MBA Finance Investors Report. Assignment: You’re working in the Finance department of Wayne Enterp

MBA Finance Investors Report. Assignment: You’re working in the Finance department of Wayne Enterprises. Your company has experienced a high volume of sales and therefore it has more liquid assets (cash) then initially anticipated. Your line manager, in an attempt to diversify the portfolio, is thinking of investing £0.5 Million in shares of Tesco plc. Your line manager has asked for your opinion on the matter and has highlighted two main concerns about the potential investment; which are: the riskiness of the investment and whether the company is profitable. The financial statements of the company in their annual reports. You are required to use the accounting figures from the before exceptional items in your analysis. – See attached – Annual Report of Tesco – Attached are the module units of course work that is to be used in writing the report on Tesco PLC (Units 1 – 12) – Especially Unit 5 which focuses on Ratios, and particularly the investors ratios The coursework should be in essay format and must be structured, with separate sections and, preferably, headings. Your essay should be 1600 – 2000 of your own words, it should be Word processed and you must keep a copy. State the word count at the end – this can be found on the ‘Tools’ tab on the menu bar in word. This word limit will require you to be selective in what you include. More marks are available for your own discussion and observations than for sections taken from books or websites. Any material that you quote or refer to in your work must be referenced fully giving details of its source, author etc. and use the APA 6th referencing system in the assignments. It is not acceptable to include large sections from such sources and journal articles: the vast majority of the essay should be in your own words.

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Global online I Core reading

Finance for Management Decision-
Making

James Brown

Donald MacAskill

Andy Moffat

Release 1.1 2012

www.napier.ac.uk/business-school

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Published by Edinburgh Napier University

The rights of James Brown, Donald MacAskill and Andy Moffat to be identified as authors of this work have been asserted by
them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988.

Apart from any fair dealing for the purpose of research or private study, or criticism or review, as permitted under the Copyright,
Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with
the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and
licenses issued by the Copyright Licensing Agency.

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enu-fmd-bk-en-GB January 6, 2015 – 15:22 3

iii

Contents

1 Financial Reporting 1
1.1 Introduction 1
1.2 Annual Reports 1
1.3 Users of Financial Reporting 6
1.4 Characteristics of Accounting Information 8
1.5 Summary 10

2 Basic Financial Statements 11
2.1 Introduction 11
2.2 Accounting Concepts 11
2.3 Financial Statements 14
2.4 Summary 30

3 Limited Liability Companies 33
3.1 Introduction 33
3.2 Types of Business Entities 33
3.3 Financial Statements of Limited Liability Companies 35
3.4 Statement of Changes in Equity 40
3.5 Regulatory Framework 40
3.6 International Accounting Standards 43
3.7 Consolidated Financial Statements 43
3.8 Summary 45

4 Profit v. Cash 47
4.1 Introduction 47
4.2 Cash Budgeting 49
4.3 Cash Flow Statements 53
4.4 Summary 56

5 Interpretation of Financial Statements 59
5.1 Introduction 59
5.2 Ratio Analysis 60
5.3 Shareholders’ Investment Ratios 70
5.4 Limitations of Ratio Analysis 71
5.5 Summary 71

6 Segmental Reporting 73
6.1 Introduction 73
6.2 Discontinued Operations 74
6.3 Segmental Reporting 76
6.4 Summary 80

7 Management Accounting 81
7.1 Introduction 81
7.2 Financial v Management Accounting 82
7.3 Main Purposes of Management Accounting 83
7.4 Cost Accounting 88
7.5 Job and Service Costing 99
7.6 Summary 104

8 Decision-Making − Cost Behaviour 107
8.1 Introduction 107
8.2 Cost Behaviour 108
8.3 Breakeven Analysis 111
8.4 Decision-Making 114
8.5 Summary 117

9 Decision-Making − Relevant Information 119
9.1 Introduction 119

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Contents

9.2 Relevant Costs 120
9.3 Limiting Factors 124
9.4 Multiple Limiting Factors 126
9.5 Uncertainty 130
9.6 Attitude to Risk 133
9.7 Qualitative Factors 134
9.8 Summary 134

10 Performance Management 137
10.1 Introduction: The Crisis in Management Accounting 137
10.2 The Development of Strategic Management Systems 138
10.3 The Balanced Scorecard 138
10.4 Stern Stewart’s Economic Value Added (EVA)TM 142
10.5 Summary 147

11 Capital Investment 151
11.1 Introduction 151
11.2 Payback 152
11.3 Accounting Rate of Return 154
11.4 Discounted Cash Flow 155
11.5 Net Present Value 156
11.6 Internal Rate of Return 159
11.7 Summary 161

12 Working Capital Management 163
12.1 Introduction 163
12.2 Inventory 164
12.3 Trade Receivables 167
12.4 Trade Payables 170
12.5 Cash 171
12.6 Summary 173

Index 175

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Chapter

Chapter
1

Financial Reporting

1.1 Introduction 1
1.2 Annual Reports 1
1.3 Users of Financial Reporting 6
1.4 Characteristics of Accounting Information 8
1.5 Summary 10

Learning Objectives

After completing the study of this unit you should be able to:

• identify the key contents in a company’s annual report

• list a number of different user groups who might be interested in reviewing aspects of a
company’s annual report

• appreciate the useful characteristics that information in the annual report should possess

• reflect on the objectives of financial reporting.

1.1 Introduction

Public limited companies are required, after each year-end, to publish their annual report and
accounts. This document is sent to each of the shareholders of the company so that they
can review how well the directors, who have been appointed by the shareholders to run the
business on their behalf, have handled the company’s affairs over the past year.

The document includes financial statements, which report firstly on the company’s perform-
ance over the trading period, in particular whether the company has achieved growth during
the year, and secondly on the company’s financial position at the end of the year. The report
is also used as a guide to predict what might happen in the future. For this reason, the annual
report contains a lot of narrative identifying events which have influenced past performance,
and changes that are likely to occur in the future.

Copies of the annual report and accounts must also be filed with the Registrar of Companies
so that they are available for public inspection. Copies are also often sent to the company’s
key customers, suppliers and other stakeholders.

Large companies also issue interim reports every six months to update their shareholders,
primarily on financial matters, but these interim reports are on a much less detailed scale than
the annual report.

1.2 Annual Reports

The annual report and accounts of a public limited company (plc in the UK) usually takes
the form of a glossy booklet. This booklet tries to combine positive promotional messages
from the management team, which often includes coloured pictures and graphs, with the
not-so-exciting, statutory, legal and financial information.

The subsections which follow should give you an idea of what you might expect to find in a
typical company’s annual report. In an attempt to link into the real world, the information on
a recent annual report of Vodafone plc is included at the end of most sections.

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Note: As the company is based in the UK, references may be made in the text to legal and
statutory requirements for UK financial reporting. However the study text will also make
reference to the International Accounting Regulations which are mandatory for multi-national
enterprises such as Vodafone.

1.2.1 Operating and Financial Review

The professional accounting bodies in the western world have recommended that large com-
panies should include an operating and financial review (OFR) in their annual report and
accounts.∗ The reason for this suggestion was that, over the past 20 years or so, businesses
had become much larger, more diversified, more multinational, and therefore, much more
complex. For many users it was becoming increasingly difficult to understand the information
contained in financial reporting because complex financial and organisational structures made
it harder to interpret the results.

The OFR gave the directors of a company an opportunity to discuss and explain, in a structured
and comprehensive way, some of the key factors affecting the business and the environment
in which it operates. The OFR covers two main areas:

• the operating review includes a discussion of the results for the period, indicating the
factors that may affect future performance, and a discussion on the areas in which the
business is investing to meet these future challenges

• the financial review covers aspects such as the capital structure of the business, current
debt position and future borrowing requirements, cash flow, treasury activities and the
tax situation.

Although not mandatory, most companies regard the inclusion of an OFR in the annual report
as good practice.

The OFR in the annual report of Vodafone plc is a mixture of graphs and bar charts covering
results, operations, product volumes, market shares and financial data. It is presented in a very
user-friendly manner and gives the reader a good insight into what happened in the past and
where the company might be heading in the future.

1.2.2 Chairman’s Statement

Another statement that is not mandatory, but which you often find early in the annual report,
is a statement from the chairman. This gives the chairman of the company an opportunity to
report on the performance of the organisation during the past financial period and on likely
future developments.

The chairman of Vodafone plc included a discussion on the following in his statement:

• summary results and comment on the market position of each business segment

• economic issues affecting performance, for example effects of the recent financial crisis

• continued cost improvements in production and distribution without any loss to customer
service

• acquisitions and disposals

• changing focus of the business for the future.

Typical of a chairman’s statement, the report is extremely positive, leaving the owners with
the belief that shareholder returns would improve as the company faced the future with
confidence.

The US equivalent is management discussion and analysis.∗

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1.2.3 Chief Executive’s Statement

Chief executives’ statements include a lot more about the detail behind the overall perform-
ance. The operation of the business is broken down into products, markets and geographical
areas of activity and a review of these operations outlines the factors affecting current per-
formance and expected changes for the future. The statement will include some brief financial
highlights including the recommended dividend payable to shareholders.

Vodafone plc covered the following in its chief executive’s report:

• turnover, profit and the recommended final dividend, which had all risen

• a report of the international divisions, highlighting market share gains, cost savings,
increased production efficiency and strong international growth.

1.2.4 Directors’ Report

The Companies Act 2006 (UK Law) states that each year the directors are to prepare a
report that gives information, among other things, about the activities of the business, its role
in the community and its dividend recommendations. The directors’ report should also make
shareholders aware of material movements in the ownership of the issued share capital.

Vodafone plc used the following subsections to comply with the statutory requirements of a
directors’ report:

• group results

• dividends

• business review and future developments

• special business from the annual general meeting

• share capital movements

• payment of suppliers

• directors

• employee relations and involvement

• political and charitable contributions

• auditors.

Following the publication of the Cadbury Committee report in 1992, the directors’ report
must now include a section on corporate governance, defined by the Cadbury Committee as
‘the system by which companies are directed and controlled’.

During the 1980s and 1990s, financial scandals like BCCI and Polly Peck led to a lack of
confidence in many aspects of financial reporting, with shareholders questioning whether they
could depend on auditors to provide the necessary safeguards for their reliance on company
annual reports and accounts. The directors’ report should now include details about the
company’s system of internal control and its committee structure.

If you doubted the significance of corporate governance, then a review of the annual report
of Vodafone plc ought to reassure you because there are several pages devoted to this topic.
Areas covered include:

• how the Board of Directors functions

• communication with institutional and private shareholders

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• the workings of the Accountability and Audit Committee

• the Board remuneration report

• statement of going concern.

As an area, corporate governance will always be relevant to the providers of accounting
information. The Cadbury Code, for example, was followed by the Greenbury, Hempel,
Combined and, more recently, the Higgs and Walker Review in 2010. You can access these
codes and evaluate their contribution to the development of corporate governance at the
website www.ecgi.org/codes/all_codes.php

1.2.5 Annual Accounts

The annual accounts section of an annual report usually contains three areas:

1. Financial statements

International Accounting Standard 1 (IAS1) covers the form and content of financial
statements and the main components are likely to be: the income statement, the balance
sheet, the statement of changes in equity and the cash flow statement. Taken together,
these statements tell you how the company performed over the trading period and what
its financial position is at the end of the trading period. You will learn a lot more about
these statements as you work through the study units.

If the company operates as part of a group, the results of all the group members are
consolidated and the financial statements listed above will be presented in consolidated
form.

2. Accounting policies

Immediately following the financial statements in the annual report is a listing, required
by the Companies Act, of the accounting policies adopted by the company in determining
the amounts shown in the income statement and the balance sheet. Policies can cover
such areas as how inventory (UK: stock) was valued or how research and development
expenditure is accounted for.

3. Notes to the accounts

In order to keep the main financial statements as user-friendly as possible, only the key
figures are required to be disclosed on the face of the statements. The detail behind each
of these figures is relegated to the supporting disclosure notes.

In summary, the criteria for selecting information to appear in the published financial statements
are as follows:

• the statements should present a true and fair view of the profits, assets and liabilities

• the information must comply with fundamental accounting concepts

• the statements should be presented in the prescribed formats

• the detail behind the key figures on the statements should be disclosed by way of notes
to the accounts.

The accounts section in the annual report of Vodafone plc consists of the group income
statement, the group and parent company balance sheets, the group statement of changes in
equity and the group cash flow statement. Following these statements are pages of ‘notes to
the accounts’, which include the accounting policies adopted by the company. The financial
statements and related notes are presented alongside comparative figures for the previous

http://ecgi.org/codes/all_codes.php

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Chapter

1Financial Reporting

trading period, enabling users to see, at a glance, significant movements in the key financial
areas.

1.2.6 Audit Report

Another statutory requirement for most limited companies is an annual audit of the accounts.
To safeguard the interests of the shareholders, who are often not involved in the day-to-day
running of the business, an external, independent firm of accountants is appointed by the
shareholders to act as auditors. Their duty is to report objectively to the shareholders as to
whether, in their opinion, the financial statements show a true and fair view and comply with
statutory, regulatory and accounting standards’ requirements. Having made reference to the
respective responsibilities of the directors and auditors in preparing and reviewing the annual
report, the audit report then concludes with an opinion of the accounts and the state of the
company’s affairs.

1.2.7 Environment Report

Over the past 10 years or so, companies have come under more and more pressure from
the general public to include comments in their annual reports about environmental and
social issues. Environmental issues naturally focus on recycling, pollution and the treatment of
waste. Social issues may include equal opportunities employment, health and safety, training
and the role the company plays in the local community. The increased attention paid to these
topics, follows concerns that traditional reporting, with its financial emphasis, has been geared
towards the requirements of the shareholders, with perhaps too little regard for the other
stakeholders. Although there is no compulsory requirement for companies to comment on
environmental and social issues, and there is no consensus on the best practice for reporting
these topics, most large companies have reacted positively to the need for such reporting.

Vodafone plc devote a couple of pages within the annual report to ‘our stakeholders’, clearly
deeming their stakeholders to be employees, shareholders, the community and environment-
alists. Key issues affecting each of the stakeholders are only covered in ‘bullet point’ format
within the annual report.

1.2.8 Five-year Record

A common debate among financial analysts is the issue of how many year’s worth of figures they
need to review before determining whether or not a trend can be established. Comparative
figures from the previous year’s financial statements are presented alongside the current year’s
figures for ease of comparison. However, to enable further interpretation, companies often
include a five-year summary of some of their key financial data.

Vodafone plc include the following data in their five-year summary:

• sales

• profit

• assets employed

• loans

• share capital

• dividend per share

• earnings per share.

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1.2.9 Notice of Annual General Meeting (AGM)

At the end of the annual report, shareholders are given notice of the time, date and venue of
the company’s AGM. Shareholders who own any voting shares, will be entitled to vote on a
number of different issues to be considered at the meeting.

The shareholders of Vodafone plc were to consider the following resolutions at its AGM:

• approve the Report of the Directors and the Annual Accounts

• re-elect the directors

• re-appoint the auditors

• special business.

1.3 Users of Financial Reporting

The objective of financial reporting is to provide information that is useful to a wide range of
users, both internal and external to the enterprise. This information will encompass details
about the financial position, the financial performance and changes in the financial condition of
an organisation. Financial reporting consists of the financial statements as well as supplementary
information provided by way of commentaries, forecasts and appraisals.

So who needs financial information, what do they need to know and what might they have
found in the latest annual report of Vodafone plc?

The main users are shown in Figure 1.1.

Figure 1.1 Main users of financial reporting

1.3.1 Shareholders/Investors − Current and Potential

These are the people who have invested in the company and, as shareholders, are part-owners
of the organisation. However, having appointed the directors to look after their investment,
they need to check how effectively the management team is running the business. As the
providers of the equity capital, they are primarily interested in the return they might receive
from their investment and the risk associated with it. In the short term, returns should come
in the form of an annual dividend while, hopefully, in the longer term, the capital value of their
investment will increase as the company prospers.

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Current shareholders need to decide whether to retain or dispose of their investment, while
potential investors need to weigh up the costs and benefits of making the investment. Both
investors and shareholders need information about the profitability of the business in order
to assess its financial strength and future prospects.

1.3.2 Suppliers

Suppliers are primarily interested in the ability of the company to meet its obligations and pay
for goods and services received on an ongoing basis. If the supplier is highly dependent on
the reporting company for a substantial proportion of its business, then it is likely to have an
increased interest in the company’s long-term viability as well.

Suppliers to Vodafone plc would have been interested in the following:

• market expansion

• current creditors’ payment period

• reliance on debt to finance the business.

1.3.3 Competitors

With all users having easy access to the annual reports of public limited companies, directors
need to be very careful when considering the content, particularly non-statutory, to be included
in the annual report. A balance needs to be struck between providing relevant information
to the company’s stakeholders while at the same time ensuring their rivals cannot gain any
competitive advantage.

Competitors will want information on market share, product performance, financial strength
and capital structure. They may be looking at the possibility of a take-over or a merger. Perhaps
they are looking to invest in new products and new markets to pose even more of a threat
within the industry.

1.3.4 Customers

The interest of customers in the financial results of a company depends on the extent to
which the customer is dependent on the company for supply of the product. The customers
of Vodafone plc should take heart from the statement of the annual review, ‘investing to
satisfy our customers’, which makes reference to training and marketing initiatives to ensure
customer satisfaction.

1.3.5 Employees

In the short term, employees, and those who represent them, are interested in the ability of the
company to pay their weekly wages or monthly salaries. Looking to the longer term, employees
will assess the potential for their continued employment and possible wage increases.

Potential employees, in addition to ensuring that remuneration will be paid, will review the
annual report for evidence of value added. Does the company invest in training? What might
future career prospects be like? Does the company operate an employee share scheme? Does
it encourage employee involvement in the running of the business? What are its environmental
and social policies?

1.3.6 General Public

Businesses affect the general public in a variety of different ways, perhaps as employers or
customers or suppliers. A particularly large business can have a dominant role in the running

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1 Finance for Management Decision-Making

of the local economy and the financial statements produced by such a company may provide
the local community with information which can be used to deduce the extent of future
contributions.

As mentioned earlier when considering environmental issues, there are particular interest
groups in society who want to gauge the company’s views on social, political and environmental
issues.

1.3.7 Government

The Government requires information in order to regulate the activities of companies, determ-
ine taxation policies and collect VAT, income tax, corporation tax and customs and excise
duties. They are also looking for potential beneficiaries of grants and other financial assist-
ance. Often the information required by the Government will come from particular industrial
and commercial sectors, but in certain circumstances they will still rely on general-purpose
financial statements.

1.3.8 Investment Analysts

Individual and institutional investors often employ the skills of stockbrokers and other analysts
to make their investment decisions. Therefore, these analysts need to know about all aspects
of a company’s performance, from the quality of earnings to the solvency situation. Linking
this to the strength of the company’s management team, the analysts will then weigh up the
risks and rewards of investing in individual companies or specific business sectors.

1.3.9 Political Parties/Charities

If contributions for political and charitable purposes together exceed £200, companies are
obliged to disclose this in the directors’ report. By reviewing annual reports, charities or
political parties that are looking for funding can often get an indication of the type of events
that companies might sponsor or a feel for the company’s political tendencies.

1.3.10 Lenders

Lenders are interested in knowing firstly whether the interest due on the loan will be paid
and, perhaps more importantly, that at some future date the loan itself will be repaid. Their
principal concern, therefore, is with the company’s solvency and cash-flow situation, although
a review of the organisation’s profitability may be an indicator that future cash flows will be
generated.

Potential lenders will be interested in the current level of borrowings and the ability of the
company to meet its annual debt commitments. They may also review the resources owned
by the company to see if loans granted could be secured against the assets of the business.

1.3.11 Managers/Directors

Although managers and directors are more likely to be using management accounts and other
internal information to aid decision-making, they will still treat the annual report as the starting
point for the future.

1.4 Characteristics of Accounting Information

A variety of different user groups seek financial information for their personal use. In order
for this information to be useful to the users, the accounting data from which it is prepared,
along with its analysis and presentation, must contain certain basic characteristics, as shown
in Figure 1.2.

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Chapter

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Figure 1.2 Characteristics of accounting information

1.4.1 Relevance

For information to be useful, it must be relevant to the needs of the users. It must possess
qualities that will influence the users in making their decisions about the enterprise. This may
be past information, it may be new information about the future or it may be information that
causes the users to change their views about the organisation.

1.4.2 Reliable and Objective

For information to be useful it must also be reliable. Users should be able to depend on the
financial statements as a faithful representation of the transactions and events that occurred
over the trading period. Financial statements that are ‘window dressed’ to present a picture
that the directors of the company would like to present, rather than the picture that reflects
the economic reality, are not objective financial statements. Freedom from bias is a basic
requirement for reliability.

Reliability is often taken to imply prudence as well. User groups like the assurance that, if
anything, the picture painted by the financial statements underplays the profitability of the
company and understates the enterprise’s financial position.

1.4.3 Comprehensibility

If the users are going to make good use of the financial information presented, then the
information must be clear and understandable. Of course, there will always be accounting
technicalities and complex business issues with which the non-financial user will have dif-
ficulties. However, the challenge for the directors preparing the financial statements is to
present these issues in a manner that is as easy to understand as possible.

1.4.4 Timeliness/Cost−Benefit
Clearly, the more out of date information becomes, the less useful it is going to be for the
user. Timely information is needed to support good decision-making. This is a problem for
companies. By the time the accountants have prepared the annual accounts, the external
auditors have audited the accounts and the directors have prepared and published the annual
report, the financial information is likely to be four or five months out of date. However, this
is about as timely as companies can make it given the legal requirements with which they are
asked to comply.

Another balance that needs to be struck is the one between cost and benefit. Improved
relevance and reliability, and therefore benefit to the user, can be achieved by preparing a 500-
page annual report but the cost of preparing and dispatching this to thousands of shareholders
may well severely damage the business.

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1.4.5 Completeness

Information presented in financial statements has to be complete. Users do not want to hear
only the good news. Relevant bad news is likely to be just as, if not even more, important than
good news to those making key economic decisions. It is, …

Financial Management for Decision Making ACC11407

Assignment – Part 1

This part of the assessment is due on: 8 March 2019 (week 8)

You’re working in the Finance department of Wayne Enterprises. Your company has
experienced a high volume of sales and therefore it has more liquid assets (cash)
then initially anticipated. Your line manager, in an attempt to diversify the portfolio, is
thinking of investing £0.5 Million in shares of Tesco plc.

Your line manager has asked for your opinion on the matter and has highlighted two
main concerns about the potential investment; which are: the riskiness of the
investment and whether the company is profitable. The financial statements of the
company in their annual reports. You are required to use the accounting figures from
the before exceptional items in your analysis.

Annual Report of Tesco attached:

https://www.tescoplc.com/media/474793/tesco_ar_2018.pdf

REQUIRED:

(a) Calculate appropriate ratios for the years 2017 and 2018. (20%)
(b) Comment on the ratios calculated indicating whether the 2018 figures

are an improvement on 2017. (20%)
(c) Identify any other information, you feel would be useful from the

annual report, to give a better overall picture of how Tesco plc is
performing. (30%)

(d) Advise your line manager, with reasons, whether she should invest. (20%)
Note: the final 10% of the grade will be allocated for presentation and

referencing. (10%)

https://www.tescoplc.com/media/474793/tesco_ar_2018.pdf

https://www.tescoplc.com/media/264194/annual-report-2016.pdf

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Chapter

Chapter
3

Limited Liability Companies

3.1 Introduction 33
3.2 Types of Business Entities 33
3.3 Financial Statements of Limited Liability Companies 35
3.4 Statement of Changes in Equity 40
3.5 Regulatory Framework 40
3.6 International Accounting Standards 43
3.7 Consolidated Financial Statements 43
3.8 Summary 45

Learning Objectives

After completing this unit of study you should be able to:

• distinguish between different types of business enterprise

• prepare the financial statements of a limited liability company

• appreciate the regulatory framework that surrounds the preparation of financial state-
ments for a limited liability company

• recognise that companies eventually become part of a group.

3.1 Introduction

There are three main categories of business entity:

• sole traders

• partnerships

• limited liability companies.

In Chapter 2, when we looked at the preparation of accounts, it was the sole trader’s finan-
cial statements that we focused on. This unit extends those statements to incorporate the
requirements for a limited liability company and considers the environment within which such
an entity operates. But before we do that, let’s consider each of the business entities noted
above.

3.2 Types of Business Entities

3.2.1 Sole Trader

The sole trader business is one which is owned and financed by one individual. It often starts
because the sole trader comes up with a good idea which he or she thinks might generate a
profit. The individual has complete flexibility in the way in which the business is conducted
because he or she is the sole decision-maker.

Unlike limited companies, a sole trader does not have to file a formal report and accounts each
year with a government bureau. However, accounting information will still have to be prepared
because the tax authorities will require annual accounts for tax purposes. Additionally, the

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Finance for Management Decision-Making

banks may need such information if a sole trader is seeking additional finance to expand the
business.

Although many businesses start out as sole traders, it is often hard to expand this type of
business because the individual can have difficulty arranging the necessary finance. The main
problem, however, is that legally a sole trader is not separate from the business. Therefore, if
the business is not successful, the sole trader must make good any losses, either from selling
the assets in the business or from selling personal possessions like the family home. Being a
sole trader can, therefore, be risky because you do not have the limited liability protection to
which shareholders of a company are often entitled.

3.2.2 Partnerships

Partnerships are very similar to sole traders except that the ownership of the business is
in the hands of two or more people. Now we have at least two bodies to help finance the
entity and, very likely, a pooling of business skills to operate more efficiently than a sole trader.
Generally, partnerships are run in accordance with a formal partnership agreement, setting
out responsibilities, profit-sharing splits and how much capital each partner should input to
the business.

In law, partners have ‘joint and several’ liability, effectively meaning that the creditors of a
partnership can call on any one partner (through business or private means) to settle the
debts of the partnership. It would then be up to that partner to seek redress from the other
partners.

For accounting purposes, the partnership is seen as a separate economic entity requiring
annual accounts to be prepared for the banks and the tax authorities.

3.2.3 Limited Companies

The big risk of being a sole trader or a partner in a partnership is that you stand to lose
your personal possessions if the business fails. That risk alone is enough to deter people from
starting or expanding a business. It became apparent in the 19th century in the UK, as the
country moved from an agricultural to an industrial economy, that industrial companies would
require large investments of capital to develop their entities. This investment could be raised
only if the owners of the business were protected from personal financial risk. The solution
was to provide the owners with limited liability so that although the business might fail and the
owners might lose the monies they invested in the business, their personal wealth was safe.

A limited company is, therefore, a legal entity separate from the owners of the business. The
entity may be a private limited company, which is prohibited by law from offering its shares to
the public. This is most often appropriate to family controlled businesses. Alternatively, the
entity may be a public limited company, which is permitted to offer its shares to the public. In
both types of entity, the owners are called shareholders because they share the ownership of
the business, whether it is sharing the profits in the good times or the losses in the bad times.

Because limited liability is a great privilege for the owners, companies are subject to much
more onerous regulations than sole trader and partnership businesses.

Although the precise detail may differ from country to country, there is likely to be a national
legal requirement governing accounting in general and the specific accounting records that
companies must maintain. Additionally, companies will be asked to comply with national and
international financial reporting standards, which seek to harmonise financial reporting across
the globe. Section 3.6 will cover these and other regulations in more detail.

For accounting purposes, the requirements for private and public limited companies are exactly
the same. The companies must produce annual accounts that are filed with a government
bureau and are, therefore, made available to the public.

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Limited Liability Companies

3.3 Financial Statements of Limited Liability Companies
Before we look at the income statement and the balance sheet of a limited liability company,
we need to consider how a company is financed by its owners. In the sole trader’s financial
statements that we looked at in Chapter 2, the investment by the owner was known as capital.

The capital of a company, however, is called share capital because the capital needed to finance
companies is divided into shares of a nominal or par value. The company will determine the
maximum share capital that it is ever likely to need to raise and this is called its authorised share
capital. The amount of shares actually in issue at any point in time will be set at a level to meet
its requirements in the foreseeable future. These shares are called the issued share capital. The
number of issued shares multiplied by the nominal value of the share will represent the value
of the share capital on the balance sheet.

However, the nominal value of a share is only likely to be the same as the market value of
a share when the company is newly established. If new shares are issued once a company
has started trading then they are likely to be issued at a price above the nominal value. The
difference between the market price and the nominal value of a share represents the share
premium (see section 3.3.14).

The two main categories of share capital are:

• ordinary shares

• preference shares.

3.3.1 Ordinary Shares

These are the equity shares in the business and the most common type of share capital. It
is the ordinary shareholders who exercise control over the company’s affairs because it is
the ordinary shares that are the voting shares. However, these are also the risk-taking shares
because it is the ordinary shareholders who are last in line when it comes to receiving a return
on their investment. Ordinary shareholders are entitled to all the profits in the business
but only after interest has been given to lenders, tax has been given to the tax authorities
and preference dividends have been set aside for the preference shareholders. Clearly, if the
business has a successful year then the ordinary shareholders stand to gain the most, but if
the company fails then they risk losing everything.

3.3.2 Preference Shares

Preference shares are usually non-voting shares, but, as their name suggests, they have priority
treatment over the ordinary shareholders in terms of receiving a dividend and with the
repayment of capital in the winding-up of a company.

Preference shares are generally regarded as a safe investment because you know exactly the
annual return that you are going to receive. The dividend is based on the capital you invested
rather than the performance of the company over the trading period, for example, if you
bought 10,000 (5%) £1 preference shares then your annual dividend would be £500 (10,000
shares × 5p per share).

3.3.3 Income Statement

Legislation prescribes two main formats which companies may use to prepare their income
statements. The format chosen depends on how the company wishes to show its expenses.
Format 1 shows expenditure by function while format 2 shows expenditure by type.

As format 1 is the more popular format, this is the format that we will use throughout the
module.

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Specimen plc − Format 1

Income statement for year ended 31 March 20×6

£000 £000

Revenue 1,000

Cost of sales 400

Gross profit 600

Distribution costs 120

Administration costs 70 190

410

Other operating income 20

Operating profit 430

Interest payable 30

Profit before tax 400

Taxation 120

Profit for the period 280

3.3.4 Expenses

Format 1, particularly popular with manufacturing companies, classifies expenses by function.
Effectively, all the expenses of running the business are categorised under one of four headings,
making the income statement a bit more user-friendly.

The headings are:

• cost of sales which deals with all the production-related costs associated with manufac-
turing the product, for example raw materials, machinery depreciation

• distribution costs which deal with all the selling and distribution costs involved in getting
the product to the customer, for example advertising, sales commission, depreciation on
distribution vehicles

• administration costs which cover the general costs of running the business, for example
stationery, telephone, photocopying, audit fee

• interest payable which refers to the annual cost of servicing borrowed monies used to
finance the business.

In the sole trader’s income statement, once expenses have been deducted from the revenue,
the resultant profit belongs to the owner and is added to the capital in the balance sheet. For
companies, the income statement needs to be extended to explain how much of the profit is
distributed to the tax authorities and how much is retained to plough back into the business
for future growth.

3.3.5 Company Tax

Companies, as separate legal entities, are responsible for their own tax. This differs from sole
traders and partnerships where the liability rests with the individual owners and partners. In

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nearly all countries, companies are taxed on the basis of their trading income. In some coun-
tries, this may be called corporation or corporate tax but the terminology of the international
accounting standard on taxation (IAS 12) calls it corporate income tax.

Companies pay corporate income tax (currently around 26% in the UK for a medium- to
large-sized company) on their taxable profits for the year. Taxable profits essentially comprise
the net profit before dividends, adjusted for certain items where the tax treatment may differ
from the accounting treatment.

For example, in the UK, depreciation is the most common example of an expense that the tax
authorities do not consider to be tax deductible. However, to counter depreciation being a
disallowable expense, companies are given capital allowances when capital investment is made
in the business.

The amount of tax to which an enterprise is assessed on its profit for an accounting period
is often referred to as its tax liability. For many countries, the payment date for corporate
income tax is after the end of the accounting period to which the tax relates; for example,
in the UK, corporation tax is paid nine months after the end of the relevant trading period.
Therefore, as well as the tax being a charge in the income statement for the period, the tax
figure will also appear as a liability in the year-end balance sheet because it is effectively an
accrued expense.

3.3.6 Profit for the Period

The profit after tax is the increase in the wealth of the company and, therefore, belongs to
the shareholders.

3.3.7 Dividends

If the company has preference shareholders then they, of course, have a fixed right to a
slice of this profit after tax because they are entitled to their preference dividend. Ordinary
shareholders will usually be paid a dividend, but the level of the dividend is likely to depend
on the profits achieved during the period. The directors, who run the business on behalf of
the shareholders, now have a tricky decision to make. How much of the profit for the period
should be distributed to the ordinary shareholders in dividends and how much should be held
as retained earnings to be reinvested in the future operations of the business?

It is generally the practice that ‘blue-chip’ companies will pay out between 30% to 40% of
their profits in the form of dividends. This leaves sufficient in the business for development
but at the same time gives the company a cushion should profits not reach similar levels in the
future. Shareholders are most displeased when the dividend offered in one year is less than
the dividend they got the previous year. By not paying all the profits out in dividends in any
one year, the business is keeping some profit in reserve, which could be used to pay dividends
in future years.

Dividends tend to be paid twice a year. An interim dividend, usually a fairly small amount, is
paid during the year. This interim dividend is effectively a charge against the company’s profit
and may be shown either on the face of the income statement or in the statement of
changes in equity, which is discussed in section 3.4. Because this interim dividend has been
paid during the year there will also be a reduction in the cash balance. Once the directors
have an idea of the financial results for the trading period, a final dividend is then proposed
at the end of the year, subject to confirmation at the company’s AGM. This proposed final
dividend, under international accounting standards, cannot appear in the company’s financial
statements until it has been approved and will most likely therefore be a deduction from the
profit in the following year’s statement of changes in equity.

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3.3.8 Retained Profits

The retained profit for the year is what is left after deducting dividends for the year. These are
profits ploughed back into the business for future growth. Because they belong to the ordinary
shareholders, they form part of the equity of the company and are added to the share capital
in the balance sheet.

3.3.9 Balance Sheet

A typical format for a company’s balance sheet is similar to the vertical layout used for the
sole trader. However, there are a few differences to note. See the example shown below.

Madeup plc

Balance sheet as at March 20×7

Non-current assets £000 £000

Intangible assets 280

Tangible assets 1,300

Investments 297 1,877

Current assets

Inventory/Stocks 839

Debtors 669

Investments 70

Cash at bank 109 1,687

Total assets 3,564

Current liabilities

Trade payables 469

Current tax payable 365 834

Non-current liabilities

Long-term borrowings 861

Deferred tax 300 1,161

Total liabilities 1,995

Net assets 1,569

Equity

Ordinary share capital 500

Preference share capital 100

Share premium account 270

Revaluation reserve account 280

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Profit and loss account 419

Total equity 1,569

3.3.10 Non-current Assets

Most of the non-current assets used by a company will be the same as those used by a sole
trader but, in addition, a company might have intangible assets and investments on their balance
sheets.

Intangible assets are non-monetary in nature and without physical substance. Examples include
goodwill, patents, trademarks and development expenditure.

Investments in the non-current assets section are assets held for the long term and for the
following purposes:

• generating income through interest, dividends or royalties, for example loans to other
companies, trade investments

• capital appreciation, for example investment properties

• trading relationships, for example investments in subsidiaries.

3.3.11 Current Assets

A company’s current assets are made up of the same main components as those of a sole
trader but they might also include short-term trade investments.

3.3.12 Current Liabilities

Included in this section of the balance sheet for companies will be the corporate income tax
payable.

3.3.13 Non-current Liabilities

Long-term loans, debentures and deferred tax are typical entries in the balance sheet of a
company.

3.3.14 Equity

The share capital and reserves represent the book value of the business to the shareholders
at any point in time. The share capital in the balance sheet represents the nominal value of the
shares that have been issued to the preference and the ordinary shareholders.

The reserves are amounts, which add to the balance sheet value of shareholders’ wealth. They
are unlikely to be held in the form of cash because normally reserves will have been reinvested
in other assets.

A revaluation reserve occurs when a company revalues an asset. The amount of the revaluation
will be shown as an increase in the asset value and the matching increase will be taken straight
to a revaluation reserve account in the balance sheet. The revaluation gain does not go through
the income statement because the gain has not yet been realised. It is only a book gain at this
stage and is not, therefore, a part of the operating transactions of the business.

A share premium account arises when shares are issued at a price above the nominal value.
The difference between the nominal value and the issue price is a premium, which has to be
recorded separately in the company’s accounts as a share premium account. For example, if

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the company issues 1,000 £1 ordinary shares at a premium price of £5, the accounting entries
would be an increase in cash of £5,000, an increase in ordinary share capital of £1,000 (the
nominal value of the shares) and an increase of £4,000 to the share premium account.

The profit and loss account reserves are the profits generated from running the business that
have been reinvested in the company for future development.

3.4 Statement of Changes in Equity

In addition to the income statement and the balance sheet, IAS 1 requires that every year
companies prepare a statement of changes in equity. This tells the shareholders and other user
groups exactly how the components making up the equity figure have changed since the end
of the previous financial period. Typical entries shown in the statement of changes in equity
are:

• issue of additional share capital

• revaluation of assets

• profit for the period

• dividends paid.

The suggested format is as follows.

Noreal plc

Statement of changes in equity for the year ended 31st December 21×1

Share
capital

Share
premium

Revaluation
reserve

Retained
earnings

Total

£m £m £m £m £m

Balance 31/12/x0 10 2 8 45 65

Profit for the period 12 12

Surplus on property

Revaluation 14 14

Issue of shares 6 3 9

Dividends paid (5) (5)

Balance 31/12/x1 16 5 22 52 95

3.5 Regulatory Framework

Prior to the 1970s, when accounting standards were first introduced, accountants had consid-
erable freedom in recording, preparing and presenting financial information. However, because
there was no formal legislation on how companies should prepare their accounts, a wide vari-
ety of accounting practices were adopted. This led to a reduction in the usefulness of financial
statements to the user because of the lack of comparability, with similar transactions being
dealt with in entirely different ways by companies nationwide.

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Nowadays, accounting is regulated by:

• ‘local’ company law

• Stock Exchange requirements

• accounting standards.

However, the actual methods used to prepare accounts can still vary from country to country
and the term ‘generally-accepted accounting practice’ (GAAP) refers to the whole regime of
regulation used by a specific country. For example, the UK GAAP refers to UK Law (the
Companies Act 2006 primarily), UK Financial Reporting Standards (FRS) and UK listing rules
for companies whose shares are traded on the Stock Exchange. A flavour of the regulatory
framework governing a UK company is given below.

3.5.1 UK Company Law

The Companies Act 1985, as amended by the Companies Act 1989 and 2006, deals with all
the legal requirements which must be followed regarding the published accounts of companies.
The key elements of this legislation are as follows.

• Limited companies are required by law to prepare an annual set of financial statements.

• Limited companies must lodge their financial statements with the Registrar of Companies
for public inspection.

• There are prescribed formats to be followed by limited companies when they prepare
profit and loss accounts and balance sheets.

• There are prescribed methods for valuing assets and liabilities when preparing the financial
statements.

However, the overriding requirement arising from the Companies Act 2006 is that the financial
statements of companies must present a true and fair view of the events from the last trading
period.

3.5.2 European Union

As a member of the European Union, the United Kingdom is obliged to develop its laws in
harmony with those of the other member countries. This process of harmonisation starts
when ‘directives’, which set out the basic rules to be followed in the national laws of each
member country, are issued by the European Commission.

The Companies Act 1985, and its amendments in 1989 and 2006, were primarily the result of
the fourth and seventh directives issued by the European Union.

3.5.3 Stock Exchange

Companies whose shares are listed on the UK Stock Exchange must conform with all the Stock
Exchange regulations. These regulations are contained in a publication called ‘The Listing Rules’
(often referred to as the Yellow Book) and they commit companies to certain procedures and
standards which can be even more extensive than the Companies Act requirements. Failure
to comply with the rules can lead to the Stock Exchange suspending a company’s listing.

3.5.4 External Auditors

As the majority of a company’s shareholders do not have day-to-day access to the accounting
records of the entity, they need someone to act on their behalf to ensure that the directors

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present a true and fair view of the results of the period. This reassurance comes from
the appointment of a firm of auditors who, following their own code of practice, Auditing
Standards, review the annual report and offer an opinion on the truth and fairness of the
financial information presented. It is important to note that the auditors are not expected to
be totally certain in their opinion, but are merely looking for ‘material’ errors.

3.5.5 Accounting Standards

Figure 3.1 Accounting bodies

The bodies shown in Figure 3.1 have been established to draft accounting policy, set accounting
standards and monitor compliance with those standards and the provisions of the Companies
Act.

3.5.6 Financial Reporting Council

The Financial Reporting Council (FRC) is in overall control of the process and comprises
about 20 members drawn from the profession, the City, industry and academia. Its objectives
are to:

• oversee the standard-setting process and the work of the ASB

• provide the finance needed to support the standard-setting process

• offer guidance to the ASB on work programme priorities

• advise the ASB on areas of public concern or controversy.

3.5.7 Accounting Standards Board

The Accounting Standards Board (ASB) has responsibility for developing, issuing and with-
drawing accounting standards. Creating accounting standards is an ongoing attempt to tackle
the diversity of treatment of items in the accounts and to continue to improve the current
standards of financial accounting and reporting.

The ASB was formed in 1990 to replace the Accounting Standards Committee (ASC) which,
primarily, had undertaken the same function between 1970 and 1990. Up to 1990, the account-
ing standards were known as Statements of Standard Accounting Practice (SSAPs) and some
of the 25 SSAPs that were introduced by the ASC are still in existence today. Accounting
standards issued by the ASB are called Financial Reporting Standards (FRS) and more than
20 have been issued since its inception, covering such topics as cash flow statements, capital
instruments and deferred taxation.

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The Board comprises nine members, including a full-time chairman and technical director, and
requires a two-thirds majority to approve its standards. These standards have no legal effect
but are simply a set of rules of professional conduct which the accounting bodies regard as
binding on their members.

3.5.8 Urgent Issues Task Force

The ASB is responsible for the operation of the Urgent Issues Task Force (UITF), whose role
is to issue abstracts where an accounting standard is in force but is not being appropriately
interpreted. If a company fails to comply with a UITF abstract, it is required to give adequate
disclosure of the fact in its financial statements.

3.5.9 Financial Reporting Review Panel

The Accounting Standards Committee’s standard-setting process lacked an effective mechan-
ism for enforcing accounting standards to be adopted. The Financial Reporting Review Panel
(FRRP) was set up as an independent body from the ASB and UITF and its remit is to review
material departures from the accounting standards. If the FRRP feels that the accounting
requirements of the Companies Act 2006, including the true and fair view requirement, have
been breached, it has the power to ask companies to revise their accounts. Although it has
the power to take companies to court in order to rectify matters, the FRRP prefers to deal
with defects by agreement and so far has not found it necessary to resort to legal action.

However, in case you doubt its powers, consider the early case of Trafalgar House. Trafalgar
House had reported profits of £122.5m for the year to 30 September 1991. The FRRP
disagreed with the company’s treatment of writing-off the value of some properties and asked
them to revise their accounts. The profit of £122.5m became a loss of £30m!

3.6 International Accounting Standards

It is the International Accounting Standards Board (IASB) that issues international accounting
standards (IASs) and international financial reporting standards (IFRSs).

Before the development of international accounting standards, there were often significant
differences in the approach taken by individual countries in treating specific items in the
financial statements. One of the key aims of international accounting standards has been to
try and harmonise these different accounting standards in order to provide one framework
for financial reporting that can be adopted by every country.

In fact, many countries (the UK is a good example) have changed and adapted their national
accounting standards in order to be more consistent with international accounting standards.
Perhaps that was just as well because from 2005 onwards, it became mandatory for all
listed companies within the European Union to publish consolidated financial statements in
accordance with IASs and IFRSs. For that reason references made throughout this unit will be
to the relevant IAS.

3.7 Consolidated Financial Statements

When we were reviewing the non-current assets that we might come across in the balance
sheet of a limited liability company, one of the categories …

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Chapter

Chapter
4

Profit v. Cash

4.1 Introduction 47
4.2 Cash Budgeting 49
4.3 Cash Flow Statements 53
4.4 Summary 56

Learning Objectives

After completing the study of this unit you should be able to:

• distinguish between profit and cash

• prepare a cash budget and appreciate the role that it plays in the running of the business

• scrutinise the figures presented in a cash flow statement.

4.1 Introduction

One of the basic errors made by new accounting students is believing that profit and cash are
the same thing. Perhaps the example in the following scenario will help to convince you that
this is not the case.

Example − scenario 1
Andy visited his local Sunday market and spotted a bargain. One of the stallholders was
selling a computer for £120. With his in-depth knowledge of IT, Andy knew that this
model of computer could sell for double the price and so he handed over £120 in cash
and took the computer home.

On his way in to work on Monday morning, Andy stopped at the offices of the local
newspaper and placed an advert in Monday evening’s edition of the paper, offering a
computer for sale at a price of £250. The advert cost Andy £20 in cash.

On Monday evening, the phone rang in Andy’s flat and a sale was agreed. The customer
came round to the flat one hour later, paid £250 in cash and went home with the
computer.

If this was Andy’s only business transaction in the month what was his profit or loss for
the one-month trading period?

Andy’s income statement

One-month trading period

£ £

Sales 250

Expenses

Computer 120

Advert 20 140

Profit 110

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Andy’s profit was £110 and, because all the transactions that took place were cash
transactions, Andy’s cash balance had also increased by £110.

Scenario 1 summary

Increase in profit £110 Increase in cash £110

Imagine, however, if the scenario happened more like the one below.

Example − scenario 2

Andy visited his local Sunday market and spotted a bargain. One of the stallholders was
selling a computer for £120. With his in-depth knowledge of IT, Andy knew that this
model of computer could sell for double the price, so he handed over £120 in cash and
took the computer home.

On Monday evening, the phone rang in Andy’s flat and a sale was agreed. The customer
came round to the flat one hour later and explained to Andy that he was a bit short of
cash at the moment. Andy agreed that the customer could pay him the following month
and the customer went home with the computer.

If this was Andy’s only business transaction in the month what was his profit or loss for
the one-month trading period?

Andy’s income statement

One-month trading period

£ £

Sales 250

Expenses

Computer 120

Advert 20 140

Profit 110

Andy’s profit was still £110 because a sale of £250 has been realised and matched against
expenses of £140 that were incurred in generating the sale.

However, what has now happened to Andy’s cash balance?

Andy’s cash balance is −£140 because he spent £140 of cash on the computer and the
advert but received no cash back on the sale of the computer.

Scenario 2 summary

Increase in profit £110 Decrease in cash £140

From the above scenario, it is evident that profit and cash are two entirely different things
and, although profits ought to help with cash generation, they are no guarantee that cash
surpluses will follow.

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Profit v. Cash

There are many examples of organisations that have reported healthy profits to the share-
holders one month but are out of business by the following month.

Companies do not necessarily go out of business because they do not make profits. Companies
go out of business because they run out of cash. It can, therefore, be argued that cash is the
most important resource for businesses today because, to survive and prosper, a business
must generate a healthy cash flow.

In this unit we will do as all sensible companies would do. We will review what has happened
to our cash over the past financial year by looking at cash flow statements. But firstly, we’ll plan
ahead to see what we think might happen to cash over the next trading period by considering
how and why businesses prepare cash budgets.

4.2 Cash Budgeting

It is vitally important that organisations plan and control their cash flows by analysing the effect
that the budgeted activities for the forthcoming period are going to have on their liquidity.
The benefits of this are that it:

• ensures there are sufficient funds to meet the deadlines for future payments. The company
needs to generate cash on an ongoing basis to pay the wages and the daily running costs

• ensures there is sufficient cash to carry out any planned investment. Purchasing a £1m
state-of-the-art piece of plant and machinery for the shop floor will make a huge hole in
your cash resources if you have not planned for such an expenditure

• allows for planning in advance for future shortfalls of cash. If cash projections suggest that
additional funding will be required, then loans or overdraft facilities can be arranged

• enables investment decisions to be made about potential cash surpluses. Money sitting
in a bank account is unlikely to generate sufficient return to please the shareholders. It
is the directors’ responsibility to invest these surplus funds wisely in order to grow the
business.

4.2.1 Constructing a Cash Budget

The cash budget is prepared to show the anticipated cash receipts and cash payments of
the firm during its budget period. However, not only is the amount of cash coming in and
going out of the business important but, for good control, knowledge of the timing of the
cash movement is vital. Typically, therefore, the cash budget is divided into smaller ‘control’
periods, usually one month, in order to highlight the cash position at regular intervals.

The main source of income generation for companies is likely to be cash received from the
goods sold, or the services provided, to the customer. However, other cash receipts could
come from a variety of different sources, such as:

• bank loans

• returns from investments, perhaps bank interest or dividend receipts

• issuing more shares to the public

• issuing debentures

• selling some fixed assets

• commission received

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• rent received from leasing out part of the business’s floor space

• royalties received.

Equally, there can be a variety of different reasons for cash leaving the organisation:

• purchasing raw materials

• paying the weekly wages and the monthly salaries

• rent and rates bills

• general overhead expenses

• buying non-current assets

• paying interest on bank overdrafts and loans

• interim and final dividend payments to the shareholders

• annual corporation tax bill to the Inland Revenue.

You should always remember that a cash budget is concerned only with the movements of
cash during the period. Cash receipts and cash payments recorded in the cash budget will not
necessarily be the same as revenues generated and expenses incurred in the profit and loss
account because of the following:

• Sales are recorded in the income statement when the goods are despatched or the
service has been provided to the customer. But if the sale was made on credit terms, the
cash may not be due to be received until some future period.

• Similarly, purchases are recorded when the goods reach your organisation. If you have
arranged credit terms with your suppliers, you may be able to delay the payment for a
month or two.

• Some expense items are paid in advance (such as rent) and some in arrears (such as
telephone bills) of the period when the expenses are actually incurred.

• Some expense items in the income statement have nothing at all to do with cash, the
most obvious one being depreciation.

Companies will work through the following stages in preparing their cash budget for the
period.

1. Sales forecast

An estimate will be made on the future level of sales to be generated by the business. The
sales figure will be built up from the products/services to be sold, the markets/regions
into which they will be sold and the selling prices that can be achieved in the various
markets.

2. Trade receivables forecast

Having arrived at a sales target, the company will then need to estimate the split of
business between cash sales and credit sales. If the average credit period being offered to
customers is known, companies can then predict when those credit sales will turn into
cash.

3. Inventory forecast

For a manufacturing business, which holds raw materials and finished goods, or an organ-
isation buying in product and selling it on to the customer, consideration will have to

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be given to the monthly inventory levels that the company wishes to hold. Knowledge
of both sales and inventory levels will be needed before companies can determine the
purchases that will be required.

4. Trade payables forecast

Having arrived at a purchases target, the company will then need to consider the level
of credit purchases and the credit periods offered by suppliers, as they do with trade
receivables. Only then can the company estimate the timing of the cash outflows.

5. Capital investment forecast

Here the company will consider their capital investment activity in terms of buying and
selling fixed assets. Buying, in particular, may involve cash up front or perhaps an initial
deposit followed by a later lump sum. Knowledge of payment terms will be crucial in
determining when the cash leaves the organisation.

6. Miscellaneous forecasts

The cash movements for all the other expenses of the business and the profit appropri-
ations will need to be predicted here. When will the company pay their dividends to the
shareholders and their tax dues to the Government? What payment arrangements exist
for rent, rates, electricity and the other overheads involved in running the business?

Armed with the above information, a company should be in a position to consolidate all the
financial information into a cash budget.

Worked example 4.1

Frank started his furniture business in January with a capital investment of £39,000 in
cash. He estimates the following for the first six months of trading.

1. Sales are expected to be £20,000 in the first month, increasing each month thereafter
by £1,000 each month. A total of 25% of the sales will be for cash, the balance being
on credit to be paid in the month following the month of sale.

2. Raw material purchases are estimated to be 50% of sales value each month. In
addition, a reserve stock of £10,000 of materials will be purchased in the first
month. On average, raw materials will be paid for in the second month following
purchase.

3. Plant and machinery costing £50,000 is to be acquired. A 20% deposit will be paid
on delivery on 1 January with the balance being paid, along with 10% interest per
annum on the outstanding balance, in the sixth month.

4. Annual rent of £10,000 will be paid in arrears on the final day of each calendar
quarter.

5. Wages of £4,000 will be paid each month.

6. General expenses are estimated to be paid at £1,500 per month, except in month 1
and month 4 when they are expected to be £2,000 per month.

Required

Prepare a monthly cash budget for the first six months of Frank’s business.

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Workings

1. The first thing to determine is what the sales will be each month and then, more
importantly, when these sales will turn into cash.

Sales Cash receipts

Cash sales Credit
sales

January £20,000 £5,000 −

February £21,000 £5,250 £15,000

March £22,000 £5,500 £15,750

April £23,000 £5,750 £16,500

May £24,000 £6,000 £17,250

June £25,000 £6,250 £18,000

2. Secondly, determine what the purchases will be each month and when Frank will
make the resultant cash payments.

Purchases Cash
Payments

January £20,000 (£10,000 + £10,000) −

February £10,500 −

March £11,000 £20,000

April £11,500 £10,500

May £12,000 £11,000

June £12,500 £11,500

3. The only other complication relates to the purchase of the plant and machinery,
particularly the calculation of the interest. The capital cost of the plant and machinery
will lead to a £10,000 (20%) cash payment in January with the £40,000 balance being
paid in June. However, also to be paid in June will be interest of £2,000. (£40,000
× 10% × 6 months).

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Cash budget for Frank − January to June

Cash inflows Jan Feb March April May June

Cash sales 5,000 5,250 5,500 5,750 6,000 6,250

Credit sales 15,000 15,750 16,500 17,250 18,000

Total cash inflows 5,000 20,250 21,250 22,250 23,250 24,250

Cash outflows

Raw materials 20,000 10,500 11,000 11,500

Plant and machinery 10,000 40,000

Interest 2,000

Rent 2,500 2,500

Wages 4,000 4,000 4,000 4,000 4,000 4,000

General 2,000 1,500 1,500 2,000 1,500 1,500

Total cash outflows 16,000 5,500 28,000 16,500 16,500 61,500

Opening cash 39,000 28,000 42,750 36,000 41,750 48,500

Net cash flow −11,000 14,750 − 6,750 5,750 6,750 −37,250

Closing cash 28,000 42,750 36,000 41,750 48,500 11,250

The monthly closing cash position shows that Frank has a positive cash balance in each of
the first six months and therefore, no immediate need for additional sourcing of finance
is evident. However, what would have happened if the balance of the plant and machinery
had been payable in March rather than June?

The capital expenditure alone would have resulted in a negative cash balance at the end
of March of £5,000 (£36,000 balance per the above cash budget less the £40,000 capital
payment plus £1,000 interest). This would have informed Frank that action needed to
be taken to compensate for this interim cash shortfall. Of course, the whole benefit
of planning ahead is that Frank can now take corrective action to remedy the future
short-term liquidity problem.

4.3 Cash Flow Statements

Where cash budgets plan ahead to determine the future cash inflows and outflows of the
company, cash flow statements work backwards and tell the user how and why the cash
position has moved from the previous trading period. The balance sheet and income statement
of a business give a good indication of how healthy it is financially and how successfully it has
been performing, but neither statement gives direct information about the most crucial aspect
in the stability and success of any business, namely its ability to generate cash.

IAS 7 requires companies to publish a cash flow statement as part of their annual accounts
and, perhaps in recognition of the fact that firms fail through lack of cash resources and not
through lack of profits, the cash flow statement is to be seen as an integral part of the financial
statements that companies produce.

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4.3.1 Objective of Cash Flow Statements

The objective of IAS 7 is to ensure that companies:

• report their cash generation and cash absorption for the period by highlighting the
significant components of cash flow in a way that facilitates comparison of the cash flow
performance of different businesses

• provide information that assists in the assessment of their liquidity, solvency and financial
adaptability.

A number of user groups are specifically interested in information which will help them to
assess the viability of businesses (see Chapter 1). Deriving this information enables a user to
predict what the future cash flows of the entity might be and, in business today, these future
cash flows are often regarded as the prime determinant in the worth of a company.

To help achieve the objective of cash flow reporting, companies are asked to comply with
a prescribed format, which classifies the cash movement for the year across three standard
headings.

4.3.2 Cash Flow Format

The following example illustrates a typical cash flow layout prescribed by IAS 7.

XYZ Group plc

Cash flow statement for year end 31 December 20×6

Cash flows from operating activities £000 £000

Net profit before interest and taxation 17,213

Adjustments for:

Depreciation 2,928

Operating profit before working capital changes 20,141

Increase in trade and other receivables (3,774)

Increase in inventories (11,280)

Increase in trade payables 10,585

Cash generated from operations 15,672

Interest paid (1,889)

Tax paid (2,887)

Net cash from operating activities 10,896

Cash flows from investing activities

Purchase of property, plant and equipment (1,085)

Proceeds from sale of equipment 220

Purchase of other companies (17,824)

Net cash used in investing activities (18,689)

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Cash flows from financing activities

Proceeds from long-term borrowings 2,947

Dividends paid (2,606)

Net cash from financing activities 341

Net decrease in cash and cash equivalents (7,452)

Cash and cash equivalents at the beginning of the period 5,129

Cash and cash equivalents at the end of the period (2,323)

A disclosure note of the breakdown of cash and cash equivalents from the opening and closing
balance sheets is also required.

Dec 06 Dec 05

Cash on hand and balances with banks (2,886) 2,450

Short-term investments 563 2,679

Cash and cash equivalents (2,323) 5,129

Let’s consider what all of the above is trying to tell us, starting with a definition of cash and
cash equivalents, and the three standard headings that break down our cash movement for
the year.

4.3.3 Cash and Cash Equivalents

Cash comprises cash in hand, while cash equivalents are short-term, highly liquid, investments
that are readily convertible into known amounts of cash and whose maturity dates are within
three months of their acquisition dates.

Note: In most countries bank overdrafts are deemed to be repayable on demand and are
therefore part of an entity’s cash management programme.

The cash movement that the company is trying to explain is simply a comparison of the
cash/cash equivalents/bank overdraft figures from the opening balance sheet compared with
the same figures in the closing balance sheet.

4.3.4 Operating Activities

Cash flows from operating activities are the cash effects of transactions and events relating to
the trading activities of the period. Typical inflows and outflows in this category are:

• the payment of wages and salaries

• the purchase of raw materials

• payment for general overhead expenses

• cash received from customers.

The method used to arrive at the total cash flow from operating activities is known as the
indirect method. Companies start with their operating profit before interest and tax and
adjust it for non-cash charges and credits, thus arriving at the cash generated from operations.

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Deducting the interest and tax payments from this figure leaves us with the net cash from
operating activities.

4.3.5 Investing Activities

The cash flows included here show the extent of new investment in assets, which will generate
future profit and cash flows for the business.

Cash inflows include:

• receipts from the sale of property, plant and equipment

• receipts from the repayment of loans made to other entities

• receipts from the sale of shares in other companies.

Cash outflows might include:

• payments to acquire property, plant and equipment

• cash payments to acquire shares in other companies

• loans made to other companies.

4.3.6 Financing Activities

Cash flows in this section mainly comprise receipts or payments of the capital amounts to or
from the providers of finance.

Cash inflows include:

• receipts from issuing shares to investors

• receipts from taking out loans from providers of short- and long-term finance.

Cash outflows include:

• the capital element of finance leases

• repayments of borrowings

• dividend payments (Note: can also be shown as an operating cash flow)

• costs of issuing equity shares

• payments to buy back the company’s own equity shares.

4.4 Summary

Many potentially successful firms in the past have failed, not because of a lack of profits, but
because of a shortage of cash. Profits do not automatically ensure cash surpluses (although
they certainly help), while similarly losses, in the short-term, may not lead to cash deficits. It
is vitally important, therefore, that organisations:

• plan and control their cash flows by analysing the effect that the budgeted activities for
the forthcoming trading period are going to have on their liquidity

• review their cash flow statement at the end of the period to see where cash was generated
and where cash was absorbed during the financial year.

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The benefits of preparing a cash budget are:

• to ensure there are sufficient funds to meet deadlines for future payments

• to ensure there is cash available to carry out any planned activities

• to enable plans to be made in advance for any future cash shortfalls

• to help with making investment decisions on future cash surpluses.

Unlike the cash budget, which plans ahead, the cash flow statement looks at what has happened
to cash in the past. If the cash balance of a company at the start of the year is £1m and the
cash balance at the end of the year is £5m, then the company has to explain why there has
been a cash increase of £4m over the year. They are asked to explain the increase across three
subheadings, namely:

• operating activities

• investing activities

• financing activities.

Basically, the cash flow statement can help assess each of the following:

• the company’s ability to generate positive net cash flows

• the company’s ability to meet its obligations whether it be servicing loan commitments
or paying a dividend to the shareholders

• reasons for the difference between the reported profit and the related cash flow.

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Chapter
5

Interpretation of Financial Statements

5.1 Introduction 59
5.2 Ratio Analysis 60
5.3 Shareholders’ Investment Ratios 70
5.4 Limitations of Ratio Analysis 71
5.5 Summary 71

Learning Objectives

After completing the study of this unit you should be able to:

• analyse and interpret accounting information through the use of ratio analysis

• calculate and interpret key ratios to help current and potential shareholders assess
investments

• recognise the limitations of ratio analysis.

5.1 Introduction

Units 1−4 have been designed to help you to appreciate the purpose and content of the main
financial statements. Now we need to consider how you can make the maximum use of the
information offered to best interpret the financial performance and the financial position of the
reporting entity. Let’s investigate this by way of the scenario shown in the following example.

ABC plc have just reported annual profits of £5m for their last trading period, so does that
mean that they have had a successful year?

Not necessarily. The figure of £5m when stated on its own is said to be an absolute measure
and is fairly meaningless. For useful interpretation, you need to be able to make comparisons
with other information.

The following data have been gathered.

• ABC plc had reported profits of £4m in the previous year.

• The capital employed in the company this year was £20m.

• ABC plc had forecast their profits to be £4.5m for the year.

• DEF plc, the major competitor of ABC plc, made a profit of £2m despite having a similar
level of capital employed in the business.

What can you now say about ABC plc’s reported profit figure?

Assuming ABC plc had a similar level of capital employed in the business during the previous
year then we can make the following deductions:

• Their profits have increased by £1m since the previous year − good

• Their profits exceeded their target by £0.5m − good

• Their return on capital employed (profit/capital employed) was higher than their main
competitor. ABC plc had a return of 25% (£5m/£20m) compared with DEF plc’s return
of 10% (£2m/£20m) − good.

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When you compare the financial performance of one company against its past results, its
budgeted results or its competitor’s results, the measures are said to be relative and it is these
relative measures that enable you to undertake useful interpretation.

With relative measures, you need to compare like with like. You cannot compare the results of
a high street bank with those of a brewing company and expect to get a very meaningful analysis.
The entities will have different capital structures, asset bases and perhaps profit ideals. Similarly,
if a company has changed dramatically since the previous year, because it has developed new
products or moved into new markets or acquired some major new subsidiaries, then again
you need to be wary of making comparisons of results.

Although the figures you interpret relate to past information, you are really trying to anticipate
what might happen in the future. Each user group has certain areas of analysis that they are
particularly interested in. If, for instance, they plot past results, perhaps a trend will emerge
which will enable them to predict the future and help to ensure that they make the correct
economic decisions.

5.2 Ratio Analysis

Because of the need to compare figures between companies or to compare the results of
one company over several years, much of the analysis is done using accounting ratios and
percentage movements. It is customary to categorise ratios in relation to the different aspects
of the business that interested parties are trying to measure. This unit focuses on five key
areas of analysis:

• profitability

• short-term solvency and liquidity

• efficiency

• long-term solvency and stability

• shareholders’ investment ratios.

As you review the main ratios in each of the above categories, you need to be aware that
ratio analysis is not an exact science. There is no legislation and there are no accounting
standards telling users which ratios to calculate and how to interpret them. Therefore, do not
be surprised if different textbooks show a different interpretation of the ratios from those
used in this unit. Remember, it is the trend given by the results that is important and, as long as
the ratio you choose to use is applied consistently from year to year, or between companies,
you will be able to interpret results with some degree of confidence.

5.2.1 Profitability

The generally accepted primary objective for management is to maximise the wealth of the
shareholders. Profitability looks at the extent to which the resources employed in the business
generate returns over and above the running costs. Profit provides new wealth to the owners,
firstly to cover dividend payments and secondly to finance the future expansion of the business.

Gross profit =
Gross profit

Revenue
× 100%

Gross profit is the difference between sales and cost of sales. Gross profit expressed as a
percentage of sales is often referred to as the gross margin. This gives the user an insight
into the relationship between the sales revenue and the production/purchasing costs, and the
eventual percentage calculated can be translated into a gross profit margin per pound (£) of
sale. For instance, if a company’s gross profit is 40% then, for every £1 sold, the company has
made a profit of 40p after deducting the costs of manufacturing the product.

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The gross profit, of course, needs to be high enough to cover all the operating expenses
(selling, distribution and administration) incurred in running the business as well as leaving an
amount for profit. If a company’s gross margin has moved from one year to the next, then
there are really only three main explanations:

• the selling price has increased or decreased

• the cost of manufacturing or buying in the product has increased or decreased.

• there has been in change in the sales’ mix.

Operating expenses =
Operating expenses

Revenue
× 100%

This ratio tells the user how much, from each £1 of sale, the company is spending on the
non-manufacturing costs of running the business. An operating expenses ratio of 25% means
that from each £1 generated in sales, the company is spending 25p on the selling, distribution
and administration costs incurred in running the business.

Operating profit =
Operating profit before interest

Revenue
× 100%

This ratio shows the profitability of the business before incurring financing costs. It effectively
tells you how much is left from each £1 of sale before the company has to account for interest
charges on borrowings. The operating profit percentage should equal gross profit percentage
minus operating expenses percentage.

When analysing performance between companies, it is often worth looking at these three
ratios together.

Company A Company B

£000 % £000 %

Revenue 100 100 100 100

Cost of sales 60 60 50 50

Gross profit 40 40 50 50

Operating expenses 20 20 40 40

Operating profit 20 20 10 10

Company B generated a higher gross profit percentage than Company A, perhaps because of
a cheaper source of raw material or more efficient shop floor operations. But Company A
appear to have much better control of their operating costs than Company B and end up with
a resultant 20% operating profit compared with Company B’s 10%.

Return on capital employed =
Operating profit before interest

Capital employed
× 100%

Arguably, the greatest measure of management efficiency, and the fairest way to assess per-
formance, is to calculate the return on capital employed (ROCE) percentage. This ratio judges
the profit generated in comparison with the amount of capital the organisation had available
to invest in the business.

The numerator is taken as profit before interest because this figure represents the genuine
return from the capital invested in the business. Interest is merely an expense incurred because
companies have chosen to finance their operations with borrowed monies. It does not affect
the company’s earnings potential.

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The denominator is a total of the finance input by the shareholders (capital), the finance
retained in the business by the shareholders (reserves and retained earnings) and the finance
provided by external lenders (non-current liabilities).

The ratio shows the investor, or potential investor, the return the company generated from
the funds they had available to use in the business and can be compared with returns from
other investments. Instead of putting funds into the business, those funds could have been
invested in a building society account offering a return of perhaps 5%. Given the near certainty
of achieving the 5% return from the building society, it is likely that the return expected from
investing in a business would need to exceed this by a fair amount in order to compensate for
the much higher risk involved.

5.2.2 Short-term Solvency and Liquidity

Liquidity refers to the availability of cash in the near future after taking account of immediate
financial commitments. In other words, is the company generating sufficient surplus funds to
meet short-term debts as they become due?

Current ratio =
Current assets

Current liabilities

This ratio is expressed as a ratio of x : 1 rather than as a percentage.

Conventional wisdom suggests that current assets should exceed current liabilities but, in
reality, the answer really depends on the type of business they relate to. The important point
is whether the ratio is comparable with that of other businesses in the same sector and
whether the trend over the years is satisfactory.

Activities vary enormously in their need for working capital and companies should maintain
the elements of working capital at the lowest possible level. If a company’s liquidity ratios are
too high, it means that resources are being used in the wrong part of the business. Instead
of being invested in income-generating assets, resources are in fact tied up in non-productive
assets like stock and debtors.

Acid test =
Current assets − stock

Current liabilities

A more rigorous ratio used to assess the potential solvency of a business is the acid test ratio,
sometimes referred to as the quick ratio. It is calculated on the same basis as the current ratio
except it excludes inventories from current assets, focusing attention on the ability of the
business to meet its short-term commitments from the more liquid assets of trade receivables
and cash.

5.2.3 Efficiency

If a company is experiencing liquidity problems, you can determine the working capital areas
that are causing the problems by analysing the efficiency of the organisation and its management.

Receivables collection period =
Trade receivables

Revenue
× 365 days

The ratio ought to be trade receivables/credit sales but, as it is unlikely that companies will
segregate cash sales from credit sales, total revenue is usually used.

This ratio tells us how efficiently a company collects cash from its credit customers. Clearly,
it is in the interests of a company to try and collect the cash as quickly as possible because,
after all, it does belong to them. However, consideration needs to be given to the actions
of the competition. If two firms have identical products in terms of selling price and quality,
the company offering the longer credit period may attract more custom because there is less

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pressure on customers to pay their debts quickly, therefore enabling them to use the cash
within their own organisation.

Payables payment period =
Trade payables
Cost of sales

× 365 days

In a similar way to the ratio we have just discussed, this ratio calculates how long it takes a
company to pay its trade suppliers the outstanding monies owed to them. Companies have
a slight dilemma here. They would like to pay their suppliers promptly in order to maintain
goodwill, but early settlement of invoices does have an adverse impact on the cash flow.
Perhaps the most significant thing here is the relationship between the trade payables payment
period and the trade receivables collection period. As long as the cash is coming in from the
customer more quickly than it is being paid out to the suppliers, the overall impact on the
company’s cash position should be favourable.

Inventory turnover =
Inventory

Cost of sales
× 365 days

This ratio checks how quickly the organisation turns its inventory into cash, or at least trade
receivables. All businesses would like to turn over their inventory as quickly as possible because
the more inventory held the greater the costs will be, not only in terms of the capital tied up
in inventory but also in related areas, such as:

• rent, rates and the other overhead expenses involved in running the warehouse

• payment of more material handlers (the more inventory you hold, the more material
handlers you need)

• increased risk of inventory obsolescence

• increased risk of inventory being damaged in the warehouse.

5.2.4 Long-term Solvency and Stability

This section considers how a business has chosen to finance itself and what potential risks
are involved. There are really only two ways of financing a business, either the shareholders
put the money in themselves or they borrow money from external sources. There is no right
or wrong answer as to how a business should finance itself, but worked example 5.1 should
prove to you that the more money that is borrowed to run the business, the greater the risk
that the company is taking.

Worked example 5.1

The capital structures of two companies operating in the same industrial sector are as
follows:

Melville plc Morris plc

£ £

Share capital and reserves 900,000 100,000

Loan capital (10%) 100,000 900,000

1,000,000 1,000,000

Scenario 1 − if both companies earn a profit before interest of £100,000 then whose
shareholders will be the happiest?

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Melville plc Morris plc

£ £

Profit before interest 100,000 100,000

Interest payable 10,000 90,000

Profit for the shareholders 90,000 10,000

In this scenario, the capital is producing a return of 10% for the shareholders of both com-
panies. Melville plc has generated a £90,000 profit from their shareholders’ investment
of £900,000 while Morris plc has generated a return of £10,000 from their shareholders’
investment of £100,000.

Scenario 2 − what happens if the profit before interest is £200,000?

Melville plc Morris plc

£ £

Profit before interest 200,000 200,000

Interest payable 10,000 90,000

Profit for the shareholders 190,000 110,000

Although profit has doubled, the interest charges remain the same. Melville plc’s return to
their shareholders is now over 21% (£190,000/£900,000) but look at the return generated
by the shareholders of Morris plc. The interest charge remained the same while profits
doubled, and the company used the borrowed money to generate a return well in excess
of what it was costing them to borrow. This excess goes back to the ordinary shareholders
who now have a return on investment of 110% (£110,000/£100,000).

Scenario 3 − what happens if the profit before interest is £50,000?

Melville plc Morris plc

£ £

Profit before interest 50,000 50,000

Interest payable 10,000 90,000

Profit for the shareholders 40,000 (40,000)

This time profit has halved, but again the interest charges remain the same. Melville plc,
being primarily financed from shareholders’ funds, still shows a small profit and, therefore,
a small return of 4.4% (£40,000/£900,000) for the shareholders. However, Morris plc,
heavily reliant on borrowed money to finance the business, has made a loss and a
negative return for their shareholders because the ROCE of 5% (£50,000/£1,000,000)
was primarily generated from capital that was costing the company 10% per annum.

This confirms that the higher the amount of borrowed monies used to finance a business,
the greater the risk that, having serviced that finance, there will be little return for the
ordinary shareholder.

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The idea of having an optimum capital structure, which maximises company value and provides
the most efficient and effective balance between sources of debt and equity finance, has been
a subject of great debate in the academic literature in this area. Any textbook will offer you
some history of how this has developed since the mid 1950s, and at the end of this unit you
will find full details of a recent paper that offers a concise summary of the literature to date
by Brounen, de Jong and Koedijk (2005).

Gearing =
Long-term borrowings

Capital employed
× 100%

Gearing is concerned with a company’s long-term capital structure and the gearing ratio
measures the extent to which capital used to finance the business has come from a borrowed
source. The denominator is the same denominator used to calculate ROCE.

There is no limit to what the ideal gearing ratio should be. A company with a gearing ratio of
more than 50% is said to be highly geared, whereas one with a ratio of less than 50% is said
to be lowly geared.

The risk associated with being highly geared is that, by definition, there is a lot of debt carrying
a fixed rate of return which must be paid regardless of profit levels. Hence, the more highly
geared the company, the greater the risk that little, if anything, will be available for distribution
to the ordinary shareholders in the form of a dividend.

Alternatively, however, if the money borrowed can be invested to generate a greater return
than the fixed annual charge paid, then the surplus belongs to the ordinary shareholders.

Interest cover =
Operating profit before interest

Interest charges

Linked with gearing above, this ratio gives the user an insight into how easily a company is
able to meet interest payments on borrowed monies. The ratio is expressed in the number
of times the interest is covered and if this figure is low or has fallen from previous years, the
company might have cause for concern.

Debt ratio =
Total liabilities
Total assets

× 100%

This ratio is another indicator of a company’s debt position because it calculates what per-
centage of the assets would need to be cashed in to pay off all the liabilities. Again, if this
percentage is increasing, shareholder returns might be affected, as might the willingness of
banks to lend more resources. See worked example 5.2.

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Worked example 5.2

Thomson Ltd is a company that manufactures nuts and bolts which are sold on to
industrial users. The abbreviated accounts for the years to June 20×5 and 20×6 are given
below.

Thomson Ltd

Income statement Year ended 30 June 20×6

20×6 20×5

£000 £000

Revenue 1,200 1,180

Cost of sales 750 680

Gross profit 450 500

Operating expenses 283 266

Profit before interest 167 234

Interest payable 8 −

Profit before tax 159 234

Tax 48 80

Profit for the period 111 154

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Interpretation of Financial Statements

Thomson Ltd

Balance sheet as at 30 June 20×6

20×6 20×5

£000 £000 £000 £000

Non-current assets 687 702

Current assets

Inventories 276 148

Trade receivables 186 102

Cash 4 466 32 282

Total assets 1,153 984

Current liabilities

Bank overdraft 26 −

Trade payables 76 60

Accruals 16 18

Tax 48 166 80 158

Non-current liabilities

Bank loan 50 −

Total liabilities 216 158

Net assets 937 826

Equity

Ordinary £1 shares 500 500

Retained earnings 437 326

Total equity 937 826

Required

You are the management accountant of Cameron plc, a company which has been asked
to supply Thomson Ltd with a substantial amount of goods. Your boss, the financial
controller, has asked for a report on the financial performance and financial position of
Thomson Ltd.

Solution

Before calculating any ratios, it is worth reviewing the financial statements of Thomson
Ltd and comparing the percentage movements from year to year for some of the key
items.

Revenue increase of 1.7% (1,200/1,180)

Cost of sales increase of 10.3% (750/680)

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This tells you immediately that profitability at the gross profit level will not be good.

Operating expenses increase of 6.4% (283/266)

This tells you that the percentage increase for both categories of expense exceeded
the percentage increase in sales and, therefore, the profit before interest (net margin
percentage) will be poorer than the previous year.

With no interest expense last year but an £8,000 expense this year, you are aware that
the company must now be using borrowed monies to finance the business.

Inventories increase of 86.5% (276/148)

Trade receivables increase of 82.4% (186/102)

From this information, you get an indication of which areas of the business have needed
additional investment.

The other significant movement you can deduce from the balance sheet is in the
cash/liquidity position. Positive cash from last year has been replaced by a bank over-
draft and a bank loan this year. This links in to the interest payment shown on the profit
and loss account.

Ratio analysis

20×6 20×5

Profitability

Gross profit 37.5% (450/1200) 42.4% (500/1180)

Operating profit 13.9% (167/1200) 19.8% (234/1180)

ROCE 16.9% (167/987) 28.3% (234/826)

Short-term solvency

Current ratio 2.81:1 (466/166) 1.78:1 (282/158)

Acid test 1.14:1 (190/166) 0.85:1 (134/158)

Efficiency

Receivables collection 57 days (186/1200) 32 days (102/1180)

Payables payment 37 days (76/750) 32 days (60/680)

Inventory turnover 134 days (276/750) 79 days (148/680)

Long-term solvency

Gearing 5.1% (50/987) Nil

Interest cover 21 times (167/8) n/a

Debt ratio 18.7% (216/1153) 16.1% (158/984)

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Report

To: Financial Controller

From: Management Accountant

Subject: Analysis of Thomson Ltd

Having been asked to supply Thomson Ltd with a substantial amount of goods, I would
suggest that our main consideration has to be the ability of the company to pay for these
goods on time. To judge this we need to consider two key aspects of their financial state-
ments. What is their current liquidity position and what are the longer-term prospects
(profitability) for the company?

It must be noted, however, that the financial data provided in the accounts relates to the
past whereas these two aspects relate to the present and future. We shall have to use
this past data to help to predict the future.

Liquidity

The current ratio has risen from 1.78 to 2.81, while the acid test ratio has risen from 0.85
to 1.14. This upward trend masks a potentially difficult situation because both inventories
and trade receivables have increased significantly. To finance these increases, Thomson
Ltd now has an overdraft and has taken on some long-term debt for the first time. This
situation gives some cause for concern, though not alarm. If possible, further details are
needed about why trade receivables have increased by 82%, resulting in an additional 25
days’ credit being offered to the customer. Similarly, we need to know why inventory
levels have risen by nearly 86% and stock has been lying around the warehouse for an
extra 55 days this year.

Profitability

The income statement shows that revenue has increased only slightly and, given the
impact of inflation, it is likely that the volume of sales has in fact decreased. All three
profitability ratios have dropped considerably, perhaps suggesting one of the following
possibilities.

• Intense competition from overseas has caused a reduction in the selling price and,
despite this, Thomson Ltd is still struggling to sell all its production because inventory
levels are rising.

• Thomson Ltd’s products are past their sell-by date. Inventory is building up and
customers have been offered improved payment terms in an attempt to attract
business.

• A few major customers are in difficulty and they neither pay on time nor make new
orders. This could be temporary or permanent.

Summary

The review of the financial statements does not reveal a thriving company but, without
further information, it is hard to decide whether the situation is so bleak that we should
seriously consider not supplying Thomson Ltd with their goods. Perhaps initial trading
could be done on a cash basis before we felt secure enough to offer credit payment
terms. Furthermore, it would be unwise of us to make any huge internal investments
(for example purchase of new machinery) until we have a bit more confidence about the
long-term future of Thomson Ltd.

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5.3 Shareholders’ Investment Ratios

Shareholders’ investment ratios are ratios which are deemed to be significant in the context
of reaching decisions about whether or not to buy, retain or sell shares in an organisation.
Investors are concerned with the risk inherent in, and the return provided by, their investment.
Ultimately, they are interested in the amount of cash that they will receive from their invest-
ment, firstly in terms of the annual dividend paid from the company’s profits and secondly from
the capital gain that might accrue should they decide, eventually, to sell their shareholding.

Earnings per share =
Profit attributable to equity shareholders

Number of ordinary shares

The earnings per share (EPS) ratio shows the profit earned in relation to each ordinary share
held. It is probably the most frequently quoted measure of a company’s performance, with
its significance perhaps being highlighted by having an International Accounting Standard (IAS
33) totally dedicated to it. Furthermore, the disclosure in the standard requires companies
to state their EPS figure on the face of the income statement. A review of the financial pages
within the daily press will also tell you the current EPS figures for quoted companies. Although
this ratio, with its focus on annual earnings, is sometimes criticised for causing ‘short-termism’
among investors, the EPS percentage change from year to year is a great indicator of company
progress.

However, many companies have been criticised for having an ‘EPS’ fixation, i.e. focusing purely
on this measure as a means of assessing overall performance. Have a look at the website
www.sternstewart.comparticularly at the research section. There is a paper here titled ‘Enron
Signals the End of the Earnings Management Game’ that highlights the trouble companies can
get into by focusing purely on EPS.

Dividend per share =
Total ordinary dividend payable

Number of ordinary shares

This ratio tells the investor the annual return that they will get for each share they purchase.
The return often comprises the interim dividend paid and the final dividend proposed by the
directors. The dividend policy of the company is one of the key decisions that the directors
have to make. Clearly, the more profit paid out to shareholders in the form of a dividend, the
less profit that can be retained in the business for future growth. However, companies are
usually keen to see the annual dividend per share at least remaining the same as the previous
year, if not increasing slightly.

Dividend yield =
Annual dividend per ordinary share

Share price
× 100%

This ratio expresses the dividend as an annual rate of return on the share price and enables
potential investors to compare this return with that of other available investment opportun-
ities. However, investors need to remember that the dividends they receive are not the only
benefit likely to accrue from their investment. Company management often take the view
that the dividend yield ought to provide an adequate investment income, but it is the wealth
that can be generated from reinvesting retained profits in the business which secures a rosier
future for the investor. Most shareholders will be happy to accept a low dividend yield if …

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Chapter
6

Segmental Reporting

6.1 Introduction 73
6.2 Discontinued Operations 74
6.3 Segmental Reporting 76
6.4 Summary 80

Learning Objectives

After completing the study of this unit you should be able to:

• understand why the International Accounting Standards Board wanted separate disclosure
of discontinued operations

• use segmental reporting information to help you interpret the performance of companies.

6.1 Introduction

In Chapter 5, we considered in depth the technique of ratio analysis and how it could start to
help the users of financial statements with their interpretation of the company results. How-
ever, as companies continue to expand and diversify, the IASB has developed new accounting
standards to help users to better assess company performance.

In this unit, the aim is to explore the rationale behind the decision of the IASB to have
separate disclosure of discontinued operations. It also looks at the use of segmental reporting
information to help you interpret the performance of companies, and understand how non-
financial measurements can also be used to help assess performance.

Twenty-five years ago, Sportsequip Ltd was a small private company based in the south of
Edinburgh that manufactured and sold tennis racquets. They sourced their raw materials from
local suppliers and sold their racquets throughout the East of Scotland.

Today, Sportsequip plc is a multinational organisation listed on the UK Stock Exchange. The
parent company is still based in Edinburgh but the company now owns a number of subsidiary
and associate companies around the globe. Some of these companies manufacture sporting
goods; some are selling agents for Sportsequip products; some solely supply Sportsequip with
raw materials, while others manufacture and sell products under their own brand name.

Do Sportsequip still make and sell just tennis racquets? No, the company has diversified and
now offers a full range of sporting equipment and clothing, from cricket bats to hockey sticks
and from tracksuits to football shirts. You name it. Sportsequip will supply it. As the structure
of the companies has become more complex over the past couple of decades, the complexity
of preparing their financial statements has grown. As the objectives of financial reporting are
to provide a wide range of users with as much information as possible in order that they
can make economic decisions, it is encouraging to see that the accounting legislators are
continually reviewing ways of improving the financial information provided in a company’s
annual report. See worked example 6.1.

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Worked example 6.1

If the legislation from 30 years ago was still in existence today, Sportsequip plc might have
the following income statement as part of its annual financial results.

Sportsequip plc

Income statement Year
to 31 December 21×3

£m

Sales 4,000

Expenses 3,000

Profit 1,000

What does this tell the user of the financial statements?

Required

You are a potential investor in Sportsequip plc and are attempting to forecast what
next year’s results might be. The Chief Executive states in the Annual Report that an
anticipated growth of 20% is expected across all markets next year. Inflation is negligible,
so selling prices and costs will all be at this year’s level. What profit will Sportsequip plc
generate next year?

Solution

Profit will be £1,200 because sales of £4,800 (£4,000 + 20%) will be offset by expenses
of £3,600 (£3,000 + 20%).

Based on the income statement information provided, that is the extent of your
analysis.

6.2 Discontinued Operations

Traditionally, users focused on a single figure, profit after tax, to determine how successful the
company had been in the past and how it might perform in the future. However, the relevance
of this single indicator would appear to be diminished today because:

• companies, and particularly groups of companies, operate worldwide and it would be
nice to know how successful each country’s operations had been

• companies usually deal with a diversified product range and users would like to know
how each product has contributed to the overall results

• companies and groups often change direction rapidly, moving out of some markets and
investing heavily in others − the impact of such decisions on performance can be a useful
indicator of future profitability

• more gains and losses may be excluded from the income statement nowadays because
legislation requires them to be taken directly to reserves in the balance sheet.

In Chapter 3, we saw how the statement of changes in equity highlighted gains and losses that
had been taken directly to the balance sheet. Section 6.3 on Segmental Reporting (IFRS 8) will
deal with countries and products but for the moment, let’s consider how IFRS5 (Non-current

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assets held for sale and discontinued operations) has helped when companies are perhaps
changing strategic direction.

6.2.1 Format of the Income Statement

There are some key changes which you should note carefully.

An entity should present and disclose information that enables the users of financial statements
to see clearly the impact that continuing operations and discontinued operations have had on
the financial results.

• Continuing operations are the areas of the business that the company intends to remain
involved in for the foreseeable future.

• Discontinued operations are those operations that have been sold or permanently ter-
minated during the past trading period.

The income statement for Sportsequip plc might now look like the one in worked example
6.2.

Worked example 6.2

Sportsequip plc

Income statement Year to 31 December 21×3

£m

Continuing operations

Revenue 3,700

Expenses 2,200

Profit from continuing operations 1,500

Discontinued operations

Revenue 300

Expenses 800

Loss from discontinued operations 500

Total profit for the period 1,000

Required

In the light of this information, what profit will Sportsequip plc now generate next year
if the conditions in worked example 6.1 were to apply?

Solution

Profit will be £1,800 because that is what the continuing operations will contribute to
profit (£1,500 + 20%).

Note: The discontinued operation, which incurred a loss of £500m last year will have no
impact on the results for the year to 31 December 21×4.

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By furnishing the potential investor with a little extra information, the income statement
allows us to anticipate profit being 50% (£1800 / £1200) higher than we estimated against
the old style income statement.

6.3 Segmental Reporting

As Sportsequip plc is a multinational company operating worldwide, it would be naïve to
assume that its subsidiaries and associate companies in all countries experience the same
trading and economic conditions. Clearly, the prediction given above that growth next year
would be 20% throughout the world is unrealistic. Why should the market for tennis racquets
and hockey sticks necessarily show the same growth pattern? Why should the market in South
Africa show the same growth rate as the market in Australia?

Where companies are operating in a variety of ‘classes of business’ (tennis racquets, hockey
sticks, etc.) and operating across a number of ‘geographical segments’ (South Africa, Australia,
etc.), then the user of financial statements would benefit greatly from feedback of how each
‘class of business’ and each ‘geographical segment’ has performed.

The IASB issued an international accounting standard, IFRS 8, on Segmental Reporting. This
standard required larger companies to include, as part of their financial statements, a disclosure
note providing an analysis of their activities. Where companies operate across several business
segments or in several geographical countries, segmental analysis enables users of the financial
statements to appreciate more thoroughly the results of the company and makes them more
aware of the impact that changes in significant components of a business can have on the
company as a whole.

6.3.1 Segmental Analysis

IFRS 8 calls for the analysis of fiveitems, each to be split by class of activity and geographical
area. These fall under the following headings.

• Revenue − consists of revenue directly attributable to a segment, whether relating to
sales to external customers or revenue relating to ‘internal sales’ to other segments
within the group. If inter-segment sales are material, they should be disclosed separately
in the segmental analysis.

• Profit or loss− the segment profit or loss should be analysed based on the results before
interest and tax. The profit before interest is taken because normally interest incurred
is a matter of overall financial policy, rather than something specifically connected to an
identifiable segment. In determining segment profit or loss, you should remember that it
is likely that costs have been incurred by the company for the benefit of more than one
segment. The normal treatment of these common costs is simply to deduct them from
the total segment results without apportionment.

• Net assets − defined as the operating assets minus the operating liabilities. As with
common costs above, there may well be assets held by the company (for example, the
head office building) which are difficult to allocate across the different segments and are,
therefore, shown as unallocated.

IFRS 8 largely leaves it to the directors to decide whether or not the company has two or
more segments but the standard expects that segmental information should be provided for
each reportable segment, defining a reportable segment as one which contributes at least 10%
of sales or contributes at least 10% of profit or one which has 10% or more of the total assets
of the company.

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A typical segmental reporting disclosure note might appear as shown in the example which
follows.

Caves plc

Segmental Report for Year ended 31 December 20×5

Business segment (£m)

Stationery Books Videos Group

20×5 20×4 20×5 20×4 20×5 20×4 20×5 20×4

Revenue 12 10 35 40 53 20 100 70

Profit before tax

Segment profit 3 2 8 10 20 10 31 22

Common costs 2 2

Group profit 29 20

Net assets

Segment net assets 20 20 45 40 60 40 125 100

Unallocated assets 20 20

Total assets 145 120

Geographical segment (£m)

Europe USA Far East Group

20×5 20×4 20×5 20×4 20×5 20×4 20×5 20×4

Revenue 60 25 25 30 15 15 100 70

Profit before tax

Segment profit 20 10 7 7 4 5 31 22

Common costs 2 2

Group profit 29 20

Net assets

Segment net assets 50 40 40 40 35 20 125 100

Unallocated assets 20 20

Total assets 145 120

The point about segmental reporting is that each segment may differ in terms of:

• profitability

• risk

• rate of growth

• potential for future development.

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Without calculating the numbers from the example above the following paragraph highlights
some of the analyses that users could carry out when given segmental data for two years are
given below.

6.3.2 Business Segment Analysis

The following features could be investigated:

• sales growth percentage for each business segment

• total sales growth percentage for the group

• percentage split of total sales between the business segments

• profit margin (profit/sales) for each business segment

• profit margin for the group

• profit growth percentage for each business segment

• the percentage that each business segment contributes to group profit

• ROCE (profit/net assets) for each business segment

• ROCE for the group

• percentage increase in investment for each business segment

• the percentage of the overall investment allocated to each business segment.

Clearly, a very similar list could be drawn up for the geographical segment.

Given the analysis above, users of the financial statements, firstly, can see the impact that
changes in individual segments have had on the results as a whole and, secondly, having this
enhanced understanding of what has happened in the past, they are in a much better position
to assess the future prospects of the organisation.

Section 6.2 illustrates how IFRS 5 on discontinued operations had started to provide users
with additional information. However, IFRS 5 should not be seen as a substitute for segmental
reporting because it does not analyse different activities in detail. IFRS 5 offers some analysis
on the face of the profit and loss account, which can give users of the financial statements an
overview of the total results, but the disclosure note on segmental analysis might just provide
them with that extra bit of detail.

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Worked example 6.3

We might now have the following information for Sportsequip plc.

Sportsequip plc

Income statement Year to 31 December 21×3

21×3 21×2

£m £m

Revenue

Tennis racquets 1,500 1,500

Hockey sticks 1,500 1,400

Sportswear 1,000 700

4,000 3,600

Expenses 3,000 2,800

Profit

Tennis racquets 500 500

Hockey sticks 100 100

Sportswear 400 200

1,000 800

Required

What could we now deduce about Sportsequip plc results?

Solution

We can determine, for both years, how much each class of business contributes to sales
and profit.

Revenue breakdown 21×3 21×2

Tennis racquets 37.5% (£1,500/£4,000) 41.6%

Hockey sticks 37.5% (£1,500/£4,000) 38.9%

Sportswear 25.0% (£1,000/£4,000) 19.5%

100% 100%

Profit breakdown 21×3 21×2

Tennis racquets 50% (£500/£1,000) 62.5%

Hockey sticks 10% (£100/£1,000) 12.5%

Sportswear 40% (£400/£1,000) 25.0%

100% 100%

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We can calculate the revenue increase for each class of business which might help us
to determine the growth area for the future:

Tennis racquets no increase

Hockey sticks 7.1% increase (£1,500/£1,400)

Sportswear 42.8% increase (£1,000/£700)

By linking the profit to the sales, we can also calculate the profit margin for each class
of business for both years.

Revenue breakdown 21×3 21×2

Tennis racquets 33.3% (£500/£1,500) 33.3%

Hockey sticks 6.7% (£100/£1,500) 7.1%

Sportswear 40.0% (£400/£1,000) 28.5%

Conclusion

The sportswear market has the highest sales growth and the highest profit margin,
suggesting a rosy future for this class of business. The tennis racquet market has gone
flat in terms of growth, although it is still the major contributor to the company’s sales
and profit. Hockey stick sales increased slightly, but at a low and declining profit margin,
perhaps due to competition in the marketplace.

The segmental analysis shown above provides so much more meaningful information than
the single profit and single sales figure that we used to see on the income statement. And
remember, there’s more! Companies must disclose their net assets (investment) for each class
of business and geographical segment. Linking profit to net assets enables us to calculate the
return on capital employed (ROCE) for each business segment so that we can see which areas
of the business are generating the best returns.

6.4 Summary

In this unit, we have seen how IFRS 5 requires companies to disclose information on areas of
the business that have been discontinued during the trading period.

In addition, , IFRS 8 requires companies to provide segmental information to user groups.
This could be either business or geographical segments. Sales, expenses, profit,assets and
liabilities must be disclosed for each segment, providing the users of financial statements with
information on the growth and decline in areas of the business, as well as enabling them to
calculate profit margins and returns on investment by segment.

Both of these standards are further evidence that the ‘accounting world’ continually strives to
improve the quality of financial reporting.

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Chapter

Chapter
10

Performance Management

10.1 Introduction: The Crisis in Management Accounting 137
10.2 The Development of Strategic Management Systems 138
10.3 The Balanced Scorecard 138
10.4 Stern Stewart’s Economic Value Added (EVA)TM 142
10.5 Summary 147

You will notice that we refer to much literature in this unit and it is to be hoped that you will
read up on some of the sources that have been cited. It is not expected that you will read all
of these sources − that would be asking a bit too much. More important to your success in
this unit, however, is that you try to find independent sources for yourself. You need to be
able to offer your own evaluation of the literature after all and seeking out your own sources
is a significant part of developing that skill. There is a list of the sources referred to in the
reference section at the back of this unit but bear in mind that it is not exhaustive. It will help
you initially, however, if you have an interest in a particular area.

Learning Objectives

After completing the study of this unit you should be able to:

• broadly provide analysis of the environment, in a management accounting and control
sense, which gave rise to developments such as economic value added (EVA) and the
Balanced Scorecard (BSC)

• appraise the contribution of the BSC to the area of performance management

• appraise the contribution of EVA to the area of performance measurement

• provide critical analysis of both these techniques, based on academic reading

• analyse the feasibility of the BSC and EVA being used together.

10.1 Introduction: The Crisis in Management Accounting

In the early 1980s, US and UK companies began to lose contracts to Japanese organisations
which, previously, they would have succeeded in attaining. There appear to have been two main
reasons for this: the Total Quality Management revolution had benefited Japanese entities to
the extent that they could simultaneously decrease cost and increase quality but, additionally,
Western companies came to the conclusion that they were not measuring and managing the
correct metrics in their companies.

For example, management accounting had always been (and remains today) very effective at
splitting costs into their fixed and variable elements and ensuring that costs are accurately
allocated to product to enable stock to be valued in line with the existing accounting regulations
(International Accounting Standard 2 and 11). This meant that a great deal of attention was
paid to determining which costs were direct and which were indirect. However, the nature
of the composition of costs had changed and companies were increasingly finding that the
majority of their costs were indirect whilst their measurement and management systems
were constructed to analyse, in detail, the costs which were direct in nature. This meant that
there was a fundamental and potentially dangerous mismatch between cost behaviour and
cost analysis. In practice, management accounting was measuring and managing aspects of the
business which suited the purposes of financial reporting (e.g. valuation of stock) but which
did not help the business to plan, control or make decisions for the future.

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Resultantly, management accounting was seen as being in crisis and the publication of a book
called Relevance Lost: The Rise and Fall of Management Accounting in 1987 by Johnson and Kaplan
made public what many companies believed, privately, to be the case. Indeed, one sentence
in that book was seen as providing the rationale for much of the research in this area for the
next 20 years:

‘management accounting information is too late, too aggregated and too distorted to
be relevant for managers’ planning and control decisions’ (p1).

It is really the task of each individual observer to assess whether relevance has been regained
or not. Certainly, there have been many developments in the field of management accounting
since then, most of which we do not have time to focus on in this unit. If you are interested,
however, you might consult any management accounting textbook to find out about things
such as activity based costing, activity based management, target costing, customer profitability
analysis, value chain costing, benchmarking and strategic management accounting. In this unit,
we will focus on two particular developments − the Balanced Scorecard (BSC) and economic
value added (EVA) − as strategic management and measurement tools. Firstly, we need to
explain what we mean by a strategic management system and to trace its development.

10.2 The Development of Strategic Management Systems
When we talk of a strategic management system we mean one which, even if only in broad
terms, considers the external environment within which the entity operates. From this, the
entity decides upon its strategy and from this comes the annual/six-monthly/monthly budget.
If the system is truly interactive, it will assess the continued viability of the entity’s strategy
and make adjustments to the internal measurement and management system accordingly.

Anthony (1965) is generally credited as being the first commentator to consider that meas-
urement and management should, perhaps, have a strategic perspective when he points out
that the aspects of control and planning should be treated as two distinct functions of manage-
ment. This conclusion had been given supporting evidence by previous commentators such as
Chandler (1962), who highlighted that expanding industries were creating problems in terms
of control for traditionally run family entities. It had become almost impossible to find one
person to control the vast number of developing divisions, emphasising how the function of
control was inadequately developed to deal with the changing environment.

Anthony (1965), therefore, with some justification, introduced his book by saying ‘the area in
which we are interested, planning and control systems, is so new as an organised field of study
that textbooks providing a framework have not yet been written’ (p.4). His main contribution
to the development of strategic management systems is, therefore, to attempt to provide one,
which he does by initially stating that he views planning and control to be indistinguishable. He
further develops his argument by drawing a distinction between strategic planning (deciding
upon objectives and upon how to obtain the resources for those objectives), management
control (how managers ensure that resources are obtained and used effectively to achieve the
objectives) and operational control (the process of ensuring that specific takes are carried out
effectively and efficiently).

Otley (1999) highlights how the literature in this area has subsequently developed, which he
summarises as going ‘beyond measurement of performance to management of performance’
(p.363) and therefore from beyond planning to managing. He highlights, as many other com-
mentators also do (Simons, 1995; Drury, 2008 for example) that the BSC is one of the most
significant developments in terms of strategic management and one which is increasingly being
adopted by companies in both the private and public sectors.

10.3 The Balanced Scorecard
The BSC is the invention of Robert Kaplan, a Harvard Business School professor, and David
Norton, a management consultant. They had undertaken some research work with major blue

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chip American companies towards the end of the 1980s/beginning of the 1990s and, using a
research approach called grounded theory (Glaser and Strauss, 1967) to analyse their work,
they developed the BSC. It is interesting to note, initially, that their model of the BSC was
built from practice, not from a theoretical construct about what should be happening. As can
be seen from Figure 10.1, the BSC is composed of four component parts:

Figure 10.1 The balanced scorecard

The double-headed arrows which join the aspects together are the key to the success of
the BSC: if the customer component is not achieved, then the financial target will not be
achieved. If the financial targets are not achieved, the internal business process targets will not
be achieved, neither will those in learning and growth, nor those in customer. The essence
is therefore one of cause and- effect in that something is achieved (or not) as a result of
performance which then enables (or not) something else to be achieved. The other principle
idea within the BSC is that it is derived from the organisation’s vision and strategy and that it
becomes, in essence, a strategic implementation tool.

10.3.1 How Might It Look in Practice?

The idea behind the BSC is that corporate goals should be devolved throughout the organ-
isation by means of each department/unit having their own BSC. The first thing that must
be decided upon, therefore, is the company’s strategy. As Kaplan and Norton (1996) make
clear in their book, it is counter-productive for any company to try and ‘borrow’ a BSC from
any other company as they operate in different environments, have different strategies and
will, therefore, want to measure different things. The strategy having been established, the
company can then decide upon the aspects that they feel it necessary to measure to ensure
strategic goals are achieved.

In a company such as amazon.com, the BSC may look something like this.

Financial perspective

Objective: Profitability

Measures: Average gross margin per sale/per customer, average customer acquisition cost

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Objective: Growth

Measure: Quarterly revenue

Objective: Survival

Measure: Cash flow

Customer perspective

Objective: Brand strength

Measures: Brand awareness, brand meaning, customer life cycle

Objective: Customer satisfaction

Measures: Customer satisfaction index, ‘traffic’ conversion rate, knowledge-base, cus-
tomer share, defection rate

Objective: Market share growth

Measure: Market share

Internal business process perspective

Objective: Quality and reliability

Measures: On-time delivery, service error rate

Objective: Efficiency

Measures: Level of disintermediation, revenue per dollar of web development

Innovation and learning perspective

Objective: Innovation

Measures: Distribution of management attention in meetings between time spent dis-
cussing past, present, future issues

Objective: Resources maximisation

Measures: Employee retention, revenue per employee, staff attitude survey

Objective: Diversification

Measures: Pareto analysis, % sales from proprietary products, % of quarterly sales from
new segments

If we assume that amazon.com’s strategy is to develop themselves as a ‘branded’ low cost
producer, these measures would, hypothetically, appear to be an appropriate balance between

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financial and non-financial. I would stress these measures are hypothetical but also that they
probably provide a realistic indication of the kind of things that the company might view as
critical success factors at a corporate level.

Kaplan and Norton have written a further two books following their original one in 1996. In
2001, they highlighted the BSC’s essence as an overall strategic management system in The
Strategy Focused Organisation and in 2004, they provided further detail and analysis on how to
map strategic direction into specific measures in Strategy Maps. To be knowledgeable about
what is happening in terms of the development of the BSC from the point of view of those
who initiated it, you should be aware of developments in each of their three books. If you find
them to be of great interest, then of course you should read them cover to cover. However,
to gain an overall feeling about what’s said, it’s necessary to read the introductory chapters of
each and then to dip in to whichever chapters you feel to be appropriate.

10.3.2 What Does the Research Say?

Much research has been carried out into the BSC and probably the main reason for this
is that many companies are using it. Unlike other theoretical developments in management
accounting (e.g. backflush accounting, modified internal rate of return), the BSC was derived
from practice which makes it clear that it is at core a practical, rather than a theoretical,
development. That is not to say there is no theory underlying its usefulness, as clearly its main
purpose is to help companies organise themselves in such a way that they can maximise their
financial return. In that sense, it is a shareholder value model.

Given its wide usage, we have a reasonably extensive variety of case study research on the
development of knowledge of the BSC in practice. The research that is cited here, and that
which refers to EVA also, is quite selective and is in no way meant to be extensive but instead to
encourage you to seek out these and other sources and to undertake your own investigations
into the area of the BSC.

Firstly, we have the work which has been undertaken by Kaplan and Norton − 1992, 1996a,
1996b, 1998, 2001, 2004. However, it would be fair to say that this work might not represent
the most balanced view as Kaplan and Norton have their own management consulting organ-
isation which specialises in BSC implementation and it is unlikely that their own publications
will offer anything in the way of critical or derogatory commentary on it.

The area of implementation is one that a few commentators have chosen to focus their
research upon. McCunn (1998) suggests that companies should implement a pilot project
before proper implementation, as the BSC involves a cultural change that staff need to take
time to adjust to. This is something which Ahn (2001) implicitly agrees with, as he highlights
that the implementation of the BSC into one business unit took four months. He indicated
that the planning and initial conception of how implementation would be undertaken should
have been better conceived. McAdam and Walker (2003) also provide evidence that failure
to implement a pilot project can have catastrophic consequences as their research details the
five-year journey to implementation of the BSC in a UK local council. Above all, McAdam and
Walker believe their study highlights the importance of having a ‘champion’ of the BSC within
the company − that is, someone in he company who is enthusiastic about the advantages
the BSc can bring to the company and who will resultantly ‘sell’ it to their colleagues. They
argue that this is a necessity, as most implementation is originally undertaken by management
consultants who must eventually rescind control to the company itself.

Many commentators would come to the broad agreement that companies believe the BSC to
be beneficial. Malmi (2001) reports that, of the 17 Finnish companies he studied, all of them
were finding the BSC to be of great benefit as a strategic implementation system. Jazayeri and
Scapens (2001) report the same in their one company case study and Campbell et al. (2002)
report on the benefits the company achieved to their measurement and management systems
as a result of adopting the BSC. Unfortunately, there are not, as yet, any studies that link

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adoption and development of the BSC to increased profitability. This is not too surprising, as
such things are difficult to show (we cannot know how the company would have performed
had it not adopted the BSC, for example), and also present a problem with regard to when
we measure success/failure. Should we, for example, wait until the company has adopted the
BSC for two years/three years/ten years? Therefore, the lack of published study in this area
does not mean that the BSC is unsuccessful; indeed, as previously indicated, research appears
to be telling us that companies are using it increasingly as a performance management system.

10.3.3 Criticisms of the BSC

Several commentators have been critical of the BSC, both in its theoretical and practical
application. Olson and Slater (2002) for example, indicate that the four component parts of
the BSC cannot work for all companies as companies differ in strategy, environment, size,
degree of technology, etc. In so doing, they are highlighting that contingency theory holds to
be true.

Contingency theory is one of the main theories that permeates management accounting
research and its basic premise is that an entity’s management accounting and control system
will be determined by a number of variables (those mentioned above and others). If you want
to read further on this, have a look at Chenhall’s 2003 paper, which gives a concise review
of the literature in the area of contingency theory. Olson and Slater’s point is that, given the
existence of contingency theory, we would not expect every company to have these four
component parts weighted to the same extent. It is illogical to conceive that this would be
the case.

Another major critic of the BSC has been Hanne Norreklit. She has published two papers in
this area in 2001 and 2003. Whereas the 2003 paper is very interesting, the 2001 paper is
essential reading. In this paper she highlights the problems with the assumptions underlying
the supposed success of the BSC and illustrates this point with the example of whether we
can assume that loyal customers (and increased loyalty of customers) equates to increased
profits. This is the kind of ‘cause-and-effect’ relationship which is crucial to the success of
the BSC. Norreklit argues that we cannot assume this to be the case, as we are making the
assumption that the customers themselves are profitable. Likewise, we cannot assume that
increased efficiency will naturally equate to increased financial performance as our efficiency
levels may not be near those that the market requires. She attacks the very basis of the BSC’s
assumptions by arguing that Kaplan and Norton use arguments based on causality when they
should be using arguments based on verifiable logic. As an example, she argues that claims
such as ‘loyal customers = increased profits’ must be shown by logical deduction to be the
case. They are not, and Norreklit concludes that all we can really say in this area is that disloyal
customers are unlikely to lead to increased profits.

Others have been critical of the BSC on the basis of its practical application. Malina and Selto
(2001) highlight how it leads to entities having too many things to measure and losing focus
about the important metrics in the company. Van Veen-Dirks and Wijn (2002) highlight how
the BSC does not explicitly track changes in the external environment and indicate that, by
the time the company has implemented the BSC, they are probably measuring and managing
the wrong things as they will have lost focus on the overall strategic environment.

10.4 Stern Stewart’s Economic Value Added (EVA)TM

The area of shareholder value has been an increasingly written-about, talked-about and
researched area over the last decade or so. At core, this idea (some might say philosophy)
involves measuring a company’s profitability based on economic profit rather than account-
ing profit. Several different management consulting companies offer their own variations on
the basic economic profit measurement (e.g. Boston Consulting Group’s Cash Value Added,
Marakon’s Equity Spread, Holt Value’s Cash Flow Return on Investment) but the most widely

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discussed is probably Stern Stewart’s Economic Value Added (EVA)TM, a performance man-
agement philosophy that the New York consulting agency has trademarked. Their client list
is distinguished and is headed by many blue chip companies and several global leaders in
their field, including Coca-Cola, CSFB, Morgan Stanley, Diageo, US Postal Service, Equifax, JC
Penney and Quaker Oats. Their calculation of EVA is straightforward (Stewart, 1999):

EVA = Net Operating Profit After Tax (NOPAT)
− Weighted Average Cost of Capital [WACC] × ({adjusted}capital base)

Stewart (1999) believes that the calculation of EVA puts the idea of NPV at the forefront of
a company’s financial management system. The principal benefit of this is that the company’s
performance is judged against whether it returns in excess of its cost of capital.

It is easy to see how this might work on a calculation basis though less straightforward to
imagine this as an overall guiding company philosophy. However, Stewart offers some practical
examples about successful EVA practices within companies, including charging the cost of
capital against every sale that the company makes, charging the cost of capital to excess stock
(which may have been bought on a false economy bulk-purchase, reduced price) and ensuring
that managers realise that the purchase of things such as new delivery vehicles must make a
positive economic return against the amount they add to the balance sheet.

10.4.1 Adjustments

Significantly, Stewart suggests that changes should be made to the way the income statement
and balance sheet are constructed. Ehrbar (1998) indicates that over 160 potential adjustments
could be made to US Generally Accepted Accounting Principles (GAAP) to produce accounts
that give a more accurate reflection of the capital used by the entity. Stewart (1999) recom-
mends, for example, that all research and development be capitalised rather than expensed
since it is to be expected by the shareholder that the company earn a return on it. He also
suggests that all goodwill be capitalised. Ehrbar develops this further in that he suggests that
aspects such as reorganisation costs be capitalised, asking what the point of reorganisation
is if not to increase shareholder value. Clearly, the capital used in the company would be
considerably higher after Stern Stewart’s adjustments than it was beforehand. This ensures
that the EVA figure is achieved against a higher hurdle that would otherwise be the case.

Stern Stewart believe this to be one of the strengths of EVA as it starts to address the
accounting conservatism at the basis of GAAP which they believe to be ‘particularly ill-suited
to the business environment that is likely to prevail in the coming decades’ (Ehrbar, 1998,
p.163). Most companies require no more than 15 adjustments in practice, according to Ehrbar
(1998), which keeps the formula for calculation simple and once established it should be
‘virtually immutable, serving as a sort of constitutional definition of performance’ (p. 166).
Other research, as we will discover later, indicates that many companies make no adjustments
at all.

10.4.2 Bonus Bank

One of the other main features of Stern Stewart’s system is their adherence to what they term
‘the bonus bank’. Ehrbar (1998, p.105) believes that it ‘solidly aligns management goals with the
creation of shareholder wealth . . . the use of a bonus bank, with a proportion of exceptional
bonuses held hostage and subject to loss if performance subsequently falls, causes managers
to focus on projects that create enduring value’. Stewart (1999) also believes that the addition
of a bonus bank will ensure that managers and directors do not take decisions that reward
single-period success but are detrimental to the long-term success of the company. He argues
that it is relatively easy to improve single period performance at the expense of the longer
term by not investing in new capital projects or cutting labour. It is, therefore, necessary for
the owners of the firm to ensure that any success that is achieved is sustainable and Stewart’s

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proposal to prevent sub-optimal decisions is to pay out 50% of the bonus bank on a yearly
basis.

This is Stern Stewart’s attempt to solve what has been termed ‘the agency problem’ (Jensen
and Meckling, 1976). The gist of this problem is how we can try to ensure that those who
run and administer the business (the management) act in the best interests of the owners
(the shareholders) and not in their own self-interest. Whether Stern Stewart begin to solve
this through the introduction of the bonus bank is a matter for personal conjecture. Most
independent research highlights that companies do not often use this ‘bank’ system even
though most are content to bonus their staff on the achievement (or otherwise) of an EVA
figure. The system is something that sounds like an excellent theoretical development but
which we would perhaps be less likely to embrace on a personal level − would you willingly
accept that you were going to receive only 50% of the bonus you had worked for in a given
period?

10.4.3 What Does the Research Say?

EVA is beneficial

There has been quite a bit of support for Stern Stewart’s views in basic texts, and such
texts tend to make claims about the success of the movement which are, if not biased,
certainly unsupported. Black et al. (1998), for example, explain that economists have discovered
no relation, over time, between earnings and stock market performance. This claim is not
supported by any citation, nor is supporting evidence supplied for a positive relationship
between shareholder value metrics and stock market performance. Morin and Jarrell (2001)
state that EVA companies consistently earn above average returns on the cost of capital.
Somehow, EVA is the crucial factor here which can lift companies to such a level of achievement.
Although this is never made explicit, the insinuation is clear − and much like Norreklit’s (2003)
criticism of the BSC literature, the reader is left to make connections that are causal, and
require evidence, rather than logical.

Black et al. (1998) also make the same unquestioning case for EVA as a panacea. They suggest
that it is a philosophy which should permeate every level in the company and which will align
strategies, policies, performance measures, rewards, organisational structure, processes and
systems. Stern and Shiely (2001), a Stern Stewart publication, provide similar unsubstantiated
claims for EVA being unquestionably the best management system available. However, perhaps
in recognition of previous criticism, they recognise that EVA adoption in itself will not tell a
company what its strategy should be and advise that it may be of more benefit to companies
that have undergone a major crisis than to others.

EVA as a management control system

EVA is a relatively recent concept and it should be no surprise that literature on its use as
a control system is limited. As with the BSC, there is a time consideration initially − how
long does a researcher wait after the implementation of a control system before it can be
investigated?

Published studies thus far have tended to focus on either an analysis of the prescriptive parts
of the EVA theory and consider them in the light of other theories, or on company case study
analysis, which tends to give conflicting results.

O’Hanlon and Peasnell (1998) are very much of the former aspect and propose the view that
EVA is a management accounting control system. They argue that the adjustments made to
GAAP are on a company specific rather than on a specified-standard basis and are hence
enterprise-contingent by design. This view is developed by placing the system which EVA,
through its adjustments, becomes somewhere in the middle of cash accounting and economic
value accounting. It is not the intention of Stern Stewart, they argue, to place their system
within the framework of either of these extremes of theory and hence EVA permits the

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company to make the decision that is most relevant to its needs. Their overall attitude to EVA
is positive, and they believe that it ‘combines ideas from finance and accounting to provide
a framework within which managers will run the business as though they owned it’ (p.441).
Theoretically, it is an amalgam of ideas which, significantly, may aid businesses in solving the
problems inherent within the agency relationship.

Adoption and Implementation

Malmi and Ikaheimo (2003) consider the practical use of EVA to adopters, and focus on six
Finnish companies in their study. Their results are inconclusive − indeed, the main conclusion
is that ‘adoption of EVA does not seem to be manifested similarly in all organisations’ (p.248).
Some companies that claimed to adopt EVA did not use it for target setting, some did; some
used it as part of the bonus structure and some did not; some had integrated it fully within
the company and some had …

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Chapter
9

Decision-Making − Relevant Information

9.1 Introduction 119
9.2 Relevant Costs 120
9.3 Limiting Factors 124
9.4 Multiple Limiting Factors 126
9.5 Uncertainty 130
9.6 Attitude to Risk 133
9.7 Qualitative Factors 134
9.8 Summary 134

Learning Objectives

After completing the study of this unit you should be able to:

• describe the nature of the decision-making process

• determine what information is relevant for decision-making

• analyse the relevant costs and revenues for each decision

• account for the problems of limiting factors

• account for uncertainty and risk in the decision-making process.

9.1 Introduction

A variety of decisions made by management involve the analysis of alternative courses of action
(Chapter 8). It is important that, in addition to understanding cost behaviour patterns, the
information available to managers focuses on the costs and revenues which are relevant to
the particular decision being made. Different costs exist that can be used for many different
purposes and no single cost can be relevant in all decision-making.

9.1.1 Decision-making

Decision-making for managers is choosing between available alternatives to help achieve some
pre-determined objectives that have been set for the department or organisation. See worked
example 9.1.

Worked example 9.1

As operations manager for your local clothing manufacturing company, consider a few
decisions that you might have to make to achieve your objective of profit maximisation.

Solution

Obviously there is a wide variety of answers that could be offered here, but it is likely
that the following are some of the potential decisions that may need to be considered.

• Should we use labour or invest in machinery?

• Should we subcontract part of our operation?

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• Should we purchase our raw materials locally or buy cheaply from overseas?

• Should we introduce labour incentive schemes?

• Should we accept additional special orders?

The process of decision-making can be broken down into a number of different stages, although
you should be aware that in practice there is considerable overlap between them.

1. Define your objectives

Managers need to be very clear about the objectives set. Therefore, it is important that
the objectives are specific and can be quantified, for example reduce shop floor wastage,
maximise product contribution, minimise labour cost, and so on.

2. Consider alternative actions to meet objectives

There are likely to be a number of ways of achieving your objectives and each of the
possible options should be considered. For example, shop floor wastage may be reduced
either by additional training for the operators or by investing in new technology which
eliminates human error.

3. Data collection and option evaluation

At this stage, all the relevant information (particularly the costs and revenues of each
alternative) should be gathered and quantified, for example, training costs, new wastage
rates, capital expenditure, learning curves.

4. Selection of best option

Having compared the alternatives, you should select the particular course of action which
best satisfies the specified objectives.

Of course, decision-making is not quite as clear cut as suggested here. There is always
competition throughout an organisation for the limited resources available, there are in-
house politics and personal pressures to be overcome, and there are risks and uncertainties
associated with all decision-making.

9.2 Relevant Costs

Although profits are often seen as the key indicator of a company’s performance, it is cash
flow that gives a more accurate picture of the impact of any potential decision − therefore
only cash flow items are included as relevant costs.

Decisions are made for the future benefit of the company and therefore only future costs are
relevant to decision-making. Past expenditures (sunk costs) or costs which have already been
committed (committed costs) are therefore not relevant to decision-making.

Costs which will be incurred regardless of whether or not a particular option is chosen should
be excluded from the decision-making process because management will be interested only in
the additional costs (incremental costs) involved with selecting an option.

Finally, costs that are relevant take into account their impact on the whole enterprise. There-
fore, benefits foregone (opportunity costs) by choosing one alternative instead of another
will have to be considered in the decision-making process. Let’s consider each of these types
in more detail.

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9.2.1 Sunk Costs

A sunk cost is the historical cost associated with purchasing an asset or acquiring a resource.
Regardless of the circumstances that exist, these past expenditures cannot be recovered.
Eventually these assets or resources will no longer be adequate to perform the tasks for
which they were originally purchased, due perhaps to obsolescence or below-par performance.
Decisions will then need to be made as to whether or not to keep or replace the asset. Sunk
costs should not be relevant costs in such decisions. See worked example 9.2.

Worked example 9.2

On the first day of the year, Alan Watkins purchases a Tomy tractor for £200,000. The
tractor is expected to have a useful life of 10 years and no salvage value. One week later,
Watkins sees an advert in the paper for a Trusty tractor for £180,000. This tractor also
has an estimated life of 10 years and no salvage value, but is guaranteed to perform as
well as the Tomy tractor and has a much better fuel usage. The Trusty tractor will save
£60,000 per year (Tomy £100,000, Trusty £40,000) in fuel costs over the Tomy tractor.
Watkins discovers that he could sell his week-old Tomy tractor for £150,000. He has two
options:

a. use the Tomy tractor

b. sell the Tomy tractor and buy the Trusty tractor.

Required

Advise Alan Watkins on the preferred option.

Solution

The relevant costs and revenues that Watkins should consider when making his asset
replacement decision are as follows.

Option 1: Use the Tomy tractor

Fuel costs over the life of the tractor (10 years × £100,000) 1,000,000

Option 2: Use the Trusty tractor

Cost of Trusty tractor 180,000

Resale value of Tomy tractor 150,000

Net outlay for new tractor 30,000

Fuel costs over the life of the tractor (10 years × £40,000) 400,000

Total cost of Trusty tractor 430,000

Incremental benefit from purchasing Trusty tractor 570,000

Note how the £200,000 purchase price of the Tomy tractor did not affect the decision-
making process. This amount was ‘gone forever’ when Watkins bought the tractor. It is
common to think initially that Watkins should not buy the new tractor because he will
incur a £50,000 net loss (200,000−150,000) on an asset that he has only had for a week.
However, consideration of the relevant facts highlights that Watkins will save enough in
fuel costs in three years to pay for the new tractor even if he gets nothing back from the
sale of the Tomy tractor. (£180,000 purchase price divided by £60,000 fuel cost savings
per annum.)

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Watkins had to resign himself to accept the past as a fact and make his new choice based
on the relevant information:

• the cost of the Trusty tractor

• the sale price of the Tomy tractor

• the annual fuel savings of the new purchase.

(Note that the time value of money has not been considered at this stage but features in
Chapter 11.)

9.2.2 Committed Costs

It is often the case with short-term decision-making that a lot of costs are either committed
or perhaps fixed within a specified period of activity. A committed cost is where a previous
managerial decision has committed the organisation to spending funds even though payment
has not yet been made, for example a three-year agreement with a supplier to purchase a
specific quantity of materials at an agreed contract price. After year one, even if an alternative,
cheaper material of improved quality becomes available in the marketplace, the company has a
pre-determined commitment to continue to source its raw materials from the original supplier.

The avoidance of this committed cost will arise only if another major decision is taken either
to amend or reverse the earlier commitment and this would usually involve the company
incurring some penalty payments for breach of contract.

Therefore, the planning and control of a committed cost can take place only at the point in
time just before the commitment is made. It is, therefore, essential that committed costs,
particularly longer-term ones, are properly evaluated before any decision is made to incur
them, thus ensuring the optimum use of the company’s resources. Once committed, the costs
cannot be relevant for future decision-making.

9.2.3 Incremental Costs

Incremental costs and revenues are the additional costs and revenues that are incurred by
following a chosen course of action, for example producing an additional weekly batch of
output. If the additional batch was not produced then the incremental costs would be avoidable,
unlike sunk costs which have already been incurred and cannot be avoided whatever future
courses of action are decided upon.

The use of incremental costs (rather than calculating the total costs of each of a number
of possible propositions), allows us to ignore costs which are unavoidable regardless of the
decision and enables us to focus more simply on the additional benefits of selecting one specific
course of action. Incremental costing is a particularly well-used method in the ‘make or buy’
decision-making situation. See worked example 9.3.

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Worked example 9.3

Dumpy Desks Ltd presently incur the following unit manufacturing costs for their desk
deluxe model.

Direct materials 600

Direct labour 200

Variable overheads 80

Fixed overheads 60

Total unit cost 940

Of the £60 fixed overheads, only £20 is actually caused by the production of the deluxe
model, and could be avoided if the firm chooses not to produce this range. The remain-
ing £40 of fixed overheads are allocated common costs that would continue even if
production of the deluxe model was dropped.

A supplier in the office furniture industry has quoted a price of £910 for supplying the
deluxe model to Dumpy Desks Ltd.

Required

Should Dumpy Desks buy the deluxe model from outside or use their own resources to
manufacture internally?

Solution

Production of the deluxe model requires an outlay of £880 for materials, labour and
variable overheads. In addition, £20 of the fixed overheads is considered to be a direct
product cost because it specifically relates to the manufacture of the deluxe model. The
£40 of fixed overheads are common costs because of general production activity and,
because these costs would continue under either alternative, they are not relevant to the
decision-making.

The relevant cost for the ‘make’ alternative is £900 − the cost that would be avoided
if the product was not made. It is this cost that should be compared wiwth the £910
cost quoted by the supplier under the ‘buy’ alternative. Each amount is respectively
the incremental cost of each alternative. It would therefore be cost-effective for Dumpy
Desks Ltd to continue to manufacture the deluxe model rather than buy it in from outside
because £10 will be saved on each desk produced rather than purchased.

9.2.4 Opportunity Costs

Not all the costs relevant to decision-making will be found in the accounting system. As
management’s role in an organisation is to improve the overall company position, it is essential
that when analysing relevant costs we consider the alternative uses of our available resources.
An opportunity cost is best described as the opportunity foregone because we selected and
followed a particular course of action. For example, if in the Dumpy Desks Ltd example
above, by purchasing externally rather than manufacturing, the available shop floor space can
be rented out to a third party then this would be an opportunity cost saving that would need
to be considered in the decision-making process. See worked example 9.4.

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Worked example 9.4

A computer consultancy firm has been asked to do an urgent job for one of its clients,
for which a price of £50,000 has been offered. The job requires the following resources.

• Thirty hours of the key operator’s time. She is the only member of staff capable of
carrying out the work and is currently paid a rate of £400 per hour. If she were not
involved on this special project, she would be working for another client where the
charge out rate is £900 per hour.

• The use of five hours of mainframe computer time, which is normally charged out
to external users at a rate of £1,000 per hour. The mainframe computer currently
runs 24 hours a day for seven days a week.

• Computer stationery and other supplies costing £4,000.

Required

Should the computer consultancy firm accept the additional work?

Solution

The opportunity cost of the job would need to be calculated as follows.

Labour (30 hours @ £900) 27,000

Computer time (5 hours @ £1,000) 5,000

Supplies 4,000

Total opportunity cost 36,000

Note that labour and computer time is charged out at the normal charge-out rate because
this is the opportunity foregone if this order is accepted.

With the quoted price of £50,000, the firm can boost its profits by £14,000 if it chooses
to accept this special order.

In Chapter 8 we looked at cost behaviour and, having analysed costs into their fixed and
variable elements, we used this analysis in a range of cost−volume−profit decision-making
scenarios. The use of contribution per product unit was seen as particularly relevant in
calculating breakeven points and when determining output required to meet targeted profit
figures.

However, our analysis in Chapter 8 did not consider the possibility that there may be a scarcity
in one or more of the resources required to meet the specific objectives that had been decided
upon. It is important that we now consider such limiting factors.

9.3 Limiting Factors

Frequently in practice, management find themselves unable to effect decisions which maximise
product contribution because of limited resources (limiting factors) which place a constraint
on the organisation’s ability to concentrate on the product yielding the greatest contribution.
The following are some of the typical limiting factors faced by businesses:

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• financial resources

• skilled labour

• manufacturing capacity

• material supply

• sales.

Where a single binding constraint can be identified (see worked example 9.5), then the
general objective of maximising contribution can be achieved by selecting the alternative
which maximises the contribution per unit of the limiting factor. The following formula would
apply.

Contribution (£)
Selected limiting factor (e.g. hours, units, etc.)

= Contribution per limiting factor

Worked example 9.5

Returning to worked example 8.5 of Bee, Cee and Dee, let us assume that the following
information is available:

• total machine capacity = 100,000 hours

• processing time per product

Bee = 1.72 hours

Cee = 1.20 hours

Dee = 2.50 hours

• unlimited demand per product

• fixed costs are £280,000

• contribution per unit:

Bee = £20

Cee = £15

Dee = £30

Required

Rank the products in order of contribution per unit of the constraint and establish the
most profitable product.

Solution

Bee Cee Dee

Contribution per unit £20 £15 £30

Process hours required 1.72 hours 1.2 hours 2.5 hours

Contribution per process hour £11.63 £12.5 £12

Ranking 3 1 2

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Maximum output

Bee Cee Dee

Maximum unit output 58,139 83,333 40,000 (note 1)

£000s £000s £000s

Total contribution 1,163 1,250 1,200 (note 2)

less: fixed expenditure 280 280 280

Profit 883 970 920

Notes

1. Given by dividing the total machine capacity by the process hours per unit (for
example Bee: 100,000 hours/1.72 hours).

2. Given by multiplying the maximum unit output by the contribution per unit (for
example Cee: 83,333 units × £15 per unit).

Conclusion

Produce the maximum amount of Cee possible.

Let’s extend the example further by assuming that the maximum demand for Cee was
50,000 units. What’s your most profitable product mix now?

Obviously you want to maximise the sales of Cee first. This requires 60,000 processing
hours (50,000 units × 1.20 hours per unit) and leaves you only 40,000 hours (capacity of
100,000 hours less the 60,000 used on Cee) to use on the other products. From your
previous ranking, Dee would seem to be the next best product to sell. With 40,000 hours
available you could manufacture and sell 16,000 units of Dee (40,000 hours/2.5 hours per
unit). This would generate a profit of £950,000 as highlighted below.

Cee Dee Total (£)

Contribution per unit £15 £30

Sales volume (units) 50,000 16,000

Total contribution £750,000 £480,000 1,230,000

less: Fixed expenditure 280,000

Profit 950,000

9.4 Multiple Limiting Factors

Where there is more than one scarce resource, it is no longer possible to use the simple
technique of ranking items in order of contribution per limiting factor to determine the profit
maximising situation. With a choice between two products, where two or more limiting
factors exist, then a graphical approach is usually used to determine the maximum objective.
See worked example 9.6.

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Worked example 9.6

Tweety plc makes two models of bird cage. The relevant unit price and cost details are
as follows.

Model A Model B

£ £ £ £

Selling price 600 1100

Variable cost 160 600

Fixed cost 240 300

400 900

Profit 200 200

The production data per unit is as follows.

1. Model A requires 5 hours of machine time and 1 kg of materials.

2. Model B requires 3 hours of machine time and 3 kg of materials.

3. The maximum available machine hours per week is 200 hours.

4. The maximum available kg of material per week is 80 kg.

Required

Determine the best production plan for Tweety plc using a graphical approach.

Solution

Stage 1 − define variables

The limiting factors facing Tweety plc are the availability of materials and machine hours.
The only things which it can vary are the quantities of each model of bird cage produced.
Assuming its objective is to maximise contribution, it needs to know the optimum quantity
of each model that it should produce. The variables are therefore as follows.

Let x = the number of model A to be produced
Let y = the number of model B to be produced

Stage 2 − establish constraints

The first constraint is the machining hours. Each unit of model A requires 5 hours while
each unit of model B requires 3 hours. The total machine hours needed to make x
number of model A and y number of model B is 5x + 3y. As the total number of
machine hours cannot exceed 200 the constraint is:

5x + 3y≤ 200

On the same basis the constraint for materials is:

1x + 3 ≤ y80

Since it cannot produce negative output, non-negativity constraints are added:

x≥ 0
y≥ 0

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Stage 3 − establish the objective function

The contributions of the two models are as follows:

Model A £600 − £160 = £440
Model B £1100 − £600 = £500

The objective of Tweety plc is to maximise contribution, and therefore the objective
function is:

Contribution (C) = 440x + 500y

Stage 4 − preparing the graph

The problem has been reduced to four constraints and one equation. Because the con-
straints are all linear expressions, by plotting them on a graph they would all give straight
lines and help us solve the problem.

You can only use a graph where, as we have here, there are two variables in the problem.
One variable is represented by the xaxis and the other by the y axis. Since we don’t
want negative outputs the graph should only show zero and positive values of x and y.

a. Plot the first constraint 5x + 3y = 200

If x = 0 then y = 66.66
If y = 0 then x = 40

Any combined value of x and y within the shaded area (known as the feasible area)
below would satisfy the constraint. See Figure 9.1.

Figure 9.1 Feasible area with one constraint

b. Plot the second constraint 1x + 3y = 80

If x = 0 then y = 26.66
If y = 0 then x = 80

Where there is a second, or several constraints, then the feasible area of combina-
tions of values of x and y must be an area where all the constraints are satisfied.
Thus by plotting the second constraint, the feasible area has reduced. See Figure 9.2.

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Figure 9.2 Feasible area with two constraints

c. Determine the optimum product mix.

This could be calculated manually by finding out what contribution each of the
possible solutions would give, but would be a very labour intensive operation.
Graphically, we can work this out by using ‘contribution lines’. Let us assume that
we wish a contribution of £8,800. The possible combinations required to earn a
contribution of £8,800 can be given by the objective function 440x+500y = £8,800
and plotted on a straight line (contribution line 1). See Figure 9.3.

If x = 0 then y = 17.6
If y = 0 then x = 20

Figure 9.3 Contribution line 1

Likewise, for a contribution of £13,200 another straight line (contribution line 2)
could be drawn (see Figure 9.4).

If x = 0 then y = 26.4
If y = 0 then x = 30

Note that the contribution lines are parallel, with the larger contribution being
shown by a line furthest from the origin. Look at Figure 9.5. As we move the
line away from the origin, there comes a point where the contribution line would
cease to lie in the feasible area and a greater contribution would not be achieved

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Figure 9.4 Contribution line 2

because of the constraints. Our optimum point in this example is, therefore, where
the contribution line (contribution line 3) passes through the intersection of the
constraint lines, and our optimum mix is approximately 30 of model A and 16 of
model B.

Figure 9.5 Contribution line 3

Self-check for constraints

Machine hours: (30 model A × 5 hrs) + (16 model B × 3 hrs) = 198 hours
Materials: (30 model A × 1 hr) + (16 model B × 3 hrs) = 78 kg

The solution approximates to the constraints of 200 hours and 80 kg respectively.

Note that in worked example 9.6, the choice was restricted to a mix of two products with
two or more limiting factors. Where the choice allows a mix of three or more products, with
two or more limiting factors, a more complicated linear programming approach has to be
used. This is, however, beyond the scope of this module.

9.5 Uncertainty

So far in this unit, we have stressed that decisions are made for the future benefit of the
organisation. If we could predict with 100% accuracy what was going to happen in the future,

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then decision-making would be greatly assisted and targets that we had set ourselves would
be achieved. Unfortunately, life is not as simple as this, and the reason that the final outcome
rarely turns out as anticipated is that uncertainty exists.

9.5.1 The Decision-Making Model

To introduce uncertainty into the decision-making model, we need to expand slightly the
process we looked at earlier in the unit. The starting point is still to define the objective that
you hope to achieve, for example minimisation of product cost, and then to consider a list
of possible alternative courses of action that will enable the objective to be achieved. At this
stage, because of the uncertain environment in which we operate, you need to consider the
following:

• All the uncontrollable factors (usually known as events) which may influence the outcome
of each possible course of action, for example an increase or no increase in the level of
interest rates, growth or no growth in the level of product demand

• The probabilities of these events occurring

• A set of possible outcomes (diagramatically expressed as decision trees) which measure
the predicted consequences of the various possible combinations of actions and events

• The attitude of the decision-maker to risk-taking.

Only on giving the above some consideration will you be in a position to select a specific
course of action which will enable you to achieve your pre-determined objective − see
worked example 9.7.

Note the distinction between actions and events. Actions are choices made by management
which are under the management’s control, for example the price an organisation should
charge for its products. Events, uncontrollable factors affecting the outcome, are occurrences
that management cannot control, for example fluctuating foreign exchange rates.

Worked example 9.7

Millie Black plans to sell her new, revolutionary, state of the art guitar at a highly respected
and extremely well-attended musician’s trade convention in London, England. Millie buys
these guitars from her uncle, who manufactures them at a cost of £2,400, and plans to
sell them for £4,000. On approaching the convention organisers she is offered three ways
of renting her stall:

• option 1 pay a fixed fee of £40,000.

• option 2 pay a fixed fee of £28,000 plus 5% of her guitar sales revenue.

• option 3 no fixed fee but pay 20% of her guitar sales revenue.

Millie estimates that there is a 0.60 probability that sales will be 40 units and a 0.40
probability that sales will be 70 units. Which of the rental options should Millie choose?

Stage 1 − define objective

Millie’s objective is to maximise her net cash inflow from the convention.

Stage 2 − identify options

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Millie has three possible options:

• pay £40,000 fixed fee

• pay £28,000 plus 5% of revenue

• pay 20% of revenue but no fixed fee.

Stage 3 − identify events

Millie’s only uncontrollable factor is the number of guitars that she can sell.

Stage 4 − assign probabilities

Millie assesses that she has a 60% chance of selling 40 guitars and a 40% chance of selling
70 guitars.

Stage 5 − identify possible outcomes

As you can see in the decision tree presentation of data shown in Figure 9.6, there are
six possible net cash flows.

Outcomes

1. 40 guitars × (£4000 − £2400) = £64,000 − fixed fee £40,000 = £24,000

2. 70 guitars × (£4000 − £2400) = £112,000 − fixed fee £40,000 = £72,000

3. 40 guitars × (£3800 − £2400) = £56,000 − fixed fee £28,000 = £28,000

4. 70 guitars × (£3800 − £2400) = £98,000 − fixed fee £28,000 = £70,000

5. 40 guitars × (£3200 − £2400) = £32,000

6. 70 guitars × (£3200 − £2400) = £56,000

Figure 9.6 Decision tree

Expected values

Option 1 (£24,000 0.6 + £72,000 0.4) = £43,200

Option 2 (£28,000 0.6 + £70,000 0.4) = £44,800

Option 3 (£32,000 0.6 + £56,000 0.4) = £41,600

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Based on what has been studied to date in this unit, Millie would most likely choose
option 2, which gives the highest net cash flow of …

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Chapter
7

Management Accounting

7.1 Introduction 81
7.2 Financial v Management Accounting 82
7.3 Main Purposes of Management Accounting 83
7.4 Cost Accounting 88
7.5 Job and Service Costing 99
7.6 Summary 104

Learning Objectives

After completing this unit of study you should be able to:

• explain the differences between financial and management accounting

• appreciate the role that management accounting plays in business today

• classify costs for management accounting purposes

• perform basic job and service costing calculations.

7.1 Introduction

The material covered in Units 1−6 predominantly falls under the heading of financial account-
ing. Financial accounting is primarily concerned with the provision of historical information
to external parties outside the organisation. Shareholders, lenders and suppliers have no
day-to-day involvement in the running of the company or daily access to the financial results.
However, as stockholders to the organisation, they clearly have a vested interest in the success,
or otherwise, of the business, and the financial reporting mechanism services their needs.

The focus of the remaining units is management accounting, which exists to provide internal
parties with the necessary information for decision-making, and for planning and controlling the
business. The board of directors, line managers and shop-floor supervisors are all required to
make decisions on a daily basis, albeit at different levels, and the success of those decisions can
often hinge on the costing or budgeted information provided by the management accountants.

In its broadest sense, management accounting adopts the following approach.

• Establish the overall company objectives.

• Consider the actions required to meet these objectives.

• Collect all relevant data.

• Select the appropriate short- and long-term courses of action.

• Implement the decisions made.

• Compare the actual performance to the targets set and, if necessary, take corrective
action.

Unit 7 outlines the key functions of management accounting, particularly with regard to cost
accounting, while Units 8−12 will provide the detail required for good decision-making and
effective budgeting.

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7.2 Financial v Management Accounting

The differences between financial and management accounting effectively arise because of the
distinct needs of the user groups that the two sides seek to address. The key differences are
given below.

7.2.1 Legal Requirements/Regulations

Financial reporting is subject to legal and accounting regulations. It is a statutory requirement
for large organisations to report annually to their shareholders and the accounting information
included in these reports is governed by international accounting standards. These regulations,
imposed by the law and the accounting profession, ensure that annual reports are produced in
a standard format with standard content, thus aiding the comprehensibility and comparability
of the information to the user groups.

Because management accounting reports tend to be for internal use only, they are not subject
to any external regulation. The important thing for management accounting reports is that
they are designed in such a way as to best meet the needs of the particular managers who will
be making use of the information.

7.2.2 Level of Detail/Accuracy

Financial accounting reports provide their users with a broad overview of the company’s
financial performance for the trading period and the financial position at the end of the trading
period. Having been subjected to the legal and accounting regulation mentioned above and
also having come under the scrutiny of the external auditors, financial accounting information
should be reasonably accurate . . . after all it deals with historic information and if its main
purpose is to to help users of the information make decisions (for example should I invest in
the company or should I supply to the company) then it is not unreasonable to expect this
information to be accurate.

Management accounting reports, however, are likely to be prepared in much greater detail
because the information provided might well be used to help managers make key operational
decisions. Although this information might be more detailed in terms of content, the accuracy
of the figures is likely to depend on the timescale covered by the report. Clearly, a lot of
management accounting information involves planning for the future, so estimates might well
have to be made on issues such as future material prices or labour rates.

7.2.3 Nature of the Reports

Allied to the comments made above on content, financial accounting reports contain inform-
ation that is likely to be useful to a broad range of users who might be making a wide range
of business decisions. They tend to be more general-purpose reports rather then be geared
towards an individual user-group.

The nature of a management accounting report, however, is that it exists in order to aid a
particular decision that needs to be made or it is for a particular manager. These reports are,
therefore, produced for a much more specific purpose.

7.2.4 Reporting Timescale

By law, financial accounting reports are required at least annually but quite often, particularly
if the company is quoted on its local Stock Exchange, a six-monthly interim report is also
produced.

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Management accounting reports are produced as frequently as managers require them; for
example a production manager might require a report

• daily for production output

• weekly for machine efficiency/labour productivity

• monthly for stocktake figures

• quarterly for projected material requirements

• annually for budgeted financial results.

These reports enable the managers to check progress on a regular basis.

7.2.5 Time Horizon

Primarily, financial accounting reports are backward looking because they report on the historic
events that impacted on the performance and the financial position of the company over the
past trading period.

In addition to providing information to managers on past performance, management accounting
reports often focus on future information. Just think back and remind yourself of all the work
you did on cash budgeting in Chapter 4.

7.2.6 Range of Information

It is really only information that can be quantified in monetary terms that you will find
in a financial accounting report. Management accounting reports will also contain a lot of
monetary information; however, they are also likely to include other quantifiable data, for
example employee absences, percentage scrap, stock quantities, and health and safety records.

Management accounting is a lot less constrained than financial accounting because it is not
governed by the same amount of external regulation. Its information may not be quite as
accurate at times but as long as it enables managers to continue to improve the quality of their
decision-making, then it will have served its true purpose.

7.3 Main Purposes of Management Accounting

Management accounting provides information to help companies in the areas of planning,
control and decision-making. The thought process that company managers go through in
considering these areas is no different from the thought process that we would go through
as individuals. So indirectly we are all management accountants. Companies manage their
business whilst we as individuals manage our lives.

Consider the following questions.

• How is planning relevant to you as an individual?

Just ask yourself what you are going to do next Friday night. Perhaps you fancy a game
of golf or maybe you would prefer a nice meal in the local restaurant. This is short-term
planning.

Where would you like to be in ten years time? Maybe you have ambitions to be on the
board of directors or maybe you would like to take early retirement to try and improve
that golf handicap. This is longer-term planning.

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• How might control be relevant to you?

Whenever you make a plan you automatically provide yourself with a control mechanism
against which you can measure your actual performance. Perhaps the first stage to
achieving your seat on the board of directors is to pass this MBA. Will you achieve this
within the timescale that you set for yourself? This is control.

• How is decision-making relevant to you?

On a daily basis you are making decisions. Should I spend 50p on a newspaper or simply
read the news on the internet? This is a decision that you will make based on all the facts
at your disposal.

7.3.1 Planning in Management Accounting

Stage 1: Set the strategic long-term aims and objectives

Most companies have a ‘mission statement’, which highlights briefly the overall aims of the
business. Here at Edinburgh Napier University our mission statement is:

‘to be a world class modern university that will focus on students in order to help
them to realise their full potential.’

Service industries often focus on offering high standards of service and quality within their mis-
sion statements, while profit-oriented businesses see the creation of value to the shareholder
as a key component of their long-term strategy.

Whilst the mission statement itself may be broad, it is important that there are specific,
quantifiable objectives supporting the achievement of this mission statement, for example a
specified percentage return on capital employed might help convince shareholders of added
value within the business.

Stage 2: Break down these long-term objectives into shorter-term requirements

It is vital for the business to identify possible courses of action that will enable it to achieve its
objectives. These courses of action are often determined after having carried out a position
audit and a SWOT analysis.

A position audit simply lets the business see how well, or otherwise, it is placed relative to
the environment within which it is operating.

A SWOT analysis enables a company to assess internally the strengths and weaknesses that
are attributes of the business while at the same time considering externally any potential
opportunities or threats that are currently present in the environment.

Some of the following might be typical factors for a business.

• Strengths − an experienced board of directors; a skilled workforce.

• Weaknesses − reliance on a sole supplier; ageing plant and machinery.

• Opportunities − new international markets; new product developments.

• Threats − new competition in the marketplace; new government legislation.

Having considered the alternative strategies available, the company will then implement the
course of action required to achieve these objectives.

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Stage 3: Construct an annual budget

The annual budget is the first step towards achieving the company’s long-term goals. This will
involve planning next year’s activities and calculating the financial effect that they will have on
the organisation.

Stage 4: Break down the annual budget into detailed short-term operational
budgets

To help control the budgeting process, the annual financial target is likely to be broken down
into monthly operational targets. You would expect most organisations to prepare a monthly
income statement and a monthly cash budget as control mechanisms.

7.3.2 Control and Performance in Management Accounting

You should note the link between planning, control and performance.

• You firstly make a plan.

• That plan then becomes your control mechanism.

• When you compare your actual performance to the target set then you have a perform-
ance measurement.

Managers can then see at a glance if things are going according to plan or not. Where actual
performance appears to be deviating from the original target, some form of corrective action
will need to be taken in order to get things back on track.

The area of management control, and strategic management control systems, is one which is
well researched. I would suggest that you review the papers listed at the end of the unit if you
want to get up to speed with what has happened in this field.

Chapter 5 briefly discussed performance measurement involving comparisons or benchmarks,
as they are sometimes known. These benchmarks can be both internal and external.

7.3.3 Internal Benchmarking

The most obvious internal benchmark is to compare actual performance to the annual budget
whether it be in terms of sales, production or even cash position.

However, we might also choose to compare actual performance this year to the previous
year’s performance, for example, how did the actual sales in July this year compare with last
July’s sales?

Managers might also get some useful information by comparing performances between differ-
ent segments of the business, for example, how did the production quantities of the day shift
compare to that of the night shift? Or, how did absenteeism for Department A compare with
absenteeism for Department B?

7.3.4 External Benchmarking

To assess your organisation’s overall standing in the environment within which you operate,
you may wish to measure your performance against your major competitors, although gaining
access to information can be quite tricky.

Some companies try to compare themselves with other ‘good quality’ organisations who are
perhaps market leaders in their field or are highly quoted on the local Stock Exchange.

Perhaps it is most important in today’s environment to compare yourself with customers’
expectations. Companies are almost totally customer-driven nowadays, and it is vital to focus

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on the following key success factors if you are hoping to achieve a high level of customer
satisfaction.

7.3.5 Cost Efficiency

In an equal world, the customer will probably buy the cheapest product. A strong management
accounting system can provide you with the cost efficiency you need to maintain a competitive
advantage.

7.3.6 Quality

Total quality management (TQM) is all about getting things right first time. The Western world
in the past tended to see quality as an additional cost and perhaps curtailed spending in such
areas as training. Now the belief is that quality saves money and it is much better to design
and build quality than it is to inspect and repair, i.e. it is cheaper to produce items correctly
first time than to waste resources on reworking goods returned by the customer.

7.3.7 Cycle Time

It is important to minimise the product cycle time wherever possible because customers want
a quick reaction to delivery or new product development. Companies should try to cut out
the processes that do not add value, for example moving, waiting and inspecting, and focus on
those processes that do add value.

7.3.8 Innovation/Flexibility

You need to be in a position to adapt quickly to ever-changing customer requirements. If you
doubt this then just ask yourself what your mobile phone looked like five years ago compared
with the one that you use now!

As you can see, customers now demand continuous improvement in all the above key success
factors. It is, therefore, important for organisations to have a management accounting system
which can support this framework because if you cannot provide customers with what they
want, you can rest assured that your competitors can.

7.3.9 Non-Financial Performance Indicators

The focus so far in this module has been the external reporting of financial information
by companies. However, you should also consider that the financial information offered to
external users in the annual report, and internally to management, in no way gives the full
picture of what is happening within the organisation.

Financial information is:

• historical

• open to different interpretations

• possibly open to manipulation

• biased or window-dressed in its reporting.

Increasingly nowadays, companies are turning more to non-financial indicators to assess how
their operations are functioning, perhaps because they give a more timely indicator of per-
formance. A selection of non-financial performance indicators that could be used by all types
of business on a regular basis is as follows.

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1. Non-financial performance indicators for manufacturing include:

• volume of output

• scrap percentage

• machine efficiency

• manufacturing lead times

• shop floor absenteeism

• customer returns.

2. Non-financial performance indicators for selling/marketing include:

• market share percentage

• customer visits per salesperson

• customer complaints

• sales volumes

• promotional activity compared with sales volume

• number of new customers.

3. Non-financial performance indicators for human resources include:

• staff turnover

• lost working days

• training days per employee

• staff absenteeism.

4. Non-financial performance indicators for purchasing include:

• number of suppliers

• stock levels per materials

• exchange rate movement

• purchase price index.

7.3.10 Decision-Making in Management Accounting

Management accounting information is broadly required to help managers in the following
decision-making areas.

1. Strategic planning

The financial information provided by the management accounting reports can lay the
foundations for selecting the most suitable courses of action to include in the strategic
plans.

2. Control

The creation of the original budget and the subsequent comparison of the budget against
the company’s actual financial performance can often lead to significant differences, which
need to be investigated and corrective action taken where necessary.

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3. Resource allocation

The resources available to a business are often restricted. It is, therefore, important that
the optimum use is made of these resources and management accounting information
can help to determine:

• the optimum level of output

• make or buy decisions

• capital investment decisions

• the optimum product mix.

4. Cost/benefit analysis

A lot of management decisions hinge on knowing the financial pros and cons of pursuing
a particular course of action. The management accountant’s expertise in calculating the
costs and benefits of such decision-making can help to ensure that the correct decisions
are usually made.

7.4 Cost Accounting

Although there are a number of differences between financial and management accounting,
there is one clear area of overlap . . . accounting for stock.

Financial accounting requires that we match costs with revenues to calculate profit. Therefore,
for a manufacturing company, if at the end of a trading period we have some unsold finished
product or we have some partly completed stock (work in progress), the costs involved
will not appear as an expense in the income statement. These will form part of the closing
inventory to be included in the company balance sheet. Cost accounting was developed to
trace costs to individual jobs or products so that the costs incurred can be correctly allocated
between the cost of goods sold and the inventories. It is only by classifying costs correctly
that the company will get an accurate performance measurement.

7.4.1 Classifying Costs

You are the manager of a small factory, Batty Limited, which manufactures wooden tennis
racquets and would welcome some help in classifying the costs of your organisation.

1. Direct materials

The direct material cost encompasses all material that can be physically identified with
a product, job or process unless the material is of such small value that it needs to be
treated as an indirect material.

Batty’s direct materials:

• wood to make the frame

• gut or nylon stringing

• leather grip for the handle

• packaging materials.

2. Indirect materials

These are the materials which cannot be specifically identified with one individual product,
but which are used for the benefit of various products. Or, as mentioned above, material

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used in such negligible amounts and/or having negligible costs. These will be included as
part of your production overheads.

Batty’s indirect materials:

• varnish and paint for the frame

• tacks or glue to apply the leather grip

• oil for the frame making machine.

Note: The first two above are direct materials, but, because their cost per racquet would
be fractions of a penny, it is easier to treat them as indirect materials and include them
as part of production overheads (where their budgeted annual cost will be used).

3. Direct labour

All wages paid for labour incurred in altering the condition or composition of a specific
product can be termed direct labour. Some indirect wages (those paid to a foreman
or supervisor), which can be accurately identified with a specific product, may also be
considered as a direct charge to the product and included as direct labour.

Batty’s direct labour:

• wages paid to the frame-makers, stringers, grippers and packers

• wages of the supervisor who solely controls the department manufacturing the
Product Y.

4. Indirect labour

These are the wages of employees who assist in the manufacturing process but who do
not work specifically on an individual product. Indirect labour costs are included as part
of production overheads.

Batty’s indirect labour:

• raw material storeman

• material handlers

• production manager responsible for all the different products.

5. Direct expenses

Any other expense incurred on a specific product (other than direct material and direct
labour) is a direct expense.

Batty’s direct expenses:

• hire of a specialist machine to string Racquet Z only

• design costs incurred on the new de-luxe model of Racquet M.

6. Production overhead

All indirect costs incurred in the factory, from receipt of the order until its completion,
are included in the production overhead.

Batty’s production overhead costs:

• indirect materials

• indirect labour

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• rent, rates and insurance in relation to the factory

• depreciation, fuel, power, repairs and maintenance of factory plant, machinery and
buildings

• factory services such as training, housekeeping, first-aid and canteen.

7. Selling and distribution overhead

These are the costs involved in the selling and distribution of the product.

Batty’s selling and distribution overheads are:

• salesmen’s salaries, commission, travel costs and general expenses

• advertising

• bad debts

• running costs of the distribution vehicles

• finished goods warehousing costs

• freight and insurance costs.

8. Administration overhead

These are the indirect costs usually related to the direction, control and administration
of the organisation.

Batty’s administration overheads:

• office salaries

• depreciation of office/computer equipment

• printing and stationery

• rent, rates and insurance of general office

• audit fees.

7.4.2 Period and Product Costs

The above cost classification has provided us with the information needed to carry out the
major function of cost accounting− the valuation of closing inventory. Remember that financial
accounting requires that you match costs with revenues to calculate profits. Therefore, any
unsold finished goods or partly completed stock (work in progress) needs to be valued and
deducted in the calculation of the cost of goods sold figure to be matched against sales revenue
for the period.

1. Product costs

Legislation on stock valuation requires that manufacturing costs only are included in the
calculation of product costs. Product costs are those costs identified with goods produced
or purchased for resale, namely the direct costs (material, labour and expenses) and the
production overheads.

2. Period costs

Costs which are not included in the stock valuation (selling, distribution and administration
overheads, primarily) are treated as expenses in the period in which they are incurred
and are referred to as period costs.

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7.4.3 Cost Analysis

Using the breakdown given above, you can break the costs of any individual process, product
or department into the categories listed and allow the managers more control within the
organisation. A typical cost analysis is as follows:

Direct materials 20,000

Direct labour 10,000

Direct expenses 2,000

Prime cost 32,000

Production overhead 16,000

Product cost 48,000

Selling and distribution overhead 6,000

Administration overhead 8,000

Total cost 62,000

Selling price 80,000

Profit 18,000

Note: The direct elements of the product are known as the prime cost of the product.

7.4.4 Overheads

It is relatively easy to allocate the material costs directly to a job or to a product because
you should know the quantities and prices of the materials used. Similarly, you should be able
to allocate the direct labour costs because you know the hours worked and the labour rates
paid.

However, it is not quite so straightforward with overheads.

Overheads are those costs which are not directly attributable to a specific product and include
the costs of indirect materials, indirect labour as well as indirect expenses. It is important, for
accurate stock valuation, that a company has control over its overhead costs.

The five-stage procedure used for accounting for overheads is shown in Table 7.1.

Table 7.1 Five-stage procedure used for accounting for overheads

1. Collect all overhead costs.

2. Allocate/apportion costs to departments.

3. Reallocate service departments.

4. Calculate overhead absorption rates.

5. Charge overheads to jobs and products.

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7.4.5 Collecting Overhead Costs

There are two types of overhead cost that need to be collected:

• The overhead cost which is directly identifiable to a department or cost centre. These
overheads can be estimated by the manager responsible for that particular work area.

• The overhead cost which is incurred as a single figure, but benefits various different
departments throughout the organisation, for example rates bill.

7.4.6 Allocate/Apportion Costs to Departments

A typical manufacturing organisation will have three types of departments: production, service
and operating.

Production departments are involved directly with the manufacture of the product, for
example a tennis racquet manufacturing company might have:

• frame-making department

• stringing department

• gripping department

• packaging department.

Service departments exist to provide essential services that primarily support the produc-
tion areas, but also help out other sectors of the organisation. They include:

• purchasing

• housekeeping

• stores

• canteen

• engineering.

Operating departments are departments not directly involved in manufacturing, but never-
theless are essential to the smooth running of the company. They are the departments which
effectively gather our ‘period’ costs. They include:

• sales/marketing

• administration

• distribution

• personnel.

Having divided the organisation into its departments or cost centres as they are typically
known, the company now needs to allocate the overhead costs to the correct departments.

1. Allocation

A lot of the overhead costs are easy to calculate because the whole of the cost can be
allocated to the one cost centre.

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Cost Department

Salary of supervisor in the stringing department Stringing

Food and other consumables Canteen

Cleaning materials Housekeeping

Depreciation on the frame-making machine Frame-making

Purchasing manager’s company car Purchasing

Glue for applying the grips …

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Chapter
12

Working Capital Management

12.1 Introduction 163
12.2 Inventory 164
12.3 Trade Receivables 167
12.4 Trade Payables 170
12.5 Cash 171
12.6 Summary 173

Learning Objectives

After completing the study of this unit you should be able to:

• explain the need to manage working capital

• describe the factors to be considered to manage inventory

• describe the factors to be considered to manage trade receivables

• describe the factors to be considered to manage cash

• assess critically different working capital scenarios.

12.1 Introduction

One of the most important tasks managers face today is to make sure that the business has
enough short-term assets to keep the business going on a day-to-day basis. It is not enough
for a firm to be profitable, since it is possible to make profits and go out of business − this is
not uncommon for new firms.

In modern business the only person who pays at the point of purchase is you − the consumer.
Business works on credit. If a business gives too much credit, it can fall into the trap of
overtrading as illustrated in Figure 12.1.

This unit begins by considering the benefits of the overall budgeting process before looking
in detail at its preparation and implementation. Knowledge of the environment, the industrial
sector, the resources available and the objectives of the company all need to be integrated in
order to develop a meaningful ‘plan of action’.

Figure 12.1 Overtrading

In order to get sales we sell on credit. We also buy goods to sell on credit. At some point we
have to pay for our inventory and if we take too long to get cash in we may end up becoming
bankrupt.

So how does a business deal with this? The solution is to plan and manage the firm’s working
capital.

What is working capital? Working capital is the short-term assets and liabilities of a company.

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Current assets Current liabilities

Inventory Trade payables

Trade receivables

Cash

Net working capital = Current assets − Current liabilities

Working capital management involves decisions about current assets and current liabilities.
Their use, mix and level and how working capital should be financed. This is a continuous
process.

Working capital is necessary to run a business. Working capital is turned over frequently.

Figure 12.2 Working capital cycle

This cycle is not necessarily synchronised.

12.1.1 Operating Cycle and Cash Conversion Cycle

The operating cycle is the length of time from receiving raw materials to receiving cash from
the final product.

The cash conversion cycle is the operating cycle minus the credit period from suppliers.

The length of the operating cycle and the cash conversion cycle is a function of operational
management, the business you are in, and financial management. The longer the operating
cycle the more finance the business requires.

The aim must be to reduce the operating cycle without affecting other objectives of the
business.

12.2 Inventory

The purchase of inventory represents an investment. There are three main types of inventory:

1. raw materials

2. work in progress

3. finished goods

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The type of business will dictate which of these different types of inventory the business will
keep. A manufacturing company holds all three types, whilst a retailer would normally hold
only finished goods.

12.2.1 Cost of Holding Inventory

The cost of holding inventory must be related to benefits. We can categorise the costs into
two areas:

1. Ordering costs

F Admin costs

F Monitoring costs

2. Carrying costs

F Costs over time

F Counting, admin, systems

F Storage and handling

F Obsolesence and deterioration

F Insurance

F Interest charges

These two types of cost vary in indirect proportion to each other. The cheapest way of
carrying costs would be to get goods delivered every day, but then the ordering costs would
be very high. The cheapest way of ordering costs would be to order a year’s supply all at once
but then we have to find room to store all this inventory.

This conundrum has led many companies to adopt just-in-time systems.

12.2.2 Inventory out Costs

We have all suffered the frustration of going to a shop and finding that the item we want is
out of stock. In one sense it is easy for a company to measure sales lost because it ran out
of inventory. We simply tally up all the orders we have had to refuse because we were ‘out
of stock’. What we don’t know is how many associated sales we have lost. How many other
things was the person, who was told we didn’t have the first thing they asked for, going to buy?

In a manufacturing concern, the cost of running out of inventory is also difficult to measure.
If we run out of raw materials or work in progress we have a delay in the production process
and during this delay we still have to pay our worker’s wages. We can also incur costs if the
delay means that order is not on time. Either financial penalties now, or loss of orders in the
future.

If the company is out of finished goods then the loss is the lost profit on the order we cannot
fulfil.

However, the cost of never being out of inventory is high. We have to pay for every square
metre of storage space. Inventory can deteriorate if kept too long. It can become obsolete
or it can be damaged or stolen. Inventory control becomes necessary. Models are required
to determine the optimal inventory levels. Inventory models vary from simple deterministic
models to more complex probabilistic models.

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Worked example 12.1

In Chapter 5 you used ratios to analyse company accounts. We will use some of these
ratios to analyse working capital

A wholesale firm supplies wine to restaurants and off-licenses.

Annual sales 3600 cases

Inventory 180 cases

Inventory turnover = Sales
Inventory =

3600
180 = 20 times per annum

or
Inventory × 365

Sales
= 180 × 365

3600 = 18.25 days

Both ratios mean exactly the same, but it is a matter of personal preference which one
we prefer to use.

Inventory and sales can be given a value, e.g. wine sells for £30 a case.

Annual sales: 3600 × £30 = £108,000
Sales value of inventory: 180 × £30 = £5,400

Inventory turnover in days = Inventory × 365
Sales

= £5 400 × 365
£108 000 = 18.25 days (as above)

This is part of the operating cycle of the business. If we reduce it, we reduce the amount
of funding required but do we also reduce sales?

For internal purposes how can this inventory model be improved?

We could have a ratio for each sales type or we could use future sales (budget) rather
than past sales. One common approach would be to have a target inventory number of
days for each commodity (wine, spirits, beers).

12.2.3 Basic Economic Order Quantity Model

The Basic Economic Order Quantity model (EOQ) is a deterministic model which assumes
that there is a known uniform demand and that lead times are known. The model can be made
more realistic, but then it becomes more complex.

EOQ – value of Q which minimises total costs (ordering & carrying)

EOQ =
√

2 BN
C

where:

EOQ = quantity in units
B = cost of placing order or set up cost
C = annual cost of carrying one unit
N = annual demand in units

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Worked example 12.2

A firm sells 3,600 cases of wine.

Ordering costs £31.25 per order

Carry cost £10 per annum per unit

EOQ =
√

2 × 31.25 × 3600
10

= 150 units (cases)

Wine should be ordered:

150 × 52
3600

= 2.16

every 2.16 weeks.

If lead time for an order is 2 weeks what is the re-order level?

Q =
Lead time × N
Weeks in year

=
2 × 3600

52
= 139 cases (round up)

The EOQ model is used by retailers, institutional caterers and by some manufacturers.

In general, Finance wants low inventory and Operations want high inventory. This is an area
of conflict between the two functions.

Inventory levels should be determined in conjunction with other variables in the system, such
as:

• Prices

• Output levels

• Sales

• Promotions

• Opportunity costs.

We must consider the implications of inventory policy in terms of the firm’s overall objectives:

• Profit

• Growth

• Survival

• Image

• Shareholder wealth maximisation.

12.3 Trade Receivables

When a business grows beyond being very small it will tend to deal with all other businesses
on a credit basis. Selling to customers on credit creates a trade receivable in your balance
sheet. This is an investment decision and like all investment decisions has an element of risk
attached to it. There are a number of benefits and costs associated with this decision.

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• Benefits

F Sales

F Gross profit

• Costs

F Opportunity cost of finance

F Operating cost of control

F Bad debts

An optimal credit policy depends on:

• Credit standard

• Credit terms

• Collection effort.

This policy will be based on evaluation of individual credit applications.

12.3.1 Credit Standards

Credit standards are the criteria used to screen credit applicants. A number of factors need
to be considered. How long will a customer take to repay? Will most of the customers pay
within the agreed time limit? Will customers default? It would be unusual for a customer to
default intentionally, i.e. commit fraud. Most customers who default do so unintentionally, i.e.
the reason they don’t pay is because they can’t pay. This could create conflict between Sales
and Finance. Sales want to give credit as easily as possible in order to stimulate interest (and
earn commission). Finance want to be sure that the money will be forthcoming when payment
time comes around

Customers can be ranked 1−10 (say), and then the costs and benefits of extending credit to
lower ranked customers can be evaluated. For an example of this, see Worked example 12.3.

Worked example 12.3

Extending credit to riskier sector of customer (10% risk they will not pay up). Should the
firm trade?

Benefits

Additional sales £2000

Less 10% bad debt 200

Additional revenue 1800

Costs

Production and selling costs 1200

Collection and interest costs 300 1500

Net incremental profit £300

From this we can see that it is worth risking losing the amount for bad debt because of
the overall incremental profit, so we should extend the credit.

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12.3.2 Credit Terms

These will include the length of the credit period and any cash discount that may be available.
Cash discount is not, as the name suggests, a discount for paying by cash. If someone paid by
cash they would not be part of our trade receivables. Cash discount is given for early payment
of an invoice amount.

The length of credit period varies from industry to industry. This can be as little as 7 days and
as long as 6 months. The most common credit period is that an invoice will say ‘30 days net’;
this means that the invoice should be paid within 30 days. In practice, regular customers will
order items all month and receive a statement at the end of a calendar month, showing the
balance due and stating the agreed date in the following month when payment will be taken
from the customer’s account by direct debit.

Large companies tend to treat small suppliers badly by delaying payment beyond the credit
periods agreed. In most countries, the largest company is the government who are frequently
proved to be the worst payers! When deciding terms, firms must balance benefit of increased
sales against increased costs.

Worked example 12.4

Murdoch Ltd is trying to decide whether cash discount of 2% should be offered to its
customers. It is estimated that 50% of customers would take advantage of the discount
and that the amount outstanding would fall by £150,000. Annual credit sales for the
company are £3,000,000.The company has a cost of capital of 20%.

Benefit – Lower collection period

Earnings on funds released: £150 000 × 20% = £30 000
Cost of discount: Annual sales × % take up × % discount

£3 million × .5 × .02 = £30 000

Therefore, the cost = benefits.

In this case, Murdoch Ltd should review the situation and try to find a more beneficial
solution.

12.3.3 Collection Effort

The collection effort involves a number of different areas. Firstly, we have to monitor the
level of Trade Receivables. We should know our customers and try to spot problems before
they occur. We should also produce an aged trade receivable analysis on a regular basis which
should serve as an early warning system. Experience will tell us that the older a debt, the less
likely it is to be paid.

We should have regular contact with our customers through statements and if there seems
to be a problem we should contact them by phone. If payment is badly in arrears, there are
a number of possible courses of action: we could cut off supplies, use a collection agency or
take legal action. When taking action, the firm must consider the effect on future customers,
as well as the costs involved.

If a regular customer with a good payment record is in arrears, does this suggest some kind
of dispute?

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12.3.4 Evaluation of Credit Applications

With credit applications, as with any decision, we gather information, analyse it and then make
our decision. There are various sources of the information we require and the amount of
information is limited by time, cost and availability.

One possible source of information is the financial statements of the company. However, this
information will normally be anything from 6 to 18 months old, and will probably be of limited
value. Another source is to go to a credit agency and find out the credit rating of the firm.
This will tell us if the firm has a previous history of bad payment. A third source is to get a
reference letter from the company’s bank. In general this is a futile exercise since this letter
will be very non-committal. The best method is to ask the company for a reference from
another supplier. This has the added benefit of usually being someone in the same trade that
will be known to us.

There is no magic formula for deciding on credit worthiness. You should look for:

Character − Willingness

Capacity − Ability

Capital − Financial strength

Collateral − Security

Conditions − General economic climate.

12.4 Trade Payables

When we buy goods on credit from our suppliers, this creates a liability on our balance sheet.
Trade payables are the opposite of trade receivables. As a company we should aim to hold off
payment for as long as we can, while still ensuring that we pay on time.

• Credit terms

F Length of payment: Generally this will be ‘30 days net’ in most circumstances but
as previously mentioned most companies work on a monthly statement with direct
debit payments on an agreed date the following month.

F Cash discounts: As before, should we pay early and take advantage of this discount?

F Retrospective discounts: This can apply where certain target amounts are reached in
a previously agreed time frame. This is ideal for the smaller firm who are unable to
take advantage of the discounts available for bulk purchases.

• Cost of trade credit

The amount of trade credit will expand as the volume of purchases expands. The idea of
using someone else’s money to fund your business makes trade credit attractive as well
as easy to access but is it free? In truth, there is no such thing as ‘free’ in business so like
everyone else the supplier bears the cost and passes it on.

A firm with cash will be able to negotiate better prices, and a firm with a lot more cash
will negotiate a lot better price!

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There are other sources of short-term funds available to a firm:

• Spontaneous

F Trade credit

F Accrued expenses

• Negotiated

F Bank credit

F Bills of exchange

F Factoring.

12.4.1 Operating Cycles

Different types of business have different operating cycles and the way they pay their debts
and receive monies due has a large bearing on the length of operating cycle they have.

Worked example 12.5

Let us look at a typical supermarket as an example.

Operating cycle of typical supermarket.

Stock days 14

Receivable days 1

Payable days 30

Cash operation cycle (15)

Who is funding the business? Why do suppliers allow supermarkets to do this?

Basically because they have no choice. Companies cannot afford to refuse to supply a
supermarket and cut off one of their biggest markets.

12.5 Cash

12.5.1 Management of Cash

One of the hardest questions in business is: How much cash should a firm have?

There is no easy answer because we have to make a subjective assessment of the future.

We must balance liquidity and profitability. If the company is too liquid, we have too much
cash and an opportunity to invest this surplus cash is lost.

If we have too little cash, the company could have difficulty with payments which could lead
to ultimate bankruptcy.

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12.5.2 Why Hold Cash?

According to economic theory (first brought to our attention by Keynes in the 1930s), we
hold cash for three reasons:

1. Transaction motive

2. Precautionary motive

3. Speculative motive.

The cycle of working capital means that cash will be required for 1.

The unpredictable nature of business and the environment requires a balance is kept for 2.

Few firms hold cash for 3.

If we have too little cash we could have difficulty with payments which ultimately could lead
to bankruptcy.

We must beware of idle cash balances − companies with lots of cash are often the target of
much takeover activity, much of this attention being unwelcome.

The key to successful cash management is cash budgeting which was covered in Unit 4. This
highlights crucial traits like seasonality and any surplus funds available.

We can also calculate borrowing required by analysing planned elements, such as:

Sales − payments

Purchases − operating cycle

Other income − timing

Payment of expenses.

Cash problems are physical as well as theoretical. Cash has no loyalty or affiliation (a credit
card or chequebook can easily be identified to the owner), and also places temptation in the
way of many employees.

Attention to detail of physical and electronic cash flows can improve the cash balance and
therefore reduce costs. We should deposit cash as soon after receipt as possible. Remember
that cheques take time to work through the clearing system.

Worked example 12.6

Annual turnover £20m (all on credit)

250 working days: £80,000 per day

Interest rate 8%

Deposits are one day faster.

− £80 000 × .08 = £6400

Annual increase in profit and one off increase in cash balance of £80,000.

In order to manage working capital successfully a company must manage all the different
elements in tandem. We must ensure every part of the system is working effectively.

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12.6 Summary

In this unit you have studied one of the most important decision-making areas for management
today − the need to manage working capital.

You are aware that:

• working capital management is part of the day-to-day running of a business

• this involves keeping a careful balance between the various elements of working capital.

It is vital, therefore, for management to appraise themselves of the key factors involved in the
cash conversion cycle.

You have considered the pros and cons of the four main elements of working capital manage-
ment:

• inventory

• trade receivables

• trade payables

• cash.

We concluded proper management of all the elements of working capital is vital for a business
to survive.

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175

Index

accounting concepts 11, 14
accounting conventions 11,

accounting information
characteristics 8, 10

accounting policies 4
accounting rate of return

(ARR) 154–155
accounting standards

regulatory framework
42–43

Accounting Standards Board
(ASB), regulatory frame-
work 42

accruals, accounting
concept 13

acid test, ratio analysis 62
administration overhead,

cost accounting 90
annual accounts, annual

reports 4
annual general meeting

(AGM), annual reports
6

annual reports 1, 6
AGM 6
annual accounts 4
audit report 5
Chairman’s statement 2
Chief Executive’s state-

ment 3
Directors’ report 3–4
environment report 5
five-year record 5
OFR 2

assets
accounting concept 14
classification 19
current 39
financial statements 17
non-current 39

associates, consolidated
financial statements 44

attitude to risk, decision-
making 133

auditors, external 41
audit report, annual reports

authorised share capital 35

bad debts, accounting
concept 13

Balanced Scorecard
criticisms 142

Balanced Scorecard, man-
agement accounting 138,
142

balance sheet
accounting concept 14
financial statements 15,

31, 38–39
layout 20
worked example 23, 30

beer wholesale business,
financial statements 23,
30

benchmarking, management
accounting 85

‘blue-chip’ companies,
dividends 37

breakeven analysis
contribution 111, 113
cost behaviour 111, 114

breakeven point 113–114
budgets/budgeting

cash budgeting 49, 53
coordination 165

business entities, types of
33–34

business segment analysis
segmental reporting 78,

worked example 79–80

capital
accounting concept 14
share capital 35

capital investment 151, 162
ARR 154–155
cost of capital 155–156
DCF 155–156
discounting 155
forecast, cash budgeting

IRR 155, 159, 161
NPV 155–156, 161
payback 152
time value of money 155–

156

worked examples 151,
161

cash
importance 49
payments 49
receipts 49

v. profit 47, 57
cash and cash equivalents,

cash flow statements 55
cash budgeting 49, 53

benefits 49, 56–57
cash flow statements 53,

constructing a cash
budget 49, 53

forecasting 50
furniture business 51, 53
worked example 51, 53

cash flow, cash budgeting
49, 53

cash flow statements
cash and cash equivalents

cash budgeting 53, 57
financial statements 14
financing activities 56
format 54–55
investing activities 56
objective 54
operating activities 55

cash management 171
Chairman’s statement 2
charities/political parties,

users, financial reporting
8

Chief Executive’s statement
3

claims, financial statements
17, 19

committed costs
decision-making 120, 122

Companies Act 41
key elements 41

company tax, financial state-
ments 36

comparability/consistency,
accounting information
10

comparisons, ratio analysis
71

competitors, users, financial
reporting 7

completeness, accounting
information 10

comprehensibility, account-
ing information 9

computer transaction, profit
v cash 47, 49

concepts, accounting 11, 14

enu-fmd-bk-en-GB January 6, 2015 – 15:22 180

176

consistency, accounting
concept 14

consistency/comparability,
accounting information
10

consolidated financial state-
ments 43, 45

contribution
breakeven analysis 111,

113

cost behaviour 111, 113
control

management accounting
84–85

conventions, accounting 11,
14

coordination,
budgets/budgeting 165

corporate governance
defining 3
financial reporting 3

corporate income tax 36
cost accounting 88, 99

administration 90
cost analysis 91
overheads 89, 91, 99
period costs 90–91
product costs 90–91
production overhead 89
selling and distribution

overhead 90
worked example 88, 90

cost analysis, cost account-
ing 91

cost behaviour
breakeven analysis 111,

114

contribution 111, 113
decision-making 107, 117
fixed costs 108, 111
semi-variable costs 109,

111

variable costs 109, 111
worked examples 107–

108, 110
cost/benefit analysis, man-

agement accounting 88
cost-benefit/timeliness,

accounting information
9

cost efficiency, management
accounting 86

cost of capital, capital
investment 155–156

costs
committed 120, 122
decision-making 120, 124

incremental 120, 122–123
opportunity 120, 123–124
sunk 120–122

credit, accounting concept
14

credit standards
worked examples 168

credit terms
worked examples 169

criticisms
Balanced Scorecard 142

current assets 39
current liabilities 20, 39
current ratio, ratio analysis

customers, users, financial
reporting 7

cycle time, management
accounting 86

debit, accounting concept
14

debt ratio, ratio analysis 65
decision-making

attitude to risk 133
committed costs 120, 122
cost behaviour 107, 117
costs, relevant 120, 124
incremental costs 120,

122–123
limiting factors 124, 130
management accounting

84, 87–88
model 131, 133
objectives 120
opportunity costs 120,

123–124
qualitative factors 134
relevant costs 120, 124
relevant information 119,

135

risk 133
sunk costs 120–122
uncertainty 130, 133
worked examples 107–

108, 114, 116, 119, 125,
133

direct expenses, cost
accounting 89

direct labour, cost account-
ing 89

direct materials, cost
accounting 88

Directors’ report 3–4
discontinued operations,

performance measure-
ment 74, 76

discounted cash flow (DCF)
155–156

discounting, capital invest-
ment 155

dividend payout, ratio ana-
lysis 70

dividend per share, ratio
analysis 70

dividends
‘blue-chip’ companies 37
financial statements 37

dividend yield, ratio analysis
70

double-entry bookkeeping,
accounting concept 14

duality, accounting concept
14

earnings per share (EPS) 70
economic value added

(EVA) 142, 147
adjustment 143
bonus bank 143
criticism 147

efficiency, ratio analysis 62–
63

employees, users, financial
reporting 7

entities, types of business
33–34

entity, accounting concept
13

environment report, annual
reports 5

EOQ
worked examples 167

equity
financial statements 39–

statement of changes in
equity 40

European Union, regulatory
framework 41

expenses
accounting concept 14
financial statements 21–

22, 36
sources 21

external auditors, regulat-
ory framework 41

external benchmarking,
management accounting
85

financial reporting 1, 10
annual reports 1, 6
characteristics, account-

enu-fmd-bk-en-GB January 6, 2015 – 15:22 181

177

ing information 8, 10
reflective exercises 8
requirements summary 1
users 6, 8
Vodafone plc 1, 8

Financial Reporting Council
(FRC), regulatory frame-
work 42

Financial Reporting Review
Panel (FRRP), regulatory
framework 43

financial statements 14, 30
accounting concepts 11,

basic 11, 31
beer wholesale business

23, 30
consolidated 43, 45
IAS1 4
interpreting 59, 72
limited liability companies

35, 40
overview 14, 16
ratio analysis 60, 71
ratio analysis limitations

real ale business 23, 30
shareholders’ investment

ratios 70–71
worked example 23, 30

financial v management
accounting 82–83
legal require-

ments/regulations
82

level of detail/accuracy 82
nature of the reports 82
range of information 83
reporting timescale 82
time horizon 83

financing activities, cash
flow statements 56

five-year record, annual
reports 5

fixed costs
cost behaviour 108, 111
semi-variable costs 109,

111

worked examples 107–
108, 110

flexibility/innovation, man-
agement accounting 86

forecasting, cash budgeting
50

furniture business, cash
budgeting 51, 53

gearing, ratio analysis 65
generally-accepted account-

ing practice (GAAP) 41
general public, users, finan-

cial reporting 7–8
global operations, perform-

ance measurement 73,
80

going concern, accounting
concept 12

government, users, financial
reporting 8

gross profit (GP)
defining 23
financial statements 23
ratio analysis 60

guitar business, decision-
making 131, 133

high-low method, semi-
variable costs 110

historic cost, accounting
concept 12

human resources, manage-
ment accounting 87

income, accounting concept
14

income statement
discontinued operations

financial statements 15,
21, 23, 30, 35–36

format 22, 30, 35–36, 75
performance measure-

ment 75
worked example 23, 30

incremental costs
decision-making 120, 122–

123

worked example 123
indirect …

enu-fmd-bk-en-GB January 6, 2015 – 15:22 155

Chapter

Chapter
11

Capital Investment

11.1 Introduction 151
11.2 Payback 152
11.3 Accounting Rate of Return 154
11.4 Discounted Cash Flow 155
11.5 Net Present Value 156
11.6 Internal Rate of Return 159
11.7 Summary 161

Learning Objectives

After completing the study of this unit you should be able to:

• explain the need to make capital investment decisions

• describe the factors to be considered prior to spending capital

• explain the main investment appraisal methods used to assess projects

• carry out simple calculations using each of the methods

• assess critically the different investment appraisal methods.

11.1 Introduction

One of the most important tasks managers face today is choosing the assets in which their
business will invest. Investments in long-term capital assets generate revenues or provide cost
savings in production, distribution or service areas, usually for more than one year. Because of
the long-term commitment of these large expenditures, managers need to minimise the risks
involved in the decision-making process.

Worked example 11.1

Belvedere plc has just exceeded its targeted profit for the year. It has no outstanding
loans with any long-term creditors. It has no overdraft at the bank. It was able to pay its
employees an annual wage rise above the rate of inflation. The annual dividend payment
to the shareholders exceeded the previous year’s rate and the market value of its shares
is rising. Despite the highly competitive market in which it operates, the business is doing
well.

Required

Write down a few reasons why Belvedere plc might still want to make some additional
capital investments.

Solution

Whatever the current working environment, the chances are that it is highly competitive,
and its pace of change is forever quickening. To maintain competitiveness and market
share, Belvedere plc will need to develop business strategies that are dynamic enough to
cope with such changes. Those strategies will unquestionably involve capital investment.

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Finance for Management Decision-Making

Despite the success of the company the management will consider some of the following
reasons for capital investment.

• expansion of existing products and markets

• replacement of assets essential to the continued success of existing products

• diversification into new products and markets

• compliance with health and safety regulations

• enhancement of total quality management

• installation of environmentally friendly working practices

• utilisation of the latest technological advances.

It is often stated that one of the most important decisions facing management is the capital
investment decision. It tends to involve a large capital outlay, spent in the knowledge that
the gain may not accrue for months or even years, which will affect the profitability of the
organisation for many years to come.

It is likely in an organisation that the demand for capital investment funds by managers will
greatly exceed the funds available. Therefore, it is important that appropriate methods are used
to assess properly which areas of the business should benefit from this capital expenditure.

Investment appraisal methods play a vital role in developing your business strategy by compar-
ing, contrasting and optimising the financial returns from the alternative uses of your capital
expenditure. In addition to perhaps developing new products for the marketplace, we need to
remember that the objective of investment is to increase ultimately the wealth of the investor.
Each product or project undertaken should therefore pay back the capital invested in it, as
well as providing a return to the investor to compensate for the risks involved. Appraisal,
therefore, requires us to forecast four key areas:

• capital outlay

• net cash inflows

• project life

• required rate of return.

This unit considers four investment appraisal methods:

• payback

• accounting rate of return

• net present value

• internal rate of return.

11.2 Payback

The payback period is defined as the number of years it would take for the net cash proceeds
generated from the investment to equal the original cost of that investment. The implication
here is that the sooner the capital invested is recovered, then the sooner it can be invested in
other projects. See worked example 11.2.

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Chapter

Capital Investment

Worked example 11.2

Pentland Ltd can purchase a machine for £600,000 to manufacture cricket bats, which
will generate the following cash flows over its five-year useful life.

Year £000s

1 80

2 140

3 180

4 200

5 300

Required

Calculate the prospective investment’s payback period.

Solution

Year Cumulative
cash flow

(£000s)

1 80

2 80 + 140 220

3 220 + 180 400

4 400 + 200 600

5 600 + 300 900

Therefore, the payback period is four years because by the end of the fourth year
£600,000 will have been generated in terms of the net cash flow from the purchase of
the machine, equating exactly to its original cost.

Despite being a very popular investment appraisal technique, the payback period has a
number of flaws.

Firstly, it ignores income arising after the payback period. The £300,000 of cash flow in
year 5 did not come into the payback calculation. If an alternative investment also had a
four-year payback but the cash flow in year 5 had been predicted as £300m rather than
£300,000 do you think that might have impacted on the investor’s final decision?

Secondly, the timing of the cash flows is ignored. If an alternative investment had the cash
flows noted below, then it would also have had a four-year payback period.

Year £000s

1 510

2 30

3 30

4 30

5 300

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Chapter

Finance for Management Decision-Making

However, there is clearly less risk with the alternative project because it recovers most
of its original cost very quickly. The payback method tends to assume that all cash flows
are equally certain, but they can be biased in favour of projects having higher cash flows
in the early years – to the detriment of projects which require market development and
a gradual production build-up before a steady cash inflow can be guaranteed.

Thirdly, the payback method makes it difficult to estimate the net cash flows and to
estimate when cash might be received or paid.

Finally, it totally ignores the time value of money, ie £1 today is worth more than £1 will
be worth in the future because of the reinvestment potential of the £ held today. This
point will be covered more fully later when discussing discounted cash flow (DCF).

In spite of its obvious drawbacks, payback is still a well-used method of investment appraisal
today, probably because of the following merits.

• It is easy to understand.

• It is simple to compute.

• It biases a company’s investment programme away from longer-term projects where the
risk is greater of future cash flows not being realised.

• It emphasises the importance of cash flow as a dominant factor in the investment decision
process.

11.3 Accounting Rate of Return

The accounting rate of return (ARR) method relates the return earned by the investment to
its cost, by expressing as a percentage the average annual net profit over the original capital
investment. In other words, the emphasis has moved away from the speed with which the
original cost was recovered (the payback method) to the volume of profits generated by the
investment.

Since an important indicator of business performance is the return on capital employed
(ROCE), we might reasonably expect that individual projects should be evaluated in the same
way. See worked example 11.3.

Worked example 11.3

Criffel Ltd has the opportunity to invest £800,000 in a four-year project. The estimated
annual net profits are as follows.

Year £000s

1 360

2 480

3 280

4 160

Total net profit 1,280

Required

Calculate the accounting rate of return for the project.

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Chapter

Capital Investment

Solution

Average annual net profits
Cost of investment

× 100% =
£1,280,000 / 4 years

£800,000
× 100% = 40%

We are aware of some of the disadvantages of the payback method, so are we right to assume
that ARR must be more accurate? Unfortunately not!

The ARR method also has several disadvantages. Firstly, it gives no indication of what would be
an acceptable return. Secondly, like payback it ignores the time value of money, suggesting that
a project which produces a gradual build-up of cash inflows over the years is just as preferable
as one with a large cash inflow in year one but whose cash inflow tails off over the remaining
years of the project’s life.

Thirdly, because the method averages results, it gives no indication of the time span of the
return, i.e. a return of 25% over one year is ranked equally with the same annual return over
five or ten years. And finally, how should we define profit? Should it be calculated before or
after depreciation?

Flawed as the method may seem, the ARR method is still often employed in practice because:

• it is easy to understand and compute

• it emphasises profitability by taking into account the proceeds over the entire life of the
project

• the concept of ROCE is familiar to most accountants and managers.

11.4 Discounted Cash Flow

A more sophisticated and increasingly more common investment appraisal consideration is
that of discounted cash flow (DCF). There are two main techniques of adopting DCF into
project appraisal − net present value (NPV) and internal rate of return (IRR).

• When the cost of supplying funds for a project is known and/or a minimum rate of return
is given, you should use the NPV method.

• Where several projects are competing for limited resources available for investment and
the funding will be given to the project which provides the highest return, then it is better
to use the IRR method.

In order to appreciate fully the workings of these methods, an understanding of the concept
of the time value of money is needed.

11.4.1 Time Value of Money

Worked example 11.4

If you invest £2,000 of your money with me today I guarantee to give you back £2,400.
Are you interested?

Required

Jot down some of the factors that you might want to consider before handing over the
cash.

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Finance for Management Decision-Making

Solution

I would imagine that if I was giving you back the £2,400 the following day then you might
be very interested because the value of your investment has risen almost immediately by
£400.

What would your decision be if the £2,400 was not going to be returned until the same
date next year?

The problem is that you cannot directly compare £1 now with £1 in a year’s time because
each £1 of present expenditure is not equal in value to each £1 receipt at some stage in
the future. Why is this the case?

Cash receivable in the future is generally considered to be worth less than cash received
now, because cash that is available now can be reinvested. If you hand me over £2,000
now then you have lost the opportunity to invest this money elsewhere and to generate
some interest.

For you to properly assess this investment you need to know what the £2,400 to be
received in one year’s time is worth in present value terms. This is called discounting,
and by using discount tables (see Appendix 1 at the end of this unit) and choosing an
appropriate rate of interest, future cash flows can be brought back to their present value.

Let’s assume that you could put the £2,000 into your building society and receive an
annual return of 10%. The 10% would be the appropriate rate of interest to be used in
the calculation because this is the rate of return you can earn on an alternative investment.
The appropriate rate of interest is known as the cost of capital.

To value your £2,400 in present day terms, simply consult the discount table:

1. Look along the top line for the cost of capital percentage, in this case 10%.

2. Work down the 10% column until you come to the line opposite the year; in our
example this is line one.

3. Multiply the cash receivable by the present value of each £1 to be received.

Your £2,400 receivable in one year’s time is worth £2,400 × 0.909 = £2,182 in present
value terms, and we can conclude that the investment is still worthwhile.

To check the calculation, if we invested £2,182 in the building society today we would
expect it to be worth 10% more than that in one year’s time, ie £2,182 × 1.10 = £2,400.

11.5 Net Present Value

The most straightforward way of determining whether an investment will yield a return in
excess of the minimum acceptable rate of return is to calculate the NPV. This is the difference
between the present values of the forecasted cash outflows and inflows resulting from the
investment. If the NPV is positive, the rate of return is in excess of the required rate.
Alternatively, if the rate of return is lower, the NPV will be negative. See Worked example
11.5.

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Capital Investment

Worked example 11.5

Hartfell Ltd has the choice of investing in one of two new projects.

Project 1 2

Estimated life 5 years 5 years

£000s £000s

Initial cost (year 0) 2,000 2,000

Net cash inflows

Year

1 600 400

2 800 600

3 1,000 800

4 400 1,000

5 600 600

The company would anticipate being able to generate a rate of return of 10% on alternative
investments.

Required

Using the NPV method, which project would you advise Hartfell Ltd to undertake?

Solution

Project 1

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 600 0.909 545

2 800 0.826 661

3 1,000 0.751 751

4 400 0.683 273

5 600 0.621 373

Net present value 603

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Chapter

Finance for Management Decision-Making

Project 2

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 400 0.909 364

2 600 0.826 496

3 800 0.751 601

4 1,000 0.683 683

5 600 0.621 373

Net present value 517

As you can see, both projects have a positive NPV. If there is no limitation on the funds
available to spend, then all projects with a positive NPV should be chosen. However, our
example suggested that Hartfell Ltd had the choice of investing in only one of the two
projects. Where funds are limited and, as in this case, the initial investments are the same,
then the project with the highest NPV should be chosen. Hartfell would be advised to
select project 1 because of its higher NPV.

Let’s assume now that instead of project 1 having an initial investment of £2,000,000, the
investment increased to £2,080,000. What impact would that have on the NPV results?

Project 1

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,080 1.000 −2,080

1 600 0.909 545

2 800 0.826 661

3 1,000 0.751 751

4 400 0.683 273

5 600 0.621 373

Net present value 523

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Capital Investment

Project 2

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 400 0.909 364

2 600 0.826 496

3 800 0.751 601

4 1,000 0.683 683

5 600 0.621 373

Net present value 517

Obviously there is no change in the NPV position of project 2, but the NPV of project
1 has dropped to £523,000. Would we still be right in assuming that Hartfell Ltd should
choose project 1 because of its higher NPV?

In instances where the initial investments are not equal, it is advisable to work out what is
known as the profitability index of each project (assuming the index is in excess of 1). The
profitability index is calculated by the formula:

Profitability index =
Present value of total cash inflows

Initial investment

The relative profitability indices are as follows and highlight that Hartfell Ltd would be advised
to choose project 2, as this offers a better ‘return’ on the initial investment.

Project 1 (£000s) 2603 (2080 + 523 ) / 2080 = 1.2514
Project 2 (£000s) 2517 (2000 + 517 ) / 2000 = 1.2585

Like all methods of project appraisal, NPV relies on subjective estimates of the annual net cash
flows over the life of the project. Its other major problem is the selection of an appropriate rate
of interest, although to choose the rate at which a company could invest its funds externally
would appear to be a sensible starting point.

But the NPV does address some of the areas that were weaknesses in the earlier appraisal
methods, notably:

• the project’s total profitability

• the return on the original investment

• the timing and present day value of the cash flows.

11.6 Internal Rate of Return

Under the internal rate of return (IRR) method, you are required to calculate the rate of
interest that would result in an NPV of zero, i.e. the rate of interest that discounts the future
cash flows back to a net present value which equals the capital cost of the project. If the rate
of interest calculated is greater than a pre-determined target rate that you have set yourself
then the project can be accepted. Alternatively, where several projects are competing, the
project with the highest IRR would be selected.

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Computations under IRR are more difficult than under the NPV method and we therefore
need to adopt the following procedures.

• Select one discount rate and calculate the NPV of the project.

• If the NPV calculated is positive then keep selecting a higher discount rate until a negative
NPV results.

• If the NPV calculated is negative then keep selecting a lower rate until the NPV is positive.

• The rate which will discount the cash flows to zero will be between the two chosen rates
and can be calculated using the following formula:

Positive rate +
Positive NPV

Positive NPV + Negative NPV
× Range of rates

Worked example 11.6

Milk Ltd is considering whether or not to invest £600,000 in a new project which would
generate the following net cash flows.

Year £000s

1 240

2 400

3 140

Required

Calculate the internal rate of return for the proposed new project.

Solution

Stage 1

Let us assume that Milk Ltd could invest funds elsewhere and achieve a return of 10%
per annum. It could use this as the first trial rate.

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −600 1.000 −600

1 240 0.909 218

2 400 0.826 331

3 140 0.751 105

Net present value 54

Stage 2

As 10% generated a positive NPV, Milk Ltd need to choose a higher rate. Let’s try 16%.

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Chapter

Capital Investment

Year Cash flow Discount factor NPV

£000s (16%) £000s

0 −600 1.000 −600

1 240 0.862 207

2 400 0.743 297

3 140 0.641 90

Net present value (6)

Stage 3

Because the NPV is negative at 16%, the rate of return at which the project would pay
for itself is therefore between 10% and 16%. Applying the formula, the company get the
following result.

IRR = 10% + (£000s, 54)(£000s, 54 + 6) × (16% − 10%)

= 10% + (0.9 × 6%)
= 15.4%

If this rate is higher than the company’s required rate of return then the project is
acceptable.

You will have noticed that IRR very closely resembles the NPV method of project appraisal.
They both take account of the time value of money and of the full cash flows of the project,
although the IRR can be a time-consuming exercise with its trial and error process of arriving
at the final result.

The main disadvantage with IRR is that it completely ignores the scale of the investment. IRR
would see a return of 20% being preferable to a return of 15% where the opportunity cost
of finance was 10%. However, with a 10% cost of finance, £1 million invested at 15% would
increase wealth more than £0.4 million invested at 20%. It should be noted that it is unusual
for projects to compete for funds where there is such a large difference in the scale of the
investment, and that typically the IRR method will give the same signal as the NPV method.
However, even though the problem is rare, the NPV method is always more reliable than IRR.

11.7 Summary

In this unit you have studied one of the most important decision-making areas for management
today − the need to make capital investment decisions.

You should now be aware that:

• capital investment tends to involve an initial large capital outlay

• the benefits from the investment might not accrue for years to come

• once agreement has been reached on the decision to be taken, it is very difficult to change
that course of action.

It is vital, therefore, for management to appraise the key factors involved in the decision before
committing to the expenditure.

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You have considered the pros and cons of four methods used in practice today:

• payback

• accounting rate of return (ARR)

• net present value (NPV)

• internal rate of return (IRR).

We concluded that although in most cases NPV and IRR will give more accurate and usually
very similar results, the simplicity of payback and ARR ensures that they also have a role to
play in capital investment decision-making.

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