FINANCIAL STATEMENTS

STATEMENT OF PROFIT OR LOSS[INCOME STATEMENT]

This statement shows the trading performance of a
business over a period of time. It records revenue and
all expenditures to calculate whether the business has
made profit or loss.

$M
Revenue 300 TRADING
Minus *Cost of sales (140) ACCOUNT
EqualsGROSS PROFIT 160
Minus Expenses/Overheads (50) PROFIT AND
Equals OPERATING PROFIT 110 LOSS ACCOUNT
Minus Interest on loans (10)
Equals PROFIT BEFORE TAX 100
Minus Tax @30% (30)
Equals PROFIT FOR THE YEAR 70
Minus Dividend (25) APPROPRIATION
Equals RETAINED PROFIT 45 ACCOUNT

*COST OF SALES=[OPENING INVENTORY+RAW MATERIAL

PURCHASED]- CLOSING INVENTORY
USES OF THE INCOME STATEMENT
1) THE REVENUE CAN BE USED TO JUDGE THE LEVEL OF CUSTOMER
LOYALTY THE BUSINESS HAS.
THE MARKET SHARE OF THE BUSINESS CAN ALSO BE CALCULATED.

2) THE GROSS PROFIT GIVES A GOOD INDICATOR HOW MUCH VALUE

THE BUSINESS HAS ADDED TO ITS PRODUCTS. IF THE GROSS PROFIT IS
VERY LOW THIS MEANS THERE IS VERY LOW VALUE ADDED.

3)IF THE OPERATING PROFIT IS LOW AND IF THERE IS A LOT OF

DIFFERENCE BETWEEN THE GROSS PROFIT AND THE OPERATING
PROFIT THIS MEANS THE BUSINESS HAS HIGH UNCONTROLLED
INDIRECT EXPENSES.

4)THE INVESTORS CAN VIEW THE PROFIT,REVENUE AND THE

DIVIDENDS TO DECIDE WHETHER TO INVEST IN THE BUSINESS OR
NOT

AMENDMENT OF INCOME STATEMENTS

EXAMPLE
Refer to Appendix A and the changes forecasted by the finance
manager. Produce a forecast Income Statement for the year ending
30 September 2019. Assume no other changes

ANSWER

INCOME STATEMENT AMENDMENTS FORECASTED

$M INCOME STATEMENT
$M
Revenue 80 80 increased by 88
10%
Cost of sales 10 10 increased by 5% 10.5
Gross profit 70 [88-10.5]= 77.5
Expenses 53 53+2 55
Operating 17 [77.5-22.5]= 22.5
profit
Financial 5 No change 5
Expenses
Profit 12 [22.5-5]= 17.5
before Tax
Corporation 1.8 17.5 x 15% 2.625
Tax@15%
Profit for 10.2 [17.5-2.625] 14.875
the year
Dividends 4 14.875 x40% 5.95

Retained 6.2 [14.875-5.95]= 8.925

Earnings

STATEMENT OF FINANCIAL POSITION

This is a statement that shows the net worth and
wealth of a business on a particular date. It records the
assets, liabilities and shareholders’ funds.

NON CURRENT ASSETS: THESE ARE ASSETS THAT ROVIDE ECONOMIC VALUE TO
THE BUSINESS FOR A LONG PERIOD OF TIME SUCH AS MACHINERY
INTANGIBLE ASSETS SUCH AS GOODWILL AND BRAND-NAME HELP THE BUSINESS
ATTRACT INVESTORS AND CUSTOMERS

CURRENT ASSETS ARE THOSE ASSETS THAT PROVIDE ECONOMIC BENEFIT TO THE
BUSINESS IN A SHORT PERIOD OF TIME . THE FORU CURRENT ASSETS ARE
-INVENTORY[FINISHED GOODS WAITING TO BE SOLD]
-TRADE RECEIVABLE[ CREDIT CUSTOMERS WHO WILL PAY CASH SOON]
CASH[ AT THE OFFICE AND IN BANK ACCOUNT]

CURRENT LIABILITIES ARE SHORT TERM PAYMENTS THE BUSINESS HAS TO MAKE
WITHIN ONE YEAR.
EXAMPLES ARE
-TRADE CREDITOR[ SUPPLIERS]
-BANK OVERDRAFTS

WORKING CAPITAL
THIS IS CALCULATED BY CURRENT ASSETS- CURRENT LIABILITIES.

WORKING CAPITAL IS THE AMOUNT OF CASH THE BUSINESS HAS TO MEET ITS DAY
TO DAY RUNNING.
IT IS AN INDICATOR OF THE LIQUIDITY OF A BUSINESS.

NON CURRENT LIABILITIES

THESE ARE THE LONG TERM LOANS A BUISNESS HAS TO PAY BACK USUALLY AFTER
3 TO 5 YEARS. EXAMPLES ARE DEBENTURES AND BANK LOANS.

SHAREHOLDERS’ EQUITY
THIS COMPRISES OF THE INITIAL AMOUNT OF CAPITAL THE SHAREHOLDERS
INVESTED IN THE BUSINESS PLUS THE RETAINED PROFITS OF THE COMPANY.

USES OF THE STATEMENT OF THE FINANCIAL POSITION

IT SHOWS THE LIQUIDITY OF THE BUSINESS AND HOW MUCH CASH IT HAS.

THIS HELPS BANKS AND SUPPLIERS DECIDE IF THEY WANT OT DEAL WITH THE
COMPANY.

IT SHOWS THE NON CURRENT ASSETS OF THE BUSINESS WHICH INDICATES THE
LEVEL OF OUTPUT AND THE SCALE OF OPERATIONS A BUSINESS CAN ACHIEVE

THE NON CURRENT LIABILITES SHOW HOW MUCH LOAN THE BUSINESS HAS
TAKEN
AMENDMENT OF STATEMENT OF FINANCIAL POSITION

EXAMPLE

INCOME STATEMENT OF N LTD COMPANY

STATEMENT OF FINANCIAL POSITION OF N LTD COMPANY

N LTD wants to takes over another company. It would involve:

-making a cash payment of $20m

- Issuing 0.5million N Ltd shares.

- N Ltd would get the other company’s assets worth $40m.

The CEO of N Ltd Company has forecast that this takeover

would result in the following changes to N LTD’s accounts:

• revenue would increase to $170m

cost of sales would increase to $46m

expenses would increase to $109m

• additional borrowing of $50m at 5% interest per year

• current assets and current liabilities increase by 10%.

Q)Make the amended income statement and the amended balance

sheet
ANSWER
AMENDED INCOME STATEMENT

GROSS PROFIT: 170-46= 124

OPERATING PROFIT: 124-109=15

INTEREST EXPENSE IS 5% OF TOTAL LIABILITIES[80+50]

5% X 130= 6.5

PROFIT AFTER TAX: 15-6.5=8.5

AMENDED STATEMENT OF FINANCIAL POSITION

$M AMENDMENTS
Non current 120 80+40
assets
Current assets 38.5 Increased by 10%
Total assets 158.5 Non current assets
+current assets
Non current (110) 60 +50(borrowing)
liabilities
Current liabilities (22) Increased by 10%

Total liabilities (132) Non current liabilities+

current liabilities
Net assets 26.5 Total assets- Total
liabilities
IMPACTS OF CHANGES ON FINANCIAL STATEMENTS

Changes Income statement Statement of

financial
position
Equipment is Recorded as an Reduces value of
depreciated
expense both non current
assets and
shareholders
equity
Raw material costs Cost of goods will Less retained
have risen
rise and gross earnings for
profit will fall shareholders in
equity
Total expenses of The business will Shareholder
the business exceed
total revenue
record loss equity will fall

Non current
liabilities will
rise to cover the
loss
Intangible asset No effect on Total non
such as brand name
revalued to higher
income statement current assets
amount and shareholder
equity will rise
Sale of inventory at The gross profit Inventory will
higher price than
inventory value
will rise fall and cash will
rise.
Higher profits
 will increase
shareholder
equity

Additional shares No effect on Non current

issued to buy
machinery
income statement assets and
shareholder
equity will rise
Trade payable ask No effect on Non current
for immediate cash
income statement liabilities and
cash will reduce

INVENTORY VALUATION

-Inventory are unsold goods in the company warehouse

-Inventory is also the raw material which has still not been used.
-Inventory is also semi finished goods still under process . This type
of inventory is called work in progress.

The invenotry of unsold goods and raw materials is values in the

statement of financial position acording to the following rule:

ORIGINAL COST OR NRV :WHICHEVER IS LOWER

What is NRV?
NRV means NET REALISABLE VALUE and it is calculated as follows:

NRV= [CURRENT MARKET PRICE OF INVENTORY]-REPAIRS COST

EXAMPLE

A jeweller bought a necklace for $65. It got damaged and

needed repairs which cost $20. At the end of the year the
necklace still has not been sold.the jeweller knows it has a
market price of $88 now as it is repaired.

Calculate the value at which it will recorded in the closing

inventory.
COST= $ 65
REPAIRS = $ 20
CURRENT MARKET PRICE= RS 88

Net realisable value = Market price- repair cost

= $88-$20
=$68

COST [$65]OR NRV[$68]:WHICHEVER IS LOWER

IT WILL BE VALUED AT $65 IN THE INVENTORY

DEPRECIATON
Non current assets such as machinery and equipment wear
and tear as they work and this causes depreciation in their
value. The loss in value of machinery caused by wear and tear
during usage is known as depreciation.

Depreciation is calculated annually and has two effects:

- Annual depreciation is an expense that reduces profits in the
income statement

-Annual depreciation reduces the net book value of the

machinery in the statement of financial position reducing
the value of non current assets.

Annual Depreciation is calculated using the STRAIGHT LINE METHOD

EXAMPLE

Original Cost of machinery= $ 80M

Expected Useful life = 5 years
Expected Residual value= $ 10M

$80M -$10M = $14M

5 Years

The Annual depreciation of the machine is $14M.

This means the machine because of wear and tear loses $14m in its
resale price each year[annually]

Effects on the Annual financial statements

1. Annually in the income statement the profit will be reduced by

$14M
2. Annually in the statement of financial position the net book value of
Non Current Assets will be reduced by $14M

QUESTION: At which value will the machine be recorded 3 years after it

has been purchased[ Hint :it depreciates $14m annually]
If it is sold by the company at the end of the third year for $28M. Will
the company have made a profit or loss on selling it?

PROS OF STRAIGHT LINE METHOD CONS OF STRAIGHT LINE METHOD

-EASY TO CALCULATE -THE USEFUL LIFE AND RESIDUAL[RE-SALE]

HAVE TO BE FORECASTED WHICH CAN BE
-SUITABLE FOR ASSETS LIKE FURNITURE INACCURATE
THAT DEPRECIATED IN A STEADY
MANNER AND DO NOT SUDDENLY -ASSETS LIKE CARS DEPRECIATE RAPIDLY IN
BECOME OBSOLETE LIKE MACHINES THEIR FIRST 2 TO 3 YEARS THEN MORE
SLOWLY.

-MACHINES HAVE MORE REPAIRS COST AS

THEY GET OLDER . THIS IS NOT CONSIDERED
IN STRAIGHT LINE DEPRECIATION
ANALYSIS OF PUBLISHED ACCOUNTS
LIQUIDITY RATIOS
LIQUIDITY IS THE BUSINESS ABILITY TO PAY THE SHORT TERM DEBTS ON TIME.

LIQUIDITY RATIOS HELP TO SHOW THE FIRM’S ABILITY TO KEEP TRADING IN THE SHORT
RUN.

CURRENT ASSETS $M CURRENT LIABILITIES $m

INVENTORY 10 TRADE PAYABLE 9

TRADE RECEIVABLE 5 BANK OVERDRAFT 1

3
BANK/CASH

1. CURRENT RATIO = CURRENT ASSETS = $18M = 1.8 : 1

CURRENT LIABILITIES $10M

THE CURRENT RATIO OF 1.8 SHOWS THAT THE BUSINESS HAS 1.8 CURRENT ASSETS
FOR EVERY 1 CURRENT LIABILITY AND CAN EASILY PAY OFF ITS SHORT TERM
DEBTS.

THE IDEAL CURRENT RATIO IS BETWEEN 1.5:1 AND 2:1.

CURRENT RATIO LIKE 1.2:1 IS CONSIDERD ADEQUATE.
IF THE CURRENT RATIO IS 4:1 THEN THIS IS EXCESSIVE AS TOO MUCH CURRENT
ASSETS HAVE BEEN PILED UP.

2. ACID TEST RATIO= CURRENT ASSETS-INVENTORY =$8M = 0.8:1

CURRENT LIABILITIES $10M

THE BUSINESS HAS AN ACID TEST RATIO OF 0.8:1. THIS MEANS WITHOUT THE SALE
OF THE INVENTORY THE BUSINESS DOES NOT HAVE ENOUGH LIQUID
ASSETS[ TRADE RECEIVABLES AND CASH] TO PAY OF THE CURRENT LIABILITIES. THE
BUSINESS IS RELYING ON ITS INVENTORY BEING SOLD TO PAY OFF SHORT TERM
DEBTS.
THE IDEAL ACID TEST RATIO SHOULD BE 1:1. THIS MEANS THE BUSINESS SHOULD
HAVE LIQUID ASSETS EQUAL TO ITS CURRENT LIABILITIES.
THE ACID TEST RATIO SHOW TRUE LIQUIDITY. THE ABILITY TO MEET SHORT TERM
LIABILITIES WITHOUT THE RELYING ON THE SALE OF INVENTORY.

WAYS OF IMPROVING LIQUIDITY:

1. THE BUSINESS SHOULD NEGOTIATE A DISCOUNT FROM THE

CREDITOR.
[DRAWBACK IS SUPPLIER MAY GIVE POOR QUALITY MATERIAL]

2. TAKE A LONG-TERM BANK LOAN WHICH WILL NOT BE ADDED

TO CURRENT LIABILITIES BUT IT WILL INCREASE THE CASH
IN CURRENT ASSESTS.
[DRAWBACK IS INTEREST EXPENSE ON LOAN WIL REDUCE
PROFIT]

3. THE BUSINESS SHOULD TRY TO SELL ITS INVENTORY FOR

HIGHER PRICES THAN ITS CURRENT VALUE IF DEMAND
INCREASES

4. SELL INVENTORIES ON DISCOUNT TO GET CASH QUICKLY

[THIS WILL IMPROVE ACID TEST RATIO AND NOT CURRENT RATIO]

5. SELL OFF NON CURRET ASSETS LIKE MACHINERY

[DRAWBACK IS OUTPUT WILL BE NEGATIVELY AFFECTED AND THE
MACHINERY MAY BE SOLD IN LOSS. NEW ASSETS MAY HAVE TO BE
LEASED INCREASING COSTS]

6. USE JUST IN TIME INVENTORY METHOD SO LESS CASH TIED UP IN

INVENTORY
[THIS WILL ONLY IMROVE ACID TEST RATIO]

PROFITABILITY RATIOS
HIGH PROFIT AMOUNT DOES NOT MEAN THE BUSINESS IS
PROFITABLE.
THE PROFITABILITY OF BUSINESS CAN BE SEEN BY COMPARING THE
PROFIT EARNED TO
1) THE REVENUE
2) THE CAPITAL EMPLOYED
 $M
REVENUE 100

COST OF GOOD (30)

GROSS PROFIT 70

EXPENSES/OVERHEADS (55)

OPERATING PROFIT 15

70 X 100= 70%
100

USES OF GROSS PROFIT MARGIN:

1. GP MARGIN SHOWS THE PRODUCT PROFITABILITY. IT SHOWS
HW MUCH PROFIT THE PRODUCT EARNS AFTER ITS COST OF
SALES HAVE BEEN DEDUCTED FROM THE REVENUE

2. A VERY LOW GP MARGIN INDICATES THAT THE BUSINESS IS

UNABLE TO ADD VALUE TOTHE PRODUCT. IT ALSO INDICATES
A HIGH COST OF RAW MATERIAL.THUS THE BUSINESS WILL
EITHER HAVE TO CHANGE THE SUPPLIER OR AWAIL
DISCOUNTS THROUGH BULK BUYING.
IN THE ABOVE EXAMPLE THE GROSS PROFIT MARGIN IS 70% .
THIS SHOWS THE BUSINESS HAS A VERY PROFTABLE PRODUCT.
 HOWEVER WE CAN COMPARE THE GROSS PROFIT MARGINS OF
PRODUCTS FROM DIFFERENT INDUSTRIES LIKE WE CANNOT
COMPARE G.P MARGIN OF CARS WITH CLOTHES.

OPERATING PROFIT MARGIN

= 15 X100= 15%
100

IN THE ABOVE EXAMPLE WE CAN SEE THAT THE GROSS PROFIT

MARGIN IS 70% WHICH SHOWS THE BUSINESS HAS A PROFITABLE
PRODUCT BUT THE OPERATING PROFIT MARGIN IS 15%. THIS MEANS
THE BUSINESS HAS HIGH UNCONTROLLED EXPENSES AND THE
MANAGEMENT DOES NOT SEEM TO BE A VERY GOOD JOB IN CUTTING
DOWN EXPENSES.
THIS BUSINESS NEEDS TO CUT DOWN ON EXPENSES TO IMPROVE ITS
PROFITABILITY.
USES OF OPERATING PROFIT MARGIN:
1. IF THERE IS A LARGE DIFFERENCE BETWEEN GROSS PROFIT
MARGIN AND OPERATING PROFIT MARGIN IT MEANS THE BUSINESS
IS HAVING VERY HIGH EXPENSES (INDIRECT COST).

2. LOW OPERATING PROFIT MARGINS SHOWSTHERE IS A LACK OF

MANAGERIAL RESPONSILITIES THUS MANAGEMENT NEEDS TO BE
IMPROVED AND MADE EFFICIENT.

BOTH GROSS PROFIT MARGIN AND OPERATING PROFIT MARGINS OF

A BUSINESS SHOULD BE COMPARED WITH THE BUSINESS PREVIOUS
YEAR TO SEE WHETHER THE BUSINESS PROFITABILITY IS
INCREAING OR NOT.

RETURN ON CAPITAL EMPLOYED[ROCE]

COMPARING THE PROFIT OF THE COMPANY TO THE CAPITAL
EMPLYED IN THE COMPANY IS THE BEST WAY TO CHECK THE
OVERALL PROFITABILITY AND EFFICIENCY OFTHE BUSINESS.
ROCE IS ALSO CALLED THE SHAREHOLDER’S RATIO AND THE
PRIMARY EFFIECIENCY RATIO.
EXAMPLE

COMPANY A B

OPERATING PROFIT $10M $2M

CAPITAL EMPLOYED $100 $5M

M

IN THE ABOVE EXAMPLE WE CAN SEE THAT COMPANY A HAS

EARNED MOREPROFIT THAN COMPANY B.
BUT THE QUESTION WE NEED TO ASK IS THAT IS COMPANY A MORE
PROFITABLE AND MORE EFFICIENT THAN COMPANY B??
WE CAN FIND THIS OUT THROUGH ROCE

COMPANY A COMPANY B
ROCE= 10 X100 = 10% ROCE= 2 X100 = 40%
100 5

WE CAN CLEARLY SEE THAT COMPNY B IS THE MORE

EFFICIENT COMPANY AS IT IS ABLETO USE ITS CAPITALTO
GENERATE 40% PROFIT AS COMPARED TO COMPANY A WHICH
OONLY MANAGES TO GENERATE 10% PROFIT FROM THE
INVESTMENT IT HAS.
COMPANY B IS OVERALL MORE PROFITABLE AND EFFICIENT AS IT
IS USING ITS REOURCES IN A MORE PRODUCTIVE WAY.
THE ROCE IS A VERY IMPORTANT RATIO AND THE ROCE MUST BE
COMPARED TO THE RATE ON INTEREST THE BANKS CHARGE ON
LOANS. THE BUSINESS MUST HAVE A GREATER ROCE THAN THE
INTEREST RATE.
METHODS OF IMPROVING PROFITABILITY

WAYS TO IMPROVE GP MARGIN:

1. ADD VALUE TO THE PRODUCT SO THAT SELLING PRICE CAN BE
RAISED BUT THE PRODUCT MAY BE HIGHLY ELASTIC
2. BULK BUYING WILL REDUCE THE COST OF RAW MATERIAL
3. IMPORT RAW MATERIALS IF CHEAPER
4. FIND A CHEAPER SUPPLIER BUT CANNOT COMPROMISE ON
QUALITY
5. INTRODUCE TECHNOLOGY IN PRODUCTION PROCESS
6. EFFECTIVE ADVERTISEMENT TO INCREASE SELLING PRICE

WAYS TO IMPROVE OPERATINGPROFIT MARGIN AND ROCE:

1. ON THE JOB TRAINING TO IMPROVE SKILLS OF WORKERS
2. MOTIVATED STAFF (NON-FINANCIAL WAYS) TO REDUCE
WASTAGES
3. EFFECTIVE MANAGEMENT (LEADERSHIP STYLE) TO HAVE
BETTER SUPERVISION AND REDUCE EXPENSES
4. DOWN SIZING: THIS WILL LOWER THE LABOUR EXPENSE BUT IN
THE LONG RUN THE REST OF THE WORKERS WILL HAVE
DEMOTIVATION DUE TO LACK OF JOB SECURITY.
5. RELOCATE TO CHEAPER RENT AREA BUT THIS MAY TARNISH
BRAND IMAGE.
6.LEAN PRODUCTION TECHNIQUES BUT THESE WILL REQUIRE TIME
TO IMPLEMENT.
INVESTMENT APPRAISAL

INVESTMENT APPRAISAL
INVESTMENT APPRAISAL IS FORECASTING THE
FEASIBILITY OF A FUTURE PROJECT/INVESTMENT.
THE STUDY OF A FUTURE PROJECT IN TERMS OF BOTH
QUALITATIVE AND QUANTITATIVE ASPECTS AND
WHETHER THE PROJECT WILL BE WORTHWHILE AND
PROFITABLE.
EXAMPLES OF PROJECTS ARE PURCHASING
MACHINERY, CONSTRUCTING FACTORIES etc

QUALITATIVE FACTORS THAT A BUSINESS MUST

CONSIDER BEFORE STARTING A PROJECT
1. ETHICAL CONSIDERATIONS/ISSUES??
2. EFFECT ON THE BRAND NAME
3. VIEWS OF THE WORKFORCE/STAFF
4. SKILL LEVEL/MOTIVATION OF THE WORKFORCE
5. VIEWS OF THE SHAREHOLDER(LONG TERM
COMMITMENT??)
6. GOVERNMENT LAWS OF THE COUNTRY

QUANTITATIVE INVESTMENT APPRAISAL

1. PAYBACK PERIOD: CALCULATES THE DURATION IT

WILL TAKE FOR THE PROJECT TO RECOVER ITS INITIAL
COST/INVESTMENT.
INITIAL INVESTMENT =$10m
PROJECT’S EXPECTED LIFE=5 YEARS
FORECASTED NET CASH FLOWS(INFLOWS-OUTFLOWS)

YEAR FORECASTED NET CASHFLOWS

1 $2m
2 $2m
3 $1m
4 $6m
5 $4m[including $2m residual capital value]

CALCULATING THE PAYBACK PERIOD

YEAR CASHFLOW CUMULATIVE

0 (10m) (10m)
1 2m (8m)
2 2m (6m)
3 1m (5m)
4 6m

Working
Year 1 : 10m-2m=8m[left to be recovered]
Year 2: 8m-2m= 6m[left to be recovered]
Year 3: 6m-1m = 5m[left to be recovered]
Year 4: cumulative is less than net cashflow so the
following formula will be used:

Cumulative x12 months =

cashflow
5m x12 month = 10 months
6m

The project will take 3 years and 10 months to recover

its initial investment
Payback period is 3 years 10 months

PROS CONS
1. IT HELPS DETERMINE FOR HOW 1. DOES NOT SHOW OVERALL
LONG A BANK LOAN WILL BE NEEDED PROFITS AND PROJECT DECISION
CANNOT BE MADE ON PAYBACK
2. PAYBACK PERIOD ALSO HELPS TO ALONE.
INFORM THE SHAREHOLDERS WHEN
THE PROJECT WILL START TO GIVE 2. IT DOES NOT CONSIDER THE NET
RETURNS CASHFLOWS AFTER THE PAYBACK PERIOD

3. PAYBACK PREFERS LIQUIDITY AND

FAVOURS PROJECTS THAT GIVE 3. PAYBACK ASSUMES THAT EACH YEAR’S
QUICKER NET CASHFLOWS. NET CASHFLOW IS RECEIVED IN EQUAL
MONTHLY INSTALLMENTS.
4. IT IS SIMPLE TO CALCULATE

5. IT CONSIDERS THE TIME VALUE OF

MONEY(MONEY KEEPS DEPRECIATING
OVER TIME) AND PREFERS PROJECTS
THAT RECOVER INVESTMENT QUICKLY

EVALUATION AID TO DECSION MAKING/LOOKS AT

CASHFLOW POSITION/ MORE USEFUL IN DYNAMIC
INDUSTRIES AND VOLATILE ECONOMIES
2.AVERAGE RATE OF RETURN
1.TOTAL PROFIT= SUM OF NCF- INITIAL INVESTMENT

2.AVERAGE PROFIT= TOTAL PROFIT

YEARS

3.AVERAGE INVESTMENT=

4.ARR= AVERAGE PROFIT X 100=%

AVERAGE INVESTMENT

CALCULATION OF ARR
1.TOTAL PROFIT= SUM OF NCF- INITIAL INVESTMENT
= $15m- $10m
= $5m

2. AVERAGE PROFIT= TOTAL PROFIT

YEARS OF PROJECT

=$5m = $1m
5years
3.3.AVERAGE INVESTMENT=

$10m + $2m = $6m

2
3. ARR= AVERAGE PROFIT X 100= %
AVERAGE INVESTMENT

$1m X 100= 16.67%

$6m

Why is the ARR of a project important? What does this result mean?
It indicates to the business that, on average over the life of the
investment, it can expect to earn an annual return of 16.67% on its
average investment.
This could be compared with:
• the ARR on other projects
• the minimum expected return set by the business. This is called the
criterion rate. If the business has decided that it must earn a minimum
20% return on investment annually then it will not accept this project.
• If the ARR is less than the interest rate the business will have to pay
on a bank loan, it will not be worthwhile taking a loan to invest in the
project.
PROS CONS
-TAKES INTO ACCOUNT -ARR IGNORES THE TIMINGS
PROFITABILTY OF THE INFLOWS AS IT ADDS
UP ALL THE NCF AND DOES
-TAKES INTO CONSIDERATION NOT CONSIDER WHETHER THE
ALL THE N.C.F OF THE LARGER NCF ARE RECEIVED IN
PROJECT THE EARLY YEARS OR LATER
YEARS IN THE PORJECT
-ALLOWS A BUSINESS TO
COMPARE ALTERNATIVE -IT IS MORE SUITABLE FOR
PROJECTS IN TERM OF SHORT PROJECTS AS IN
PROFITABILITY LONGER PROJECTS
FORECASTED NCF WILL NOT
-IT IS A MEASURE OF BE ACCURATE.( too optimistic)
EFFIECIENCY /productivity
-IT
IGNORE THAT THE VALUE OF
MONEY FALLS EACH YEAR

4. NET PRESENT VALUE

THE PAYBACK PERIOD AND ARR ARE GOOD METHODS BUT
THEY HAVE ONE MAJOR WEAKNESS AND THAT IS THEY DO
NOT TAKE INTO CONSIDERATION THAT THE PURCHASING
POWER OF MONEY FALLS OVER TIME. THE RS.1000 OF TODAY
IS NOT THE SAME AS RS.1000 OF TWO YEARS AGO AND
CERTAINLY NOT THE SAME AS THE RS.1000 OF FIVE YEARS IN
THE FUTURE.

IN A PROJECT THE INVESTMENT IS DONE TODAY IN THE

PRESENT BUT THE NET CASHFLOWS COME IN THE FUTURE SO
IT IS IMPORTANT TO MAKE SURE THAT ALL THE
MONEY[INVESTMENT AND FUTURE NETCASHFLOW] ARE
EXPRESSED IN PRESENT VALUE.
SHOWING THE VALUE OF FUTURE MONEY IN PRESENT
VALUE IS DONE THROUGH DISCOUNTING THE NET
CASHFLOWS

-THE BUSINESS HAS TO SEE THE CURRENT INTEREST

RATES AND THEN USE THE DISCOUNT FACTORS[THEY
WILL BE GIVEN IN THE EXAM]

IF THE CURRENT INTEREST RATE IS 10% THEN THE

TABLE SHOWS HOW MONEY WILL LOSE ITS VALUE.

YEAR 10% DISCOUNT FACTORS

1 .91
2 .86
3 .75
4 .69
5 .65

IF THE CURRENT INTEREST RATE IS 10% AND IF YOU

GET $100 AFTER ONE YEAR ITS PRESENT VALUE IS:
$100 X0.91=$910

IF THE CURRENT INTEREST RATE IS 10% AND IF YOU

GET $100 AFTER TWO YEARS ITS PRESENT VALUE IS:
$100 X0.86=$860

IF THE CURRENT INTEREST RATE IS 10% AND IF YOU

GET $100 AFTER THREE YEARS ITS PRESENT VALUE IS:
$100 X0.75=$750
CALCULATING NET PRESENT VALUE

P.V=PRESENT VALUE

YEAR NCF($m) 10%DISCOUNT FACTORS

P.V
1 2 .91 1.82
2 2 .86 1.72
3 1 .75 0.75
4 6 .69 4.14
5 4 .65 2.6
15M
11.03M

NPV= SUM OF P.V-INVESTMENT

= $11.03m - $1Om
=+ 1.03m

The NPV shows that this project will earn $1.03m in

real terms/ in today’s value.
PROS CONS
-NPV CONSIDERS THE TIME -IF THE WRONG DISCOUNT
VALUE OF MONEY FACTORS ARE SELECTED THEN THE
WHOLE INVESTMENT APPRAISAL
-NPV CONSIDERS THE TIMINGS WILL BE WRONG
OF THE INFLOW OVER THE
PROJECT’S LIFE. IF THE LARGE NPV CAN GO OUT OF DATE
INFLOWS COME EARLY IN THE
PROJECT LIFE THEN IT WILL HAVE -IT IS COMPLEX METHOD AND
A GREATER NET PRESENT VALUE. PRONE TO HUMAN ERROR

-IT CONSIDERS THE EXTERNAL -NPV CAN ONLY COMPARE TWO

FACTORS SUCH AS INTEREST PROJECTS WITH THE IDENTICAL
RATES IN THE ECONOMY. INITIAL INVESTMENTS.
THE USE OF ACCOUNTING DATA IN STRATEGIC DECISIONS

THE CONTENTS OF AN ANNUAL REPORT

-INCOME STATEMENT AND STATEMENT OF FINANCIAL POSITION

-CHAIRMAN’S STATEMENT-SUMMARY OF MAJOR ACHIEVEMENTS OF

THE COMPANY

-CHIEF EXECUTIVE’S REPORT- A MORE DETAILED ANALYISIS OF LAST

YEAR’S PERFORMANCE PRODUCT AND DIVISION WISE AND REPORT ON
ANY EXTERNAL GROWTH SUCH AS MERGER

-AUDITOR’S REPORT- REPORT OF INDEPENDENT CHARTERED

ACCOUNTANT VERIFYING THE ACCOUNTS ARE TRUE AND FAIR

NOTES TO THE ACCOUNTS- DETAILS OF THE TYPES OF NON CURRENT

ASSETS THE COMPANY HAS.
THE METHOD OF DEPRECIATION AND INVENTORY VALUATION USED
AND OTHER SPECIFIC INFORMATION.

USEFULNESS OF THE ANNUAL REPORT

WORKERS TO CHECK WHETHER THE BUINESS CAN GIVE THEIR PAY

CHECK FOR JOB SECURITY

TRADE UNION STRIKES CHECK TO ASK FOR WAGE INCREASE

GOVERNMENT TO SEE TAX PAYMENTS

TO CHECK IF WORKERS ARE PAID MINIMUM WAGE
RATES
TO CHECK THAT THE BUSINESS IS NOT INTO
MONOPOLISTIC BEHAVIOUR
TO MAKE SURELAWS ARE BEING FOLLOWED.
SUPPLIER TO JUDGE THE LIQUIDITY AND THE WORKING
CAPITAL AND DECIDE IF CREDIT SHOULD BE GIVEN

BANKS BANKS CHECK THE GEARING RATIO TO DECIDE IF LOAN CAN BE

GIVEN
ALSO CHECK THE BUSINESS PROFITABILITY AND SALES TO
SEE IF BUSINESS CAN REPAY LOAN WITH INTEREST

SHAREHOLDERS AND - CHECK THE BUSINESS PERFORMANCE AND COMPARE

INVESTORS WITH OTHER FIRMS TO DECIDE WHETHER TO INVEST IN
THE BUSINESS OR SELL SHARES
- CHECK THE AMOUNT OF DIVIDEND THEY EXPECT TO
RECEIVE ANNUALLY

CUSTOMERS CUSTOMERS WHO PLACE BIG ORDER WITH A BUSINESS

CHECK ITS PROFITABILITY AND LIQUIDITY BEFORE
PLACING THE ORDER TO CHECK IF THE BUSINESS IS
FINANCIALLY SECURE.
COMMUNITY - TO SEE IF THE BUSINESS IS PROFITABLE SO THAT IN
FUTURE IT WOULD BE ABLE TO GIVE JOBS AD DONATIONS
AND CHARITY FOR THE BETTERMENT OF THE
COMMUNITY.

MANAGERS - TO CHECK IF THEIR BUSINESS PROFITABILITY AND

LIQUIDITY IS IMPROVING OR NOT SO THEY CAN THEN
MAKE THE RIGHT STRATEGIES

- TO SET BUDGETS FOR THE FUTURE.

THE USE OF ACCOUNTING DATA AND RATIO ANALYSIS

Ratios are used for both internal comparison and comparing with the
other firms in the industry

Trend Analysis [using ratios to compare with previous years

perfromance

The firm could compare the gross profit margins and the profit margins
with the previous years to see if the profitability of the firm was
increasing or going down to make important decisions such as cutting
costs and prices

Other stakeholders like banks and suppliers can also judge whether the
liquidity of the business is improving or going down.
The shareholders could also judge if they should buy more shares or
sell their shares in the business.

Ratios can also be used to compare a firm’s performance with its

competitors.
Shareholders can look at the gearing ratios to judge which firm is
operating on a very high risk.

THE IMPACT OF ACCOUNTING DATA AND RATIO ANALYSIS ON

BUSINESS STRATEGY

Whenever Businesses want to develop short and long run strategies

the first have a detailed analysis of their accounting data and their
ratios.

For example after the analysis of its accounting data if the business
finds out its gross profit margin is falling year on year this means they
will now have to develop strategies to make their product more value
added in order to increase the gross profit margin.
The business would have to adopt strategies like adding more value to
the product or finding cheaper raw material through backward
integration in order to improve the declining gross profit margins.
If the gearing ratio is very high above 50% the business will have to
reduce dividends and also sell off some assets to reduce the gearing
ration.

THE IMPACT OF DEBT OR EQUITY DECISIONS ON RATIO RESULTS

How a business finances its growth and expansion would have an

impact on the firm’s ratios.

If the business decided to issue shares to get the finance to open new
branches then the investor ratios would be affected.
Issuing more shares would mean more shareholders and both the
earning per share and dividend per share would fall and this would
affect the dividend yield as well as the price to earning ratios.

If the business decided to take a bank loan to finance the growth then
the non current liabilities would rise and this would increase the
gearing ratio of the business. The interest expense paid on the loan
would lower the profit margin and the ROCE in the short run too.

If the business finances growth by taking loans and the new branches
are a success then it is better for the shareholders as they will not have
to share the dividends with new shareholders.

THE IMPACT OF CHANGES IN DIVIDEND STRATEGY ON RATIO RESULTS

EXAMPLE
A company has calculated the following from its latest accounting
data

Dividend per share = $1

Market share price =$10

EPS[Earning per share] = $2.5

PE ratio[price to earning ratio]= 4

Dividend yield ratio= 10%

The directors have made the following decisions for next year
-reducing dividend per share to $0.5

The directors predict that the EPS will rise to $3

FIND OUT THE EFFECT ON THE DIVIDEND YEILD AND P.E RATIO.

THE IMPACT OF BUSINESS GROWTH AND OTHER BUSINESS STRATEGIES

ON RATIO RESULTS

1) TAKEOVER:If a business decides to takeover another competitor

then initially when it makes the payment to buy the competitor then
there will be a huge cash outflow and the liquidity ratios will decrease
drastically.
In the long run the business after the takeover will avail economies of
scale and the average costs will fall and this will increase the profit
margins and the ROCE.

2) NEW PRODUCT DEVELOPMENT: if the new product development

is being financed by internal sources such as retained profits then the
dividend yield in the short run will fall as the business will reinvest all
the profits it making into the new product development.
The high costs of new product development will also decrease the
profit margins and the ROCE in the short run.
However if the product is successful then there will be large rise in
sales and there will be a
huge cash inflow improving the liquidity ratios as well as the
profitability ratios.
When a firm’s new product is a success many investors want to buy the
shares of the company and this raises the share price of the company
increasing the price to earning ratio.
THINKING POINTS
Suggest the impact on different ratios of the following business
decisions:

-gaining market share through higher advertising

-lowering prices to fight competitors

LIMITATIONS OF FINANCIAL ACCOUNTS

1. FINANCIAL ACCOUNTS ARE HISTORICAL IN NATURE WHICH MEANS THEY
RECORD THE PAST PERFORMANCE AND CANNOT PREDICT THE FUTURE.
MANAGERS CANNOT RELY ONTHEM TO MAKE FUTURE DECISIONS IN DYNAMIC
INDUSTRIES.

2. DO NOT SHOW QUALITATIVE INFORMATION AND ONLY SHOW QUANTITATIVE.

QUANTITATIVE INFORMATION SUCH AS PROFIT AND SALES AND LIQUIDITY ARE
SHORT RUN INDICATORS. THEY TELL ABOUT THE CURRENT POSITION BUT ARE NOT
HELPFUL IN PREDICTING THE LONG RUN PROSPECTS OF THE BUSINESS
QUALITATIVE INFORMATION SUCH AS WORKER MOTIVATION, RELATION OF
BUSINESS WITH ITS SUPPLIERS AND COMMUNITY ,THE ECO FRIENDILY
PRODUCTION HELP TLL US ABOUT THE LONG RUN OF THE BUSINESS.

IF A COMPANY IN THE SHORT RUN IS USING CHILD LABOUR IT WILL SHOW HIGH
PROFITSIN THE FINANCIAL ACCOUNTS = IS THIS SUSTAINABLE??

A COMPANY CARRYING OUT CSR WILL HAVE LOW PROFITS IN THE SHORT RUN DUE
TO THE HIGH COST OF CSR. HOWEVER THE FUTURE POTENTIAL BENEFITS WILL BE
HIGH
3. FINANCIAL ACCOUNTS CAN BE EASILY WINDOW DRESSED( MANIPULATING THE
PUBLISHED ACCOUNTS TO SHOW A MORE FAVOURABLE FINANCIAL
PERFORMANCE)

EXAMPLES OF WINDOW DRESSING ARE SHOWING THE INVENTORY AND NON

CURRENT ASSETS AT HIGHER VALUES
SHOWING A CUSTOMER AS A TRADE RECEIVABLE TO BOOST UP THE CURRENT
ASSETS EVEN THOUGH THE MANAGEMENT KNOWS THAT THE CUSTOMER IS
BANKRUPT AND WILL NOT PAY

4. PUBLISHED ACCOUNTS ARE MADE IN THE CONSOLIDATED FORMATS. CANT

PINPOINT THE PERFORMANCE OF A SPECIFIC BRANCH OR PRODUCT.

LIMITATIONS OF RATIO ANALYSIS:

1. RATIOS ARE ONLY SHOWING QUANTITATIVE DATA AND DO NOT SHOW THE
EXACT REASONS BEHIND THE RATIO BEING HIGH OR LOW.

2. A RATIO SUCH AS GROSS PROFIT MARGIN ON ITS OWN IS NOT VERY HELPFUL
UNTIL IT IS COMAPRED EITHER TO THE PAST YEAR GROSS PROFIT MARGIN OR
WITH A COMPETITOR
.
3. THERE ARE NO STANDARD FORMULAE FOR RATIOS AND FIRMS USE THE
FORMULAE THAT SUITS THEM SO IT IS VERY DIFFICULT TO COMPARE THE RATIOS
OF TWO FIRMS EVEN IN THE SAME INDUSTRY.
4. RATIOS ONLY HIGHLIGHT AN ISSUE FOR EXAMPLE THE FIRM WILL FIND OUT BY
CALCULATING ROCE THAT THE ROCE IS FALLING COMPARED TO THE LAST YEARS.
BUT THE RATIO WILL NOT TELL WHY IT IS FALLING NOR WILL IT GIVE ANY
SOLUTION ON HOW TO IMPROVE IT.

CONCLUSION:

FINANCIAL ACCOUNTS AND RATIOS ARE :

-AIDS TO DECISION MAKING

-MORE INDICATORS OF SHORT RUN PERFORMANCE RATHER THAN LONG RUN

- MUST BE COMPLIMENTED WITH OTHER INFORMATION ABOUT BUSINESS AND

CAN NOT BE USED IN ISOLATION

-. WITHOUT OTHER INFORMATION (FOR EXAMPLE PREVIOUS YEAR, COMPETITOR,

TARGET) RATIOS ARE JUST NUMBERS

QUANTITATIVE ASPECTS IS NEVER ENOUGH TO JUDGE TO SEE THE BUSINESS’ LONG

RUN SUSTAINIBILITY and qualitative information must be looked into too

QUALITATIVE INFORMATION
- WORKER EXPLOITATION/ TRADE UNION/LABOUR TURNOVER

- ENVIRONMENTAL IMPACTS
- SOCIAL MEDIA /REVIEWS/STORIES/ACCUSATIONS

- LEGAL ISSUES-- MISLEADING CLAIMS???/ WARRANTIES???

- MEDIA REPORTS

- FACILITATING PAYMENTS????/ INCENTIVES/GIVING BRIBES

-OUT OF COURT SETTLEMENTS