ENTR 9000 BU Financial Performance of A Business Questions

Assessment Cover Sheet
Programme Code: (e.g. DT401)
Year: e.g 1
Module Code:
Entr9000
Module Name:
Managerial Finance and Entrepreneurship
Assessment Title:
Final Assessment
Student Name:
Student Number:
Lecturer Name:
Donncha O’ Donoghue / Norah Cussen
Assessment Due Date:
15/5/2020
Word Count:
3500 max
Notes: (any
relevant
comments by student regarding
the submission)
Plagiarism Declaration
I hereby certify that this material, which I now submit for assessment as a continuous
assessment / project is entirely my own work and has not been submitted in whole or in part
for assessment for any academic purpose other than in fulfilment for that stated above.
I am fully aware of the consequences of plagiarising assessment work.
Signature:
Assignment Brief
PLEASE NOTE: Students must attempt to answer both Questions 1 & 2
Question 1 – possible 200 Marks
Question 2 – possible 200 Marks
Students are required to attempt both questions detailed below. All submissions should be word
processed and submitted via the guidelines. All sources used in preparation should be referenced.
This is an individual assessment and submission should be students own work.
Submission Guidelines
Students should return work by the 15th of May 2020 @5pm
Submission should be emailed to both:
donncha.odonoghue@tudublin.ie
norah.cussen@tudublin.ie
Students must use the following structure for subject of email submission
Email Subject: Programme Code – ENTR9000
QUESTION 1 (200 marks)
a) Discuss the factors that must be taken into account when providing a context for analysing the financial
performance of a business.
(15 marks)
b) The following are extracts from the 2019 published financial statements of City-Hotels
Group Plc., an international hotel and leisure company.
City-Hotel Group Plc.
Consolidated Income Statement for year ended 31 December
2019
2019
2018
€’000
€’000
Revenue
112,200
93,400
Cost of sales
(51,300)
(44,700)
Gross profit
Selling and administrative
expenses
60,900
48,700
(25,400)
(21,500)
Depreciation and amortisation
(6,400)
(5,600)
Operating profit
29,100
21,600
Loan interest
(8,400)
(5,400)
Profit before tax
20,700
16,200
Corporation tax
Profit for the
year
(2,500)
(1,800)
18,200
14,400
Dividends paid
(7,600)
(5,400)
City-Hotels Group Plc.
Consolidated Balance Sheet at 31 December
2019
2019
2018
€’000
€’000
301,300
240,600
17,500
10,400
318,800
251,000
Inventories
2,900
2,400
Accounts receivable
5,600
4,900
Prepayments
4,400
4,100
Cash and Bank
9,800
7,800
22,700
19,200
341,500
270,200
ASSETS
Non-current
assets
Property, plant & equipment (net book value)
Intangible assets
Current assets
Total assets
EQUITY
Issued share capital (note 1)
7,200
6,500
Share premium
39,100
17,700
Revaluation reserve
84,500
84,500
2,600
2,200
Other reserves
Retained earnings
47,500
36,900
180,900
147,800
130,900
96,700
Trade payables
5,700
4,400
Accrued expenses
9,200
8,900
LIABILITIES
Non-current liabilities
Loans and borrowings
Current
liabilities
Bank overdrafts
2,700
2,600
10,700
8,700
1,400
1,100
29,700
25,700
Total Liabilities
160,600
122,400
Total equity and liabilities
341,500
270,200
Short term loans and borrowings
Corporation tax liabilities
Additional Information, note 1:
Nominal (par) value per share in €cent
25
c
25
c
Market price / share, year-end, €cents
930
c
750
c
Required:
(a) Calculate, for each year, 18 ratios under the headings of profitability, Use of assets,
capital structure, liquidity and investment
(60 marks)
(b)
(c)
(d)
(b) Based on (a), comment on the company’s performance and position over the two years
(70 marks)
(c) Apply the Taffler & Tisshaw model of business failure prediction and calculate a z-score
for the business for both 2019 and 2018
(20 marks)
(d) Comment on your answers to (c)
(10 marks)
(e) Accounting statements are often accused of presenting a limited picture of a business.
In the context of this statement discuss the limitations of ratio analysis.
(25 marks)
QUESTION 2 (200 Marks):
The relevant literature debates how the entrepreneurial process occurs. Shane’s (2003)
Individual Opportunity Nexus suggests a model to illustrate the entrepreneurial journey.
Discuss this model in detail and include a minimum of 15 references. This discussion
should include a debate with alternative perspectives on the entrepreneurial process.
Criteria
Housekeeping
Introduction
Detailed discussion of Individual
Opportunity Nexus
Quality of supporting sources applied in
the discussion
Quality of discussion and debate of the
literature
Conclusions from the review of the
literature
Total
Possible Marks
10
10
60
30
50
40
200
CHAPTER 5
Financial Forecasting and preparing forecast
financial statements
Learning Outcomes
By the end of this chapter you will be able to:
❑ Outline the role of the master budget within an organisation.
❑ Distinguish between operating and capital budgets.
❑ Outline key forecasting variables used in developing projected financial
statements and the factors to consider when forecasting these variables.
❑ Describe the various approaches to budget preparation including zero-based
budgeting, incremental budgeting, activity based budgeting and rolling
budgets.
❑ Prepare a forecast profit and loss account and balance sheet for a business
based on key forecast assumptions.
❑ Outline the importance of cash budgeting and be able to prepare monthly
budgeted cash projections.
❑ Outline how management use forecast financial statements for decisionmaking.
Introduction
It is vitally important that a business develops plans for the future. Planning provides a focus for a
business. It provides objectives or goals which the business should see as the stepping stones to
achieving its strategy. A business is unlikely to be successful unless its managers have a clear plan
regarding its future direction and finance lies at the heart of the planning process. Plans require
financial resources (money) and generally the financial resources of a business are limited.
Financial planning and the preparation of financial projections are an essential element of strategy
evaluation. It is essential for each business to evaluate the financial implications of pursuing each
proposed course of action and much of this is done through the use of financial forecasting.
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The Development of Business Plans – Key steps
The development of plans involve the following key steps
1. Setting the aims and objectives of the business.
The aims of a business are often couched in broad terms and may be set out in the form
of a mission statement. This statement is usually brief and will generally articulate high
standards or ideals for the business.
The objectives of a business are usually quantifiable and more specific and should be
consistent with the aims of the business. Examples would include.
 The kind of market it wishes to serve and market share it wishes to achieve
 The market share it wishes to achieve.
 The range of products services to be offered.
 The desired levels of profit and return on capital.
 Levels of growth as measured in sales employee’s physical assets etc
2. Identifying the options available
These are in effect the range of strategies available to the business to achieve its
objectives. This task is undertaken by management and involves much data collection
and analysis of both the external market and an internal analysis of the resources and
expertise available to the business to pursue each option.
External Analysis
Market size and growth prospects
Competition with the market place
Period of likely competitive advantage
Threat of substitute products
Exchange rates
Tax rates and incentives
Government Policy
Sociocultural values (attitude to leisure)
Internal Analysis
Organisation culture
Human resources and capability
Physical capacity
Finance resources
Research and development
Information systems
Any deficiencies in these areas could effect the ability of the business to pursue a
particular option or strategy.
3. Evaluate the options and select a strategy.
By comparing the environmental influences (opportunities and threats) and the resource
limitations (strengths and weaknesses) a strategic plan can be put together setting the
organisation on a course it is able to follow in the hope of reaching specific goals in the
end. When deciding on the most appropriate option(s) to choose management must
examine information relating to each option to see if that option fits with the objective
that have been set and assess whether or not it is feasible to provide the resources
required. The management must consider the effects of pursuing each option on the
future financial performance and position of the business. The projected financial
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statements play an invaluable role in the evaluation of the various options open to
management.
The Role of Projected Financial Statements
Projected financial statements or budgets portray the predicted financial outcomes of
pursuing a particular course of action. By showing the financial implications of certain
decisions, managers should be able to allocate resources in an efficient and effective
manner.
Where management require a decision from a range of options, projected statement can
show the expected revenues and costs associated with each option as well as the impact
each option will have on the future profitability, liquidity, and financial position of the
business. Where management is considering only one course of action the preparation of
projected financial statements can highlight periods where the business may not have the
required resources to sustain the particular course of action. Thus financial plans can
warn management of possible future constraints for which they can plan for now. E.g. A
projected cash budget can highlight periods when the business may be under financed
and the possible length of this period. Thus management can take action now (arrange a
bank overdraft) in anticipation of these events. Financial institutions require financial
projections as well as audited accounts when deciding on a business loan application.
‘budget set prior to the control period and not subsequently changed in response
to changes in activity, costs, or revenues.’
Fixed Budget as defined by CIMA Official Terminology
The term fixed or master budget refers to the financial projections that set out the plans
for a business for the next accounting period based on various assumptions of sales and
sales growth, operating costs, inflation (in particular labour inflation), interest rates,
taxation and capital expenditure (expenditure on assets). This master budget is known as
the fixed budget as it is based on these fixed assumptions of trading performance and
financial outlook. Its chief role is at the planning stage, in setting the overall direction or
plan for the business.
There are three summary budgeted statements that are the end result of any budgetary
planning process and that make up the master budget.
❑ The income statement (also known as the trading, profit and loss account). This is
made up of a number of separate operating budgets such as sales, cost of sales,
payroll, operating expenses budgets, and fixed expenses budgets.
❑ The balance sheet (also known as the statement of financial position). The balance
sheet is influenced by the capital expenditure budget, stock budget, debtor’s budget
and creditors budget. Collectively these budgets are known as the capital budgets.
❑ The cash budget. This budget is primarily concerned with the timings of future cash
inflows and outflows and is based on data from the operating and capital budgets.
The cash budget assists in the management of company finances by disclosing the
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cash peaks and troughs within the budget period indicating when extra funds will
be needed. If the extra funding is required only for a number of months and
thereafter the situation becomes self-financing, then the shortfall may be met with
short-term sources of finance such as bank overdraft. Otherwise long-term funding
is preferable as it gives the business more cash leeway and will not require the
business to start refinancing a few months later should anything unexpected
happen. The cash budget is normally presented showing all cash inflows (both of a
revenue and capital nature) and cash outflows (both capital and revenue
expenditure) on a month by month basis.
The above budgets come together to form the fixed or master budget which is the projected
income statement, balance sheet and cash flow of the business. The diagram below outlines
this relationship.
Diagram 5.1: The master budget
The master budget brings together all the financial projections from the various operating
and capital budgets within an organisation for the period. It embraces the impact of both
operating decisions (running the business) and investment and financing decisions that the
business has planned for the next time period (usually 12 months). It sets out the
organisations targets for the coming period in a quantifiable and easily understood format,
helping to provide direction and ensuring goal congruence.
It is vitally important to understand the purpose and the relationship that exists between the
income statement, the balance sheet and the cash budget.
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Diagram 5.2: The master budget statements
When preparing the profit and loss/income statement, the normal rules of accounting
(accruals and matching concepts) must be followed. This results in, for example, sales
revenue recorded in the income statement including all sales incurred irrespective of receipt
of income. The cash budget is concerned with cash inflows and outflows, therefore only
cash received in the period will be recorded in the cash budget. Thus cash receipts and
payments in the cash budget are not the same as the sales, cost of sales and expenses in the
profit and loss statement.
Example 5.1: The effect of sales in the master budget
Joseph Flynn is in the process of setting up a new business enterprise which involves selling
quality music products from an outlet in Galway Retail Park under the banner ‘Flynn Music
Sales’. Joseph anticipates sales in the first month to be €80,000, rising to €100,000 per
month thereafter. As Joseph plans on attracting corporate business, he expects 10 per cent
of each months sales to be given one months credit.
You are required to demonstrate to Joseph how sales representing the first three months
of trading will be recorded in a master budget.
Approach
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The total cash received in the first three months of trading should amount to €270,000
(€72,000 + €98,000 + €100,000) and can be seen in the cash budget above. In accordance
with accounting concepts, the sales revenue in the profit and loss statement is recorded at
€280,000, representing both cash and credit sales achieved during the period. The balance
sheet shows the amount of cash outstanding from debtors at the end of the period at €10,000
(10 per cent of month 3 sales of €100,000).
The recording of sales transactions is not the only cause for differences between the profit
and loss statement and the cash budget. Similar to sales revenue, purchases may be on
credit and the full cost of purchases should appear in the profit and loss statement while
the cash budget will only include the amount paid in the period.
Example 5.2: The effect of purchases and stock in the master budget
Pauline Murphy is about to operate a souvenir shop in a transport museum. She has
estimated that €50,000 of goods will be purchased each month for the first three months of
trading, and has negotiated one months credit with all suppliers. At the end of this period
she expects to have stock of €20,000.
Show how purchases and stock will be recorded in a master budget representing the first
three months of trading.
Approach
6
One can see that due to the timing differences between receiving and paying for purchases
and the movement in stock, cost of goods sold amounts to €130,000 in the profit and loss
account, whereas only €100,000 is recorded as purchases in the cash budget.
Other differences between the profit and loss account/income statement and cash budget
can be due to:
❑ The purchase cost or sales proceeds of fixed assets not being shown in the profit and
loss statement but appearing in the cash budget. The income statement will only
contain the profit or loss on disposal of fixed assets.
❑ Depreciation appearing in the income statement but not in the cash budget as it does
not give rise to a movement in cash.
❑ The fact that not all cash flows are presented in the income statement. For example, the
proceeds from the issue of shares and proceeds from any loans acquired are recorded
in the cash budget and balance sheet.
The three key steps to financial forecasting are
1. Forecast key variables
2. Prepare forecast financial statements from these forecast variables
3. Prepare key ratios as a test of reasonableness of the financial projections
Forecasting Key Variables
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‘A prediction of future events and their quantification for planning purposes’
A forecast as defined by CIMA Official Terminology
Three essential elements are required before one can begin to prepare projected financial
statements. These are:
❑ Forecast of sales.
❑ Forecast of costs / expenditure.
❑ Forecast of the required investment in net assets to achieve these sales (capital
expenditure.
❑ Forecasting taxation, financing structure and the cost of debt, dividends.
Forecasting value drivers
In financial forecasting one must know what factors to forecast. What are
the key variables in forecasting financial statements. In his book ‘Creating
shareholders value’ (1986) Alfred Rappaport called them value drivers.
These are
1. Turnover/sales and sales growth rates
2. Operating profit margins (profit before interest and tax)
3. Expenditure on fixed assets
4. Expenditure on working capital
5. The marginal corporation tax rate that the company pays.
6. The planning period
7. The cost of capital
The following are the main issues which should be considered when developing these
forecasts.
Forecasting sales
When preparing projected financial statements, the forecast of sales is the initial task or
starting point. A reliable sales forecast is essential as many items such as cost of goods
sold, other variable costs, stock levels, fixed assets and capital requirements will be
significantly influenced and determined by the level of sales forecast.
Forecasting future sales is not an easy task. It is made up of three variables namely sales
volume, sales price and sales mix. These variables are influenced by a number of factors
that should be taken into account when forecasting sales.
Factors influencing sales
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Past sales volume and mix
Quality of the product or service
Strength of the brand name
Planned advertising expenditure
Pricing policy
Capacity
Advance bookings
Level of competition
Consumer behaviour
State of the economy
Political and industrial outlook
Local activities and events
Seasonality
Demand analysis
Forecasting issues in retailing
Research by Luby (2006) identified the following issues in relation to
forecasting sales demand in the retail sector:
❑ Weather can influence shopping patterns and have a significant
impact on sales. It is difficult to forecast weather.
❑ Macro-economic factors such as interest rates and petrol prices
affect retail sales demand and can be difficult to determine.
❑ The level of competition. A competitor who changes pricing policy
or opens a new store can have a significant effect on sales
demand which is difficult to forecast.
❑ For retail outlets targeting tourists, it can be difficult to predict
accurately the number of tourists visiting the area.
❑ Some respondents reported that sales forecasting ‘can be almost
useless’ and that sales forecasting relating to new outlets ‘is
virtually impossible’.
In practice, sales forecasts can be developed in a number of ways such as:
1. To aggregate projections made by the sales force on the basis of their assumptions of
the market and changes in market conditions. On one hand this can be quite a subjective
approach, however a good sales team should know its market well and should anticipate
any significant changes that could affect sales.
2. Using market research techniques would be particularly appropriate when considering
the launch of a new product.
3. Large businesses sometimes develop economic models to predict sales. These models
would incorporate a number of the variables identified above and take into account the
relationship between them and their effect on sales.
Forecasting sales is extremely difficult and the costs and benefits of each method must be
properly assessed. For example, for small businesses the cost of developing a complex
economic model would probably outweigh the benefits of such a model.
Sales structure in hotels
Hotel operations employ a complicated sales structure. Sales includes rooms,
catering, telephone, club and other services. Catering sales can involve the
same food items sold at different prices if served in the bar compared to the
restaurant. Thus prices and margins vary throughout the hotel. However
according to B.S.Wijeysinghe in his article ‘Break-even Occupancy for a Hotel
Operation’ (Management Accounting, February 1993), catering, telephone,
club and other sales are largely dependant on room-sales and thus have a
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fairly consistent sales to room-sales ratio. Thus a reasonably accurate
calculation of occupancy can lead to an accurate assessment of sales from
other products and services offered by a hotel due to this relationship or level
of dependence.
Forecasting sales – a practical approach
Sales revenue is made up of three items sales volume, sales price and sales
mix.
Sales volume:
• Focus on similar businesses in similar locations developing an
awareness of the trends in sales volume and the factors that
influence it.
• Be mindful of the capacity limitations of your own business.
• Be prudent and grow sales volume slowly and incrementally.
• For a multi product business (restaurants) estimate an average spend
that deals with different prices and menus.
Sales Price:
• Focus on the market niche and copy the prices in similar businesses
• If you have a distinctive competitive advantage then add in a price
premium that values that advantage
Sales mix:
Sales mix refers to the different proportions of product sales that make up
total sales. Depending on the business size it can be important to estimate
the sales mix especially if there is a wide range of different products all sold
at different prices and profit margins. However for a small business with
similar products/services it is best to sue an average spend if that is feasible
Other factors to take into account
1. Past sales and sales growth rates. – Identify continuing business and new
acquisitions if any in base year. If any new acquisitions establish how
many months the results of these new acquisitions are included in the
accounts and thus project forward for a full 12 months.
2. Capital investment /proposed capital expenditure: – For example if
current sales to fixed assets ratio is 0.3 and the company’s plans include
investing in a new hotel half way through the next year. Then we could
predict annual sales for the new hotel = £2m x 0.3 = £600,000.
3. What if a business is downsizing. Then one can expect sales, operating
costs and probably debt and debt interest to fall ( if the proceeds of sales
are used to reduce debt levels). The best way to assess the effect on
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sales and costs when downsizing is to review the interim accounts to see
the effects on sales costs and operating margins. It would also be
important to review brokers reports.
4. General Economy of the countries in which operations exist- Where are
these countries in terms of economic cycle. (Boom to Bust). Try and get
projected sales for each Zone/ region. Focus on world/global economy
also.
5. Competition.- How will it affect sales and profit margins.
6. Euro and exchange rates in relation to UK and USA. – This can help
predict hard or good times.
Forecasting costs
To accurately estimate future costs, it is important to understand cost behaviour patterns
and how some costs are affected by fluctuating sales activity levels. Costs may be
classified into the following categories:
❑ Fixed costs. These are costs which are not expected to vary with sales. For example
if sales increase by 10 per cent, fixed costs would remain fixed and not increase in
proportion to sales. Examples are rent, rates, depreciation, salaries and insurance.
From a forecasting perspective, the level of sales activity forecast will not
significantly influence these costs unless the sales forecast is beyond the relevant
range of sales activity for these costs. Thus the main factors that influence fixed
costs are inflation, legal agreements, economic outlook and national wage
agreements/minimum wages level as labour costs are a major element of the fixed
costs of any business.
❑ Variable costs. These are costs that are expected to vary with sales. Thus if sales
increase by 10 per cent, these costs are expected to increase proportionately.
Examples would include cost of sales, sales commissions and part-time labour. In
reality, although these costs should increase as sales increase, it may not be strictly
proportionate because factors such supplier’s prices, commissions and part-time
labour rates may vary.
❑ Semi-variable costs. These have both a fixed and a variable element and so may
vary partially with sales. Such costs may be identified by examining the past
records of the business. For example light and heat costs could be classified as a
semi-variable cost as a certain amount of light and heat will be incurred irrespective
of the level of sales. However if sales increase significantly, then more rooms will
be used requiring extra power. Semi-variable costs can be broken down into their
separate fixed and variable components (through the use of the high-low method,
scatter-graph approach and statistical techniques such as regression analysis). By
doing this, one can establish the total variable and total fixed costs of a business.
The analysis of costs into fixed and variable components is vitally important when
forecasting future costs. Variable costs will increase in relation to sales whereas fixed costs
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may only increase with the rate of inflation (unless there is evidence to the contrary such
as a new leasing agreement or new wage agreements).
Forecasting Operating Costs – a practical approach
Costs can be classified according to the elements of costs which are
materials, labour and overheads.
Materials:
This relates to purchases of goods for resale. Purchases of goods for re-sales
are considered a variable costs and are based on the sales and stock levels of
a business. The calculation of a monthly purchases figure will be explained
in example 5.3 below.
Labour costs:
This can be estimated by either focusing on the labour costs to sales
percentage of a similar business operating at a similar activity level.
However the best approach is to work through the number of personnel
required and researching the ‘going rate’ payment. Remember to add to any
salary employers PRSI requirements.
Be aware of the labour costs to sales percentage and compare to industry
averages
Overheads:
• Researching the operating overheads of similar businesses can
highlight the key expense categories
• Get a number of quotes for overhead items such as insurance,
advertising, rent, rates etc.
• Depreciation rates should be based on a reasonable estimate of the
life of the assets. Motor vehicles-5 years, Furniture, fixtures and
fittings-5-10 years, Equipment-5-10 years.
Other factors to take into account:
• Be aware of the norms comparing overhead to sales percentage
• Be aware of the operating profit margin that is being predicted and
compare to industry norms and be aware of the trends in these
norms
• Expect that as sales improve, operating margins will improve and, as
sales decrease, operating margins will decrease. This is due to the
high fixed costs element in total operating costs.
• Competition levels for the future. This will effect margins
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Forecasting the balance sheet (net assets requirement)
Sales activity will also have a significant effect on the balance sheet. A number of items
on the balance sheet of a company will increase as sales increase. For example a significant
increase in sales will most likely lead to increases in the following balance sheet items:
❑ Debtors: Debtors tend to increase as sales increase.
❑ Stock levels: More stock is required to meet increased demand.
❑ Cash: More cash is required to meet increased costs associated with the increase in
sales.
❑ Creditors: More credit is required from suppliers as purchases increase in line with
sales.
❑ Accrued expenses: More accrued expenses occur as a result of increased overheads.
❑ Bank overdraft: A bank overdraft is frequently used to bridge any financing gaps
caused by increases in activity.
❑ Non-current (fixed) assets: As the business expands new fixed assets are required.
(Note that fixed assets will not increase as sales increase, but only as the business
reaches capacity and requires expansion). Hence there is a long-term relationship
between sales and the fixed assets requirement. Focusing on the fixed assets
turnover ratio over previous periods can give an indication of this relationship
❑ Long-term finance: As fixed assets expand, one will also expect long-term finance
in the form of equity and more likely long-term debt to increase.
The relationship between sales and balance sheet items must be taken into account when
forecasting balance sheet items. A simple approach to forecasting some balance sheet items
is to express the balance sheet items as a percentage of forecast sales. To use this method
requires management to examine past records to see the effect fluctuations in sales have on
various balance sheet items. For example, if past records indicate that trade debtors levels
amount to 10 per cent of sales, then if forecast sales amount to €10m, debtors levels could
be taken as €1m unless management have a policy or cap on maximum debtor levels. This
method is quite simple and assumes a linear relationship between sales and the balance
sheet item. Other more sophisticated methods involving statistical methods (regression
analysis) can also be used. In forecasting balance sheet items, one must be aware of the
policies of a business. For example, has the company set maximum levels for loan capital,
fixed assets, debtors, creditors etc? The commitments and policies of a business and their
influence on forecasting are discussed below.
Forecasting Investment in net assets – a practical approach
1. Past growth in net assets/capital employed. For hotels the main focus
should be on fixed assets.
2. Existing fixed assets to sales ratios. It is important that whatever level of
fixed assets you decide on that the sales to fixed assets ratio should be
reasonable and in line with norms. This can be another justification.
3. Operating working capital: It would be reasonable to assume it will stay
as a fixed percentage of sales.
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Other forecasting issues
Forecasting involves an awareness of the economic environment and government policy.
These influence the following items:
❑ Taxation and rate of corporation tax.
❑ Variable interest rates on borrowings.
❑ The rate of inflation.
❑ The policies and commitments of the business.
All financial projections will be based on assumptions made on these items. The rate of
corporation tax is a significant item in the income statement as well as a significant item in
current liabilities in the balance sheet. For long-term financial forecasting it is important to
be aware of government policy in relation to rates of taxation. For example, it is
government policy at present to maintain the rate of corporation tax at 12.5 per cent for the
foreseeable future.
Generally, interest rates track inflation and as inflation increases interest rates increase. It
is important to be aware of where the economy is in relation to its economic cycle. Is it on
the rise with increased production and growth? If so this would indicate possible increases
in inflation in the future with the associated increases in interest rates. If it is in a depressed
state then this would indicate low inflation with a monetary policy of low interest rates to
try and boost the economy and domestic demand. Most businesses lock themselves into
fixed interest debt as it is easier to plan for and is less risky. However if the long-term view
of interest rates is that they will fall, then the temptation would be to ensure the cost of debt
is based on variable rather than fixed rates.
With regard to the effect of inflation on individual items of expense, each category should
be dealt with separately. Using an average rate of inflation for all items in the profit and
loss account is usually inappropriate, as the level of inflation can vary significantly between
individual items.
The policies and existing commitments of a business must also be considered when
preparing projected financial statements. These may relate to such matters as:
1. Capital expenditure.
2. Financing methods (debt or equity).
3. Dividends.
The level of capital expenditure is directly influenced by the strategic plan. Financing is a
direct result of the level of capital expenditure planned. Financing methods are influenced
by the level of existing debt in the business as well as company policy on debt levels. The
costs and risks associated with equity and debt levels must be taken into account in this
decision.
14
For dividend payments, there is no problem determining the rate of preference dividend as
this is generally specified in the share agreement. However, ordinary share dividends are
decided on by the directors of a company who propose dividends based on annual results.
This indicates that ordinary share dividends fluctuate with the fortunes of the company.
However evidence suggests that directors have usually a target rate of dividend and are
generally reluctant to deviate from this level. Remember, dividends tell the market a lot
about the directors confidence in the future of the company and a sudden reduction or even
increase can affect share price. Generally the target level of dividends is linked to the level
of profit for the period.
Dividend policy
Jury’s Doyle plc tend to ensure their rates of dividend are in excess of 30 per
cent of profits available for dividend. For the years 2002 and 2003, the
company declared dividend amounting to 33 per cent and 39 per cent
respectively, of profits available for dividend.
Ryanair plc has not declared any dividends since it floated on the stock
exchange as it is a young company experiencing rapid growth and thus all
profits are retained in the company for expansion. However at present
(November 2005), there are indications that Ryanair may relax this policy.
Preparation of Projected Financial Statements
Let us now take the following comprehensive example of an existing business and develop
projected financial statements from their forecast budget figures. An existing business will
always have an actual balance sheet at the beginning of the budget forecast period.
Example 5.3: Projected financial statements
The following is the balance sheet for Super Fast Foods Ltd as at 31st December. The
company own and operate a number of fast food restaurants in the midlands.
Balance Sheet as at 31st December
€
Fixed assets (net book value)
134,800
Current assets
Stock
Trade debtors
Cash
10,200
5,000
5,600
Capital and Liabilities
Share capital
Profit and loss account
70,000
25,900
20,800
155,600
95,900
15
Non-current liabilities
10% fixed interest loan
25,000
Current Liabilities
Trade creditors
Accruals
14,700
20,000
25,000
34,700
155,600
The following data has been agreed by the budget committee for the next four months. The
committee believe the company will experience increased demand for its products and are
keen to plan for this expansion.
1. Sales, labour and overheads have been forecast as follows:
Month
Budgeted
Labour
Overheads
sales
costs
€
€
€
January
55,000
14,500
11,580
February
60,500
15,950
12,738
March
68,063
17,545
14,012
April
76,911
19,300
15,413
2. Stock is sold at a 68 per cent gross profit margin and management policy is to hold
sufficient stock on hand to meet 20 per cent of sales demand for the next month.
3. On average, 90 per cent of the sales are cash sales with debtors on average paying the
following month.
4. Suppliers of materials offer one month’s credit for purchases.
5. Labour costs are paid in full by the end of each month.
6. Overheads which are paid as incurred, include depreciation of €2,500 per month, but
exclude the rental charge for the company’s premises. This is an annual charge of
€36,000 paid in two equal instalments on 1 January and 1 July.
7. The accruals figure in the balance sheet at 31 December represents arrears of VAT and
corporation tax. The company have come to an agreement with the Revenue
Commissioners that the amount will be paid by 28 February. This figure is inclusive of
penalties and interest.
8. There will be a repayment of €5,000 on the existing loan on 31 March. Interest on the
loan is paid at the end of each month.
a) Prepare a budgeted trading, profit and loss account for the three months ended 31
March.
b) Prepare a monthly forecast cash budget for January, February and March.
c) Prepare a forecast balance sheet as at 31 March.
Approach
The budgeted trading, profit and loss account, cash budget and balance sheet are
presented below with detailed notes showing workings and explaining the figures.
16
a) Budgeted Trading, Profit and Loss Account for three months ending 31 March
January February March
€
€
€
55,000
60,500
68,063
Sales
Less Cost of goods sold
Opening stock
10,200
Purchases
11,272
Closing stock
(3,872)
Cost of goods sold
(17,600)
Gross profit
37,400
Less Expenses
Labour costs
Overheads
Depreciation
Rent
Loan interest (€25,000 x 10% x 3/12)
3,872
19,844
(4,356)
(19,360)
41,140
4,356
22,346
(4,922)
(21,780)
46,283
€
Total
€
183,563
Note 1
(58,740)
124,823
Note 4
Note 3
Note 2
Note 2
10,200
53,462
(4,922)
47,995
30,830
7,500
9,000
625
Note 5
Note 5
Note 5
Note 5
95,950
28,873
Net profit
b) Cash Budget
January
€
Cash inflow – income
(90% current month)
Cash sales
(10% previous month)
Credit sales
Total
Cash outflow – expenditure
Purchases
Rent
Labour
Overheads
Taxation
Loan repayment
Loan interest
Total expenses
Net inflow / (outflow)
Opening balance
Closing balance
February March
€
€
Total
€
49,500
5,000
54,500
54,450
5,500
59,950
61,257
6,050
67,307
165,207
16,550
181,757
14,700
18,000
14,500
9,080
11,272
19,844
15,950
10,238
20,000
17,545
11,512
45,816
18,000
47,995
30,830
20,000
5,000
625
168,266
208
56,488
208
57,668
5,000
209
54,110
(1,988)
5,600
3,612
2,282
3,612
5,894
13,197
5,894
19,091
c) Balance Sheet as at 31st March
Cost
€
Depreciation
€
NBV
€
17
Note 6
Note 7
Note 8
Note 9
Note 10
Note 11
Note 12
Note 12
13,491 Note 13
5,600 Note 13
19,091
Fixed assets
134,800
Current assets
Stock
Trade debtors(10% x march sales
Prepayments (Rent 3 months x €3,000)
Bank
7,500
127,300 Note 14
Note 15
4,922
6,806
9,000
19,091
39,819
167,119
Share capital and Liabilities
Share capital
P&l Reserves(€25,900+€28,873)
70,000
54,773
124,773 Note 18
Long-term liabilities
10% Loan
20,000
20,000 Note 17
Current liabilities
Trade creditors
22,346
Note 16
22,346 Note 16
167,119
Notes explaining the figures:
The projected profit and loss account
Note 1: Sales
The trading, profit and loss account is based on the following simple formula:
Sales – expenses = net profit
It is important to remember that in preparing the profit and loss account, we are only
concerned with revenues earned and expenses charged for the forecast period. The profit
and loss account is not concerned with whether or not we have received these monies, or
when we will pay the various expenses. Thus sales are simply the forecast figures for
January, February and March of €55,000, €60,500 and €68,063.
Note 2: Gross profit and cost of sales
The gross profit of a business is simply the difference between the selling price and the
cost price of goods sold, multiplied by the quantity of goods sold. Most businesses will be
able to calculate an average gross profit margin. In the above example we are told in point
(2) of the example that the company’s stock (goods) is sold at a 68 per cent gross profit
margin. This tells us that on average, for every €100 sales, the business will make a gross
profit of €68 and thus the cost of buying the goods will amount to €32. In this example, we
calculate gross profit per month by simply multiplying sales by the gross profit margin of
68 per cent and cost of sales is simply the difference between sales and gross profit.
Gross profit margin and gross profit mark-up
18
Gross profit margin
The gross profit margin, (sometimes called the gross profit percentage), is
calculated as follows:
Gross profit x 100
Sales
This tells us that if the gross profit margin is 68 per cent, then gross profit equals
68 per cent and sales equals 100 per cent (the denominator in the fraction). Hence
cost of goods sold will equal 32 per cent.
Gross profit and cost of sales can be calculated by simply multiplying sales by 68
per cent and 32 per cent respectively.
Gross profit = sales multiplied by the gross profit percentage.
Cost of sales = sales multiplied by the cost of sales percentage.
Gross profit mark-up
Sometimes a business will express its gross profit percentage in terms of gross
profit mark-up. This percentage expresses gross profit as a percentage of cost of
sales as follows:
Gross profit x 100
Cost of sales
For example, a gross profit mark-up of 70 per cent would imply that gross profit is
70 per cent and cost of sales is 100 per cent (the denominator in the fraction).
Hence sales will equal 170 per cent.
We can calculate gross profit by simply dividing sales by 170 and multiplying by
70. Cost of sales can be calculated by dividing sales by 170 and multiplying by
100. Gross profit mark-up is sometimes called gross profit as a percentage of cost
or as a percentage of cost of sales.
Note 3: Stock figures
Most businesses that sell goods will have a policy of holding a certain amount of stock.
Some businesses will try and ensure stock levels stay within a certain range. Stock levels
are generally dependant on sales demand. If sales are expected to increase, then stock levels
tend also to increase. Depending on the business sector, stock levels can be extremely high
(manufacturing and retail) to very low (restaurants, hotels). However they are a product of
demand. In this example we are told in point (2) that it is management policy to have
sufficient stock in hand to meet 20 per cent of sales demand for the next month. In other
words the closing stock at the end of January should equal 20 per cent of February’s
projected sales. Closing stock at the end of January should equal €12,100 (€60,500
multiplied by 20 per cent). However, the €12,100 figure values stock at selling price. The
cost concept requires that stock should be valued at cost price unless selling price is less
than cost price. We do know that the cost of sales percentage equals 32 per cent (100 per
cent minus 68 per cent). Thus we need to mark down the stock valuation to cost price by
multiplying €12,100 by 32 per cent to get €3,872. Remember, closing stock at the end of
January is the opening stock for February.
Calculation of closing stock
Next month’s sales x stock percentage required x cost
of sales percentage
19
€60,500 x 20% x 32% = €3,872
€68,063 x 20% x 32% = €4,356
€76,911 x 20% x 32% = €4,922
Closing stock end of January
Closing stock end of February
Closing stock end of March
Opening stock of €10,200 at the beginning of January is provided in the balance sheet at
31 December.
Note 4: Calculation of purchases figures
At this stage we have calculated sales, cost of sales, opening stock and closing stock for
each of the months. The figure that is missing is purchases, which is simply calculated as
the balancing figure. Let us look at January again.
Trading Account – January
€
Sales
Less Cost of sales
Opening stock
Purchases
Less Closing stock
Cost of goods sold
Gross profit
€
55,000
10,200
?
(3,872)
(32% x 55,000)
(68% x 55,000)
17,600
37,400
Sales of €55,000 are provided in the example. The gross profit is found by applying the
gross profit margin. The cost of goods sold is the difference between sales and gross profit.
Purchases can be calculated using the following formula:
Calculation of purchases
Purchases = cost of goods sold + closing stock – opening stock
January
February
March
Sales
(given)
€
55,000
60,500
68,063
Cost of sales
(sales x 32%)
€
17,600
19,360
21,780
+ Closing
stock
€
3,872
4,356
4,922
– Opening
stock
€
10,200
3,872
4,356
= Purchases
€
11,272
19,844
22,346
It is important to calculate the purchases figures for each month as there is a time lapse of
one month between receiving the goods and paying for them. Thus purchases in January
will be paid for in February. We need to know the purchases figure for each month to know
when it is paid, as this information is required for the cash budget.
20
There are many calculations involved in preparing a forecast trading account. The
following step by step approach may be helpful.
Preparing trading accounts
Step 1
Outline the trading account, inserting the figures given
in the question. These are generally the sales and
opening stock figures.
Step 2
Identify the gross profit and cost of sales percentages
and calculate these figures.
Step 3
Calculate the closing stock figure.
Step 4
Calculate the purchases figures. In the above
example, purchases is the balancing figure, however,
one should note that in some questions, the purchases
figures will be given, with closing stock acting as the
balancing figure. (See question 9.9).
Note 5: Expenses
In the profit and loss account we are concerned with expenses charged and not if, or when,
they are paid. Labour costs and overheads are as given for each month. Depreciation of
€2,500 per month was included in overheads but is shown separately in the profit and loss
account.
The rental charge on the company’s premises, point (6) in the example, is €36,000 per
annum. As we are only preparing the profit and loss account for three months then only
3
/12 of €36,000 will be charged to the profit and loss account irrespective of what is paid.
There is a repayment of €5,000 on a loan. This is a capital transaction affecting the balance
sheet, not the profit and loss account. However the cost of a loan is the interest charged and
this should appear as an expense in the profit and loss account. We are told from the balance
sheet, and point (8) in the example, that loan interest is charged at 10 per cent on the amount
of the loan. The amount of the loan has been €25,000 for the period and thus interest is
charged to the profit and loss account for each month as €208 (€25,000 by 10 per cent by
1
/12).
The projected cash budget
Here we are concerned with when revenues are received and expenses are paid. There is
no distinction between revenues and expenses of a capital or operating nature. For example,
if a business had sales for January of €5,000 and also received a loan of €10,000, then in
the profit and loss account we would only take into account the sales figure as the loan
would appear as a liability in the balance sheet. However in the cash budget, there is no
distinction between transactions of a capital or revenue nature and hence we would show
both on the income side of the cash budget.
21
The cash budget is the same as a bank or cash account and is governed by the formula:
Receipts – payments = net cash inflow / (outflow) + opening cash balance
= closing cash balance
It is generally presented in a monthly or quarterly format. It shows for each period whether
the business has a shortfall or an excess of cash. The following are examples of typical
cash inflows and outflows for a business:
Cash inflows
Cash sales
Cash received from debtors
Cash from issue of shares
Loans received
Cash from the sale of fixed assets
Tax refunds
Cash outflows
Expenses paid
Cash purchases
Payments to creditors
Dividend
Loan repayments
Purchase of fixed assets
Payments to Revenue
Commissioners
Note 6: Income / receipts
Income or receipts would include income from sales as well as any monies received from
the sale of fixed assets or any monies received by way of loans to the business. In this
example, the only income for the business is its trading income or monies received from
sales. The income section of the cash budget is reproduced below, with the calculation of
each figure outlined:
Cash Budget
January February March
€
€
€
Cash inflow – income
(90% current month)
Cash sales
(10% previous month)
Credit sales
Total
49,500
5,000
54,500
54,450
5,500
59,950
Total
€
61,257
6,050
67,307
165,207
16,550
181,757
In point 3 of the example, we are told that on average, 90 per cent of the company’s sales
are cash with the balance (10 per cent) debtors paying one month later. Thus 90 per cent of
January’s sales of €55,000 will be received in January, amounting to €49,500, with the
balance of €5,500 received in February. Regarding February’s sales of €60,500, 90 per
cent will be received in February amounting to €54,450 with the balance of €6,050 received
in March. Regarding March’s sales of €68,063, 90 per cent will be received in March
amounting to €61,257 with the balance amounting to €6,806 received in April. Thus at the
end of March, debtors will be shown in the balance sheet as €6,806.
To establish cash sales
22
January
€
55,000
February
€
60,500
March
€
68,063
90% of €55,000
90% of €60,500
90% of 68,063
49,500
54,450
61,257
Sales (profit and loss)
Cash budget
Cash sales
Sales (profit and loss)
To establish credit sales
January
February
€
€
55,000
60,500
Cash budget
Credit sales
10% of €55,000
5,000
5,500
March
€
68,063
10% of €60,500
6,050
Debtors at the end of
March is 10% of
€68,063 = €6,806
Comes from
opening
balance sheet
It is important to note that the debtors figure in the balance sheet at 31 December of €5,000
represents monies that it is assumed will be received in January and hence it is recorded in
the cash budget for that month.
Note 7: Expenditure (purchases)
We have calculated the purchases figures in the profit and loss account, but for the cash
budget we need to know when they are paid. We are told in point (4) of the example that
suppliers of materials offer one months credit for purchases. In other words January’s
purchases are paid in February (€11,272) and February’s purchases are paid in March
(€19,844). March’s purchases are paid in April. Thus at the end of March, trade creditors
will amount to March’s purchases of €22,346. In the opening balance sheet at 31 December,
under current liabilities, creditors amounts to €14,700. These represent December’s
purchases which will be paid in January.
Note 8: Expenditure (rent)
We are told in point (6) that the annual charge for rent is €36,000, which is paid in two
equal instalments on 1 January and 1 July. Hence €18,000 will come out of the bank
account in January. It is important to note that at the end of March we will have prepaid
three months rent as we have paid rent up until the end of June. Thus at the end of March
there is three months rent prepaid and this should appear in the balance sheet as a
prepayment under current assets amounting to €9,000.
Note 9: Expenditure (labour)
23
Labour is paid as incurred by the end of each month, point (5) in the example, hence the
figure for labour costs in the profit and loss account is the same as in the cash budget.
Note 10: Expenditure (overheads)
We are told in point (7) that overheads are paid as incurred, hence there is no timing
difference between overheads being charged and paid. However overheads do include
depreciation which is a non-cash transaction and does not affect the cash budget. Thus we
need to take depreciation of €2,500 per month out of overheads and charge the balance to
the cash budget.
Note 11: Expenditure (taxation)
In point (7) we are told that the accruals figure in the opening balance sheet at 31 December
represents arrears of taxation which will be paid in February. This €20,000 is treated as an
outflow / expenditure in the cash budget in February. It is important to note that this
taxation figure does not appear in the profit and loss account for January, February or
March as it represents tax unpaid from previous years and has already been charged in the
profit and loss account in previous years.
Note 12: Expenditure (loan repayment and loan interest)
In point (8) we are told that there will be a repayment of the existing loan of €5,000 in
March. This is a cash outflow to be recorded in the cash budget in March. It does not appear
in the profit and loss account as it is a transaction of a capital nature. The loan interest is
paid as charged in the month and thus is treated as an outflow in the cash budget.
Note 13: Opening and closing balance
The opening balance of €5,600 is the money in the bank account at 31 December (see
opening balance sheet). As January’s expenditure exceeded income by €1,988, the cash
balance at the end of January amounts to €3,612. As income exceeds expenditure in
February by €2,282, the businesses bank balance is projected to increase to €5,894. In
March, income is projected to exceeds expenditure by €13,197 and hence the business bank
account balance is projected to increase to €19,091.
The balance sheet
Note 14: Non-current (Fixed) assets
There were no increases to fixed assets during the three month period, hence the fixed
assets cost figure stays the same at €120,000. Three months depreciation of €2,500 per
month is deducted to get the net book value of fixed assets which amounts to €112,500.
Note 15: Current assets
• Stock: This is the closing stock figure at the end of March. (See note 3).
• Debtors: This figure represents 10 per cent of March’s sales. Payment will be received
in April, but at the end of March it is owed to the business. (See note 6).
• Prepayments: This represents three months rent prepaid. By the end of March the
business had already paid rent up until the end of June and thus is prepaid by three
months. (See note 8).
• Bank: This is the closing balance in the cash budget at the end of March.
24
Note 16: Current liabilities
These are trade creditors representing monies owed for purchases. It represents March’s
purchases unpaid at the end of March. (See note 7).
Note 17: Long-term liabilities
This is the loan which has fallen to €20,000 due to a repayment of €5,000 at the end of
March. (See note 12).
Note 18: Share capital and reserves
There were no new issues of share capital thus it remains unchanged. Reserves represent
the amount of profit retained in the business (not given out as dividend). Up to 31
December, reserves amounted to €25,900 (see opening balance sheet). Add to that, the
projected profits from the profit and loss account of €28,873 and reserves stand at €54,773
on 31 March.
Financial Forecasts- Assessment and decision-making
Projected financial statements, once prepared, must be critically examined by management
as to their reasonableness and reliability. Management must assess the reasonableness of
the assumptions underlying the projections and also whether all relevant items have been
accounted for. They must attain a sense of whether the projected targets are overambitious
or too easily attainable. The two more popular approaches to achieve this are:
1. The use of techniques such as sensitivity analysis (chapter 6), can be useful in
developing a feel for the reliability of these projections.
2. A popular approach to assessing the reasonableness of financial projections is to
prepare key financial indicators for each year of the forecast period based on the
forecast financial statements. If any ratio is out of line with norms or past period
trends then management may review and reassess some of the forecast
assumptions. The following key ratios should be prepared
Return on capital employed (ROCE)
▪ Capital employed turnover.
▪ Operating profit margin.
▪ Return on owner’s equity (after tax).
▪ Earnings per share (EPS).
▪ Net debt to equity.
▪ Interest cover.
▪ Dividend cover/dividend payout ratio.
▪ Operating cash flow as a percentage of operating profit
▪ Operating cash flow as a percentage of net debt
Once management are satisfied as to the reasonableness and reliability of the projections,
they can then be used to inform management decision-making on the following issues:
25
1. Is the projected profit satisfactory in relation to the risks involved and the required
return on capital? If not, what can be done to improve this?
2. Are sales and individual expense items at a satisfactory level?
3. How adequate are the projected cash flows of the business and can they be
improved?
4. Should management consider additional financing?
5. What type of financing is required, long, medium or short-term financing?
6. What type of financial instruments are appropriate, debt or equity?
7. Will there be surplus funds and if so, what plans have the company as regards
investing these funds?
8. Is the business overly financed through debt?
9. How liquid is the business?
10. Is the financial position at the end of the period acceptable?
Alternative Approaches to Budget Preparation
There are a number of different approaches or techniques used to formulate and prepare
budgets. These are considered under the following headings:
❑ Incremental budgeting.
❑ Zero-based budgeting.
❑ Activity based budgeting.
❑ Rolling budgets.
Incremental budgeting
‘Method of budgeting based on the previous budget or on actual results, adjusting
for known changes and inflation’
Incremental budgeting as defined by CIMA Official Terminology
This is where the current budget and actual figures act as the starting point or base for the
new budget. The base is adjusted for forecast changes to, for example, the product mix,
sales volume, sales price, expenses and capital expenditure that are expected to occur over
the next budget period. It is called incremental budgeting as the approach does not focus
on the base, but focuses on the increment (the changes from the base). An example would
include increasing last years operating expenses by the rate of inflation to calculate the new
budgeted figure. The major disadvantage of this is that the major part of the expense (the
base) does not change and in fact is overlooked and not questioned under this approach.
For example the base figure may be distorted due to extraordinary events in the previous
period which are not expected to reoccur. Thus if this is not taken into account, the budget
could be misleading.
Zero-based budgeting
‘Method of budgeting that requires all costs to be specifically justified by the
benefits expected’
Zero-based budgeting as defined by CIMA Official Terminology
26
This approach requires that every year, all costs and capital expenditure are questioned and
thus require justification and prioritising before any decision is taken regarding the
allocation of resources. Thus a zero base is adopted which effectively means that both the
base and the increment are questioned. In fact the whole activity that leads to the item of
expenditure is questioned and requires justification. Zero-based budgeting changes the
approach of traditional or incremental budgeting from focusing on changes in expense
items from year to year, to an approach that looks at each department budget as if it were
undertaking its activities or programmes for the first time. It requires a detailed justification
and cost-benefit approach to each expense item in the department budget. It forces
managers to prioritise activities and related expenses based on a value for money concept.
In effect, it overcomes the limitations of incremental budgeting.
Advantages
❑ It fosters a questioning attitude to all revenues and costs in preparing operating budgets.
❑ It focuses attention on the value for money concept.
❑ It can help identify inefficient work processes and operations.
❑ It helps minimise waste.
❑ It should result in more efficient allocation of resources.
Disadvantages
❑ It is a costly and time consuming approach.
❑ It may require management to develop and learn new skills.
Many companies today do not apply a full-scale zero-based approach to their budgeting
process but only apply it to selected revenue and expense items or departments within an
organisation. These expense items would often include advertising, research and the costs
associated with developing new products and product lines.
Activity based budgeting
‘Method of budgeting based on an activity framework and utilising cost driver data
in the budget setting and variance feedback processes’
Activity based budgeting as defined by CIMA Official Terminology
Activity based budgeting (ABB) involves the build up of budgeted costs using an activity
approach. All the activities that are undertaken in the organisation, function or department
are defined, and costs attributed to that activity are established. Resources are allocated
according to activity levels. ABB can be used in all types of organisations. For example,
ABB in the front office of a hotel would involve ascertaining such activities as answering
customer queries, processing a reservation, preparing a quotation and updating customer
accounts. The costs of each activity would then be established and resources would be
allocated based on the planned level of activity.
ABB is an extension of the zero-based budgeting approach and goes into far greater detail
in identifying value and non-value activities. It can be more effective than zero-based and
incremental budgeting because:
❑ It avoids slack that is often included in the incremental approach.
❑ ABB focuses attention on each activity, highlighting those that do not add
value.
27
Rolling budgets
‘Budget continuously updated by adding a further accounting period (month or
quarter) when the earliest accounting period has expired’
Rolling budgets as defined by CIMA Official Terminology
A rolling budget is a twelve month budget which is prepared several times each year (say
once each quarter). The purpose of a rolling budget is to give management the chance to
revise its plans, but more importantly, to make more accurate forecasts and plans for the
next few months. When rolling budgets are used, the extra administration costs and effort
of producing several budgets instead of just one, should be balanced with more accurate
forecasting and planning.
Advantages
❑ Budgets are reassessed regularly and thus should be more realistic and accurate.
❑ Because rolling budgets are revised regularly, uncertainty is reduced.
❑ Planning and control is based on a recent updated plan.
❑ The budget is continuous and will always extend a number of months ahead.
Disadvantages
❑ Rolling budgets are time consuming and expensive as a number of budgets must be
produced during the year.
❑ The volume of work required with each reassessment of the budget can be off-putting
for managers.
❑ Each revised budget may require revision of standards or stock valuations which is time
consuming.
Budget approaches in practice
In research conducted by Smullen and O’Donoghue (2005) into the use and
influence of certain financial based decision-making models in the Irish
hospitality industry, it was found that 12 per cent of hotels surveyed used the
zero-based approach to forecasting whereas 23 per cent used the
incremental approach. However 65 per cent of hotels used a balance of zerobased and incremental for different forecast variables. The research was
conducted in early 2005 and was based on hotels with a 3-star standard or
higher and with 30 or more bedrooms.
Research by Luby (2006) found the following uptake on the budgeting
approaches in the retail sector:
Incremental budgets
55%
Flexible budgets
36%
Rolling budgets
27%
Activity based budgets
27%
Zero-based budgets
0%
28
Summary
The preparation of projected financial statements is based on the same principles as the
preparation of historic financial statements. The only difference is that projected data is
employed in their preparation rather than actual data. Projected statements are only useful
if the projections made are reliable. Hence the starting point in any evaluation of projected
financial statements is to examine the underlying assumptions on which the data is
prepared.
The main information points covered in this chapter are as follows:
❑ The master budget contains three summary budgeted statements that are the end result
of any budgetary planning process.
▪ The income statement, made up of a number of budgets such as sales, cost
of sales, payroll, operating expenses budget, and fixed expenses budget.
Collectively, these are known as the operating budgets.
▪ The balance sheet, made up of the capital expenditure budget, stock, debtors
and creditors budgets.
▪ The cash budget, which is primarily concerned with the timings of future
cash flows and is based on data from the operating and capital budgets.
❑ The master budget brings together all the financial projections from the various
operating and capital budgets within an organisation for the period. It embraces the
impact of both operating decisions (running the business) and investment or financing
decisions that the business has planned for the next time period (usually twelve
months). It sets out the organisations targets for the coming period in a quantifiable and
easily understood format, helping to provide direction and ensuring goal congruence.
❑ Three essential elements are required before one can begin to prepare projected
financial statements. These are:
▪ Forecast of sales.
▪ Forecast of costs.
▪ Forecast of the required investment in net assets to achieve these sales.
❑ Forecasting involves an awareness of the economic environment and government
policy. These influence the following items:
▪ Taxation and rate of corporation tax.
▪ Interest rates for borrowings with variable interest rates.
▪ The rate of inflation.
▪ The policies and commitments of the business.
❑
There are a number of different approaches or techniques used to formulate and
prepare budgets. These are considered under the following headings:
▪ Incremental budgeting.
▪ Zero-based budgeting.
29
▪ Activity based budgeting.
▪ Rolling budgets.
❑ After projected financial statements have been prepared, they must be critically
examined by management as to their reasonableness and reliability. Management must
assess the reasonableness of the assumptions underlying the projections and also assess
whether or not all relevant items have been accounted for. They must attain a sense of
whether the projected targets are overambitious or too easily attainable.
30
Review Questions
Review Questions
The solutions to these questions are available at
www.blackhallpublishing.com/managementaccounting.htm
Click on student resources and go to chapter 9
Note: The question numbers begin with the number 9 indicating chapter 9. This is because the
solutions on the above website are located in chapter 9 and hence the number changes are
necessary to reduce confusion in accessing the solutions
Question 9.1
a) Distinguish between operating and capital budgets.
b) What are the main advantages of preparing monthly cash budgets?
c) Outline the main objectives of budgetary planning.
Question 9.2
a) Outline the main factors that influence sales.
b) Why is the sales forecast of critical importance to the preparation of projected
financial statements?
c) Outline the main ways in which a business can forecast its operating costs.
Question 9.3
Briefly outline the following approaches to budget preparation:
a) Incremental budgeting.
b) Zero-based budgeting.
c) Activity based budgeting.
d) Rolling budgets.
Question 9.4
Maura Young is considering leaving the health and fitness centre where she is employed
as a yoga instructor and starting a new venture. Maura plans on providing yoga instruction
for clients in their own homes, commencing in January. Maura will charge a fee of €450
for a course of eight weekly sessions. The fee includes a DVD and a book. Half the fee
will be payable upfront, the remainder will be due at the beginning of the following month.
The following details have been estimated:
1. Cash of €20,000 and some equipment worth €500 will be invested in the business by
Maura before January. The equipment will be depreciated at a rate of 10 per cent per
annum, straight-line.
31
2. A second hand jeep will be purchased at the commencement of business for €13,000
and will be paid for in cash. This will be depreciated at a rate of 25 per cent per
annum, straight-line.
3. Maura will take on 30 clients in January and work with them for January and February.
As a promotion, the first 10 clients to sign up will receive a 10 per cent discount. In
March, 40 new clients will be taken on and trained in the period from March to the end
of April.
4. The DVDs cost €15 each and the books €12 each. Maura will buy the amount required
at the beginning of January and March and has negotiated one months credit.
5. Office services will be provided by a local agency. Initial set-up costs will amount to
€500 in the first month and €200 thereafter. Office services must be paid in the
month the service is provided.
6. Insurance of €750 per quarter will be payable in advance.
7. General overheads of €100 per month will be payable as incurred.
8. Maura will receive wages of €2,500 per month.
Required
a) Prepare a cash budget outlining the first four months of trading.
b) Prepare a profit and loss account for the first four months ending 30 April.
c) Prepare a balance sheet as at 30 April.
Question 9.5
Collins Solutions, a small business wholesaling stationery items, is just reaching the end
of its first year in operation. Data is currently being gathered in preparation for budgets
for the first quarter of the next financial year. The financial year-end is the 31 December.
The following information is available:
Balance Sheet as at 31 December
Fixed Assets
Cost
Accumulated
depreciation
Equipment
€250,000
€25,000
Furniture & fittings €165,000
€16,500
€415,000
€41,500
Current Assets
Stock
€ 30,000
Debtors
€180,000
Bank
€ 10,000
€220,000
Current liabilities
Creditors
Financed by:
Capital
(€130,000)
N.B.V.
€225,000
€148,500
€373,500
€90,000
€463,500
€463,500
€463,500
32
Projections for first quarter are detailed below:
January
February
Sales
€240,000
€256,000
Purchases
€140,000
€150,000
March
€252,000
€148,000
Total Quarter
€748,000
€438,000
Other information available:
1. 20 per cent of sales are for immediate payment, the balance is received one month
following the sale.
2. All purchases benefit from 30 days credit.
3. Wages have been estimated at €60,000 for January with a 5 per cent increase planned
from the 1 February. Wages are paid in the month due.
4. Expenses of €25,000, payable in the month incurred, have been estimated for each of
the first three months.
5. Purchases have been planned to facilitate an increase in stock levels of 25 per cent by
the end of the first quarter.
6. All depreciation is at a rate of 10 per cent per annum straight-line, calculated on the
basis of one month’s ownership equals one months depreciation. Depreciation is
included in the expenses above.
7. A new piece of equipment will be purchased on the 1 January for €35,000.
Required
a) Prepare a profit and loss account for the quarter ending 31 March.
b) Prepare a cash budget for January, February and March.
c) Prepare a balance sheet as at 31 March.
Question 9.6
The Ballyyahoo Tourism Co-operative, as part of its overall strategy to attract more tourists
to the locality, has finalised plans to open a restaurant on its riverbank in part of an old
renovated warehouse leased to the co-operative and which will eventually consist of a
heritage centre with restaurant and bar. The opening date of the restaurant is 1 July with
pre-opening expenditure estimated as follows:
Furniture and equipment
Stock of food and beverages
€38,000
€2,000
€40,000
The initial requirements will be financed through the issue of 40,000 €1 shares in the cooperative. Any additional needs will be financed with the aid of a bank overdraft. The
shares will be issued and paid for by early June with the equipment and stock purchased
and ready by 1 July.
Meals are expected to be sold at 150 per cent above food cost (gross profit margin of 60%)
and it is estimated that 10 per cent of sales will be paid for in the month after sale. Expected
sales revenue is €5,000 for the first three months and €6,000 thereafter.
33
One months credit is expected from the suppliers of food, with the initial stock, along with
the furniture and equipment, being paid for in June. Monthly overheads are expected to
amount to €1,200 per month (including depreciation of €200 per month). This does not
include leasing and insurance of €5,000 for the first year which will be paid quarterly in
advance from 1 July. Advertising for the first six months costing €1,600 will be paid in
July.
The restaurant expects to receive a refund of VAT of €3,210 in September and a VAT
payment of €1,210 will be paid in November. Wages and salaries are estimated at €1,500
per month, paid in the month charged, however, €300 of the €1,500 relates to PAYE and
PRSI which is paid in the following month. It is agreed that there should be sufficient stock
in hand at the end of each month to meet 50 per cent of the following months demand.
Required
a) Prepare a projected profit and loss account for the 5 month period ending 30
November.
b) Prepare a monthly projected cash budget for the 5 month period ending 30 November.
Question 9.7
The following is the balance sheet for McQuaid Leisure Suppliers Ltd at the beginning of
the year. The company is involved in supplying the leisure industry with leisure and fitness
systems.
Opening Balance Sheet
Fixed assets (net book value)
€
100,000
Current assets
Stock
Debtors
Cash
9,000
24,000
2,500
35,500
Current liabilities
Creditors
Accruals
15,000
25,000
(40,000)
Long-term liabilities
10% fixed interest loan
Financed by
Share capital
Profit and loss account
(19,500)
76,000
57,000
19,000
76,000
34
The following data has been agreed by the budget committee for the next six months. The
committee believe the company will experience increased demand for its products during
this period and are keen to plan for this expansion.
1. Sales, labour and overheads have been forecast as:
Budgeted Labour Overheads
Month
sales
costs
€
€
€
January
60,000
15,000
12,000
February
66,000
16,500
13,200
March
72,600
18,150
14,520
April
79,860
19,965
15,972
2. The company’s stock is sold at a 65 per cent gross profit margin and management’s
policy is to have sufficient stock in hand to meet sales demand for the next month.
3. On average, 50 per cent of the company’s sales are cash sales with debtors, on average,
paying the following month.
4. Suppliers of stock offer one months credit for purchases.
5. Labour costs are paid in full by the end of each month.
6. Overheads include depreciation of €2,000 per month but exclude the rental charge for
the company’s premises. This is an annual charge of €24,000 paid in advance in two
equal instalments, on 1 January and 1 July.
7. The accruals figure in the opening balance sheet represents arrears of VAT and
corporation tax. The company have come to an agreement with the Revenue
Commissioners that the amount will be paid by 28 February. This figure is inclusive of
penalties and interest.
8. The company expects to invest in new plant and equipment in March. The investment
will amount to €30,000 and will be paid in March.
9. The fixed interest loan is repaid on a quarterly basis with equal instalments of capital
plus interest outstanding at the end of the three month period. The capital repayment,
excluding interest, amounts to €300 per month. The next payment date is 28 March.
Required
a) Prepare a budgeted trading, profit and loss account for the three months ended 31
March.
b) Prepare a monthly cash budget for January, February and March.
c) Prepare a balance sheet as at 31 March.
Question 9.8
The following is the balance sheet for Leisure Hire Ltd at the end of August. The company
is involved in hiring out all leisure, catering and party equipment for all social occasions.
Opening Balance Sheet
€
Fixed assets (net book value)
268,000
35
Current assets
Debtors
22,000
Cash
3,560
Rent prepaid 2,000
Current liabilities
Creditors
Accruals
27,560
15,000
15,000 (30,000)
Long-term liabilities
10% fixed interest loan
Financed by
Share capital
Profit and loss account
(33,000)
232,560
205,000
27,560
232,560
The following data has been agreed by the budgeting committee for the next six months.
The committee believe the company will experience increased demand for its products
during this period.
1. Sales, labour and overheads have been forecast as:
Month
September
October
November
December
Budgeted
sales
€
66,000
72,600
79,860
87,846
Labour
costs
€
16,500
18,150
19,965
21,961
Overheads
€
13,000
14,300
15,730
17,303
2. The direct cost of equipment hire and set-up generally, amounts to 10 per cent of the
contract price (sales). These direct costs are paid as incurred.
3. On average, 50 per cent of the company’s sales are cash sales, with debtors on average
paying the following month.
4. Labour costs are paid in full by the end of each month.
5. Overheads include depreciation of €2,000 per month, but exclude the rental charge for
the company’s premises, which is an annual charge of €24,000, paid in two equal
instalments in advance on 1 April and 1 October.
6. The accruals figure in the opening balance sheet represents monies owed for accounting
services which will be paid by 28 October.
7. The creditors figure in the opening balance sheet represents the amount due for
equipment purchases made in August. These will be paid in September.
8. The company expects to invest in new plant and equipment in November. The
investment will amount to €30,000. This will not be paid until December.
36
9. Interest will accrue on the loan as usual, based on the amount outstanding at the
beginning of September. A capital repayment of €3,000 plus the interest accrued for
the three months will be paid on 30 November.
Required
a) Prepare a budgeted trading, profit and loss account for the three months ended 30
November.
b) Prepare a budgeted monthly cash budget for September, October and November.
c) Prepare a forecast balance sheet as at 30 November.
Question 9.9
The following is the summarised balance sheet of the ‘Hendy’ Sports Bar and Restaurant at
their financial year-end 31 May.
Balance sheet as at 31 May
€
Fixed assets
Leasehold property
Furniture and equipment
200,000
50,000
250,000
Current assets
Stock Beverage
Food
Trade debtors
Bank
Current liabilities
Trade creditors
Rent received in advance
Preliminary tax due
800
500
1,000
2,360
4,660
2,230
1,000
10,000
(13,230)
Long-term liabilities
Loan capital
(43,430)
198,000
Financed by
Share capital
Reserves
150,000
48,000
198,000
The following are forecast figures and information relating to the next three months to 31
August.
Month
Sales
.
Purchases
.
Wages
Expenses Depreciation
37
Food
€
June
24,000
July
30,000
August 36,000
Beverage
€
8,800
10,000
11,200
Food Beverage
€
€
13,000
4,000
14,000
4,400
17,000
5,000
€
10,000
12,000
12,500
€
6,000
7,000
7,500
€
850
850
850
The following additional information is also available:
1. 90 per cent of sales of both food and beverages are for cash, with the balance settled in
the month following the transaction.
2. All stock purchases are on credit with payment made in the month following the date
of transaction.
3. The bar works on a gross margin of 55 per cent and the restaurant on a gross margin of
60 per cent.
4. 70 per cent of wages are paid in the month worked, with 30 per cent representing PAYE
and PRSI paid the following month.
5. Expenses are paid as incurred, except insurance premiums (included in expenses) of
€3,000 per annum which are paid in advance on 1 of June each year.
6. The business sublets part of its premises and receives rent at quarterly intervals in
advance on 1 August, 1 November, 1 February and 1 May each year.
7. Capital repayments on the loan amount to €1,200 per month with interest charges
amounting to €450 per month. Both these items of expenditure are paid for as incurred.
8. Preliminary corporation tax due for last year’s profits of €10,000 will be paid in August.
9. The depreciation charge of €850 per month can be broken down into depreciation of
leasehold €600 and furniture and equipment of €250.
Required
a) Prepare a budgeted departmental trading, profit and loss account for the three months
ended 31August.
b) Prepare a monthly forecast cash budget for June, July and August.
c) Prepare a budgeted balance sheet as at 31 August.
Question 9.10
The following information is available regarding ‘Play World’, a family run children’s play
centre with coffee shop and fast food outlet.
1. The bank balance on 1 June is €10,000.
2. Sales are expected to be €10,000 per month for the quarter ended 31 August and €9,000
per month for the following quarter. 10 per of sales are estimated to be on credit, with
the monies received in the month following the sale.
3. The gross profit margin for the business is expected to be 30 per cent for the budget
period.
4. Insurances are €1,900 per annum, payable annually in advance on 1 June.
5. Rates are €450 per annum, payable half yearly in advance on 1 August and 1 February.
6. Stock costing €500 is on hand at 1 June and will be maintained at this level throughout
the period.
38
7. A 12 per cent mortgage of €100,000 exists at 1 June, with nine years to run from that
date. It is being repaid on a quarterly basis by equal instalments of capital plus interest
outstanding at the end of each quarter. The next repayment is due on 1 August.
8. Part of the premises is sublet on a five year lease at €250 per month payable quarterly
in advance from 1 May.
9. Trade creditors will allow accounts to be settled in the month following that in which
goods are supplied.
10. Other business expenses are expected to be €950 per month, to be paid at the end of the
month following that in which they are incurred.
11. Private drawings are estimated to be €800 in total per month.
Required
a) A forecast trading, profit and loss account for the period 1 June to 30 September
inclusive.
b) A forecast monthly cash budget for the above period.
c) Relevant extracts from the balance sheet as at 30 September.
Question 9.11
A new hotel company, Shamrock Ltd, has been formed and will commence business on
January 1. The following forecast data for the first three months has been prepared:
1. Share capital to be issued
€250,000
2. Bank loan to be raised, at an annual interest rate of 6%
€180,000
3. Equipment and furniture to be purchased
€384,000
The amount is payable 50% in January and 50% in March.
The annual depreciation charge is on a straight-line basis at 12.5%.
4. Budgeted Monthly Data:
Sales
Month
€
January
50,000
February
60,000
March
80,000
Closing
stock
€
70,000
80,000
96,000
Wages and
salaries
€
12,000
13,500
15,500
General
expenses
€
6,000
6,500
7,500
5.
6.
7.
8.
Cash sales as a percent of total sales will be 30 per cent.
The period of credit allowed to debtors will be two months.
The gross profit margin is expected to be 70 per cent.
Monthly purchases will depend on the level of sales and stocks. The period of credit
received from suppliers will be one month.
9. Wages and salaries will be paid in the month incurred.
10. Annual rent of premises, payable six months in advance, amounts to €150,000.
11. General expenses, which exclude rent and depreciation, are payable one month in arrears.
12. The bank loan of €180,000 will be repaid over 10 years in equal monthly instalments.
Loan interest will be paid each month, based on the balance at the start of the year.
39
Required
a) A forecast profit and loss account for the three months ending 31 March.
b) A monthly cash budget for the three months from January to March.
c) A forecast balance sheet at 31 March.
40
Chapter 3
The Interpretation of Financial Statements
Learning Outcomes
By the end of this chapter you will be able to
Outline the use of ratio analysis as a tool in assessing organisational financial
performance.
Outline the advantages and disadvantages of financial statements and ratio
analysis.
Identify the key areas of relevance to the main users of financial statements.
Identify and prepare key ratios from financial statements under the headings of
profitability, liquidity, management’s use of assets (efficiency), capital structure
and stock market indicators.
Compute and interpret key operating ratios unique to the hospitality, tourism and
leisure sectors.
Compare financial statements over time.
Write reports interpreting the ratios calculated and analysing the financial
performance of a commercial organisation.
Introduction
The financial statements are all that is available to external users (Investors, lenders,
accounts payable, suppliers, Revenue Commissioners and the general public) when
evaluating the performance of an organisation. An income statement and statement of
1
financial position (balance sheet) indicate the profit (or loss) made by an organisation
during an accounting period and provide a summary of the assets, liabilities and capital at
a given date. On their own they do not provide the user with very much information
about how that organisation has performed. A net profit of €100,000 might at first sight
appear to be adequate but how does the profit measure in relation to sales? How much
capital was required to generate such a profit and what percentage return on capital does
that profit represent to an investor or potential investors?
It is possible to gain a better understanding of how an organisation has performed by
examining the figures contained in the financial statements using ratio analysis. Ratios
are relationships between figures expressed as a ratio or more commonly as a percentage.
Interpretation of accounts can be defined as the explanation of, and translation into clear
and simple form, the data presented by the income statement and statement of financial
position of a business.
Performance measurement through ratio analysis
Ratio analysis is usually carried out under the following headings as the performance of
an organisation is appraised:
Profitability: Is the business profitable, both as to return on capital invested and
as to the proportion of sales revenue remaining as profit? Has the company the
potential to remain profitable and increase profitability in the future?
Efficiency/ use of assets: Is the business managed efficiently with particular
reference to control over the level of assets? For example are management
efficient in dealing with the following:
−
Ensuring assets generate sufficient revenue/turnover.
−
Ensuring assets are efficiently used to minimise costs but not at the
expense of quality.
2
−
Collecting debts due from customers
−
Minimising inventory holding and related costs.
−
Ensuring financial resources are available when needed.
Liquidity: Is the Business on a sound financial footing, able to pay its accounts
payable and other obligations as they fall due?
Capital structure: What are the organisations long-term financing arrangements?
How dependant is the organisation on borrowed funds (financial risk)?
Return to investors: Investors returns come in the form of a dividend (share of
current profits) and a capital gain (an increase in the value of the business). Any
return whether of a capital or dividend nature must be sufficient to reward the
investor for the risk attached to that investment. Ultimately the main objective of
a company is to increase the wealth of its shareholders. This wealth is not just
measured in terms of present performance but also in terms of future potential.
Why use Ratio Analysis
As stated above, the final accounts provide limited information about an organisation.
Applying a set of measures from which the performance of an organisation can be
evaluated will give a useful framework from which a more informative view can be
established. The use of ratios is this regard can be quite useful.
1. They make it easier to compare an organisations performance with that of
previous years. Ratios provide a framework, which ensures a more informative
comparative analysis than simply comparing turnover or profit figures.
2. Ratio analysis can help spot trends toward better or poorer performance from
which areas of concern can be identified.
3
3. As target performance measures can be set, ratio analysis can helps in finding
significant deviations from agreed standards or targets.
4. Looking at an organisation in isolation can be unwise. Ratio analysis allows
comparisons by applying the same measures to similar organisations operating in
the same sector or industry.
This allows an organisation to benchmark its
performance.
Ratio Formulae and Calculations
Measuring the performance of an organisation through ratio analysis is relatively simple.
Example 3.1 shows a sample set of financial statements for two years based on the
accounts of a hotel company, Elite Hotels Plc. The company is listed on the ISEQ index
and is presently quoted at €1.76. Financial ratios will be calculated based on the key
performance headings of profitability, efficiency, liquidity, capital structure and investor
analysis.
Example 3.1 – Financial Statements
Statement of Comprehensive Income
31/10/13
€(OOO)
9,100
2,639
6,461
Revenue
Cost of goods sold
Gross profit
Administration expenses
Selling and Distribution expenses
Operating Profit
Interest
Net profit before Tax
Corporation Tax
Net Profit after Tax
2,002
2,275
Dividend Paid
4,277
2,184
529
1,655
298
1,357
340
4
31/10/12
€(OOO)
10,825
2,706
8,119
2,165
2,706
4,871
3,248
492
2,756
496
2,260
564
Statement of Financial Position
2013
€(OOO)
14,102
123
Non-Current Assets At N.B.V.
Investments at Cost
Current Assets
Inventory
Accounts receivable
Short-term Investments
Bank
Total Assets
275
71
25
371
14,596
Equity and Liabilities
Equity
Ordinary shares Nominal value 0.50 per share
Reserves: General reserve
Retained Profits
2012
€(OOO)
12,687
722
300
85
12
120
3,000
1,724
2,107
6,831
Non-current Liabilities
Debentures
Bank Loans
5,600
1,000
Current Liabilities
Accounts payable
Accruals and Deferred Income
Taxation
Bank Loans and Borrowings
Equity and Liabilities
320
15
460
370
Market price per share as at 31/10
6,600
1,165
14,596
517
13,926
3,000
724
2,089
5,813
6,122
900
301
12
496
282
7,022
1,091
13,926
1.70
Approach
Before preparing any ratios it is helpful to scan the financial statements for any
significant changes in key figure. For example in the year to 31 October 2013:
Revenue has fallen by 16%
Admin and selling expense have fallen by 12%
Operating profit has fallen by 33%
Profit after tax and dividend has fallen by 40%
Non-current assets have increased by 11%
Long-term debt has fallen by 6%
5
2.00
These figures give an indication that 2013 was not an easy year for the company with
very significant falls in sales and profits despite increased investment in non-current
assets. Table 3.1 shows the ratios and their calculation for 2013 and 2012
Table 3.1 – Ratio Calculations
2013
PROFITABILITY
Gross profit margin
Gross profit x 100
€6,461
Sales
Operating profit
margin
operating profit (PBIT) x 100
€2,184
sales
Expenses to sales
Expenses x 100
€4,277
ROOE (after tax)
LIQUIDITY
Current ratio
Quick-acid test ratio
EFFICIENCY
Non-current asset
turnover
Capital employed
turnover
Inventory Turnover
Inventory days
A/c’s receivable days
24.0%
€2,184
Capital Employed
€13,431
NP after Interest & Tax x 100
€1,357
Shareholders funds
€6,831
Current Assets
€371
Current Liabilities
€1,165
Current Assets – Stock
€96
Current Liabilities
€1,165
Sales
€9,100
Non-current assets
€14,102
Sales
€9,100
Capital employed
€13,431
Cost of Sales
€2,639
Average stock
287.5
Average stock x 365
€287.5
Cost of sales
€2,639
Trade debtors x 365
€71 x 365
Credit sales
€9,100
6
75.0%
€3,248
30.0%
€10,825
47.0%
€9,100
Operating profit (PBIT) x 100
€8,119
€10,825
€9,100
sales
ROCE
71.0%
€9,100
2012
€4,871
45.0%
€10,825
16.3%
€3,248
25.3%
€12,835
19.9%
€2,260
38.9%
€5,813
0.3 : 1
€517
0.5 : 1
€1,091
0.1 : 1
€217
0.2 : 1
€1,091
0.6 : 1
€10,825
0.9 : 1
€12,687
0.68 : 1
€10,825
0.844 : 1
€12,835
9.18 times
€2,706
9 times
300
39.8 days
€300
40.5 days
€2,706
2.8 days
€85 x 365
€10,825
2.86 days
A/c’s payable days
Capital Structure
Gearing
Interest cover
INVESTMENT
Earnings per share
Price earnings ratio
(P/E)
Dividend cover
Dividend yield
44.3 days
Trade creditors x 365
€320
Credit purchases
€2,639
Fixed interest debt
€6,600
Shareholder’s funds
€6,831
Net profit (PBIT)
€2,184
Interest
€529
PP after I & T & pref div
€1,357
Number of shares
6,000
0.226
(22.6
cent)
Market price of share
170 cent
7.5 times
EPS
22.6 cent
Profit available to pay div
€1,357
Dividends paid and proposed
€339
Dividend per share x 100
0.057
Market price per share
1.7
€300
40.5 days
€2,706
0.97 : 1
€7,022
1.21 : 1
€5,813
4.1 : 1
€3,248
6.6 : 1
€492
€2,260
0.377
6000
(37.7 cent)
200 cent
5.3 times
37.7 cent
4 times
€2,260
4 times
€565
3.3%
0.094
4.7%
2
Note :
•
Capital employed is calculated as share capital + reserves + deferred tax +
government grants + long-term loans. Alternatively this can be calculated as noncurrent assets + current assets less current liabilities.
•
Shareholders’ funds are calculated as share capital + reserves.
Each of the ratios outlined in Example 3.1 will now be explained in detail. The key
performance ratios of the following companies that operate within the hospitality,
tourism, leisure and event sectors will also provide context.
Intercontinental Hotel Group Plc (Hotels): This is a leading branded group of hotels
currently operating in the Americas, China, Europe, ASIA Middle-East and Africa.
7
The group had a very successful year in 2011 delivering an 8.6% growth in sales and
a 26% increase in Operating profit.
‘Fitzer’s’ Holding Ltd (Restaurants): This is an Irish restaurant group which operate a
number of restaurants in Dublin city. The company reported a pre-tax profit of
€150,972 in 2011 compared to a loss in of €10,528 in 2010.
Ryanair Holdings Plc (Travel and Leisure): Ryanair is a pioneer in European
discount air travel. The carrier flies to about 160 destinations, including more than
two dozen in Ireland and the UK. It serves more than 25 countries throughout Europe,
and specializes in short-haul routes between secondary and regional airports. It
operates from more than 40 bases and maintains a fleet of about 270 Boeing 737800s. The company also holds a 29% stake in Aer Lingus. The company generated
increased sales of 21% and profit after tax of 26% in 2011.
Haven leisure Ltd (leisure). This company owns and operates 35 caravan leisure
parks in England Scotland and Wales. It is part of the Bourne leisure group which
also owns Warner leisure Hotels and Butlins Resorts. All 35 parks offer outdoor and
indoor pools as well as range of other leisure and entertainment activities. The 2011
financial statements show a 0.4% increase in turnover and a 14.5% increase in profit
before tax.
Events International Ltd. (Events) This company is considered one of the UK’s
leading providers of corporate hospitality and VIP hospitality. It has over 25 years’
experience and is an authorised supplier of hospitality events for many of the major
sporting events in the UK including RFU Twickenham, Cheltenham National Hunt
Festival, F1 British Grand Prix at Silverstone, Royal Ascot and Wimbledon. The
company experienced a bumper year to 31 September 2011 recording a 47% increase
in revenue and a 69% increase in operating profit.
Ratios Appraising Profitability
8
Profit is the excess of revenues less expenses and is the ultimate measure of the success
of a business. However the profit figure on its own can only say so much about an
organisation. What is more informative to users of accounts is to compare profit to the
level of sales and investment required to achieve these profits.
As can be seen from the diagram above profitability is normally measured in two ways:
1. Against Sales
2. Against Capital employed
Gross profit x 100
Gross profit margin
Revenue (Sales)
The gross profit margin indicates the margin of profit between sales and cost of sales. In
example 3.1 a gross profit percentage of 71% was calculated in 2013 compared to 75% in
2012. This tells us that for every €100 of sales, a gross profit of €71 was earned and
hence cost of goods sold will amount to €29 per €100 sales. In 2013 the company is
generating less gross profit from its sales compared to 2012
The gross profit percentage can fluctuate and management should be aware of the main
reasons for the fluctuation. A fluctuating gross profit percentage can be caused by;
Reduction
Increase
Reduction in Selling Price
Increase in Selling Price
Increase in the cost price of stock
Reduction in cost Price of stock
purchases
purchases
9
Changes in the product sales mix
Changes in the product sales mix
with the business selling a higher
with the business selling a higher
proportion of goods with a lower
proportion of goods with a higher
gross profit margin
gross profit margin
Theft Cash Stock/Waste
An increase in sales volume will lead to an increase in gross profit but NOT necessarily
to an increase in gross profit percentage.
The hospitality sales mix
The sales mix represents the mix of products or services that make
up the total sales generated by a business. The sales mix within the
hotel sector can be made up of revenues from accommodation, bar,
restaurant, leisure facilities, and conferencing and banqueting. These
elements are all interrelated. For example, revenues f…

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