FINANCIAL MANAGEMENT

Cost Classification
Total product/ service
The total cost of making a product or providing a service consists of the following.
 Cost of materials
 Cost of the wages and salaries (labour costs)
 Cost of other expenses
(i) Rent and rates
(ii) Electricity and gas bills
(iii) Depreciation

Direct cost and indirect cost

 A direct cost is a cost that can be traced in full to the product, service or department that is being costed.
 An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service or
department.

Functional
Classification by function involves classifying costs as production/manufacturing costs, administration costs or
marketing/selling and distribution costs.

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Cost Behavior
Cost behavior pattern
 A Fixed cost is a cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
 A variable cost is a cost which tends to vary with the level of activity.
 A step cost is a cost which is fixed in nature but only within certain levels of activity.
 A semi-variable/semi-fixed/mixed cost is a cost which contains both fixed and variable components and
so is partly affected by changes in the level of activity.

Examples of fixed and variable costs

(a) Direct material costs (costs of materials consumed in the manufacturing process) are variable costs because
they rise as more units of a product are manufactured.
(b) Sale commission is often a fixed percentage of sales turnover, and so is a variable cost that varies with the
level of sales.
(c) Telephone call charges are likely to increase if the volume of business expands, but there is also a fixed
element of line rental, and so they are a semi- variable overhead cost.
(d) The rental cost of business premises is a constant amount, at least within a stated time period and so it is a
fixed cost.
(e) The salary paid to a factory supervisor might be considered a step- fixed cost. For example the factory may
be able to produce up to 20,000 products units with one supervisor, but needs a second supervisor once this
level of activity is exceeded.

Example: The high-low method

DG Co has recorded the following total costs during the last five years.
Year Output volume Total cost
Units $
20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000

Required
Calculate the total cost that should be expected in 20X5 if output is 85,000 units.

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Exercise Question
Question – 1
A company has recorded the following data in the two most recent periods.
Total costs of production Volume of production
$ Units
13,500 700
18,300 1,100

What is the best estimate of the company’s fixed costs per period?

Question – 2
The total cost of production for two levels of activity is as follows:
Level 1 Level 2
Production (units) 3,000 5,000
Totals cost ($) 6,750 9,250

The variable production cost per unit and the total fixed production cost both remain constant in the range of
activity shown.
What is the variable cost per unit of the product?

Question -3
The following data relate to the overhead expenditure of a contract cleaner at two activity levels.
Square metres cleansed 13,500 15,950

Overheads $84,865 $97,850

What is the estimate of the overheads if 18,300 square metres are to be cleaned?

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Marginal costing
Marginal cost is the variable cost of one unit of product or service.
The marginal production cost per unit of an item usually consists of the following.
 Direct material
 Direct labour
 Variable production overheads

Example -1
ABC is a business manufacturing men’s suits. The information relating to
December’s production was as follows:
- Direct materials $27.50 per suit.
- Direct labour was paid $7.00 per hour.
- Overheads were $17 100 per month plus $2.50 per suit produced.
Each suit took an average of 2 hours 15 minutes to produce.
Each suit was sold for $95.00
In December, 1 200 suits were produced and 960 were sold.
Calculate the:
(i) marginal cost of producing one suit
(ii) absorption cost of producing one suit.

Example -2
Rain until September Co makes a product, the Splash, which has a variable production cost of $6 per unit and a
sales price of $10 per unit. At the beginning of September 20X0, there were no opening inventories and
production during the month was 20,000 units. Fixed costs for the month were $ 45,000 (production,
administration, sales and distribution). There were no variable marketing costs.
Required
Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales were as
follows.
(a) 10,000 units
(b) 15,000 units
(c) 20,000 units

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Exercise question
Question -1
Davy Crockett Co makes hats, mainly for fancy dress costumes. The company expected to produce 25,000 hats
during the year which would be expected to incur $125,000 in fixed costs. The total cot of each hat is $30
(including fixed costs) and the company can sell them for $40 each. Sales during the year were 15,000 hats from
a production volume of 20,000. Actual fixed costs were $80,000 and there was no opening inventory.

What is the marginal costing net profit for the year?

Question -2
Cost and selling price details for product Z are as follows.
$ per unit
Direct materials 6
Direct labour 7.5
Variable overhead 2.5
Fixed overhead absorption rate 5
21
Profit 9
Selling price 30

Budgeted production for the month was 5,000 units although the company managed to produce 5,800 units,
selling 5,200 of them and incurring fixed overhead costs of $27,400.
What is the marginal costing profit for the month?

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Long term Decision; Method of Investment Appraisal

Example – 1
XYZ company is considering two alternative investment projects, both of which require the purchase of new
equipment.
The following information relates to the two projects.
Project Aye Project Bee
Duration 4 years 3 years
Purchase cost of equipment – Year 0 $500,000 $330,000

Estimated annual net cash inflows:

Year 1 $160,000 $140,000
Year 2 $160,000 $140,000
Year 3 $160,000 $140,000
Year 4 $140,000 NIL
Estimated disposal value of equipment $60,000 $40,000

Cost of capital is 10% per annum.

Discount factors:
Year 10% 20%
1 0.909 0.833
2 0.826 0.694
3 0.751 0.579
4 0.683 0.482

Required:
(a) The payback periods
(b) Net present value
(c) Internal rate of return

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Example – 2
ABC company is considering two alternative investment projects both of which require the purchase of new
equipment with a lifespan of four years.
The following information relates to the two projects:
Project Aye Project Bee
$000 $000
Purchase cost of equipment - Year 0 600 720
Estimated accounting profits:
Year 1 50 60
Year 2 125 150
Year 3 90 108
Year 4 30 36
Estimated disposal value of equipment 80 96

The company’s depreciation policy is to write off the cost of equipment using the straight-line method.
Cost of capital is 15% per annum.
Discount factors: Year 15% 20%
1 0.870 0.833
2 0.756 0.694
3 0.658 0.579
4 0.572 0.482

Required;
(a) Calculate for both Project Aye and Project Bee:
(i) The payback period
(ii) The net present value
(iii) The internal rate of return.
(b) Recommend which project should be undertaken, giving reasons for your decision.

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Exercise Question
Question -1
A company is considering investing $320,000 in a project which will generate the following cash inflows.
Year cash flow

1 $73,400
2 $282,000
3 $37,900

Discount factor 17%

Year 1 0.855

Year 2 1.585

Year 3 2.210

What is the net present value of the projects’ cash flows at a cost of capital of 17 % .

Question -2
A project requiring an investment of $1,200 is expected to generated to generate returns of $400 in years 1 and
2 and $350 in years 3 and 4. If the NPV = $22 at 9% and the NPV = -$4 at 10%, what is the IRR for the project?

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Budget
Question -1
Budgeted sales of X for December are 18,000 units. Opening inventories of X for December are budgeted to be
15,000 units and closing inventories will be 11,400 units. All inventories of finished goods must have successfully
passed the quality control check.
What is the production budget for X for December?

Question -2
Budgeted sales of X for December are 18,000 units. At the end of the production process for X, 10% of
production units are scrapped as defective. Opening inventories of X for December are budgeted to be 15,000
units and closing inventories will be 11,400 units. All inventories of finished goods must have successfully
passed the quality control check.
What is the production budget for X for December?

Question 3
Each unit of product Alpha requires 3 kg of raw material. Next month’s production budget for product Alpha is as
follows.
Opening inventories:

Raw material 15,000kg

Finished units of Alpha 2,000 units

Budgeted sales of Alpha 60,000 units

Planned closing inventories:

Raw materials 7,000 kg

Finished units of Alpha 3,000 units

How many kilograms of raw materials should be purchased next month?

Question -4
Budgeted production in a factory for next period is 4,800 units. Each unit requires five hours to make. Labour is
paid $10 per hour.
What is the budgeted total labour cost for the next period?

Question -5
Budgeted production in a factory for next period is 4,800 units. Each unit requires five hours to make. Labour is
paid $10 per hour. Idel time represents 20% of the total labour time.
What is the budgeted total labour cost for the next period?

Question -6
Catherine Aragon is planning the cash flow of her business for the three months
January to March 2018 and the following information is available.
 The business will have an opening balance of $1 500 on 1 January 2018.

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 Sales and purchases will be as follows:

November December January February March
$ $ $ $ $
Sales 24,000 26,000 28,000 29,000 27,000
Purchases 11,000 11,600 12,100 12,500 11,900

 40% of the sales income will be received in the month following the sale and 57% will be received two months
after the sale. The remainder will be written off as an irrecoverable debt.
 Purchases will be on one month’s credit.
 Wages and salaries will be $2,450 per month, payable in the month in which they are incurred.
 Drawings of $1 800 will be taken each month.
 Heat, light and power will be $320 per month and paid quarterly in February, May, August and November.
 Other costs will be $2,200 plus 4% of sales per month, payable in the month they are incurred.
 Bank interest of 2% per month will be charged on the closing bank balance of the previous month if it is an
overdraft.
 A delivery van costing $16,400 will be bought and paid for in January.
 The business has other non-current assets that had cost $150,000 in September 2014, which are expected to
have a residual value of $15,000 at the end of their 5-year useful life.
Required
Prepare the Cash Budget for each of the three months January to March 2018. The budget should be in
columnar format and all calculations made to the nearest $.

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Sources of finance

Short-term sources of finance

A range of short-term sources of finance are available to businesses including overdrafts, short-term loans, trade
credit and operating lease finance

Overdrafts
Where payments from a current account exceed income to the account for a temporary period, the bank may
agree to finance a deficit balance on the account by means of an overdraft. Overdrafts are the most important
source of short-term finance available to businesses. They can be arranged relatively quickly and offer a level of
flexibility with regard to the amount borrowed at any time, while interest is only paid when the account is
overdrawn.

Short-term loans
A term loan is a loan for a fixed amount for a specified period, usually from a bank. The loan may have a specific
purpose, such as the purchase of an asset. It is drawn in full at the beginning of the loan period and repaid at a
specified time or in defined instalments. Term loans are offered with a variety of repayment schedules. Often, the
interest and capital repayments are predetermined.
The bank establishes a separate loan account for the loan, charging interest to the account and setting off loan
payments against the balance on the account.

Trade credit
Trade credit is a major source of short-term finance for a business. Current assets such as raw materials may be
purchased on credit, with payment terms normally varying from between 30 and 90 days. Trade credit therefore
represents an interest-free short-term loan. In a period of high inflation, purchasing via trade credit will be very
helpful in keeping costs down. However, it is important to take into account the loss of discounts suppliers offer
for early payment.
Unacceptable delays in payment will worsen a company's credit rating and additional credit may become difficult
to obtain.

Leasing
Rather than buying an asset outright, using either available cash resources or borrowed funds, a business may
lease an asset. Leasing is a popular source of finance.
Leasing can be defined as a contract between lessor and lessee for hire of a specific asset selected from a
manufacturer or vendor of such assets by the lessee.
The lessor retains ownership of the asset. The lessee has possession and use of the asset on payment of
specified rentals over a period.
Operating leases are in effect a short-term source of finance for non-current assets, and finance leases are a
long-term source of finance. This is because the lessor purchases the asset and the lessee can use it without
having to incur the initial cost immediately.
Many lessors are financial intermediaries, such as banks and insurance companies. The range of assets leased
is wide, including office equipment and computers, cars and commercial vehicles, aircraft, ships and buildings
Sale and leaseback
A company which owns its own premises can obtain finance by selling the property to an insurance company or
pension fund for immediate cash and renting it back, usually for at least 50 years with rent reviews every few
years.

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Long – term sources of finance

A range of long-term sources of finance are available to businesses including debt finance, leasing, venture
capital and equity finance
Long-term finance is used for major investments and is usually more expensive and less flexible than short-term
finance

Reasons for seeking debt finance

Sometimes businesses may need long-term funds, but may not wish to issue equity capital. Perhaps the current
shareholders will be unwilling to contribute additional capital; possibly the company does not wish to involve
outside shareholders who will have more onerous requirements than current members.
Other reasons for choosing debt finance may include lesser cost and easier availability, particularly if the
company has little or no existing debt finance. Debt finance provides tax relief on interest payments.

Deep discount bonds

Deep discount bonds are bonds or loan notes issued at a price which is at a large discount to the nominal value
of the notes, and which will be redeemable at nominal value (or above nominal value) when they eventually
mature.

Zero coupon bonds

Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on
them.

Convertible
Convertible bonds are bonds that give the holder the right to convert to other securities, normally ordinary
shares, at a predetermined price/rate and time.

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Company account
Question
The trial balance extracted from the books of Tailor Times Ltd at 31December 20X2 was as follows:
$ $
Share capital 200,000
Retained profits 31 December 20X1 27,500
Freehold premises at cost 271,000
Provision for depreciation on freehold premises at 31 December 20X1 54,000
Machinery at cost 84,000
Provision for depreciation on machinery account as at 31 December 20X1 21,000
Purchases 563,700
Sales 925,300
General expenses 14,600
Wages and salaries 179,400
Business rates 6,100
Electricity 4,800
Irrecoverable debts 1,400
Allowance for doubtful debts at 31 December 20X1 1,200
Trade receivables 74,200
Trade payables 68,300
Inventory at 31 December 20X1 81,900
Bank balance 16,200
1,297,300 1,297,300

You are given the following additional information:

(i) The authorized and issued share capital is divided into 400,000 ordinary shares of 50c each
(ii) Inventory at 31 December 20X2, $94,300
(iii) Wages and salaries due at 31 December 20X2 amounted to $1,800
(iv) Business rates paid in advance at 31 December 20X2 amounted to $700.
(v) A dividend of $20,000 is proposed for 20X2.
(vi) The allowance for doubtful debts is to be increased to $1,500
(vii) A depreciation charge is to be made on freehold premises of $25,000 and machinery at the rate of 25 per
cent annum on cost.
Required
An income statement for 20X2 and a statement of financial position as at 31 December 20X2

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Bonus (capitalization) issues

A company may wish to increase its share capital without wishing to raise additional finance by issuing new
shares.
Advantages
 Increases capital without diluting current shareholders' holdings
 Capitalizes reserves, so they cannot be paid as dividends

Disadvantages
 Does not raise any cash
 Could jeopardize payment of future dividends if profits fall

Question
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3 (EXTRACT)
$
Share capital(50c) 10,000
Share premium 7,000
Retained earning 8,000
25,000
Clarke Fringland Co has decided on a bonus issue of shares of 1 for 4 and will use the share premium account
for this purpose.

Required
What is the double entry to record the bonus issue of shares and what is the adjusted financial position extract
after the bonus issue?
Rights issues
A rights issue (unlike a bonus issue) is an issue of shares for cash. The 'rights' are offered to existing
shareholders, who can sell them if they wish. This is beneficial for existing shareholders in that the shares are
usually issued at a discount to the current market price.
Advantages
 Raises cash for the company
 Keeps reserves available for future dividends

Disadvantage
Dilutes shareholders' holdings if they do not take up rights issue

Question
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3 (EXTRACT)
$
Share capital (50c) 8,000
Share premium 7,000
Retained earnings 10,000
25,000
Clarke Fringland Co decides on a rights issue of 1 for 4 at $1.20
Required
What is the double entry to record the issue of shares and what is the adjusted financial position extract after the
issue?

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Ratio Analysis
Example:
To illustrate the calculation of ratios, the following statement of financial position and statement of profit or loss
figures will be used.
FURLONG CO STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8
Notes 20X8 20X7
$ $
Revenue 1 3,095,576 1,909,051
Operating profit 1 359,501 244,229
Interest 2 17,371 19,127
Profit before tax 342,130 225,102
Income tax 74,200 31,272
Profit for the year 267,930 193,830

FURLONG CO STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8

Note 20X8 20X7
$ $ $ $
Assets
Non-current asset
Tangible non-current assets 802,180 656,071
Current assets
Inventories 64,422 86,550
Receivables 3 1,002,701 853,441
Cash at bank and in hand 1,327 68,363
1,068,450 1,008,354
Total assets 1,870,630 1,664,425

Equity and liabilities

Equity
Ordinary share 10c each 5 210,000 210,000
Share premium account 48,178 48,178
Retained earnings 630,721 393,791
888,899 651,969
Non-current liabilities
10% loan notes 20X4/20X9 100,000 100,000
Current liabilities 4 881,731 912,456
Total Equity and liabilities 1,870,630 1,664,425

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NOTES TO THE ACCOUNTS

20X8 20X7
$ $
1 Sales revenue and profit
Sales revenue 3,095,576 1,909,051
Cost of sales 2,402,609 1,441,950
Gross profit 692,967 467,101
Administration expenses 333,466 222,872
Operating profit 359,501 244,229

Depreciation charged 151,107 120,147

2 Interest
Payable on bank overdrafts and other loans 8,115 11,909
Payable on loan notes 10,000 10,000
18,115 21,909
Receivable on short-term deposits 744 2,782
Net payable 17,371 19,127
3 Receivables
Amounts falling due within one year
Trade receivables 884,559 760,252
Prepayments and accrued income 97,022 45,729
981,581 805,981
Amounts falling due after more than one year
Trade receivables 21,120 47,460
Total receivables 1,002,701 853,441
4 Current liabilities
Trade payables 627,018 627,018
Accruals and deferred income 81,279 81,279
Income taxes 108,000 108,000
Other taxes 65,434 65,434
881,731 912,456
5 Share capital
Authorised ordinary shares of 10c each 1,000,000 1,000,000
Issued and fully paid ordinary shares of 10c each 210,000 210,00

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Return on capital employed (ROCE)

Profitability ratios include:
 Return on capital employed
 Net profit as a percentage of sales
 Asset turnover ratio
 Gross profit as a percentage of sales

Capital employed = 20X8: $1,870,630 – $881,731 = $988,899

20X7: $1,664,425 – $912,456 = $751,969

Return on equity (ROE)

Return on equity (ROE) gives a more restricted view of capital than ROCE, but it is based on the same
principles.

ROE =

Note

Gross profit margin, net profit margin and profit analysis

Depending on the format of the statement of profit or loss, you may be able to calculate the gross profit margin
as well as the net profit margin. Looking at the two together can be quite informative.

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For example, suppose that a company has the following summarised statements of profit or loss for two
consecutive years.
Year 1 Year 2
$ $
Revenue 70,000 100,000
Cost of sales 42,000 55,000
Gross profit 28,000 45,000
Expenses 21,000 35,000
Profit for the year 7,000 10,000

Although the net profit margin is the same for both years at 10%, the gross profit margin is not.

In Year 1 it is: = = 40%

and in Year 2 it is: = = 45%

The improved gross profit margin has not led to an improvement in the net profit margin. This is because
expenses as a percentage of sales have risen from 30% in Year 1 to 35% in Year 2.

Liquidity, gearing/leverage and working capital

Liquidity and working capital ratios include:
 Current ratio
 Quick ratio
 Receivables collection period
 Payables payment period
 Inventory turnover period

Debt and gearing/leverage ratios include:

 Debt ratios
 Gearing ratio/leverage
 Interest cover

Long-term solvency: debt and gearing ratios

Debt ratio
The debt ratio is the ratio of a company's total debts to its total assets.

Debt ratio =

(a) Assets consist of non-current assets at their statement of financial position value, plus current assets.
(b) Debts consist of all payables, whether they are due within one year or after more than one year.

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Gearing / leverage
Gearing or leverage is concerned with a company's long-term capital structure.
These assets must be financed by long-term capital of the company, which is either:
(a) Shareholders' equity
(b) Long-term debt

Gearing = 100%

Leverage = 100%

(or) 100%

Interest cover
The interest cover ratio shows whether a company is earning enough PBIT to pay its interest costs comfortably,
or whether its interest costs are high in relation to the size of its profits, so that a fall in
PBIT would then have a significant effect on profits available for ordinary shareholders.

Interest cover =

Question
Returning to the example of Furlong above, what is the company's interest cover?
Ans:
Interest payments should be taken gross, from the note to the accounts, and not net of interest receipts
as shown in the statement of profit or loss.
20X8 20X7
=
= 20 times = 11 times
Furlong has more than sufficient interest cover. In view of the company's low gearing, this is not too surprising
and so we finally obtain a picture of Furlong as a company that does not seem to have a debt problem, in spite of
its high (although declining) debt ratio.

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Liquidity ratios: current ratio and quick ratio

The 'standard' test of liquidity is the current ratio. It can be obtained from the statement of financial position.

Efficiency ratios: control of receivables and inventories

A rough measure of the average length of time it takes for a company's customers to pay what they owe is the
accounts receivable collection period.

Payable payment period

Accounts payable payment period is ideally calculated by the formula:

365

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Question
Calculate liquidity and working capital ratios from the accounts of the TEB Co, a business which provides service
support (cleaning etc) for customers worldwide. Comment on the results of your calculations.
20X7 20X6
$m $m
Revenue 2,176.2 2,344.8
Cost of sales 1,659.0 1,731.5
Gross profit 517.2 613.3
Current assets
Inventories 42.7 78.0
Receivables (Note 1) 378.9 431.4
Short-term deposits and cash 205.2 145.0
626.8 654.4
Current liabilities
Loans and overdrafts 32.4 81.1
Tax on profits 67.8 76.7
Dividend 11.7 17.2
Payables (Note 2) 487.2 467.2
599.1 642.2
Net current assets 27.7 12.2

Notes
1 Trade receivables 295.2 335.5
2 Trade payables 190.8 188.1

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