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TOPIC 5: FINANCIAL INFORMATION AND FINANCIAL DECISIONS

The finance manager is the person who is responsible for the money side of the organization. The duties
include:

(a) Sourcing finance

(b) Recording transactions
(c) Preparing financial statements for internal and external use

5.1 BUSINESS FINANCE: needs and sources

5.1.1 The need for business finance:

Reasons why Businesses need finance

 start-up / start a business venture

 cash flow problems / survive (BOD)
 pay creditors
 offer credit to customers
 fund expansion
 replace machinery / investment
 working capital/ day-to-day
 pay for advertising (promotion)

 start – up capital
 start – up capital is the finance needed by a new business to pay for essential non-
current and current assets before it can begin trading
 e.g. buildings, equipment, inventory/raw materials
 if these are available, the business can be launched
 additional/increasing working capital
 working capital is the finance/money needed by the business to pay for its day – to –
day costs
 examples of costs are: wages, raw materials, electricity bills etc.
 To expand operations by buying non-current assets (capital for expansion)/expand the existing
business
 so, additional non-current assets, e.g. buildings and machinery can be bought
 and or another business can be bought through a takeover
 To invest in new products or in research and development
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 so, the business can reach new markets

 it is another way of growth
 BUT, a lot of R&D finance is needed, hence, it is very costly
IMPORTANT DEFINATIONS:
 Capital expenditure is money spent on non-current assets such as buildings and will last for
more than one year.
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 Revenue expenditure is money spend on day-to-day expenses, e.g. wages or rent

5.1.2 The main sources of capital - Sources of finance

The business can make use of internal or external, short term or long term sources of finance.

 An internal source means that the business will be using its own resources e.g. selling old assets
or running down inventory (selling stock).
 External sources means the funds are obtained from outside sources for example loans, hire
purchase and leasing.
 Short term sources are funds that must be repaid in less than one year, for example short term
bank loans and overdrafts.
 Long term sources means they have to be repaid in more than one year, for example long term
loans, ordinary shares.

Retained profits/ploughed back profits (Long-term)

Internal Sale of fixed (non-current) assets (Short-term)

Sale of inventories (Short-term)

Long-term -Long-term bank loans

-Debentures
SOURCES OF FINANCE -Sale of shares (rights issue or
preference or ordinary shares)
- Grants and subsidies

External -Leasing services

-Hire purchase

Short-term -Bank overdraft

-Debt factoring
-Trade credit
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-Short-term loan

INTERNAL SOURCES

1. Retained Profits/ploughed back profits

 this is profits kept in the business after the owners have taken their share of the profits
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Advantages
 do not have to be repaid, unlike a loan
 no interest to pay – since capital is raised from within the business, so expenses
will not increase much
 avoid the need to sell furthers shares, so existing shareholders can retain
control
 it is a permanent source of capital, so it can be used for long- term projects e.g.
expansion
Disadvantages
 a new business will not have any retained profits
 small firms may have too low retained profits to finance growth
 keeping more profits reduces payments to owners e.g. dividends, so this source
may not be popular with shareholders/ It may cause conflicts with shareholders
because they may be forced to forego dividends
 there is a sacrifice for the reinvested profits, since interest on money that could
be invested in the bank account is lost
 it takes time to raise adequate profit reserves, since the business have to wait at
least for the whole financial year

Sale of existing non-current/idle assets

 e.g. redundant buildings or surplus equipment

Advantages
 there is better use of capital tied up in a business, so the business may become
more efficient
 it does not increase the debts of the business, so gearing in not increased
 do not have to borrow any money;
 no interest is paid; .
Disadvantages

 may not raise enough money

 assets may be required in future
 it may take time to find buyers of the asset, so the finance may not be available
in the short -term
 new businesses may not have the surplus/spare assets to sell, so they may have
to find other sources
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 it reduces collateral security for the business, so it becomes difficult to get loans
in future
 loses potential revenue from assets, since the business lose access to
sold assets

Sale of inventories
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Advantages

 it releases cash tied up in inventory, so the business may become more efficient
 it reduces storage costs of high inventories – so, profits may rise
Disadvantages
 it may lead to failure to meet customer demand if inventories left are not
enough

Owner’s savings

 a sole trader or a member of the partnership can put own savings into the business
Advantages
 it should be available to the firm quickly
 no interest is paid
Disadvantages
 savings may be too low
 it increases the risk taken by the owners
EXTERNAL SOURCES
Issue of shares
 the source is only available to limited companies
 A business can invite general public to bring in capital in exchange of share certificates.
 People will become shareholders and will have a right to vote or participate in decision
making.
 Shareholders get dividends depending on the profits made

Advantages (CIE – s10 12, Q2c)

 does not have to be repaid /it is a permanent source of capital, so the
business can use the money to finance long term projects.
 no interest has to be paid
 Large amounts of capital can be raised. This will enable the business to finance
projects that require a lot of money.
 Dividends are fluctuating. This means the business will not have a fixed
obligation as compared to loan interest which must be paid even if losses are
reported.
 does not carry any interest charges/cheaper
 does not require assets to be offered as collateral security
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 less financially risky.

Disadvantages
 dividends are paid after tax, whereas interest on loans is paid before tax is
deducted
 dividends will be expected by shareholders
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 control is diluted so the ownership of the company could change hands if many
shares are sold
 Issuing shares is expensive and time consuming, so small businesses can not use
this method to raise finance

Bank Loans –Short – term or long-term

 It is a sum of money obtained from a bank, which must be repaid and on which interest is
payable.
 OR is the amount of money provided to a business for a stated purpose in return for a payment
in the form of interest charges
 Before being granted a loan the business will have to answer a number of questions which
include:
(1) How much is required and for what purpose?
(2) How was your profitability in the past years?
(3) What assets do you have as collateral security?
(4) Where is your business located?
(5) What is going to be the repayment period?
(6) What products do you sell?

The business may be required to submit a business plan or proposal and financial statements from the
past.

Benefits of loans

 Ownership and control is not diluted. This means the owners will continue to enjoy total control
over the business and decisions will be made quickly.
 Loan interest is fixed which makes planning easy. This will also benefit the owner in times of
high profits because more dividends will be received.
 Large amounts can be sourced. This will help the business to finance long term projects like
factory expansion.
 Loans are usually quick to arrange
 can be of varying lengths of time

Disadvantages

 A loan will have to be repaid eventually

 Loan interest is an expense. This means the profit available to the owners will be reduced.
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 Loan providers can force the business to close if it fails to repay the borrowed amount. This
means a loan is a risk source of finance.
 collateral security is required, so loans may not be available to new start ups because they will
be having no collateral security.

Distinguish between loans and ordinary shares

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Long –term Loans/Debentures Ordinary shares

 Loan providers expect loan interest
 Loans have to be repaid
 Loans require collateral security
 Interest is fixed
 They represent creditors of the business
 Loan providers do not have voting rights
 Loans are repaid first in the event of
liquidation
 Shareholders expect dividends
 They may not be repaid
 No collateral security is required
 Dividends fluctuate
 They represent the owners of the business
 Shareholders have voting rights
 Ordinary share capital is the last to be
repaid in the event of liquidation

Selling Debentures

Debentures are long term certificates issued by limited companies

Advantages

 Can be used to raise very long term finance, e.g. 25 years

Disadvantages
 as with loans, interest is charged
 they must be repaid, unless if they are convertible debentures

Debt Factoring

Debt factors are specialist institutions that ‘buy’ the claims on debtors of firms for immediate cash.

Advantages

 immediate cash is made available to the business

 the risk of bad debts is transferred to the debt factor
 can be used by businesses with little power to negotiate favorable trade credit terms

Disadvantages

 the firms do not receive a 100% of the value of its debts

 the way debt is collected may damage the reputation of the business in the market
 may not be viable for firms making little profits since there is a sacrifice on profit margin

Grants and subsidies

 A government grant is a sum of money given to entrepreneurs for a specific purpose.

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Advantages

 usually they do not have to be re-paid, as long as they meet conditions of the grant
 ideal for start-up or expansion, so set-up/expansion costs are reduced

Disadvantages
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 they are often given with ‘strings attached’, e.g. the firm must locate in a particular area
 not available to any business, accept for those meeting the requirements

Micro-financing

 It refers to providing financial services – including loans - to poor people not served by
traditional banks.
 OR, provision of financial services for poor and low-income clients
 small amounts of capital loaned to entrepreneurs [1] in countries where finance is
difficult to obtain [+ 1]
 OR small loans [1] to people not traditionally served by banks [1]
 OR loan to poor people [1] not traditionally served by banks [1]

Importance to developing countries

Advantages

 the size of the loans provided are required by poor entrepreneurs, which a bank cannot loan at
a profit
 they take the risk of lending a borrower with no collateral security – hence assisting the poorer
group
 allows money to be transferred from high income to low income countries

Disadvantages

 In Zimbabwe, the rate of interest they charge is very high, that

 is why they are so called, ‘loan sharks’
 In Zimbabwe, they only provide short – term loans

SHORT – TERM FINANCE

Overdrafts

It refers to when the business is allowed to withdraw more money as compared to its current account
balance, up to an agreed limit.

Advantages

 Only interest payable on amount overdrawn

 Quick and easy to arrange
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 No collateral security is required

 the most flexible source, since the business can vary amount overdrawn, depending on its
financial needs
 turn out to be cheaper than loans in the short-term
 simple to arrange
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Disadvantages

 They are repayable on demand, so they are not appropriate for long term finance needs
 Can be expensive as interest tends to be high
 Little amounts may be raised
 They are not available to non- current account holders
 the bank can ‘call back’ the overdraft facility and demand immediate payment, so that can
create liquidity problems for the business

Trade Credit

It is when a business delays paying its suppliers, leaving the business with a better cash position.

Advantages

 It is almost an interest free loan to the business

 Control is not diluted

Disadvantages

 It may lead to poor business relationships with suppliers if the business delays paying suppliers
 Business foregoes cash discount

Debt factoring – see external sources

LONG –TERM SOURCES

Leasing/Hiring

It refers to a contract whereby the business is allowed to use an asset in return of rentals without having
to buy the asset.

Advantages

 Allows business to have an asset without a huge capital outlay and reserve money for purchase
of raw materials, so liquidity is preserved
 Repairs and maintenance is done by the leasing company, so the expenses of the business are
reduced
 Updates are possible as technology changes, so efficiency is maintained
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Disadvantages

 It is more expensive in the long – run than buying an asset outright.

 Asset taken back to the owner at the end of the lease period, so the business will not benefit
from scrap value.

Hire purchase
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It is when a business

buys a fixed asset over a long period of time with monthly payments which include an interest charge

Advantages

 the firm does not have to find a large sum of cash to purchase the asset

Disadvantages

 a cash deposit is paid at the start of the period

 interest payments can be quite high, so the asset can become more expensive than outright
purchase

Issue of shares – see internal source

Long-term loans – see external finance

Retained profits – see internal sources

Forming a partnership

Advantages

 Raise additional capital

 Additional expertise in business
 Share losses

Disadvantages

 Partners have to share profits

 Partners share ownership and control
 Conflict between partners may occur

Factors considered when choosing a source of finance

Effect on control

If the owners intend to retain control, they can use loans and retained profits rather than issuing shares
or taking another partner. This is because, if you issue shares, control is diluted and more people will be
involved in decision making.
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The cost of capital

The business must consider what is to be paid in return of the capital. Loans attract fixed interest, shares
attract dividends and retained profits do not attract any interest or dividends. This means if the business
intends to avoid costs, it may decide to use retained profits, sell old assets or use personal savings.
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Purpose and repayment period

 Is the finance needed to fund growth or solve a short-term cash crisis?

 The general rule is to match its use and repayment period.
a long – term source for a long term project e.g. buying a fixed asset
a short –term source for a short – term use e.g. buying additional inventories during a
busy period

Structure of the organization (Legal structure of the business)

Some businesses are not allowed to issue shares, for example, sole traders and partnerships. This means
they will not make use of other sources.

Question with a recommendation on the appropriate source of finance

5.2 CASH FLOW FORECASTING AND WORKING CAPITAL

5.2.1 The importance of cash flow forecasting:

Reasons why a cash flow forecast might be important for business (s19p11)

 Can identify possible causes of cash flow problems [k]

 Help manage cash flow better OR help avoid cash flow problems [k]
 Supports a loan application / attract investors [k]
 Show how much is spent each month [k]

Reasons why cash is important to a business

 the business must have sufficient cash in order to:

1. pay its workers, suppliers, landlord, tax to the government
2. ensure that production of goods and services continue, since workers may stop working and
suppliers refuse to supply if they are not paid
3. avoid liquidation – where a business sell everything it owns in order to pay debts

What is a cash flow forecast?

 Cash flow refers to the cash inflows and cash out flows over a period of time
 OR, a financial plan showing the likely cash inflows and cash outflows
 OR, table showing estimated cash flows of the business over a period of time – helps
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when budgeting or when asking for an overdraft.

 They are prepared ahead of a long operating period.
 Cash inflows are the sums of money received by a business over a period of time
 Cash inflows are items that increase the cash position of a business and these include:
cash sales/sale of products for cash
receipts from trade receivables
cash received from sell of non-current assets
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borrowing money from an external source

investors – e.g. issue of shares, since more money is put into the business

 Cash outflows are the sums of money paid out by the business over a period of time
 Cash outflows are items that reduce the cash position of the business and these include:
purchasing goods or materials for cash
paying wages, salaries and other expenses in cash
payment to trade payables
purchase of non current assets for cash
purchase of fixed assets
repaying loans
 A cash flow forecast is an estimate of future cash inflows and outflows of a business, usually on
a month – by - month basis
 It therefore shows the expected cash balance at the end of each month

HOW A CASH FLOW FORECAST IS CONSTRUCTED:

Cash flow forecasts /Cash budget for the period ending ……………

Jan Feb
Cash Inflows/Receipts
Cash sales *** ***
Dividends received *** ***
Total Receipts *** ***
Cash outflow/payments
Cash purchases *** ***
Purchase of a vehicle *** ***
Total payments *** ***
Net receipts (Total receipts – total payments) *** ***
Balance b/d *** ***
Balance c/d *** ***

FOR EXAMPLE, given the following information:

Purchase of a van for December 5 000

Prepare a cash flow forecast/cash budget for the period ended 31 December.

Cash flow forecast/cash budget for the period ending 31 December

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Cash inflows/Receipts Nov Dec

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Cash sales 30 000 20 000

Cash outflow /payments
Payments to suppliers 16 000 17 000
Purchase of a van 5 000
Total payments 16 000 22 000
Net receipts 14 000 (2 000)
Balance b/d ------- 14 000
Balance c/d 14 000 12 000

For example, a business proposed the following for the month of November and December. Cash sales
for November $30 000 and for December $20 000. Payments to suppliers were $16 000 and 17 000.

Causes of cash flow problems

 A cash flow problem means that the organization has cash or a negative cash balance
 This is caused by:
(a) excessive drawings by the owner
(b) Unplanned purchase of non-current assets
(c) Mis-match between trade payables and trade receivables period
(d) Credit sales and bad debts

Ways in which the short –term cash flow problems may be overcame

 There are several ways in which a short-term cash flow problem could be overcome.
 These are explained below- and the limitations of each method are outlined too.

ethod of overcoming cash flow How it works Limitations

problem
Increasing bank loans
Delaying payments to suppliers
Asking debtors to pay more
quickly – or insisting on only
Bank loans will inject more cash
into the business
Cash outflows will decrease in
the short term
Cash inflows will increase in the
short term.
Interest must be paid – this will
reduce profits
These loans will have to be
repaid eventually – a cash
outflow
Suppliers could refuse to supply.
Suppliers could offer lower or no
discounts for late payments
Customers will take their custom
to another business that still
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‘cash sales’ offers them time to pay i.e. trade

credit
Delay or cancel purchases of Cash outflows for purchase of The long-term efficiency of the
capital equipment equipment will decrease. business could decrease without
up-to-date equipment.
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5.2.2 Working capital

 It is money available to pay for day-to-day expenses of the business

 Working capital = current assets – current liabilities
 It is the life blood of the organization

Importance of working capital

 having enough working capital assists in raising the credit reputation of the business
 to ensure that the business run effectively
 to take advantage of any opportunity to buy goods at a discount if offered
 to implement a customer’s special order

5.3 INCOME STATEMENTS

5.3.1 What is profit?

 Profit is the ‘surplus’ that remains after costs have been subtracted.
 Profit = sales revenue – costs of making products
 Profits can be increased by:
1. increasing sales revenue by more than costs
2. reducing costs of making products
3. a combination of 1 and 2

Importance of profit to private sector businesses

1. Reward for enterprise – so if successful , entrepreneurs receive profits

2. reward for risk taking – entrepreneurs take risks by providing capital to the business, so profits
reward them for taking these risks by allowing payments to be made e.g. dividends
3. source of finance – retained profits are a very important source of finance, especially for
expansion
4. Indicator of success – so high levels of profitability, provides a signal that the business is doing
well as compared to loss making businesses

The difference between profit and cash/Reasons why profitable businesses can have cash flow problems

1. Profit and cash are calculated using different basis. The statement of comprehensive income is
prepared using accruals concept that credit sales are recognized without cash inflow. Meaning,
profit figure will be high compared to cash received by the business.
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2. The statement of comprehensive income recognizes revenue only and the cash account
recognize capital and revenue items. This means, if a business purchases non-current assets, it
will reduce the cash balance and not the profits.
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3. Cash drawings by the owner. These also affect the cash account only and not the profits. This
means if the owner withdraws cash, it may cause liquidity problems.

4. Non cash items like a decrease in the provision of bad debts may increase profits of the business
and not the cash balance. This means a business may end up having many profits compared to
profits available.

5.3.2 Income statements/Statement of comprehensive income

 It refers to a financial document that records the revenue, costs and profit for a given
period of time (w19p13).

Main features

 It shows operating profit generated by a business, revenue generated and expenses incurred by
a business in the day to day operations. Revenue is income realized from sales of products.
 Revenue = Quantity × Selling Price.
 Illustration:
Trading account:
Income statement for XYZ
Limited
For the year ending 31/10/13 $000 000
Sales revenue ***
Less Cost of sales ***
Equals Gross Profit ***
 Gross profit is surplus revenue when cost of sales is subtracted
 cost of sales refers to cost of producing or buying in the goods actually sold by the business
during a time period.

Profit or loss account

Chapangaza Meats Pvt Ltd:Income

statement for the year ending 31/10/16
Gross profit $ 32000
Non-trading income $5000
$ 37000
Less expenses:
Wages and salaries $12000
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Electricity $6000
Rent $3000
Depreciation $5000
Selling and advertising expenses $5000
$31000

Profit (Previously known as Net profit) $6000

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Profit (Previously known as net profit)

 the surplus income made by the business after all costs have been deducted from sales revenue
 It is calculated by subtracting overhead costs from gross profit
Depreciation
 It is the fall in value of a non – current asset over time
 It is included as an annual expense in the business
Retained Profit
 It is the profit reinvested into the business after all payments and payments to owners e.g.
dividends have been made

The statement can be used by various users to make decisions, e.g.

(a) Government to calculate corporate tax and GDP.

(b) Employees. When negotiating salary increments.
(c) Suppliers – when assessing whether to supply on credit or not
(d) Banks/Lenders – when assessing whether to offer credit or not

Managers (w19p13)

 To assess the effectiveness of their policies.

 Able to calculate the profitability ratios [k] to see the effect of the changes in costs or
revenue
 Helps assess efficiency [k] e.g. to see benefit from advances in technology
 Able to compare performance with similar businesses [k]
 Able to compare performance between different time periods [k]
 Show shareholders / owners how business performed [k]
 It is used to measure business success / decide if the business should continue trading
[k]
 Used to support an application for a loan [k]

Banks/Lenders (w18 p11)

 To decide whether to give the loan [k] because they can see if they can repay it [an]
 To identify assets for security [k] to reduce the risk of non-payment [an]
 Calculate liquidity / cash flow [k] so they know the business can pay its short-term debts
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 To offer advice [k] on choosing the best source of finance [an]

 To compare financial documents over time [k] to help them to improve [an]

HOWEVER, the statement of comprehensive income may not be reliable because:

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 it is prepared using assumptions and it is historical. This means it is used together with other
financial statements so as to assess the true and fair position of the business.

5.4 BALANCE SHEET/STATEMENT OF FINANCIAL POSITION

 It is a snapshot of the financial position of a business at a particular point in time

 Or, it is a financial statement that shows the value of business’s assets and liabilities and capital
at a particular time.

5.4.1, It shows:

(a) Assets
 Assets are those items of value owned by the business
 They can be non-current assets: - items owned by the business for more than one year
e.g. buildings, equipment, furniture, motor vehicles etc.
 Or current assets: - items owned by a business and used within one year. e.g. cash, trade
receivables, inventory etc.
 There are also intangible assets: - those that do not exist physically but still have a value
e.g. brand names, patents, goodwill and copyrights.

(b) Liabilities
 these are debts owed by the business
 They can be non-current liabilities:- long-term debts owed by the business e.g.
debentures or long-term loans
 Or current liabilities: - short-term debts owed by the business e.g. bank overdraft,
creditors/payables, accruals, outstanding tax, and short-term loans.

Why businesses might have creditors

 helps with cash flow/short-term funding
 purchase of raw materials/stock to resell
 interest-free source of finance
 standard way of carrying out business transactions
 taken an overdraft.

Why businesses might have debtors

 debtors can be used as a marketing device, so can encourage customers to buy more
goods as they are able to pay later
 standard practice in the industry
 customers don't pay/can't pay.
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(c) How the business is financed. This can be used by shareholders and lenders to assess the
gearing of the business when deciding on whether to invest or not.

Shareholder’s Funds:
 Value of equity capital plus reserves [2]
 Funds/money invested into the business [1] by the owners [+ 1].
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5.4.2 Interpreting balance sheet data and deductions that can be made from it

 Shareholders can see if their stake in the business have increased or fallen in value over the last
12 months by looking at the ‘total equity’ figures for two years
 Shareholders can also analyse how expansion by the business has been paid for – by increasing
non- current liabilities (such as long-term loans); from retained profits or by increasing share
capital (sale of shares). If inventories have been sold off to provide capital for business
expansion, then the figure will clearly decline on the balance sheet.
 Working capital can be calculated from the balance sheet data. Working capital = Current assets
– current liabilities. This is also known as net current assets.
 Capital employed can also be calculated by using data from the balance sheet. Capital employed
= shareholder’s funds + non-current liabilities. This is the total long-term and permanent capital
of the business which has been used to pay for the assets of the business
 Balance sheet data can also be used to calculate ratios which are used to assess business
performance.
NB: the statement can be of limited use because it is historical. The statement also ignores qualitative
aspects of the business like employees’ motivation and quality of products.

5.5 ANALYSIS OF ACCOUNTS

5.5.1 Interpreting accounts by calculating and analyzing accounting ratios

Analysis of published accounts

Profitability and Liquidity Ratios

Profitability ratios
They compare the gross and net (operating) profits of the business with sales revenue.
More to these there is ROCE.

Gross profit margin

This ratio compares Gross profits (GP)/ profits before deduction of overheads with sales
turnover – thus, expressing GP as a percentage of sales.

𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭
Formula: Gross Profit Margin = × 𝟏𝟎𝟎%
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𝐒𝐚𝐥𝐞𝐬
It shows the percentage of profit from a sale which is available to pay for overheads.
The GP Margin is a good indication of how effectively managers have “added value” to the Cost
of Goods Sold.

Gross Profit Mark-up

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 Profit expressed as a percentage of cost price is mark-up.

 Mark-up is the amount of profit added to Cost of Goods Sold.
 A low mark-up might reflect an attempt to increase GP by gaining a longer volume of
sales
Gross Profit
Formula: Gross Profit Mark-up = × 100%
Cost of Goods Sold
Example: Given a cost price of $4 000. Selling Price = $5 000. Calculate a % of mark-up.
$5 000 - $4 000
1 000 1
Gross Profit Mark-up = × 100% = 20% or 4
4 000
The relationship between mark-up and margin is that both are regarded as profit.

Importance of profit margins to the business [CIE 12 W15,Q1c]

 Profit as a proportion of sales revenue, a higher margin, so more profit is
made for each product sold
 Influence price charged
 Indicates efficiency
 Measure of success/performance/comparison with other years

Causes of falling or low Gross Profit Margin

 It could be due to failure/inability to pass on cost increases to customers
 Stock losses
 Fraud – e.g. stolen inventory not identified
 The change in the mix of sales/product mix in favour of lower margin goods than in the
previous period
 An attempt to increase market share by reducing prices
 Bulk discounts being given to major customer
 Opening inventory overstated
 Closing inventory understated

Return on Capital Employed (ROCE) (CIE – 10 11, Q2a)

 ROCE means the profit of the business expressed as % of capital invested in the
business
 It a measure of profit made from each dollar invested

𝑝𝑟𝑜𝑓𝑖𝑡
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Formula: Return on Capital Employed (ROCE) = × 100%

Capital Employed
Importance of ROCE
 Owners can use this measure to see how well their investment in the business is doing.
 Investors can assess in percentage terms, the level of profits that can be generated by
every dollar that they invest
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 Investors will be satisfied with a return that is higher than what they expect to be
compensated by the capital employed in the business.
 Investors and managers can apply it to analyse alternative forms of investment
 It can be used as a base of evaluating investment projects, those with low ROCE will be
undesirable

Causes of declining ROCE

 An increase in the costs of borrowing may turn the business into a loss making firm
 Additional borrowing may have an adverse effect on profitability
Methods of Improving Profitability
All businesses will want to improve performance for the benefit of the stakeholders

Increasing ROCE
 It can be increased by making higher profits with the same level of investment.
 It may be done by growth funded externally, thus increasing sales using fresh capital

Increasing Profit Margin

 Raising prices – if the business raises prices, it will earn more revenue on each unit sold.
If costs remain constant, profitability should improve. However, it might have an impact
on cost of sales; there is a risk of fall in demand. It is never certain.
 Lowering costs – this can be done by buying supplies from cheaper sources or using the
existing ones effectively. The business can also find new providers of essential services
e.g. telecommunication, cheap labour, information services etc.

Drawbacks of these measures

 Cheap materials means poor quality
 Cheap sources may be unreliable
 Moving abroad to cheap labour may be disruptive

Using existing resources effectively

Making better use of resources will improve resources and lower costs
This can be done by introducing new working practices or train staff
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Benefits
 Raise labour productivity
 Upgrading machinery by acquiring newer and efficient models
 Raise capital production
 Business can also reduce waste by re-cycling
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Drawbacks
 Workers might resist new working practices
 New technology often has teething problems
 Could disrupt production

5.5.2 LIQUIDITY – The concept of Liquidity and importance

Liquidity Ratios
It is a measure of the ability of the business to meet its short term financial commitments using
its current assets.
The ratios focus on current assets to current liabilities.

Importance
 It illustrates solvency of the business or ability of the business to meet its short term
financial obligations or pay up its debts.
 These ratios are an important measure of the short-term financial health of the business
 New suppliers/creditors may ascertain the liquidity situation of the business and assess
the risk of non-payment before extending credit
 Existing creditors may also look at the liquidity position to assess whether they will
receive the money they are owed.
 To management, liquidity ratios may help to identify working capital items which are
poorly managed e.g. capital being tied up in stock, receivables or cash lying idle in the
bank instead of being invested to increase profit.

Current Ratio/Working Capital Ratio [O/N2010, P11]

 Current ratio is a measure of the relationship between current assets to current
liabilities.
 It is a liquidity test designed to show the ease by which a company can pay off debts on
demand.
Current Assets
 It is calculated by the formula: Current Ratio = Current Liabilities
 For Example: Current Assets = $100. Current Liabilities = $50
$100
 Current Ratio = = 2:1 or 2
$50
 Current ratio 2:1 is the standard ratio.
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 The business is said to have sufficient resources if current ratio is between 1.5:1 and 2:1
thus 1.5 or 2
 It implies that the business is in a sound financial position to meet its short term
obligations and able to operate with enough working capital
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 Operating above the ratio 2:1 is not favorable e.g. 3:1. It may suggest that the business
has too much money that is tied up unproductively – assets are under utilized.
 Current ratio which is below 1.5:1 (1.5) and 2:1 (2) is not favorable
 It includes stock which is less liquid. The business is said to have insufficient working
capital or inadequate working capital which means it will have difficulties to meet
financial obligations leading to liquidity crisis.
 This might mean that the business is overtrading
 Overtrading occurs when a firm attempts a large volume of production with inadequate
cash.
 Rapid expansion resulting in excessive investment in stocks leading in liquidity problems
 When the business expands without securing necessary long term finance leading to a
strain on working capital
 In the absence of long-term finance the business may end up pressurising debtors to
settle debts or extend credit payment period to creditors.
 Over borrowing - Businesses may borrow to finance growth with more loans without
taking into account that it attracts more interest leading to a rise in costs.

2007 2008
Given Current Assets 9 600 12 000
Current Liabilities 7 000 8 100
9 600 12 000
Current Ratio = 7 000 = 1.37:1 = = 1.48:1
8 100

Comment
 The current ratio has slightly improved over the period.
 BUT, in both cases, the business is experiencing liquidity problems
 Firm may increase current assets relative to current liability or reduce current liabilities
relative to current assets through getting short term credit.
 HOWEVER, current ratio includes stock which is less liquid. A stricter measure of
liquidity is needed.

Acid Test/Quick Ratio

 It is a measure of the ability of the business Current Assets excluding stock to meet
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Current Liabilities.
 Stock is not a liquid resource because there is no guarantee that it will be sold and may
become obsolete or deteriorate.

Current Assets−Stock Liquid Assets

Acid Test/Quick Ratio = or Current Liabilities
Current Liabilities
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The standard ratio is 1:1, meaning that there is 1 liquid asset to meet every unit of current
liability.

Ways of improving Liquidity

Method to increase Examples Evaluation of method

liquidity
Sell off fixed assets for cash  Land and property
- Could lease back if
still needed by the
business
Sell off inventories for
cash: note: this improves
the acid test ratio, but not
the current ratio
Increase loans to inject
cash into the business and
increase working capital
 If assets are sold quickly,
could be sold to a they might not raise
leasing company their true value
 If assets are still needed
by the business, then
leasing charges will add
to overheads and reduce
net profit margin
 Stocks of finished This reduce the gross profit
goods could be sold margin if inventories are
off at a discount to sold at a discount
raise cash. Consumers may doubt the
 JIT stock image of the brand if
management will inventories are sold off
achieve this cheaply
objective Inventories might be
needed to change
consumer demand levels –
JIT
 Long-term loans These will increase the
could be taken out gearing ratio
if the bank is Will lead to increase in
confident of the interest costs
company’s collateral
prospects.

Assess the possible usefulness of financial statements of four users of accounts. (20)
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J15p1; J14p12 Qe; N14p12 Qe

5.5.3 – WHY AND HOW ACCOUNTS ARE USED:

Needs of different users of accounts and ratio analysis:

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User of accounts
Managers: they will be able to have much more
detailed and frequent accounting information than
any of the other groups.
Shareholders: limited companies are owned by
shareholders and they have a legal right to receive
the published accounts each year.
Creditors: these are other businesses which have
supplied goods to the company without yet
receiving a payment.
Banks: these have lent money to the business on a
short – or – long – term basis.
government
- CIE
What they use accounts for
They will use accounts information to help them
keep control over the performance of each
product or division of the business.
Managers will be able to identify which parts of
the business are performing well or poorly.
Accounting data will help in decision making, for
example whether to expand the business, change
price levels or close down a product or division
that is not doing well.
Managers will calculate accounting ratios too.
Ratios are very useful and a quick way for
managers to compare their company’s profit,
performance and liquidity. Ratio results may be
compared with:
Other years
Other businesses.
Shareholders – and potential investors – want to
know, from the statement of comprehensive
income, how big the profit or loss the company
has made is. The profitability ratios will be
compared with last year’s. The higher the
profitability ratios are, the more likely
shareholders will want to invest by buying more
shares in the company. They would want to know
from the statement of financial position if the
business is worth more at the end of the year than
it was at the beginning of the year. They will also
assess the liquidity of the business – they do not
want to invest in a company with serious cash or
liquidity problems.
The statement of financial will indicate to creditors
the total value of debts that the company has to
pay and the cash position of the business.
Liquidity ratios, especially when compared with
the previous year, will indicate the ability of the
company to pay back all
They use the accounts in a similar way to creditors.
If the business seems to be at risk of becoming
illiquid, it is unlikely that a bank will be willing to
lend more.
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The government and the tax office will want to
check on the profit tax paid by the company. If the
company is making a loss, this might be bad news
for the government’s control of the whole
economy, especially if it means that worker’s jobs
may be lost.
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Workers and trade unions Workers and trade unions will want to assess
whether the future of the company is secure or
not. In addition, if managers are saying that they
can not afford to pay workers a pay rise, it would
be useful for workers and unions to assess
whether the profits of the company are increasing
or not.
Other businesses – especially those in the same The managers of other companies may be
industry considering a bid to take over the company or they
may just compare the performance of the business
with that of their own. Other businesses will
compare their performance and profitability with
other in the same industry.

April 11, 2016