Yo u r road to success

Your road to success

LEVEL 4
FINANCE FOR
MANAGERS

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STUDY
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 © ABE 2017

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ISBN: 978-1-911550-11-2

Copyright © ABE 2017

First published in 2017 by ABE
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ii © ABE
 Contents
Using your study guide iv

Chapter 1 The World of Accounting 2

1.1 The purpose of financial and management accounting 3

1.2 Applying accounting principles, processes and concepts to financial and management
accounting data 8
1.3 Assess the needs of business stakeholders in relation to financial and management
accounting information. 16

Chapter 2 Financial Statement Interpretation 20

2.1 Assessing the contents of financial statements to review the performance of business
organisations 21
2.2 Using financial ratios to assess the financial performance of a business organisation 35
2.3 How to make justified recommendations for business improvements based on the results
of financial analysis 44

Chapter 3 Cash Flow and Budget Preparation 48

3.1 Preparing cash flow forecasts for internal management control 49

3.2 Preparing organisational budgets to aid management decision making 53
3.3 Evaluating completed cash flow forecasts and financial budgets to make
informed business 57

Chapter 4 Costing and Pricing Methods 58

4.1 Explaining costing and pricing methods used to make business decisions 59
4.2 Applying contribution and break-even calculations and analysis to make
effective business decisions 62
4.3 Assessing the implications of using different costing methods 67

Glossary 72

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 Using your study guide
Welcome to the study guide Level 4 Finance for Managers, designed to support those completing
an ABE Level 4 Diploma.
Below is an overview of the elements of learning and related key capabilities (taken from the
published syllabus), designed to support learners in assessing their own skillsets in terms of
employability, and in creating their own personal development plans.

Element of learning Key capabilities developed

Element 1: Introduction to financial • Understanding of the role of management and financial
and management accounting accountants
• Understanding of how to apply accounting principles,
processes and concepts to financial and management
accounting data
• Understanding of the importance of financial reports for
internal and external stakeholder use
Commercial awareness, numerical dexterity
Element 2: Financial statements • Ability to identify and understand the contents of
financial statements to review the performance of
business organisations
• Ability to use ratios to assess the performance
of a business organisation and make appropriate
recommendations for the future
Commercial awareness, numerical dexterity, writing
objectively and succinctly
Element 3: Cashflow forecasts • Ability to prepare cash flow forecasts and operational
and budgets budgets
• Ability to interpret cash flow forecasts and operational
budgets; evaluate forecasts and budgets to make
informed business decisions
Commercial awareness, numerical dexterity, integrity,
writing objectively and succinctly, understanding of the
link between quantitative and qualitative issues
Element 4: Costing and pricing • Ability to use costing and pricing methods to make
appropriate business decisions
• Ability to use break-even analysis to make informed
business decisions.
Commercial awareness, numerical dexterity, integrity,
writing objectively and succinctly, understanding of the
link between quantitative and qualitative issues

This study guide follows the order of the syllabus, which is the basis for your studies. Each chapter
starts by listing the syllabus learning outcome covered and the assessment criteria.

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L4 descriptor
Knowledge descriptor (the holder…) Skills descriptor (the holder can…)
• Has practical, theoretical or technical • Identify, adapt and use appropriate
knowledge and understanding of a subject cognitive and practical skills to inform
or field of work to address problems that actions and address problems that are
are well defined but complex and non- complex and non-routine while normally
routine. fairly well-defined.
• Can analyse, interpret and evaluate relevant • Review the effectiveness and
information and ideas. appropriateness of methods, actions and
• Is aware of the nature of approximate scope results.
of the area of study or work.
• Has an informed awareness of different
perspectives or approaches within the area
of study or work.

Contained within the chapters of the study guide are a number of features which we hope will
enhance your studies:

‘Over to you’: activities for you to complete, using the space provided.

Case studies: realistic business scenarios to reinforce and test your understanding of what
you have read.

REVISION
‘Revision on the go’: use your phone camera to capture these key pieces of learning, then
on the go
save them on your phone to use as revision notes.
‘Need to know’: key pieces of information that are highlighted in the text.

Examples: illustrating points made in the text to show how it works in practice.
Tables, graphs and charts: to bring data to life.
Reading list: identifying resources for further study, including Emerald articles (which will be
available in your online student resources).
Source/quotation information to cast further light on the subject from industry sources.
Highlighted words throughout and glossary terms at the end of the book.

Note
Website addresses current as of June 2017.

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Chapter 1
The World of Accounting

Introduction
In this chapter you will learn how to explain the purpose of financial management and accounting,
as well as how to apply accounting principles to financial data.

Learning outcome
On completing this chapter, you will be able to:
1 Explain the purpose of financial and management accounting

Assessment criteria
1 Explain the purpose of financial and management accounting
1.1 Explain the purpose of financial and management accounting
1.2 Apply accounting principles, processes and concepts to financial and management
accounting data
1.3 Assess the needs of business stakeholders in relation to financial and management
accounting information.

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 Level 4 Finance for Managers

1.1 The purpose of financial and management

accounting
What is accounting?
All business activities involve:
• the purchase of resources,
• the transformation or use of these resources,
• goods and/or services to be produced, and
• the selling of these goods and/or services.

The sale of these goods and/or services is an example of a business transaction. These transactions
must be recorded and are usually written into either a manual or computerised “Book”.

It is from here that the term “bookkeeping” is derived.

Luca Pacioli was the father of double entry bookkeeping. He was born in Sansepolcro and was a
successful Professor of Mathematics at Perugia, Rome, Naples, Pisa and Venice. The last years of his
life were spent in Florence and Venice.

Pope Paul II compelled Luca to become a Franciscan friar and helped to enforce the right use of
symbolism in science and the arts.

This period in history is known as the Renaissance period and became famous for religious works of
art. The period established many artists, scientists and mathematicians.

One of Luca’s pupils was Leonardo da Vinci. During the seven years Pacioli and da Vinci spent
together, the two helped each other create two masterpieces that would withstand the test of time.

Pacioli taught da Vinci perspective and proportionality. This knowledge allowed da Vinci to create
one of his greatest masterpieces, a mural on the north wall of the Santa Maria de Gracia Dominican
cloister. This mural is the most famous painting of the fifteenth century, known as “The Last Supper”.
Pacioli wrote the Summa de arithmetica, geometria, proportioni et proportionalita – it was this book
that contained the outline that every debit has a corresponding credit.

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 Chapter 1  The World of Accounting

Over to you
Activity 1: Summa de arithmetica, geometria, proportioni et proportionalita

Research the Summa de arithmetica, geometria, proportioni et proportionalita and note

down definitions of:

Debit
Credit

Over to you
Activity 2: Financial transactions – a new restaurant

Emile is thinking of opening a new restaurant in the centre of the city. Make a list of the
financial transactions that would apply to his new business.

Accounting is defined as a process that involves the recording, classification and summarisation of
financial transactions in a business.

The overall aim is to prepare financial information that can be communicated to a wide range of
business stakeholders.

The accounting process is shown in Figure 1.

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The accounting process

Identification

Recording

Classification

Measurement

Reporting

Communication

Figure 1: The accounting process Revision

on the go

In very large businesses, bookkeepers will complete the first four steps of this process.
An accountant will then produce and interpret the accounts prior to their communication
with business stakeholders.
There are two main strands of accounting:
• Financial accounting – this comprises the two key stages of:
• Bookkeeping (the recording of day-to-day business transactions) and
• Accounts preparation.
• Management accounting aims to provide information in a form that aids decision making in
a business organisation.

Accounting process:
Identification Classification Reporting
Recording Measurement Communication. Revision
on the go

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 Chapter 1  The World of Accounting

Differences between financial and management accounting

Financial accounting Management accounting

Objectives To disclose period-end results and To provide information that can

the financial health of a business be used by business management
organisation. to plan for the future, set goals
and objectives and evaluate the
Provide financial statements in
achievement of these.
accordance with current legislation.

Intended audience Financial accounting information Management accounting

is produced for release to information is produced for
both internal and external internal use only. This information
stakeholders of a business is used by managers and
organisation. employees.
These may include: shareholders,
lenders, tax authorities, the
Government and customers.

Legal requirement For incorporated businesses and Management accounting

others where legislation dictates, information is not a legal
there is a legal requirement to requirement.
prepare and distribute financial
accounting statements.
Required segments Financial accounting statements Management accounting
are produced for a whole information will relate to
business organisation or in the individual departments or
case of consolidated accounts for sections within a business
a group of business organisations. organisation.

Focus Financial accounting focuses on Management accounting focuses

historical data and reports on on the present and produces
information from the previous budgets and forecasts for the
trading period. future.

Format Depending on the type of Management accounting data is

business organisation, set formats presented informally and adapted
may be used depending on to meet the needs of individual
the applicable legislation. For departments.
example, in the UK, public limited
companies (PLCs) use formats
as defined by the Companies
Act. International Accounting
Standards provide companies
around the world with guidance
on final accounts.

Rules and A number of financial accounting Management accounting

regulations standards are prescribed. reports are only for internal use.
International Accounting Therefore, there are no rules or
Standards (IAS) provide regulations that apply.
guidance to companies around
the world.

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The World of Accounting Chapter 1

Financial accounting Management accounting

These standards could include:

IAS 7 – Statement of cash flows
IAS 10 – Events after the
reporting period
IAS 16 – Property, plant and
equipment
IAS 18 – Revenue
IAS 23 – Borrowing costs
IAS 36 – Impairment of assets
IAS 37 – Provisions, contingent
liabilities and contingent assets

Reporting Financial Accounting Statements are Management Accounting

frequency produced/published at pre-defined Statements are prepared as
times. The reports are usually required. The usual frequencies
published on an annual basis. are daily, weekly or monthly.

Information Financial Accounting Information Management Accounting

is usually verifiable and Information could be quantitative
quantifiable information based on and / or qualitative. This
monetary data. information is usually based on
monetary data, based on the
businesses goals and objectives.
“These reports typically show the
amount of available cash, sales
revenue generated, amount of
orders in hand, state of accounts
payable and accounts receivable,
outstanding debts, raw material
and inventory, and may also
include trend charts, variance
analysis, and other statistics.”

Over to you
Activity 3: International Accounting Standards
Complete the following table:

IAS Title of IAS Brief overview of International Accounting Standard

IAS 1
IAS 2

IAS 8

IAS 33

IAS 38

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1.2 Applying accounting principles, processes

and concepts to financial and management
accounting data
Accounting principles and concepts

Over to you
Activity 4: Financial legislation

1 Identify financial legislation that affects business organisations in your country.

2 Choose one charity in your local area. Consider how this charity meets its financial
requirements and complies with current financial legislation.

Accounting concepts
When preparing a business’s accounts and financial statements, accounting concepts, standards
and principles must be applied. There are four fundamental accounting concepts:
1 Accruals – This concept is also known as the “matching” principle. The concept states that revenue
should be recognised when it is earned and not when money is received. This means that revenue
should be matched against expenditure when calculating profit. It is often seen as an extension of
the realisation concept. Profit is earned when the ownership of goods transfers to the customer,
not when the goods are actually paid for. For example, the figures shown in an income statement
must relate to the period of time being considered in the statement. If a company purchases
goods during this period then this purchase would be included in the purchases total in the income
statement. The receipt of money can take place at a later time outside of the accounting period.
2 Consistency – An accounting concept that requires accountants, when faced with a choice
between different accounting techniques, to not change policies without good reason.
3 Going concern – An accounting concept that assumes a business will continue to trade in the
foreseeable future.
4 Prudence – An accounting concept that requires accountants to recognise revenue or profit
only when they are realised.

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Over to you
Activity 5: Accounting concepts

Clark, a farmer, orders three new tractors direct from the manufacturer on 3 March.
The tractors are delivered to him on 19 March and his payment to the manufacturer is
received in full settlement on 1 April.
On what date should this sale be recorded by the tractor manufacturer? On what
date has the profit from the sale been realised? Give reasons for your answers.

Additionally, businesses may apply a number of other concepts that may include:
• Materiality – An accounting concept which states that accountants should not spend time
trying to accurately record items that are either trivial or immaterial.
• Money Measurement – This is an accounting concept which states that all transactions
recorded by businesses should be expressed in monetary terms.
• Historical Cost – This concept states that assets should be stated at their cost when
purchased, rather than their current value.
• Realisation – An accounting concept which states that revenue should be recognised when the
exchange of goods or services take place.
• Dual aspect – This is the idea that every transaction has two effects on the account. This is
known as double entry book keeping – there will be one debit and one credit entry for every
financial transaction. One of the transactions would be “giving” and the other “receiving”. For
example, when Samira purchases a motor vehicle in cash there would be two effects. The motor
vehicle account would increase and the cash account would decrease. This concept relates to the
accounting equation. The accounting equation recognises that the assets owned by the business
are always equal to the claims against the business. Assets = Capital + Liabilities. The Statement
of Financial Position (Balance Sheet) is a formal way of showing the accounting equation.
• Business entity – This is an accounting concept which states that the financial affairs of a business
should be completely separate from those of the owner. An entity is a business organisation.

Over to you
Activity 6: Key accounting concepts

Summarise each of the key accounting concepts described in this section, which you can
use for revision purposes. You may wish to produce the summary on revision cards or in a
notebook for later reference.

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Accounting principles
Accounting principles are rules that organisations will follow when reporting financial data and
information to internal and external stakeholders.

Relevance – this means that financial data and records produced by an organisation must
meet the needs of both internal and external stakeholders. Thereby influencing any decision
that may be made. Any irrelevant information should be removed from the financial information
of the organisation.

Reliability – an organisation must ensure that published information is accurate and provides a
true and fair view of their financial conditions and operating records. An organisation’s financial
statements are the result of a management team’s judgements and estimates. By applying
appropriate accounting principles, the organisation will have shown a true and fair view.

Comparability – this is an important feature of accounting information. As long as accounting

policies and procedures remain consistent, financial data and information will be comparable with
previous financial periods. For inter-firm comparisons accounting standards, policies and procedures
need to be standardised. The introduction of the International Accounting Standards (ISAs) has
aided comparability around the world.

Understandability – this means that financial information should be understandable by anyone

who has a background knowledge and understanding of business. The information should be
concise, fully complete and explicit in its presentation.

Over to you
Activity 7: Accounting concepts

Identity the accounting concept that applies to each of the following scenarios. Explain
your reasoning.

Mr Janis, a sole trader, has taken goods originally costing $450 from his retail shop for his
own personal use.

Pendle Delivery Service has good industrial relations and would like to record this in the final
accounts at a value of $25,000.

Dewar Decorating Supplies have purchased two doormats costing $5 each. They are
expected to last for a number of years and the business thinks it should record them under
non-current assets in the final accounts.

Prior to completing the final accounts for the local greengrocer shop, the accountant has
asked the owner, Mr Smithers, to prove that his business is likely to continue for many years
to come.

Mrs Rogero, who owns a local retail store, would like to change the depreciation method
she uses for her fixtures and fittings. The change of method will increase her net profit.

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Application of accounting concepts

Non-current asset valuation

Non-current assets (fixed assets) are those of material value that are:
• of long life, and
• to be used in the business, and
• not bought with the main purpose of resale.

Examples may include Premises, Motor Vehicles and Fixtures and Fittings.

Over to you
Activity 8: Non-current assets

List five non-current assets which would be present in a supermarket store.

The historical cost concept states that assets are to be recorded in the financial accounts at the cost
for which they were purchased. Organisations will be expected to apply depreciation on some of
these assets.

When accounting for non-current assets, it is important to consider the application of capital and
revenue expenditure.

Capital expenditure is money spent on acquiring, improving and adding value to non-current
assets. This is usually expenditure, a one-off payment.

Revenue expenditure is money spent on the day to day running of the business i.e. expenses.
Payments have the potential to be repeated throughout the year(s).

It is important to make the distinction between capital and revenue expenditure because:
• Capital expenditure affects the statement of financial position.
• Revenue expenditure affects the income statement.
• If these expenditures are confused then distortions will occur in the final accounts resulting in
incorrect reporting to “users”.

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Examples of capital and revenue expenditure

Example Capital expenditure Revenue expenditure

Delivery Vehicle Purchase cost Road tax

Delivery cost Insurance

Modification of the vehicle Fuel

Sign-writing on the vehicle Servicing

Repairs

Drivers’ wages

Machinery Purchase cost Power costs

Delivery cost Insurance

Installation Maintenance

Testing Servicing

Repairs

Depreciation
Depreciation is the cost of a non-current asset consumed over its lifetime. That is the part of
the cost of the non-current asset that will be transferred to the expenses in the income statement
every year until all of the cost has been transferred. This is an application of the accruals/
matching concept.

Depreciation is the measure of the wearing out, consumption or other reduction in the useful economic
life of a non-current asset. It is not a movement of money, it is simply a bookkeeping entry. In day
to day life, it is often referred to as a reduction in the value of an asset, for example a motor vehicle.
Depreciation is an expense that is charged to the Income Statement and will reduce profit for the year.

There are three main methods of calculating depreciation:

1 Straight line depreciation.
2 Reducing balance deprecation.
3 Revaluation depreciation.

International Accounting Standard 16 (IAS 16 – Property, Plant and Equipment) details the
accounting procedures for non-current assets and the provision of depreciation. The causes of
depreciation are shown in Figure 2.

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Inadequacy

Wear and Time factors,

Tear e.g. Goodwill

Depreciation
Causes
Obsolescence–
Physical
out of date
Detoriation

Rust, Rot and

Erosion Decay

Figure 2: Causes of depreciation Revision

on the go

Over to you
Activity 9: IAS16

Research IAS16 and summarise its main contents.

Alone, or with a study partner if you have one, discuss whether you think depreciation is a
movement of cash. Make your notes here.

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Note that some assets will increase in value, a process which is called “appreciation”. Normal
accounting procedure is to ignore any such appreciation. To bring appreciation into the accounts
would contravene both the cost concept and the prudence concept.

Concepts that relate to the application of depreciation include:

Historical States that all non-current assets should be shown in the accounts at their
cost original cost.

Prudence States that businesses should not overstate the value of their assets.

States that, once a depreciation method is chosen, the policy should not be
Consistency
changed without a valid reason.

Inventory valuation
An organisation’s inventory may include:
• raw materials
• work-in-progress
• finished goods
• goods for resale
• consumables, used within the business for maintenance and repair, for example
cleaning materials.

To comply with accounting concepts and principles the inventory is valued at the lower of cost and
net realisable value.

Example inventory valuation for a sports shop

Inventory group Cost NRV Valuation

$ $ $

T-shirts 5 000 13 000 5 000

Shorts 2 000 3 500 2 000

Trainers 3 500 6 000 3 500

Coats 5 500 4 000 4 000

Accessories 6 200 5 000 5 000

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Over to you
Activity 10: Inventory valuation

Complete the following table to show the inventory valuation for the local bakery.

Inventory group Cost NRV Valuation

£ £ £

French bread 2 500 2 000

Tea cakes 1 500 2 000

Loaves 3 000 4 000

Cream cakes 2 200 5 000

Pies 1 850 1 500

Accruals/matching concept
The matching concept states that revenues and expenses are to be matched to the same
accounting period.

Expenses
• An accrual is an amount due in an accounting period that remains unpaid at the end of that
period, for example heat and light outstanding.
• A prepayment is a payment made in advance of the accounting period to which it relates – for
example a prepayment for electricity.

Accruals of expenses are:

• added to the relevant expense in the income statement and
• included in the “amounts falling due within one year” in the statement of financial position.

Prepayments of expenses are deducted from the:

• relevant expense in the income statement and
• included in the current assets in the statement of financial position.

Income
• Prepaid income is income received in advance of the period to which it relates – for example
rent received.
• Accrued income is income due in the period but not yet received – for example,
commission receivable.

Prepayments of income are:

• deducted from the relevant additional income in the income statement and
• included in the “amounts falling due within one year” in the statement of financial position.

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Accruals of income are:

• added to the relevant additional income in the income statement and
• included in the current assets in the statement of financial position.

Provision for doubtful debts

A provision for doubtful debts occurs if a trade receivable that owes money to a business
has the potential to not pay the debt due. They are not definitely irrecoverable, there is still the
potential that the trade receivable will pay the money owed.

The concept of prudence requires a business to account for the potential loss.

1.3 Assess the needs of business stakeholders in

relation to financial and management accounting
information.
Who/what are stakeholders?
A stakeholder is any person that has an interest in a business organisation or will be impacted by
the organisation’s decisions. Stakeholders can include individuals, groups of people or organisations
that are affected by the business organisation.

Internal stakeholders – these are stakeholders within a business organisation. For example,
owners and employees.

External stakeholders – these are stakeholders outside of a business organisation. For example,
customers, suppliers, the government, lenders, local residents and the broader public.

Users of accounting information

The main users of financial accounts are:
• The owners – sole proprietor, partners, shareholders, investors.
• Investors – banks, financial advisers, financial institutions, individuals, groups, or organisations
that have invested in or are considering investing in a business.
• Management – the board of directors and other management responsible for the financial
performance of the business or parts of the business.
• Employees.
• Potential/prospective owners: possible new partners, share buyers or companies considering
buying the business.
• Business contacts – customers, suppliers and competitors.
• Analysts/advisers – those outside the business involved in analysing the level and state of
economic activity in the economy.
• The government.
• The public.

Information on the way in which key parties use the accounts is provided below.

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Owners
The owners of sole trader or partnership will be interested in how the business is doing, for
example any profit or loss and the extent of monies owed to the business by trade receivables and
monies owed by the business to trade payables. Owners will be able to take whatever money they
want from the business in the form of drawings. Shareholders are those who have invested money
in the company and are considered owners of the business. The company will be run by a team
of managers, and the shareholders require the managers to account for the “stewardship” of the
business – so how the shareholders’ funds have been used.

Investors
Banks and other lending institutions require to know if the business is likely to be able to repay
loans and to pay the interest charged. Currently available accounts of a business may be several
months old and not show an up-to-date position. In these cases, the lender will ask for cash flow
forecasts to show what will happen in the business. Therefore, accounting techniques have to be
flexible and adaptable to meet users’ needs.

Management
The board of directors require up-to-date, in depth information so that they can plan for the long
term, medium future of the business.

Management will compare results with past decisions and forecasts. As other levels of management
will require access to different types and detail of accounting information managers will need to see
financial information about areas of the business for which they are responsible.

Employees
Employees must be assured of the future outlook and job security of their employment. They also
need to see the financial position of the business and how that may affect their pay levels. For
example, claiming pay rises or performance-related pay.

Prospective owners
Any individual entering into an established partnership – e.g. those thinking of buying shares in a
company or making a takeover bid for an existing business – will want to know the financial viability
of the business, the price of the ownership, the share price/asking price for a takeover. This must be
fair and in consideration of the current financial position and the business’s future prospects.

Business contacts: customers, suppliers and competitors

These are suppliers to who the business owes money. This may be for goods and services
bought on credit – trade payables, and for customers who owe money for goods and services
received on credit – trade receivables. Financial information provided by the businesses should
not adversely affect the financial failure of another. Competitors may compare their own results
with those of other similar businesses. They need to ensure they are performing as well-or
better-than their competitors.

Government
All businesses have to submit their accounts to determine their liability for taxation.
The government’s primary source of revenue to fund public spending is through businesses
liability for taxation.
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CASE STUDY: Go International

”Go International” is a holiday company based in the North
West of the UK.
It was started in 1998 by David Douglas who is
the current Managing Director. He started as a
sole trader but as demand for package holidays
increased the demand for his expertise rose
dramatically.
David formed a partnership in 2001 with Sheila
Stokes.
David and Sheila had different skills that complemented each other. They were able to exchange
ideas and launch new and exciting holiday experiences around the world. Sales continued to rise and
David and Sheila opened several outlet shops to market and sell their holidays. In 2005 the business
was converted to a limited company.

Over to you
Activity 11: Go International

Using the case study information above, answer the following questions.
Suggest why Go International may have struggled to borrow money from a bank and
obtain credit from suppliers, in the early stages of its business.

At which point in its development would Go International have most been affected by the
accounting standards?

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At which stage in the development would Go International have a distinct “legal

personality”?

Reading list
Frank Wood’s Business Accounting Volume 1, 13th Edition, Alan Sangster, Frank Wood, July
2015, ISBN13: 9781292084664

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Chapter 2
Financial Statement
Interpretation

Introduction
In this chapter you will learn how to interpret financial statements in order to review business
organisations performances as well as how to report to stakeholders.

Learning outcome
On completing this chapter, you will be able to:
2 Interpret financial statements to review the performance of business organisations and
report to stakeholders

Assessment criteria
2 Interpret financial statements to review the performance of business organisations and
report to stakeholders
2.1 Assess the contents of financial statements to review the performance of business
organisations
2.2 Calculate financial ratios to assess the financial performance of a business organisation
2.3 Make justified recommendations for business improvements based on the results of
financial analysis

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 ABE Level 4 Finance for Managers

2.1 Assessing the contents of financial

statements to review the performance of
business organisations
Types of business organisations

NEED TO KNOW: types of business organisations

Note that naming conventions and legal definitions of business types vary by country and you
should be aware of those in your country, if they differ from the ones described here.

• Sole trader – a business that is owned and controlled by one person. They may however
employ other workers. Examples may include plumbers, hairdressers etc. These organisations,
often succeed as they can offer specialist services to their customers and are able to be sensitive
to the customer’s needs and wants. They frequently cater for the needs of the local community
and are able to respond more quickly than larger business organisations.
Sole traders may begin as very small organisations, possibly on a part time basis and then
expand over time. A small business in a local area can build up a customer base in the
community due to trust. A sole trader has unlimited liability. This is an important concept. It
is an additional risk faced by the sole trader. The sole trader will be responsible for all debts
of the business organisation. They may have to sell their own possessions to pay off the
business debts.
• Partnerships – these are business owned by two or more people. These usually operate
under a deed of partnership and will benefit from increased capital and shared expertise.
Partnerships also have unlimited liability. As with the sole trader, the partners will be
responsible for all debts the business organisation acquire. They may have to sell their own
possessions to pay off the business debts. Each partner would be responsible for the debts
of the partnership and therefore it is important for individuals to carefully choose any partner
they decide to work alongside. It is beneficial for the partners to draw up agreements on the
responsibilities and rights of each partner. These are known as Deeds of Partnership or Articles
of Partnerships. The most common examples of partnerships are veterinarians, accountants
and solicitors.
As stated here most partners in a partnership face unlimited liability for their debts. There is one
exception to this – the formation of a Limited Partnership.
Limited partnerships occur when partnerships wish to raise additional finance but not recruit
active partners. To solve the problem, a partnership may accept Sleeping (or Silent) Partners.

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These partners will provide finance for the business but will not have any input into how the
business is run. The Sleeping Partners face limited liability for the debts of the partnership.
A partnership, like a sole trader, is an unincorporated business.
• Limited companies – all limited companies are incorporated, which means they can sue or
own assets in their own right, in other words they are treated as separate legal entities. Limited
companies are owned by shareholders. The shareholders of a company have no personal liability
for the company’s debts. A Public Limited Company (PLC) has tradable shares which can be
bought and sold on the Stock Market, however, a Private Limited Company (LTD) does not have
shares which are so easily tradable.
• Third sector organisations – these organisations are non-profit making and generally
operate to provide services to the community as a whole or to specific groups of people within
the community.

A summary of the features of these organisation types is provided in the table below:

Sole traders Partnerships Private Limited Public Limited Third sector

Companies Companies organisations
Legal Issues No legal No formal On formation Relevant Relevant to
requirements requirements memorandum to national national company
of incorporation company legislation and
Subject will be required legislation national charities
relevant legislation
to national On formation
partnership Memorandum On formation
legislation. of incorporation, Memorandum of
will be required incorporation, will
be required
Ownership Only one Two or more Shareholders – Shareholders – There are no
owner owns partners own friends and available to the owners.
and manages and manage family general public
their business their business Answerable to
trustees
Formal No legal Partnership Relevant Relevant Relevant to
Documentation requirements agreement to national to national national company
company company legislation
legislation legislation
Capital The owner Partners Shares to family Shares sold to Dependant on
and friends the general donations and
public grants
Availability The owner Partners Current and Available to the Available to
of Financial prospective general public members and the
Information shareholders public
Owner Profits given Profits paid Dividends paid Dividends Income is not
Payments to the owner to partners to shareholders distributed to paid to members
shareholders
Financial Optional Optional Annual financial Annual financial Annual financial
Statement reports which reports which are statements which
Requirements are compulsory compulsory are compulsory

Revision
on the go

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Financial Statement Interpretation Chapter 2

Over to you
Activity 1: Types of business organisations

Review the advantages and disadvantages of each form of business ownership in your
region, from the point of view of the business owner.

Sole trader and partnership annual accounts

There are generally fewer legal requirements for the annual accounts for a sole trader or
partnership than for other types of organisation.

Typical layouts for the annual accounts of sole traders followed by those for partnerships are shown
on the next few pages.

SOLE TRADER
Name of firm

Income statement (trading and profit and loss Account) for the year ended
31 December 20XX

$ $ $

Sales x

Less returns inwards x

Net sales x

Less cost of sales

Opening stock x

Purchases x

Carriage inwards x

Less returns outwards (x)

Less closing stock (x)

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$ $ $

Cost of sales (x)

Gross profit x

Additional income

Decrease in provision for doubtful debts

Discounts received

Rent received x

Less expenses (add accrued, minus prepaid)

Sundry expenses x

Wages and salaries x

Telephone x

Insurance x

Carriage outwards x

Increase in provision for doubtful debts x

Discounts allowed x

Bad debts x

(x)

Net profit x

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SOLE TRADER
Name of firm
Statement of financial position (balance sheet) as at 31 December 20XX
Non-current assets Cost Depreciation Net book value
$ $ $
Premises X X X
Fixtures and fittings X X X
Motor vans X X X
X X X

Current assets $ $
Closing inventory X
Trade receivables X
Less provision for doubtful debts (X)
X
Cash at bank X
Cash in hand X
Accrued income X
Prepaid expenses X
X
Current liabilities
Bank overdraft X
Trade payables X
Short term loan X
Accrued expenses X
Prepaid income X
(X)
Working capital X
Total assets less current liabilities X
Long term liabilities
Loan X
(X)
Net assets X
Financed by:
Capital X
Net profit X
X
Drawings (X)
X

Figure 1: Annual accounts for sole traders Revision

on the go

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Let’s look now at the accounts for partnerships.

Capital account
Partner Partner Partner Partner Partner Partner
1 2 3 1 2 3
$ $ $ $ $ $
Balance brought
New goodwill X X X X X X
down (b/d)
Revaluation Bank / cash
X X X X X X
Dec 20XX introduced
Assets introduced X X X
Old goodwill X X X
Balance carried Revaluation
X X X X X X
down (c/d) increase

X X X X X X
Balance brought
X X X
down
Current account
Partner Partner Partner Partner Partner Partner
1 2 3 1 2 3
$ $ $ $ $ $
Balance b/d X X X Balance b/d X X X
Share of loss X X X Interest on capital X X X
Drawings X X X Salaries X X X
Interest on
X X X Share of profit X X X
drawings
Balance c/d X X X Balance c/d X X X

X X X X X X

Balance b/d X X X Balance b/d X X X

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Appropriation account for the year ended 20XX

$ $ $
Net profit X

Add Charged for interest on drawings:

Partner 1 X
Partner 2 X
X
X

Less Salary: Partner 1 X

Less Interest on capital:

Partner 1 X
Partner 2 X
X
(X)

X
Balance of profits shared:

Partner 1 X
Partner 2 X

Figure 2: Annual accounts for partnerships Revision

on the go

Annual accounts for private limited and public limited companies

Private limited companies are not required to follow the same legal requirements as public limited
companies. In general, it is required that private limited companies will produce:

Income statement
This is a statement which measures a company’s achievement over a period of time, usually one
year. It is often also referred to as the profit and loss account.

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The income statement will look at the income of the company and compare this against the cost
of sales and other expenses for the same period. By doing this the company’s gross profit can
be calculated. To calculate its net profit for the same period the company will deduct the expenses
incurred from their gross profit.

Statement of financial position

At a particular moment in time, usually the end of the financial year, the statement of financial
position will detail the company’s assets and liabilities. The date will usually coincide with the year
end of the income statement.

There are a number of business costs that will be included in the financial statements. These include:
• Direct costs – similar to a variable cost in that it compares the cost with the level of
output. However, a direct cost is any cost that is directly related to the output level of a
particular product.
• Indirect costs – any cost that cannot be linked with the output of any particular product.
These costs are sometimes known as overheads. They are related to the level of output of the
firm but not in a direct manner and not for any one product.

A summary of a PLCs, Annual Report is provided in the table below:

Section of PLCs,
Detail
Annual Report

General corporate This section of the annual report shows a general overview of the
information company. Readers can familiarise themselves with the company’s
corporate strategies, objectives and market objectives.

Accounting policies When preparing a company’s annual report the company has
a legal obligation to identify the accounting policies that have
been used: these will include doubtful debt policies, depreciation
methods and inventory valuation.

Income statement This calculates the profit figure for the year of a company. An
income statement of a sole trader is not the same as one for a
company. A company will produce an appropriate account which
will have been included after the net profit has been calculated.
Appropriation refers to how profit will be divided up.

As a company has its own legal entity the business will pay tax in its
own right. The income statement:
• Provides information to shareholders.
• Enables shareholders to calculate the return they may achieve
from a potential investment opportunity.
• Helps to ensure that the company meets its legal requirements.
• Helps investors to decide whether profit earned will ensure the
business is sustainable for the future.
• Enables comparisons to be made with similar companies.
• Provides evidence and support for loan applications.

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Section of PLCs
Detail
Annual Report

Statement of The financial position of a company on a given date. There are

financial position three main sections:
1 Assets
2 Liabilities
3 Capital and Reserves

The main differences between a sole trader and a limited company

are identified in the capital section. The company’s share capital is a
separate section. The statement of financial position allows interested
parties to assess the security of their investment. They will be able to
review credit risk, liquidity risk, business risk and financial risk.

Statement of cash This is a summary of cash inflows and cash outflows. Generally, it is
flows over the most recent period. The summary identifies the liquidity
of the company and any changes in their most recent cash flow. It
enables the company to:
• Identify changes in the capital structure of the company.
• Identify liquidity issues.
• Highlight profits-that are “high quality” or “poor quality” and
those which are not sustainable.
• Assess the link between one statement of financial position and
the next.
• Meet legal requirements.

Notes to Detailed information to support the figures that are included in the
the financial statement of financial position, statement of cash flows and
statements/ income statement.
accounts
Chairperson’s and This will include:
directors’ report
• A review of the company’s performance.
• A discussion of corporate governance.
• Details of directors’ pay.

Auditor’s report The company’s auditors will give their opinion on the company’s
accounts and whether they show “a true and fair view of the
financial performance and position of the company” at that time.

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Sections of a PLCs, annual report

General corporate information Statement of Cash Flows

Accounting Policies Notes to the financial statements

Income Statement Chairperson’s and Director’s Report

Statement of Financial Position Auditor’s Report Revision

on the go

NEED TO KNOW: Stakeholder groups for publicly available

reports
Stakeholders can be individuals, groups or organisations that have an interest in a particular
business enterprise.

Internal stakeholders are those who work in a business organisation.

Employees will want to be sure that they will be paid for the work they have done. To ensure
job security they will check and review the annual statements.

Managers will also want job security and to ensure they receive their wages. They will review the
financial status of the business and compare its performance against other similar businesses.

Directors will want to be sure that the business will continue in the future and is a going concern.
They will also calculate and review the profitability and liquidity of the business organisation.

Shareholders will review information about the business and the annual reports to ensure that
the business is profitable. They will want to be absolutely sure that their investment will continue
to grow and share prices rise. In addition, they will review the dividends they have received in
the past and may receive in the future.

Potential Investors potential investors will want to review future profitability and assess the
risks of their potential investment. In addition, they will want to examine dividends they may
receive in the future.

Suppliers will need to ensure that they will be paid for the goods that the business has
purchased. They will need to assess the businesses credit status and risk profile.

Customers will want to review business information to ensure that they are charged the correct
price for goods and services. They will want to ensure that price strategies are adhered to and
that any discounts have been applied. The business will want to reinforce its reputation and
encourage repeat business.

Lenders will want to be absolutely certain that a business is able to repay loans on time. They will
use the financial information and reports to assess creditworthiness and any risks they may incur.

Government – all business organisations must pay the tax they owe the government.

Analysts will look at the data and compare it with the data of other firms. Their conclusions
will predict the future performance of the business and may be used to offer advice to the
government.

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Over to you
Activity 2: Annual reports

Select a company of your choice and download their annual report from the internet.
In the report, find all of the sections that have been considered in the notes and consider
what information they are giving you, as a potential shareholder.

Public limited company accounts example

The layout of a typical publicly available account report is shown below for reference.

Income statement
1 January – 31 December
Note 20XX 20XX
Revenue
Gross profit
Other operating expenses
Operating profit
Net profit for the year from subsidiaries
Financial income
Financial expenses
Profit before income tax
Tax on profit for the year
Net profit for the year
Proposed distribution of profit:
Dividend
Reserve from the use of the equity method
Retained earnings

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Balance sheet
at 31 December
Note 20XX 20XX
Assets
Non-current assets:
Patents
Intangible assets
Land, buildings and installations
Property, plant and equipment
Deferred tax assets
Investments in subsidiaries
Investments in associates
Receivables from subsidiaries
Other non-current assets
Total non-current assets
Current assets:
Other receivables
Total current assets
Total assets

Balance sheet
at 31 December
Note 20XX 20XX
Equity and liabilities
EQUITY
Share capital
Reserve from the use of the equity method
Retained earnings
Proposed dividend
Total equity

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Note 20XX 20XX

Liabilities
Non-current liabilities:
Debt to related parties
Total non-current liabilities
Current liabilities:
Debt to subsidiaries
Trade payables
Current tax liabilities
Other short-term debt
Total current liabilities
Total liabilities
Total equity and liabilities

Cash flow statement

1 January – 31 December
Note 20XX 20XX
Cash flows from operating activities:
Cash generated from operations
Interest paid etc.
lnterest received etc.
Income tax paid
Net cash generated from operating activities
Cash flows from investing activities:
Purchases of intangible assets
Purchases of property, plant and equipment
Proceeds from sale of property, plant and equipment
Net cash used in investing activities
Cash flows from financing activities:
Divided paid to shareholders
Payment to related parties
Repayment from related parties
Payments to borrowings
Repayments of borrowings
Net cash used in financing activities
Total cash flows

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Note 20XX 20XX

Cash and cash equivalents at 1 January
Exchange gains/(losses) on cash at banks
Cash at banks at 31 December

Figure 3: Example Public Limited Company Accounts. Revision

on the go

Roles and responsibilities of directors and auditors regarding

company accounts
Directors
It is the responsibility of the directors to prepare a company’s annual report and accounts in
accordance with the law. Under company law, directors prepare financial statements for each year
which give a “true and fair view” of the affairs of the company. A director’s role involves the following:
• To select and apply accounting policies.
• To make reasonable and prudent judgement and estimates.
• To state and ensure “the financial statement complies with all relevant accounting standards”.

Directors must ensure that the company keeps accurate accounting records and information. They
must prevent and detect fraud. The name and function of each director is usually stated in the
business overview section of the annual report.

Auditors
In order to ensure that a company’s financial statements show a “true and fair” view of their
financial affairs, an external, independent auditor is appointed. This increases confidence for
stakeholders regarding the accounting records. The auditor will ensure that the financial information
is accurate. Auditing duties include:
• Ensuring the management and employees understand the company, in particular company
operations, fraud and financial reporting.
• Evaluating and understanding internal control systems.
• Observing a physical inventory stock take.
• Investigating differences or variances in account balances.
• Confirming balances of accounts receivable and accounts payable.

An auditor can offer objective advice on internal control and improving financial reporting. They
must ensure that they remain independent from the company. The auditor can only offer an opinion
on the businesses validity.

An auditor cannot:
1 Supervise the company’s employees.
2 Maintain company assets.

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3 Sign tax returns.

4 Hire or terminate the employment of an employee.
5 Authorise/complete any financial transactions on behalf of the company.
6 Design/maintain internal controls or financial management systems.
7 Approve invoices for payment.
8 Report to the board of directors on behalf of the management.

Internal final accounts vs publicly available final accounts of a

limited company
Internal final accounts
• The purpose of internal final accounts is to provide managers with information about the
business on which to make informed decisions. The accounts enable management to make
decisions on profitability, sales, inventory levels, cost of expenses and liquidity. Management can
assess any changes over time and plan to make improvements if required.
• The content of the internal final accounts is left entirely for the company to decide. However, this
would usually include an income statement and appropriation account, a statement of cash flows
and a statement of financial position. Management may produce further accounting data for
internal use such as standard costing, break-even analysis and cash flow forecasts.
• Companies are able to choose a structure and a format that best serves their needs. For internal
use they will include data and information that would be damaging if a competitor received it.
As an example, for internal use very detailed sales figures may be included but only a total sales
figure would be included in publicly available accounts.

Publicly available final accounts

• Publicly available final accounts are to provide information to stakeholders who have an interest
in a company. The accounts will enable each stakeholder group to make informed decisions
about that company.
• The content of publicly available final accounts must be in accordance with strict regulations
and will include reports from the director, auditor and chairperson, notes to the final statement,
statement of cash flows, financial position and income statement-including appropriation
account. In addition, it will include general corporate information and accounting policies.
• Guidance on the format of the final accounts is given by national legislation. Publicly available
accounts must meet the requirements and the regulations that are set out. Complex instructions
and guidance for different types and sizes of business organisations have to be legally adhered
to in order to publish their accounts.

2.2 Using financial ratios to assess the financial

performance of a business organisation
Ratio analysis
The purpose of accounting is to convey appropriate financial information to interested parties.
Absolute numbers in isolation are meaningless; they need to be related to other figures to put
them into perspective. For example, a net profit of $35000 could be excellent, satisfactory or
poor depending on the type of business concerned. It is in this situation that ratio analysis can
be useful.
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Ratio analysis is helpful when looking at trends in the same business over a number of years. This
will show progression or deterioration. Results in one business may be compared with the results
of another business (“inter-firm comparison”) to see if it is performing as well as expected. Clearly,
there are pre-requisites in such a comparison:
• They should be in the same line of business, for example two local coffee shops.
• The structures of the business should be similar, for example two sole traders.

Limitations
Ratio analysis has some limitations, as follows:
• Ratios only show the results of businesses that will continue for the foreseeable future.
• The accuracy of the ratio analysis depends upon the quality of the information from which they
are calculated.
• As mentioned above, ratios can only be used to compare “like with like”.
• Ratios tend to ignore the time factor in seasonal businesses.
• They can be misleading if accounts are not adjusted for inflation.

Before we look at ratio analysis in more detail, who do you think are its users?

Users of ratio analysis

The users of ratio analysis are summarised in the table below.

User Use

Management To analyse past results.

To plan for the future – say in budgeting.

To control their business.

Investors To compare investment opportunities.

Bankers and lenders To assess the credit worthiness of a business

organisation.

Financial analysts To inform the Financial Press, Trade Associations and

Trade Unions, for example.

Government To compile national statistics.

There are several types of ratios used in this context; we will cover each in turn:
• profitability ratios
• efficiency ratios
• liquidity ratios
• stability ratios and
• investor ratios.

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Profitability ratios
These ratios tell us whether a business is making profits – and if so whether at an acceptable rate.
The key ratios are explained below. Note that the “/” sign denotes “divided by”.

Ratio Formula Comments

Gross Profit [Gross Profit / Revenue] This ratio tells us something about the
Margin x 100 (expressed as a business’s ability consistently to control its
percentage) production costs or to manage the margins
it makes on products it buys and sells. Whilst
sales value and volumes may move up and
down significantly, the gross profit margin
is usually quite stable (in percentage terms).
However, a small increase (or decrease) in
profit margin, despite how it is caused can
produce a substantial change in overall
profits.
Operating (Net) [Operating Profit Assuming a constant gross profit margin, the
Profit Margin / Revenue] x 100 operating profit margin tells us something
(expressed as a about a company’s ability to control its other
percentage) operating costs or overheads.
Earnings Before [Earnings Before Interest EBITDA is a finance/accounting term used
Interest Tax Tax Depreciation and by lenders, investors and the management
Depreciation Amortisation / Revenue] team of a business. It is recognised as
and Amortisation x 100 (expressed as a being the best measure (true reflection) of
Margin percentages) how the business is performing in terms
of profit generated from normal operating
activities. This ratio is used globally and is
often used as a financial covenant in lending
documentation. It is of particular interest
where business organisations have large
amounts of non-current assets which are
subject to large depreciation charges.
Return on Net profit before tax, ROCE is sometimes referred to as the
Capital interest and dividends “primary ratio”; it tells us what returns
Employed (“EBIT”) / total assets (or management has made on the resources
(“ROCE”) total assets less current made available to them before making any
liabilities) distribution of those returns.

Over to you
Activity 3: Profitability ratios

Visit an international or national online business news site (such as Bloomberg or Reuters).
Search through the business performance commentary and see if you can find any
mention of the profitability ratios in the table above. Make your notes below.

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Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resources
invested in fixed assets and working capital.

Ratio Formula Comments

Sales revenue/ Sales revenue/ This ratio is about fixed asset capacity. A
Non-current assets Non-current assets reduction of sales or profit being generated
from each pound invested in fixed assets may
(Asset Turnover) indicate overcapacity or poorer-performing
equipment.
Inventory turnover Cost of sales/Average Inventory turnover helps answer questions
inventory value such as “have we got too much money tied
up in inventory?” An increasing inventory
turnover figure or one which is much larger
than the “average” for an industry, may
indicate poor inventory management.
Credit given/“Trade (Trade receivables This ratio indicates whether debtors are
receivables days” (average, if possible)/ being allowed excessive credit. A high figure
(Sales)) x 365 (more than the industry average) may suggest
general problems with debt collection or the
financial position of major customers.
Credit taken/“Trade ((Trade payables + A similar calculation to that for trader
payables Days” accruals)/(cost of sales receivables, giving an insight into whether a
+ other purchases)) x business is taking full advantage of the trade
365 credit available to it.

Liquidity ratios
Liquidity ratios indicate how capable a business is of meeting its short-term financial obligations as
they fall due:

Ratio Formula Comments

Current ratio Current assets/Current A simple measure that estimates whether
liabilities the business can pay its debts due from the
assets that it expects to turn into cash, within
one year. A ratio of less than one is often a
cause for concern, particularly if it persists for
any length of time.
Quick ratio (or Cash and near-cash Not all assets can be turned into cash quickly
“acid test” (short-term investments or easily. Some – notably raw materials and
+ trade debtors) other inventory – must first be turned into final
product, then sold and the cash collected from
trade receivables. The quick ratio therefore
adjusts the current ratio to eliminate all assets
that are not already in cash (or “near-cash”)
form. Once again, a ratio of less than one
would start to cause concern.

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Over to you
Activity 4: Liquidity ratios

Why do you think that either a current ratio or a quick test ratio of less than one is often a
cause for concern?
What do you think the reactions to such a trend might be of the key users of ratios? Make
your notes alongside each category below:

Management

Investors

Bankers and lenders

Financial analysts

Government

Stability ratios
These ratios concentrate on the long-term health of a business – particularly the effect of the
capital/finance structure on the business:

Ratio Formula Comments

Gearing Borrowing (all long- Gearing measures the proportion of assets
term debts + normal invested in a business that are financed by
overdraft)/Net Assets borrowing. In theory, the higher the level
(or Shareholders’ of borrowing the higher are the risks to a
Funds) business, since the payment of interest and
repayment of debts are not “optional” in the
same way as dividends. However, gearing
can be a financially sound part of a business’s
capital structure particularly if the business
has strong, predictable cash flows.

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Over to you
Activity 5: Gearing ratio

Using an internet search engine, see what commentary you can find in the media about
a company’s “Gearing”? In what context is it being discussed and what conclusions are
being drawn? Make your notes here.

Investor ratios
There are several ratios commonly used by investors to assess the performance of a business as
an investment:

Ratio Formula Comments

Earnings per share Earnings (profits) A requirement of the London Stock
(“EPS”) attributable Exchange – an important ratio. EPS
to ordinary measures the overall profit generated for
shareholders/ each share in existence over a particular
Weighted average period.
ordinary shares in
issue during the year
Dividend yield (Latest dividend It provides a guide as to the ability of a
per ordinary share/ business to maintain a dividend payment.
current market price It also measures the proportion of earnings
of share) x 100 that are being retained by the business
rather than distributed as dividends.

Let’s have a look at a fictional business and apply some of the ratios we’ve looked at to derive some
key information about that business.

CASE STUDY
Zaheer Motors
Zaheer Motors have provided the following details from their final
accounts for the year’s ending 31 March 2016 and 31 March 2017.
See how ratio analysis has been used to analyse the performance of
Zaheer Motors.

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Income statement (profit and loss account)

2016 2017
$ ‘000 $ ‘000
Sales Revenue 1 632 1 605
Cost of Sales 623 702
Gross Profit 1 009 903
Expenses 914 805
Profit for the Year (Net Profit) 95 98

Statement of financial position (balance sheet)

2016 2017
$ ‘000 $ ‘000

Non-current (fixed) assets 732 820

Current assets

Inventory (stock) 132 147

Trade receivables (debtors) 188 165

Cash in hand 80 51

400 363

Current liabilities

Trade payables (creditors) 263 274

Bank overdraft 10 80

273 354

Non-current (long-term) liabilities 585 462

Net assets 274 367

Total shareholders’ funds 274 367

The table below shows all workings for the ratios that are possible to calculate from the information
available in the case study. All calculations are shown to two decimal places and financial values are
in thousands of dollars ($’000 as per the accounts above):

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Ratio 2016 2017

Gross profit margin 1009/1632 x 100 = 61.83% 903/1605 x 100 = 56.39%

Operating (net) profit 95/1632 x 100 = 5.82% 98/1 605 x 100 = 6.11%
margin

Return on capital 95/(274 + 585) x 100 = 11.06% 95/(367 + 462) x 100 = 11.46%
employed (“ROCE”)

Asset turnover 1632/732 x 100 = 222.95% 1605/820 x 100 = 195.73%

Current ratio 400/273 = 1.47:1 363/354 = 1.03:1

Quick ratio (or “acid 400 – 132/273 = 0.98:1 363 – 147 / 354 = 0.61:1
test”)

Inventory turnover 623/132 = 4.71 times 702/147 = 4.78 times

Trade receivables 188/1632 x 365 = 42.05 days 165/1605 x 365 = 37.52 days
collection period

Gearing (585 + 10)/274 x 100 = 217.15% (462 + 80)/367 x 100 =147.68%

Many conclusions can be drawn from these ratio calculations, as follows:

The company’s cost of sales has increased from 2016 to 2017.
The business organisation’s gross profit has declined from 2016 to 2017.
The company’s net profit has improved by $3000 as their expenses have decreased.
The gross profit margin has deteriorated in 2017. This would require investigation by the
management due to the decrease in the sales revenue. However, the operating (net) profit margin
has improved. This could be due to the decrease in business expenses.
The return on capital employed has remained relatively constant from 2016 to 2017. A return
of 11% is acceptable and takes some account of the risk involved in investment in a business
organisation.
The current ratio has decreased. Both values are below the benchmark of 2:1. The business
would currently struggle to pay their short-term debts. This follows through into the liquid
(acid test or quick) ratio. The value in 2016, is in line with the ideal of 1:1, implying that the
business organisation is holding too much inventory. In 2017, the value is too low and would
suggest that the business organisation has a liquidity issue.
The rate of inventory turnover has improved very slightly in 2017 and will help to ensure that
out of date inventory is not left unsold.
The trade receivables turnover period has decreased. This will have a positive impact on the
business organisation’s working capital. The business organisation needs to chase their trade
receivables and collect their debts as soon as possible. Both Gearing ratios are very high and
imply that the business organisation is high risk. It would be difficult for them to secure future
funding and investment if required.
Now it’s your turn to calculate some ratios and undertake some ratio analysis.

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CASE STUDY
Copland Machinery Supplies PLC
Copland Machinery Supplies PLC have provided the following
details from their final accounts for the years ending 31 January
2016 and 31 January 2017.

Income statement (profit and loss account)

2016 2017
£‘000 £‘000
Sales revenue 26 431 27 387
Cost of sales 7 894 7 648
Gross profit 18 537 19 739
Expenses 11 145 11 932
Profit for the year (net profit) 7 392 7 807

Statement of financial position (balance sheet)

2016 2017
$  ‘000 $  ‘000

Non-current (fixed) assets 27 783 24 913

Current assets

Inventory (stock) 3 969 3 873

Trade Receivables (debtors) 5 242 5 576

Cash at bank 4 184 5 714

Other 297 1 004

13 692 16 167

Current liabilities

Trade payables (creditors) 8 054 7 359

Loans 5 761 8 808

13 815 16 167

Non-current (long-term) liabilities 20 913 17 243

Net assets 6 747 7 670

Total shareholders’ funds 6 747 7 670

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 Chapter 2  Financial Statement Interpretation

Over to you
Activity 6: Copland Machinery Supplies PLC

Use ratio analysis to analyse the performance of Copland Machinery Supplies PLC – whose
accounts are shown in the case study above.

Guidance is provided at the end of the chapter, but please attempt this yourself before
checking it – to reinforce your learning.

2.3 How to make justified recommendations for

business improvements based on the results of
financial analysis
Interpreting financial analysis to make business recommendations
You can use the results of financial analysis to make business recommendations, or decisions in your
own business. With a reminder of the main ratios, the following section identifies some of the key
ways in which to use ratios to do this.

Profitability ratios
Gross profit margin
This expresses as a percentage, the gross profit as a percentage of sales. It should be similar from
one year to the next within the same business. It will vary between businesses in different areas of
industry, e.g. gross profit margin on motor vehicles is considerably higher than that on fresh food.
A significant change from one year to the next, particularly a fall in the percentage, requires review
into the buying and selling prices.
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Financial Statement Interpretation Chapter 2

Gross profit margin, and operating/net profit margin needs to be considered in context. For
example, a supermarket may well have a lower gross profit percentage than a small local retail shop
but, because of the supermarket’s much higher turnover, the amount of profit will be much higher.

Operating/net profit margin

As with gross profit margin, the operating/net profit margin should be similar from year-to-year for the
same business. It should also be comparable with other organisations in the same line of business. Net
profit margins should ideally, increase from year-to-year. This would indicate that the business expenses
are being kept under control. Any significant fall should be evaluated to see if it has been caused by:
• a fall in gross profit margin and/or
• an increase in one particular expense, e.g. wages and salaries, advertising etc.

Return on capital employed (ROCE)

This expresses the profit of a business in relation to the owner’s capital. It is normally compared
with other forms of investment such as a building society or bank account.

A person running a business is investing a sum of money in that business and the profit is the
return that is achieved on that investment. However, it should be noted that the risks in running a
business are considerably greater than depositing the money with a building society or bank, and
an additional return to allow for the extra risk is needed.

Liquidity ratios
Current ratio
The current ratio uses figures from the balance sheet and measures the relationship between current
assets and current liabilities. An acceptable ratio is about 2:1. However, a business in the retail trade
may be able to work with a lower ratio, e.g. 1.5:1 or even less, because it deals mainly in sales for cash
and so does not have a large figure for trade receivables. A current ratio can be too high; if it is above
3:1 a review of current assets and current liabilities is needed; e.g. the business may have too much
inventory, too many trade receivables, or too much cash at the bank, or even too few trade payables.

Liquid (acid test or quick) ratio

The liquid ratio uses the current assets and current liabilities from the statement of financial position
but closing inventory is omitted. This is because inventory is the most illiquid current asset. Inventory
has to be sold, turned into debt and then the cash has to be collected from the trade receivables.

This ratio provides a direct comparison between trade receivables and cash/bank and short term
liabilities. The balance between liquid assets and current liabilities should ideally be about 1:1, i.e. $1
of liquid assets to each $1 of current liabilities. At this level, a business organisation is expected to be
able to pay its current liabilities from its liquid assets. A figure below 1:1 e.g. 0.75:1, indicates that the
business organisation would have difficulty in meeting demands from trade payables. However, as with
the current ratio, some business organisations are able to operate with a lower liquid ratio than others.

Efficiency ratios
Inventory turnover
Inventory turnover is the number of times inventory is changed during a year. The figure depends
on the type of goods sold by the business. For example, a market trader selling fresh bread who
finishes every day when sold out will have a stock turnover of 365 times per year.

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By contrast, a motor vehicle garage – because it may hold a large inventory of vehicles – will have
a much slower inventory turnover, perhaps 4 or 5 times per year. Nevertheless, inventory turnover
must not be too long, bearing in mind the type of business, and a business which is improving in
efficiency will have a quicker inventory turnover comparing one year with the previous one, or with
the inventory turnover of similar businesses.

Inventory that is held for too long may become out of date and obsolete. A business organisation
must also remember the costs of storing inventory when considering its inventory turnover.

Guidance on Activity 6: Copland Machinery Supplies PLC

The table below shows all workings for the ratios that are possible to calculate from the information
available in the case study. All calculations are shown to two decimal places and financial values are
in thousands of dollars ($’000 as per the company accounts above).

2016 2017

Gross profit 18537/26431 x 100 = 70.13% 19739/27387 x 100 = 72.07%

margin

Operating (net) 7392/26431 x 100 = 27.97% 7807/27387 x 100 = 28.51%

profit margin

Return on capital 7392 / (6747 + 20913) x 100 = 7807/(7670 + 17243) x 100 =

employed 26.72% 31.34%
(“ROCE”)

Asset turnover 26431/27783 x 100 = 95.13% 27387/24913 x 100 = 109.93%

Current ratio 13692/13815 = 0.99:1 16167/16167 = 1:1

Quick ratio (or 13692 – 3969/13815 = 0.70:1 16167 – 3873/16167 = 0.76:1

“acid test”)

Inventory turnover 7894/3969 = 1.99 times 7648/3873 = 1.97 times

Trade receivables 5242/26431 x 365 = 72.39 days 5576/27387 x 365 = 74.31 days
collection period

Gearing 20913/6747 x 100 = 309.96% 17243/7670 x 100 = 224.81%

The conclusions that can be drawn from these ratio calculations are as follows:
• The company’s cost of sales has decreased from 2016 to 2017.
• The business organisation’s gross profit has improved from 2016 to 2017.
• The company’s net profit has improved by $415000 due to the increase in gross profit.
However, the company expenses have increased.
• The gross profit margin has improved in 2017, as has the operating (net) profit margin. The
company could have used cheaper suppliers to decrease the cost of their purchases.
• The return on capital employed has increased from 2016 to 2017. Both returns are acceptable
and take account of the risk involved in investment in a business organisation.

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• The current ratio has remained constant. Both values are below the benchmark of 2:1.
The business would currently struggle to pay their short-term debts. This follows through into
the liquid (acid test) ratio. Both values are lower than the ideal of 1:1, which would suggest that
the business organisation has a liquidity issue.
• The rate of inventory turnover has remained relatively constant, although the rate is
particularly low.
• The trade receivables turnover period has increased. This will have a negative impact on the
business organisation’s working capital. The business organisation need to chase their trade
receivables and collect their debts as soon as possible.
• Both Gearing ratios are very high and imply that the business organisation is high risk. It would
be difficult for them to secure future funding and investment if required.

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Chapter 3
Cash Flow and
Budget Preparation

Introduction
This chapter will help you understand how to prepare cash flow forecasts and financial budgets so
as to aid management decision making.

Learning outcome
On completing this chapter, you will be able to:
3 Prepare cash flow forecasts and financial budgets to aid management decision making

Assessment criteria
3 Prepare cash flow forecasts and financial budgets to aid management decision making
3.1 Prepare cash flow forecasts for internal management control
3.2 Prepare organisational budgets to aid management decision making
3.3 Evaluate completed cash flow forecasts and financial budgets to make informed business
decisions

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3.1 Preparing cash flow forecasts for internal

management control
Cash flow forecasts
The maintenance of adequate cash flow is vital to the success of any business organisation. A
business can survive without profit but cannot survive without adequate cash flow. One of the main
causes of business failure is a lack of day-to-day working capital.

A cash flow forecast will allow a business to predict their future inflows and outflows over a period of time.

Existing businesses will use historical data to predict their cash flows for the future, whereas new
businesses will need to research to make suitable estimates for their plans.

Detailed cash flow forecasts are usually required by business organisations when they wish to take
out a loan or other financial product.

Businesses will choose an appropriate timescale for which to complete their cash flow forecast. It
is usually a twelve-month time period. They need to adjust for any credit periods that are offered
or taken by trade receivables or trade payables. In a cash flow forecast, the transaction is recorded
when the money or cash is paid or received.

There are three main sections to a cash flow forecast:

• Cash inflows – for example sales income, commission received, money from a bank loan.
• Cash outflows – for example raw materials, salaries, heat and light expenses.
• Balances – these are the opening and closing balances for each month.

Over to you
Activity 1: Inflows and outflows
Identify the cash inflows and cash outflows for a supermarket that would be included in a
cash flow forecast.

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Cash flow forecast sections

Cash inflows Cash outflows Balances Revision
on the go

Cash flow forecast example

January February March

$ $ $
Cash inflows
Capital 10000
Cash sales 5000 3000 7000
Credit sales 3000 5000 7000
Rent received 1500 1500 1500
Total cash inflow 19500 9500 15500

Cash outflows
Cash purchases 3000 5000 7000
Credit purchases 2000 2000 3000
Salaries and wages 1000 1000 1000
Heat and light 500 500 500
General expenses 300 300 300
Total cash outflow 6800 8800 11800
Net cash flow 12700 700 3700
Opening balance 5000 17700 18400
Closing balance 17700 18400 22100

Table 1: Jones Jewellery Makers cash flow forecast for the three months
ending 31 March 2017 Revision
on the go

CASE STUDY
Butai Golf and Leisure Club and Shop
This financial information relates to a fictional company: the Butai
Golf and Leisure Club and Shop.
The projected bank account balance on 1 January is $52180.
Projected shop sales figures:

December January February March April

Credit sales ($) 5350 3150 5600 3725 6900

Cash sales ($) 3250 2050 1200 1375 2300

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• Projected gym takings:

January – $32,400
February – $30,200
March – 5% increase on February
April – $700 increase on March

• Estimated purchases:
All purchases are on credit and suppliers are paid one month after goods are bought.
December – $5000
January – $1000 less than December
February – 5% increase on January
March – Same as February
April – 10% increase on March

• Expenses:
Wages are $7000 per month. A 5% wage increase is expected from 1 April.
Light and Heat is $750 per month. A 10% increase is expected from 1 March.
Maintenance is carried out three times a year – February, June and October. This costs
$60,000 per year.
General expenses are estimated at $10,000 per year, paid every 2 months starting in February.

Over to you
Activity 2: Butai Golf and Leisure Club and Shop
Prepare a three-month cash flow forecast for the Butai Golf and Leisure Club and Shop to
estimate the cash balance at the end of April from the information in the case study above.

How to improve cash flow in businesses

1 Increase cash inflows:
• Chase trade receivables
• Reduce trade credit periods offered to trade receivables
• Reduce potential bad debts and the possibility of doubtful debts

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• Seek additional sources of finance:

• Bank loan
• Overdraft
• Debt factoring.
2 Decrease cash outflows: Delay payments to trade payables
• Request more favourable credit terms from trade payables
• Reduce business costs, for example wages and salaries
• Delay business expansion, for example the purchase of non-current assets.

Cash versus profit

Cash flow and profit are interrelated terms, however, they are different and should not be confused.

Net cash flow = cash inflow – cash outflow

Profit = sales – variable costs – fixed costs

There are various ways in which net cash flow differs from net profit for a business organisation
during an accounting period.

Timing differences need to be considered. They arise as a business may not receive cash from a
customer immediately; they may delay payment for several weeks. The sale would be included at
the time of transaction in a profit calculation but not in cash flow calculation until the money has
been received. For example, a business wins a contract to supply branded goods to a company for
a large corporate event. The business owner works out it will cost his business $50,000 to supply
the branded goods, and the contract value is for $75,000, meaning he should expect a $25,000
profit. However, if he has to pay his supplier much earlier than his client pays him, there will be an
impact on cash flow and he may need to borrow funds to pay his supplier and –if the bank refuses
to extend the credit to him – the cash flow for the project is unsustainable, even though it will make
a profit. There’s also the risk of the client going out of business – even if it’s profitable on paper!

Liquidity is a measure of how much money a business organisation has for its day to day running. A
liquid asset is one that is cash or can easily be turned into cash, for example a trade receivable, who
is likely to pay their debt in a short period of time is known as a liquid asset.

Inventories that will be sold in the near future would be another example of a liquid asset.

Working Capital, calculated as current assets minus the current liabilities, is a measure of liquidity.
If a business organisation has large amounts of working capital, it can be described as having good
levels of liquidity. A low or negative working capital figure implies low or very low levels of liquidity.

It is assumed that there is a clear relationship between profits and liquidity. Profits are calculated by
taking costs from sales revenue, and liquidity is measured by taking current liabilities which include
trade payables (created by purchases) from Current Assets (which includes cash and bank balance,
the revenue generated from the selling of goods and services).

There are a number of important differences between the two. These include:
1 Cash inflows: if a business organisation receives capital from their owners that has not arisen
from its trading activities, it will improve the availability of cash.
2 If a business organisation borrows money for investment, this will increase the amount of
working capital available for the business to use. This will therefore improve liquidity. Borrowing
will not increase profits, the costs of borrowing will increase expenses and decrease profit.
However, the business will have extra money/cash available.

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3 Depreciation: depreciation is a bookkeeping transaction. No actual spending of money occurs,

therefore there is no effect on the cash flow or liquidity of the business organisation. Depreciation
is, however, a business expense that will reduce the profit of the business organisation.

Over to you
Activity 3: The purpose of cash flow forecast
Identify three cash inflows and three cash outflows for a textile manufacturing business
organisation.
Identify five additional sources of finance available to a technology business
organisation.

3.2 Preparing organisational budgets to aid

management decision making
Budgeting
A budget is a financial plan for the future. It will aid a business to achieve its objectives. Budgets
are usually constructed within the broader framework of a company’s long-term strategic plan
(covering the next five to ten years).

The UK’s Chartered Institute of Management Accounts (CIMA) define a budget as:

A plan quantified in monetary terms, prepared and approved

prior to a defined period of time, usually showing planned income
to be generated and/or expenditure to be incurred during that period
and the capital to be employed to attain a given objective.

The main budgets that a business will prepare are:

• Sales budget – forecasts the number of units of each product that a business aims to sell in the
next financial year, the price level to be charged, and the sales revenue that should be received.
• Purchases budget – this will predict the quantity of goods that need to be purchased for the
following year. This may include a material budget which predicts the quantity of raw material
that are required for the next year.
• Production budget – forecasts the number of units of each product that a business aims to
produce over the next financial year.
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• Trade receivables budget – forecasts the amount that is due from trade receivables at the
end of the budget period.
• Trade payables budget – forecasts the amount that is owed to trade payables at the end of
the budget period.
• Cash budget – this will predict the closing bank balance, and allow organisations to make
informed decisions relating to cost savings, the need for additional borrowing etc.

Formats
Sales budget

Month 1 Month 2 Month 3

Sales unit X X X
Sales value ($) X X X

Purchases budget

Month 1 Month 2 Month 3

Units
Sales X X X
Opening inventory (X) (X) (X)
Closing inventory X X X
Purchases X X X
Purchases cost $X $X $X

Production budget (units)

Month 1 Month 2 Month 3

Sales X X X
Opening inventory (X) (X) (X)
Closing inventory X X X
Production X X X

Trade receivables budget

Month 1 Month 2 Month 3

$ $ $
Opening trade receivables X X X
Credit sales X X X

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Month 1 Month 2 Month 3

$ $ $
Receipts from trade receivables (X) (X) (X)
Discounts allowed (X) (X) (X)
Bad debts written off (X) (X) (X)
Closing trade receivables X X X

Trade payables budget

Month 1 Month 2 Month 3

$ $ $
Opening trade payables X X X
Credit purchases X X X
Payments to trade payables (X) (X) (X)
Discounts received (X) (X) (X)
Closing trade payables X X X

Cash budget

Month 1 Month 2 Month 3

$ $ $
Cash inflows
Capital X X X
Cash sales X X X
Credit sales X X X
Xxx X X X
Total cash inflow X X X
Cash outflows
Cash purchases X X X
Credit purchases X X X
Xxx X X X
Xxx X X X
Xxx X X X
Total cash outflow X X X
Net cash flow X X X
Opening balance X X X
Closing balance X X X

These budgets are then merged together to form a master budget.

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 Chapter 3  Cash Flow and Budget Preparation

Variance analysis
Any differences that occur between budgeted and actual figures (for example sales, costs, etc.) are
known as variances. Businesses need to investigate any variances and attempt to determine the
reason for these. This is known as budgetary control.

Variances can be positive or negative. Positive variances are referred to as “Favourable” and
negative variances as “Adverse”. A favourable variance occurs when a business performs better than
was predicted. An adverse variance occurs when a business performs worse than was predicted.

Example:

Budget Actual Variance

$m $m $m
Sales revenue 500 605 105 F
Raw materials 100 110 10 A
Direct labour 50 45 5F
Distribution costs 20 20 0
Heat and light 30 10 20 F

Managers will concentrate on the large favourable or large adverse variances and ignore smaller
variances that have occurred. This is known as management by exception.

Over to you
Activity 4: Variances
Zodiak Limited have provided the following data. Calculate the variance for each item.

Budget Actual Variance

$m $m $m
Sales revenue 200 180

Rent received 300 310

Raw materials 20 23

Indirect labour 35 31
Delivery costs 10 9

Repairs and maintenance 15 29

Heat and light 17 15

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3.3 Evaluating completed cash flow forecasts and

financial budgets to make informed business
Improving cash flow management
Business managers may need to solve cash flow management issues. The managers will need to
address the following questions:
• How much finance is required?
• Can the finance be secured internally?
• How long is the finance required for?
• What period of time should the finance be repaid?

The amount and nature of the finance required will vary from business organisation to business
organisation. It is usually influenced by a business’s size, form of ownership, type of technology and
age of the business assets.

Internal sources
This is finance attained from within the business organisation. There is no time limit and generally
no interest to be paid.
• Retained profit – this is a cheap and flexible source of finance. The retained profit can be
used to generate future profits and therefore, with shareholder permission, be used to solve
cash flow problems. The opportunity cost of this would need to be assessed.
• Sale of assets – in a cash flow crisis, the business organisation could sell one or more of their
non-current assets in order to gain instant cash. This may lead to a decrease in profitability in the
longer term.
• Sale and leaseback – this will allow the business organisation to receive a cash payment
thereby improving short term cash flow. However, having to pay rent on the non-current asset
would mean that profitability would be reduced in the longer term.

External sources
This is finance attained from outside of the business organisation.
• Share issues – only available to limited companies. These may issue ordinary or preference
shares in order to raise extra funds. They will, however, have to pay dividends to the shareholders.
• Loans – usually short/medium term loans which can be used for a variety of purposes and will
be repaid with interest.
• Debentures – long term loans to a business organisation at an agreed fixed interest rate,
repayable on a stated date. These are usually offered for up to 25 years.
• Mortgages – usually used to purchase property where the asset will act as collateral for the
loan. They are usually offered for up to 30 years.
• Government grants – these are selective and usually take the form of grants for selected
purposes.
• Overdrafts – used for cash flow problems. Very expensive if used over a long period of time as
the interest rates are usually very high.
• Debt factoring – business organisations will receive immediate payment for their credit sales,
however, the factoring company will charge for the collection of the debt.

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Chapter 4
Costing and
Pricing Methods

Introduction
This chapter will demonstrate the use of costing and pricing methods that contribute to business
decision-making.

Learning outcome
On completing this chapter, you will be able to:
4 Demonstrate the use of costing and pricing methods to contribute to business decision making

Assessment criteria
4 Demonstrate the use of costing and pricing methods to contribute to business decision making
4.1 Explain costing and pricing methods used to make business decisions
4.2 Apply contribution and break-even calculations and analysis to make effective business
decisions
4.3 Assess the implications of using different costing methods

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 Level 4 Finance for Managers

4.1 Explain costing and pricing methods used to

make business decisions
Pricing models
There are a number of factors that will influence the pricing of a product/service, for example
elasticity of demand (the extent to which demand varies with price), competition, brand image,
profit ambitions and costs. Pricing methods will include:
• Cost plus pricing occurs when a business organisation adds a percentage mark-up to the cost of a
product or service. This will ensure the business will always make a profit on the products being sold.
• Competitive pricing occurs when a business organisation sets the price of a product based
on the prices charged by their rivals.
• Value based pricing occurs when a business organisation sets the price of a product based
on its perceived value to a customer. The cost of the product is ignored and usually results in
high selling prices and high profits.
• Discounting is a technique where a business organisation offers discount prices on their
products in order to attract new customers or to boost sales.

Businesses will determine the appropriate pricing method to use from the start – and may vary
it over time. For example, on entering a new market with lots of competitors a business may use
discounting, followed by competitive pricing when they have become more established. In the
luxury goods market, businesses may use value-based pricing.

Cost behaviour
Costs are expenses that a business incurs when producing and supplying products and services to
customers. Accountants are generally concerned with monetary cost of resources, whereas economists
consider opportunity costs. This is the benefit lost from not purchasing the next best alternative.

For management or cost accounting purposes, business organisations often divide into cost
centres. A cost centre acts as a “collecting point” for costs before they are reviewed and
considered further. An individual product or service is called a cost unit.

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Types of costs
Fixed costs
Fixed costs are costs that remain unchanged as the output level of a business organisation
changes. Examples include:
• Rent • Office salaries
• Advertising • Insurance.

Fixed
Costs (£)

costs

Units

Figure 1: Fixed costs Revision

on the go

Fixed costs can increase when a business approaches its full operating capacity. For example, a business
may need to purchase a new production line. Such an increase in fixed costs is called a step cost.

Fixed
costs
Costs (£)

Units

Figure 2: Step costs Revision

on the go

Variable costs
Variable costs are those which vary directly with the level of output for a business organisation.
This means that the total variable costs will be dependent on the level of output produced. For
example, if output doubles, then the variable costs will double. Examples include:
• Direct labour
• Raw materials
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• Packaging costs
• Royalties (a type of commission based on sales – paid to a third party with an interest in the
product – e.g. an author or songwriter).

Variable costs

Costs (£)

Units

Figure 3: Variable costs Revision

on the go

Semi-variable costs
In a business setting it is very difficult to classify costs either as fixed or variable. Many costs fall into
both classifications – these are known as semi-variable costs. For example, an electricity invoice will
consist of a standing charge (fixed cost) and a variable element for usage.

Total costs
Total costs are calculated as all the costs totalled together for any particular level of output.
At zero output, the total costs would equal the fixed costs of the business.

Total costs = total fixed costs + total variable costs

Revision
on the go

Total costs

Variable costs
Costs ($)

Fixed costs

Output

Figure 4: Fixed, variable and total costs Revision

on the go
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Direct costs
A direct cost is similar to a variable cost. A direct cost compares the costs incurred with the level of
output of the business organisation. For example, the direct costs of producing a door for retail sale
would include the wood, the labour and the metal fixings on the door.

Indirect costs
An indirect cost is similar to a fixed cost. An indirect cost cannot be linked with the output of a
particular product. For example, an indirect cost of a local bakery would be its advertising costs
such as fliers and newspaper advertising.

Cost plus pricing occurs when a business organisation adds a percentage mark-up to the
cost of a product or service. This will ensure the business will always make a profit on the
products being sold.

Competitive pricing occurs when a business organisation sets the price of a product based on
the prices charged by their rivals.

Value based pricing occurs when a business organisation sets the price of a product based on
its perceived value to a customer. The cost of the product is ignored and usually results in high
selling prices and high profits.

Discounting is a technique where a business organisation offers discount prices on

their products in order to attract new customers or to boost sales. Revision
on the go

4.2 Applying contribution and break-even

calculations and analysis to make effective
business decisions
Contribution
Contribution is the amount remaining after variable costs have been deducted from sales
revenue. This is not the same as profit as fixed costs are not included in the calculation.

Contribution per unit = selling price per unit – variable costs per unit

Total contribution = total sales revenue – total variable costs Revision

on the go

Figure 5 builds on Figure 4 by showing sales revenues and therefore the break-even point at the
intersection between sales revenues and total costs. (Break-even analysis is discussed further in a
moment.)

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Total costs
Profit
Break even point

Variable costs

Costs ($) Loss

Fixed costs

Output

Figure 5: Break-even point Revision

on the go

Total revenue
Revenue is the income that is earned from selling output.

Total revenue = selling price per unit x output level

Revision
on the go

Break-even analysis
Most business organisations exist to make the maximum profit possible. New and small firms may
find that generating profits is difficult and may set a more realistic objective. This objective would
be to “break-even”. This means that a business organisation will make neither a profit nor a loss.

The break-even point is the level of sales where total costs equal total revenue.
Revision
on the go

Assumptions of break-even analysis

• All output is sold.
• There is no inventory remaining unsold.
• The business organisation only makes one type of product.
• All costs are classified as either fixed costs or variable costs.

Break-even formula

Break-even point in units = total fixed costs/contribution per unit

Where contribution per unit = selling price per unit – variable costs per unit
Note that contribution – costs = profit (or loss) Revision
on the go

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CASE STUDY
XBX Computer Sales Ltd
Break-even example – XBX Computer Sales Ltd
XBX Computer Sales Ltd sells 1000 units at $1000 per unit
in a year. During the year:
• Total sales revenues are $1,000,000
• Fixed costs are $250,000
• Total variable costs are $600,000 (i.e. $600 per unit)
• Profit is $150,000.
Total sales revenues – total variable costs = contribution
Break-even point = fixed costs/contribution per unit

Therefore:
Total “Contribution” is ($1,000,000–$600,000) = $400,000
As sales are 1000 units, contribution per unit is $400

The break-even point is calculated as follows:

Fixed costs/contribution per unit or $250,000/$400 = 625 units
625 units = $625,000 revenues

Margin of safety
When a business organisation generates a profit, then its output level will be higher than the
break-even output level. A business organisation will need to know how far output can fall before
the business will start to experience a loss.

Margin of safety in units = actual output in unit – break-even output in units Revision
on the go

Over to you
Activity 1: Break-even and margin of safety

Calculate the following for each of the five firms shown in the table below:

Break-even point in units

Break-even point in sales revenue
Margin of safety in units
Margin of safety in sales revenue

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Firm AAA ABB ABC ACC ACD

$ per unit $ per unit $ per unit $ per unit $ per unit

Direct materials 9 10 15 31 5

Direct labour 2 9 4 8 4.5

Other variable costs 1 2 2 4 1

Fixed costs 4 5 8 15 2

Profit 5 7 10 20 3.5

Selling price 20 31 40 80 15

Number of units 10000 25000 20000 40000 12 500

produced and sold

Over to you
Activity 2: SteamVu kettles

The following information is provided for the production and sales of SteamVu, a new
electric kettle.

The data is based on an output of 2000 units of Cost per SteamVu $

Steam Vu.
Raw materials 10
Produce a break-even graph from the information
Components 3
shown. From the graph, determine:
Direct labour 3
The break-even point in units
Royalties 2
The break-even point in sales revenue
Fixed costs 5
The margin of safety in units
Selling price 35

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4.3 Assessing the implications of using different

costing methods
Advantages and limitations of break-even analysis

Advantages Limitations

Visual impact. Uncertain data – data is based on estimates.

Acts as a risk assessment by calculating the Fixed costs do not necessarily remain
margin of safety. constant – stepped costs occur in all business
organisations.

Allow consideration of “What if” scenarios. Non linear relationships – not all lines on a
break-even graph would be straight.

It cannot be assumed that all costs are either

fixed or variable.

Many businesses sell more than one product,

whereas break-even assumes that the
business only sells one product.

Most businesses hold inventory and have

unsold production.

Selling prices do not always remain constant.

Over to you
Activity 3: Leguma Production Ltd

Leguma Production Ltd produces a single product for vegetable preparation. Your task is
to advise the business organisation of whether the changes should be made.

Its costs and sales for the year ended 31 January were as follows:

The selling price and all costs were at a constant

Units sold 20000
rate throughout the year.
$
To improve profit for the next year, the
following changes are planned: Sales revenue 900000

Units to be sold to increase by 10%. Direct wages 200000

Direct materials 300000

Selling price to be maintained at the current
price. Variable overheads 120000

Wages to be increased by 5% per unit. Fixed costs 205000

Material costs to be reduced by 7.5% per unit,

this being achieved by changing from a local supplier to an overseas supplier.

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Variable overheads to be reduced by $0.35 per unit.

Fixed costs to increase by $9500 per annum.

Marginal costing
Marginal cost is defined as the cost of raising output by one more unit. Marginal cost is the same
as the variable cost of production. It only includes those costs that vary with the level of output.
Marginal costing is a costing and decision making technique that is used by managers in business
organisations. It is an alternative to Absorption Costing (see below) and can be known as variable
costing or direct costing.

Unlike absorption costing, which ensures that all costs are charged to a cost unit, marginal costing
charges only the variable cost of production. Fixed costs are ignored.

Marginal costing and break-even analysis have a number of applications:

• Make or buy – business organisations may choose to make or manufacture products that they
can sell on to their consumers. This could be because their product is unique, there is a secret
recipe/design or they can make the product cheaper than an outside organisation. The decision
depends on whether the costs of purchase exceed the costs of production and therefore
whether the business should make the product or buy it in from a supplier.
Firms may manufacture their own products for various reasons such as:
• The product is unique, is not produced by anybody else, and there is a demand for it.
• The firm wants to supply its own brand of a particular product.
•  he firm does not want to be dependent upon outside suppliers who may be unreliable
T
regarding delivery and price.
•  he firm believes it can manufacture its products more cheaply than it can buy them from
T
outside.
• Special order decisions – business organisations may be asked to produce a one-off order
for another company. The business needs to decide whether this special order is financially
worth the costs of production. Considerations such as whether other production needs to cease
to allow for this product to be made or whether other customers may demand the same terms
as the one-off order need to be considered prior to acceptance of the special order.

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Circumstances may sometimes justify selling goods below the normal selling price:
• To combat competitors who are selling similar goods at a lower price.
•  cceptance of an order to produce and sell goods at a special price and if this will increase
A
profit or help to cover overheads.
•  o maintain production in temporarily difficult trading conditions so that a skilled workforce
T
may be retained.
• To dispose of obsolescent or perishable goods.
• To promote a new product.
• Acceptance of additional work – as with a make or buy decision, businesses need to decide
whether they have sufficient capacity in order to take on the additional work.
• Discontinuing a product or service – this decision will be made based on the contribution
of the product or service. A business will make the decision to discontinue a product if its unit
contribution is less than other products or if the product has a negative contribution. Before making
the decision, the business must ensure that the decision will not affect the sales of any products.
• Price setting – a business organisation will use break-even analysis to work out the best selling
price to charge for a product or service. It is possible to increase a business’s profit by increasing
the selling price of a product or service without increasing the number of sales made.
• Scarce resources – a scarce resource is something that limited a business’s ability to operate
at their full capacity. They may include a shortage of skilled labour, raw materials, factory
materials, factory space, machine availability or finance availability. Once a scarce resource has
been identified, a business will quantify the scarce resource and then allocate its best use based
on the contribution earned by each product being made.
• “What if” scenarios – this will evaluate the expected return or value of a proposed change
in business activities. A business organisation will create various scenarios that may occur
in their organisation. They will then review the potential outcomes of each scenario prior to
making a final decision.

Absorption costing
Absorption costing values inventory at the full production cost of a product. Absorption costing
values will vary to those of marginal costing. As the inventory values are different, this will affect the
profits reported in the income statement for the period.

The benefits of absorption costing include:

• Absorption costing includes an element of fixed overheads in its inventory value in accordance
with accounting legislation.
• For small business organisations, absorbing overheads into product costs is the most effective
way of estimating job costs and profits.
• The analysis of under/over absorption of overheads using absorption costs is useful in controlling
costs of a business organisation.

Whole-life costing
Whole-life costing considers the total cost of a product or service over its entire lifetime. This means
from design to disposal, including purchase, hire, lease, maintenance, operation, utilities, staff training and
disposal. When making financial decisions relating to procurement, it is vital that the business organisation
considers all of the costs, as purchase costs are only a small proportion of the operation costs.

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Opportunity costs
Economists value products and services in terms of opportunity costs. An opportunity cost
measures the cost of any choice in terms of the next best alternative foregone. For example, the
opportunity cost of a business organisation investing $2 million in a new production line might be
$2 million less money to spend on research and development.

Inventory control
When deciding how much inventory a business organisation should hold, the business organisation
must balance the costs of holding inventory against the benefits. The costs include:
• Warehousing and storage
• Insurance
• Risk of pilferage or obsolescence
• Financial cost of tying up funds in inventory (opportunity cost).

The benefits of holding inventory include:

• Ability to meet customer demand immediately
• Ability to maintain continuous production
• Avoidance of having to reorder at short notice (at unfavourable prices or time scales that the
suppliers cannot meet)
• Avoidance of having to reorder frequently and thereby avoiding the administration costs.

Economic order quantity

The economic order quantity is a mathematical technique that is used for calculating the
optimum, i.e. best amount of inventory that a business should hold. It assumes that the main costs
associated with inventory are holding costs and ordering costs. The cost of holding inventory
increases as more is held, so managers might wish to decrease the amount. However, by reducing
inventory levels there will be a rise in the number of orders made, so ordering costs will increase. It
is possible to work out the inventory level where costs are minimised.

Figure 6 shows that holding costs increase and ordering costs decrease as inventory levels increase.
The point at which total costs are at a minimum is at output Q.

Total costs
Annual costs ($)

Holding costs

Ordering costs
Q

Inventory level (units)

Figure 6: Economic order quantity Revision

on the go

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Just in Time (JIT)

Just in Time means that inventory arrives on the production line just as it is needed. This minimises
the amount of inventory that has to be stored (reducing storage costs).

Just in Time has many benefits and may appear an obvious way to organises production but it is a
complicated process which requires efficient handling.

For example, Just in Time relies on sophisticated computer systems to ensure that the quantities of
inventory ordered and delivered are correct. This process needs to be carried out very accurately or
production could come to a standstill.

Advantages of JIT Disadvantages of JIT

Reduces costs of holding inventory e.g. Needs suppliers and employees to be

warehousing rent reliable

No money tied up in inventory, funds can be May find it difficult to meet sudden increase
used elsewhere in demand

Methods of inventory valuation

Method Definition Advantages Disadvantages

FIFO (first The FIFO method of It is realistic because The prices at which
in first valuation assumes that it is based on the inventory is issued to
out) inventory is used, or assumption that issues production are likely
sold, in the order in from inventory are to be out of date, so
which it is purchased. made in the order in the selling price of the
So, inventories of which the goods are finished goods might
goods that are bought received. not accurately reflect
first are used first. the most recent costs.
It is relatively easy to
calculate. When the prices of
inventory are rising,
The inventory values the FIFO method
are based on the most values the inventory at
recent prices paid. the highest, i.e. latest
prices.

The effect is to reduce

the cost of sales and
therefore to raise profit.
Such a policy could
result in more tax being
paid because profits are
higher than they might
otherwise have been.

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Method Definition Advantages Disadvantages

LIFO (last The last in, first out, The system is based on There might be
in first method of inventory the prices most recently problems in issuing
out) valuation assumes paid for inventory, new inventory first,
that the most recent therefore selling prices particularly if the
deliveries of inventory will reflect up to date inventory is perishable
are used first. So, new costs. or is likely to go out of
inventory is always date.
issued before old It is relatively easy to
inventory. The value of calculate. The closing inventory
unused inventories at is valued at out of date
the end of the trading prices, which might be
year is therefore based lower than the current
on the cost of earlier prices.
purchases.

AVCO This method of It is logical since all The average cost has
(Average inventory valuation identical units of to be recalculated
Cost) is sometimes also inventory are given an every time the price of
known as the weighted equal value. purchased inventory
average cost. It involves changes.
recalculating the Fluctuations in the
average cost (AVCO) of purchase price of The average cost might
inventory every time a inventory are evened not be the same as any
new delivery arrives. out so the impact on of the prices actually
costs and profit is paid for inventory.
reduced.
If inventory prices
are rising rapidly, the
average cost will be
much lower than the
replacement price.

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 Glossary  

Glossary

Absorption costing values inventory at the Competitive pricing occurs when a

full production cost of a product. Absorption business organisation sets the price of a
costing values will vary to those of marginal product based on the prices charged by their
costing. As the inventory values are different, rivals.
this will affect the profits reported in the income
statement for the period. Consistency An accounting concept that
requires accountants, when faced with a choice
Accounting The process of identifying, between different accounting techniques, not
measuring and communicating financial to change policies without good reason.
information to a range of business stakeholders.
Contribution is the amount remaining after
Accounting equation Assets – Liabilities = variable costs have been deducted from sales
Capital revenue.

Accounting principles rules that Cost the cost of the item plus any expenses
organisations will follow when reporting incurred in bringing the product to its present
financial data and information to internal and location and condition.
external stakeholders.
Cost centre a “collecting point” for costs
Accruals This concept is also known as the before they are reviewed and considered.
“matching” principle. The concept states that
revenue should be recognised when it is earned Cost plus pricing occurs when a business
and not when money is received. organisation adds a percentage mark-up to the
cost of a product or service.
AVCO (Average cost) a method of
inventory valuation is sometimes also known Cost unit an individual product or service.
as the weighted average cost. It involves
recalculating the average cost (AVCO) of Current ratio uses figures from the balance
inventory every time a new delivery arrives. sheet and measures the relationship between
current assets and current liabilities.
Break-even analysis the point at which a
business organisation will make neither a profit Debentures long term loans to a business
nor a loss. organisation at an agreed fixed interest rate,
repayable on a stated date. These are usually
Budget a financial plan for the future. offered for up to 25 years.

Business entity an accounting concept Debt factoring business organisations will

which states that the financial affairs of a receive immediate payment for their credit
business should be completely separate from sales, however, the factoring company will
those of the owner. charge for the collection of the debt.

Capital expenditure money spent on Depreciation the cost of a non-current asset

acquiring, improving and adding value to consumed over its lifetime.
non-current assets.
Direct costs a direct cost is similar to a
Cash budget this will predict the closing variable cost in that it compares the cost with
bank balance, and allow organisations to make the level of output.
informed decisions relating to cost savings, the
need for additional borrowing etc. Discounting a technique where a business
organisation offers discount prices on their
Comparability as long as accounting policies products in order to attract new customers or
and procedures remain consistent financial to boost sales.
data and information will be comparable with
previous financial periods.
72 © ABE
 Glossary

Discontinuing a product or service this IAS (International Accounting Standards)

decision will be made based on the contribution accepted as the basis for accounting in many
of the product or service. A business will make countries.
the decision to discontinue a product if its unit
contribution is less than other products or if the Income statement (Profit and Loss
product has a negative contribution. Account) financial statement that shows
revenues, expenses and profit.
Dual aspect the idea that every transaction
has two effects on the account. This is known as Indirect costs an indirect cost is any cost
double entry book keeping there will be one that cannot be linked with the output of any
debit and one credit entry for every financial particular product.
transaction.
Internal stakeholders these are stakeholders
Economic order quantity a mathematical within a business organisation. For example,
technique that is used for calculating the owners and employees.
optimum, i.e. best amount of inventory that a
business should hold. It assumes that the main Inventory turnover inventory turnover
costs associated with inventory are holding is the number of times inventory is changed
costs and ordering costs. during a year. The figure depends on the type
of goods sold by the business.
External stakeholders these are
stakeholders outside of a business Just in Time (JIT) means that inventory
organisations. For example, customers, arrives on the production line just as it is
suppliers, the government, lenders, local needed. This minimises the amount of inventory
residents and the broader public. that has to be stored (reducing storage costs).

Financial accounting the external reporting LIFO (last in first out) a method of
by a business in financial terms. inventory valuation assumes that the most
recent deliveries of inventory are used first.
FIFO (first in first out) a method of valuation So, new inventory is always issued before old
assumes that inventory is used, or sold, in the inventory. The value of unused inventories at
order in which it is purchased. So, inventories of the end of the trading year is therefore based
goods that are bought first are used first. on the cost of earlier purchases.

Fixed costs these are costs that remain Limited companies all limited companies
unchanged as the output level of a business are incorporated, which means they can sue or
organisation changes. own assets in their own right, in other words
they are treated as separate legal entities.
Going concern an accounting concept that Limited companies are owned by shareholders.
assumes a business will continue to trade in the
foreseeable future. Limited partnerships occur when
partnerships wish to raise additional finance but
Government grants these are selective not recruit active partners.
and usually take the form of grants for selected
purposes. Liquid (acid test or quick) ratio the
liquid ratio uses the current assets and current
Gross profit a company's total sales minus liabilities from the statement of financial
the cost of goods sold. position but closing inventory is omitted.

Gross profit margin expresses as a Liquidity a measure of how much money a

percentage, the gross profit as a percentage of business organisation has for the day to day
sales. running of the business organisation.

Historical cost this concept states that Loans usually short/medium term loans which
assets should be stated at their cost when can be used for a variety of purposes and will
purchased, rather than their current value. be repaid with interest.

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 Glossary  

Make or buy business organisations may Price setting a business organisation will use
choose to make or manufacture products that break-even analysis to work out the best selling
they can sell on to their consumers. price to charge for a product or service.

Management accounting the reporting Production budget forecasts the number

of accounting information within a business for of units of each product that a business aims to
management use only. produce over the next financial year.

Marginal cost defined as the cost of raising Profit sales less variable costs and fixed costs.
output by one more unit.
Provision for doubtful debts occurs when
Materiality an accounting concept which a trade receivable that owes money to a business
states that accountants should not spend time has the potential to not pay the debt due.
trying to record accurately items that are either
trivial or immaterial. Prudence an accounting concept that
requires accountants to recognise revenue or
Money measurement an accounting profit only when they are realised.
concept which states that all transactions
recorded by businesses should be expressed in Purchases budget will predict the quantity
money terms. of goods that need to be purchased for the
following year.
Mortgages usually used to purchase
property where the asset will act as collateral Realisation an accounting concept which
for the loan. They are usually offered for up to states that revenue should be recognised when
30 years. the exchange of goods or services take place.

Net cash flow cash inflow less cash outflow. Relevance means that financial data and
records produced by an organisation must
Net profit sales minus cost of sales less all meet the needs of both internal and external
administrative and selling costs. stakeholders. Thereby influencing any decision
that may be made.
Net realisable value (NRV) the estimated
resale value of the inventory, less any selling or Reliability an organisation must ensure that
distribution costs. published information is accurate and provides
a true and fair view of their financial conditions
Non-current assets long term assets of and operating records.
material value.
Retained profit a cheap and flexible source
Notes to the financial statements/ of finance. The retained profit can be used
accounts information supplied in published to generate future profits and therefore with
accounts that gives detail about items in the shareholder permission be used to solve cash
financial statements. flow problems.

Opportunity costs measures the cost of Return on Capital Employed (ROCE)

any choice in terms of the next best alternative expresses the profit of a business in relation
foregone. to the owner’s capital. It is normally compared
with other forms of investment such as a
Overdrafts used for cash flow problems. building society or bank account.
Very expensive if used over a long period of
time as the interest rates are usually very high. Revenue expenditure money spent on
the day to day running of the business i.e.
Partnerships these are business owned by expenses.
two or more people. These usually operate
under a deed of partnership and will benefit Sale and leaseback will allow the business
from increased capital and shared expertise. organisation to receive a cash payment thereby
improving short term cash flow. However,

74 © ABE
 Glossary

having to pay rent on the non-current asset Total costs are calculated as all of the costs
would mean that profitability would be reduced totalled together for any particular level of
in the longer term. output.

Sales budget forecasts the number of units Total revenue revenue is the income that is
of each product that a business aims to sell next earned from selling output.
financial year, the price level to be charged and
the sales revenue that should be received. Trade receivables budget forecasts the
amount that is due from trade receivables at
Sale of assets in a cash flow crisis, the the end of the budget period.
business organisation could sell one or more of
their non-current assets in order to gain instant Trade payables budget forecasts the
cash. amount that is owed to trade payables at the
end of the budget period.
Scarce resources a scarce resource is
something that limited a business’s ability to Understandability means that financial
operate at their full capacity. They may include information should be understandable by
a shortage of skilled labour, raw materials, anyone who has a background knowledge and
factory materials, factory space, machine understanding of business.
availability or finance availability.
Value based pricing occurs when a business
Share issues only available to limited organisation sets the price of a product based
companies. These may issue ordinary or on its perceived value to a customer.
preference shares in order to raise extra funds.
They will, however, have to pay dividends to the Variable costs those which vary directly with
shareholders. the level of output for a business organisation.

Sole trader a business that is owned and Variances occur when there are differences
controlled by one person. between budgeted and actual figures.

Special order decisions business Variance analysis the difference between a

organisations may be asked to produce a one budgeted and actual cost incurred. Categorised
off order for another company. The business as adverse or favourable.
needs to decide whether this special order is
financially worth the costs of production.
“What if” scenarios will evaluate the
expected return or value of a proposed change
Stakeholders a term that refers to any in business activities. A business organisation
person who has an interest in a business will create various scenarios that may occur in
organisation. their organisation.

Statement of cash flows provides Whole-life costing considers the total cost
information about changes in a company’s of a product or service over its entire lifetime.
financial position. This means from design to disposal, including
purchase, hire, lease, maintenance, operation,
Statement of financial position (balance utilities, staff training and disposal.
sheet) statement showing assets, liabilities
and capital. Working capital current assets less current
liabilities.
Third sector organisations these
organisations are non-profit making and
generally operate to provide services to the
community as a whole or to specific groups of
people within the community.

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