University of Warwick

January 2023

Foundations of Financial and Management Accounting

Suggested solutions

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Question 1 – solution

(a) Equivalent ratios for 2022 of Pears Plc (workings in £’000)

2021 2022
ROCE 12.2% 22·0% (8,400+3,600)/(54,600)x100
Pre-tax ROE 19.1% 50% 8,400/16,800 x 100
Net asset turnover 1.2 times 2·3 times 123,000 / 54,600
Gross profit margin 12.5% 12·2% 15,000/123,000 x 100
Operating expenses to sales ratio 2.0% 2.4% 3,000/123,000
Operating profit margin 10.5% 9·8% 12,000/123,000 x 100
Current ratio 1.2 1·3 43,800/34,200
Quick ratio 0.7 0.6 (43,800-21,600) / 34,200
Closing inventory holding period 70 days 73 days 21,600/108,000 x 365
Trade receivables’ collection period 73 days 66 days 22,200/123,000 x 365
Trade payables’ payment period 108 days 77 days 22,800/108,000 x 365
Gearing (LT debt / CE) 47% 69% 37,800 / 54,600 x 100
Interest cover 6.0 times 3·3 times 12,000/3,600
Dividend cover 3.6 times 1·4 times 6,000/4,200
EPS 45p 50p 6,000 / 12,000 shares

Capital employed = total assets less current liabilities = 88,800 – 34,200 = £54,600

(b)
Assessment of the relative performance and financial position of Pears Plc for the year ended 31
December 2022

Overview of the financial statements

Revenue increased by 71% [(123,000 -72,000) / 72,000 x 100%]

Cost of sales increased by 71%
Gross profit increased by 67%
Operating expenses increased by 108%
Finance costs increased by 186%
Profit before tax increased by 33%
Income tax expense increased by 167%
Profit for the year increased by 11%
[(108,000-63,000) / 63,000 x 100%]
[ (15,000-9,000) / 9,000 x 100%]
[(3,000 - 1,440) / 1,440 x 100%]
[(3,600 - 1,260) / 1,260 x 100%]
[(8,400 - 6,300) / 6,300 x 100%]
[(2,400 - 900) / 900 x 100%]
[(6,000 - 5,400) / 5,400 x 100%]

Inventories decreased by 80% [(21,600-12,000) / 12,000 x 100%]

Trade receivables increased by 54%
Current assets increased by 46%
Plant increased by 40%
Non-current assets decreased by 20%
Total assets increased by 3%
[(22,200 - 14,400) / 14,400 x 100%]
[(43,800 - 30,000) / 30,000 x 100%]
[(42,000 -30,000) / 30,0000 x 100%]
[(45,000 - 56,400) / 56,400 x 100%]
[(88,800 - 86,400) / 86,400 x 100%]

Trade payables increased by 23% [(22,800-18,600) /18,600 x 100%]

Taxation payable decreased by 30% [(6,000 - 4,200) / 6,000 x 100%].
Bank balance decreased to an O/D by 300% [(3,600+7,200) /3,600x 100%].
Current liabilities increased by 39% [(34,200 - 24,600) / 24,600 x 100%]
Non-current liabilities/loans increased by 31% [(37,800-28,800) / 28,800 x 100%]

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No change in share capital
Retained earnings decreased by 77% [(4,800 - 21,000) / 21,000 x 100%]
Dividends paid increased by 180% [(4,200 - 1,500) / 1,500 x 100%]
Equity decreased by 49% [(16,800 - 33,000) / 33,000 x 100%]

A positive bank balance (£3.6 million) in 2021 decreased (by 300%) to an overdraft (£7.2 million) in
2022. The huge increase (by 180%) in dividends paid reduced the retained earnings (by 77%), equity
(by 49%) and also resulted into the bank overdraft. The increase (by 40%) in plant (due to purchase
of new plant during the year) also resulted into the bank overdraft.

Profitability

The ROCE in 2022 is 22% which is far superior to the 12·2% return achieved in 2021. ROCE is
traditionally seen as a measure of management’s overall efficiency in the use of the finance / assets
at its disposal. More detailed analysis reveals that the superior performance in 2022 is due to its
efficiency in the use of its net assets; it achieved a net asset turnover of 2·3 times compared to only
1·2 times in 2021. Put another way, in 2022 Pears Plc makes sales of £2·30 per £1 invested in net
assets compared to sales of only £1·20 per £1 invested in 2021. The other element contributing to
the ROCE is profit margins. In this area the company’s overall performance in 2022 is slightly inferior
to that of 2021, gross profit margins are almost identical, but the operating profit margin in 2021 is
10·5% compared to 9·8% in 2022. In this situation, where one year’s ROCE is superior to another’s it
is useful to look behind the figures and consider possible reasons for the superiority other than the
obvious one of greater efficiency in 2022.

The ROCE measures the overall efficiency of management. It would also be useful to consider the
return on equity (ROE). The ratios calculated are based on pre-tax profits; this takes into account
finance costs, but does not cause taxation issues to distort the comparison. Clearly the ROE in 2022
at 50% is far superior to 19·1% in 2021.

Liquidity

In both years, the company has relatively low liquid ratios (of current ratio 1.2 and 1.3 for 2021 and
2022 respectively; and quick ratio 0.7 and 0.6 for 2021 and 2022 respectively).

Efficiency

The company has similar inventory days; the company collects its receivables one week earlier in
2022 than in 2021 (perhaps its credit control procedures are more active due to its large overdraft),
and of notable difference is that the company receives (or takes) a lot longer credit period from its
suppliers in 2021 (108 days compared to 77 days in 2022). This may be a reflection of the company
being able to negotiate better credit terms in 2021.

Gearing

From the gearing ratio (LT debt / CE), it can be seen that 69% of the assets in 2022 are financed by
borrowings. This is very high in absolute terms compared to the level of gearing in 2021. The effect
of gearing means that all of the profit after finance costs is attributable to the equity even though (in
2022’s case) the equity represents only 31% of the financing of the net assets. Whilst this may seem
advantageous to the equity shareholders, it does not come without risk. The interest cover in 2022 is
only 3.3 times whereas that of 2021 is 6 times. The low interest cover in 2022 is a direct
consequence of its high gearing and it makes profits vulnerable to relatively small changes in

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operating activity. For example, small reductions in sales, profit margins or small increases in
operating expenses could result in losses and mean that interest charges would not be covered.

Investment

ROE in 2022 at 50% is far superior to 19·1% in 2021. The EPS increased from 45p in 2021 to 50p in
2022 (an increase by 11%). The dividend cover was 3.6 times in 2021 and 1.4 times in 2022 (a
decrease by 61%).

Conclusion

The company’s sales revenues in 2022 are over 70% more than those of 2021. Profitability has
increased i.e. gross profit increased by 67%, profit before tax increased by 33% and profit for the
year increased by 11%. The ROCE in 2022 is 22% which is far superior to the 12·2% return achieved
in 2021. The liquidity is very low. The company’s overdraft of £7.2 million requires serious attention.
The company is financed by high levels of debt which brings some risks. The company’s policy of high
dividend pay-outs in 2022 (leading to a low dividend cover, low retained earnings and bank
overdraft) is very questionable.

Question 2 - solution

(a)

Product Profitability Analysis

Under Current Costing System
Product Ace Bee Total
£ £ £
Revenue 600,000 448,000 1,048,000
Direct Costs:
Materials 6,000 8,000 14,000
Labour 7,000 7,000 14,000
Contribution 587,000 433,000 1,020,000
Overheads 624,324 299,676 924,000
(Machine hours x OAR based on machine hours)
Total costs 637,324 314,676 952,000
Total Profits -37,324 133,324 96,000
Profit Margins -6.22% 29.76% 9.16%

Total Overhead Costs/Total Machine Hours= £924,000 / 7,400 MHs =

£124.8648649 / MH

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 Burden Rates Calculations:

Cost Drivers Total Cost Burden

Activities Costs
Driver levels Rates
£ £
Machining 400,000 Machine hours 7,400 54.05
Set-up 160,000 Number of set ups 1,333.33
120
Packing Orders 184,000 Number of packing orders 80 2,300
Quality Control 180,000 Number of inspections 60 3,000
Total Overheads 924,000

Product Profitability Analysis

Under Proposed Activity-Based Costing System

Product Ace Bee Total

£ £ £
Revenue 600,000 448,000 1,048,000
Direct Costs:
Materials 6,000 8,000 14,000
Labour 7,000 7,000 14,000
Contribution 587,000 433,000 1,020,000
Machining 270,270 129,730 400,000
Set-up 53,333 106,667 160,000
Packing Order 55,200 128,800 184,000
Quality control 60,000 120,000 180,000
Overheads 438,803 485,197 924,000
Total costs 451,803 500,197 952,000
Total Profits 148,197 -52,197 96,000
Profit Margins 24.70% -11.65% 9.16%

b)

The two costing systems give different results. Under traditional costing system, Bee is profit making
(profit margin 29.76%) product whilst Ace is loss making (profit margin -6.22%) product. Under ABC,
Ace is profit making (profit margin 24.70%) product whilst Bee is loss making (profit margin -11.65%)
product. The difference in the results is due to the way overheads are absorbed under each costing
system i.e. one cost driver (machine hours) is used in traditional costing system whilst ABC uses
multiple cost drivers. The traditional costing system assigns a higher proportion of overheads to Ace
which uses more machine hours. ABC correctly re-assigns some of the overheads from Ace to Bee.

The Conventional two-stage cost allocation systems are likely to systematically distort product costs
because they break the link between the cause for the costs and the basis for assignment of the cost

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to the individual products. Cost distortions may arise when using conventional two-stage cost
accounting systems either due to the use of unit-related measures or because of differences in relative
consumption ratios. Unit-related measures are used to allocate support costs to products, but the
demand for activities might be driven by batch-related and product-sustaining cost drivers. Also, costs
distortions tend to be greater when the differences between relative proportions of the activity cost
drivers and the base for second-stage assignment are greater.

Activity-based costing systems use cost drivers that link the activities performed to the products that
are manufactured. These cost drivers measure the demand placed on each activity by each product.
Activity-based costing systems are more flexible in using different cost drivers to better link the
activities performed to the products manufactured. The reason they provide more accurate product
costs is that they take into account the demand placed on activities by different products, not because
they use more cost drivers. A system that uses many cost drivers that do not match the activity costs
is also likely to distort product costs.

Question 3 – solution

a) Calculation of NPV and payback period

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Unit sales price 11,000 11,000 9,800 9,100 8,900
Less: Unit variable costs 8,000 8,200 8,300 8,400 8,600
Contribution per unit 3,000 2,800 1,500 700 300
Sales units 750 900 1,650 1,450 1,250
Total contribution 2,250,000 2,520,000 2,475,000 1,015,000 375,000
Less: fixed overheads 600,000 600,000 600,000 600,000 600,000
Operating cash flows 0 1,650,000 1,920,000 1,875,000 415,000 -225,000
Less: Investment in
equipment -2,000,000
Equipment resale value 300,000
Working capital -200,000 200,000
Net Cash flows -2,200,000 1,650,000 1,920,000 1,875,000 415,000 275,000
11 % discounting factors 1.000 0.901 0.812 0.731 0.659 0.593
Present values -2,200,000 1,486,650 1,559,040 1,370,625 273,485 163,075
NPV +2,652,875
Payback period:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net Cash flows -2,200,000 1,650,000 1,920,000 1,875,000 415,000 275,000
Cumulative cash flows -2,200,000 -550,000 1,370,000 3,245,000 3,660,000 3,935,000

Payback = 1 year + [(550,000 / 1,920,000) x 12]

Months
= 1 year and 3.4 months
Notes:
1. £350,000 feasibility study cost is a sunk cost, therefore not a relevant cash outflow.
2. Depreciation of (£2,000,000 - £300,000) / 5 = £340,000 is not cash based, therefore not a
relevant cash outflow.
3. The relevant annual fixed overheads is £940,000 - £340,000 Depreciation = £600,000

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Accept the project

1. Project has a positive NPV +2,652,875 (project maximises shareholder wealth by that
amount).
2. Project has a short payback period (approximately 1 year 3.4 months – good for liquidity of
the company).

b)
Students should critically discuss some issues beyond what the NPV / Payback calculations suggest i.e.

 How the initial investments (equipment and working capital) would be financed and the
feasibility of the financing options (debt or equity).
 Possibility for an incorrect NPV and payback period: other costs excluded (e.g. site restoration
costs, etc.); inflation and taxes paid that have been ignored.
 Project risks – arising from economic and legal factors.
 Sustainability issues - social and environmental factors.
 Consistency with strategy and building a competitive advantage.
 Value of real options.

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