defined as the Discount rate which gives zero NPV. The
Internal Rate of Return (IRR) is the discount rate that will cause the
present value of the benefits to equal the present value of the cost. In
other words, the IRR is the situation described in the middle line of the
above table. We use a trial-and-error process to find this percentage rate.
Once the IRR has been computed, it is compared to the company’s

Required Rate of Return (cost/ discount factor). The required rate of
return is simply the minimum rate of return that an investment
project must yield to be acceptable. If the IRR is greater then or equal
to the required rate of return, then the project is acceptable. If the IRR is
less than the required rate of return, then the project is rejected. The IRR
can be estimated by the following formulae:
IRR = Positive rate + Positive NPV X (Positive-

Negative
Positive NPV + Negative NPV

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OR
IRR = L + NL x(H- L)
NL - NH
WHERE:
L = Lower Rate of interest
H = Higher rate of Interest
NL = NPV at Lower rate of interest
NH = NPV at Higher rate of interest
The reasons are that if a project cannot earn returns which is more or
greater than the cost of investment (the cost of capital) then the project is
not profitable).
In order to calculate IRR it is necessary to calculate the NPV of the

investment at two different costs of capital rates. (one cost of capital
giving a positive NPV and the other a negative NPV.)
Having calculated the two NPVs, the technique is to interpolate to try to

estimate the IRR.
The internal rate of return tells us the rate at which the NPV of a project is
neither positive nor negative. There are four steps to an IRR calculation:
1. Calculate the project's NPV at any reasonable discount rate (this

may be given to you in the exam).
2. If the above NPV is positive, choose a higher discount rate (again
this may be given in the exam) and calculate the NPV again. If the
above NPV was negative, choose a lower discount rate.
3. Either way, you must end up with one positive and one negative
NPV. You must now calculate Where A is the lower discount rate and
B is the higher rate, a is the NPV at the lower rate and b is the NPV
at the higher rate.
4. The IRR must then be compared to the company's required rate of
return. If it is higher than the required rate of return, the project
should be accepted. If it is lower than the required rate of return,
the project should be rejected.
EXAMPLE 1:

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MORE LTD is considering investment of $ 24,000 in a project which is
expected to generate the following cash flows.
Cash inflows ($)
Year 1 7,800
Year 2 6,000
Year 3 4,200
Year 4 7,400
Year 5 9,200
Please note that all workings should be shown when performing NPV
calculations. Even if you are using a sophisticated calculator to help you,
you won't gain full marks unless your workings are clearly set out. Such
calculators are really not that useful in this exam, and will not give you a
competitive advantage. The advantages and disadvantages of IRR as a
method of project appraisal are set out below:
Advantages
• it takes into account the time value of money, which is a good basis
for decision-making
• results are expressed as a simple percentage, and are more easily
understood than some other methods
• It indicates how sensitive decisions are to a change in interest rates.
Disadvantages
• projects with unconventional cash flows can have either negative or

multiple IRRs - this can be confusing to the user
• IRR can be confused with ARR or Return on Capital Employed since
all methods give answers in percentage terms - hence, a cash-based
method can be confused with a profit-based method
• it may give conflicting recommendations to NPV
• some managers are unfamiliar with the IRR method
• IRR cannot accommodate changes in interest rates over the life of a
project
• it assumes funds are re-invested at a rate equivalent to the IRR
itself, which may be unrealistically high.
PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the present value of
future cash inflows with the initial investment on a relative basis.
Therefore, the PI is the ratio of the present value of cash flows (PVCF) to
the initial investment of the project.

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PVCF
PI =
Initial investment
In this method, a project with a PI greater than 1 is accepted, but a
project is rejected when its PI is less than 1. Note that the PI method is
closely related to the NPV approach. In fact, if the net present value of
a project is positive, the PI will be greater than 1. On the other hand, if
the net present value is negative, the project will have a PI of less than
1. The same conclusion is reached, therefore, whether the net present
value or the PI is used. In other words, if the present value of cash
flows exceeds the initial investment, there is a positive net present
value and a PI greater than 1, indicating that the project is acceptable.
PI is also known as a benefit/cash ratio.
POST-COMPLETION/ POST IMPLEMENTATION

APPRAISAL
This is a review of all aspects of a completed project in order to assess
whether its objectives were achieved or it has lived up to expectation.
IMPORTANCE OF POST-IMPLEMENTAION REVIEW
i. it enables speedy modification of under-performing or over-
performing projects, by identifying the reasons for over/under
performance
ii. it provides a means of improving control mechanisms by
highlighting areas where weakness have caused problems.
iii. It highlights reasons for successful projects.
iv. It improves the quality of decision making by providing a
mechanism whereby past experience can be made available for
future decision makers. Thus it can produce lessons for decision
making process and people will make better evaluation and
significance of future projects
v. It makes it more likely that ‘bad’ projects are
terminated/abandoned and at an earlier stage.
vi. It improves a company’s performance.
vii. It allows changes to be made more swiftly in projects which are not
doing well.
QUESTION 1
MORE LTD has a choice of two investment projects. The estimated costs
and returns are as follows:
Project B Project A
£ £

121
Students
Cost 215,000 154,000
Year 1 Cash inflows 44,000 (18,000)
Year 2 Cash inflows 96,000 115,000
Tasks:
a) Calculate the payback period of project B (in years and months)
b) The payback period of A is 2 years 9 months. Advice the
management of MORE LTD which project is better investment. Give
reasons for your answer.
c) Using a discount factor of 15%, calculate the net present Value
for project B.
Extracts from NPV (DCF) tables:
Rate of discount8% 9% 10% 15%
Year 1 .926.917 .909 .870
Year 2 .857.842 .826 .756
Year 3 .794 .772 .751 .658
Year 4 .735 .708 .683 .572
d) Using the same discount rate of 15%, the Net Present Value of
project A is (£4,884) and at a discount rate of 10%, it has a positive
value of £19,692. Calculate the Internal Rate of return (IRR) of
project A.
QUESTION 1:SOLUTION

£’000

140,000

90,000
= 2yr + 75,000 X 12 months

90,000
= 2yrs 9.99 months
= 2yrs 10 months
Explanation: At the end of year 2, £140,000 has been recouped/ earned;

remaining £75,000 so that the full amount of £215,000 would be
recouped (that is the amount used to invest in the project)
This we will get from year 3 cash inflows which is equal to the cost of the
project less the cash flow./
c)
Year Cash flow (CF) DCF (15%) PV (DCF
x CF)

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Students
0 (154,000) 1.000
(154,000)
1 (18,000) 0.870 (15,660)
2 115,000 0.756 86,940
3 76,000 0.658 50,008
4 57,500 0.572 32,890
N
PV 178
QUESTION 2
Marstep Ltd is considering investing in a project which has the following
cash flows:
£000
Cash flows:
Year 1 600
Year 2 1,000
Year 3 1,100
Year 4 700
Year 5 300
The cost of capital is 8%.
Rate of discount 8% 9% 10%
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
a) Calculate the payback period (in years and months).
b) Calculate the ARR (accounting rate of return).
c) Calculate the NPV (net present value).
d) Explain briefly if you think that the project is viable.
e) Explain the benefits of using investment appraisal techniques in
the allocation of large capital sums.
Solution:
a) Pay back period
b) Accounting Rate of Return (ARR) = Average Annual Profit (after
depreciation) X100
Initial Investment
Average annual profit = total annual profit

No. of years
= 600,000 + 1000,000 +1,100,000 +700,000

+300,000 = 3700,000 = £ 740,000

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Students
5 years
5 years
ARR = £ 740,000 X 100

£2,500,000
=29.6%
c)
Year Cash flow (CF) DCF (8%) PV (DCF x CF)
Year 0 (2,500,000) 1.000 (2,500,000)

Year 1 600,000 .857 550,200
Year 2 1,000,000 .794 857,000
Year 3 1,100,000 .735 873,400
Year 4 700,000 .681 514,500
Year 5 300,000 .630 204,300
NPV 499,400
QUESTION 2
prices:
Year 1 £42,000
Year 2 £53,000
Year 3 £59,000
Year 4 £61,000
Year 5 £65,000
The firm’s cost of capital is 8%.
Present Value Factors 8%
Year 1 .926
Year 2 .857
Year 3 .794
Year 4 .735
Year 5 .681
Year 6 .630
TASKS
b) Calculate the Accounting Rate of Return.
c) Calculate the net present value.
d) Explain briefly whether, in your opinion, the firm should invest
in the training centre project.
e) Explain the importance of capital budgeting.
a) Payback period = 2 yrs + (120,000 – 95,000) X 12 months
59,000

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Students
= 2 yrs + 25,000 X 12 months
59,000

depreciation)
Initial investment
Average Annual Profit after depreciation = 280,000 – 120,000 =

£32,000
5years
ARR = 32,000 X 100
120,000
= 26.67%
Year 0 (2,500,000) 1.000 (2,500,000)

Year 1 600,000 .917 550,200
Year 2 1,000,000 .857 857,000
Year 3 1,100,000 .794 873,400
Year 4 700,000 .735 514,500
Year 5 300,000 .681 204,300
NPV 499,400
NET PRESENT VALUE
QUESTION 3
SOB Ltd. has a limited capital budget available for investment in suitable
projects this year, and has short-listed two possible choices. Details
are as follows:
Project X Project Y
Capital cost £2,200,000 £2,300,000
Expected life 5 years 5 years
Residual value nil nil
Budgeted cash inflows: £000 £000
Year 1 200 300
Year 2 800 900
Year 3 1,400 1,500
Year 4 700 600
Year 5 400 400
The cost of capital to SOB Ltd. is 9%.
Extracts from NPV tables are as follows:
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .841 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS

125
Students
a) Calculate the payback period for EACH project.
b) Calculate the accounting rate of return for EACH project.
c) Calculate the NPV for EACH project
d) State which project you would recommend (if any).
e) Explain why it is important to use investment appraisal techniques, and
to monitor actual results.
QUESTION 4
REM Ltd is considering investing in a project, which has the following cash
flows:
£000
Cash flows:
Year 1 700
Year 2 900
Year 3 1,100
Year 4 800
Year 5 400
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564

d) Explain briefly whether you think that the project is viable.
e) Explain why firms increasingly look at ‘non-financial’ factors
during the decision-making process.
QUESTION 5
are as follows:
Project X Project Y
Capital cost £2,200,000 £2,300,000
Year 1 200 300
Year 2 800 900
Year 3 1,400 1,500
Year 4 700 600

126
Students
Year 5 400 400
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .841 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS
c) Calculate the NPV for EACH project.
e) Explain why it is important to use investment appraisal
techniques, and to monitor actual results.
QUESTION 6
DEC Ltd. has a limited capital budget available for investment in suitable
projects this year, and has short-listed two possible choices. Details are as
follows:
Project A Project B
Capital cost £2,300,000 £2,300,000
Year 1 700 800
Year 2 1,000 1,100
Year 3 1,200 1,300
Year 4 800 700
Year 5 300 400
The cost of capital to FGT Ltd. is 10%.

Year 8% 10% 12%
1 .926 .909 .893
2 .857 .826 .797
3 .794 .751 .712
4 .735 .683 .636
5 .681 .621 .567
TASKS
e) Explain why it is important to monitor the actual performance of
the investment choice throughout the lifetime of the project.

127
Students

PROJECT B
£’000
£’000
Cash inflows: year 1 700
800
year 2 1,000
1,100
1,700
1,900
Payback period = 2years + (2,300 – 1,700) X 12 months 2

years+ (2,300 – 1,900) X 12months
1,000
1,300
= 2yr + 7.2 months =
2yrs + 3.69 months
= 2yrs 7months
= 2yrs 4 months

depreciation) X 100
Initial investment
Average Annual Profit before depreciation

£000 £000
Year 1 700 800
Year 2 1,000 1,100
Year 3 1,200 1,300
Year 4 800 700
Year 5 300 400
4,000 4,300
Note that, the total represents the cash inflows from the project. At the end of the
5years, the total depreciation charges will be equal to the initial cist of the
project.
Average Annual Profit after depreciation =total profit – total

depreciation
No. of years
PROJECT A
PROJECT B
= 4,000,000 –2,300,000 X100 =

4,300,000 –2,300,000 X 100
5years
5years

128
Students
Average Annual Profit after depreciation =1,700,000
2,000,000
5 yrs
5yrs
=£340,000
£400,000
Accounting Rate of Return (ARR) = 340,000 X 100
400,000 X 100
2,300,000
2,300,000
= 14.78%
= 17.39%
TRY QUESTIONS
1. ROB Ltd. has a limited capital budget available for investment in
suitable projects this year and has short-listed two possible choices.
Details are as follows:
Project A Project B
Capital cost £2,700,000 £2,900,000
Budgeted cash inflows:£000 £000
Year 1 700 800
Year 2 1,100 1,200
Year 3 1,400 1,900
Year 4 700 1,000
Year 5 200 500
The cost of capital to ROB Ltd. is 9%.
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .842 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS
d) Explain which project you would recommend (if any).
2. (Cost accounting September 2005)

HJB Ltd. has a limited capital budget available for investment in suitable
are as follows:
Project X Project Y
Capital cost £2,400,000 £2,300,000

129
Students
Year 1 120 700
Year 2 900 1,400
Year 3 1,100 1,600
Year 4 800 500
Year 5 600 -
The cost of capital to HJB Ltd. is 9%.

Year 8% 9% 10%
1 .926 .909 .893
2 .857 .826 .793
3 .794 .751 .712
4 .735 .683 .567
5 .630 .621 .507
TASKS
b) Calculate the accounting rate of return for EACH project. c)
Calculate the NPV for EACH project.[8]
b) State which project you would recommend (if any)
c) Explain why it is important to use investment appraisal techniques.
Disadvantages
• simple payback does not take into account the time value of money
• it ignores cash flows received after the end of the payback period
• it does not take into account the overall profitability of the project Net Present Value
(NPV)
POST-COMPLETION/ POST IMPLEMENTATION

APPRAISAL
This is a review of all aspects of a completed project in order to assess
whether its objectives were achieved or it has lived up to expectation.
IMPORTANCE OF POST-IMPLEMENTAION REVIEW
viii. it enables speedy modification of under-performing or over-
performing projects, by identifying the reasons for over/under
performance
ix. it provides a means of improving control mechanisms by
highlighting areas where weakness have caused problems.
x. It highlights reasons for successful projects.
xi. It improves the quality of decision making by providing a
mechanism whereby past experience can be made available for
future decision makers. Thus it can produce lessons for decision

130
Students
making process and people will make better evaluation and
significance of future projects
xii. It makes it more likely that ‘bad’ projects are
terminated/abandoned and at an earlier stage.
xiii. It improves a company’s performance.
xiv. It allows changes to be made more swiftly in projects which are not
doing well.
QUESTION 1
MORE LTD has a choice of two investment projects. The estimated costs
and returns are as follows:
Project B Project A
£ £
Cost 215,000 154,000
Year 1 Cash inflows 44,000 (18,000)
Tasks:
d) Calculate the payback period of project B (in years and months)
e) The payback period of A is 2 years 9 months. Advice the
management of MORE LTD which project is better investment. Give
reasons for your answer.
f) Using a discount factor of 15%, calculate the net present Value for
project B.
Rate of discount8% 9% 10% 15%
Year 1 .926.917 .909 .870
Year 2 .857.842 .826 .756
Year 3 .794 .772 .751 .658
Year 4 .735 .708 .683 .572
d) Using the same discount rate of 15%, the Net Present Value of
project A is (£4,884) and at a discount rate of 10%, it has a positive
value of £19,692. Calculate the Internal Rate of return (IRR) of
project A.
QUESTION 1:SOLUTION

£’000

140,000

131
Students
90,000
= 2yr + 75,000 X 12 months

90,000
= 2yrs 9.99 months
= 2yrs 10 months
Explanation: At the end of year 2, £140,000 has been recouped/ earned;

remaining £75,000 so that the full amount of £215,000 would be
recouped (that is the amount used to invest in the project)
This we will get from year 3 cash inflows which is equal to the cost of the
project less the cash flow./
c)
Year Cash flow (CF) DCF (15%) PV (DCF
x CF)
0 (154,000) 1.000
(154,000)
1 (18,000) 0.870 (15,660)
2 115,000 0.756 86,940
3 76,000 0.658 50,008
4 57,500 0.572 32,890
N
PV 178
QUESTION 2
Marstep Ltd is considering investing in a project which has the following
cash flows:
£000
Cash flows:
Year 1 600
Year 2 1,000
Year 3 1,100
Year 4 700
Year 5 300
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS

132
Students
e) Explain the benefits of using investment appraisal techniques in
the allocation of large capital sums.
Solution:
a) Pay back period
depreciation) X100
Initial Investment
Average annual profit = total annual profit

No. of years
= 600,000 + 1000,000 +1,100,000 +700,000

+300,000 = 3700,000 = £ 740,000
5 years
5 years
ARR = £ 740,000 X 100

£2,500,000
=29.6%
c)
Year 0 (2,500,000) 1.000 (2,500,000)

Year 1 600,000 .857 550,200
Year 2 1,000,000 .794 857,000
Year 3 1,100,000 .735 873,400
Year 4 700,000 .681 514,500
Year 5 300,000 .630 204,300
NPV 499,400
QUESTION 2
prices:
Year 1 £42,000
Year 2 £53,000
Year 3 £59,000
Year 4 £61,000
Year 5 £65,000
The firm’s cost of capital is 8%.
Present Value Factors 8%

133
Students
Year 1 .926
Year 2 .857
Year 3 .794
Year 4 .735
Year 5 .681
Year 6 .630
TASKS
b) Calculate the Accounting Rate of Return.
c) Calculate the net present value.
d) Explain briefly whether, in your opinion, the firm should invest
in the training centre project.
e) Explain the importance of capital budgeting.
a) Payback period = 2 yrs + (120,000 – 95,000) X 12 months
59,000
= 2 yrs + 25,000 X 12 months
59,000

depreciation)
Initial investment
Average Annual Profit after depreciation = 280,000 – 120,000 =

£32,000
5years
ARR = 32,000 X 100
120,000
= 26.67%
Year 0 (2,500,000) 1.000 (2,500,000)

Year 1 600,000 .917 550,200
Year 2 1,000,000 .857 857,000
Year 3 1,100,000 .794 873,400
Year 4 700,000 .735 514,500
Year 5 300,000 .681 204,300
NPV 499,400
NET PRESENT VALUE

QUESTION 3

134
Students
are as follows:
Project X Project Y
Capital cost £2,200,000 £2,300,000
Year 1 200 300
Year 2 800 900
Year 3 1,400 1,500
Year 4 700 600
Year 5 400 400
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .841 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS
c) Calculate the NPV for EACH project
e) Explain why it is important to use investment appraisal techniques, and
to monitor actual results.
QUESTION 4
REM Ltd is considering investing in a project, which has the following cash
flows:
£000
Cash flows:
Year 1 700
Year 2 900
Year 3 1,100
Year 4 800
Year 5 400
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683

135
Students
Year 5 .681 .650 .621
Year 6 .630 .596 .564

d) Explain briefly whether you think that the project is viable.
e) Explain why firms increasingly look at ‘non-financial’ factors
during the decision-making process.
QUESTION 5
are as follows:
Project X Project Y
Capital cost £2,200,000 £2,300,000
Year 1 200 300
Year 2 800 900
Year 3 1,400 1,500
Year 4 700 600
Year 5 400 400
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .841 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS
e) Explain why it is important to use investment appraisal
techniques, and to monitor actual results.
QUESTION 6
DEC Ltd. has a limited capital budget available for investment in suitable
projects this year, and has short-listed two possible choices. Details are as
follows:
Project A Project B
Capital cost £2,300,000 £2,300,000

136
Students
Year 1 700 800
Year 2 1,000 1,100
Year 3 1,200 1,300
Year 4 800 700
Year 5 300 400
The cost of capital to FGT Ltd. is 10%.

Year 8% 10% 12%
1 .926 .909 .893
2 .857 .826 .797
3 .794 .751 .712
4 .735 .683 .636
5 .681 .621 .567
TASKS
e) Explain why it is important to monitor the actual performance of
the investment choice throughout the lifetime of the project.

PROJECT B
£’000
£’000
Cash inflows: year 1 700
800
year 2 1,000
1,100
1,700
1,900
Payback period = 2years + (2,300 – 1,700) X 12 months 2

years+ (2,300 – 1,900) X 12months
1,000
1,300
= 2yr + 7.2 months =
2yrs + 3.69 months
= 2yrs 7months
= 2yrs 4 months

depreciation) X 100
Initial investment

137
Students
Average Annual Profit before depreciation
£000 £000
Year 1 700 800
Year 2 1,000 1,100
Year 3 1,200 1,300
Year 4 800 700
Year 5 300 400
4,000 4,300
Note that, the total represents the cash inflows from the project. At the end of the
5years, the total depreciation charges will be equal to the initial cist of the
project.
Average Annual Profit after depreciation =total profit – total

depreciation
No. of years
PROJECT A
PROJECT B
= 4,000,000 –2,300,000 X100 =

4,300,000 –2,300,000 X 100
5years
5years
Average Annual Profit after depreciation =1,700,000

2,000,000
5 yrs
5yrs
=£340,000
£400,000
Accounting Rate of Return (ARR) = 340,000 X 100

400,000 X 100
2,300,000
2,300,000
= 14.78%
= 17.39%
TRY QUESTIONS
1. ROB Ltd. has a limited capital budget available for investment in

suitable projects this year and has short-listed two possible choices.
Details are as follows:
Project A Project B
Capital cost £2,700,000 £2,900,000
Budgeted cash inflows:£000 £000
Year 1 700 800

138
Students
Year 2 1,100 1,200
Year 3 1,400 1,900
Year 4 700 1,000
Year 5 200 500
The cost of capital to ROB Ltd. is 9%.
Year 8% 9% 10%
1 .926 .917 .909
2 .857 .842 .826
3 .794 .772 .751
4 .735 .708 .683
5 .630 .650 .621
TASKS
d) Explain which project you would recommend (if any).
2. (Cost accounting September 2005)
HJB Ltd. has a limited capital budget available for investment in suitable
are as follows:
Project X Project Y
Capital cost £2,400,000 £2,300,000
Year 1 120 700
Year 2 900 1,400
Year 3 1,100 1,600
Year 4 800 500
Year 5 600 -
The cost of capital to HJB Ltd. is 9%.

Year 8% 9% 10%
1 .926 .909 .893
2 .857 .826 .793
3 .794 .751 .712
4 .735 .683 .567
5 .630 .621 .507
TASKS

139
Students
b) Calculate the accounting rate of return for EACH project. c)
Calculate the NPV for EACH project.[8]
b) State which project you would recommend (if any)
c) Explain why it is important to use investment appraisal techniques.

140
NOTES & EXERCISES ON Financial Management -For ICM Students
CHAPTER FIVE
BUDGETING
THE BASIC FRAMEWORK OF BUGDETING

Budget defined:
A budget is a detailed plan for acquiring and using financial and other
resources over a specific period of time. A detailed and formal definition is
given by CIMA as:
“A quantitative statement, for a defined period of time, which may include
planned revenue, expenses, assets, liabilities and cash flows
The act of preparing a budget is called budgeting. The use of budgets to
control firm’s activities is known as budgetary control (to be discussed later
in this chapter).
Budgets has four main purposes (1) to co-ordinate the activities of the
various departments in the organization to achieve a single goal; (2) to
communicate the targets to the departmental managers; (3) to establish a
system of control by comparing the budgeted and the actual results and (4)
to compel planning.
FUNTIONS/ OBJECTIVES OF BUDGETS

Budgets serve a number of useful purposes which include the following
1) Planning annual operations
2) Co-ordinating the activities of the various of the organization and
ensuring that all parts of the organization are in harmony with each
other.
3) Communicating plans to the various responsibilities (departmental)
center managers.
4) Motivating managers to strive to achieve the organizational goals
5) Controlling activities
6) Evaluating the performance of managers
ADVANTAGES OF BUDGETING
The advantage of budgeting stems from the functions budget plays in an
organization.
Among the benefits that companies realize from budgeting program are:
1. Budgets provide a means of communicating management’s plans
throughout the organization.
2. Budgets forces managers to think and plan for the future.
3. the budgeting process provides a means of allocating resources to
those parts of the organization where they can be used more
effectively
4. the budgets process can uncover potential bottlenecks before they
occur
5. Budgets coordinate the activities of the entire organization by
integrating the plans of the various parts. Budgets ensure that
everyone in the organization is pulling in the same direction.
6. Budgets define goals and objectives that serve as benchmarks for
evaluating performance.

141
PROBLEMS IN BUDGETING
Whilst budgets may be an essential part of any marketing activity they do have a
number of disadvantages, particularly in perception terms.
1. Budgets can be seen as pressure devices imposed by management, thus

resulting in:
a) Bad Labour relations
b) Inaccurate record-keeping.
2. Departmental conflict arises due to:
a) Disputes over resource allocation
b) Departments blaming each other if targets are not attained.
3. It is difficult to reconcile personal/individual and corporate goals.
4. Waste may arise as managers adopt the view, "we had better spend it or
we will lose it". This is often coupled with "empire building" in order to
enhance the prestige of a department.
Responsibility versus controlling, i.e. some costs are under the influence
of more than one person, e.g. power costs.
5. Managers may overestimate costs so that they will not be blamed in the
future should they overspend.
DEFINITION OF TERMS:
BUDGET: A plan quantified in monetary terms, prepared and approved prior
to a defined period of time, usually showing planned income to be generated
and/or expenditure to be incurred during that period and the capital to be
employed to attain a given objective.
BUDGET PERIOD: The period for which a budget is prepared and used,
which may then be subdivided into control periods over which controls takes
place.
BUDGETARY CONTROL: The establishment of budgets relating the
responsibilities of executives to the requirements of a policy and the
continuous comparison of actual with actual budgeted results, either to
secure by individual action, the objective of that policy or to provide a basis
for its revision.
FIXED BUDGET: A budget which is designed to remain constant
(unchanged) irrespective of the volume of output or sales achieved
FLEXIBLE BUDGET: A budget which, by recognizing the difference in cost
behavior between fixed cost and variable costs in relation to fluctuations in
output, turnover or other variable factors such as number of employees, is
designed to change appropriately with such change or fluctuations.
MASTER BUDGET: A budget which is prepared from, the functional budgets
and summarizes the functional budgets.
PRINCIPAL BUDGET FACTOR / LIMITING FACTOR:
A factor which at any particular time, or over a period will limit the activities
of an organisation and therefore taking into account in preparing the
budgets.
DIRECT EXPENSES: costs other than materials or labour which can be
identified in a specific product or saleable service.

142
DIRECT LABOUR COST: The cost of remuneration for employees’ efforts

and skills applied to a product or saleable service.
BUDGETARY CONTROL
DEFINITION: Budgetary control is a system of controlling costs through
budgets. Budgeting is thus only a part of budgetary control. Budgetary
control is one of the key tools for planning and control. It involves a constant
comparison of actual performance with budgeted goals of the organization.
ICMA (London) defined budgetary control as “the establishment of budgets
relating to the responsibilities or executives of a policy and the continuous
comparison of the actual with the budgeted results either to secure by
individual action, the objectives of the policy or by individual to provide a
basis of its revision.
The use of budgets in controlling operations is known as budgetary control.

The centrepiece of budgetary control is the use of budget reports that
compare actual results with planned objectives.
The budget reports provide the feedback needed by management to see

whether actual operations are on course.
OBJECTIVES OF BUDGETRY CONTROL

The objectives of budgetary control are as follows:
(1) To Coordinate: Budgetary assists managers in coordinating the
activities / efforts of the organization so that objectives of the organization in
general will be in harmony with individual departmental objectives. Budgets
thus help all departments to work in the same direction. For example the
production budget is prepared in co-ordination with the sales budget.
(2)To communicate: A budget is a communicating device. Usually, when a
budget is approved, copies are distributed to all management personnel for
them to understand what is expected of them and the policies to be followed
to achieve the set targets before the budget is carried out. Thus budget
communicates management plans to all people in an organization.
(3) To Control: Control is the action which is required to ensure that plans
and objectives are being achieved. Thus control is necessary to ensure that
plans and objectives as laid down in the budget are being achieved. In
budgeting, control is a systematic effort that aims at keeping management
informed of whether the plans are being followed/ conformed to or whether
they are not followed.
(4) To Plan: A budget provides a detailed plan of action for a business over
a definite period of time. Planning helps to anticipate many problems before
they arise and the possible solutions can be sought to solve these problems.
CHARACTERISTICS / FEATURES OF BUDGETRY CONTROL

1. Establishment of performance standards / budget for each department
2. Record the actual performance
3. Compare the actual performance with the budgeted performance.
4. Evaluate / calculate variances (differences) and analysis the reasons for
the variances

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5. Take corrective/ suitable remedial actions to correct the variance

immediately to achieve performance.
ADVANTAGES /BENEFITS OF BUDGETARY CONTROL

Benefits that may be obtained by the business that adopts budgetary control
are as follows.
1) Budgetary control coordinates the activities of various departments
and functions of the organization. Co-ordinated managerial activity is
facilitated
2) Budgetary control aims at maximization of profit through careful
planning and control.
3) It provides a yardstick against which actual results can be compared.
4) Budgetary control system creates the necessary condition for the
introduction of standard costing techniques
5) Budgetary control creates cost consciousness and introduces an
attitude of mind which waste and efficiency cannot thrive
6) The technique relates the overall objectives to specific managers and
identifies the part each executive must play in converting the
intentions of top management into reality.
7) Accountability for results is secured in financial terms on an organized
basis through the medium of plans which have been expressed in
terms of their profit impact on the company.
8) In the control situation, management is provided with information as a
routine which would be difficult to obtain promptly without the
budgetary control system.
DISADVANTAGES/LIMITATIONS OF BUDGETARY CONTROL

Budgetary controls have some drawbacks. Factors preventing the most
effective budgetary control technique are as follows:
1) Rigidity: There is a danger that the budget program will be too rigid
to accommodate changing conditions. A budget program must be
dynamic and continuously change with the changing circumstances
2) High cost of installation: The installation and operation of
budgetary control system is a costly and expensive as it may call for
the employment of specialized staff and other expenditure. Due to the
high cost, small businesses can not afford to adopt it.
3) Use of estimates: Budgets are based on estimates and forecast. The
strength and weakness of a budgetary control therefore based on the
accuracy of the forecast.
4) Staffs regard the technique as a pressure rather than a procedure to
assist the executive to do a better job.
5) Because the technique is so closely identified with the management
control process, executives imagine that the technique can replace
management. There is no substitute for good management.
6) The required degree of management co-operation may not be
obtained and top management support may be inadequate
BUDGET ORGANIZATION AND ADMINISTRATION:

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In organizing and administering a budget system the following characteristics may

apply:
a) Budget centre
Units responsible for the preparation of budgets. A budget centre may encompass
several cost canters.
b) Budget committee: This may consist of senior members of the organization,

e.g. departmental heads and executives (with the managing director as chairman).
Every part of the organization should be represented on the committee, so there
should be a representative from sales, production, marketing and so on
FUNCTIONS OF THE BUDGET COMMITTEE
Functions of the budget committee include:
a) to provide historical data to all departmental heads to help them in

estimation
b) issue instructions to departments regarding requires, dates of
submission of estimates etc
c) To defined the general policies of the management in relation to the
budget.
d) To record budget estimates from variances departments for
consideration and review.
e) To discuss difficulties with departmental heads and suggest possible
revision.
f) Coordination of the preparation of budgets, including the issue of a manual
g) Issuing of timetables for preparation of budgets
h) Provision of information to assist budget preparations
i) Comparison of actual results with budget and investigation of variances.
c) BUDGET OFFICER: Controls the budget administration. The job involves:
i. liaising between the budget committee and managers responsible for

budget preparation
ii. dealing with budgetary control problems
iii. ensuring that deadlines are met
iv. Educating people about budgetary control.
d) Budget manual:
i. details the budget procedures

ii. contains account codes for items of expenditure and revenue
iii. timetables the process
iv. Clearly defines the responsibility of persons involved in the budgeting
system.

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TYPES OF BUDGETS
There are several ways in which budgets can be classified. One way is to
classify them into the different purposes they serve.
Budgets can be classified by
1) The coverage the encompass
a) Functional budgets
b) Master budgets
2) The capacity to which they are related
a) Fixed budget
b) Flexible budget
3) The condition on which they are based
a) Basic budget
b) Current Budget
4) The period with which they cover
a) Long-term budget
b) Short-term budgets
TYPE OF
BUDGEGET
COVERAGE CAPACITY CONDITION PERIOD
Functional master fixed flexible basic current long-

term short-term
Budget budget budget budget budget budget
budget budget
FUNTIONAL BUDGET: A functional budget is a budget which relates to any

of the functions of an organization. They are subsidiary to the master
budget. The most frequently used functional budgets are:
a. Sales budget
b. Production budget (which comprise Raw material budget, Labour
budget, overheads etc.)
c. Purchase budget
d. Plant utilization budget
e. Capital expenditure budget
f. Administrative cost budget
g. Selling and distribution cost budget
h. Cash budget etc.
MASTER BUDGET:
It is defined by the Institute of Cost and Management Accountants as ‘the
summary budget, incorporating its components functional budgets
and which is faintly approved, adopted and employed’

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The master budget is a collection of the individual budgets that

encompasses the planed operating and financial activities throughout the
firm.
It is a summary of a company’s plans that sets specific targets for sales,

production, distribution and financing activities. It generally culminates in a
cash budget, a budgeted income statement (profit and loss) and a budgeted
balance sheet. This budget summarizes the various functional budgets to
produce a Budgeted Profit and Loss Account at the end of the budget period.
The master budget is prepared by the budget committee on the basis of co-
ordinated functional budgets and becomes the basis for the target of the
company during the budget period when the committee finally approves it.
In short, it represents a comprehensive expression of management’s plans
for the future and how these plans are to be accomplished.
MASTER BUDGET INTERRELATIONSHIPS
FIXED BUDGET: It is defined as a budget which is designed to remain

unchanged irrespective of the volume of activity or turnover attained. It is a
budget prepared for a given level of activity. It is a single budget with no
analysis of cost. It does not take into consideration any change in
expenditure arising out of changes in the level/ volume of activity. The major
purpose of fixed budget is at the planning stage when it serves to define the
broad objectives of the organization.
FLEXIBLE BUDGET: It is defined as ‘A budget which, by recognising

different cost behaviour patterns, is designed to change as the
volume of activity changes’
THE BUDGETING PROCESS
The stages in the budgetary process can be summarized into
three:

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1. . Identify the limiting factor/principal budget factor: The

limiting factor or principal budget factor is the factor which
limits the activities of an organization.
2. Prepare the functional budgets. The functional budget may
include the following
i. The sales budget
ii. The production budget
iii. The direct material usage budget
iv. Direct material purchase budget
v. Direct Labour cost budget
vi. Overheads cost budget
vii. Selling and administrative cost budget
viii. Capital expenditure budget
ix. The cash budget
x.
PREPARING THE BUDGETS
STAGES INVOLVED IN THE PREPARATION OF FUNCTIONAL BUDGETS
1. THE SALES BUDGET: The sales budget is the starting point in the
preparation of the functional budgets. The sales budget is prepared in
units of production and sales value. The finished goods stock budget
can be prepared at the same time. The finished goods stock budget
shows the planned increase or decrease in stock levels.
2. THE PRODUCTION BUDGET: With the information from the sales and
stock budget, the production budget can be prepared. This is simply
the sales budget (plus or minus increase or decrease in the stock
levels). The production budget is stated in terms of production units. It
lists the number of units that must be produced to meet the sales
budget.
THE SALES BUDGET

A sales budget is a detailed schedule which shows the expected sales for the
budget period.
The sales budget is expressed / prepared in units of production and sales
value. It is therefore the bases of all the other budgets.
Example 1
MORE LTD produces two products: P.K and Tom-tom. The forecasted sales of
the two products for the second quarter will be 15,000 units of P.K and
22,500 units of Tom-tom. The marketing manager has estimated the selling
price of P.K to be £45 and the selling price of Tom-tom to be £37.5
Required: Prepare the sales budget.

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Suggested Answer: example 1

MORE LTD: Sales Budget
Products P.K TOMTOM TOTAL
Selling price £45 £37.5
Sales (units) 15,000 22,500
Sales budget £ 675,000 £ 843,750
£1,518,750
Workings:
P.K (15000 units X £45) = £675,000
Tom-tom (22,500 X £37.5) =£843,750
Example 2
More Co. Ltd has two core products, A and B. The next year’s forecasts for
the products are estimated to be:
A (21,000 units at a selling price of £300)
B (19,000 units at a selling price of £310)
Required: Prepare the sales budget
Solution: example 2
Products A B Total
Sales (units) 21,000 19,000
Selling price £300 £310
Sales budget £6,300,000 £5,890,000
£12,190,000
EXAMPLE 3: FORDHAM INSTITUTE produces to products, Books and Pens.

Sales for the year 2008 are budget to be as follows:
Books: 12000 copies @ ₤300
Pens : 9000 boxes @ ₤360
Required: Prepare the sales budget for the year 2008.

Solution: example 3
Products: sales (units) selling price
Total sales (₤)
Books 12,000 ₤ 300
3,600,000
Pens 6,000 ₤360
2,160,000
5,760,000
TRY QUESTION

149
MORE LTD produces three kinds of medicines which are sold in the
government hospitals.
The estimated sales for the next 3 months are as follows:
Medicine APC PARA B.CO
Sales (In packets) 1000 1,200 1,500
Selling price £110 £80 £100
Required: prepare the sales budget for the three months period.
THE PRODUCTION BUDGET:

This is simply the sales budget (plus or minus increase or decrease in the
stock levels). The production budget is stated in terms of production
units/quantities. It lists the number of units that must be produced to meet
the sales budget.
It is prepared as follows:
Budgeted sales (units) XXX
Add: Expected closing stock of finished goods XXX
XXX
Less: closing stock of finished goods XXX
Budgeted production XXX
NB: The production budget changes from the sales budget when there is
opening or closing stock. Budgeted production = budgeted sales (units) –
opening stock + closing stock
EXAMPLE 4
MORE Systems Ltd produces and sells computers. Next year’s budgeted
sales are estimated to be as follows:
Computers Laptops Desktop

Budgeted sales (quantities) 9,500 14,250
At the beginning of the year, the following quantities were in stock- Laptop
950 unites and desktop 4750 units. It is planed that, the stock level of
Laptops should be increased by 10% and decrease the stock level of
Desktop by 50%.
Required: Prepare the production budget for MORE Systems LTD
Solution: Production Budget

Products Laptop Desktop
Budgeted sales (units) 9,500 14,250
Add: expected closing stock:
Laptops (110% x 950) 1,045
Desktop (4750 x 50%) 2,375
Less: Opening stock (950) (4,750)

150
Budgeted production 9,595

11,875
Tutorial:
i. Closing stock- the stock levels at the beginning of the year were,
Laptops- 950 and Desktops – 4750 units. The stock level of Laptops is
to be increased by 10% (10% x 950 = 95 unites). Therefore total
closing stock level for Laptop= 95 +950= 1,045 units. This can be
calculated as 110% x 950 = 1,045
ii. Desktop stock level is to be decreased/ reduced by 50% (4750x 50%)
= 2,375. Closing stock level will be 4750-2375 = 2375
EXAMPLE 5:
FORDHAM INSTITUTE produces to products, Books and Pens. Sales for the
year 2008 are budget to be as follows:
Books: 12000 copies @ ₤300
Pens : 9000 boxes @ ₤360. The company plans to keep the following as
closing stock at the end of 2008.
Books 4,000 copies
Pens 3,000 boxes
Opening stocks in the warehouse were: books 2,000 copies and Pens 1,600
boxes.
Required: prepare the production budget for the year 2008.
Solution: example 5
Required: Prepare the sales budget for the year 2008.

Solution: Example 5
Production Budget
Products Books Pens
Budgeted sales (units) 12,000
9,000
Add: closing stock 4,000
3,000
Less: Opening stock (2,000)
(1,600)
Budgeted production 14,000
10,400
DIRECT MATERIAL USAGE BUDGET

This budget shows the direct materials that must be purchased in order to
meet production requirement (i.e. the production budget) and sometimes to
meet closing stock requirement.
It is calculated as follows:
Raw materials to meet production schedule XXX
Add: expected closing stock of raw materials XXX
Raw materials needed XXX
Less opening stock of raw materials XXX
Raw materials to be purchased XXX

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MATERIAL PURCHASE BUDGET
Example 1
Young Manufacturing Company Ltd manufactures two products, Milo and
Chocolate which uses the same raw materials cocoa and sugar. One unit tin
of Milo uses 3kg of cocoa and 4kgs of sugar. One tin of chocolate uses 5kg of
cocoa and 2kg of sugar. A kg of cocoa is expected to cost £3.00 and a kg of
sugar will cost £7.00 per kg.
Budgeted sales for 2008 were 8,000 tins of Milo and 6,000 tins of Chocolate.
Finished goods in stock at 1st January 2008 are; 1,500 tins of Milo and 300
tins of chocolate. The company has decided to have a closing stock of 600
tins of each product at the end of the year.
The stocks of raw materials are; 6,000 kg of cocoa and 2,800kg of sugar as
at 1st January 2008. Again the company plans to hold 5,000kg of cocoa and
3,500kg of sugar at the end of the year.
The warehouse and stores manager has suggested that a provision of should
be made for damages and deterioration of items in the store as follows:
Product: Milo loss of 50 tins

Chocolate loss of 100 tins
Material: Cocoa loss of 500kg
Sugar loss of 200kg
TASK: You are required to prepare the material purchase budget for the year
2008.
COMPREHENSIVE QUESTION
MORE INVESTMENT LTD manufactures one product called NOKIA N95. The
following information relates to the preparation of the budget for the year
ended January 2009.
1) Sales budget for the NOKIA N 95 are:

Expected sales (units): 10,000
Selling price £100.
All sales are made on credit basis
2) To manufacture one NOKIA N95 requires 5 units of material E and 10
units of material C. The cost of material E is expected to be £3.00 per
unit, and the cost of material C is expected to be £4.00 per unit.
3) Two departments are involved in producing NOKIA N95: Machining and
Assembling. The following information is relevant:

152
Direct labor per Direct

Labour rate
Unit of product (hours) per
hour
£
Machining 1.00 6
Assembling 0.50 8
4) The finished production overhead costs are expected to amount to

£100,000.
5) At 1st April 2008, 800 units of NOKIA N95 are expected to be in stock at
a value of £52,000, 4500 units of raw material E at a value of £13,500,
and 12000 units of raw materials are planed to be 10% above the
expected opening stock levels as at 1st April 2008.
6) Administration, selling and distribution overhead is expected to
amount to £150,000.
7) Other relevant information include the following:
a. Opening trade debtors are expected to be £80,000. Closing
trade debtors are expected to amount to 15% of the total sales
for the year.
b. Opening trade creditors are expected to be £28,000. Closing
trade creditors are expected to amount to 10% of the purchases
for the year.
c. All other expenses will be paid in cash during the year.
d. Other balances at 1st April 2008 are expected to be as follows:
£ £
i. Share capital: ordinary shares
255,000
ii. Retained profits 17,500
iii. Proposed dividend 75,000
iv. Fixed assets at cost 250,000
Less Accumulated depreciation 100,000
150,000
v. Cash at bank and in hand 2,000
8) Capital expenditure will amount to £50,000 payable in cash on 1 April

2008.
9) Fixed assets are depreciated on a straight-line basis at a rate of 20%
per annum on cost.
Required:
Prepare the annual budget for More Investment Ltd for the year to
31 January 2009.

153
SOLUTION
To make it easier for you to understand what is happening, the procedure
will be out lined step by step.
Step 1: prepare the sales budget

SALES BUDGET
Sales (Units) 10,000
Selling price per unit (£100)

Sales (£) £1,000,000
Step 2: prepare the production budget

PRODUCTION BUDGET
Sales budget (units) 10,000
Less : opening stock 800
9,200
Add: desired closing stock (opening stock+10%)*
880
Production required 10,080
*Desires closing stock= 800x 10% = 88 plus opening stock (800)

=880
Step 3: prepare the direct material usage budget
Direct material:
E: 5units X 10,080 50,400units
C: 10units X 10,080 100,800units
• Step 4: prepare the direct materials purchases budget
Direct materials
E C
(units)
(units)
Usage (as per step 3) 50,400
100,800
Less: opening stock 4,500
12,000
45,900
88,800
Add:desired closing stock (opening stock + 10%) 4,950
13,200
50,850
102,000

154
QUESTION:
MORE COMPUTERS manufactures two products: Keyboard and Mouse. The

2009 annual budget is about to be prepared and the following information
has been gathered
PRODUCT KEYBOARD MOUSE

Demand/sales 600 1000
Selling price £60 £80
Opening stock (finished goods) 500 1400
Required closing stock 1200 400
Material: A (Kg/unit) 4kg 6kg
B (Kg/unit) 8kg 12kg
Expected closing stock of material 200 600
Opening stock of material 600 500
Direct labour hours required per unit 4hours
6hours
Other information received from the accounts departments shows the

following estimates.
Material A is expected to cost £3.00 per Kg and material B is expected to
cost £4.00 per kg.
SOLUTION:
SALES BUDGET
PRODUCTS Sales (Units) Selling price per unit

Total Revenue
Keyboard 6,000 £60 360,000
Mouse 10,000 £80 800,000

Budgeted sales £1,160,000
PRODUCTION BUDGET
Keyboard Mouse
Budgeted sales 6,000 10,000
Add expected closing stock 1,200 400
7,200 10,400
Less Opening stock 500 1,400
Budgeted production 6,700 9,000
MATERIAL USAGE BUDGET

MATERIAL A (kg) B (kg)
Keyboard: (6,700X 4kg per unit) 26,800 (9,000 X 6kg
per unit) 54,000

155
Mouse: (6,700X8kg per unit) 53,600 (9,000 X 12kg per

unit) 108,000
Materials to meet production 80,400
162,000
Add expected closing stock 200
600
80,600
162,600
Less opening stock 600
500
Material usage 80,000
162,100
MATERIAL PURCHASE BUDGET
EXAMPLE 3: (MASTER BUDGET)

The following information relates to the accounts of AMBA ltd as at January
2008.
£ £ £
Total fixed asset (at cost) 128,000
Less accumulated depreciation
30,720
97,280
Current assets:
Stocks 38,720
Debtors 40,000
78,720
62,720
160,000
Long term loan (15%) 64,000
Net assets 96,000
CAPITAL AND RESERVES:
Ordinary shares 64,000
96,000

156
c) The company’s sales, purchases and expenses are estimated to
be as follows:
January February
march
Sales 240,000 320,000
480,000
Purchases 160,000 240,000
448,000
Total expenses 32,000 40,000
48,000
d) All sales are made on credit. Past experience shows that, 80% of
sales made in a particular month are paid in the same month. A
discount of 4% is given for payment within this period. The
remaining 20% is paid in subsequent month
e) Purchases are paid for in the month of purchase in order to take
advantage of a 10% discount on the total purchases in the month
f) There are no changes in the stock levels for the period
g) Machinery is depreciated at 12% per annum. This is included in
the total expenses. It is the company’s policy to charge
depreciation on one-month ownership.
h) Expenses are paid for in the month in which they are incurred.
i) The 15% loan interest will be paid in march 2008
j) Proposed dividends will be paid in January 2008
REQUIRED:
a) Prepare the cash budget for the three month January to march 2008
b) Prepare the budgeted profit and loss account for the period
c) Prepare the budgeted balance sheet
SOLUTION
AMBA LTD
CASH BUDGET FOR THE PERIOD JANUARY –MARCH 2008
JAN. FEB MAR
Balance b/d (14,400) 33,600
72,640
RECEIPTS
Debtors:
(Current month’s sales)-80% 192,000 256,000
384,000
(4% discount) (7,680) (10,240)
(15,360)
Previous month’s sales 40,000 48,000
64,000
209,920 327,360
505,280

157
PAYMENTS
Purchases 160,000 240,000
448,000
Discount received (10%) (16,000 ) (24,000)
(44,800)
Expenses (less depreciation) 30,720 38,720
46,720
Dividend 1,600
Loan interest
2,400
176,320 254,720
410,272
Balance c/d 33,600 72,640
95,000
AMBA LTD
PROFIT AND LOSS ACOOUNT FOR THE PERIOD ENDED 31ST MARCH 2008
£ £
Sales 1,040,000
Less cost of sales:
Purchases 848,000
Goods available for sale 886,720
Less closing stock (38,720) (848,720)
Add discount received 84,000
276,800
Expenses (including depreciation) 120,000
Interest on loan 2,400
Discount allowed 33,280 (155,680)
Net profit 121,120
AMBA LTD
BUDGETED BALANCE SHEET AS AT 31ST MARCH 2008
CASH BUDGET
A cash budget is a statement in which estimated future cash receipts and
payments are tabulated in such a way as to show the forecast cash balance
of the business at defined intervals.

158
It is a detailed plan that shows how cash resources will be acquired and used
over a specific period of time.
OBJECTIVES OF CASH BUDGET
The objectives of a cash budget include the following.
i. To anticipate cash shortages or surpluses and how plans should be
made to invest the surplus or go for overdraft.
ADVANTAGES /USEFULNESS OF CASH BUDGET

The cash budget has the following benefits
i. It shows the cash effect of all plans made within the budgetary
process and hence its preparation leads to the medication of the
annual budgets.
ii. It also gives management an indication of potential problems that
could arise and allows them the opportunity to take action to avoid
problems
iii. Also, it may be used in planning your short-term credit needs.
iv. The cash budget determines your future ability to pay debts as well as
expenses.
v. Banks and other credit-granting institutions are more inclined to
grant you loans under favourable terms if your loan request is
supported by a methodical cash plan.
vi. Also, a monthly cash budget helps pinpoint estimated cash balances
at the end of each month which may foresee short-term cash
shortfalls.
FORMAT OF CASH BUDGET

MORE LTD
CASH BUDGET FOR THE PERIOD JANUARY –JUNE 2008
JAN FEB MARCH APRIL

MAY JUNE
BAL b/d XXX XXX XXX XXX

XXX XXX
RECEIPTS
DEBTORS XX XX XX XX
XX XX
INVESTMENT INCOME XX XX XX XX
XX XX
SALE OF ASSETS XX XX XX XX
XX XX
GOVERNMENT GRANT XX XX XX XX
XX XX
CAPITA INTRODUCED XX XX XX XX
XX XX

159
OTHER ICOMES XX XX XX XX
XX XX
TOTAL RECEIPTS XX XX XX XX
XX XX
PAYMENTS
CREDITORS XX XX XX
XX XX XX
WAGES/SALARY XX XX XX
XX XX XX
PURCHASE OF ASSET XX --
--- --- ---
EXPENSES XX XX XX
XX XX XX
OTHER EXPENSES XX XX XX
XX XX XX
TOTAL PAYMENTS XX XX XX
XX XX XX
EXAMPLES 1: CASH BUDGET
The following is the forecast data of a company for the first three months of
its budget cycle:
APRIL MAY JUNE JULY
£ £ £ £
Sales 120,000 140,000 180,000 160,000
Purchases 70,000 110,000 100,000 90,000
Overheads 24,000 24,000 26,000 26,000
Wages 20,000 21,000 21,000 22,000
Other Information:
• 50% of sales are on a cash basis, and 50% are on a credit basis.
• Debtors are given one month’s credit.
• Suppliers give one month’s credit.
• Overheads are paid one month in arrears.
• Overheads include £4,000 in respect of the depreciation of fixed
assets.
• Wages are paid in the month in which they are incurred.
• New equipment costing £80,000 will be paid for in May.
• The sale of old equipment will bring income of £5,000 in June.
• A Government grant of £10,000 is due in June.
• The bank balance is predicted to be £18,000 on 1 May 2007.
TASKS
a) Prepare a receipts schedule for the period May–July 2007.
b) Prepare a payments schedule for the period May–July 2007.
c) Prepare a cash budget for the period May–July 2007.
d) Outline the benefits of maintaining a budgetary control system.

160
SOLUTION: EXAMPLE 1
a) RECEIPTS SCHEDULE FOR THE PERIOD MAY – JULY 2007
May June July

£ £ £
Debtors: 50% cash 70,000 90,000 80,000
50% credit 60,000 70,000 90,000
Sale of equipment --- 5,000 ----
Government Grant --- 10,000 -------
Total receipts 130,000 175,000 170,000
b) PAYMENT SCHEDULE FOR THE PERIOD MAY – JULY 2007

May June July
£ £ £
Purchases 70,000 110,000
100,000
Wages 21,000 20,000 22,000
Overheads 20,000 20,000 22,000
Equipment 80,000 --- --
Total payments 191,000 151,000
144,000
c) CASH BUDGET FOR THE PERIOD MAY – JULY 2007

MAY JUNE JULY
£ £ £
Balance b/d 18,000 (43,000)
(19,000)
Receipts:
Debtors 130,000 160,000
170,000
Government Grant 10,000
Sale of equipment 5,000 ---
148,000 132,000
151,000
Payments:
Purchases 70,000 110,000 100,000
Wages 21,000 21,000 22,000
Overheads 20,000 20,000 22,000
Purchase of equipment 80,000 --- ----
Total payments 191,000 151,000
144,000

161
EXAMPLE 2
The following information relates to a proposed business partnership, for the
six months ending 31Decmber 2003:
a. Sales (in units at £60 per unit)
July Aug Sept Oct Nov Dec
Units 250 425 580 560 770 850
b. All sales will be on credit and debtor will be given two months credit.
c. Production
July Aug Sept Oct Nov Dec
Unit 600 450 600 750 750 900
d. Materials have been costed at £31 per unit, suppliers give on e month’s
credit.
e. Direct labour will cost £8 per unit, payable during the month of
production.
f. The partners will rent a small unit at an annual rent of £6000. However,
they have negotiated an initial rent –free period of three months.
Subsequent payments are to be made quarterly in advance.
g. Office salaries will cost £350 per month for the first four months and then
an office junior will be employed from 1 November at an annual salary of
£3000.
h. Other fixed costs are anticipated to be at the rate of £425 per month, and
variable cost at the rate of £6 per unit, payable during the month of
production.
i. A partner (J Raul) has purchased £6000 of equipment personally already,
and wishes to be reimbursed in full equally over the three months of
production.
j. Additional equipment will be purchased on 1 October at a cost of £2000.
k. The other partner (Mrs Smith) will introduce £9000 in cash on 1 July and
Mr Raul will contribute £5000 on 1 July.
l. The partners will cash draw £800 per month from the business, with Mrs
Smith withdrawing an additional £1,200 in December.
TASKS:
Prepare a cash budget for the six month ending 31 December 2003, clearly
showing the net cash flow of funds per month, and cash balance at the end
of each month.
SOLUTION: EXAMPLE 2
CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008

JULY AUG SEPT. OCT. NOV. DEC.
₤ ₤ ₤ ₤ ₤
₤
Balance b/d 5625 (20,150) (28,975)
(31,650) (35,375)
RECEIPTS
Debtors --- ---- 15,000 25,000
34,800 33,600
Capital 14,000 ----- ----- -----
----- -----

162
14,000 5,625 (5,150) (3,475)

(3,150) (1,775)
PAYMENTS
Direct material --- 18,600 13,950 18,600
23,250 23,250
Direct labour 4,800 3,600 4,800 6,000
6,000 7,200
Rent --- --- 1,500 ---
--- 1,500
Office salaries 350 350 350 350
1,750 1,750
Fixed costs 425 425 425 425
425 425
Equipment (re-imburse) 2,000 2,000 2,000 ----
----- ----
Equipment-purchase ---- ---- ----- 2,000
----- ----
Drawings 800 800 800 800
800 2,000
8,375 25,775 23,825 28,175
32,225 36,125
Balance c/d 5,625 (20,150) (28,975) (31,650)
(35,375) (37,900)
WORKINGS:
SALES
JULY AUG SEPT. OCT. NOV. DEC
SALES(UNITS) 250 425 580 560
770 850
SELLING PRICE (₤60)
SALES (₤) 15,000 25,500 34,800 33,600
46,200 51,000
PRODUCTION COST
JULY AUG SEPT. OCT. NOV. DEC

Production (UNITS) 600 450 600 750
750 900
Material (₤31/unit) 18,600 13,950 18,600 23,250
23,250 27,900
Direct labour (₤8/unit) 4,800 3,600 4,800 6,000
6,000 7,200
Variable cost (₤6/unit) 3,600 2,700 3,600 4,500
4,500 5,400
Tutorial
i. Debtors: sales are made on credit. Customers are allowed two months credit.
Therefore sales in July will be received in September (two months after sales).
ii. Raw materials: The suppliers of the raw material for production give one month
credit. This means purchase of raw material in July will actually be paid in August
and purchases for August paid in September in that order.

163
EXAMPLE 3:
You are given the information below by your Director for the period November 2007 to June
2009
Sales purchases wages overheads dividends

capital expenditure
November 2007 160,000 80,000 20,000 20,000 ---

-----
December 2007 200,000 120,000 24,000 20,000 40,000

---
January 2008 220,000 160,000 32,000 30,000 ---

60,000
February 2008 260,000 180,000 40,000 30,000 ---

----
March 2008 280,000 210,000 48,000 30,000 ---

---
April 2008 300,000 260,000 56,000 40,000 ----

80,000
May 2008 320,000 280,000 64,000 40,000 ---

---
June 2008 360,000 300,000 72,000 40,000 80,000

----
1. Sales are 40% cash and 60% credit. All credit sales are paid in two months after the
month of sales
2. suppliers are paid the month following purchase
3. Wages: 75% of wages are paid in the month they are incurred. The remaining 25% is
paid in the following month.
4. Overheads are paid in the month after they are incurred.
EXAMPLE 4
As the accountant of SUANAD enterprise, you are preparing the budget for the
three months ending June 30 2008. You are given the following data
d) Sales are projected to be
2008 £

164
January 31,500
February 24,000
March 30,000
April 39,000
May 36,000
June 42,000
July 45,000
e) All sales are on credit and on avereage 80% of the sales results
in the customer paying in the month of sales, taking a 5%
setlement discount, 10% pay in the month following the sale
and 8% in the second month following the sale. 2% prove
uncollectable.
f) Goods are purchesed on anticipation os sales in the months
preceeding the sales. Sales are invoiced at cost plus 20%
g) Suppliers are paid two months after receiveing the goods.
h) Overheads are £7,500 per month and are paid as incurred.
i) The overdraft as at march 30 2008 will be £4,650
REQUIRED: you are required to prepare:
EXAMPLE 5:
FANMILK Ltd supplies Ice cream in Ghana. The following forecast were made for
a quqter of a year ending September 2008.
JUNE JULY AUGUST SEPT.
£ £ £ £
CASH SALES 184,000 212,000 220,000
240,000
CREDIT SALES 480,000 520,000 530,000

560,000
CREDIT PURCHASES 240,000 360,000 280,000

304,000
SELLING EXPENSES 34,000 38,000 42,000

44,000

165
ADM. EXP. 24,000 32,000 30,000

36,000
DEPRECIATION 30,000 30,000 30,000

30,000
CAPITAL EXPENDICTURE - - 90,000 -
NOTES:
1. 40% of credit sales are collected the month of sales. The balance of 60%
is collected in the month following sales.
2. 50%of credit purchases are paid for in the month of purchase and the rest
paid in the next month.
3. The opening balance was in overdraft of £200,000.
4. All other expenses are paid for in the month they are incurred except
capital expenditure which is spread over six months starting from the
month it is incurred.
YOU are required to prepare the cash budget for the quarter ending 30
September 2008.
SOLUTION:
CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008
JULY AUG SEPT.
₤ ₤ ₤
Balance b/d (200,000) 138,000 475,000
RECEIPTS
Debtors 496,000 524,000 542,000
Cash sales 212,000 220,000 240,000
508,000 882,000 1,257,000
PAYMENTS
Creditors 300,000 320,000 292,000
Selling expenses 38,000 42,000 44,000
Administrative expenses 32,000 30,000 36,000
Capital expenditure --- 15,000 15,000
370,000 407,000 387,000
Bal c/d 138,000 475,000 870,000
WORKINGS:
DEBTORS SCHEDULE
JULY AUG SEPT
June sales (60% X 480,000) 288,000

166
July sales (40% X 520,000) 208,000
(60% X 520,000) - 312,000
August (40% X 530,000) 212,000
(60% X 530,000) 318,000
September sales (40% X 560,000) 224,000
--------- -------- -----------
496,000 524,000 524,000
CREDITORS SCHEDULE
JULY AUG SEPT
June Purchase (50% X 240,000) 120,000
July purchase (50% X 360,000) 180,000
(50% X 360,000) - 180,000
August purchase (50% X 280,000) 140,000
(50% X 280,000) 140,000
September purchase (50% X 304,000) 152,000
--------- -------- -----------
300,000 320,000 292,000
Note: depreciation is non-cash flow item hence not treated in the cash budget.
QUESTION 2:
The managing director of MORE LTD, has asked you to prepare his cash
budget for the coming period. He provide you with the following information
to enable you do the job for him
i.
EXAMPLE 3 (JUNE 2006) Q 6

Mirzer Ltd. intends to commence business on 1 July 2006 with share
capital of £180,000. On 1 July 2006 Mirzer Ltd. will also receive

167
£30,000 in various grants from government and EU sources.Other

Information:
• Mirzer Ltd. will spend £90,000 on fixed assets on 1 July 2006.
• The following are the costs per unit:
£
Direct material 8
Direct wages 6
Variable overhead 4
18
• The selling price will be £25 per unit.
• Mirzer Ltd. have agreed to pay rent of £40,000 per year – payable
quarterly in advance.
• Other fixed overheads are estimated to be £14,000 per month
payable in arrears.
• Budgeted production will be 10,000 units per month for the first
three months, increasing to 12,000 units per month thereafter.
• Budgeted sales are estimated to be 9,000 units per month for the
first three months, increasing to 12,000 per month thereafter.
• All sales are to be on credit. Mirzer Ltd. will allow one month’s
credit.
• The suppliers of direct material will allow one month’s credit.
• Direct wages costs will be paid in the month of production.
• Variable overheads will be paid for in the month following
production.
TASKS
a) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31
December 2006, clearly showing the budgeted cash balance at the
end of each month.
b) Comment on the budgeted cash flow position of Mirzer Ltd.

c) Outline the potential sources of short-term finance available to Mirzer
Ltd.
QUESTION 4:
Mr. Timore has just decided to enter into the production and sale of A4
Rimes starting on 1st July 2008. He has a personal savings amounting to
£15,000 of which he wants to start the business with. This amount will be
paid into the companies account non 1st July 2008. The forecasted cash flow
for the first six (6) month is as follows:

168
1) Production: He plans to produce 1,500 Rims per month for the first 6
months for the printing industry.
2) Sales: The selling price of each Rim will be £37.5. The sales for the six
month will be as follows:
July August September October November
December
1200 1440 1440 1680 1920
1200
3) Variable overheads: Variable Overheads per Rim (based on output)
will be £4.5. This will be payable in the month of production.
4) Fixed cost: A fixed cost of £3,000 will be incurred per month, payable
after the month of production.
5) Wages: Wages of production staff will be £9 per Rim, payable in the
month of production.
6) Salaries: Salaries of £1,500 per month will be paid until October when
salaries are expected to increase by 10% for the rest of the months.
7) £24,000 will be used to purchase a new plant in September. The seller
of the plant has agreed to accept a deposit of 25% and the balance
paid in equal installment in October and November.
8) Raw materials: cost per Rim of raw material will be £6. The supplier
of the material will allow one month credit period.
9) Debtors: Sales are basically on credit. Debtors are expected to pay in
one month following their purchases.
You are required to prepare the cash budget for the six month period
ending 31st December 2008
SOLUTION:
CASH BUDGET FOR 6 MONTH ENDING 31 DECEMBER 2008
Jul. Aug. Sept. Oct.
Nov. Dec.
£ £ £ £
£ £
Bal. b/d -
Receipts
Capital 15,000
Debtors - 45,000 54,000 63,000
72,000 45,000
Total receipts 15,000
Payments
Overhead (£4.5X1500) 6,750 6,750 6,750 6,750
6,750 6,750
wages
TRY QUESTIONS

169
1. Bonedage is to open a retail clothes store on 1 June 2007. He will put in

£130,000 in the bank as capital. His plans are as follows:
• On 1 June to buy and pay for premises £75,000, shop fittings
£14,000 and a vehicle £13,000.
• To employ two staff each to get a salary of £1,700 per month
(ignore tax and NI).
• To buy the following quantity of garments:
• June – Aug. inclusive 600
• Sept. – Nov. inclusive 700
• To sell the following quantity of garments:
• June – Aug. inclusive 500
• Sept. – Nov. inclusive 650
• The average cost per garment will be £8, and the suppliers will be
paid in the same month.
• The average selling price per garment will be £25. 90% of the sales
will be on a cash basis. The other 10% will be on one month’s
credit.
• Bonedge will draw £1,800 per month as drawings.
• Bonedge expects to spend £1,000 per month on advertising. This is
to be paid in the same month.
• Other expenses are estimated to be £2,000 per month, payable in
the month following.
• Bonedge plans to depreciate the fittings at the rate of 10% pa, and
the vehicle at the rate of 20% pa.
TASKS
a) Prepare a cash-flow budget for the period 1 June 2007 to 30 November
2007.
b) Comment on the budgeted cash-flow position of Bonedge.
c) Explain the benefits of maintaining cash budgets.
Q2. Cost accounting (September 2005)

The following is the forecast data of a company for the first three months of
2006:
DEC (05) JAN FEB MAR
£ £ £ £
Sales 90,000 130,000 140,000 160,000
Purchases 45,000 70,000 80,000 95,000
Overheads 22,000 24,000 27,000 28,000
Wages 18,000 22,000 24,000 26,000
Other Information:
• 50% of sales are on a cash basis, and 50% are on a credit basis.
• Debtors are given one months credit.
• Suppliers give one months credit.
• Overheads are paid one month in arrears.
• Overheads include £4,000 in respect of the depreciation of fixed
assets.
• Wages are paid in the month in which they are incurred.
• New equipment costing £60,000 will be paid for in March.

170
• The sale of old equipment will bring income of £5,000 in March.

• The bank balance is predicted to be £30,000 on 1 January, 2006.
TASKS
a) Prepare cash budget for the period January – March 2006.
b) Comment on the budgeted cash position of the company.
c) Explain the principal benefits of preparing and monitoring a cash
budget.
Question 3 (cash budget):

The following projections were obtained from SUANAD Ltd, Retail Company
for the years 2008 and 2009.
NOV. DEC. JAN. FEB. MAR. APR.
2008 2008 2009 2009 2009 2009
£’000 £’000 £’000 £’000 £’000 £’000
Bills issued 940 1,020 1,280 1,420 1,080 1,800
Rights issue ---- ----- 50 120 20
---
Interest receivable 25 23.50 32.50 30 28.50
25
Loan payable 120 110 98 95 92
89
New equipment 1,800
1) Recurrent expenditure is estimated at 40% of bills issued and is paid
every month.
2) 60% of bills issued is collected in the month after issue and 30% in the
next month.
3) The new equipment will be paid for in two equal installments starting
from the month of purchase.
4) All the other receivables and payables are settled in the month in
which they occur.
5) Any shortfall will be financed by an overdraft which is obtained in
multiples of £50,000 at 5% interest per month payable in the next
month.
6) The opening balance will be an overdraft of £50,000.
You are required to prepare a cash budget for Suanad Ltd for the first four
months of the year 2009.
CHAPTER SIX
BREAK-EVEN ANALYSIS
Introduction
Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

171
It is a term used to describe the study of the relationship between costs, volume and profit at
different levels of activities. It shows the relationship that exists between cost, revenue, level
of output and profit. Another term for Break-even analysis is Cost-Volume-Profit analysis.
Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").
An important factor in break-even analysis is the ability to distinguish total cost into fixed costs
and variable cost.
FIXED COST AND VARIABLE COST
FIXED COST: Fixed costs are those business costs that are not directly related to the level of
production or output. It is defined by CIMA as “a cost which is incurred for an accounting
period, and which, within certain output or turnover limits, tends to be unaffected by
fluctuations in the level of activity (output or turnover” In other words, even if the business has
a zero output or high output, the level of fixed costs will remain broadly the same. In the long
term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding
a new factory unit) or through the growth in overheads required to support a larger, more
complex business. Examples of fixed costs include: Rent and rates, depreciation, research and
development, marketing cost (I .e. none-revenue related cost)
VARIABLE COST:
Variable costs are those costs which vary directly with the level of output. It is defined as “ a
cost which varies with a measure of activity” They represent payment output-related inputs
such as raw materials, direct labour, fuel and revenue-related costs such as commission.
A distinction is often made between the following:
"DIRECT" VARIABLE COSTS: Direct variable costs are those which can be directly
attributable to the production of a particular product or service and allocated to a particular cost
centre. Raw materials and the wages those working on the production line are good examples.
INDIRECT VARIABLE COSTS cannot be directly attributable to production but they do vary
with output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorizing
business costs, in reality there are some costs which are fixed in nature but which increase when
output reaches certain levels. These are called semi-variable costs.
ASSUMPTIONS OF BREAK-EVEN ANALYSIS
The main assumptions behind C-V-P/Break-even Analysis includes

172
1) All costs can be classified into fixed and variable costs

2) Fixed costs will remain constant over relevant range
3) Costs and revenues behave in a linear fashion.
4) Volume or output is the only factor which affects costs and revenue.
5) Technology, production methods and efficiency remain unchanged.
6) All quantities produced are sold.
7) There are no stock level changes and stocks are valued at marginal costs only.
BREAKEVEN ANALYSIS – MATHEMATICAL METHOD
C.V. P analysis can be done using simple formulae

1. Break-even point (in units) = fixed costs
Contribution per unit
2. Break-even point (£ sales) = fixed cost X selling price

OR
Fixed costs
Contribution to sales ratio(C/S ratio)
3. (C/S Ratio) = contribution per unit X 100

Selling price
4. Level of sales to achieve a target profit (in units)
= Fixed cost +Target profit

Level of sales to achieve a target profit (£ sales)
= fixed cost + target profit X selling price

The Break-Even Chart
THE BREAK EVEN CHART

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:

173
In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.
QUESTION 1
A company is about to bring a new product to the market. The following
budgeted data has been gathered:
Direct material cost per unit 30

Direct labour cost per unit 30
Variable overhead cost per unit 50
Selling price per unit 200
Fixed overhead cost 420,000
Planned production and sales 12,000 units. Maximum possible output 16,000
units.
TASKS:
a) Calculate the original budgeted profit.
b) Calculate the original budgeted break-even point.
c) The sales manager thinks that if he was allowed to spend an extra
£100,000 on marketing, the company would be able to sell 14,000 units at a
price of £210 per unit. Calculate the profit.
d) The production manager thinks that if he implemented a cost reduction
programme he could reduce direct materials by 10%, direct labour by 5%
and variable overheads by 5%. He also thinks that he could achieve saving
of £30,000 on fixed overheads.
Calculate the profit based on selling 12,000 units at £200 each.
e) Explain which option you would recommend.

174
a)
£ £
Sales (£200 X 12,000)
2,400,000
Variable costs:
Direct material (£30 X 12,000) 360,000
Direct labour (£30 X12, 000) 360,000
Variable overheads (£50 X12,000) 600,000
(1,320,000)
Total contribution
1,080,000
Fixed overhead cost
(420,000)
Budgeted profit
660,000
b) Break-even point = Fixed cost

Contribution per unit = total contribution = 1,080,000 = £90.00

No. of units 12,000
Break-even point = 420,000 = 4,667 units
90
c)
£ £
Sales (£210 X 14,000)
2,940,000
Variable costs:
Direct labour (£30 X14, 000) 420,000
Variable overheads (£50 X14, 000) 700,000
(1,540,000)
Total contribution
1,400,000
Fixed overhead cost (420,000 +100,000)
(520,000)
Net profit
880,000
d) £ £
Sales (£200 X 12,000)
2,400,000
Variable costs:
Direct labour (£28.5 X12, 000) 342,000
Variable overheads (£47.5 X12,000) 570,000
(1,236,000)
Total contribution

175
1,164,000
Fixed overhead cost (420,000-30,000)
(390,000)
Budgeted profit
774,000
e) From the above calculations, I will recommend option (c) since it

produces the highest profit.
Tutorial:
i. The extra £100,000 on marketing is a fixed cost hence it is
added to the fixed overheads
ii. The (d) part of the question requires the following calculations:
Direct material (£30x10%= 3; it is to be reduced by 10% =
£30 -£3=£27. it can be calculated as 90% x 30= ₤27 (i.e 100% -
10% = 90%)
Direct Labour (95%x £30= £28.50)
Variable overheads (£50x95%) =£ 47.50
Q2 . Cost accounting (September 2005)
A company is about to bring a new product to the market. The following

budgeted data has been collected:
£
Fixed overhead cost 1,000,000
Planned production and sales 18,000 units. Maximum possible output 22,000
units.
TASKS:
a) Calculate the original budgeted profit.
b) Calculate the original budgeted break even point.
c) It is thought that if an extra £80,000 was spent on marketing it would
be possible to sell 19,500 units at the original budgeted selling
price. Calculate the profit.
d) It is thought that if the price was increased to £260 per unit it would
only be possible to sell 15,000 units. Calculate the profit.
e) It is thought that by improving the product, at a cost of £10 extra per
unit, and increasing the selling price to £270 per unit it would be
possible to sell 18,500 units. Calculate the profit
f) Explain the term margin of safety.
a)
£ £
Sales (£230 X 18,000)
4,140,000

176
Variable costs:
Direct labour (£40 X18, 000) 720,000
Variable overheads (£50 X18,000) 900,000
(2,160,000)
Total contribution
1,980,000
Fixed overhead cost
(1,000,000)
Budgeted profit
980,000
b) Break-even point = Fixed cost

Contribution per unit = total contribution = 1,980,000 = £110.00

No. of units 18,000
Break-even point = 1,000,000 = 9,091 units
110
c)
£ £
Sales (£230 X 19,500)
4,485,000
Variable costs:
Direct labour (£40 X19, 500) 780,000
(2,340,000)
Total contribution
2,145,000
Fixed overhead cost (1,000,000 +80,000)
(1,080,000)
Budgeted profit
1,065,000
d) £ £
Sales (£260 X 15,000)
3,900,000
Variable costs:
Direct material (£30 X 15000) 450,000
Direct labour (£40 X15000) 600,000
Variable overheads (£50 X15000) 750,000
(1,800,000)
Total contribution
2,100,000
Fixed overhead cost (1,000,000)
(1,000,000)

177
Budgeted profit
1,100,000
e)
Sales (£270 X 18,500)
4,995,000
Variable costs:
Direct labour (£40 X18, 500) 740,000
Improvement (10 x 18,500) 185,000
(2,405,000)
Total contribution
2,590,000
Fixed overhead cost (1,000,000 +80,000)
(1,000,000)
Budgeted profit
1,590,000
f) From the above calculations, I will recommend option (c) since it

produces the highest profit.
Tutorial:
i. The extra £100,000 on marketing is a fixed cost hence it is
added to the fixed overheads
ii. The (d) part of the question requires the following calculations:
Direct material (£30x10%= 3; it is to be reduced by 10% =
£30 -£3=£27. it can be calculated as 90% x 30= ₤27(i.e 100% -
10% = 90%)
Direct Labour (95%x £30= £28.50)
Variable overheads:(£50x95%) =£ 47.50

178
CHAPTER SEVEN
SOURCES OF BUSINESS FINANCE
Sources of finance refer to the various means or areas through

which a business gets funds to achieve its objectives.
Sources of finance can be grouped into two main groups:
A. LONG TERM SOURCES OF FINANCE

B. SHORT TERM SOURCES OF FINANCE
LONG TERM SOURCES OF FINANCE
1. SHARE CAPITAL:
A major source e of finance for companies is through the issue shares to

existing or new members. A company willing to raise additional capital
issues shares. There are two main types of share of a company.
Ordinary (equity) shares

These are shares that have no special rights or privilege in relation to
dividends or the sharing of assets on dissolution of the company. Ordinary
are the shares which do not carry a fixed dividend. Instead, the directors
decide how much to pay to the shareholders each year (after considering
the profit made for the year. It is the commonest type of shares. Ordinary
shareholders carry the risks of the business and will only receive dividend
when preference shareholders are paid dividend. In the event of the
company dissolution, they can only get a share of the money received from
the sale of the assets after all the debts of the company is paid. Normally
each ordinary shareholder has a voting right. Non-voting ordinary shares
(called ‘A’ shares) may be issued. The voting ordinary shareholders are
called ‘B’ shares
a) PREFERENCE SHARES: Preference shares are shares carrying fixed

rate of dividend. The dividend must be paid first before any dividend is
paid to ordinary shareholders. Preference shares have a fixed percentage
dividend before any dividend is paid to the ordinary shareholders. As with
ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference
shares the right to an unpaid dividend is carried forward to later years. The
arrears of dividend on cumulative preference shares must be paid before any
dividend is paid to the ordinary shareholders.
ADVANTAGES OF PREFERENCE SHARES

179
1. Dividends do not have to be paid in a year in which profits are poor,

while this is not the case with interest payments on long term debt
(loans or debentures).
2. Since they do not carry voting rights, preference shares avoid diluting
the control of existing shareholders while an issue of equity shares
would not.
3. Unless they are redeemable, issuing preference shares will lower the
company's gearing. Redeemable preference shares are normally
treated as debt when gearing is calculated.
4. The issue of preference shares does not restrict the company's
borrowing power, at least in the sense that preference share capital is
not secured against assets in the business.
5. The non-payment of dividend does not give the preference
shareholders the right to appoint a receiver, a right which is normally
given to debenture holders.
DISAVANTAGES OF PREFERENCE SHARES

1. Dividend payments on preference shares are not tax deductible in the way that interest
payments on debt are.
2. Furthermore, for preference shares to be attractive to investors, the level of payment
needs to be higher than for interest on debt to compensate for the additional risks.
3. For the investor, preference shares are less attractive than loan stock because:
a) They cannot be secured on the company's assets
b) The dividend yield traditionally offered on preference dividends has
been much too low to provide an attractive investment compared with
the interest yields on loan stock in view of the additional risk involved.
RIGHT ISSUE
A right issue represents the offer of shares to existing shareholders in

proportion of their shareholding at a stated price usually below the current
market price of the shares. Existing ordinary shareholders are given a right
certificate which entitles them to take up a specified number of shares at a
specified price. The right issue price is sufficiently below listed price to make
the offer attractive.
Shareholders who do not wish to exercise any or all of their rights may sell
them to third parties who then apply for the shares or he may renounce his
right.
It is one way through which to reduce the cost of raising new shares and
another device used by companies whose shares are listed on the stock
exchange is to make right issues to its existing shareholders
A rights issue provides a way of raising new share capital by means of an

offer to existing shareholders, inviting them to subscribe cash for new
shares in proportion to their existing holdings.
A company making a rights issue must set a price which is low enough to secure the acceptance
of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid
excessive dilution of the earnings per share.

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ADVANTAGES OF RIGHT ISSUES AS A SOURCE OF FINANCE

i. A right issue is the simple and cheapest way by which a company
can get funds
ii. It has a greater chance of success since the buyers are the existing
known shareholders of the company.
iii. Shareholders of the company have the choice either to accept the
offer or sell their right to other shareholders for money.
iv. A right issue enables the company to at least maintain its
dividends.
v. A right issue automatically lowers the gearing ratio of the company
vi. The finance is fully guaranteed if the issue is underwritten.
vii. It might give the impression that the company is expanding.
viii. Investors see a right issue as a healthy sign of future growth
prospect of the company.
DISADVANTAGES OF RIGHT ISSUE

i. The amount of money required may not be able to obtain.
ii. Right issues are normally made at a discount, which usually
involves diluting the Earnings Per Share of the company.
iii. Underwriter’s fees and other administrative expenses of the issue
may be costly.
iv. The market is often skeptical about the reason for the right issue,
tending to assume that the company needs cash seriously.
v. A right issue usually forces shareholders to either buy the shares or
sell their right.
2. RETAINED EARNINGS (Plough-back profit)
Simply retaining profits, instead of paying them out in the form of dividends, offers an
important, simple low-cost source of finance, although this method may not provide enough
funds, for example, if the firm is seeking to grow.
This is where earnings from operations are ploughed.
For any company, the amount of earnings retained within the business has a direct
impact on the amount of dividends. Profit re-invested as retained earnings is profit
that could have been paid as a dividend. The major reasons for using retained
earnings to finance new investments, rather than to pay higher dividends and then
raise new equity for the new investments, are as follows:
a) The use of retained earnings as a source of funds does not lead to a payment of
cash. Retained earnings are an attractive source of finance because investment
projects can be undertaken without involving either the shareholders or any
outsiders.
c) The use of retained earnings as opposed to new shares or debentures avoids

issue costs.
d) The use of retained earnings avoids the possibility of a change in control

resulting from an issue of new shares.

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Another factor that may be of importance is the financial and taxation position of
the company's shareholders. If, for example, because of taxation considerations,
they would rather make a capital profit (which will only be taxed when shares are
sold) than receive current income, then finance through retained earnings would be
preferred to other methods.
A company must restrict its self-financing through retained profits because

shareholders should be paid a reasonable dividend, in line with realistic
expectations, even if the directors would rather keep the funds for re-investing. At
the same time, a company that is looking for extra funds will not be expected by
investors (such as banks) to pay generous dividends, nor over-generous salaries to
owner-directors.
back into the firm, i.e. they are used for investment in other potential
profitable projects.
The use of retained earnings is the most common source of finance in
practice.
ADVANTAGES:
1. Flexible, particularly for small amounts
2. No cost involved in raising the finance
3. No new shareholders are involved hence all gains from any investment
will go to the existing shareholders
3. BANK LOAN
Loan stock is long-term debt capital raised by a company for which interest is paid,
usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term
creditors of the company.
ADVANTAGES OF BANK LOAN
4. DEBENTURES
Debentures are a form of loan stock, legally defined as the written

acknowledgement of a debt incurred by a company, normally containing provisions
about the payment of interest and the eventual repayment of capital.
Debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.
a) Fixed charge: Security would be related to a specific asset or group of assets,

typically land and buildings. The company would be unable to dispose of the asset
without providing a substitute asset for security, or without the lender's consent.

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b) Floating charge: With a floating charge on certain assets of the company (for
example, stocks and debtors), the lender's security in the event of a default
payment is whatever assets of the appropriate class the company then owns
(provided that another lender does not have a prior charge on the assets). The
company would be able, however, to dispose of its assets as it chose until a default
took place. In the event of a default, the lender would probably appoint a receiver
to run the company rather than lay claim to a particular asset.
Mortgages are a specific type of secured loan. Companies place the title deeds of
freehold or long leasehold property as security with an insurance company or
mortgage broker and receive cash on loan, usually repayable over a specified
period. Most organisations owning property which is unencumbered by any charge
should be able to obtain a mortgage up to two thirds of the value of the property.
As far as companies are concerned, debt capital is a potentially attractive source of

finance because interest charges reduce the profits chargeable to corporation tax.
LEASING
A lease is an agreement between two parties, the "lessor" and the "lessee". The
lessor owns a capital asset, but allows the lessee to use it. The lessee makes
payments under the terms of the lease to the lessor, for a specified period of time.
Leasing is, therefore, a form of rental. Leased assets have usually been plant and
machinery, cars and commercial vehicles, but might also be computers and office
equipment. There are two basic forms of lease: "operating leases" and "finance
leases".
Operating Leases
Operating leases are rental agreements between the lessor and the lessee
whereby:
a) The lessor supplies the equipment to the lessee
b) The lessor is responsible for servicing and maintaining the leased equipment
c) The period of the lease is fairly short, less than the economic life of the asset, so
that at the end of the lease agreement, the lessor can either
i) Lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment second-hand.
Finance Leases
Finance leases are lease agreements between the user of the leased asset (the
lessee) and a provider of finance (the lessor) for most, or all, of the asset’s
expected useful life.
Other important characteristics of a finance lease:

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a) The lessee is responsible for the upkeep, servicing and maintenance of the
asset. The lessor is not involved in this.
b) The lease has a primary period, which covers all or most of the economic
life of the asset. At the end of the lease, the lessor would not be able to lease
the asset to someone else, as the asset would be worn out. The lessor must,
therefore, ensure that the lease payments during the primary period pay for
the full cost of the asset as well as providing the lessor with a suitable return
on his investment.
c) It is usual at the end of the primary lease period to allow the lessee to
continue to lease the asset for an indefinite secondary period, in return for a
very low nominal rent or the lessee might be allowed to sell the asset on the
lessor's behalf (since the lessor is the owner) .
Why might leasing be popular
The attractions of leases to the supplier of the equipment, the lessee and the lessor
are as follows:
5. The supplier of the equipment is paid in full at the beginning. The equipment is
sold to the lessor, and apart from obligations under guarantees or warranties,
the supplier has no further financial concern about the asset.
6. The lessor invests finance by purchasing assets from suppliers and makes a
return out of the lease payments from the lessee. Provided that a lessor can
find lessees willing to pay the amounts he wants to make his return, the lessor
can make good profits. He will also get capital allowances on his purchase of
the equipment.
7. Leasing might be attractive to the lessee:
i) if the lessee does not have enough cash to pay for the asset, and would
have difficulty obtaining a bank loan to buy it, and so has to rent it in one
way or another if he is to have the use of it at all; or
ii) Finance leasing is cheaper than a bank loan. The cost of payments under
a loan might exceed the cost of a lease.
Operating leases have further advantages:
i. The leased equipment does not need to be shown in the lessee's published
balance sheet, and so the lessee's balance sheet shows no increase in its
gearing ratio.
j. The equipment is leased for a shorter period than its expected useful life. In
the case of high-technology equipment, if the equipment becomes out-of-
date before the end of its expected life, the lessee does not have to keep
on using it, and it is the lessor who must bear the risk of having to sell
obsolete equipment secondhand.
6. HIRE PURCHASE
Hire purchase is a form of installment credit. Hire purchase is similar to leasing,

with the exception that ownership of the goods passes to the hire purchase
customer on payment of the final credit installment, whereas a lessee never
becomes the owner of the goods.

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Hire purchase agreements usually involve a finance house.
i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase
them.
iii) The hire purchase arrangement exists between the finance house and the
customer.
The finance house will always insist that the hirer should pay a deposit towards the
purchase price. The size of the deposit will depend on the finance company's policy
and its assessment of the hirer. This is in contrast to a finance lease, where the
lessee might not be required to make any large initial payment.
An industrial or commercial business can use hire purchase as a source of finance.

With industrial hire purchase, a business customer obtains hire purchase finance
from a finance house in order to purchase the fixed asset. Goods bought by
businesses on hire purchase include company vehicles, plant and machinery, office
equipment and farming machinery.
Government assistance
The government provides finance to companies in cash grants and other forms of
direct assistance, as part of its policy of helping to develop the national economy,
especially in high technology industries and in areas of high unemployment.
Venture capital
The term 'venture capital' is more specifically associated with putting money,
usually in return for an equity stake, into a new business, a management buy-out or
a major expansion scheme.
Venture capital is money put into an enterprise which may all be lost if the
enterprise fails. The institution that puts in the money recognises the gamble
inherent in the funding. There is a serious risk of losing the entire investment, and
it might take a long time before any profits and returns materialise. But there is
also the prospect of very high profits and a substantial return on the investment. A
venture capitalist will require a high expected rate of return on investments, to
compensate for the high risk.
A venture capital organisation will not want to retain its investment in a business
indefinitely, and when it considers putting money into a business venture, it will
also consider its "exit", that is, how it will be able to pull out of the business
eventually (after five to seven years, say) and realise its profits. Examples of
venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo
American Corporation Services Ltd.
The directors of the company must then contact venture capital organisations, to
try and find one or more which would be willing to offer finance. A venture capital
organisation will only give funds to a company that it believes can succeed, and
before it will make any definite offer, it will want from the company management:
a) a business plan

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b) details of how much finance is needed and how it will be used
c) the most recent trading figures of the company, a balance sheet, a cash
flow forecast and a profit forecast
d) details of the management team, with evidence of a wide range of

management skills
e) details of major shareholders
f) details of the company's current banking arrangements and any other

sources of finance
g) any sales literature or publicity material that the company has issued.
A high percentage of requests for venture capital are rejected on an initial

screening, and only a small percentage of all requests survive both this screening
and further investigation and result in actual investments.
FRANCHISING
Franchising is an arrangement whereby a franchisee pays a franchisor for

the right to operate a local business, under the franchisor's trade name. The
franchisor must bear certain costs such as establishment costs, legal costs,
marketing costs and the cost of other support services) and will charge the
franchisee an initial franchise fee to cover set-up costs. These regular
payments will usually be a percentage of the franchisee's turnover.
Although the franchisor will probably pay a large part of the initial
investment cost of a franchisee's outlet, the franchisee will be expected to
contribute a share of the investment himself. The franchisor may well help
the franchisee to obtain loan capital to provide his-share of the investment
cost.
THE ADVANTAGES OF FRANCHISES

The advantages of franchises to the franchisor are as follows:
i. The capital outlay needed to expand the business is reduced
substantially.
ii. The image of the business is improved because the franchisees will be
motivated to achieve good results and will have the authority to take
whatever action they think fit to improve the results.
SHORT TERM SOURCES OF FINANCE

Short –term sources of finance are defined as those which allow a company
to borrow money for up to a year before repayment is due. That is, a debt
originally scheduled for payment within one year. A variety of short term
finance is available to companies and the finance manager must know the
advantages and the disadvantages associated with each option. The
advantage of a franchise to a franchisee
The major short term sources of finance are described below:

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1. TRADE CREDIT: In the ordinary course of business, a firm may buy

its goods and services from other companies without paying for them
immediately. Trade credit is a spontaneous financing in that it arises
from the ordinary business transactions. Delaying settlement of debts
enables firms to use internally the funds that otherwise would be paid
to suppliers or creditors. Trade credit is free, no interest charges are
involved. However, discounts that could have been earned on cash
purchase will be lost. Also suppliers will eventually refuse credit and
demand cash payment on delivery.
ADVANTAGES OF TRADE CREDIT AS A SOURCE OF

FINANCE
i. Trade credit convenient and easily accessible by small and large
companies than loan from the bank.
2. BILL OF EXCHANGE:
Bills of exchange are used by firms to raise short-term finance by selling the
bill to the discount house. A bill of exchange is defined in section 3 of the
bill of exchange
Act 1882 as “ an unconditional order in writing, address by one person to
another, signed by the person giving it, requiring the person to whom it is
addressed to pay on demand, or at a fixed or determinable future time a
sum certain in money to or to the order of s specified person or bearer”.
The bill of exchange is originated by a creditor and addressed to the debtor
who by signing the bill agrees to pay the bill at maturity. The creditor can
sell the bill immediately on the discount market.
3. BANK OVERDRAFT
This is a short term source of finance to small and large companies where
the company is permitted to withdraw in excess of their current account
balance or deposit. It is a common source of short term finance where the
company is not able to secure loan from the bank. To obtain an overdraft,
the company must have an account with the bank. Thus the main difference
between a bank loan and an overdraft is that, a bank loan does not require
an account with the bank before one can secure the loan, whereas a bank
overdraft requires and account with the bank. Usually, the bank has limits at
which the company may be allowed overdraft. When the limit is exceeded,
further overdraft may not be allowed. The bank charges interest on the
overdraft and the company can be called to pay the overdraft at any time.
ADVANTAGES OF BANK OVERDRAFT AS A SOURCE FINANCE

i. Lower interest rate: Overdraft interests are lower than long
term loan.
ii. Flexibility: overdraft are more flexible in terms of payment than
bank loan
iii. Tax-deductible interest: The interest paid on overdraft is
allowed as a deductible expense by the tax authorities.

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DISADVANTAGES
The major problems of overdraft interest are
i. Technically overdrafts are payable on demand
ii. Interests rates may increase due to inflation
4. FACTORING & INVOICE DISCOUNTING

Factoring involves the outright sale (at a discount) of debts owed to the
company to an outside body in exchange for cash. Thus companies can use
factoring to raise immediate cash on the security of the companies debt. A
company anxious to restore liquidity can be helped by a factor. Factors
are specialist financial institutions, usually a subsidiary of major
banks)
The factor takes over the administration of the client company’s invoices,
collects the money and also assumes the risk of customer default. How
much is paid for the invoice is subject to negotiation but usually depends on
the volume of debt involve, degree of customer default and the extent of
paperwork involve.
A typical factoring arrangement include the following
a. The company sells and invoices goods to customers
b. The company (supplier) sells the debt/ the invoice amount to the
factor
c. The factor then releases a loan of about 80% of the invoice amount
to the supplier
d. At the agreed payment date by the customer, the customer pays the
amount to the factor
e. The factor then releases the remaining 20% to the company after
deducting interest charges and commission.
A typical factor’s cost can be divided into the following:

i. A service charge ( usually 1% or 2% of the sales value) to cover the
cost of administering the invoices
ii. A finance charge (i.e. loan interest) on the amount paid by the factor
to the company, usually between 3% - 4%. The interest is calculated
up the time that debtors settle their bills.
iii. A premium ( about 1% ) to cover bad debts
iv. Extra charges for legal fees incurred by the factor during the debt
collection
5. INVOICE DISCOUNTING
This involves the buying of invoices issued to customers by the discounter.

The discounter then issues immediate cash to the supplier up to say 80% of
the invoice values. That is with invoice discounting, the company receives a
cash payment (thus a loan) from the invoice discounter against the value of
the invoices issued to customers but the company retains the responsibility
for the debts collection but not the discounter who collects the debt as in
factoring. Charges in invoice discounting are usually higher than factoring.

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One advantage of invoice discounting is that, customer goodwill is

maintained
ADVANTAGES OF FACTORING & INVOICE DISCOUNTING

1. Factors are experts in debt collection and may be able to
persuade debtors to settle their outstanding debts more
conveniently than the company’s own accounting staff.
2. Factoring speeds up cash flows of a company thereby preventing
cash flow difficulties.
DISADVANTAGES OF FACTORING & INVOICE DISCOUNTING

1. One of the problems with factoring is that, the client company looses
contact with its customers. The factor may collect the debts in its own
name or under the letter head of the come. Some times the customer
is irritated during the process.
2. Factors are not always interested to deal with small companies where
the debt is small.
3. The interest charged by these factors are usually costly
4. Factoring can be applied to few customers with huge debt.
6. DEFERED TAX PAYMENT

Another source of short-term funds similar character to trade credit is the
credit supplied by the tax authority. This is created by the interval that
elapses between the earnings of the profits by the company and the
payment of the taxes due on them. As long as the company continues to
earn stable or expanding profit, tax payment deferred in this way comprises
a virtually permanent source of finance. Provisional assessments and
payment of deposit on account by Ghana tax authorities has render this
source of finance non-effective.
CHAPTER EIGHT
MERGERS AND TAKEOVERS

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A merger is a combination of two companies into one larger company.

MERGER means the combination of two or more firms to form a single
company.Thus a merger is the joining of two separate companies to form a
single company It is a tool used by companies for the purpose of expanding
their operations often aiming at an increase of their long term profitability.
Corporate mergers may be aimed at reducing market competition, cutting

costs (for example, laying off employees, operating at a more
technologically efficient scale, etc.), reducing taxes, removing management,
"empire building" by the acquiring managers, or other purposes which may
or may not be consistent with public policy or public welfare. .
A merger can resemble a takeover but result in a new company name

(often combining the names of the original companies) and in new branding;
in some cases, terming the combination a "merger" rather than an
acquisition is done purely for political or marketing reasons.
Acquisition on the other hand is the purchase of a controlling interest in

another company.
TYPES OF MERGER:
Mergers can be classified into four groups:
1. horizontal merger
2. vertical merger
3. concentric/ congeneric merger
4. conglomerate merger
1) HORIZONTAL MERGER: This is a combination of two or more

companies that produce the same type of goods and services.
Horizontal mergers take place where the two merging companies
produce similar product in the same industry. That is when one firm
combines with another in its same line of business. eg MTN & TIGO
2) VERTICAL MERGER: A merger between a firm and one of its suppliers
or customers e.g. a steel company acquiring a coal mining firm.
Vertical mergers occur when two firms, each working at different
stages in the production of the same good, combine.
3) COMGLOMERATE MERGER: A merger of companies in totally
different industries. Conglomerate mergers take place when the two
firms operate in different industries.
Hostile Merger: A form of merger where the target firm’s management

resists or opposes the acquisition.
Friendly Merger: A merger whose which is supported and whose terms are
approved by the management of the two companies.

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ACQUISITION
Acquisition or takeover is the purchase of a controlling interest in one
company by another. An acquisition may be friendly or hostile. In the former
case, the companies cooperate in negotiations; in the latter case, the
takeover target is unwilling to be bought or the target's board has no prior
knowledge of the offer. Acquisition usually involves a purchase of a smaller
firm by a larger one. Sometimes, however, a smaller firm will acquire
management control of a larger or longer established company and keep its
name for the combined entity.
NOTE: Mergers are generally differentiated from acquisitions partly by the

way in which they are financed and partly by the relative size of the
companies.
REASONS FOR MERGER:

A. SYNERGY: “the conditions where in the whole is greater than the sum
of its parts”. In a synergistic merger, the post -merger value exceeds
the sum of the separates companies’ pre-merger values. The primary
motivation for most mergers is to increase the value at the combined
enterprise. e.g. If A Ltd and B Ltd merge to form AB Ltd AB Ltd values
exceeds that of A and B taken separately then synergy is said to exist
Synergy effect can arise from 4 sources
1. operating the economies of scale generally cost reduction
2 .Financial economies lower cost of debt greater debt capacity.
3. Differential management efficiency
4. Increase market power resulting from reduced competition.
2. Tax consideration: Tax consideration has stimulated a number of merges

e.g. a company which is highly profitable and has highest tax could acquire
a company with large accumulated tax losses, and set off the losses to its
profit. A profitable company can buy a loss maker to use the target's loss as
their advantage by reducing their tax liability.
B. PURCHASE OF ASSETS BELOW THEIR REPLACEMENT COST
Another reason which will allow firms to merge is the fact that sometimes
the replacement cost of the assets of the target company is higher than its
market value.
C. ECONOMIES OF SCALE: This refers to the fact that the combined

company can often reduce duplicate departments or operations, lowering
the costs of the company relative to the same revenue stream, thus
increasing profit.
REASONS FOR ACQUISITIONS

The following are some reasons why one company may decide to acquire a
controlling interest in another company.
1) Marketing advantages:

191
a. To eliminate major competitor and protect the company’s

existing market.
b. To enter an new market ( i. g . enter overseas market)
c. To buy a market presence
The classic reasons for acquisition as a part of the broader corporate

strategy are as follows:
1) MARKETING ADVANTAGES
i. To buy a new product range.
ii. To buy a market presence (especially true if acquiring a
company with overseas offices and contracts that can be
utilized by the mother company).
iii. To eliminate competition or to protect an existing market.
iv. To unify sales departments or to rationalize distribution and
advertising.
2) PRODUTION ADVANTAGES
i. To gain a higher utilization of production facilities and reap
economic of scale y larger runs, less time spent on change over
ii. To buy in technology and skills
iii. To obtain greater production capacity
iv. To safeguard future supplies of raw materials.
v. To improve the purchasing position through better bulk
purchasing opportunities
3) FINANCE AND MANAGEMENT
i. To buy a high quality management team, which exist in the
acquired company.
ii. To obtain cash resources where the acquired company is very
liquid.
iii. To gain under valued assets or surplus assets that ca be sold
off.
iv. To obtain tax advantages (e.g. purchase of a tax loss company).
4) RISK SPREADING
i. Reduce the risk of reliance on a single market or product.
5) TO RETIAN INDEPENDENCE :A company threatened by a takeover

might take over another company just to make itself bigger and so a
more expensive “target” for the predator company.
6) INCREASED MARKET SHARE: This can increase market power: In an
oligopoly market, increased market share generally allows companies
to raise prices.
7) RESOURCE TRANSFER: resources are unevenly distributed across
firms (Barney, 1991) and the interaction of target and acquiring firm
resources can create value through either overcoming information
asymmetry or by combining scarce resources
The following must also be evaluated before the merger or acquisition.
1. The prospects of technological change in the industry.
2. The size and strength of competitors.
3. The reaction of competitors to an acquisition.

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4. The likelihood of government intervention and legislation.

5. The state of the industry and its long term prospects.
6. The amount of synergy obtainable from the merger or acquisition.
Whatever the reason for the merger or acquisition, it is unlikely it is unlikely
to be unless if offers the company opportunities that cannot be found within
the company itself and unless the new subsidiary fits closely into the
strategic plan outlined for growth.
1. Increase in sales/revenues
2. Venture into new businesses and markets
3. Profitability of target company
4. Increase market share
5. Decrease competition (from the perspective of the acquiring company)
6. Reduction of overcapacity in the industry
DISADVANTAGES OF MERGERS AND ACQUISITIONS
1. Reduced competition and choice for consumers in oligopoly markets

2. Likelihood of price increases and job cuts
3. Cultural integration/conflict with new management
4. Hidden liabilities of target entity.
CHAPTER NINE: PAST QUESTIONS

JUNE 2009
FINANCIAL MANAGEMENT

193
1. Explain the following terms:

a) Underwriting fees
b) The major contents of a prospectus (as regards an offer for shares)
c) Gilt-edged securities
d) Debenture
2. The following information relates to Clifton Ltd and has been taken from their books as at 31 May 2009:
£
Turnover 1,600,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 May 2009 was £17 per share.
TASKS
a) Prepare the profit and loss account of Clifton Ltd for the year ended 31 May 2009.
i the EPS
ii the PE ratio
iii the dividend per share
iv the operating profit as a percentage of sales
c) The following are the simplified individual balance sheets of two companies P (the parent company) and S
(the subsidiary company) immediately after acquisition:
£m £m
P S
Fixed Assets
Investments in S (75% of the shares) 24
Tangible assets 30 14
54 14
Current Assets
Stock 20 7
Debtors 15 9
Bank 5 3
40 19
Current Liabilities
Creditors (15) (5)

79 28
=== ===
Ordinary share capital 60 20
Profit and loss account balance 19 8
=== ===
TASK
Construct the group balance sheet immediately after acquisition.
OR
Explain the following terms:
i Minority interest
ii An associated company
3. Homunol plc is considering investing in a project that has the following cash flows:
£000
Cash flows:
Year one 900

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Year two 1,200

Year three 1,800
Year four 1,200
Year five 600
Year one .926 .917 .909
Year two .857 .842 .826
Year three .794 .772 .751
Year four .735 .708 .683
Year five .681 .650 .621
Year six .630 .596 .564
TASKS
e) Outline any ‘non-financial’ factors that might be considered by Homunol plc during the decision
making process.
f) Explain the importance of a project review.
4. a) Prepare a cashflow statement of a company called BMU plc for the year ended 31 May 2009 from the
following data:
£000
Purchase of new premises 290
Purchase of new computers 80
Tax paid 140
Repayment of long-term loans 380
Interest paid 40
Interest received 5
b) Comment on the cashflow position of BMU plc during the year ended 31 May 2009.
c) Explain the principal sources of long-term finance available to a plc.
5. The following figures have been extracted from Piterson Ltd’s accounts for the two years to 31 May 2009:
2008 2009
Stock £110,000 £180,000
Debtors £180,000 £290,000
Cash in bank 20,000 –
Creditors £130,000 £180,000

Bank overdraft – 30,000
Long-term loans £200,000 £450,000

TASKS
i the current ratio
ii the acid test ratio
iii the gearing percentage
b) Comment on the liquidity position of Piterson Ltd.

195
c) Explain the importance of using a cash budget to control and monitor the cash flow position of a
business.
6. a) Explain what you understand by the term vertical integration.

b) Explain what you understand by the term horizontal integration.
c) Explain the potential sources of short-term finance available to a large company.
7. Write notes on FOUR of the following:

a) the principal role of a central bank
b) VAT
c) a rights issue
d) intangible fixed assets
e) breakeven analysis
f) a master budget
g) venture capitalists
MARCH 2009

a) a share issue
b) marginal costing
c) gilt-edged securities
d) a cash flow statement
2. The following figures have been extracted from Ronon Ltd’s accounts for the two years to 28 February
2009:
2009 2008
Stock £170,000 £110,000
Debtors £310,000 £200,000
Cash in bank – £30,000
Creditors £230,000 £180,000

Bank overdraft £30,000 –
Long-term loans £480,000 £240,000

TASKS
i the current ratio
ii the acid test ratio
iii the gearing percentage
b) Comment on the liquidity position of Ronon Ltd.
c) Explain what a rights issue is.
3. a) Explain the importance of an efficient budgetary control system.

b) Explain which ratios you might use to measure the efficiency of your management of working
capital.
4. a) Prepare a cashflow statement of a company called Venasius plc for the year ended 28 February 2009
from the following data:
£000
Purchase of new machines 170
Tax paid 140

196

Interest paid 25
Interest received 5
b) Comment on the cashflow position of Venasius plc during the year ended 28 February 2009.
c) Explain the sources of long-term capital available to a major company.
5. The following information relates to Shabalal Ltd and has been taken from their books as at 28 February
2009:
£
Turnover 2,100,000
OTHER INFORMATION:
• There are 1,500,000 £1 ordinary shares in issue.
• The market price of an ordinary share on 28 February 2009 was £5.80 per share.
TASKS
a) Prepare the profit and loss account of Shabalal Ltd for the year ended 28 February 2009.
i the EPS
ii the PE ratio
iv the interest cover
c) The following are the simplified individual balance sheets of two companies P (the parent company)
and S (the subsidiary company) immediately after acquisition:
£m £m
P S
Fixed Assets
Investments in S (60% of the shares) 20 –
---- ----
48 10
---- ----
Current Assets
Stock 20 6
Debtors 12 6
Bank 3 1
---- ----
35 13
---- --
Current Liabilities
---- ----
Creditors (12) (2)
---- ----
71 21
=== ===
=== ===
TASK
Construct the group balance sheet immediately after acquisition.
OR

197

i Minority interest
ii An associated company
6. a) Explain why a company will use investment appraisal techniques in the choice of allocating finance
to potential investment projects.
b) Explain the role of an external auditor.
c) Explain the role of a financial director.

a) VAT
b) vertical integration
c) horizontal integration
e) goodwill
f) venture capitalists
g) a bonus issue of shares
DECEMBER 2008
1. a) Explain the BENEFITS of a budgetary control system.[12]

b) Explain the sources of short-term finance available to a large company.[8]
2. The following information relates to JayJay B Ltd and has been taken from their books as at 31 November
2008:
£
Turnover 1,450,000
Interest received 5,000
OTHER INFORMATION:
• The market price of an ordinary share on 30 November 2008 was £6.60 per share.
• The total capital employed in the business on 30 November 2008 was £1,600,000.
TASKS
a) Prepare the profit and loss account of JayJay B Ltd for the year ended 30 November 2008. [5]
i the EPS
ii the PE ratio
v the operating profit (PBIT) as a percentage of total capital employed.[2 each]
c) Explain what a bonus issue of shares is.[5]
3. Carbus Ltd is considering investing in a project which has the following cash flows:
£000
Cash flows:
Year 1 800
Year 2 1,300
Year 3 1,200
Year 4 700
Year 5 300

198

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
a) Calculate the payback period (in years and months).[2]
b) Calculate the ARR (accounting rate of return).[2]
c) Calculate the NPV (net present value).[4]
d) Explain briefly if you think that the project is viable.[4]
e) Explain the sources of long-term finance available to a large company.[8]
4. a) Fully explain the synergetic benefits usually associated with a takeover.[12]
b) Explain the function of a stock exchange.
[8]
5. a) A company makes a single product. The following is the cost structure:
£
Total fixed costs 590,000
=======
Budgeted production and sales 50,000 units.
Maximum possible production 64,000 units.
TASKS
i Calculate the budgeted profit.[3]
ii Calculate the break even point in units.[2]
iii Calculate the profit if an extra £80,000 was spent on marketing and 56,000 units are made and
sold.[3]
b) Explain the term MINORITY INTEREST.[6]
c) Explain the importance of the audit function.[6]
6. The following are the assets and liabilities of Rovfort Ltd as at 30 November 2008:
£000
Premises 800
Bank overdraft 190
Creditors 190
Goodwill 100
Debtors 300
Vehicles (net) 250
Share premium 120
Tax owing 110
Dividends owing 100
Equipment 400
Closing stock 230
Long-term loans 250

199
Credit sales 2,900

Opening stock 240
Purchases 1,290
TASKS
a) Prepare the balance sheet of Rovfort Ltd as at 30 November 2008.[8]
i current
ii acid test
iv the rate of stock turnover[2 each]
c) Comment briefly on the liquidity position of Rovfort Ltd as at 30 November 2008.[4]

a) the purposes of a cash budget
b) accounting standards
c) a cash flow statement (FRS 1)
d) financial gearing (leverage)
e) efficiency ratios
f) IRR
g) a rights issue[5 each]
SEPTEMBER 2008

a) cash budget
b) stock exchange
c) a share prospectus
d) marginal costing[5 each]
2. The following information relates to LEN Ltd and has been taken from their books as at 31 August 2008:
£
Turnover 1,960,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 August 2008 was £9.40 per share.
• The total capital employed in the business on 31 August 2008 was £1,850,000.
TASKS
a) Prepare the profit and loss account of LEN Ltd for the year ended 31 August 2008. [5]
i the EPS
ii the PE ratio
v the profit before tax to total capital employed percentage[2 each]
Note. The following ratios on 31 08 07 were:
EPS 52 pence per share
PE ratio 12 times
c) Give an opinion as regards the performance of LEN Ltd from the view of an existing shareholder. [5]

200
3.Giles Ltd is considering investing in a project which has the following cash flows:
£000
Cash flows:
Year 1 600
Year 2 900
Year 3 1,100
Year 4 600
Year 5 200
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums.
[8]
4. Explain the importance of using an effective budgetary control system.[20]
5. a) Prepare a cash flow statement for KAB plc from the following data:
£000
Purchase of fixed assets 260
Tax paid 70
Interest paid 60
Interest received 10
Increase in long-term loans 200
Issue of ordinary shares 500
Cash inflow from operating activities 250[6]
b) Explain the sources of long-term capital that might be considered by KAB plc.[8]
c) Explain briefly why a large company may wish to expand by taking over a number of smaller
competitors. [6]
6. The following are the assets and liabilities of Lucas Ltd as at 31 August 2008:
£000
Premises 700
Bank overdraft 100
Creditors 110
Goodwill 150
Debtors 370
Vehicles (net) 190
Share premium 140
Tax owing 110
Dividends owing 70
Equipment 450
Closing stock 320
Long-term loans 350

201

Credit sales 3,700
Opening stock 290
Purchases 1,400
TASKS
a) Prepare the balance sheet of Lucas Ltd as at 31 August 2008.[8]
i current
ii acid test
iv the gearing percentage[2 each]
c) Comment briefly on the liquidity position of Lucas Ltd as at 31 August 2008.[4]

a) accounting standards (or international accounting standards)
b) group accounts
c) short-term sources of finance
d) the role of an external auditor
e) a rights issue
f) the role of a management accountant
g) IRR [5 each]
JUNE 2008
1. The summarised financial statements of Barista Ltd for 2006 and 2007 were as follows:
Barista Ltd balance sheets as at 31 December
2006 2007
£000 £000 £000 £000
Depreciation (9,000) 10,000 (13,000) 22,000
Current assets
Stock 10,000 8,000
Debtors 15,000 17,000
Bank 8,000 1,000
-------- --------
33,000 26,000
-------- --------
Current liabilities
-------- --------
13,000 8,000
-------- --------

-------- --------
25,000 30,000
-------- --------

202

-------- --------
25,000 30,000
-------- --------
Barista Ltd profit and loss account for the year ended 31 December 2007:
£000
---------
Taxation (3,000)
--------
Dividend (3,000)
--------
--------
TASKS
a) Prepare a cash flow statement for Barista Ltd for the year ended 31 December 2007.[10]
i the dividend per share for BOTH years[3]
ii the EPS for year ended 31 December 2007[2]
c) Comment briefly on the major inflows and outflows of cash during the year ended 31 December
2007.[5]
2. A company is about to bring a new product to the market. The following budgeted data has been
assembled:
£
Fixed overheads allotted to the product 320,000
The first draft budgeted production and sales is 12,000 units.
The maximum possible output is 20,000 units.
TASKS
a) Calculate the first draft budgeted profit.[3]
b) Calculate the first draft budgeted break-even point.[2]
c) The marketing department have carried out some market research and are convinced
that if an extra £50,000 was spent on marketing sales would rise to 15,000 units.
Calculate the profit.[3]
d) It is thought that if the selling price is increased to £180 per unit it would only be possible to sell
11,000 units. Calculate the profit. [3]
e) The production department thinks that by improving the quality and packaging of the product by
spending an extra £4 per unit making the product, sales would rise to 14,500 units. The selling price would
be kept at £170. Calculate the profit.[3]
f) Fully evaluate the above options.[6]
3. The following information relates to Karos Ltd and has been extracted from their books as at 31 May 2008:
£
Turnover (all credit sales) 2,200,000
Selling and distribution costs 220,000
Stock at 01 06 07 300,000
Purchases 970,000
Stock at 31 05 08 280,000
Proposed ordinary dividend 100,000

203
-------------
Total closing debtors 190,000
TASKS
a) Prepare the profit and loss account for the year ended 31 May 2008.[5]
ii the operating profit (PBIT) to sales percentage
iv the PE ratio
v the debtor collection period in days[10]
c) Comment on the financial performance of Karos Ltd.[5]
4. Domone plc is considering investing in a project that has the following cash flows:
£000
Cash flows:
Year one 700
Year two 1,000
Year three 1,100
Year four 600
Year five 300
Year one .926 .917 .909
Year two .857 .842 .826
Year three .794 .772 .751
Year four .735 .708 .683
Year five .681 .650 .621
Year six .630 .596 .564
TASKS
a) Calculate the payback period.[2]
e) Explain the long-term sources of finance available to Domone plc.[8]
5. a) Explain why budgetary control is used by most successful companies.[12]

b) Explain the importance of controlling inventory (stock) levels.[8]
6. Explain why the international trend is for growth via mergers or takeovers.[20]
7. Explain FOUR of the following:

a) share issues
b) cash budgets
c) accounting standards
d) gilt edged securities
e) liquidity ratios
f) the potential dangers of high gearing
g) the role of a central bank[5 each]
MAY 2008

204
1. a) Explain the term SYNERGY, and outline the typical synergetic benefits gained by a company that
acquires a major competitor.[10]
b) Explain the major sources of long-term finance available to a large plc company.[10]
2. The following information relates to Column Ltd and has been taken from their books as at 31 April 2008:
£
Turnover 1,900,000
Other information:
• The market price of an ordinary share on 31 April 2008 was £7 per share.
TASKS
a) Prepare the profit and loss account of Column Ltd for the year ended 31 April 2008.[5]
i the EPS
ii the PE ratio
iv the dividend cover[2 each]
£m £m
P S
Fixed assets
Investments in S (80% of the shares) 24 -
50 13
Current assets
Stock 14 9
Debtors 8 6
Bank 4 3
26 18
Current liabilities
Creditors (10) (6)
66 25
=== ===
=== ==
EITHER
Construct the group balance sheet immediately after acquisition.[7]
OR
i Minority interest[4]
ii An associated company[3]
3. a) Explain the major reasons for using a budgetary control system.[12]

b) Explain the process of raising finance via a new issue of shares. [8]
4. a) Prepare a cashflow statement of a company called ROK plc for the year ended 31 April 2008 from the
following data:
£000
Tax paid 120

205

Interest paid 30
b) Comment on the cashflow position of ROK plc during year ended 31 April 2008.[5]
c) Explain a rights issue.[5]
d) Sketch a breakeven chart, clearly labelling the key features.[5]
5. The following figures have been extracted from Jasper Ltd’s accounts for the two years to 31 April 2008:
2008 2007
Stock £170,000 £120,000
Debtors £350,000 £190,000
Creditors £230,000 £210,000

Long-term loans £600,000 £300,000

TASKS
a) For both years calculate the following:
b) Comment on the liquidity position of Jasper Ltd.[5]
c) Explain the importance of preparing and monitoring a cash budget.[6]
to potential investment projects.[10]
b) Explain the potential sources of short-term finance available to a large company.[10]

a) accounting standards
b) company taxation
c) gilt edged securities
d) depreciation
e) arbitrage
f) currency hedging
g) venture capitalists
h) the role of an auditor[5 each]
MARCH 2008
a) A public issue of shares[8]
b) Capital investment appraisal[12]
2. The following information relates to Diamonte Ltd and has been taken from their books as at 29 February
2008:
£
Turnover 2,100,000

206

OTHER INFORMATION:
• The market price of an ordinary share on 29 February 2008 was £11.40 per share.
• The total revenue reserves at 1 March 2007 was £1,420,000.
• Diamonte Ltd do NOT have any form of long-term loan finance.
TASKS
a) Prepare the summarised published profit and loss account of Diamonte Ltd for the year ended 29
February 2008. [4]
i the EPS
ii the PE ratio
v the operating profit as a percentage of total capital employed[2 each]
£m £m
P S
Fixed Assets
Investments in S (75% of the shares) 34 –
75 19
Current Assets
Stock 19 12
Debtors 15 9
Bank 7 4
41 25
Current Liabilities
Creditors (12) (6)
104 38
=== ===
=== ===
TASK
3. a) Explain the importance of budgetary control.[15]

b) A company is about to introduce a new product to the market. The cost data is as follows:
£
Direct wages cost per unit 22
Associated total fixed costs 200,000
The company thinks that it can make and sell 20,000 units.
TASKS
i Calculate the budgeted profit.[3]
ii Calculate the break-even point in units.[2]
4. a) Prepare a cashflow statement of a company called RSP plc for the year ended 29 February 2008 from
the following data:
£000

207
Purchase of new computer equipment 140

Tax paid 120
Interest paid 40
b) Comment on the cashflow position of RSP plc during the year ended 29 February 2008.[5]
c) Explain what a rights issue is.[5]
d) Explain the term synergy.[5]
5. The following figures have been extracted from Vijay Ltd’s accounts for the two years to 29 February
2008:
2008 2007
Stock £210,000 £190,000
Debtors £420,000 £210,000
Cash in bank – £30,000
Creditors £280,000 £200,000

Bank overdraft £40,000 –
Long-term loans £700,000 £200,000

TASKS
b) Comment on the liquidity position of Vijay Ltd.[5]
c) Explain the importance of preparing and monitoring a cash budget.[6]
6. a) Explain potential sources of long-term funding available to a large plc.[10]

b) Explain the potential sources of short-term finance available to a large plc.[10]

b) company taxation
d) depreciation
e) arbitrage
f) currency hedging
g) venture capitalists[5 each]
DECEMBER 2007
1. The following information relates to Yasmin Ltd and has been taken from their books as at 30 November
2007:
£
Turnover 1,800,000

208

Other Information:
TASKS
a) Prepare the profit and loss account of Yasmin Ltd for the year ended 30 November 2007[5]
i the EPS
ii the PE ratio
iv the profit before tax as a percentage of sales[2 each]
£m £m
P S
Fixed Assets
47 12
Current Assets
Stock 18 8
Debtors 11 7
Bank 2 1
31 16
Current Liabilities
Creditors (10) (4)
68 24
=== ===
=== ===
TASK
OR

a) Underwriting fees
b) A subsidiary company
c) Gilt edged securities
d) Contribution[5 each]
3. a) Explain the principal purposes of using a budgetary control system.[12]

b) Explain the sources of finance available to a multinational company. [8]
4. a) Prepare a cashflow statement of a company called VFR plc. for the year ended 30 November 2007
from the following data:
£000
Purchase of new equipment 210
Tax paid 130

209
Interest paid 30
Interest received 5
b) Comment on the cashflow position of VFR plc. during the year ended 30 November 2007.[5]
c) Explain the purpose of accounting standards.[5]
d) Explain the difference between fixed and variable costs.[5]
5. The following figures have been extracted from Gleeson Ltd.’s accounts for the two years to 30 November
2007:
2007 2006
Stock £190,000 £120,000
Debtors £320,000 £190,000
Creditors £240,000 £210,000

Long-term loans £550,000 £250,000

TASKS
b) Comment on the liquidity position of Gleeson Ltd.[5]
c) Explain the importance of monitoring the cash flow position of a business.[6]
b) Explain the potential sources of short-term finance available to a large company.[10]

b) VAT
c) a rights issue
e) goodwill
f) currency hedging
SEPTEMBER 2007
1. The following information relates to Steric Ltd and has been taken from their books as at 31 August 2007:
£000
Turnover (all credit sales) 290,000
Stock at 01/09/06 42,000
Purchases 142,000
Stock at 31/08/07 44,000

210

Investment income 5,000
Balance on profit and loss account 01/09/06 121,000
Other information:
• The market price of an ordinary (equity) share on 31 August 2007 was £1.50 per share.
• There are 1 million ordinary shares in issue.
TASKS
a) Prepare a profit and loss account for the year ended 31 August 2007.[8]
i the gross profit as a percentage of sales
ii the profit before tax as a percentage of sales

iii the EPS
iv the PE ratio[2 each]
c) Comment on the profitability of Steric Ltd.[4]
2. The following are the assets and liabilities of Didi Ltd as at 31 August 2007:
£000
Creditors 140
Share premium account 40
Equipment (net) 60
Premises (net) 200
Debtors 210
Stock 280
Goodwill 110
Vehicles (net) 140
Dividends owing 80
Tax owing 80
Long-term loans 160
Overdraft 80
Retained profits 220
TASKS
a) Prepare the balance sheet as at 31 August 2007.[8]
b) Calculate TWO liquidity ratios.[4]
c) Calculate the gearing ratio.[2]
d) Explain the generally accepted advantages and disadvantages of a company being high geared.[6]
3. a) Explain the advantages of leasing fixed assets (e.g. vehicles, computers, etc.) as opposed to outright
purchase.[10]
b) Explain the potential sources of long-term finance available to a large PLC.[10]
4. a) Explain the following terms:

i vertical integration
ii horizontal integration
iii conglomerate integration[12]
b) Explain the terms:
i minority interest
ii associated company[4 each]
5. A company is about to introduce a new product. The following budgeted data has been prepared:
£
Proposed selling price per unit 220
Fixed costs allocated to the product 750,000

211
TASKS
b) Calculate the following – based on the first draft budget:
i breakeven point in units
ii margin of safety in units[3]
c) It is thought that if an extra £20 per unit was spent on improving the quality and presentation of the
product, 23,000 units could be sold at £230 each.
d) It is thought that if an extra £50,000 was spent on advertising the product, and the quality and price
kept as per the first draft budget, 22,000 units could be sold.
e) Sketch a breakeven chart/graph based on the first draft budgeted data.[6]
6. a) Explain the advantages and disadvantages of the following three commonly used capital appraisal
techniques:
i payback
ii accounting rate of return
iii net present value (NPV)[4 each]
b) Explain the following terms:
i a bonus issue of shares
ii a rights issue of shares[4 each]

a) budgetary control
b) accounting standards
d) venture capital
e) a stock exchange
f) monitoring financial performance
g) a cash flow statement[5 each]
JUNE 2007
a) group accounts
b) master budget
c) a rights issue
d) horizontal integration [5 each]
2. The following information relates to RIC Ltd. and has been taken from their
books as at 30 April 2007:
£
Turnover 1,650,000
OTHER INFORMATION:
• The market price of an ordinary share on 30 April 2007 was £5.00 per share.
• The total capital employed in the business on 30 April 2007 was £1,680,000.
TASKS
a) Prepare the profit and loss account of RIC Ltd. for the year
ended 30 April 2007. [5]

212

i the EPS
ii the interest cover
v the operating profit to total capital employed percentage [2 each]
c) Explain what a bonus issue of shares is. [5]
3. Nathalie Ltd is considering investing in a project which has the

following cash flows:
£000
Cash flows:
Year 1 700
Year 2 1,000
Year 3 1,400
Year 4 700
Year 5 300
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
a) Calculate the payback period (in years and months). [2]
b) Calculate the ARR (accounting rate of return). [2]
c) Calculate the NPV (net present value). [4]
d) Explain briefly if you think that the project is viable. [4]
e) Explain the benefits of using investment appraisal techniques
in the allocation of large capital sums. [8]
4.a) Explain why many large companies seek to continue to expand

by merging with or taking over smaller competitors. [10]
b) Explain the process of setting a budget. [10]
5. a) Prepare a cash flow statement from the following data:

£000
Tax paid 60
Interest paid 30
Long-term loan paid off 400
Cash inflow from operating activities150 [6]
b) Explain the consequences of ‘over borrowing’ during a recession. [8]
c) Explain the reasons why firms monitor financial performance via the
use of financial ratios. [6]
6. The following are the assets and liabilities of Chantal Ltd. as at 30

April 2007: £000

213
Premises 800
Bank overdraft 130
Creditors 110
Goodwill 150
Debtors 400
Vehicles (net) 190
Share premium 140
Tax owing 110
Dividends owing 80
Equipment 460
Closing stock 300
Long-term loans 330

Credit sales 3,400
Opening stock 260
Purchases 1,500
TASKS
a) Prepare the balance sheet of Chantal Ltd. as at 30 April 2007. [8]
i current
ii acid test
iv the rate of stock turnover [2 each]
c) Comment briefly on the liquidity position of Chantal Ltd. as

at 30 April 2007. [4]

a) international accounting standards
b) stock markets
c) a share prospectus
d) the role of an external auditor
e) accounting concepts
g) IRR [5 each]
MARCH 2007
1. The summarised financial statements of Carla Ltd. for 2005 and 2006 were as follows:
Carla Ltd. balance sheets as at 31 December
2005 2006
£000 £000 £000 £000
Depreciation (7,000) 8,000 (9,000) 9,000
Current assets
Stock 7,000 9,000
Debtors 11,000 10,000
Bank 3,000 4,000
21,000 23,000
Current liabilities

214
13,000 12,000

13,000 16,000
13,000 16,000
Carla Ltd. profit and loss account for the year ended 31 December 2006:
£000
---------
Taxation (5,000)
--------
Dividend (4,000)
--------
--------
TASKS
a) Prepare a cash flow statement for Carla Ltd. for the year ended
31December2006.
i. the dividend per share for BOTH years
ii the EPS for year ended 31 December 2006
c) Comment briefly on the financial performance during year
ended December2006.
2. A company is about to bring a new product to the market.
The following budgeted data has been assembled:
£

TASKS
a) Calculate the first draft budgeted profit. [3]
b) Calculate the first draft budgeted break even point. [2]
c) The marketing department have carried out some market research
and are convinced that if an extra £60,000 was spent on marketing
Sales would rise to 18,000 units. Calculate the profit. [3]
d) It is thought that if the selling price is increased to £175 per unit it would
only be possible to sell 13,500 units. Calculate the profit. [3]
e) The production department think that by improving the quality and
Packaging of the product by spending an extra £6 per unit making the
Product, sales would rise to 18,000 units. The selling price
would be kept at £150. Calculate the profit [3]
f) Fully evaluate the above options. [6]
3. The following information relates to Rollo Ltd and has been extracted from their books as at 28 February
2007:
£
Turnover 2,900,000

215

Stock at 01 03 06 360,000
Purchases 1,200,000
Stock at 28 02 07 380,000
TASKS
a) Prepare the profit and loss account for the year ended 28 February 2007 [5]
ii the profit after tax to sales percentage
iv the PE ratio
v the stock turnover period in days [10]
c) Comment on the financial performance via the use of ratios. [5]
4. Boris Ltd is considering investing in a project that has the following cash flows:
£000
Cash flows:
Year one 800
Year two 1,200
Year three 1,400
Year four 700
Year five 400
Year one .926 .917 .909
Year two .857 .842 .826
Year three .794 .772 .751
Year four .735 .708 .683
Year five .681 .650 .621
Year six .630 .596 .564
TASKS
a) Calculate the payback period [2]
e) Explain why large firms often seek to grow larger by taking
over or merging with a similar business. [8]

a) Purchased goodwill
b) Share capital
c) Sale and leaseback
d) Group accounts [5 each]
6. Capers Ltd. intends to commence business on 1 April 2007 with share capital
of £250,000. On 1 April 2007 Capers Ltd. will also receive £40,000 in various grants from government and EU
sources.
Other Information:
• Capers Ltd. will spend £80,000 on machinery and office equipment on 1
April 2007.
• The following are the costs per unit: £
Direct material 7

216
Direct wages 8
Variable overhead 4
19

• Capers Ltd. have agreed to pay rent of £30,000 per year – payable monthly in arrears.
• Other fixed overheads are estimated to be £18,200 per month payable in arrears. This INCLUDES
depreciation of £1,200.
• Budgeted production will be 10,000 units per month for the first three months, increasing to 11,000
units per month thereafter.
• Budgeted sales are estimated to be 8,000 units per month for the first three months, increasing to
11,000 per month thereafter.
• 50% of sales are to be on credit. Capers Ltd. will allow one month’s credit.
• 50% of sales are to be on a cash basis.
• Variable overheads will be paid for in the month following production.
TASKS
a) Prepare the cash budget for Capers Ltd. for the period 1 April to 30 September 2007, clearly showing
the budgeted cash balance at the end of each month. [10]
b) Comment on the budgeted cash flow position of Capers Ltd. [5]
c) Outline the potential sources of long-term finance available to Capers Ltd.
[5]

a) A rights issue
b) An offer of shares to the general public
c) Accounting standards
d) gilt edged securities
e) The principal benefits of budgetary control
f) The potential dangers of high gearing
g) The role of a central bank [5 each]
MAY 2007
FINANCIAL MANAGEMENT (ROI)
1. a) Explain the principal sources of long-term finance available to a

multi-national company. [10]
b) A company is experiencing short-term cash flow problems. The company has a good track record as regards
profits, and is low geared. Explain how the company might go about solving the short-term cash flow
position. [10]
2. The following information relates to CAL Ltd. and has been taken from their books as at 30 April 2007:
£
Turnover 1,450,000
OTHER INFORMATION:
• The market price of an ordinary share on 30 April 2007 was £4.60 per share.

217
• The total capital employed in the business on 30 April 2007 was £1,550,000.
TASKS
a) Prepare the profit and loss account of CAL Ltd. for the year ended 30 April 2007. [5]
i the EPS
ii the PE ratio
v the operating profit to total capital employed percentage [2 each]
c) Explain what a bonus issue of shares is. [5]
3. Marstep Ltd is considering investing in a project which has the following cash flows:
£000
Cash flows:
Year 1 600
Year 2 1,000
Year 3 1,100
Year 4 700
Year 5 300

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
e) Explain the benefits of using investment appraisal techniques
in the allocation of large capital sums. [8]
4.a) Fully explain the synergetic benefits usually associated with

a takeover. [12]
b) Explain the function of a stock exchange. [8]

£000
Tax paid 70
Interest paid 40
Long-term loan paid off 340
Cash inflow from operating activities 130 [6]
b) Explain the disadvantages that a ‘low gear’ company might suffer from
during a sustained period of very low operating profits [8]
c) Explain the advantages of an existing company raising finance via
a rights issue. [6]

218
6. The following are the assets and liabilities of Narich Ltd. as at 30 April 2007:
£000
Premises 900
Bank overdraft 180
Creditors 160
Goodwill 150
Debtors 410
Vehicles (net) 180
Share premium 140
Tax owing 90
Dividends owing 100
Equipment 490
Closing stock 270
Long-term loans 310
Credit sales 3,100
Opening stock 250
Purchases 1,400
TASKS
a) Prepare the balance sheet of Narich Ltd. as at 30 April 2007 .[8]
i current
ii acid test
c) Comment briefly on the liquidity position of Narich Ltd.

as at 30 April 2007 . [4]

a) accounting standards
b) the importance of monitoring working capital
c) budgetary control
d) the role of an auditor
g) IRR [5 each]
DECEMBER 2006
1.a) Explain the typical synergetic benefits gained by a company that

acquires a major competitor. [8]
b) Explain the principal sources of long-term finance available to a multinational company.

[12]
2. The following information relates to Sirus Ltd. and has been taken from their
books as at 30 November 2006:
£
Turnover 1,800,000

219

OTHER INFORMATION:
TASKS
a) Prepare the profit and loss account of Sirus Ltd. for the year ended 30 November 2006.
[5]
i the EPS
ii the PE ratio
iv the dividend cover [2 each]
£m £m
P S
Fixed Assets
47 12
Current Assets
Stock 12 8
Debtors 6 7
Bank 4 2
22 17
Current Liabilities
Creditors (9) (5)
60 24
=== ===
=== ===
TASK
Construct the group balance sheet immediately after acquisition [7]
OR
i Minority interest [4]
ii An associated company [3]
3.a) Explain the principal purposes of using a budgetary control system. [12]
b) Explain the process of raising finance via a new issue of shares. [8]
4.a) Prepare a cashflow statement of a company called CRE plc for the year ended
30 November 2006 from the following data:
£000
Tax paid 130
Interest paid 30

220
Interest received 5
b) Comment on the cash flow position of CRE plc during the year ended 30 November 2006.
[5]
c) Explain a rights issue. [5]
d) Explain the term contribution. [5]
5. The following figures have been extracted from Horace Ltd.’s accounts for the two years to 30 November
2006:
2006 2005
Stock £170,000 £120,000
Debtors £350,000 £190,000
Creditors £230,000 £210,000

Long-term loans £600,000 £300,000

TASKS
i the current ratio [3]
ii the acid test ratio [3]
iii the gearing percentage [3]
b) Comment on the liquidity position of Horace Ltd. [5]
c) Explain the importance of preparing and monitoring a cash budget. [6]
6.a) Explain why a company will use investment appraisal techniques in the
choice of allocating finance to potential investment projects. [10]
b) Explain the potential sources of short-term finance
available to a large company. [10]

b) company taxation
d) depreciation
e) arbitrage
f) currency hedging
g) venture capitalists [5 each]
SEPTEMBER 2006
1.a) Explain the principal elements of a master budget. [10]

b) Explain the principal sources of long-term finance available to a large international company.
[10]
2. The following information relates to FHB Ltd. and has been taken
from their books as at 31 August 2006:
£
Turnover 1,230,000

221

OTHER INFORMATION:
• The total capital employed in the business on 31 August 2006 was £1,350,000.
TASKS
a) Prepare the profit and loss account of FHB Ltd. for the year ended 31
August 2006. [5]
i the EPS
ii the PE ratio
v the profit before tax to total capital employed percentage [2 each]
c) Explain what a rights issue is. [5]
3. Rebet Ltd is considering investing in a project which has the following cash flows:
£000
Cash flows:
Year 1 700
Year 2 1,100
Year 3 1,200
Year 4 800
Year 5 400

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
e) Explain the purpose of a breakeven chart. [4]
f) Explain briefly the role of venture capitalists. [4]
4. a) Fully explain the synergetic benefits usually associated with a takeover. [12]
b) Explain the function of a stock exchange. [8]
5. a) Explain the role of accounting standards. [8]

b) Explain the importance of the audit function. [6]
c) Explain the term financial gearing. [6]
6. The following are the assets and liabilities of EtNat Ltd. as at 31 August 2006:
£000
Premises 750

222
Bank overdraft 160

Creditors 170
Goodwill 204
Debtors 400
Vehicles (net) 152
Share premium 140
Tax owing 90
Dividends owing 100
Equipment 380
Closing stock 250
Long-term loans 260

Credit sales 2,700
Opening stock 230
Purchases 1,240
TASKS
a) Prepare the balance sheet of EtNat Ltd. as at 31 August 2006. [8]
i current ratio
ii acid test ratio

c) Comment briefly on the liquidity position of EtNat Ltd. as at 31 August

2006. [4]

a) horizontal integration
d) limiting factors
g) IRR [5 each]
JUNE 2006
1. The summarised financial statements of Gucki Ltd. for 2004 and 2005 were as follows:
Gucki Ltd. balance sheets as at 31 December
2004 2005
£000 £000 £000 £000
Depreciation (6,000) 6,000 (8,000) 9,000
Current assets
Stock 8,000 11,000
Debtors 10,000 9,000
Bank 4,000 7,000
-------- --------
22,000 27,000
-------- --------

223
Current liabilities
-------- --------
15,000 17,000
-------- --------

-------- --------
11,000 15,000
-------- --------
-------- --------
11,000 15,000
-------- --------
Gucki Ltd. profit and loss account for the year ended 31 December 2005:
£000
Interest paid (500)
---------
Taxation (7,000)
--------
Dividend (6,000)
--------
--------
TASKS
a) Prepare a cash flow statement for Gucki Ltd. for the year ended 31 December 2005.[10]
b) Calculate the following for BOTH years:
i the current ratio
c) Comment briefly on the financial performance during 2005.[4]
2. A company is about to bring a new product to the market. The following budgeted data has been
assembled:
£

TASKS
b) Calculate the first draft budgeted break even point.[2]
c) The marketing department are convinced that if an extra £40,000 was spent on marketing, sales
would
rise to 14,000 units. Calculate the profit.[3]
d) It is thought that if the selling price is increased to £220 per unit it would be possible to sell 10,000
units. Calculate the profit. [3]

224
e) The production department think that by improving the quality and packaging of the product by
spending an extra £5 per unit making the product, sales would rise to 14,500 units.
The selling price would be kept at £200. Calculate the profit.[3]
f) Fully evaluate the above options.[6]
3. The following information relates to Dormey Ltd. and has been extracted from their books as at 31 May
2006:
£
Turnover 2,500,000
Stock at 01 06 05 350,000
Purchases 1,000,000
Stock at 31 05 06 390,000
-------------
Issued ordinary share capital 400,000
TASKS
a) Prepare the profit and loss account for the year ended 31 May 2006.[5]
ii the operating profit to sales percentage
iv the dividend payable per share
v the price earnings ratio (PE ratio)[10]
c) Explain the importance of monitoring financial performance via the use of ratios.[5]
4. Vaughn Ltd. is considering investing in a project that has the following cash flows:
£000
Cash flows:
Year one 900
Year two 1,400
Year three 1,600
Year four 1,100
Year five 600

Year one .926 .917 .909
Year two .857 .842 .826
Year three .794 .772 .751
Year four .735 .708 .683
Year five .681 .650 .621
Year six .630 .596 .564
TASKS
a) Calculate the payback period.[2]
e) Outline the potential sources of long-term capital available to Vaughn Ltd.[8]

a) A rights issue

225
b) Vertical integration
c) Master budget
d) Group accounts [5 each]
6. Mirzer Ltd. intends to commence business on 1 July 2006 with share capital of £180,000. On 1 July 2006
Mirzer Ltd. will also receive £30,000 in various grants from government and EU sources.
Other Information:
• Mirzer Ltd. will spend £90,000 on fixed assets on 1 July 2006.
• The following are the costs per unit:
£
Direct material 8
Direct wages 6
Variable overhead 4
---
18
---
• Mirzer Ltd. have agreed to pay rent of £40,000 per year – payable quarterly in advance.
• Other fixed overheads are estimated to be £14,000 per month payable in arrears.
• Budgeted production will be 10,000 units per month for the first three months, increasing to 12,000
units per month thereafter.
• Budgeted sales are estimated to be 9,000 units per month for the first three months, increasing to
12,000 per month thereafter.
• All sales are to be on credit. Mirzer Ltd. will allow one month’s credit.
• Variable overheads will be paid for in the month following production.
TASKS
a) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31 December 2006, clearly showing
the budgeted cash balance at the end of each month.[10]
b) Comment on the budgeted cash flow position of Mirzer Ltd. [5]
c) Outline the potential sources of short-term finance available to Mirzer Ltd.[5]

a) international accounting standards
b) an offer of shares to the general public
c) a bonus issue of shares
d) the functions of a stock exchange
e) the principal contents of a balance sheet
f) efficiency ratios
g) minority interest[5 each]
MARCH 2006
1. a) The trend of international acquisitions and mergers continues. Explain the reasons for such
takeovers/mergers.[12]
i a rights issue
ii underwriting fees[4 each]
2. a) Prepare a cashflow statement of a company called LED plc for the year ended 31 March 2006 from
the following data:
£000

226

Tax paid 110
Interest paid 40
Interest received 5
b) Comment on the cashflow position of LED plc during year ended 31 March 2006.[5
c) Explain the purpose of accounting standards.[5]
d) Explain the term break-even point.[5]
3. The following figures have been extracted from Jasper Ltd.’s accounts for the two years to 31 March 2006:
2006 2005
Balance sheet closing balances:
Stock £160,000 £110,000
Debtors £340,000 £180,000
Creditors £220,000 £200,000

Long-term loans £600,000 £300,000

TASKS
b) Comment on the liquidity position of Jasper Ltd. [5]
c) Explain the importance of maintaining safe levels of liquidity.[6]
4. The following information relates to Status Ltd. and has been taken from their books as at 31 March 2006:
£
Turnover 1,400,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 March 2006 was £11.20 per share.
TASKS
a) Prepare the Profit & Loss account of Status Ltd. for the year ended 31 March 2006. [5]
i the EPS
ii the PE ratio
iv the operating profit as a percentage of sales[2 each]
£m £m
P S
Fixed Assets

227
38 9
Current Assets
Stock 12 7
Debtors 9 6
Bank 2 1
23 14
Current Liabilities
Creditors (8) (3)
53 20
=== ==
Profit & Loss account balance 13 10
53 20
=== ===
TASK
OR
5. a) Explain the principal purposes of using a budgetary control system.[12]

b) Explain the sources of short-term finance available to a large company. [8]
b) Explain the potential sources of long-term finance available to a large company.[10]

b) company taxation
e) goodwill
f) currency hedging
DECEMBER 2005
1. a) Explain the principal sources of long-term finance available to a large PLC.[10]
b) A company is facing short-term cash flow difficulties. The company is making good profits, has a
good ‘track record’ and has excellent long-term financing in place.
Explain how the company might solve the short-term cash flow problems.[10]
2. The following information relates to REB Ltd. and has been taken from their books as at 30 November
2005:
£
Turnover 980,000

228
OTHER INFORMATION:
• The total capital employed in the business on 30 November 2005 was £720,000.
TASKS
a) Prepare the Profit & Loss account of REB Ltd. for the year ended 30 November 2005. [5]
i the EPS
ii the PE ratio
v the operating profit to total capital employed percentage[2 each]
c) Explain the term floatation costs.[5]
3. Eteinne Ltd is considering investing in a project which has the following cash flows:
£000
Cash flows:
Year 1 500
Year 2 900
Year 3 1,000
Year 4 800
Year 5 500

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
d) Explain briefly whether you think that the project is viable.[4]
e) Explain the term marginal costing.[4]
f) Explain the term absorption costing.[4]
4. a) Explain the synergetic benefits usually associated with a takeover.[10]

b) Gilt-edged securities are often referred to as:
i shorts
ii mediums
iii longs
Outline the meaning of these THREE descriptions.[2 each]
c) Distinguish between a rights issue and a bonus issue.[4]
5. Budgetary control is at the centre of a firm’s management accounting system. Discuss.[20]
6. The following are the assets and liabilities of RebEt Ltd. as at 30 November 2005:
£000
Equipment (net) 280
Bank overdraft 110
Creditors 156
Goodwill 190
Debtors 412

229
Vehicles (net) 140

Share premium 120
Tax owing 90
Dividends owing 100
Premises 700
Closing stock 224
Profit & Loss account balance 390
Long-term loans 280
TASKS
a) Prepare the balance sheet of RebEt as at 30 November 2005.[8]
i current
ii acid test[2 each]

c) Comment briefly on the liquidity position of RebEt as at 30 November 2005.[4]
d) Explain briefly the reasons for accounting standards.[4]

a) gearing
d) fixed assets
f) the function of a stock market
g) IRR [5 each]
SEPTEMBER 2005
1. a) Explain the typical synergetic benefits gained by a company that

acquires a major competitor. [12]
i arbitrage
ii the average cost of capital [4 each]
2. The following information relates to AVCE Ltd. and has been taken from their books as at 31 August
2005:
£
Turnover 1,120,000
OTHER INFORMATION:
TASKS
a) Prepare the Profit & Loss account of AVCE Ltd. for the year ended
31 August 2005. [5]
i the EPS
ii the PE ratio

230
v the profit after tax to sales percentage [2 each]

c) Explain the term floatation costs. [5]
3. REM Ltd is considering investing in a project, which has the following cash flows:
£000
Cash flows:
Year 1 700
Year 2 900
Year 3 1,100
Year 4 800
Year 5 400
Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
d) Explain briefly whether you think that the project is viable. [4]
e) Explain why firms increasingly look at ‘non-financial’ factors during the
decision-making process. [4]
f) Explain the IRR investment appraisal method/technique. [4]
4 .a) Explain the principal sources of long-term capital available to a very

large international company. [10]
b) Explain the importance of Modigliani and Miller as regards capital
structure and valuation. [10]
5. a) Prepare a cashflow statement of a company called HUG plc for the year ended 31 August 2005 from
the following data:
£000
Tax paid 100
Interest paid 30
Interest received 5
b) Comment on the cashflow position of HUG plc during the year ended
31 August 2005 [5]
c) Explain the purpose of a cashflow statement. [5]
d) Cashflow is more important than profitability. Discuss. [5]

231
6. The following figures have been extracted from VROOM Ltd.’s accounts for the two years to 31 August
2005:
2005 2004
Stock £140,000 £100,000
Debtors £350,000 £190,000
Creditors £230,000 £200,000

Long-term loans £500,000 £350,000

TASKS
i the current ratio [3]
ii the acid test ratio [3]
iii the gearing percentage [3]
b) Comment on the liquidity position of VROOM Ltd. [5]
c) Explain briefly why new businesses will often prefer to lease
fixed assets rather than buy them. [6]

e) international accounting standards
f) currency hedging
g) venture capitalists [5 each]
JUNE 2005
1. a) Explain the principal sources of finance available to a large plc company.

[9]
b) Explain briefly the principal role of a stock exchange. [5]
c) Explain briefly the following:
i a rights issue
ii a bonus issue [3 each]
2. The following information relates to TLC Ltd. and has been taken from their books as at 31 May 2005:
£
Turnover 990,000
OTHER INFORMATION:
• The market price of an ordinary share on 31 May 2005 was £6.00 per share.
TASKS

232
a) Prepare the Profit & Loss account of TLC Ltd. for the year ended 31 May 2005.
[5]
i the EPS
ii the PE ratio
iii the dividend cover
v the operating profit to sales percentage [2 each]
c) Outline the contents of a prospectus (re. a share issue). [5]
3. LBW Ltd is considering investing in a project that has the following cash flows:
£000
Cash flows:
Year 1 900
Year 2 1,200
Year 3 1,500
Year 4 900
Year 5 600

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
e) Explain the process of project review and post audit. [8]
4.a) Explain the synergetic benefits usually associated with a merger or

takeover [10]
b) Explain the importance of managing working capital effectively [10]
5. Explain briefly the following:

a) the Capital Asset Pricing Model
b) The advantages of leasing high value and ‘hi-tech’ equipment
c) Arbitrage Pricing Theory
d) The risk-return relationship [5 each]
6. The following are the assets and liabilities of Milo Ltd. as at 31 May 2005:
£000
Long-term loans 160
£1 preference share capital (6%) 300
£1 ordinary share capital 500
Stock 280
Debtors 435
Goodwill 100
Dividends owing 100
Tax owing 140
Land and buildings 655

233
Equipment 270
Creditors 135
Bank overdraft 80
Vehicles 170
Share premium 30
Profit & Loss account balance (31 05 05) 465
TASKS
a) Prepare the balance sheet of Milo Ltd. as at 31 May 2005. [8]
i the current ratio
ii the acid test
iii the gearing ratio [2 each]
c) Comment on the liquidity position of Milo Ltd. [6]

a) the beta factor
b) the ASB
c) the average cost of capital
d) intangible assets
f) gilt-edged securities
g) IRR
h) budgetary control [5 each]
MARCH 2001
PART A:
1. The summarised accounts of Trusso Ltd are shown below
Profit and loss account for the year ended:
31/1/00 31/1/01
£’000 £’000
Sales 2,661 3,219
Cost of goods sold (1,464) (1,674)
Gross profit 1197 1545
Less expenses (997) (1191)
Operating profit 200 354
Interest paid (20) (12)
Net profit before tax 180 342
Corporation tax (36) (68)
Net profit after tax 144 274
Dividends (50) (75)
Retained profit 94 199
Summarized Balance sheet as at:

£’000 £’000
Fixed assets 690 880
Current assets:
Stock 366 372
Debtors 633 596
Bank - 25
999 993
Creditors due in one year
Creditors and accruals (175) (186)
Taxation (36) (68)
Dividends owing (50) (75)
Bank overdraft (28) -
(289) (329)
Creditors due in over one year
Bank loan (120) (65)
Net assets 1280 1479

234
Issued share capital 800 800

Reserves 480 679
Shareholder’s funds 1280 1479
TASK:
a) Calculate for both years
i. Three profit ratios
ii. Two liquidity ratios
iii. Two efficiency ratios
b) Comment on the financial progress of Trusso Ltd during the year ended 31/12/01.
2. The following are the capital structures of two companies and their operating profits their first year of trading.
COMPANY X Y
£’000 £’000
£1 ordinary shares 300 600
£1 preference shares 100 -
Debenture stock (10%) 400 200
Operating profit 120 120
Ordinary share price at year end £2 £1.6
TASK:
a) Calculate the commencing gearing ratio of each company
b) Prepare Vertical schedules which show the interest payable, tax charge and preference dividends.
Note: corporation tax is 20% of taxable profit.
c) Calculate for both companies the EPS
d) Calculate for both companies the PE ratio
e) Comment briefly on the financial position of both companies from the standpoint of an ordinary shareholder.
3. Module Ltd is considering investing in a project which has the following budgeted cash flows:
£’000
Initial investment (1,200)
Cash flows:
Year 1 300
Year 2 500
Year 3 700
Year 4 600
Year 5 200
DCF tables:
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
TASKS
a) Calculate the payback period
b) Calculate the Accounting rate of return
c) Calculate the NPV
d) Explain whether or not your would advise Module Ltd to invest in e project
e) Explain the following terms:
i. Risk free rate of interest
ii. Risk adverse investor

235
£
Equity dividends paid 36,000
Tax paid 30,000
Cash outflow from operating activities 58,000
Purchase of premises 120,000
Issue of equity shares 274,000
Purchase of plant and equipment 100,000
b) Explain the principal sources of finance of long term capital available to a private Ltd company.
c) Explain the term venture capital
5. a) Explain the following terms:

i. Horizontal merger (or horizontal integration)
ii. Vertical merger (or vertical integration)
iii. Conglomerate merger (conglomerate integration)
b) Explain the principal general reasons for mergers.
6. a) Explain the principal benefits of a successful budgetary control system

b) Explain the following TWO terms:
i. Break-even analysis
ii. Contribution pricing
7. Write notes on four of the following

i. CAPM
ii. Flotation costs
iii. Intangible assets
iv. Lease financing
v. Historic cost
vi. Standard costing
vii. Cash budget
viii. Inflation.

236

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NOTES & EXERCISES ON Financial Management -For ICM

MEMORANDUM OF ASSOCIATION AND ARTICLE OF ASSOCIATION

1. MEMORANDUM OF ASSOCIATION: The memorandum of association

More Lecture Series – by TIMORE B. F

THE CORPORATE CONSTITUTION (The Contents of the Article &

The constitution of a company consists of its memorandum of association

1. The Memorandum of Association

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

(a) Name Clause

A company can change its name by special resolution.

(b) Registered Office Clause

(c) Objects Clause

Company’s memorandum must contain an objects clause - a clause which

The Ultra Vires Rule

More Lecture Series – by TIMORE B. F

(ii) Change of Objects Clause

A company can change its objects clause by special resolution.

(d) Limitation of Liability Clause

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

(e) Capital Clause

(f) Alteration of Memorandum

A company cannot change its memorandum except in the circumstances

When company resolves to alter its memorandum, a copy of the

(a) Articles Generally

The articles govern the internal management and organization of the

3. Legal Effect of Memorandum and Articles

The memorandum and articles operate as a contract between the

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

(c)The memorandum and articles do not constitute a contract binding the

(e) The memorandum and articles constitute a contract between each

MEETINGS AND RESOLUTIONS

1. Shareholders and Shares

It must be noted that the day to day management of a company is in the

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

(i) Anyone who subscribes the memorandum.

(b) Register of Members

CA 1985 requires every company to keep a register of its members. The

- Name and address of each member.

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Most companies must hold an AGM.

Members of a private company can choose to dispense with the holding of

(b) Usual Business of an AGM

Auditor's term of office ends at AGM, so they must be re-appointed or new

Resolutions may be required to pay directors’ and auditors’ fees. (Now

Shareholders may have their own resolutions placed on the agenda.

(c) Extraordinary General Meetings

Where auditor has resigned and has made a statement of circumstances

TYPES/ CLASSIFICATION OF COMPANIES

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A) LIMITED COMPANIES AND UNLIMITED COMPANIES.

B: PRIVATE OR PUBLIC COMPANIES

PRIVATE COMPANY: A private company is any company that is not

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FINAL ACCOUNTS OF LIMITED COMPANIES

THE CAPITAL OF A COMPANY

Nature of Shares and Share Capital

A company raises capital by the issue of shares. Shareholders are then

A share is the unit of a capital structure of a company. That is the unit of

There are two main types of share;

1) Ordinary shares / Equity shares

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