Managing Financial

Resources and
Decisions
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[Pick the date]

Executive summary
Finance is the art and science of managing the funds of a business. Effective financial
management is of utmost importance for a business and is a key determinant of its success. This
report studies the various aspects of financial management. Firstly, the report identifies the
different types of sources of funds available to a business, their respective costs, their
appropriateness in the context of a particular business etc. Secondly, the report examines the
importance of financial planning, the financial informational need of different stakeholders and
the impact that a particular source of finance has on the financial statements of a firm. Thirdly,
the report makes a critical analysis of budgets and how they can be used to make decisions.
Moreover, an illustration of the application of different investment appraisal tool is also there.
Finally, the report describes the various types of financial statements, how they differ from
according to business types and how they can be analyzed and interpreted.

Table of Content
pg. 1

Table of Content...............................................................................................................................2
Introduction......................................................................................................................................3
1

Task 1........................................................................................................................................3
1.1

General sources of finance available to businesses..........................................................3

1.2

Implication of different sources of Finance......................................................................5

1.3

Most appropriate source of finance for Sweet Menu restaurants plc................................6

Task 2........................................................................................................................................8
2.1

Costs of the sources of finance identified for Sweet Menu restaurants plc......................8

2.2

Importance of Financial Planning.....................................................................................9

2.3

Decision makers of Sweet Menu restaurants and their informational needs....................9

2.4

Impact of sources of Finance on the financial statements..............................................10

Task 3......................................................................................................................................12
3.1

Analyzing Budgets and taking decisions........................................................................12

3.2

Explanation of the unit cost and pricing decisions.........................................................13

3.3

Investment appraisal.......................................................................................................14

3.3.1

Payback period...................................................................................... 15

3.3.2

Net present value Analysis....................................................................15

3.3.3

Final Investment decisions.....................................................................16

Task 4......................................................................................................................................17
4.1

Discussion of the main financial statements...................................................................17

4.2

Comparison of the financial statement format of different types of businesses.............19

4.3

Interpretation of Financial statements.............................................................................20

Conclusion.....................................................................................................................................23
References......................................................................................................................................24

pg. 2

Introduction
Financial management can be defined as the process of identifying, acquiring, investing and
repaying the required funds in a business in a manner which facilitates the achievement of the
organizational goals. Strategic financial management requires managers to take important
financing, investing and dividend related decisions. These decisions have a direct impact upon
the composition of a firms financial resources (Peirson, 2009).

1.1

Task 1

General sources of finance available to businesses

Funds are the engine of a business. An organization requires financing to support its start up, to
meet its day to day expenses, to expand operations etc. In other words, access to appropriate
amount of cost effective financing is a prerequisite for survival for firms these days. There are
different sources of fund available to businesses. These can be broadly be classified as follows:
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Internal Sources: These refer to financing obtained from within the firm. Thus, they enhance
the equity base of the firm and do not require repayment. Some of the major types of internal
financing are as follows:

pg. 3

 Retained Earnings: Retained earning refers to the undistributed portion of a firms profits.
In other words, retained earnings is the residual profit left after a firm has paid dividends
to shareholders and made the necessary investments. Healthy retained earnings can be
used by firms for future endeavours. Retained earnings are the largest source of internal
financing (Cinnamon et al ., 2010).
Sale of Asset: This involves selling off some of the assets of a business in order to
generate funds. For example, a business could sell an abandoned warehouse under its
ownership to generate cash, to be used elsewhere. This source of finance is relatively less
common (Dlabay and Burrow, 2008).
Owners capital: This refers to the amount of capital provided by the owners themselves.
It usually comes from the personal savings or wealth of the owner and forms the seed
capital used to establish a business.
External Financing: External financing involves obtaining funds from partys external to
the firm. Unlike internal financing, external financing is capable of providing large amount of
capital to a firm. The most common types of external financing available to businesses are as
follows:
Share issue: Shares are ownership rights of a company. A public limited company can
raise substantial amount of capital by issuing shares to the general public or
sophisticated institutional investors (Peirson, 2009).
Debt Issue: These involves borrowing money from the general public or institutional
investor by issuing debt financial instrument like bonds, debentures etc. Debt issue is
also capable of raising large amount of funds (Dlabay and Burrow, 2008).
Loans: One of the major external financing available to firms is loans taken from
Banks and other NBFIs. Loans are very flexible in nature. They can be short term or
long term and thus are used by firms to fund both its working capital needs as well its
capital investment needs.
Lease Financing: This source of financing is used by firms to obtain fixed assets like
equipment, vehicles etc. A lease is an agreement between two parties, the lessor
(owner of asset) and the lessee under which the lessor allows the lessee to use the

pg. 4

asset for periodical lease payments. This reduces the initial cash outlay of a firm and
frees up cash that can e used elsewhere (Cinnamon et al ., 2010).
In addition to the above, there are many other external sources of financing available to a
business. For example, there is factoring, trade credit, borrowing from friends and family,
venture capital, angel investors etc.
1.2

Implication of different sources of Finance

The fact that there are so many sources of financing available to a firm has necessitated
management to carefully evaluate each of the sources to identify the best one. The advantages,
disadvantages and implication of some of the major sources of finance are as follows:
Internal Financing
Retained Earnings: Since retained earning is an internal form of financing, it does not
need to be repaid. Moreover, it is free of any direct costs such as interests, dividends etc.
The implication of this is that funding projects through retained earnings reduces the
overall cost of capital. However, using retained earnings might jeopardize a firms future
condition as it will have less cushion in case of sudden setbacks (Friedlob and Plewa,
2010).
Sale of Asset: The advantage of this source is that it can be used to raise cash quickly and
thus is appropriate if a firm is in need of immediate cash. However, the amount of cash
that can be raised through it relatively low. Moreover, selling off assets might hinder a
firms operational ability and might send negative signals to the stakeholders of the firm.
External Financing
Share issue: Shares are equity securities and thus do not need to be repaid. As such they
do not impose significant financial obligations on a firm. Moreover, a large amount of
fund can be raised through shares issue. However, there are some disadvantages as well.
Firstly, share issue is an option available only to public limited companies. Secondly,
shares dilute the ownership and thus might infuriate the existing shareholders. Thirdly,
pg. 5

share issuance is a costly and time consuming process. Finally, dividend has to be paid to
shareholders.
Debt issue: The advantage of debt issues like bond, debentures is that they allow a firm to
raise huge amount of funds. Moreover, they are flexible as firms can alter the terms and
conditions like the coupon rate, maturity, security status etc of these securities according
to their needs. However, there are some disadvantages as well. Firstly, the securities
include the obligation of paying interests. Secondly, there might be restrictive covenants
which might impede a firms operation. Thirdly, potential agency conflict between
bondholders and stakeholder might arise. Finally, issuing debt might increase the gearing
level of a firm to excessive levels (Friedlob and Plewa, 2010).
Thus, it is seen that different sources have different merits and demerits. A prudent financial
manager must consider all of these carefully before choosing any particular source.
1.3

Most appropriate source of finance for Sweet Menu restaurants plc

Sweet menu restaurants Ltd is planning to expand its operations by opening two new branches
and will require 300000 to 500000 to do so. There are different sources from which the firm
can raise the necessary funds. However, among these sources bank loans and debt issue seem to
be the most appropriate. Firstly, the amount required by Sweet menu ltd is pretty large and thus
certain sources like retained earnings, owners contribution etc can be easily ruled out. Even if
the company had the necessary retained earnings, it would still be rash to invest such a huge
amount from the retained earnings. Secondly, a share issue would have been a good option if not
for the dilution of ownership. The restaurant is owned by three friends since the last 10 years and
this is probably indicative of the fact that they do not want to diminish their control and power.
Share issue will do exactly that (Peirson, 2009). Moreover, a share issue is time consuming and
involves a lot of floatation cost. Finally, there is a risk of under subscription of shares since
restaurants are not that charismatic a stock to investors. Other viable sources of finance
available to the business are bank loans and debt issues. This is because the firm can raise the
required fund from these sources easily without diluting control and ownership. Moreover, the
firm can also match the borrowing horizon with the investment horizon. However, the
management of sweet menu restaurants ltd must consider that both of these sources will
significantly increase the leverage of the firm and entail interest and principal payments which
pg. 6

will increase the periodic financial obligation of the firm. Moreover, they might require collateral
as well. Thus, if the management is too worried about the debt to equity ratio then they might go
for a combination of shares issue and bank loan to fund the expansion project (Friedlob and
Plewa, 2010)
.

pg. 7

Task 2

2.1

Costs of the sources of finance identified for Sweet Menu restaurants plc

Different sources of finance have different direct and indirect costs. The implications of these
costs are immense since they are one of the major factors that must be considered by
management before deciding on which source to pursue. The major costs of the sources of
finance identified for sweet menu restaurant ltd is as follows:

Bank Loans: The direct cost of obtaining funds through bank loans is interest. Interest is
the extra amount over principal that a borrower must pay to the lender in order to
compensate the lender for the risk that he bears and for his time value of money. The
interest rate charged by banks is usually very high. Thus, they are a significant cost to the
borrower. In addition to interests, there are some other direct costs associated with bank
loans also like application fee, commission, service fee etc. The indirect costs of bank
loan include the financial distress costs that might arise due to it. For example, if a firm
fails to pay its interests on time then it might be subject to legal action by the bank. This
will force the firm to incur some costs like lawyers fee, loss of reputation etc. These are
all indirect costs. Moreover, firms usually have to post collateral against bank loans. The
discomfort caused by this arrangement is also an indirect cost to the firm (Holland and

Torregrosa, 2008).
Debt Issue: The direct costs of issuing debt securities like bond, debenture etc is also
interests. Firms usually have to pay a fixed coupon rate of interest to the bondholders
unless its a zero coupon bond. Even in that case, the bond is sold at a discount and this
discount represents a cost. In addition to interests another major cost of issuing debt
security is the floatation cost. These include the underwriters fee, the SEC fees, bank
charges, printing charges etc. Indirect costs of debt issue include an increase in the
financial risk, an increase in agency cost due to conflict between shareholders and
bondholders, an increase in financial distress costs, hindrances on operation caused by
restrictive covenants etc (Holmes, 2012).

2.2

Importance of Financial Planning

pg. 8

Financial planning can be defined as the process of analyzing a firms past and current financial
and non financial performance and using the insights gained through such analysis to develop
plans regarding future financial state of the business. Financial planning can be a great source of
competitive advantage for any firm and most certainly for Sweet Menu restaurants ltd and is thus
of great importance for Sweet menu restaurants ltd for a variety of reasons. Firstly, financial
planning will help the firm systematically set short term and long term future goals which will
act as a guide for activities. For example, setting the goal of opening two new branches of the
restaurant will guide future financial strategies required to achieve this goal. Secondly, financial
planning allows a firm to better manage its resources and boost its profitability. For example, the
management of the restaurant could use planning tools like sensitivity analysis, investment
appraisal etc to identify the location in which profit will be maximized from opening branches
(Cinnamon et al .,2010). Thirdly, financial planning allows a firm to prepare for any sudden
future setbacks, in advance. For example, cash flow forecasts might show a cash deficit in the
future thereby allowing the management of Sweet menu to arrange alternate financing for that
period in advance. Fourthly, financial planning installs financial discipline within a firm by
constantly reviewing the financial aspects. Finally, financial planning reduces the risks of a firm
by ensuring that proper contingency plans are made. For example, if the financial forecasts
suggest a sudden rise in cost of food production then the management can prepare against this by
gradually raising the menu price thereby not catching the customers by surprise (Friedlob and
Plewa, 2010).
2.3

Decision makers of Sweet Menu restaurants and their informational needs

There are various types of decision makers in Sweet menu restaurants. Each of them seek
different types of information in order to take an objective decision. Some of these decision
makers along with their informational needs are described below:

Managers: Managers are the primary decision makers in a firm and are regular users of
various types of information. For example, the finance manager might require
information on the existing capital structure of the firm before deciding whether to take
on more leverage or not. Similarly, the procurement manager might require information
regarding the firms liquidity position before negotiating credit terms with the suppliers
of the raw materials. The HR manager might seek information regarding the financial
pg. 9

health and profitability of the firm before deciding whether to give a raise to the waiters
and the restaurant manager might require historical information regarding the amount of
sales of different dishes in order to decide how much of which to produce (Peirson,

2009).
Owners/Shareholders: Owners/ shareholders usually take corporate level decisions that
affect the strategic direction of the business. Taking such decision requires in depth
information. For example, the shareholders might require information regarding the
profitability of the firm and its future outlook before deciding whether to expand or not.
Moreover, they also need financial information to evaluate the performance of their

managers (Ittelson, 2009).

Employees: Employees seek financial information in order to assess their job security and
the value of their stock plans if any. In order to do this they check the balance sheet and
the income statement to evaluate the profitability and solvency of the firm.

In addition to the above decision makers in Sweet menu restaurants ltd, there are some other
external decision makers also who might seek the financial information of the firm. For
example, a prospective lender or supplier might require information regarding the
profitability, liquidity and solvency of the restaurant before deciding whether to approve the
loan/credit or not. Similarly, a prospective investor might also require financial information
of the restaurant in order to decide whether to invest money or not in the firm (Ittelson,
2009).
2.4

Impact of sources of Finance on the financial statements

The choice regarding the financing source has a significant impact upon the financial statements
of a company. It does so by altering the major line items of the statements. In the above case, the
management of Sweet Menu Restaurants ltd have been suggested to take bank loans or issue debt
securities in order to finance the expansion project. Both of these sources will affect the financial
statements. Firstly, if the company takes a bank loan than this will increase the future interest
expense in the income statement from 10000 to something greater. This will reduce the profit
before tax for sweet menu restaurants providing other factors (sales, cost of sales, administrative
expenses etc) remain constant. However, since interest provides a tax shield, the tax obligation of
the firm will decrease. This will also happen for a bond issue since interest has to be paid at a
pg. 10

fixed coupon rate to the bond holders also. All in All, taking a bank loan or issuing bonds will
reduce the profit after tax of the restaurant. In the balance sheet, a bank loan or a bond issue will
appear under the classification of the long term debt. Moreover, assets value will also increase
since the proceeds of the loan will be used to purchase assets for the two new branches.
Furthermore, the increase in long term loans by 300000 to 500000 will seriously alter the debt
to capital ratio of the firm converting it into a highly levered firm (Whittington, 2013).

pg. 11

3
3.1

Task 3
Analyzing Budgets and taking decisions

A budget is a quantitative plan regarding activities related to some future period of time. A
budget is an important financial planning tool to managers and has various advantages. Firstly,
preparing a budget is a comprehensive process and helps the managers in identifying areas of
strength and weaknesses of the firm. Secondly, a budget helps managers identify red flags and
prepare contingency plans for such red flags. Thirdly, a budget by setting profitability/ cost
targets, may serve as a motivational tool for employees. Finally and most importantly, the
analysis of a budget might provide critical insights to the managers which can then be used to
take decisions (Hammonds, 2009). The cash and payables budget of Blue Island restaurant is
analyzed below.
An evaluation of the cash budget of the restaurant for the period September 2015 to December
2015 shows that the firm is expecting a cash deficit in the month of September and December
and a cash surplus in October and November. Moreover, the amount of deficit in September is
very large at 7350 and this has caused a cumulative cash deficit in all of the three future
months except November. There are multiple factors causing the cash deficit. Firstly, the sales
revenue of the restaurant is poor relative to its costs. Secondly, the firm has made substantial
capital expenditure in the purchase of a van and fixtures and fittings in September and December
resulting in cash outflow exceeding cash inflow and thereby causing the deficit (Coyle, 2010).
This is worrying since a cash deficit will cause liquidity problems for the restaurant and might
make it difficult for the firm to meet its day to day expenses like labour wage, supplier payments
etc. This could lead to labour unrest, halted operation and even bankruptcy. Moreover, the
analysis of the payables budget shows that Blue Island restaurant follows a credit purchase
policy which involves paying 60% of a particular months purchase in cash on that month and the
rest 40% a month later. This could also have contributed to the cash deficit by increasing the
burden of inventory payments on a particular month (Hammonds, 2009). In order to overcome
the problem of a cash deficit, the management of Blue Island restaurants could take the following
decisions:

pg. 12

Arrange short term financing through loans or ploughing back of retained profits to cover
the cash shortfalls in September, October and December and thus ensure the smooth

operation of the firm.

Reduce the cash outflow of the firm by cutting back on some items so as to reduce the
amount of cash deficit. For example, instead of purchasing, the firm could lease the van
therefore reducing the amount of initial cash outlay. Similarly, instead of purchasing the
fixtures and fittings on cash, the firm could buy it on credit or at least pay for it in

multiple instalments.
Increase the cash inflow of the firm by boosting sales. This could be done by offering
discounts, broadening the menu, better marketing etc. Moreover, the firm can also
consider increasing the price of its dishes. Currently, the restaurant applies a mark up of
only 40%. This is very little in the industry context. Thus, the management should raise
the mark up to 70%. In order to avoid disgruntled customers, the management must

increase the quality of the dishes also.

Renegotiate a better credit term with the suppliers. Thus, instead of the 60%-40% credit
policy in existence now, the management could try to get a 40%-30%-30% credit policy.
This will reduce the cash outflows of a particular month.

3.2

Explanation of the unit cost and pricing decisions

Reviewing of the meal cost calculation clearly shows that the management of the firm is using
the full costing/ absorption costing technique.
Calculation of Meal cost
Item
Direct Materials:
Steak
Vegetables and other
ingredients
Direct Labor
Overheads
Total Cost per meal

Cost
()
3
1.5
3.5
2
10

pg. 13

Under this costing technique the unit cost is calculated by adding all the direct variable costs like
direct material and direct labour with the overheads attributable to the meal. Even though an
absorption costing technique such as the one used by Blue Island restaurant has its advantages,
there are criticisms as well. For example, the incorporation of fixed overheads in the unit cost is
questionable. Thus, the managers of the restaurant might consider using variable costing to
calculate the meal unit cost. Under Variable costing, only variable direct and indirect costs will
be used in calculating the unit cost. Therefore, the cost per meal under this technique will be
lower than that under the full costing method (Dlabay and Burrow, 2008).
The choice of costing techniques is crucial since costs are a direct input in the pricing decisions
of a firm. Thus, inappropriate costing could lead to faulty pricing decisions which in turn might
have a negative effect upon sales. The management of Blue Island Restaurants ltd uses a mark up
of 40% on its meal cost to arrive at a price of 14. VAT of 20% on cost is added to this to arrive
at the final selling price. However, this price is too low and results in inadequate cash inflow for
the firm as reflected in the cash forecast. Instead, the firm should increase its mark up. For
example, it could charge a mark up of 80%. In this case the final price will be as follows:
Calculation of Meal price

Item
Total Cost per
meal
Mark up of 80 %
VAT
Price per meal

Amount
(
10
8
18
2
20

This price increase will contribute positively to the profitability and cash flow of the firm.
Moreover, since good foods tend to be price inelastic, the increase in price wont significantly
reduce sales volume provided the management can maintain or increase its quality.
3.3

Investment appraisal

Investment decisions are one of the key decisions that firms have to make since profitable
investments are a prerequisite for company survival and success. However, since the capital
available for investment is usually limited, it is essential that the management carefully evaluate
pg. 14

alternative projects to identify the most feasible ones. There are many investment appraisal tools
like the payback period method, NPV analysis, IRR analysis etc that can be used for this purpose
(Holmes, 2012). Two of these methods are applied below to evaluate the alternative projects
available to Blue Island Restaurant.
3.3.1

Payback period

Payback period is the amount of time it takes to recover investments made in a project through
the cash inflow generated by the said project. The investment project with the smaller payback
period is preferred since the earlier the investments are recovered, the earlier it can be reinvested
elsewhere (Langdon, 2010). The payback period of the two proposals is as follows:

Above it is seen that the payback period of proposal 1 (1.67 years) is much less than that of
proposal 2 (3 years). Thus, according to the payback period method, project 1 should be selected
by the management.

3.3.2

Net present value Analysis

Net present value is the present value of all the expected cash flows of a particular project
discounted at the projects required rate of return net of the initial investment in the project. NPV
calculates the value that a project will add to a firm. Projects with higher NPV are preferred over
projects with lower NPV (Holland and Torregrosa, 2008). The NPV of the two projects are as
follows:

pg. 15

NPV calculation of proposal 1

Details
Net Cash Flow
Discounting factor
@ 10%
PV of cash flows
NPV

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

-1200
800
600
400
200
50
0.909
0.826
0.751
0.683
0.620
1
091
446
315
013
921
727.2
495.8
300.5
136.6
31.04
-1200
727
678
259
027
607
491.3
152
NPV calculation of proposal 2

Details
Net Cash Flow
Discounting factor
@ 10%
PV of cash flows
NPV

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

-1200
300
400
500
600
500
0.909
0.826
0.751
0.683
0.620
1
091
446
315
013
921
272.7
330.5
375.6
409.8
310.4
-1200
273
785
574
081
607
499.2
319

As can be seen above, the NPV of the two projects are very close to each other with Proposal 2
having a higher NPV ( 499.2319) than proposal 1 ( 491.3512).Thus, based on the NPV
method, proposal 2 should be accepted.
3.3.3

Final Investment decisions

The application of the two investment appraisal methods have given conflicting results with the
payback period method suggesting proposal 1 and the NPV method suggesting proposal 2. Under
such circumstance, the management of Blue Island restaurants should follow the suggestion of
NPV method since this method is a discounted one. Moreover, it takes into consideration the
time value of money and acknowledges the risk factors better than the payback period method
(Holmes, 2012).

pg. 16

4
4.1

Task 4
Discussion of the main financial statements

Financial statements are prepared by the companies to know about the financial performance and
liquidity position of them. There are four major statements prepared by the companies which are
income statement, statement of financial position, statement of cash flow and statement of
owners equity. The statements are discussed below with their elements:

Statement of Financial Position:

This is known as the balance sheet which shows the financial position of a company by
describing the condition of the assets, liabilities and equity of the company on a particular date
(Ittelson, 2009). The assets of a company are always equal to the sum of the equities and
liabilities. The three elements of balance sheet are:

pg. 17

Assets are shown in the left side of the balance sheet which includes all the things that
are owned and controlled by a company. The assets may be current such as cash or

inventory or may be fixed such as plant and machinery, land etc.

Liabilities of a company include the short term and long term obligation of a company to

other external parties such as notes payable, bills payable etc.

The owners equity represents owners claim on the company such as the invested
capital or the retained earnings of the company.

Income Statement:
Income statement shows the net profit or net loss of a company for a particular period which is
the financial performance of that time period (Whittington, 2013). The components of the
statement are revenue, expense and net income for the time period that areexplained below:

Revenue is the amount earned by the company by the operation of the business such as

sales revenue.
Expense is the cost of earning the revenue during the specific period such as

depreciation, salaries etc.

The net income is the excess of income over the expenses and it can be net loss when
expenses are more.

Statement of Cash Flow:

Cash flow statement shows the cash inflows and outflows of a company over a period. The
elements of this statement are:

Cash flows from operating activities include the cash inflows and outflows from the

basic business activities.

Cash flows from investing activities present the transaction of purchase and sale of fixed

assets.
Cash flows from financing activities show the cash flow related to the liabilities and
equities.

Statement of Owners Equity:

pg. 18

The movement of the equity of the shareholders of a company is shown in this statement for a
certain time period. The equity position is comprised for the following elements:

4.2

The retained earnings from the previous profits and shareholders. equity of the company

at the beginning.
The net profit of the company for the existing period increases the equity.
The new shares issued by the company enhance owners equity and the share repurchase

does the opposite.

The payment of dividend and recognized gains on equity also changes equity position.
All the changes for a particular period result in the ending equity position.
Comparison of the financial statement format of different types of businesses

The financial statements prepared by different types of business have to follow the appropriate
formats. The formats can be different according to the nature of business such as sole
proprietorship, partnership or company (Ittelson, 2009). As sole proprietorship is the simplest
form of business, the financial statements are not required to be presented according to strict
formats. The income statement shows the very basic revenues and expenses for a business as the
balance sheet will not show any debt or retained earnings of the business. The partnership
businesses prepare income statement in the similar way but this income is presented to be
distributed among the partners of the business. Partnerships prepare balance sheet where capital
accounts must be shown to identify the contributions and distributions of the partners (Peterson
Drake and Fabozzi, 2012).
Again, the companies are the most complex businesses having a variety of items in their
financial statements which are needed to be presented according to strict formats.The financial
statements for companies can be maintained according to the formats prescribed by US GAAP
(Generally Accepted Accounting Practice) or IFRS (International Financial Reporting
Standards). There are several differences in the prescribed formats of the statements according to
the two for different types of business. For preparing the balance sheet, IFRS does not provide
any structure of presentation of elements of balance sheet but loosely support presentation of
assets according to illiquidity whereas GAAP requires the assets to be presented in the sequence
of their liquidity. According to IFRS the shareholders equity are shown before liabilities and
GAAP directs the opposite (Cook, 2015).
pg. 19

According to both IFRS and GAAP, for the income statement the comprehensive income of the
companies is shown in it. But GAAP provides an extra option to present the comprehensive
income in the owners equity statement (Van der Meulen et al.,2011). For recording the expenses,
GAAP has provides formats of single and multiple steps of presenting where expenses are
recorded by nature and IFRS requires the expenses to be reported by nature or by function in
which true reality can be seen.
Last of all, for preparing the statement of changes in owners equity, statement of recognized
income and expense (SoRIE) is used as a primary statement by IFRS and other information is
shown in the notes. Capital transactions and some important items are mandated to be presented.
GAAP does not require the SoRIE but it has similar format for other components.
The Cash flow statement follows almost similar format under GAAP and IFRS for direct and
indirect method. The only difference is that GAAP has been more specific regarding the
classification of the operating, investing and financing items than IFRS.
4.3

Interpretation of Financial statements

The financial statements of the two close competitor restaurants namely Sweet Menu Restaurant
and Blue Island Restaurant can be interpreted appropriately using the profitability, liquidity,
solvency and efficiency ratios. The ratios are compared in the following section to know about
the strength and weakness of the two competitors.

Profitability Ratios
Profitability Ratios

Ratio
Gross profit margin

Net Profit Margin

Return on capital employed

Sweet Menu
Restaurant
222500/350000
63.57%

Blue Island
Restaurant
198000/299000
66.22%

85000/350000
24.29%

94800/299000
31.71%

85000/
(164000+31000)
43.59%

94800/
(118000+5000)
77.07%

pg. 20

The profitability condition for Blue Island is better than that of Sweet Menu as the gross profit,
net profit and the ROCE are higher for Blue Island. The company earned moderately higher
profits and especially the return on the employed capital is far better than the ROCE of Sweet
Menu as it earned more for less amount of employed capital. So Sweet Menu has borne more
costs and expenses against the generated revenue and the employed capital. On the other hand,
the revenues generated by Blue Island are more than the costs incurred by the company.

Liquidity Ratios

Liquidity Ratios

Ratio

Sweet Menu
Restaurant

Blue Island
Restaurant

Current Ratio

68000/38000

41000/65000

1.789473684

0.630769231

(68000-44000)/38000

(4100031000)/65000

0.631578947

0.153846154

11000/38000

5000/65000

0.289473684

0.076923077

Quick Ratio

Cash Ratio

Maintaining liquidity is a major determinant of the health of a business and so the liquidity ratios
can be used for this purpose. Sweet Menu is more liquid than Blue Island as all the liquid ratios
indicate better condition for this company. Sweet Menu is having a liquidity position which is
very close to the standard liquidity for a business. The company has enough current and quick
assets and cash against its operating liabilities.
On the other hand, Blue Island has cash ratio of .63 which means the company takes more
current liabilities than can be supported by its current assets like cash, inventory etc. which is a
bad sign for the future performance of the business. The quick ratio is .15 which is very risky
position for Blue Island as the quick assets are maintained at very low amount. The cash held for
mitigating the current liabilities claim is only 7%. All of the ratios show worse liquidity position
for Blue Island.
pg. 21

Solvency Ratios

Solvency Ratios

Ratio

Sweet Menu
Restaurant

Blue Island Restaurant

Debt to equity Ratio

31000/164000

5000/118000

18.90%

4.24%

31000/
(165000+68000)

5000/(147000+41000)

13.30%

2.66%

164000/
(165000+68000)

118000/
(147000+41000)

70.39%

62.77%

Debt to assets ratio

Equity Ratio

The solvency ratios of the two companies will show the equity and liability conditions for the
two companies. Sweet will has more debts in its capital structure than Blue Island. According to
the asset base, Sweet will again has more debts than the other. So Sweet Menu is more leveraged
than Blue Island according to these two ratios. The equity ratio shows that Sweet Menu has
70.39% equity for its total assets where Blue Island has only 62.77% equity for the total assets.
Considering the ratios, it can be said that Blue Island is having more solvency as it has less
external liabilities for long term causing less risk of being insolvent.

Efficiency Ratios

Efficiency Ratios

Ratio

Sweet Menu
Restaurant

Blue Island
Restaurant

Inventory Turnover ratio

127500/44000

101000/31000

2.897727273

3.258064516

350000/165000

299000/147000

2.121212121

2.034013605

Fixed Asset Turnover

pg. 22

Receivables turnover ratio

350000/13000

299000/5000

26.92307692

59.8

The efficiency ratios are used here to know about the most efficient competitor of the two. The
higher inventory turnover ratio of Blue Island means that it is more efficient to use its inventory
for the business than Sweet Menu. Blue Island has used its inventory three times in the
production whereas Sweet Menu has used only two times. On the contrary, Sweet Menu is
slightly more efficient to generate sales from its fixed assets than Blue Island. Last of all, the
receivable turnover ratio is greater for Blue Island and so it is efficiently managing its
receivables against its total sales. Sweet Menu has more receivable for its total sales which has
occurred because of using fixed assets efficiently but the emergence of larger amount of
receivable shows its inefficiency in collecting money from the debtors. So Blue Island is
managing its business more efficiently than Sweet Menu.

Conclusion
Finance is the science and art of managing funds. As such effective financial management is of
utmost importance for the success of businesses. Financial managers nowadays should possess
adequate knowledge regarding the various aspects of finance like those identified in this report.

pg. 23

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