Unit2 Managing Financial and Resources Decisions

Student Name

AHMAD AL-MARZOOQI

Task 1
1.1: Identify the sources of finance available to business?
There are different sources of finance for businesses:
1. Own finance - You may choose to start your own business using your own financial
resources. This may be from savings accounts or other investments that you have.
Typically, it is not advised that you should fund your start-up from personal overdrafts,
loans or credit cards as these are not necessarily tailored to your business needs or
requirements.
2. Family and friends - You may have family and friends who wish to invest in your
business. This is often convenient and may allow you to get finance on favourable
terms. However, make sure you have a formal agreement of loan terms in place so you
or your family and friends are not left unprotected in the event that you are unable to
repay the loan.
3. Banks: The most common forms of finance used by start-ups are:
Business overdrafts - Banks offer overdrafts as a form of short-term finance. These
are available to companies that have business current accounts. They are a good way
of covering any fluctuations of money coming in and going out of your business.
Term loans - Loans are designed to help you buy equipment and supplies for your
business. They are best if you need to buy fixed assets, such as machinery or office
equipment, where the amount you need is not going to change.
4. Grants - These are a good option for businesses looking for financial assistance for
specific projects. Typically, funding comes from EC and UK government sources,
including local authorities, charitable trusts and corporate sponsors.
5. Loans - It is not just banks that can provide a loan. Business support organisations
such as enterprise and development agencies can help businesses looking for loans.

6. Business Angels - Often high net worth individuals, Business Angels invest in high
growth businesses on their own or as part of a syndicate. In addition to providing
finance, Business Angels often make available to companies their own skills,
experience and contacts.
7. The Princes Charities - This is a group of notforprofit organisations, headed up by
The Prince of Wales who acts as Patron or President. A good example of support
available to start-ups is from the Princes Trust Enterprise Programme, which helps
unemployed young people aged 18-30 work out if their business ideas are viable and
whether self-employment is right for them.
8. Community Development Finance Association (CDFA). The Association
represents a network of regional Community Development Finance Institutions (CDFIs).
CDFIs provide loans and support to businesses, social enterprises, community
organisations or charities. They are mostly based within the UKs most disadvantaged
communities.

Short term sources of finance:

o Bank overdraft
o Trade Credit
o Leasing
o Bank loans
o Credit cards
Long term sources of finance:
o Bank loans
o Share capital
o Debentures
o Asset sales
o Venture capital
o Retained profit
o Owners' capital
o Government, local authority or EU grant

1.2: Assess the cost and benefits of these sources?

The standard definition of cost as 'that expenditure which has been incurred in the
normal course of business in bringing the product or service to its present location and
condition'.

For a trading business such as a retailer, cost will therefore be the purchase price plus
the cost of delivery to the retail store. For a manufacturing business, the cost of finished
goods will be the direct costs of labour, materials and expenses, and in addition will
include factory overheads absorbed into the product.
Cost benefit analysis is a process of identifying, measuring and comparing the social
benefits and costs of an investment project or program. A program is a series of
projects undertaken over a period of time with a particular objective in view. The project
or projects in question may be public projects undertaken by the public sector or
private projects. Both types of projects need to be appraised to determine whether they
represent an efficient use of resources. Projects that represent an efficient use of
resources from a private viewpoint may involve costs and benefits to a wider range of
individuals than their private owners. For example, a private project may pay taxes,
provide employment for the otherwise unemployed, and generate pollution. These
effects are termed social benefits and costs to distinguish them from the purely private
projects from social viewpoint as well as to appraise public projects.
It should be noted that the technique of social benefit- cost analysis can also be used to
analyse the effects of changes in public policies such as the tax/subsidy or regulatory
regimes. Public projects are often thought of in terms of the provision of physical capital
in the form of infrastructure such as bridges, highways and dams. However there are
other less obvious types of physical projects that augment environmental capital stocks
and involve activities such as land reclamation, pollution control, fishery management
and provision of parks. Other types of projects are those that involve investment in
forms of human capital, such as health, education and skills and social capital through
drug-use and crime prevention, and the reduction of unemployment. There are few, if
any, activities of government that are not amenable to appraisal and evaluation by
means of social benefit-cost analysis.
1.3: Implications of various sources of finance for a business project?
Investment involves diverting scarce resources- land, labour and capital- from the
production of goods for current consumption to the production of capital goods which

will contributes to increasing the flow of consumption goods available in the future. An
investment project is a particular allocation of scarce resources in the present which will
result in a flow of output in the future: for example land, labour and capital could be
allocated to the construction of a dam which will result in increased electricity of output
in the future (in reality there are likely to be additional output such as irrigation water,
recreational opportunities and flood control but we will assume these away for the
purposes of the example). The cost of the project is measured as an opportunity costthe value of the goods and services which would have been produced by the land,
labour and capital inputs had they not been used to construct the dam. The benefit of
the project is measured as the value of the extra electricity produced by the dam.
1.4: What should be the appropriate source of finance for your selective company
Shares: Limited companies could look to sell additional shares, to new or existing

shareholders, in exchange for a return on their investment.

Loans: There are debenture loans, with fixed or variable interest, which are usually
secured against the asset being invested in, so the loan company will have a legal
shared interest in the investment. This means that the company would not be able to
sell the asset without the lenders prior agreement. In addition the lender will take
priority over the owners and shareholders if the business should fail and the cost will
have to be repaid even if a loss is made.
There are other types of loan for fixed amounts with fixed repayment schedules. These
may be considered a little more flexible than debenture loans.
Overdraft: A bank overdraft may be a good source of short-term finance to help a
business flatten seasonal dips in cash-flow, which would not justify or need a long-term
solution. The advantage here is that interest is calculated daily and an overdraft is
therefore cheaper than a loan.
Hire purchase: Hire purchase arrangements enable a firm to acquire an asset
quickly without paying the full-price for it. The company will have exclusive use of the
item for a set period of time and then have the option to either return it or buy it at a
reduced price. This is often used to fund purchases of vehicles, machinery and printers.

Credit from suppliers: Many invoices have payment terms of 30 days or longer. A
company can take the maximum amount of time to pay and use the money in the
interim period to finance other things. This method should be treated with caution to
ensure that the invoice is still paid on time or else the firm might risk upsetting the
supplier and jeopardise the future working relationship and terms of business. It should
also be remembered that its not found money but rather a careful balancing act of
cash-flow.
Task 2
2.1: Explain the importance of financial planning?
It is important to plan finances in order to reap long term benefits through the assets in
hand. The investments that one makes are structured properly and managed by
professionals through financial planning. Every decision regarding our finances can be
monitored if a proper plan is devised in advance. The following points explain why
financial planning is important.
Cash Flow: Financial planning helps in increasing cash flow as well as monitoring the
spending pattern. The cash flow is increased by undertaking measures such as tax
planning, prudent spending and careful budgeting.
Capital: A strong capital base can be built with the help of efficient financial planning.
Thus, one can think about investments and thereby improve his financial position.
Income: It is possible to manage income effectively through planning. Managing income
helps in segregating it into tax payments, other monthly expenditures and savings.
Family Security: Financial planning is necessary from the point of view of family
security. The various policies available in the market serve the purpose of financially
securing the family.
Investment: A proper financial plan that considers the income and expenditure of a
person, helps in choosing the right investment policy. It enables the person to reach the
set goals.

Standard of Living: The savings created by through planning, come to the rescue in
difficult times. Death of the bread winner in a family, affects the standard of living to a
great extent. A proper financial plan acts as a guard in such situations and enables the
family to survive hard times.
Financial Understanding: The financial planning process helps gain an understanding
about the current financial position. Adjustments in an investment plan or evaluating a
retirement scheme becomes easy for an individual with financial understanding.
Assets: A nice 'cushion' in the form of assets is what many of us desire for. But many
assets come with liabilities attached. Thus, it becomes important to determine the true
value of an asset. The knowledge of settling or canceling the liabilities, comes with the
understanding of our finances. The overall process helps us build assets that don't
become a burden in the future.
Savings: It is good to have investments with high liquidity. These investments owing to
their liquidity can be utilized in times of emergency and for educational purposes.
2.2: Assess the information needs if different decision makers?
Budgeting decisions: Analysis and monitoring of cash and other budgets.
Costing and pricing decisions: Calculations of unit costs, use within pricing decisions,
sensitivity analysis
Investment appraisal: payback period, accounting rate of return, discounted cash-flow
techniques i.e net present value, internal rate of return
Nature of long-term decisions: nature of investment importance of true value of money,
cash flow, assumptions in capital investment decisions, advantages and disadvantages
of each.
Financial statements: basic form, structure and purpose of main financial statements i.e
balance sheet, profit and loss account, cash-flow statement, notes, preparation not
required; distinction between different types of business i.e limited company,
partnership, sole trader.

Interpretation: use of key accounting ratios for profitability, liquidity, efficiency and
investment, comparison both external i.e other companies, industry standard and
internal i.e previous periods, budgets
Financial statements provide an overview of a business or person's financial condition in
both short and long term. All the relevant financial information of a business enterprise,
presented in a structured manner and in a form easy to understand, are called the
financial statements. There are four basic financial statements:
Balance sheet: also referred to as statement of financial position or condition, reports on
a company's assets, liabilities, and Ownership equity at a given point in time.
Income statement: also referred to as Profit and Loss statement (or a "P&L"), reports on
a company's income, expenses, and profits over a period of time. Profit & Loss account
provide information on the operation of the enterprise. These include sale and the
various expenses incurred during the processing state.
Statement of retained earnings: explains the changes in a company's retained earnings
over the reporting period.
Statement of cash flows: reports on a company's cash flow activities, particularly its
operating, investing and financing activities.
It has great impact on finance because:Owners and managers require financial statements to make important business
decisions that affect its continued operations.
Employees also need these reports in making collective bargaining agreements (CBA)
with the management, in the case of labour unions or for individuals in discussing their
compensation, promotion and rankings.
Prospective investors make use of financial statements to assess the viability of
investing in a business. Financial analyses are often used by investors and are
prepared by professionals (financial analysts), thus providing them with the basis for
making investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether
to grant a company with fresh working capital or extend debt securities (such as a longterm bank loans or debentures) to finance expansion and other significant expenditures.
Government entities (tax authorities) need financial statements to ascertain the
propriety and accuracy of taxes and other duties declared and paid by a company.
2.3: Explain the impact of finance on the financial statements?
According to theory, maximising shareholders wealth is the fundamental objective of a
firm. (Watson & Head -Corporate Finance principles and practice 2007), Investors
generally expect to earn satisfactory returns on their investments as they require
increasing the value of their investments as much as possible. This is usually
determined by dividend payout and or capital gains by increasing the market value of
the share price. The managers of the company act on behalf of the investors, such as
operating day to day activities and making decisions within the business. In another way
they do have the control of the business entity. However, firms may have other
objectives to achieve such as maximising of profits, growth and increasing its' markets
share. When achieving these objectives of a firm, conflicts may arise as a result of
ownership and control. Managers may make their decisions on their own interests
rather than achieving investors' wealth.
Value of the business is measured by valuing firms' price of shares. It's essential to
consider maximising of stock prices, and its' impact to the investors and the economy as
a whole simultaneously.
Maximising profits is also an objective of a firm. It is determined by maximising the firm's
net profits. It is also can be described as a short term objective whilst maximising the
value of the company is a long term objective for a firm (Financial Management -Kaplan
Publishers 2009). Therefore it is not necessary, maximising profits as maximising
shareholders wealth because there are number of potential problems can occurr
adapting to an objective of profit maximisation.

Earnings per share (EPS) is one of the main indicators of the firms' profitability and it is
a broadly used method measuring firm's success, as it is determined return to equity in
theory(Financial Management - Kaplan Publishers 2009).However, EPS doesn't expose
the firm's wealth since it is determined by using firms' net profits.

Task 3
3.1: Analyses budgets and make appropriate decisions?
Every organization knows the significant of a cash budget and how it can be determine
the future directions of its business. In fact, cash budget is one of the key components
of a master budget. Never the less, it is the most difficult budget to prepare as
compared to the rest. Cash budget in reality is a foretell of cash inflow and cash outflow
actions, which are likely to take place in the future. It can be a net cash surplus or net
cash shortfall position.
Cash Inflows
Operating Activities
From sales of goods and services
From returns on investment
Investing Activities
From sales of plant, property and equipment
From sales of investment
From collection of principal on loans to other companies
Financing Activities
From sales of equity securities (issuing companys own stock)

From issuing debt

Cash Outflows
Operating Activities
To suppliers for inventory and expenses
To employees for service
To government for taxes
To lenders for interest
Investing Activities
To purchase property, plant and equipment
To purchase investments in other companies (debt or equity)
To make loans to other entities
Financing Activities
To shareholders as dividend
To repay long-term debt
Cash Surplus
A cash surplus is the cash that exceeds the cash necessary for routine operations.
Deciding where to use cash surplus requires planning and better judgment. The most
common uses are paying down the debt, investing in capital projects, payments to
stakeholder or placing the cash surplus in short term investments so that the business
has cash for an urgent situation.
Preparing a cash budget helps every organization and its management to make wise
decisions. By using a cash budget the organization can make better decisions on
effects such as, whether the company has sufficient cash to meet its every day needs

3.2. Explain the calculation of unit costs

Manufacturing Account
Where a business engages in manufacturing activities a manufacturing account would
be prepared with the objectives of establishing the total cost of manufacturing. Having
established the total cost of manufacturing, it would then be transferred to the trading
account under cost of sales.
Manufacturing Account

Materials
Opening stock xxx
Purchase xx
Carriage inwards xx
Import duties xx
Warehousing charges xx
Any other direct expenses relating materials xx
XX
Returns outwards (x) xxx
xxx
Closing stock (x)
Raw materials consumed XXX Direct wages x
Royalty charges x
Any other direct expenses x xx
Prime cost XXX
Factory overheads
Factory rents & rates xx
Repairs & maintenance xx
Depreciation xx
Insurance xx
Heat & light xx

Factory managers salary xx xxx

Factory cost of production XXX
Work in progress
Opening stock xx
(-)Closing stock (x) xx
Factory cost of goods completed XXX
(Transferred to trading account)
Following are the methods to find one unit of the total cost of manufacturing
Total cost of a unit can be calculated by combining variable cost and fixed cost.
TC=VC+FC
Total cost of a unit can be calculated by in view of the prime cost and the overheads.
Total cost = prime cost + overheads
Costs are classified in three different rudiments, they are,
By nature this includes material cost, labour cost and expenses
By function this includes production cost, administration cost, selling and distributing
cost and RD cost
By behavior fixed, variable, semi variable
By Nature
Direct costs costs that can be easily and conveniently traced out to a unit of product or
other cost objectives. Example: direct material and labour
Indirect costs costs cannot be easily and conveniently traced out to a unit of product
or other objectives.

Example: manufacturing overhead

Manufacturing costs
Direct labour those labour costs can be easily traced to individual units of product.
Example: wages paid to workers
Direct material those materials that become an integral part of the product and that
can be conveniently traced directly to it.
Example: a radio fixed to a car
Direct expenses those expenses that can be easily charged to individual units of
products.
Example: design cost of car
By Function
Classification by function means that when an examination is based on the function of
the event (or cost of sales method), this will catalog expenses according to their function
as part of cost of sales, distribution or administrative activities. While this arrangement
can provide information that is more relevant to users, the allotment of costs to function
can often be arbitrary. Organizations who chose to do this should unveil additional
information on the nature of expenses, including decline and staff costs. The enterprise
should choose the analysis that provides the fairest presentation of the business
activities.
By Behavior
Variable cost
Total variable cost changes with activities. Total cost of materials depend on how much
materials are been used. Example: raw materials, electricity. Variable costs can also be
called direct costs as they are directly associated with production.
Variable cost per unit

Per unit, material cost will remain constant.

Fixed costs
Fixed cost probably does not change when a production is completed. Example:
salaries, rent, tax, insurance, heating and lighting. Fixed costs can also be called
indirect costs, as they are not directly associated with the final product.
Fixed cost per unit
The average fixed cost per unit decreases as more production is finished.
Semi variable costs
These costs have fixed and variable elements. Example: a person working for the
company may have a fixed salary but may also earn commission on sales.
3.3: Make pricing decisions using relevant information?
Information Needed to make Pricing Decisions
Pricing is one of the four aspects of marketing. The other three parts of the marketing
mix are product management, promotion and distribution. It is also a key variable in
microeconomic price allocation theory. Following are the information needed to make
pricing decisions.
Demand of Customers
The demands of customers are very important for all business operations, especially
when setting prices. For an instance, if a customer wants higher quality equipment, it
will enmesh greater production and expensive raw materials. The result will be a higher
price. Then again, the management should be vigilant not to price the products out of
the market. Hence, the customer demand is gravely important in this process.
Therefore, the companies should price their products based on customer survey and
market research.
Cost

Firms that combined accurate cost data with internally and externally generated market
information appear to be able to follow more flexible and adaptive pricing practice.
When analyzing cost, the marketers consider all costs needed to get the product to
market. Looking at an example, in the agriculture industry, where grain and meat prices
are market driven, farmers must meet the market price. Therefore, to make profit, they
must produce at a low cost below the market price. Moreover, looking at a public utility
pricing, a request will be made to the public utility commission for a rate increase based
on its current and projected production cost. No organization or industry can price its
products below their production costs indefinitely. In addition, no companies
management can set prices blindly at cost plus a markup without keeping an eye on the
market.
Competitors
Marketers should undoubtedly look to market competitors for indications of how price
set. Price analysis can be somewhat more complicated for products sold to the
business market since a number of factors including if competitors allow customers to
negotiate their final price may affect final price.
Direct Competitor Pricing - pricing will include an evaluation of competitors offerings.
The impact of this information on the actual setting of price will depend on the
competitive nature of the market. Marketers must not only research competitive prices
but must also pay close attention to how these companies will respond to the marketers
pricing decisions. For instance, in highly competitive industries, such as gasoline or
airline travel, competitors may respond quickly to competitors price adjustments thus
reducing the effect of such changes.
Related Product Pricing - For example, a marketer of a new online golf instruction
service that allows customers to access golf instruction via their computer may look at
prices charged by local golf professionals for in-person instruction to gauge where to set
their price. While on the surface online golf instruction may not be a direct competitor to
a golf instructor, marketers for the online service can use the cost of in-person
instruction as a reference point for setting price.

Primary Product Pricing - For example, Bluetooth headsets are considered

complementary to the primary product cell phones. The pricing of complementary
products may be affected by pricing changes made to the primary product since
customers may compare the price for complementary products based on the primary
product price.
Political and Legal Issues
In the legal area, managers must hold on to certain laws. The law generally prohibits
companies from discriminating among their customers in setting prices. Adding up, it is
also prohibited in collusion price setting, where the major firms in an industry all agree
to set their prices at a high level.
Taking political environment to consideration, for an example, if the firms in an industry
are perceived by, the public are reaping unduly large profits; there may be political
strain on legislators to tax those profits differentially or to mediate in some way to
control price.
3.4: Assess the viability of a project using investment appraisal techniques?
Investment Appraisal
Net present value
(-2000) 1
500 (1 + r)^-12
500 (1 + r )^-13
600 (1 + r )^-14
600 (1 + r )^-15
400 ( 1 + r )^-16
There for the answer will be,
( -2000 ) 1 = -2000
500 ( 1 + 0.12 )^12 =128.33

500 ( 1 + 0.12 )^13 =114.58

600 ( 1 + 0.12 )^14 =122.77
600 ( 1 + 0.12 )^15 =109.61
400 ( 1 + 0.12 )^16= 65.24
540.53
NPV=( -2000 ) ( 540.53 )
= ( - 1459.47 )
Internal rate of value
A=5% B=10%
500 ( 1 + 0.5 )^-12= 3.85 500 ( 1 + 0.1 )^ -12=159.31
500 ( 1 + 0.5 )^-13= 2.56 500 ( 1 + 0.1 )^ -13=144.83
600 ( 1 + 0.5 )^-14= 2.05 600 ( 1 + 0.1 )^ -14=157.99
600 ( 1 + 0.5 )^-15= 1.37 600 ( 1 + 0.1 )^ -15= 143.63
400 ( 1 + 0.5 )^16= 0.60 400 ( 1 + 0.1 )^ -16=87.05
A= 10.43 B=692.81
IRRA= A+ NPVa ( b a ) %
NPVa - NPVb
= 10.43+ 10.43 692.81 10.43 %
10.43 692.81
= ( - 4710.34 )
Concepts of Payback Period
It is said to be the length of time required to recover the cost of an investment.
Calculated as:
=

The payback period is a simple technique for assessing an investment by considering

how long it would take to be repaid. Payback period is easy to calculate and is easy to
understand. In addition the payback period has limitations such as, ignorance of time
value of money and the ignorance of benefits that occur after the payback period.
For example, if a company project requires an investment of $100,000 is expected to
endow with annual cash flow of $25,000, the PP would be four years.
Accounting Rate of Return
The accounting rate of return of the investment appraisal goes under a number of
guises, with a multitude of definitions as to its calculations. There is no accepted
formula for the ARR; therefore, the management of a company should select whichever
formula suits them the best. Although a distinction is made between the accounting
rates of return based on initial investment and average investment.
The ARR is theoretically similar to payback period, and the flaws in particular, are
similar. The highlighted disparity is that it tends to favour higher risk decisions unlike the
PP, which leads to excessively traditional decisions.
Task 4
4.1: Discuss the main financial statements?
Purpose of the Main Financial Statements
Financial statements are the basic elements one need to start or manage the business.
Balance sheet
The balance sheet gives an idea of the financing structure of the company. It lists in
detail the tangible and intangible goods that the company owns or owes. These goods
can be categorized as shown below.
Assets
Current Assets
These can be easily converted in cash within a short period. Such current assets
include cash, marketable securities, accounts receivable, inventories and any other item
that could be converted into cash with a years time in the normal course of business.
Fixed Assets

Fixed assets refer to property, plant and equipment, buildings, land and machines
owned by the company. They represent long-term liquid investments and support
depreciation.
Other Assets
These include any intangible assets, such as patents, copyrights, other intellectual
property and notes receivable from employees and officers.
Liabilities
Liabilities are all the debts and obligations a company owes to outside people such as
suppliers and banks.
Cash flow Statement
The purpose of this financial statement is to keep an account of the different activities of
the council. As for the income statement, the cash flow statement covers only one year.
This also provides information on the mode of generation of funds required for payment.
Nonetheless, the cash flow statement can also be used to evaluate the cash that would
be essential to meet the operating costs.
Income Statement
This type of financial statement keeps an account of the net surplus or deficit. By having
a detailed account of the past, one can forecast and assess the future performance of
the company.
Profit and Loss Accounts
These summarize the income and expenses of a company in a given period. This can
be used to include accruals as well. The P&L can be used in computing net income for
the period and identifying major revenue and expenses items that affect net income. For
example, if a company has $10 million in monthly revenues and $7.5 million in
expenses, net income for the month is $2.5 million. The company also may review
revenue and expense accounts to identify major customers and suppliers.
Difference between the Formats of Financial Statements for Different Businesses
Difference of P&L in Partnership and Sole trade
Profit
In sole trade, the profit will not be shared among many but only the owner himself will
gain it. Yet, in partnership, the profit will be shared among two or more shareholders.

Income
In a sole trade, the income can be earned by the sole trade sales, while in a partnership
the income will be gained by shares, dividends received and by sales.
Difference of Balance Sheet in Partnership and Sole trade
Capital
The capital in a sole trade will be invested with the owners cash, while in partnership,
the capital will be by long-term loans or it can also be shareholder capital.
Debentures
Sole trade does not experience debenture, yet in a partnership, debentures can be
found.
Assets
Only a few numbers of assets are there in sole trade. In a partnership, a great number
of assets can be easily found.

Subways Franchise
INCOME STATEMENT A/C
INCOME
Sales

662,000

Cost of sales

364,100

Gross profit

81, 82

EXPENDITURE
Wages& NIC

132,400

Rates& insurance

37,200

Lighting &heating

10,800

297,900

Repairs &Renewals

600

Telephone

1800

Advertising

12000

Motor expenses

5400

Packing costs

2400

Legal& Professional fees

3000

Cleaning& Genera

l3600

Depreciation

68478

Depreciation: Vehicles

1560

Bank Charges

3000

Loan Interest

1120

283358
14542

NET PROFIT FOR THE YEAR

4.2: Compare appropriate formats of financial statements for different types of

business?
There are three types of financial statements:
It has been my experience that all watchful business owners have an innate sense of
how well their business is doing. Almost without thinking about it, these business
owners can tell you any time during the month how close they are to hitting budgeted
figures. Certainly, cash in bank plays a part, but it's more than that.

Helpful is the routine review of financial statements. There are three types of financial
statements. Each will give you important info about how efficiently and effectively your
business is operating.
Income Statement:
The income statement shows all items of income and expense for your arts or crafts
business. It reflects a specific time period. So, an income statement for the quarter
ending March 31, shows revenue and expenses for January, February and March; if the
income statement is for the calendar year ending December 31, it would contain all your
information from January 1 to December 31.
Income statements are also known as statements of profit and loss or P&Ls. The
bottom line on an income statement is income less expenses. If your income is more
than expense, you have a net profit. Expense more than income? You have a net loss.
Balance Sheet:
Accounting is based upon a double entry system - for every entry into the books there
has to be an opposite and equal entry. The net effect of the entries is zero, which
results your books being balanced. The proof of this balancing act is shown in the
balance sheet when Assets = Liabilities + Equity.
The balance sheet shows the health of a business from day one to the date on the
balance sheet. Balance Sheets are always dated on the late day of the reporting period.
If youve been in business since 1997 and your balance sheet is dated as of December
31 of the current year, the balance sheet will show the results of your operations from
1997 to December 31.
Statement of Cash Flows:
The statement of cash flows shows the ins and outs of cash during the reporting period.
You may be thinking well who needs that type of report? Ill just look at the check
book. Good point, unless youre reporting things that dont immediately affect cash such
as depreciation, accounts receivable and accounts payable.

If I could only choose one of those three financial statements to evaluate the ability of a
company to pay dividends and meet obligations (indicating a healthy business) I would
pick the statement of cash flows. The statement of cash flows takes aspects of the
income statement and balance sheet and kind of crams them together to show cash
sources and uses for the period.
4.3: Interpret financial statements using appropriate ratios and comparisons, both
internal and external?
Sole traders
Prepared accounts for their own use to know how much profit/loss for the year.
Partnerships
Prepared accounts to get to the profit and how it should be distributed among partners.
There is no legal obligation to produce any accounts, but sometimes it does help if they
are applying for a loan /mortgage.
Public and Private company
They are legally obliged to be registered by the company house and to follow the
required rules, policies and procedures. Therefore they are legally obliged to prepare a
set of accounts for each accounting year, showing the following,
Income Statement for the period ending
Statement of movement in Equity for the period ending
Balance sheet
Cash flow statement showing operational, investing and Dividend transactions
Bear in mind management can change depreciation policy and showing less profit. The
change of policy cannot be change very often and should be explain before it does.
Accounts should be prepared according to saps and proper accounting conditions.

Company can vary the mixture source of finance like your company but they have
different area with particular risk and demand.
Analysis of Financial Statements using ratios and comparisons, both internal and
external
Gross Profit Margin
The figure shows the company is very healthy and is producing a high return comparing
the cost of sales to the revenue
Net Profit Margin
The figure shows a drastic decline compare to gross profit as its due to level of activity
(107 to 175 Number of stores) which has increased thus reflect the increase in
expenses and running cost.
Net Profit margin after tax
The decrease between the PBIT and PAIT is the effect of the debenture interest (10%)
and tax incurred during the year.
Interpretation of Financial Statements (Using UK GAAP)
Profitability ratios
Return on capital employed (ROCE)
Capital employed is normally measured as fixed assets plus current assets less
current liabilities and represents the longterm investment in the business, or
owners capital plus longterm liabilities. Return on capital employed is frequently
regarded as the best measure of profitability.
ROCE =
Capital employed
Profit before interest and taxation (PBIT) 100%
Note that the profit before interest is used, because the loan capital rewarded

by that interest is included in capital employed.

A low return on capital employed (assets used) is caused by either a low profit
margin or a low asset turnover or both. This can be seen by breaking down the
primary ROCE ratio into its two components: profit margin and asset turnover.
ROCE =
Capital employed
PBIT
=
Sales
PBIT
Capital employed
Sales
= Profit margin Asset turnover
Profit margin (on sales)
Margin =
Sales
Profit before interest and taxation 100%
A low margin indicates low selling prices or high costs or both.
Asset turnover
This will show how fully a company is utilising its assets.
Asset turnover =
Capital employed
Sales
Liquidity ratios and asset utilisation
Current ratio

This indicates the extent to which the claims of shortterm creditors are covered
by assets that are expected to be converted to cash.
Current ratio =
Current liabilities
Current assets
Acid test ratio (quick ratio)
This is calculated in the same way as the current ratio except that stocks are
excluded from current assets.
Acid test ratio =
Current liabilities
Current assets - Stock
This ratio is a much better test of the immediate solvency.
Debtors ratio
This is computed by dividing the debtors by the average daily sales to determine
the number of days sales held in debtors.
Average collection period =
Credit sales
Trade debtors 365 days
Creditors ratio
This is computed by dividing the creditors by the average daily credit purchases
to determine the number of days purchases held in creditors.
Average payment period =
Credit purchases
Trade creditors 365 days
Stock turnover

This ratio indicates whether stock levels are justified in relation to sales. The higher
the ratio, the healthier the cash flow position.
Stock turnover =
Stocks
Cost of sales
Stock turnover can also be calculated in days as:
Stockholding period =
Example
Now calculate all of the above ratios on the following profit and loss account and
balance sheet for a company called JG Ltd.
SUMMARISED BALANCE SHEET AT 31 DECEMBER 20X8
000 000
Fixed assets 2,600
Current assets
Stocks 600
Debtors 900
Balance at bank 100
_____
1,600
Trade creditors 800
_____
800
_____
3,400
Debenture stock 1,400
_____
2,000
_____
Capital and reserves
Ordinary share capital (1
shares)
1,000
Preference share capital 200
Profit and loss account 800
_____
2,000
_____
SUMMARISED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31
DECEMBER 20X8

000
Sales 6,000
Cost of sales (including purchases 4,300) 4,500
_____
Gross profit 1,500
Administrative and distribution costs 1,160
_____
Trading profit 340
Debenture interest 74
_____
Profit before tax 266
Taxation 106
_____
Profit after tax 160
Preference dividend 10
_____
Profit available for ordinary shareholders 150
Ordinary dividend 10
_____
Retained profit 140
_____
-6Solution
ROCE = 10% 340/3,400 100%
Profit margin = 5.7% 340/6,000 100%
Asset turnover = 1.8 times 6,000/3,400
Gross profit margin = 25% 1,500/6,000 100%
Return on owners equity = 14.2% (266 10)/(1,000 + 800) 100%
Current ratio = 2 times 1,600/800
Acid test ratio = 1.25 times (900 + 100)/800
Debtors ratio = 55 days 900/6,000 365 days
Creditors ratio = 68 days 800/4,300 365 days
Stock turnover = 7.5 times 4,500/600
Earnings per share = 15p 150/1,000
Dividend cover = 15 times 150/10
Gearing = 47% (1,400 + 200)/3,400 100%
Interest cover = 4.6 times 340/74

References
http://www.ukessays.com/essays/finance/managing-financial-resources-anddecisions.php#ixzz2E0F1TYuW

http://www.extension.iastate.edu/agdm/crops/html/a1-19.html
http://www.citefin.com/152-investment-appraisal-methods-considerations.html