UNDERSTANDING FINANCIAL

STATEMENTS

Task Brief
1. General Task Guidance


The submission word limit is 1,500 words. You must comply with the word count guidelines. You
may submit LESS than 1,500 words but not more. Tables, diagrams, bibliography, appendices,
annex and headings are NOT included within word count calculations. You must specify total
word count on the front page of your report.


Please use font size 12 for body text and the typeface (font) should be Arial or Times New
Roman with minimum 1.5 spacing.

 For headers and titles, please use font size 14. Your submission must have standard margins and
page numbers.

 Please use English (UK) as your language in the submission.

•
You are required to use only Harvard Referencing System. Any content which is already
published by other author(s) and is not referenced will be considered as a case of plagiarism.

•
You should include a completed copy of the Task Cover sheet.
2. Task Brief

IMPORTANT POINTS TO NOTE

You must submit a Word document (NOT PDF).

Do not include in appendices any work you wish to consider as part of your answer.

USE OF EXCEL

You may use excel to support your workings. However please take note of the following points:

1. You must NOT submit an excel file. It will not be considered.

2. You may NOT ‘embed’ excel files into the Word document. If you are unsure what is meant
by this see: https://support.office.com/en-us/article/Link-or-embed-an-Excel-worksheet-
41bf021e-ba7c-44ef-9914-0d7e88062257

3. You may copy and paste workings from excel into your Word submission. However the
layout must be such that your calculations can be understood. In other words do not
simply copy a series of calculations. You must include explanations of each step of your
workings.
2.1 CASE STUDY – HORIZON LIMITED (LTD)

Background – Horizon Ltd

Horizon Ltd (Horizon) was formed in 2004 as an energy exploration company. Exploration
is the process of trying to find oil and natural gas trapped under the Earth’s surface.

The exploration is done on behalf of energy producers (businesses such as BP, Shell, Exxon
Mobil). Production is the process of recovering those hidden resources for processing,
marketing and use.

What is Energy Exploration?

IMPORTANT – This section is for information, an understanding of it is NOT

important for this assessment. However, you may find it interesting, and it
should give relevant context to your understanding of the industry which
will be useful particularly for the Commercial Awareness task.

There isn't any way to be absolutely sure where new oil and natural gas reserves are
located, so exploration companies (such as Horizon) need to collect clues as to what lies
deep beneath the earth's surface.

Engineers can gather surface (above-ground) clues

using airplanes and satellites to map the earth’s surface,
to identify promising geological formations, and to look for
oil and natural gas escaping to the surface (known as
seeping or seeps). Ships can do a similar task on
exploring the ocean floor.

But engineers often get much more useful information by looking at geological structures
and rock properties below the surface. They use a

number of methods including:

Seismic surveys are done by sending high-energy

sound waves into the ground and measuring how long
they take to reflect back to the surface. Since sound
travels at different speeds as it passes through different
materials, computers can use seismic data to create a
3-D map of what lies below the surface.

Geologists and geophysicists – known as “explorationists" – use these 3-D seismic images
to look for pockets (reserves/reservoirs) of oil and natural gas. Engineers then use the
data to plan the safest, most cost-effective well path to the reservoir.
When surface clues indicate a likely site for oil and natural gas reserves, an exploration well
is often drilled. Rock samples from the well are brought to the surface and analysed. Well logs
measure the electrical, magnetic and radioactive properties of the rocks.

By examining this information, a geologist can learn a great deal about

the sub-surface structures and whether or not the site is likely to produce
oil and natural gas at a volume which will allow the producer to make a
profit.

Gravity and Geomagnetic Surveys are a relatively

inexpensive techniques which can identify potential oil and
natural gas bearing sedimentary basins (rock structures
whose shape might indicate the existence of natural gas or
oil). High-resolution aero-magnetic surveys done by special
aircraft can also show fault traces and differentiate between
different rock types near the earth’s surface.

Recent events at Horizon

In 2011, the company decided to expand into exploration of sites suitable to produce
renewable energy (including wind farms, solar farms and hydro plants). As commented on
in Exhibit 4 the company struggled to make a profit in this area. So Horizon decided to sell
this division off to an established renewable energy producer at the end of 2014..

With the company now focusing on Oil and Gas exploration, Horizon has been able to take
advantage of the discovery and growth in Shale Gas production in the United States.

To learn more about Shale Gas see [http://geology.com/energy/shale-gas/] . (A

technical understanding of how fracking works is not required for this task, but you
may find this interesting.)

Keen to maximise the opportunity of this new resource, the Board of Horizon are keen
to expand their coverage in Shale Gas exploration. They have identified a company
(Naxol) which specialises in Shale Gas exploration in Western Europe which they wish
to buy.

The 2015 financial statements for Horizon have been recently released and at the last
board meeting the board members raised a number of questions which you agreed you
would respond to at the next meeting.
Your role
You are the Finance Director of Horizon, Clara Jones

You have been asked to analyse the financial performance and position of the company
and produce a Board report which sets out your findings and makes a
recommendation as to whether Horizon should buy Naxol. This will be your
task for Understanding Financial Statements.

You will also produce a report on various matters concerning the acquisition of Naxol,
and about the potential for Horizon to become a Public Limited Company (PLC).
This will be your task for Commercial Awareness.

To assist you with this task you have been supplied with the following information:

Exhibit 1: Extracts from Horizon’s Financial Statements for 2015.

Exhibit 2: Additional Financial information which supports the financial statements

in Exhibit One.

Exhibit 3: Key ratio analysis for 2014 and 2015 of Horizon’s financial statements.

Exhibit 4: Finance Director’s notes.

Exhibit 5: Naxol Ltd Financial statements for 2015, & notes about the company.

Exhibit 6: Two different views of fracking.

Horizon Limited: Statement of Financial Position as at 31 December 2015

2015 2014
£'000 £'000

ASSETS
Non-current Assets
Property, Plant and Equipment 1,000 1,880
Patents and Trademarks 150 330
Development costs 250 440

1,400 2,650
Current Assets
Trade and other receivables 7,963 8,213
Cash and cash equivalents 2,143 0
10,106 8,213

Total Assets 11,506 10,863

EQUITY AND LIABILITIES

Equity
Share Capital 5,000 5,000
Retained Earnings 2,621 1,101
Total Equity 7,621 6,101

Non-current Liabilities
Long term loans 1,850 3,500

Current Liabilities
Trade payables 2,035 1,062
Bank overdraft 0 200
2,035 1,262

Total Liabilities 3,885 4,762

Total Equity and Liabilities 11,506 10,863

Exhibit 4: Finance Director’s notes

The notes taken below are to assist me (The FD) in preparing the board report.

Board members without a financial background raise the following queries.

In reviewing Non-Current Assets on the Statement of Financial Position (SOFP),

what are patents and trademarks?

The advanced technology we use in resource exploration means that we spend

significant sums on Research and Development (R&D). When a piece of
technology is developed we are able to protect it for a period of time (usually 25
years) from competitors using it via the registering of a patent (for which the
Patent Office charges us a fee. This fee is reflected in the SOFP.
In reviewing Non-Current Assets on the SOFP, what are development costs?

This relates to the R&D mentioned above. The general research undertaken in the
field of exploration is charged to administrative expenses (see Note 1 on Exhibit
2). When that research moves onto the specific development of exploration
technology which we can use, accounting standards allow it to be categorised as
an Asset (when it meets certain criteria). All the development costs shown as a
Non-Current Asset in Exhibit 1 meet this criteria.
What is included in Other Operating Income on the Income Statement?

This includes an element of the contracts we have with energy producers, which
is in addition to the fees paid for the exploration (which we show in our revenue).
If the exploration successfully discovers Oil or Gas we receive a small commission
based on the volume of Oil or Gas extracted. This is paid to us on an annual basis.
What is Amortisation?

Where we charge depreciation to reflect the use of tangible Non-Current Assets,

amortisation is the equivalent of this for intangible Non-Current Assets.
Why do we spend so much money on Legal and Professional Fees?

Our contracts with the big energy producers are specific to the sites and the type
of resource being explored. Due to their length and complexity we use a legal firm
who specialise in these types of contract to develop them on our behalf.

Discussion with the Chief Executive

Though expansion into renewable energy made strategic sense in 2011, this is an area in
which we have struggled to make a good level of profit. We found that:
 The exploration methods are simpler and therefore we have not been able to
charge a high price for the work undertaken.
 Because we are relatively new to the area, we were spending relatively high
amounts on research with only a small proportion developing into usable
exploration technology.

Therefore following the board’s review of the company’s profit and cash position during
2014 we decided that we needed to either stop this activity or sell it to another company.
An established renewable energy provider called Iberdrola was interested in gaining
access to the UK renewable energy market and therefore we were able to negotiate a sale
of the division at the start of 2015. The sale included:

 Exploration plant and equipment used to identify suitable renewable energy sites.
 Patents (including associated development costs) related to the technology used
in the plant and equipment above.
 The divisional director, geologists, sales team and back office support (finance,
Human resources) for the renewable energy division. (This was done by
transferring the employment contracts and people to Iberdrola – all the staff
affected agreed to the transfer so no redundancies were required).

The sale did not include £1.65 million of loans linked to financing the division between 2011
and 2014, which we repaid once the sale of the division was finalised.

Whether we decide to buy Naxol or not, Shale Gas is a major opportunity and could see
our company significantly expand in the next few years. To help finance such an expansion
we are considering listing the company on the London Stock Exchange and becoming a
Public Limited Company (plc). I understand that this might increase our costs so that we
comply with the UK Corporate Governance requirements, I will be interested to get your
views as to what types of cost we might incur if we decide to list.

Discussion with the Operations Director

Reviewing the segment analysis (Exhibit 2):

 We were able to secure new contracts during 2015 as a result of the

expansion of Shale Gas production in the USA.
 The scarcity of Oil and Gas resources (with the exception of Shale Gas) makes
successful exploration important to the energy producers and therefore we have
had the opportunity to raise the price of the exploration fees we charge.
 Advanced technology which came into use during 2015, has revolutionised the
exploration process for oil and gas, and helped us identify potential reserves with
greatly improved accuracy. This has resulted in fewer exploration wells, and
reduced exploration costs for the company.

Other matters

 The board’s review of the cash position in 2014 involved a closer look at how we
manage working capital.

o There was no flexibility in the credit terms we provide to our customers, which
are big energy producers. These are big companies which tend to dictate the
payment terms for our invoices, and the industry standard is 90 days
between undertaking the exploration and receiving the money for the fees
we charge for the exploration.
o The industry standard noted above for the renewable energy sector was 60
days.
o Our suppliers are mainly specialists we use on a sub-contracting basis
when undertaking exploration anywhere across the world. (We hire local
expertise) We found that we were paying the subcontractor as soon as we
received their invoice. However, standard invoice terms are for payment 30
days from the invoice date, and therefore we decided to use that credit
period to manage our cash position.

Financial Criteria for deciding on whether to buy Naxol

ALL the financial criteria below need to be achieved by Naxol for the Finance Director to
recommend that the company is purchased by Horizon:

 Return on Capital Employed (ROCE) above 20%

 Profit margins that are no less than 5% below Horizon’s profit margins in 2014
(for instance if our profit margin was 20% then Naxol’s would need to be greater
than 15%) – this is on the basis that Horizon believes it could find cost savings
following the purchase of Naxol to bring the profit margin up to Horizon’s present
levels.
 Relevant Liquidity and Solvency ratios are within the standard industry safety limits.
Exhibit 5; Extracts of Naxol's 2015 Financial Statements

Naxol Limited: Statement of Profit or loss for the year ended 31 December 2015
2015
£'000

Revenue 9,317
Cost of Sales (8,264)
Gross Profit 1,053
Overheads
Administration expenses (598)
Operating Profit 455
Finance costs (142)
Profit/(Loss) before Tax 313
Income Tax expense (94)
Profit/(Loss) for the period 219

Naxol Limited: Statement of Financial Position as at 31 December 2015

2015
£'000
ASSETS
Non-current Assets
Property, Plant and Equipment 635
Patents and Trademarks 101
Development costs 96
832
Current Assets
Trade and other receivables 2,614
Cash and cash equivalents 0
2,614

Total Assets 3,446

EQUITY AND LIABILITIES
Equity
Share Capital 500
Retained Earnings 661
Total Equity 1,161
Non-current Liabilities
Long-term borrowings 1,000
Current Liabilities
Trade payables 1,263
Bank overdraft 22
1,285
Total Liabilities 2,285

Total Equity and Liabilities 3,446

 Exhibit 6: Two different views of fracking

Sussex Wildlife Trust

Environmental Impacts
Many concerns have been raised about environmental risks associated with the
fracking process. The Trust considers that the most significant local issues for
biodiversity are:

 The impact of the footprint of the physical development e.g. buildings, parking areas,
waste water storage tanks and well-heads
 The impact from flaring off of gasses and light pollution
 The impact of the transport footprint on the landscape, wildlife sites and noteworthy
habitats and species
 The safe disposal of waste
 The use and management of water resources
 The climate change implications
Is the UK fit to frack?
The Sussex Wildlife Trust recognises that all forms of energy generation will entail
some environmental costs and that the risks and benefits associated with each must
be weighed against each other and considered in the context of location and scale.
We believe that the UK Government should retain its focus on sustainable energy
production and energy conservation, and ensure that funding is prioritised for the
development and implementation of renewable energy technologies.

There are a number of improvements that could be made to the regulatory system
which would minimise the potential environmental impacts and we urge Government
and its regulators to put these into practice. However, even if these measures are
implemented, our view of the current evidence base suggests that shale gas
exploitation is not compatible with UK emissions reduction targets and wider
commitments to tackling climate change.

We are deeply concerned about the impact that fracking could have on the species
and habitats of Sussex.
THU RSDAY, SEPTEM BER 29, 2016 0 COM M ENTS

Nick Grealy
from ReimagineGas

Would 'fracking', the nasty sounding word for what is in reality a mundane process of
onshore natural gas extraction, lock us 'into an energy infrastructure that is based on fossil
fuels long after our country needs to have moved to renewables' as Barry Gardiner MP told
the Labour Party conference[…]?

It need not. It should not. It cannot. It must not. 'Fracking' and renewable energy isn't an
either/or choice. It's both - and many another besides.

Energy is not electricity. Many technologies can produce not only the light we need to shed
on the UK climate debate, but also the heat, industry, mobility and connectivity upon which
we all depend. Natural gas, the lowest carbon fossil fuel has led not to damage, (or at least
little any US tort attorneys have discovered) or an increase in CO2 emissions. Shale gas
makes up 70% of US production, passing the 'unconventional' stage long ago and is the new
normal in natural gas. Gas cut CO2 and empowered wind and solar power in the US as the
coal to gas switch accelerates. It clearly need not lock out wind: Texas produces 40% of its
electricity from wind, double the UK share. It doesn't compete or replace solar technology as
drops in price worldwide accelerate. The COP21 Paris climate treaty was made possible by
the all of the above (except coal) energy strategy proposed first by President Obama and
Hillary Clinton and then jointly with China. The foundation was the extensive, ubiquitous and
lower carbon resources uncovered by the shale revolution.

COP21 arose because the vast majority of climate scientists don't make Barry Gardiner's, or
the Friends of the Earth's, mistake of making a perfect future the enemy of the present good.
Natural gas isn't perfect. It isn't the only solution. But the shale revolution, founded not only
on fracking but also with horizontal drilling and thus an extremely low surface impact shows
the nearest gas is the best gas.
2.2 Questions

You are the Finance Director of Horizon, Clara Jones. You have been asked to
analyse the financial performance and position of the company and produce a
Board report which sets out your findings (based on the questions below) and
makes a recommendation as to whether Horizon should buy Naxol Limited..

1. Purpose and key features of Horizon’s Financial Statements (22)

The table below is relevant to question 1a

The Board has heard the following descriptions discussed in board meetings during
2015 and are interested to know how they have been treated in Horizon’s financial
statements.

Description 1 During the year Horizon received and paid an Invoice for
£50,000 from their legal advisors for drafting contracts
agreed with energy producers in the period July-September
2015.
Description 2 Horizon paid £20,000 to the patent office in March 2015 to
register the design of a new piece of exploration equipment.
The registration allows Horizon exclusive use of the
equipment for 25 years.

Description 3 Horizon received a supplier statement from a subcontractor

who provides ships to undertake Seismic Surveys around South
America. The statement indicates that Horizon owe the
subcontractor £90,000 as at 31 December 2015.

Description 4 Horizon paid £40,000 in interest charges to HSBC on bank

loans which are due to be repaid in 2025.

a. For Horizon, consider the FOUR descriptions above and for each of them:
i. Choose whether the description relates to a transaction in the
Statement of Profit or Loss and Other Comprehensive Income
(SPLOCI) or balance in the Statement of Financial Position
(SOFP).
(4)
ii. Explain where the transactions would be specifically allocated in
the Statement identified in 1a(i) above.

(8)
b “Where we charge depreciation to reflect the use of tangible Non-Current Assets,
amortisation is the equivalent of this for intangible Non-Current Assets.”

i. Describe ONE key difference between tangible and intangible Non-

Current Assets
(2)
ii. Using the criteria from the conceptual framework for recognising an
asset, explain why Horizon’s expenditure of £150,000 on patents meet
these criteria and is therefore recognised as an asset.
(8)

2.Interpretation of the Statement of Profit or Loss (SPLOCI) (32)

a. The board’s review of the 2015 SPLOCI has led to some confusion, raising the
question of “How has a decrease in our revenue between 2014 and 2015
resulted in our gross profits increasing during the same period?”

Using the segment analysis in Exhibit 2:

i. Calculate the gross margin ratio for each division in 2014 and 2015;
(5)
ii. Apply a trend analysis to ascertain the movement in total revenue
between 2014 and 2015;
(2)
iii. Apply a trend analysis to ascertain the movement in both Gas
and Oil exploration revenue between 2014 and 2015; and
(4)

iv. Using the information calculated above along with information from the
case study give ONE reason as to why Horizon’s revenue has
decreased and ONE reason as to why gross profit has increased.
(6)

b. Use the case study information to analyse and comment on THREE

movements in Horizon’s SPLOCI (financial performance) in Exhibit One
during the year 2015 compared to 2014.

EXCLUDE Revenue, Cost of Sales and Gross Profit from your selection
(covered in part a above).

Use the additional financial information in Exhibit 2 and the relevant ratios
shown in Exhibit 3 to enhance the quality of your analysis.

For each item you select to analyse and comment upon

i. Ensure you use an appropriate financial technique (Ratio, Trend

analysis) to ascertain the movement between 2015 compared to
2014;
(3)
 ii. Reflect and comment upon whether the movement is a
positive or negative indicator of financial performance; and
(3)
iii. Use the case study to identify and explain at least ONE reason why
each movement analysed in part 3b(i) has happened.
(9)

3.Interpretation of the Statement of Financial Position (25)

a. Use the case study information to analyse and comment on TWO

movements in Horizon’s Statement of Financial Position (financial condition)
in Exhibit 1 during the year 2015 compared to 2014.

Use the information in Exhibit 2, and the relevant ratios shown in Exhibit 3 to
enhance the quality of your analysis.

For each item you select to analyse and comment upon

i. Ensure you use an appropriate financial technique (Ratio, Trend
analysis) to ascertain the movement between 2015 compared to
2014;
(2)
ii. Reflect and comment upon whether the movement could have a
positive or negative impact on Horizon’s financial condition (which
could cover Liquidity, Solvency or Efficiency) ; and
(4)
iii. Use the case study to identify and explain at least ONE reason why
each movement analysed in part 3a(i) has happened.
(6)

b. Using Naxol Ltd’s financial statements set out in Exhibit 5:

i. Calculate the following ratios:

 Return on Capital Employed (ROCE)

 Gross profit margin
 Operating profit margin
 Current ratio
 Interest Cover
 Gearing ratio
(6)
ii. Compare your calculations in 3b(i) with the criteria set out in Exhibit
4 and recommend whether Horizon should buy Naxol Limited.
(7)
4. Interpretation of the Cash Flow statement (16)

In reviewing the 2015 financial statements a member of the board commented that:

“Since deciding to review our cash position in 2014 it is good to see our
Statement of Cash Flows shows we have made a significant improvement in
2015.”

i. Identify the SPECIFIC part of the Statement of Cash flow which indicates
Horizon’s cash position has significantly improved.
(2)
ii. Reviewing the Operating Activities section of the Cash Flow
Statement, identify ONE figure that has been taken directly or been
derived from the SPLOCI, and ONE figure that has been taken
directly or been derived from the SOFP.
(4)
iii. Explain, using the information in the case study and the ratios in
Exhibit 3, how the company has been able to ‘improve its working
capital’ (receivables and payables) to improve its cash flow.
(6)
iv. Identify TWO other reasons for the improved cash flow from the
statement of cash flows.
(4)

5. Professional report format (5)

Make sure your answers are in the format of a professional business report.

(5)

TOTAL: 100

The report should be no longer than 1500 words (excluding tables, diagrams,
bibliography, appendices and headings), a suggested format in which to incorporate
your answer is set out below.
 Suggested report format

To: The Board of Horizon Ltd

From: Clara Jones, Finance Director.

Date: Assessment Day

Title: To complete

Introduction: To complete

Executive summary: To complete

Main Report:

Include Subsections/Paragraphs etc for each of the 4 main areas listed

below

Part one - Purpose and key features of Horizon’s financial

statements

Part two - Interpretation of the Statement of Profit or Loss

Part three – Interpretation of the Statement of Financial Position

Part four - Interpretation of the Statement of Cash Flows

Part five – Analysis of the potential purchase of Naxol Ltd.

Guidance
The following table shows the allocation and the approach required.

Task Part Approach

Q1 Features of Horizon’s 22 A good knowledge of the content from weeks

Financial Statements 1-4 will help with part a.

You will also require the ability to apply the

conceptual framework to a particular
balance/transaction.
Q2 Interpreting the 32 There are a lot of requirements in this
SPLOCI section, so it is important to approach them
systematically and ensure you cover ALL the
requirements.

The content from weeks 1, 7 and 8 will help

with this question.

You will need to be comfortable with the

following to answer the questions in this
section

 Calculating trends and ratios using

financial data
 Reviewing case study narrative to
identify why movements in figures
have occurred
 An understanding that some
movements in numbers are explained
by other numbers
 An understanding of how gross profit
interacts with revenue and cost of
sales, and that net profit is the profit
after deduction of all the costs.

Q3 Interpreting the SOFP 25 As above, there are a lot of requirements in

this section, so it is important to approach
them systematically and ensure you cover
ALL the requirements.

The content from weeks 2,3,7 and 8 will help

with this question.

In part b) you will be comparing results of

ratios with criteria to determine whether
Horizon should take over Naxol. This is one
of the main uses for the interpretation of
Financial statements. Remember to use
Naxol’s accounts here, not Horizon’s!
Q4 Interpreting the SOCF 16 The content from week 6 will help with this
question. You will need to be able to link the
financial statements by identifying a figure
from the SPLOCI and the SOFP (or derived
from those figures) which is shown in the
SOCF.

This section also calls on your understanding

of the working capital (efficiency) ratios, to
explain how the company has improved its
cash flow by improving its working capital.

Q5 Professional report 5 See section 2.3 above for approach.

Since this is a business report, you should

include a recommendation in your executive
summary as to whether Horizon should
acquire Naxol ltd.

Total 100