Firm’s cash flow will show you whether your working capital is adequate. Clearly, if their projected cash balance ever goes negative, they will need more start-up capital. This plan will also predict just when and how many firms will need to borrow. Firms are required to explain their major assumptions; especially those that make the cash flow differ from the Profit and Loss Projection. For example, if firm’s make a sale in month one, when do they actually collect the cash? When to buy inventory or materials, do they pay in advance, upon delivery, or much later? How will this affect cash flow? Are some expenses payables in advance? When? Are there irregular expenses, such as quarterly tax payments, maintenance and repairs, or seasonal inventory build up, that should be budgeted?
Loan payments, equipment purchases, and owner's draws usually do not show on profit and loss statements but definitely do take cash out. Firms are required to be sure to include them. And of course, depreciation does not appear in the cash flow at all.
Opening Day Balance Sheet:
A balance sheet is one of the fundamental financial reports that any business needs for reporting and financial management. A balance sheet shows what items of value are held by the company (assets), and what its debts are (liabilities). When liabilities are subtracted from assets, the remainder is owners’ equity.
Use a startup expenses and capitalization spreadsheet as a guide to preparing a balance sheet as of opening day. Then detail how firm calculated the account balances on its .
Optional: Some people want to add a showing the estimated financial position of the company at the end of the first year. This is especially useful when selling proposal to investors.
Break-Even Analysis:
A predicts the sales volume, at a given price, required to recover total costs. In other words, it’s the sales level that is the dividing line between operating at a loss and operating at a profit.
Expressed as a formula, break-even is:
(Where fixed costs are expressed in dollars, but variable costs is expressed as a percent of total sales.)
It is advisable that firm should include all assumptions upon which its break-even calculation is based.
(Own Analysis & Course notes)
1. (c) Explain the purpose of creating a “starting balance sheet”.
Reply:
A balance sheet is a financial statement at a given point in time. It provides a snapshot summary of what a business owns or is owned.
It states what assets the business owns (assets) and what it owes (liabilities), at a particular date. The balance sheet is used show how the business is being funded and how those funds are being used. Balance sheet is also referred as financial statement. Balance sheets are sort of financial statements that are usually prepared at the close of an accounting period such as month-end, quarter-end, or year-end. New business owners should not wait until the end of 12 months or the end of an operating cycle to complete a balance sheet. Savvy business owners see a balance sheet as an important decision-making tool.
Over time, a comparison of balance sheets can give a good picture of the financial health of a business. In conjunction with other financial statements, it forms the basis for more sophisticated analysis of the business. The balance sheet is also a tool to evaluate a company's flexibility and liquidity.
Purpose of Financial statements Including Balance Sheet:-
The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization's financial position. Reported income and expenses are directly related to an organization's financial performance. Financial statements are intended to be understandable by readers who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently.
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Owners and managers require financial statements to make important business decisions that affect its continued operations. are then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.
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Employees also need these reports in making agreements (CBA) with the management, in the case of or for individuals in discussing their compensation, promotion and rankings.
External Users: are potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons.
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Prospective make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and is prepared by professionals (financial analysts), thus providing them with the basis in making investment decisions.
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Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh or extend debt (such as a long-term or ) to finance expansion and other significant expenditures.
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Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of and other duties declared and paid by a company.
- Media and the general public are also interested in financial statements for a variety of reasons.
Government financial statements:-
The rules for the recording, measurement and presentation of may be different from those required for business and even for non-profit organizations. They may use either of two : accrual , or cash accounting, or a combination of the two. A complete set of is also used that is substantially different from the chart of a profit-oriented business
Audit and legal implications:-
Although the legal statutes may differ from country to country, an of financial statements are usually, but not exclusively required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. Results of the audit are summarized in an that either provides an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. The audit opinion on the financial statements is usually included in the annual report.
There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the , they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have .
In the , especially in the post- era there has been substantial concern about the accuracy of financial statements. Corporate officers (the (CEO) and (CFO)) are personally liable for attesting that financial statements "do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report." Making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability.
Inclusion in annual reports:-
To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an , attempting to capture the excitement and culture of the organization in a "marketing " of sorts. Usually the company's chief executive will write a letter to shareholders, describing management's performance and the company's financial highlights.
(Various Internet Sources)
1. (d) Construct a “Cash Flow Forecast” for Bata Footwear for the three months, 1 July to 30 September 2006.
Cash Flow Forecast for Bata Footwear Between 01/07/2006 to 30/09/2006
Jul Aug Sep Total
Cash Inflows:
Capital £25,000 0.00 0.00 £25,000
Cash Sales £10,000 £10,000 £10,000 £30,000
Credit Sales £0.00____ £2,000 £2,000 £4,000 £35,000.00 £12,000 £12,000 £59,000
Cash Outflows:
Fixture & Fittings £0.00 £0.00 £30,000 £30,000
Purchases £0.00 £0.00 £5,000 £5,000
Overheads £5,000 £5,000 £5,000 £15,000
Drawings £1,500 £1,500 £1,500 £4,500_
£6,500 £6,500 £41,500 £54,500
Net Cash Flow £28,500 £5,500 (£29,500) £4,500
Cumulative Cash B/F £0.00 £28,500 £34,000 £4,500
Cumulative Cash C/F £28,500 £34,000 £4,500 -
Comments:-
Cash Flow Forecast shows the predicted movement of cash over a period of time (usually one year) & is divided into months, with a total column at the end to summarize the period covered.
It predicts as accurately as possible the amount of cash that is expected to come in & go out of the business, & the expected timing of these cash transactions which may be monthly, quarterly or annually.
I have prepared the cash flow forecast for Sheila new business. The biggest drawback which I found in the Sheila’s planning for new business is her payment plan for furniture & fixtures. Though she has delayed the payment plan till September 2006 but she has not planned the said payment in installments. This decision forces her to pay the amount in lump sump in September 2006 which results into loss of £29,500 for that particular month.
I would suggest following options for Sheila to be considered in order to improve the business situation:
- To obtain a bank overdraft or loan along with actual capital inserted into business. This option would enable her to start new business with more investment capability.
- Try to avoid provision of credit sales to the customers enabling her to have immediate cash inflow in the business.
- To make an effort to obtain 3 month’s credit plan from the supplier.
- To look for the cheaper shop option in the town centre.
- Try to obtain the furniture & fixture on lease, hire purchase or on more flexible payment plan rather than burdening herself for lump sum payment to be paid in one month.
- Overhead expenses should be controlled to the maximum possible extent.
At present, the cumulative cash flow situation of Sheila’s business is not depressing but the current business situation could be improved if the blend of above mentioned options would be adopted for the betterment of profitability.
Conclusion:-
It can easily be observed that Cash Flow Information is useful in number of ways. Planned cash flow information can be used to construct a cash flow forecast that predicts the monthly cash flows for the first accounting period (usually one year) for a new business.
I would say that exactly the same construction is used for the existing businesses for subsequent periods, but it’s usually known as cash flow budget. A cash flow budget is prepared in advance of the accounting period & predicts the cash flows for the following year as accurately as possible. Once the year starts, the actual figures in the cash flow statements are compared with the budgeted figures to check that the business is meeting its targets. If the target is not being met, the owner or manager can take whatever action is appropriate in order to make sure that the business meets its economic objectives.
(Guidance obtained from course notes)
Task 2:- (P3.1)
1. (a) Discuss the different types of business entities that exist. Describe the differences between the formats of financial statement for different types of business.
Reply:
Classifying Business:-
The most common type of business entities are as follows:
- Sole Proprietorship
- Partnership Concern
- Limited Liability
Sole Proprietorship:-
The sole proprietorship is the simplest form of business entity. It is an unincorporated entity because it has not gone through process of incorporation by which it is registered as a limited liability entity. It is owned by one person, who is in business with a view to making a profit e.g. Hairdresser, Newsagent etc. There is no formal procedure to form a sole proprietorship and there are few formal accounting requirements. There are no separate tax forms; file taxes on own personal income tax return. Sole Proprietor can easily exchange personal and business assets. It does not have any legal formalities & obligations to disclose financial information to the public.
The downside of these “loose” requirements is that sole proprietors are personally liable for debts, obligations and the like of the business, including lawsuits. Personal assets are essentially treated, for liability purposes, as assets of the business. They may run the business alone or employ part time staff. The owners in sole proprietorship may experience difficulty in raising capital to start the business as the finance is limited to personal investment & loans.
Additionally, since business income is reported on personal return, deductions expenses like medical insurance are limited to the caps and restrictions for individuals. In most cases, these deductions are less favorable to take as personal expenses than as business expenses.
Partnership Concern:-
A partnership (sometimes called a “general partnership”) is also a simple form of business entity. It is a form of an entity in which two or more people join together in a business with a view to making a profit. Partnership is a popular form of business for professional firms such as accountants, doctors, dentists, solicitors etc.
A partnership operates from a tax perspective as a “pass through” entity which means that all items of income and deductions pass through the partnership to the partners according to percentage of ownership or partnership agreement. Those items are then reported on each partner’s respective personal tax return. No income tax is paid at the partnership level (though a partnership may be subject to other state and local taxes).
As a result, personal and business assets are not separate and personal assets can be subject to the liabilities and obligations of the partnership. Additionally, just like with a sole proprietorship, the availability of certain types of deductions are limited to the tax floors and ceilings on your personal income tax return. The capital invested in this sort of business is restricted to what the partners have to invest, supplemented by what the partners can borrow.
Limited Liability:-
Limited liability entity is a business that, through the process of Legal Corporation, is considered to have a legal entity that is separate from its owners, who are known as members.
The capital invested in the business is raised by selling shares to members (shareholder) and can be supplemented by loans and other forms of debt finance.
The partners may run the business alone or employ full-time or part-time staff. The relationship must be formalized in shape of contract.
A written partnership agreement is a deed of contract that relates to the agreement to form a partnership.
In this type of business, members have limited liability, which means that even if the business fails owing significant amounts, the owner’s liability for those debts is limited to the capital they have invested.
Formats of Financial Statements:-
There are four formats of financial statements:
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Balance Sheet: Statement of financial position at a given point in time.
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Income Statement: Revenues minus expenses for a given time period ending at a specified date.
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Statement of Owner’s Equity: Also known as Statement of Retained Earnings or Equity Statement.
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Statement of Cash Flows: Summarizes sources and uses of cash; indicates whether enough cash is available to carry on routine operations.
Balance Sheet:-
The balance sheet is based on the following fundamental accounting model:
Assets = Liabilities + Equity
Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets include land, buildings, and equipment. Such assets are recorded at historical cost, which often is much lower than the market value.
Liabilities represent the portion of a firm's assets that are owed to creditors. Liabilities can be classed as short-term liabilities (current) and long-term (non-current) liabilities. Current liabilities include accounts payable, notes payable, interest payable, wages payable, and taxes payable. Long-term liabilities include mortgages payable and bonds payable. The portion of a mortgage long-term bond that is due within the next 12 months is classed as a current liability, and usually is referred to as the current portion of long-term debt. The creditors of a business are the primary claimants, getting paid before the owners should the business cease to exist.
Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation. The equity owners of a business are residual claimants, having a right to what remains only after the creditors have been paid. For a sole proprietorship or a partnership, the equity would be listed as the owner or owners' names followed by the word "capital". For example:
In the case of a corporation, equity would be listed as common stock, preferred stock, and retained earnings.
The balance sheet reports the resources of the entity. It is useful when evaluating the ability of the company to meet its long-term obligations. Comparative balance sheets are the most useful; for example, for the years ending December 31, 2000 and December 31, 2001.
Income Statement:-
The income statement presents the results of the entity's operations during a period of time, such as one year. The simplest equation to describe income is:
Net Income = Revenue - Expenses
Revenue refers to inflows from the delivery or manufacture of a product or from the rendering of a service. Expenses are outflows incurred to produce revenue.
Income from operations can be separated from other forms of income. In this case, the income can be described by:
Net Income = Revenue - Expenses + Gains - Losses
Where gains refer to items such as capital gains, and losses refer to capital losses, losses from natural disasters, etc.
Statement of Owners' Equity (Statement of Retained Earnings):-
The equity statement explains the changes in retained earnings. Retained earnings appear on the balance sheet and most commonly are influenced by income and dividends. The Statement of Retained Earnings therefore uses information from the Income Statement and provides information to the Balance Sheet.
The following equation describes the equity statement for a sole proprietorship:
Ending Equity = Beginning Equity + Investments - Withdrawals + Income
For a corporation, substitute "Dividends Paid" for "Withdrawals". The stockholders' equity in a corporation is calculated as follows:
Note that the premium on the issuance of stock is based on the price at which the corporation actually sold the stock on the market. Afterwards, market trading does not affect this part of the equity calculation. Stockholders' equity does not change when the stock price changes!
Cash Flow Statement:-
The nature of accrual accounting is such that a company may be profitable but nonetheless experience a shortfall in cash. The statement of cash flows is useful in evaluating a company's ability to pay its bills. For a given period, the cash flow statement provides the following information:
- Sources of cash
- Uses of cash
- Change in cash balance
The cash flow statement represents an analysis of all of the transactions of the business, reporting where the firm obtained its cash and what it did with it. It breaks the sources and uses of cash into the following categories:
- Operating activities
- Investing activities
- Financing activities
The information used to construct the cash flow statement comes from the beginning and ending balance sheets for the period and from the income statement for the period.
(, Financial Statements: A Step-By-Step Guide to Understanding and Creating Financial Reports, Career Press – First Edition (1998), ISBN: 1564143414)
1. (b) Describe the general purpose of the Profit & Loss Account & explain
the difference between this financial statement & the Cash Flow Statement.
Reply:
Profit & Loss Account:-
The general purpose of the profit and loss account is to:
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Show whether a business has made a PROFIT or LOSS over a financial year.
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Describe how the profit or loss arose – e.g. categorizing costs between “cost of sales” and operating costs.
A profit and loss account has three parts:
Trading account:-
The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year. This records the money in (revenue) and out (costs) of the business as a result of the business’ ‘trading’ i.e. buying and selling. This might be buying raw materials and selling finished goods; it might be buying goods wholesale and selling them retail. The figure at the end of this section is the Gross Profit.
Profit and Loss Account:-
This starts with the Gross Profit and adds to it any further costs and revenues, including overheads. These further costs and revenues are from any other activities not directly related to trading. An example is income received from investments.
The Appropriation Account:-
This shows how the profit is ‘appropriated’ or divided between the three uses mentioned above.
Uses of the Profit and Loss Account:-
1). The main use is to monitor and measure profit, as discussed above. This assumes that the information recording is accurate. Significant problems can arise if the information is inaccurate, either through incompetence or deliberate fraud.
2). Once the profit(loss) has been accurately calculated, this can then be used for comparison i.e. judging how well the business is doing compared to itself in the past, compared to the managers’ plans and compared to other businesses.
3). There are ways to ‘fix’ accounts. Internal accounts are rarely ‘fixed’, because there is little point in the managers fooling themselves (unless fraud is going on) but public accounts are routinely ‘fixed’ to create a good impression out to the outside world. If you understand accounts, you can usually (not always) spot these ‘fixes’ and take them out to get a true picture.
Example Profit and Loss Account:-
An example profit and loss account is provided below:
Differences between Profit & Loss Account and Cash Flow Statement:-
Cash Flow Statements do not show the profitability of a business, they show either an historic view, or a prediction of the flows of cash into and out of the business. It is only a Profit and Loss Account that tells us about profitability of a business.
After all, many if not most of the features are the same. They both show income, they both show expenses. So why is not the bottom line on the Profit and Loss Account the same thing as the Net Cash Flow? The answer is quite simple, the figures included in each are similar but they are not identical. The table below gives details of the main differences between the two, showing how the main differences arise, and why profit and loss accounts and cash flows are in fact quite different financial animals.
(Main Theme from Course Notes)
1. (c) Using the relevant figures in the above trial balance, construct a trading profit & loss account for Keel Artworks for the year ending 31st December 2006.
Reply:
Trading Profit & Loss Account for Keel Artworks As At 31st December 2006
Debit(£) Credit(£)
Sales 114,740.00
Less: Cost of Sales 69,880.00_
Gross Profit 44,860.00
Add: Commission Income 4,030.00_
48,890.00
Less: Expenses 29,550.00_
Operating Profit 19,340.00
Preliminary Calculations of Trading Profit & Loss Account:-
1. Cost of Sales = Opening Stock + Purchases – Closing Stock
£18,600.00 + £62,680.00 - £11,400.00
Cost of Sales = £69,880.00
2. Expenses:
Depreciation by Straight Line Method = Cost – Residual Value
Useful Economic Life
Depreciation on fixture & fittings = 15,000 – 0.00 / 3 = £5,000.00
Depreciation on Equipment = 5,000 – 1,000 / 4 = £1,000.00
3. Wages = £10,550.00
4. Business Rates = £8,000
Less: Prepaid = £2,000 ___ £6,000.00
5. Insurance = £2,580
Less: Prepaid = £580 ___ £2,000.00
6. Advertising = £2,200.00
7. Telephone = £830
Add: Accrued = £250 £1,080.00
8. Electricity = £800
Add: Accrued = £150 _ £950.00
9. Misc. Expenses = £160.00
10. Provision for doubtful debt = £6,100 × 10% = £610.00
Total Expenses = £29,550.00
1. (d) Describe the purpose of balance sheet & explain the difference between this financial statement & the profit & loss.
Reply:
The purpose of the balance sheet is to show a company's Assets, Liabilities and Equity at a given point in time, usually the company's fiscal year end. This is as opposed to an Income Statement, for example, which shows earnings throughout the year. A balance sheet is as of a given day. it does not show activity for a whole year, although you can compare year-to-year balance sheets to deduce some information.
A balance sheet is divided into two sides. On one side is the total assets of the Company, such as cash, working capital, fixed assets (machinery, land, equipment, autos, etc), and other assets. On the other side are the Liabilities, such as accounts payable, debt, and other liabilities. Assets minus liabilitiese equal equity, which is the remaining ownership in the company - that accorded to shareholders.
The Companies Act requires the balance sheet to be included in the published financial accounts of all limited companies. In reality, all other organizations that need to prepare accounting information for external users (e.g. charities, clubs, partnerships etc.) will also product a balance sheet since it is an important statement of the financial affairs of the organization.
A balance sheet does not necessary "value" a company, since assets and liabilities are shown at "historical cost" and some intangible assets (e.g. brands, quality of management, market leadership) are not included.
Definition of Assets:
An asset is any right or thing that is owned by a business. Assets include land, buildings, equipment and anything else a business owns that can be given a value in money terms for the purpose of financial reporting.
Definition of Liabilities:
To acquire its assets, a business may have to obtain money from various sources in addition to its owners (shareholders) or from retained profits. The various amounts of money owed by a business are called its liabilities.
Long-term and Current:
To provide additional information to the user, assets and liabilities are usually classified in the balance sheet as:
- Current: those due to be repaid or converted into cash within 12 months of the balance sheet date;
- Long-term: those due to be repaid or converted into cash more than 12 months after the balance sheet date;
Fixed Assets:
A further classification other than long-term or current is also used for assets. A "fixed asset" is an asset which is intended to be of a permanent nature and which is used by the business to provide the capability to conduct its trade. Examples of "tangible fixed assets" include plant & machinery, land & buildings and motor vehicles. "Intangible fixed assets" may include goodwill, patents, trademarks and brands - although they may only be included if they have been "acquired". Investments in other companies which are intended to be held for the long-term can also be shown under the fixed asset heading.
Definition of Capital:
As well as borrowing from banks and other sources, all companies receive finance from their owners. This money is generally available for the life of the business and is normally only repaid when the company is "wound up". To distinguish between the liabilities owed to third parties and to the business owners, the latter is referred to as the "capital" or "equity capital" of the company.
In addition, undistributed profits are re-invested in company assets (such as stocks, equipment and the bank balance). Although these "retained profits" may be available for distribution to shareholders - and may be paid out as dividends as a future date - they are added to the equity capital of the business in arriving at the total "equity shareholders' funds". At any time, therefore, the capital of a business is equal to the assets (usually cash) received from the shareholders plus any profits made by the company through trading that remain undistributed.
Difference between Profit & Loss Account and Balance Sheet:-
Two of the most important for a business are the Profit and Loss Account, and the Balance Sheet. The Profit and Loss Account shows the of a business over a given period of time e.g. 3 months, 1 year, etc.
In contrast, the Balance Sheet is like a photograph taken at an instant in time giving a picture of what the business owns and what the business owes at that moment in time. As we shall see it will always balance because what the business owns is financed by what the business owes.
The Profit and Loss (P & L) Account:-
One of the most important of a business is to make a profit. The P&L account shows the extent to which it has been successful in achieving this objective.
Companies are expected to keep their P & L accounts in certain formats. Typically the P&L account will show the received by a business and the involved in generating that revenue.
In simple : Revenues - Costs = .
A typical P&L account will look like the following:
Case Study:
P & L Account for Superior Traders as at 31/12/2004
You can find out the gross profit of a business by deducting cost of sales from :
£100,000 - £50,000 = £50,000
You can find out the by deducting the expenses from the gross profit:
£50,000 - £30,000 = £20,000
You may also come across the term . Operating profit is earned from carrying out a businesses normal e.g. producing confectionery, or selling Christmas cards. Net profit takes account of other sources of income and expenditure that are not involved in normal operations e.g. paid on loans and interest received on having a positive balance in a bank account.
Turnover - is the value of sales made in a trading period. It is sometimes referred to as sale revenue and is calculated by the average price of items sold x the number sold.
Cost of sales - calculates the direct costs of manufacturing items, or buying in items to sell them on.
Expenses - are the overhead costs of running a business. These can't be tied down to particular cost units. For example, it would be very difficult to calculate what fraction of the heating cost of a pen factory can be allocated to just one pen.
Balance Sheet:-
The Balance Sheet is a statement showing the , and owner's of a business at a particular moment in time, for example the year end.
The Balance Sheet balances because the assets that a business possesses at a specific time have been financed either through the provision of capital by the owner's or by the creation of external liabilities:
Value of assets = Value of Liabilities Value of Owner's capital.
There are a number of things that we can see from looking at a balance sheet, for example:
1. The of the business, i.e. the difference between the value of the assets and the value of the liabilities. A growth in net assets tends to indicate a growing business.
2. How solvent the business is. In other words, does it have enough assets that are short term, and hence easily converted into cash, to pay any pressing short-term liabilities.
Case Example:
A typical balance sheet will be set out in the following way (note that we use two columns. The first column is for minor calculations; the second column is for grand totals):
Balance Sheet of Superior Traders, as at 31st December 2004
Fixed assets consist of those items that are kept within the business to create wealth over a period of time e.g. machinery, equipment, vehicles, computers, etc.
Current assets are used in the short period to generate income for a business. For example, in a manufacturing like Kraft, stocks would represent products that have already been made and are waiting to be sold onto . Typically stocks will be sold on for periods of one month, two months, or three months. Retailers buying stocks on credit from Kraft would become Kraft's . At the end of the credit period they will pay up in the form of cash, enabling Kraft to buy more to create further stocks.
Creditors due within one year are the sums that a business owes money to in the short period - otherwise known as .
Net current assets are a measure of how solvent or a business is.
Many businesses need to have working capital. Working capital is calculated by subtracting current liabilities from current assets:
Working capital = Current assets - Current liabilities
Note that the figure for net current assets appears almost in the centre of a balance sheet, and is a figure that many people will look at first to check on the solvency of a business.
- current liabilities is a sum that appears in the balance sheet simply doing what the title suggests.
Creditors due after more than one year shows the longer term liabilities of the business.
Total net assets is calculated by taking away all the liabilities (both current and long term) from all of the assets (both current and long term).
Shareholders' funds show the value of the in the business. It will always be the same value as the total net assets and it balances the account.
(Main Theme from Course Notes & Various Internet Sources)
1. (e) Using the relevant figures in the above trial balance, construct a balance sheet for Keel Artworks as at 31 December 2005.
Reply:
Balance Sheet of Keel Artworks As At 31st December 2005
(£) (£)
Fixed Assets
Premises 120,000
Fixtures & Fittings 10,000
Equipment 4,000__
Total Value of Fixed Assets 134,000
Current Assets
Stock 11,400
Trade Debtors 5,490
Cash in Hand 2,500
Prepaid Expenses 2,580
Commission Income Due 360___
Total Value of Current Assets 22,330
Less: Creditors due within one year
Trade Creditors £8,050
Bank Overdraft £1,380
Accrued Expenses £400__ 9,830
Net Current Assets 12,500
Total Assets Less Current Liabilities 146,500
Less: Creditors Amount due after one Year
Long term Loan 20,000__
Total Net Assets 126,500
Capital Shared & Reserves
Capital 120,000
Add: Operating Profit 19,340_
139,340
Less: Drawings 20,000_
119,340
Note: I am very much satisfied with my working on balance sheet. However, it does not get balanced due to some unknown error in figures in trial balance.
Task 3:-
1 (a) Explain the purpose of Capital Investment Appraisal.
Reply:
Capital Investment Appraisal:-
From time to time most companies have to consider capital expenditure. Generally, expenditure that is likely to be of benefit in more than one accounting period is classed as Capital. However, expenditure that is classed as capital would normally have other significant characteristics. These can be summarized as follows:
- It will help the entity to achieve its organizational objective.
- It will probably involve substantial expenditure.
- The benefits may be spread over very many years.
- It is difficult to predict what the benefits will be?
- It will have some impact on the entity’s employees.
Such capital expenditures usually entail the outlay of very large sums in the expectations that the investment will yield economic benefits over a period of years. These sorts of investment decisions are crucial because:
- If mistakes are made, the adverse effect on the business would be considerable and
- It is often difficult &/or expensive to ‘bail out’ of an investment once it has been undertaken.
Indeed, if the entity is to survive & especially if it wants to grow, it will need to invest continually in capital projects. Existing fixed assets will begin to wear out & more efficient ones will become available. Furthermore, capital expenditure may be required not just in the administration, production & stores departments but also on social & recreational facilities. In the public sector also, universities & colleges may be faced with capital expenditure decisions that go beyond providing lecture halls & tutorial rooms, e.g. student accommodation & union facilities.
In view of the fact that capital investment decisions are so important, it is vital that all proposals are properly screened. Research shows that there are basically four methods used in practice by business through out the world to evaluate proposals for capital expenditure. These are:
- Accounting Rate of Return (ARR)
- Payback Period (PBP)
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
1. (b) Calculate the following for each project:
- Accounting Rate of Return
- Payback Period
- Net Present Value
For each calculation show your workings & append brief comments that explain & interpret your results. Also comment on the limitations of the techniques used.
Reply:
Accounting Rate of Return (ARR):- The ARR is calculated by taking Average Annual Profit that the investment will generate expressing it as a percentage of the average investment. Thus:
ARR = Average Annual Profit________________ X 100%
Average Investment to earn that Profit
We calculate ARR for Project 1 as follows:
Project 1:-
Investment Cost = £ 500,000/-
Five years Residual value of Equipment = No Value
Now, we calculate Average Profit before depreciation over five years as follows:
= £ 80,000 + £ 100,000 + £ 180,000 + £ 140,000 + £ 100,000
5
Average Profit before Depreciation = £ 120,000/-
Then, we calculate depreciation by using straight line method as follows:
= Cost - Residual Value
Number of Years
= £ 500,000 – 0.00
5
Depreciation = £ 100,000/-
Thus,
Average Annual Profit = Average Profit before Depreciation - Depreciation
= £ 120,000 - £ 100,000
Average Annual Profit = £ 20,000/- Per Annum
Now, we can calculate Average Investment over 5 years as:
= Cost of Machine + Disposal Value
2
= £ 500,000 + £ 0.00
2
Average Investment over 5 years = £ 250,000/-
Now,
ARR = Average Annual Profit______________ X 100%
Average Investment to earn that Profit
= £ 20,000__ x 100%
£ 250,000
ARR for Project 1 = 8.0%
In order to ascertain whether 8.0% is acceptable it is necessary to compare this with the percentage with the minimum required by the business.
Project 2:
Investment Cost = £ 500,000/-
Five years Residual value of Equipment = No Value
Now, we calculate Average Profit before depreciation over five years as follows:
= £ 90,000 + £ 110,000 + £ 190,000 + £ 110,000 + £ 80,000
5
Average Profit before Depreciation = £ 116,000/-
Then, we calculate depreciation by using straight line method as follows:
= Cost - Residual Value
Number of Years
= £ 500,000 – 0.00
5
Depreciation = £ 100,000/-
Thus,
Average Annual Profit = Average Profit before Depreciation - Depreciation
= £ 116,000 - £ 100,000
Average Annual Profit = £ 16,000/- Per Annum
Now, we can calculate Average Investment over 5 years as:
= Cost of Machine + Disposal Value
2
= £ 500,000 + £ 0.00
2
Average Investment over 5 years = £ 250,000/-
Now,
ARR = Average Annual Profit______________ X 100%
Average Investment to earn that Profit
= £ 16,000__ x 100%
£ 250,000
ARR for Project 2 = 6.40%
In order to ascertain whether 6.40% is acceptable it is necessary to compare this with the percentage with the minimum required by the business.
Limitations of ARR:-
- Net Profit can be subject to different definitions, e.g. it can mean net profit before or after allowing for depreciation on the project.
- It is not always clear whether the original cost of the investment should be used, or whether it is more appropriate to substitute an average for the amount of capital invested in the project.
-
The use of residual value in calculating the average amount of capital employed means that higher the residual value, the lower the ARR. The estimation of residual value is very difficult & it can make all the difference between one project & another.
- The method gives no guidance on what is an acceptable rate of return.
- The benefit of earning a high proportion of the total profit in the early years of the project is not allowed for.
- The method does not take into account the time value of money.
Notwithstanding these limitations, the ARR method may be suitable where very similar short term projects are being considered.
Payback Period (PBP):-
The Payback Period (PBP) seems to go some way to overcoming the timing problem of ARR although it too has its limitations as will be seem.
Project 1:-
The PBP is the length of time it takes for the initial investment to be repaid out of the next cash inflows from the project. The PBP for Project 1 is derived by calculating the cumulative cash flow as follows:
Year 1 - £ 80,000 = £ 500,000 - £ 80,000 = £ 420,000
Year 2 - £ 100,000 = £ 420,000 - £ 100,000 = £ 320,000
Year 3 - £ 180,000 = £ 320,000 - £ 180,000 = £ 140,000
Year 4 - £ 140,000 = £ 140,000 - £ 140,000 = £ 0.00
Thus: PBP for Project 1 = 04 Years
Project 2:-
The PBP for Project 2 is derived by calculating the cumulative cash flow as follows:
Year 1 - £ 90,000 = £ 500,000 - £ 90,000 = £ 410,000
Year 2 - £ 110,000 = £ 410,000 - £ 110,000 = £ 300,000
Year 3 - £ 190,000 = £ 300,000 - £ 190,000 = £ 110,000
Year 4 - £ 110,000 = £ 110,000 - £ 110,000 = £ 0.00
Thus: PBP for Project 2 = 04 Years
Limitations of PBP:-
As can be seen, the Payback Period method is a fairly straightforward technique, but it does have several limitations. These are as follows:
- An estimate has to be made of the amount & the timing of cash installments due to be paid on an original investment.
- It is difficult to calculate the net cash flows & the period in which they will be received.
- There is a danger that the projects with the shortest payback periods may be chosen even if they are less profitable than projects that have longer payback period. The method only measures cash flow; it does not measure profitability.
- The total amount of the overall investment is ignored & comparisons made between different projects may result in a misleading conclusion. Thus a project with an initial investment of £10,000 may have a shorter payback period than one with an initial investment of £100,000, although in the long run the larger investment may prove more profitable.
- The technique ignores any net cash flow received after the payback period.
- The timing of the cash flow is not taken into account: £1 received now is preferable to £1 received in five year’s time. Thus, a project with a short payback period may recover most of its investment towards the end of its payback period while another project with a longer payback period may recover most of the original investment in the first few years. There is clearly a less risk in accepting a project that recovers most of its cost quickly than there is an accepting one where the benefits are deferred.
Notwithstanding these limitations, the payback period method has something to be said for it. While it may appear to be rather simplistic, it does help managers to compare projects & to think in terms of how long it takes before a project has recovered its original cost.
Net Present Value (NPV):-
One of the main disadvantages of ARR & PBP methods in capital investment appraisal is that both methods ignore the time value of money.
The NPV method recognizes that cash received today is preferable to cash receivable sometime in future. There is more risk in having to wait for future cash receipts &, while a smaller sum may be obtained now, at least it is available for other purposes. For example, it can be invested & subsequent rate of return may then be compensated for smaller amount received now (or at least be equal to it). This means that £91 received now (assuming a rate of interest of 10%) is just as beneficial as receiving £100 in a year’s time. This is also the principle behind the NPV method. Basically it involves the following steps:
- Calculate the annual net cash flows expected to rise from the project.
- Select an appropriate rate of interest, or acquired rate of return.
- Obtain the discount factor appropriate to the chosen rate of interest or rate of return.
- Multiply the annual net cash flow by the appropriate discount factors.
- Add together the present values for each of net cash flows
- Compare total net present value with initial outlay.
-
Accept the project if total NPV is positive.
On the basis of above description, we can now calculate NPV of Project 1 & 2 as follows:
Project 1:-
Years Cash Inflow Discount Factor
Year 1 £ 80,000 X 0.943 = £ 75,440
Year 2 £ 100,000 X 0.890 = £ 89,000
Year 3 £ 180,000 X 0.840 = £ 151,200
Year 4 £ 140,000 X 0.792 = £ 110,880
Year 5 £ 100,000 X 0.747 = £ 74,700___
£ 501,220
Now:
NPV = £ 501,220 – Original cost of equipment
NPV = £ 501,220 - £ 500,000
NPV = £ 1, 220
Project 2:-
Years Cash Inflow Discount Factor
Year 1 £ 90,000 X 0.943 = £ 84,870
Year 2 £ 110,000 X 0.890 = £ 97,900
Year 3 £ 190,000 X 0.840 = £ 159,600
Year 4 £ 110,000 X 0.792 = £ 87,120
Year 5 £ 80,000 X 0.747 = £ 59,760___
£ 489,250
Now:
NPV = £ 489,250 – Original cost of equipment
NPV = £ 489,250 - £ 500,000
NPV = £ -10,750
Limitations of NPV:-
- Some difficulties may incur in estimating the initial cost of the project & time periods of installments.
- It is difficult to estimate accurately the net cash flow for each year of the projects life.
- It is not easy to select an appropriate rate of interest.
1. (c) Give your recommendation as which of the two projects is likely to be better investment for Wren Electronics.
Reply:
On the basis of calculations made step by step by using ARR, PBP & NPV methods of CI Appraisal, I would suggest that as ARR & NPV calculations clearly showed us that Project 1 should be considered as better investment for Wren Electronics than Project 2.
1. (d) Explain the advantages & disadvantages of using discount cash flow techniques for CI Appraisal.
Reply:-
Discounted Cash Flow Techniques:-
Discounted cash flow techniques comprises of:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Advantages:-
1. The use of net cash flows emphasizes the importance of liquidity.
2. Different accounting policies are not relevant as they don’t affect the calculation of net cash flow.
3. The time value of money is taken into account.
4. It is easy to compare NPV of different projects & reject projects that don’t have acceptable NPV.
5. An appropriate rate of return does not have to be calculated by using IRR method.
6. IRR method gives a clear percentage return on an investment.
Disadvantages:-
1. In case of NPV method, Some difficulties may incurred in estimating the initial cost of the project & time periods of installments must be paid back (although this is a common problem in CI Appraisal).
2. By using NPV technique, it is difficult to estimate accurately the net cash flow for each year of the project’s life.
-
It is not easy to select an appropriate rate of interest by using NPV method.
4. IRR method is not easy to understand.
5. Its difficult to determine which two suitable IRR rates to adopt unless a computer is used.
6. IRR method only gives an approximate rate of return.
7. In complex CI situations, IRR method can give some misleading results – for example, where there are negative net cash flows in subsequent years & where there are mutually exclusive projects.
(Main Theme from J. R. Dyson, Accounting for Non-Accounting Students – 2004)
TASK 4:-
1. (a) Describe the difference between “Profitability Ratios” & “Liquidity Ratios” in analyzing the financial performance of an organization.
Reply:
Profitability Ratios:-
Profitability ratios are used to assess the operating profit of a business. These include:
- Return on Capital Employed (ROCE)
- Net Profit Margin (NPM)
- Capital Turnover (CTO)
- Gross Profit Margin (GPM)
Liquidity & Efficiency Ratio:-
Liquidity & Efficiency ratios are used to evaluate the solvency & financial stability of the business & to assess how effectively it has managed its working capital. These include:
- Acid Test
- Debtor Collection Period
- Creditor Collection Period
1. (b) Analyze the financial statements you have prepared for Keel Artworks in Task 2 by calculating the following ratios:
Return on Capital Employed (ROCE):-
ROCE measures the percentage return on the total investment of funds in the business. This provides useful information about management’s effectiveness in generating revenue from resources & their ability to control costs. The Formula is:
ROCE = Profit before Interest & Tax X 100 (%)
Capital Employed
How to look up in Financial Statement:
Profit before Interest & Tax = Operating Profit (From Profit & Loss Account)
Capital Employed = Total Assets less Current Liabilities (From Balance Sheet)
Thus, we calculate ROCE for Keel Artworks as follows:
ROCE = £ 19,340__ X 100 (%)
£ 146,500
ROCE = 13.201%
ROCE should reflect the element of risk in the investment & can be compared with interest rates for other investments where there is barely any risk, such as Building Society Interest Rates.
Net Profit Margin (NPM):-
NPM measures the percentage return on sales. The Formula is:
NPM = Profit before Interest & Tax x 100 (%)
Turnover
How to look up in Financial Statements:
Profit before Interest & Tax = Operating Profit (From Profit & Loss Account)
Turnover = Sales Turnover (From Profit & Loss Account)
Thus, we can calculate NPM as follows:
NPM = £ 19,340__ X 100 (%)
£ 114,740
NPM = 16.855%
The NPM can be increased by improved increasing selling prices (if the market permits) or finding ways to reduce cost.
Capital Turnover (CTO):-
CTO measures the number of times capital employed (From Balance Sheet) has been used during the year to achieve the sales revenue we refer to as turnover. It is usually expresses as the number of times rather than a percentage & the formula is:
CTO = _______Turnover__________
Capital Employed
Thus:
CTO = £ 114,740
£ 146,500
CTO = 0.783 Times
The level of activity should be as high as possible for the lowest level of investment.
Gross Profit Margin (GPM):-
GPM measures the gross profit (From Profit & Loss Account) as a percentage of sales. The formula is:
GPM = Gross Profit X 100 (%)
Turnover
GPM = £ 44, 860__ X 100 (%)
£ 114,740
GPM = 39.097%
The Gross Profit Margin is much higher than the Net Profit Margin because it is calculated before the overhead expenses have been deducted.
Acid Test:-
Acid Test is a Liquidity ratio that shows the relationship between the business’s liquid assets i.e. all current assets except stock (From Balance Sheet), which takes longer to convert into cash & its current liabilities i.e. Creditors amount due within one year (From Balance Sheet).
The ratio is usually expressed as a ratio of x:1 rather x% & the formula is:
Acid Test = Current Assets – Stock____________ X 100 (%)
Creditors amount due within one year
Acid Test = £ 10,930 - £ 11,400 X 100 (%)
£ 9,830
Acid Test = -4.78:1
This implies that business had £-4.78 of liquid assets for every £1 of current liabilities. Therefore, if all the creditors had to be paid immediately, the business would not be able to do so unless & until obtain a loan to do so.
Stock Turnover:-
Stock Turnover is an efficiency ratio that measures the average number of times stock has been sold & replaced during the year. The formula is:
Stock Turnover = Cost of Sales__
Average Stock
We need to look at the Profit & Loss Account to obtain the figures for the Cost of Sales & Average Stock. For Average Stock if figures are disclosed we can use the following formula:
Average Stock = Opening Stock + Closing Stock
2
However, if a figure for opening stock is not provided, we can use closing stock as a proxy. In general, the more frequently the stock is turned over, the better.
Thus, we calculate Average Stock as follows:
Average Stock = £ 18,600 + £ 11,400
2
Average Stock = £ 15,000/-
Hence, Stock Turnover can be calculated as follows:
Stock Turnover = £ 69,880
£ 15,000
Stock Turnover = 4.65 Times
Debtors Collection Period:-
Debtors Collection Period is an efficiency ratio that gives an indication of the effectiveness of the management of working capital. It measures the average time trade debtors i.e. customers (From Balance Sheet) have taken to pay the business for goods & services bought on credit over the year. It can be calculated by using the formula:
Debtor Collection Period = Trade Debtors X 365
Turnover
Debtor Collection Period = £ 5,490__ X 365
£ 114,740
Debtor Collection Period = 17.46 Days
Creditors Collection Period:-
Creditors Collection Period is an efficiency ratio that measures the average time that business has taken to pay its trade creditors (From Balance Sheet). The credit payment period in days is calculated by using the formula:
Creditors Collection Period = Trade Creditors X 365
Purchases
Figures for Purchases are provided in Profit & Loss Account. If figures fro Purchases are not given, we can use the figures of Cost of Sales instead.
Thus:
Creditors Collection Period = £ 8,050_ X 365
£ 62,680
Creditors Collection Period = 46.87 Days
It may be noted that this is not quite a good measure because it is affected by changes in the level of stock. However, as long as we are consistent, it is possible to draw conclusion from it.
1. (c) Describe the main limitations of Ratio Analysis as a tool for evaluating the financial statements of the business.
Reply:
Limitations of Ratio Analysis:-
Ultimately the choice of analysis depends on the needs of the user & the availability of the data. The possibility that the data required for a particular ratio may not be available leads us to consider the limitations of ratio analysis, as like any other technique there are always number of drawbacks.
The main limitations are as follows:
- There are no agreed definitions of the terms used, so ratios based on different definitions will not be comparable.
- The figures needed to calculate the ratios may not be disclosed & less precise alternatives may have to be used.
- Comparative data may not be available for previous periods.
- Comparative data may not be available for similar companies in the same industry (for example if the industry operates in a niche market & there are no industry benchmarks).
- Figures in financial statements may be misleading if there is high inflation, window dressing (any creative accounting practice that attempts to make a situation look better than it really is).
- The financial statements do not take account of non-financial factors, for example: reputation of business, strong customer base, loyal employees, reliable suppliers etc.
Despite these drawbacks, ratio analysis is an invaluable tool for interpreting the financial statements of an organization. Users should not treat ratios as absolute answers, but an indication of where further investigation might be directed to find out the underlying reasons for the financial performance or position.
(Main Theme from J. R. Dyson, Accounting for Non-Accounting Students – 2004)
Task 5:-
1. (a) Discuss the benefits of forecasting for an organization. (Use examples to explain your answer.
Reply:-
Forecasting:-
Budgeting for future profit or cash flows requires us to forecast future costs & revenues at varying levels of activity. How do we use past experience to make forecasts?
A system of forecasting must be designed, with the following components:
Data: Any forecast will take into consideration results which have been obtained in the past. No situation is static & most up-to-date results are the most relevant to the forecasting model.
Models: The forecaster must try to make a model which will fit the situation under review. He will need to plot graphs of past results to look for patterns, trends, seasonal fluctuations & other cycles which might appear from past results, which must be reflected in the model.
Future Conditions: The projections of the model must then be evaluated in light of any outside factors or changed conditions.
Errors: Any forecast is, at best, a close approximation of an actual result, & the forecaster will want to make allowances for errors. Statistical theory can be applied to errors in forecasting by assuming that errors came from a normal distribution with a mean of zero. This enables the forecaster to calculate the tolerances on the forecast.
Benefits of Forecasting:-
Forecasting is valuable for following reasons:
- Without being able to forecast revenues & costs, firms would be unable to implement any budgetary control system. All budgets are based on forecasted figures, even if those figures are based on intuitions. Obviously, the more accurate the forecasts, the more accurate & useful will be the budgets & hence the control on costs.
- If an organization uses standard costing as a control method, it needs to set the standards as accurately as possible taking into account the management philosophy of standard setting, i.e. low but obtainable, or high as an incentive. Such costs & selling prices included in the standard will all be forecast figures.
- The end-result itself can sometimes be valuable, because an accurate forecast may improve the quality of the plan(s) based on it. It may help identify and evaluate risks, clarifying factors and reveal assumptions.
- More often it is the forecasting process that is valuable, because it sensitizes managers to change and to the relevant factors, helps them understand what is likely to occur, and builds a consensus.
- Sometimes the consensus is crucial. The fact that everybody is agreed on a forecast may be more important than its accuracy. Particularly if the consensus involves many organizations or units, crossing organizational and cultural barriers. Consensus works both ways. An agreed forecast can be self-fulfilling. But beware the self-disfulfilling prophecies!
1. (b)
Reply:-
Computing the regression line of y on x:-
Assuming that the equation of regression line of y on x is:
Y = a + bx
As it will be if we are trying to predict cost (y) from activity level age (x), it is necessary to calculate the value of a and b so that the equations can be completely determined.
The following formulae are used; a knowledge of their derivation is not necessary. They do not need to be memorized.
a = y¯ - bx¯ = Σy - bΣx
n n
b = nΣxy - ΣxΣy
nΣx² - (Σx)²
n is the number of pairs of x, y values, i.e. the number of points on scatter graph. The value of b must be calculated first as it is needed to calculate a.
Now, the calculation is set out as follows, where x is the activity level age & y is the total cost:
x y xy x²
5 190 950 25
10 240 2,400 100
15 250 3,750 225
20 300 6,000 400
30 310 9,300 900
30 335 10,050 900
30 300 9,000 900
50 300 15,000 2,500
50 350 17,500 2,500
60 395 23,700 3,600
Σx = 300 Σy = 2,970 Σ(xy) = 97,650 Σx²= 12,050
As we know n = 10
Then:
b = nΣxy - ΣxΣy
nΣx² - (Σx)²
Hence:
b = 10 X 97,650 – 300 X 2,970
10 X 12,050 – (300)²
b = 2.80
Now,
a = y¯ - bx¯ = Σy - bΣx
n n
so,
a = 2,970 - 2.80 X 300
10 10
a = 213
Now we can calculate y as:
y = a + bx
Hence:
y = 213 + 2.80 x
Let’s suppose x = 40, So:
y = 213 + 2.80 X 40
Therefore,
y = 325/- (i.e. we predict total cost of £325 for production of 40 units)
and if we suppose x = 90, Then:
y = 213 + 2.80 X 90
y = £465/- (i.e. we predict total cost of £465 for production of 90 units)
(Main Theme from Course Work)
Bibliography:-
1.
2. Own Analysis & Course Notes / Work
3. , Financial Statements: A Step-By-Step Guide to Understanding and Creating Financial Reports, Career Press – First Edition (1998), ISBN: 1564143414)
4. Various Internet Sources
5. J. R. Dyson, Accounting for Non-Accounting Students – Sixth Edition (2004),
ISBN: 0 273 68385 3
