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Accounting

Workbook
Developed by Matt Davies
Aston Business School

Contents
Part 1: Study Material
1.1 What is accounting?
1.2 Understanding accounting information and
jargon

4
5 16

Part 2: Exercises
2.1 Tesco key financial ratios
2.2 Cash v profit
2.3 Management accounting

18 19
20 23
24 27

Part 3: Solutions to Exercises


3.1 Cash v profit
3.2 Management accounting

29 31
32 35

Part 4: Reference material


4.1 Tesco financial statements

37 41

Part 5: Glossary of terms


Glossary of terms

43 58

Part 1:
Study Material

1. What is accounting?
Accounting can be defined as the process of measuring, analysing and reporting financial
information about a business to enable to the user of that information to make better judgements and
decisions.
There are two main branches to accounting: financial accounting and management accounting.
Financial accounting is the process of generating and reporting financial information to external
users such as shareholders, the bank, suppliers, customers, and so on. Management accounting on
the other hand is the process of generating and reporting financial information to management to
assist them in running the business.

2. Understanding Accounting Information and Jargon


The Balance Sheet, Income Statement (or Profit and Loss Account) and Cash Flow Statement are
traditionally regarded as the three key financial statements for a business.
As the diagram below illustrates, the Balance Sheet represents the financial position of a business at
a single point in time, which for the companys annual published accounts is as at the companys
financial year-end.

The Income Statement and Cash Flow Statement, on the other hand, report the financial
performance of a business during a period of time, for example for the year-ended 31st December, or
for a specific month or for the year-to-date for a companys internal management accounts. The
Income Statement reports the business performance in terms of generating sales revenue in excess
of expenses for a period, whereas the Cash Flow Statement reports the business performance in
generating cash flows for a period.
We will now explore the content and format of these three statements in more detail.

2.1. The Balance Sheet


First the Balance Sheet which, as we have already established, reports the financial position of a
business at a snapshot in time.
It contains information on three key items:
Assets:

which in simple terms are items of value to the business


which the business either owns or controls (for example
via a long-term lease contract).

Liabilities:

which are the amounts the business owes.

Equity:

which include the amounts paid into the business by the


shareholders for the purchase of ordinary shares plus the amounts that
the business has retained on the shareholders behalf (for example, all
profits earned by the business during its existence that have not been
paid out to shareholders as dividends, which are known as retained
earnings).

To understand a Balance Sheet requires an understanding of the relationship between these three
items:
Assets

= Liabilities + Equity

In other words, the financial value of the assets in the Balance Sheet must equal the sum of the
value of the business liabilities plus the equity.
Put simply, the assets represent what has been done with the money and the liabilities plus equity
represent where the money came from.
To illustrate, imagine you wanted to buy a factory (an asset) to start up a business that would cost
1m. The purchase of this asset would need to be financed either through borrowing money from a
bank or through your own money. Lets assume the business borrowed 800,000 and you invested
200,000 of your own cash. The business Balance Sheet would then be as follows:
Assets

= Liabilities + Equity

1m

= 800,000 + 200,000

Another way of arranging the Balance Sheet relationship is to say:


Assets Liabilities = Equity
This is not fundamentally different of course, but the Balance Sheet this time balances to Net
Assets (sometimes called Net Worth).
Returning to our previous example, the business Net Assets can be found as follows:
Net Assets = Assets Liabilities = 1m - 0.8m = 0.2m
We will now look at the three categories of information contained in a Balance Sheet in more detail.

2.1.1. Assets
Assets are subdivided into two types: Non Current (Fixed) Assets and Current Assets.
2.1.1.1. Non Current (Fixed) Assets
Non Current Assets are those assets that are used in the business on a continuing basis and are not
intended for resale. Non Current Assets can be tangible (e.g. land and buildings, plant and
machinery, computer equipment and motor vehicles) or intangible (e.g. goodwill, copyrights and
patents). Intangible Non Current Assets are generally only recognised when they are purchased by
a business, since the measurement of the value of such assets in the Balance Sheet would otherwise
be highly subjective.
An example of an Intangible Non Current Asset is goodwill. Goodwill effectively represents the
difference between the value of a company as a whole and the sum of the value of its separately
identifiable net assets. Only goodwill arising from an acquisition can be included on a companys
Balance Sheet. For example, if a company paid 25m to acquire a company with separate net assets
valued at 10m, then this would give rise to goodwill of 15m to be included on the Balance Sheet.
This goodwill will relate to a number of factors such as the companys reputation, customer loyalty,
home-grown brands, the skills of its workforce, and so on, none of which are incorporated on the
acquired companys Balance Sheet. Home-grown goodwill, however, cannot be included on the
Balance Sheet. This leads to an important conclusion: the Balance Sheet does not measure the true
value of a business!

All Non Current Assets (except for land, investments and goodwill) must be either depreciated (if
Tangible) or amortised (if Intangible) over their useful economic lives. For example, we buy a
machine for 100,000 with a 10-year economic life. Assuming the straight-line depreciation
method is used, whereby an equal charge for depreciation is made each year, then the depreciation
charge will be 10,000 per annum. In the Balance Sheet, Non Current Assets are recorded after
deducting the accumulated deprecation charged to date (which gives what is called the net book
value of the Non Current Asset).
Using the machine introduced above to illustrate, after 6 years the machine will be recorded in the
Balance Sheet at:
100,000 60,000 = 40,000

2.1.1.2. Current Assets


Current Assets are those assets that are used-up or turned over regularly and frequently in the
course of business. In other words, while Non Current Assets represent the long-term assets, these
are the short-term assets of a business. Current Assets include inventories (raw materials, work in
progress and finished goods), receivables (the amounts owed by customers for goods received but
not paid for at the year-end) and cash. (Inventories are sometimes called Stock and Receivables
are sometimes called Debtors).

2.1.2. Liabilities
Liabilities are subdivided into two types: Current Liabilities and Non Current Liabilities.
2.1.2.1. Current Liabilities
Current Liabilities are those obligations of the business that are due for payment within 12 months
of the Balance Sheet date.
Current Liabilities include: Accounts Payable (the amounts owed to suppliers for goods and
services received before the year-end, for which invoices have been received but not paid), Unpaid
Wages and Salaries (if employees have not been paid by the year-end for all of the work
performed), Accruals (amounts owed to suppliers for which invoices have not been received at the
time the time the financial statements are prepared) and Unpaid Taxes. (Accounts Payable is
sometimes called Trade Creditors).

2.1.2.2. Non Current Liabilities


Non Current Liabilities are those obligations of the business that are due for payment in more than
12 months after the Balance Sheet date.
Examples of long-term liabilities include loans and other forms of long-term borrowing (including
amounts owed under long-term lease arrangements).

2.1.3. Equity (Capital and Reserves)


This section of the Balance Sheet records the shareholders investment in the company. The main
items to be found in the Equity section of a Balance Sheet are as follows:
Ordinary Share Capital:

the nominal value of ordinary shares issued by the


company.

Share Premium Account:

the surplus cash raised when ordinary shares


are issued at a price which is above their nominal value.

Retained Earnings:

the total accumulated profits earned by


the business that have not been paid out as dividends
(i.e. total retained earnings to date).

2.1.5. Interpreting a Balance Sheet


The interpretation of a Balance Sheet focuses on three key aspects of a business financial position:
2.1.5.1. The mix of Non Current Assets and Working Capital investment
First, we are interested in whether a business has invested in the right mix of long-term and shortterm assets. This is revealed by a comparison of the level of Non Current Assets compared with
the Net Current Assets of the business (which is also known as Working Capital). Net Current
Assets is the difference between Current Assets and Current Liabilities.
The total level of Non Current Assets plus Working Capital is referred to as the business Capital
Employed.
2.1.5.2. Liquidity
Second, we are also interested in the business ability to meet its short-term obligations when they
fall due for payment. This is revealed by the comparison of Current Assets to Current Liabilities.
As a general rule, we are generally relaxed about a business liquidity if it has more Current Assets
than Current Liabilities.
2.1.5.3. Stability
Finally, we are also interested in the business long-term stability or solvency. This is revealed by
the comparison of the amount of Debt (borrowings and other fixed-income sources of finance)
versus the Equity that is used to finance the business. The greater the reliance on Debt finance, the
greater the risk that the business will be unable to meet its obligations to pay interest and repay the
debt at maturity.

10

2.2. The Income Statement (Profit and Loss Account)


The Income Statement reports the financial performance of a business during a period of time
through comparing income (eg revenue) with expenses.
Income and expenses are recorded in the Income Statement according to the matching concept.
This means, on the one hand, that income is included in the period in which it is earned and not
necessarily when cash is received. Income is earned according to when the economic activity that
gives rise to income is performed. For example, this might be the date goods are collected by the
customer (for retailers), the date goods are delivered (manufacturing companies) or the date the
service is performed (for service providers).
Expenses, on the other hand, are included in the period in which they are consumed in earning
income (not necessarily when cash is paid). Some examples of how the matching concept is
applied (for a company with a 31st December 2007 year-end) for determining expenses are provided
below:
1. An electricity bill for 45,000 for the 3-months to 31st January 2008 is received in February
2008. How much of this bill should be recorded as expense for the 2007 year-end Income
Statement?
Answer: 2/3rds of the period covered by the bill falls into the year-ended 31st December 2007 so
2/3rds of the bill should be recorded as an expense in the Income Statement: 30,000. In the
Balance Sheet, an accrual of 30,000 will be included within Current Liabilities.
2. On 1st July 2007, an amount of 120,000 is paid to cover the cost of insurance cost for the
period 1st July 2007 to 30th June 2008. How much of this payment should be recorded as an
expense in the 2007 year-end Income Statement?
Answer: 6/12ths of the period covered by this payment falls into the year-ended 31st December
2007 so 6/12ths of the payment should be recorded as an expense in the Income Statement:
60,000. In the Balance Sheet, a prepayment of 60,000 will be included within Current Assets.

11

2.2.1. The Income Statement Format

X
(X)
X
(X)
X
(X)
X
(X)
X

Revenues
Cost of Sales
Gross Profit
Selling and Administrative Expenses
Operating Income
Interest
Profit Before Tax
Tax
Net Profit After Tax

2.2.2. Definitions of Income Statement Items


Revenues

The sales revenue earned by the business in the period.

Cost of Sales

The cost of making the goods that were sold during the
period.

Gross Profit

The difference between sales revenue and cost of


sales.

Selling and Administrative


Expenses

Selling and administrative costs incurred in the period.

Operating Profit

The profit generated by the operations of the business before


deducting interest and tax

Interest

The interest expense (net of interest receivable) for the period.

Tax

The amount of income tax (corporation tax) payable in relation to the


profit earned in the period.

Net Profit

The profit generated by the business after all expenses have been
deducted. Once the dividend paid for the year has been deducted, the
surplus retained profits for the year are added to the retained earnings
reserve in the Balance Sheet.

12

2.3. The Cash Flow Statement


The Cash Flow Statement reports the cash performance of a business during a period of time. It
ultimately provides an explanation of the movement in the business cash position from the start to
the end of a period, by analysing cash flows across three main categories:
-

cash flow provided from (or used in) operating activities


cash flow provided from (or used in) investing activities
cash flow provided from (or used in) financing activities

The Cash Flow Statement complements the Balance Sheet and Income Statement by providing
information that helps in the assessment of a business cash management. Whilst profit is an
important measure of business performance, clearly it is also important, and perhaps arguably even
more important, that the business is able to generate sufficient cash to meet the necessary payments
required to sustain and develop the business, and provide returns such as interest and dividends to
those who provide the finance.
The Cash Flow Statement provides a comparison of the profit performance to the cash performance
of the business for the period. Therefore, before examining the format of a Cash Flow Statement in
more detail, it is important to consider the reasons why profit performance does not necessarily
equal cash flow performance for a period. The reasons include the following:
-

sales revenue included in the Income Statement includes sales made on credit which
may not have been received in cash by the year-end. This would be reflected in an
increase in Receivables in the Balance Sheet.

expenses included in the Income Statement can include items not paid for in cash by the
year-end. This would be reflected by an increase in Payables in the Balance Sheet.

the cost of buying (or manufacturing) Inventories is only treated an expense (Cost of
Sales) in the Income Statement in the period in which the Inventories are sold

depreciation charged in the Income Statement is a non-cash expense

cash spent on investments in new Non Current Assets (capital expenditure) is not
recorded an expense in the Income Statement

cash flows with respect to obtaining new finance (such as new issues of common stock
or new borrowings) or repaying existing finance (such as the repurchase of stock or the
repayment of borrowings) are not recorded in the Income Statement

13

2.3.1. The Cash Flow Statement Format

Net Cash Provided by (Used In) Operating Activities:


Operating profit
Depreciation/amortisation/impairment
Decrease (increase) in working capital
Cash generated by operating activities before impacts of
finance costs and taxes
Cash payments for financial expenses
Cash payments for corporation tax
Net cash provided by operating activities

X
X
X/(X)
X
(X)
(X)
X

Net Cash Provided by (Used In) Investing Activities:


Capital expenditures and investments
Cash proceeds from disposals
Net cash provided by (used in) investing activities

(X)
X
(X)

Net Cash Provided by (Used In) Financing Activities:


Proceeds from issuing common stock
Dividends paid
Proceeds from issuing long-term debt
Repayment of long-term debt
Increase (decrease) in short term debt
Net cash provided by (used in) financing activities

X
(X)
X
(X)
X/(X)
X

Increase (Decrease) in Cash


Cash at Start of Year
Cash at End of Year

X
X
X

14

2.3.2. Explanation of Key Cash Flow Statement Items


Net Cash Provided By (Used In) Operating Activities
A key source of cash to a business is the amount generated from the operation of the business. The
net cash provided by the operating activities is found by taking the operating profit and converting
this into the amount of cash generated in the period by making a number of adjustments:
-

charges made in the Income Statement for depreciation, amortisation and impairment are
added back to net income since these are non-cash expenses

movements in working capital. For example, an increase in Inventories over the period
has a negative cash impact, as does an increase in Receivables. An increase in Payables
over the period, on the other hand, has a positive cash impact.

After these adjustments are made the actual cash payments made for finance costs (interest) and
income taxes are then deducted to give typically a net cash inflow to the business provided by the
operating activities for the period.
Net Cash Provided By (Used In) Investing Activities
The next section of the Cash Flow Statement deals with cash flows associated with investing
activities, and therefore shows:
-

the amount of cash spent on Non Current Assets (eg capital expenditure such as the
purchase of new machinery and equipment, or the amount of cash spent on investments
such as purchasing shares in a new joint venture)

the amount of cash received from the disposal of Non Current Assets (eg machinery and
equipment, or the sale of shares in a company that has been treated as a long term
investment).

The net effect of these two items typically gives rise to a net outflow of cash used in investing
activities.

15

Net Cash Provided By (Used In) Financing Activities


The third section of the Cash Flow Statement deals with cash flows associated with financing
activities, and therefore shows:
-

the amount of cash received from the sale of new common stock (ie ordinary shares)

the cash paid to common shareholders in the form of a dividend (ie the ordinary
dividend)

the amount of cash received from new long-term debt (eg a new long-term bank loan)

the amount of cash used to repay long-term debt

the movement in short-term debt. An increase in short-term debt provides an inflow of


cash, whilst a reduction in short-term debt requires an outflow of cash.

The net effect of these items could either be an inflow or outflow of cash, depending upon the
financing requirements of the business in the light of the net amount of cash provided by the
operations and the net amount of cash used in investing activities.
Reconciliation of Cash at Start to End of Period
The final section of the Cash Flow Statement reconciles the opening to the closing cash balance,
taking into account the movement in cash for the period.
In other words: the net cash movement for the period (being the sum of cash flows related to
operating, investing and financing activities) is added to the opening balance to give the closing
cash balance.
A simplified Cash Flow Statement is provided below to illustrate:
m
100
(120)
40
20
5
25

Net cash provided by operating activities


Net cash used in investing activities
Net cash provided by financing activities
Increase (Decrease) in Cash
Cash at Start of Year
Cash at End of Year

16

Part 2:
Exercises

17

2.1.TescoKeyFinancialRatiosExercise
CalculatekeyratiosforTescofor2009.Thesolutionstothisexercise
areprovidedwithintheelearningcourse.(Tescosfinancial
statementsaresummarisedonpages3738).
2009

2008

1. Return on Capital Employed

14.0%

Operating profit /
Total assets less current liabilities

2791
(23864+630010263)

2. Return on Sales

5.9%

Operating profit / Revenue

2791
47298

3. Gross Margin %

7.7%

Gross profit / Revenue

3630
47298

4. Sales Revenue on Capital Employed

2.38

Revenue /
Total assets less current liabilities

47298
(23864+630010263)

5. Sales Revenue on Non Current Assets

1.98

Revenue / Non current assets

47298
23864

18

2009
6. Current ratio

2008
0.61

Current assets / Current liabilities

6300
10263

7. Quick ratio

0.38

Current assets less inventories/


Current liabilities

(6300-2430)
10263

40.4%
8. Gearing ratio
(2084+5972)
(2084+5972+11
902)

Debt / Debt + Equity

9. Interest cover

44.3

Operating profit /
Net finance expense

2791
(250-187)

19

2.2CashVersusProfitExercise
PartAProfitStatement
On1stApril2009,amanufacturingbusinessstartedtrading.Thebusinesshasthefollowing
manufacturingcostsperunit:

10
8
2
20

Materials
Labour
Manufacturing overheads
Total unit cost

Inaddition,excludingdepreciation,thecompanyincursselling,generalandadministrative
overheadsof4,000permonth.Inaddition,thecompanywillinvest120,000inmachineryand
equipmentwhichisexpectedtohavea5yeareconomiclife,withazeroresidualvalue.The
depreciationonthismachineryandequipmentwillbetreatedasanoperatingexpenseandnotadded
tothecostofproduction.
Thecompanyhasasellingpriceof30perunit.
Thecompanyexpectstomakeandsellthefollowingduringitsfirst6monthsoftrading:

April
May
June
July
August
September

Production quantity
1000
1000
1000
1000
1000
1000

20

Sales quantity
500
600
700
800
900
1000

Required
a)Usingthetablebelow,calculatetheamountofprofitgeneratedbythebusinessduringthefirst6
monthsoftrading.
April
000

May
000

June
000

July
000

Sales Revenue
Cost of Sales
Gross Profit

S, G & A
Depreciation
Total
expenses
Profit

21

August
000

September
000

Total
000

PartBCashFlowForecast
Youareprovidedwiththefollowingfurtherinformationrelatingtothecashflowsforthisbusiness:
1.On1stApril2009,theownersofthebusinessinvested100,000inthebusiness.
2.Materials,salariesandmanufacturingoverheadsarepaidinthemonthinwhichtheyareincurred.
Thecompanywillmaintainnosurplusstockofrawmaterials.
3.S,GandAoverheadsarepaidonemonthinarrears.
4.Customerswillbegiven2monthscredit.
5.ThemachineryandequipmentwaspaidforinApril.
Required
Usingtheinformationaboveandthetablebelow,calculatetheamountofcashgeneratedbythe
businessforthefirst6monthsoftrading.
April
000

May
000

June
000

July
000

August
000

September
000

Cash Receipts:
Owners investment
From customers
Total receipts
Cash Payments:
Materials
Labour
Manufacturing
overheads
S, G and A
Capital expenditure
Total payments
Surplus/deficit
Opening balance
Closing balance

b)Whatimprovementswouldyourecommendtoimprovethecashperformanceofthisbusiness?

22

Total
000

PartCCashFlowStatement
Required
Usingthetablebelow,reconciletheoperatingprofitforthebusinesstoitscashflowforthefirst6
monthsoftrading:
000
Profit
Add: depreciation
+ or - change in inventory (1)
+ or - change in receivables (2)
+ or - change in payables (3)
Less: capital expenditure
Add: owners investment
= Change in cash over period

Workings:
1. Changeininventory=totalcostofgoodsmanufacturedlesstotalcostofgoodssoldin
period,pluscostofopeninginventory.(Inthiscaseopeninginventoryiszero).
Totalcostofgoodsmanufactured
Totalcostofgoodssold
Increaseininventory

..
..
..

2. Changeinreceivables=totalsalesrevenuelesstotalcashreceivedfromcustomersin
period,plusopeningreceivables.(Inthiscaseopeningreceivablesiszero).
Totalsalesrevenue
Totalcashreceivedfromcustomers
Increaseinreceivables

..
..
..

3. Changeinpayables=totalcostofgoodsandservicesreceivedlesstotalamountspaidto
suppliers,plusopeningpayables.(Inthiscaseopeningpayablesiszero).
Totalcostofgoods/servicesreceived
Totalamountspaidtosuppliers
Increaseinpayables

..
..
..

23

2.3ManagementAccounting:Exercises
1. CostVolumeProfitAnalysis
Amanufacturingbusinesshasthefollowingvariablecostsofproduction(perunit):

20
12
8
40

Direct materials
Direct labour
Variable overheads

Thebusinesssellingpriceis65perunit.Nextyearthebusinessexpectstoincur8moffixed
productionoverheadsand7.5moffixedselling,generalandadministrativecosts.
Required
a) Assumingthebusinessisexpectingtosell750,000unitsnextyear,whatisthebudgeted
profitfornextyear?
000
Sales value
Variable costs
Contribution
Fixed production costs
S, G and A
Profit
b) Whatisthebusinessbreakevenpoint?

c) Howmanyunitswouldthebusinessneedtosellinordertoachieveitstargetprofitof5m?

24

2. DiscontinuingaProductLine
Amanufacturingbusinesshasthreeproductlines:A,BandC.Financialinformationrelatingto
eachproductisprovidedbelow:

Sales value
Variable costs
Contribution
Product-line specific
overheads
Share of general
business overheads
Profit

A
000
5,000
(3,000)
2,000
(600)

B
000
8,000
(6,500)
1,500
(300)

C
000
2,000
(1,700)
300
(250)

Total
000
15,000
(11,200)
3,800
(1,150)

(500)

(800)

(200)

(1,500)

900

400

(150)

1,150

Required
a) AdvisemanagementonwhetherProductCshouldbediscontinued.

b) Whatfurtherinformationmightberelevanttoadecisionwhetherornottodiscontinuea
particularproductline?

25

3. ProductProfitabilityAnalysis

Amanufacturingbusinessproducestwoproducts:AlphaandBeta.
Thecompanyusesabsorption(full)costingandabsorbsproductionoverheadsonadirectlabour
hourbasis.Directlabourispaid10perhour.
Thecompanyexpectstomakeandsell100,000unitsofAlphaand30,000unitsofBeta.Further
financialinformationrelatingtothetwoproductsisprovidedbelow:

Sales price/unit
Direct material costs/unit
Direct labour costs/unit

Alpha

120
30
50

Beta

80
25
20

Thecompanyexpectstoincur2,240,000ofproductionoverheadsperannum.

Required
a) Calculatethebusinessproductionoverheadabsorptionrateperlabourhour:

b) Usingthetablebelow,andyouranswertoa)above,calculatethebudgetedprofitperunitof
eachproduct:
Alpha

Beta

Sales price/unit
Direct material cost/unit
Direct labour cost/unit
Production overhead/unit
Total product cost/unit
Profit per unit

26

c) Furtheranalysisofthecompanysproductionoverheadshasrevealedtheoverheadcanbe
analysedacrossthreedifferentcosts,withthefollowingcostdriversandactivitylevelsfor
eachproduct:
Overhead

Cost driver

Alpha

Beta

Set up costs

600,000

Number of
set ups

200 set ups


per annum

400 set ups


per annum

1,200,000

Machine
hours

440,000

Number of
production
orders

100,000
machine
hours per
annum
800
production
orders per
annum

60,000
machine
hours per
annum
3,600
production
orders per
annum

Machine related costs

Production planning costs

Total

2,240,000

Required
Usingtheaboveinformationandthetablebelow,recalculatethebudgetedprofitperunitof
eachproductusingtheprinciplesofActivityBasedCosting(ABC):

Sales price/unit

Alpha

120.00

Beta

80.00

Direct material cost/unit


Direct labour cost/unit
Prime cost/unit

(30.00)
(50.00)
(80.00)

(25.00)
(20.00)
(45.00)

Overhead analysis:
Set up costs/unit
Machine costs/unit
Production planning
Production overhead/unit
Total product cost/unit
Profit per unit
27

28

Part 3:
Solutions to Exercises

29

3.1CashVersusProfitExercise
PartAProfitStatementSolution
April
000
15

May
000
18

June
000
21

July
000
24

August
000
27

September
000
30

Total
000
135

Cost of Sales

(10)

(12)

(14)

(16)

(18)

(20)

(90)

Gross Profit

10

45

S, G & A

(4)

(4)

(4)

(4)

(4)

(4)

(24)

Depreciation

(2)

(2)

(2)

(2)

(2)

(2)

(12)

Total
expenses

(6)

(6)

(6)

(6)

(6)

(6)

(36)

Profit

(1)

Sales Revenue

Workings:
1. Salesrevenue=salesquantityxsalesprice
2. Costofsales=salesquantityxunitcost
3. Depreciation=120,000/5years=24,000perannum=2,000permonth

30

PartBCashFlowForecastSolution
a)
April
000

May
000

June
000

July
000

August
000

September
000

Total
000

Cash Receipts:
Owners investment

100

100

From customers
Total receipts

15

18

21

24

78

100

15

18

21

24

178

Materials

(10)

(10)

(10)

(10)

(10)

(10)

(60)

Labour

(8)

(8)

(8)

(8)

(8)

(8)

(48)

Manufacturing
overheads
S, G and A

(2)

(2)

(2)

(2)

(2)

(2)

(12)

(4)

(4)

(4)

(4)

(4)

(20)

Cash Payments:

Capital expenditure

(120)

(120)

Total payments

(140)

(24)

(24)

(24)

(24)

(24)

(260)

Surplus/deficit

(40)

(24)

(9)

(6)

(3)

(82)

Opening balance

(40)

(64)

(73)

(79)

(82)

Closing balance

(40)

(64)

(73)

(79)

(82)

(82)

(82)

b)Whatimprovementswouldyourecommendtoimprovethecashperformanceofthisbusiness?
-

negotiatebettercredittermswithsuppliers

negotiatebettercredittermswithcustomers

improvemanagementofinventoryoffinishedproduction

spreadcapitalexpenditure(egbyleasing)

obtainmorefinance(egfromownersorviabankloan)

31

PartCCashFlowStatementSolution
000
Profit

Add: depreciation

12

+ or - change in inventory (1)

(30)

+ or - change in receivables (2)

(57)

+ or - change in payables (3)

Less: capital expenditure

(120)

Add: owners investment

100

= Change in cash over period

(82)

4. Changeininventory=totalcostofgoodsmanufacturedlesstotalcostofgoodssoldin
period,pluscostofopeninginventory.(Inthiscaseopeninginventoryiszero).
Totalcostofgoodsmanufactured(6000x20)
Totalcostofgoodssold(4500x20)
Increaseininventory

120,000
90,000
30,000

Anincreaseininventoryhasanegativeeffectoncashflow.
5. Changeinreceivables=totalsalesrevenuelesstotalcashreceivedfromcustomersin
period,plusopeningreceivables.(Inthiscaseopeningreceivablesiszero).
Totalsalesrevenue
Totalcashreceivedfromcustomers
Increaseinreceivables

135,000
78,000
57,000

Anincreaseinreceivableshasanegativeeffectoncashflow.
6. Changeinpayables=totalcostofgoodsandservicesreceivedlesstotalamountspaidto
suppliers,plusopeningpayables.(Inthiscaseopeningpayablesiszero).
Totalcostofgoods/servicesreceived
(60,000+12,000+24,000) 96,000
Totalamountspaidtosuppliers(60,000+12,000+20,000)
92,000
Increaseinpayables
4,000
Anincreaseinpayableshasapositiveeffectoncashflow.
32

33

3.2ManagingFinancialPerformance:Solutions
1.CostVolumeProfitAnalysis
d) Assumingthebusinessisexpectingtosell750,000unitsnextyear,whatisthebudgeted
profitfornextyear?
000
48,750
(30,000)
18,750
(8,000)
(7,500)
3,250

Sales value
Variable costs
Contribution
Fixed production costs
S, G and A
Profit
e) Whatisthebusinessbreakevenpoint?
Breakevenpoint

=Fixedcosts/contributionperunit
=15,500,000/25perunit
=620,000units

f) Howmanyunitswouldthebusinessneedtosellinordertoachieveitstargetprofitof5m?
Unitstoachievetargetprofit=Fixedcosts+targetprofit/contributionperunit
=(15,500,000+5,000,000)/25perunit
=820,000units

34

2.DiscontinuingaProductLine
Amanufacturingbusinesshasthreeproductlines:A,BandC.Financialinformationrelatingto
eachproductisprovidedbelow:

Sales value
Variable costs
Contribution
Product-line specific
overheads
Share of general
business overheads
Profit

A
000
5,000
(3,000)
2,000
(600)

B
000
8,000
(6,500)
1,500
(300)

C
000
2,000
(1,700)
300
(250)

Total
000
15,000
(11,200)
3,800
(1,150)

(500)

(800)

(200)

(1,500)

900

400

(150)

1,150

Required
c) AdvisemanagementonwhetherProductCshouldbediscontinued.
ProductCmakesapositivecontributiontowardssharedgeneralbusinessoverheadsof
50,000(contributionlessproductlinespecificoverheads).Therefore,theredoesnotseemto
beanyfinancialjustificationwhyProductCshouldbediscontinued.
d) Whatfurtherinformationmightberelevanttoadecisionwhetherornottodiscontinuea
particularproductline?
Furtherinformationrelevanttoproductlinediscontinuationdecisionsmightinclude:
a. whethersalesofeachproductarecomplementary
b. whethertherearealternative(potentiallymoreprofitable)usesforthecapacity
usedbyProductC
c. longtermperformancepotentialforeachproduct
d. relativeamountofcapitalemployedrequiredtosupporteachproduct

35

3.ProductProfitabilityAnalysis
Amanufacturingbusinessproducestwoproducts:AlphaandBeta.
Thecompanyusesabsorption(full)costingandabsorbsproductionoverheadsonadirectlabour
hourbasis.Directlabourispaid10perhour.
Thecompanyexpectstomakeandsell100,000unitsofAlphaand30,000unitsofBeta.Further
financialinformationrelatingtothetwoproductsisprovidedbelow:

Sales price/unit
Direct material costs/unit
Direct labour costs/unit

Alpha

120
30
50

Beta

80
25
20

Thecompanyexpectstoincur2,240,000ofproductionoverheadsperannum.

Required
d) Calculatethebusinessproductionoverheadabsorptionrateperlabourhour:
Totalproductionoverhead=2,240,000
Totaldirectlabourhoursperannum=(100,000x5)+(30,000x2)=560,000
Productionoverheadperlabourhour=2,240,000/560,000hours=4perhour
e) Usingthetablebelow,andyouranswertoa)above,calculatethebudgetedprofitperunitof
eachproduct:

Sales price/unit

Alpha

120

Beta

80

Direct material cost/unit


Direct labour cost/unit
Production overhead/unit
Total product cost/unit

(30)
(50)
(20)
(100)

(25)
(20)
(8)
(53)

20

27

Profit per unit

36

f) ABCanalysis

Sales price/unit

Alpha

120.00

Beta

80.00

Direct material cost/unit


Direct labour cost/unit
Prime cost/unit

(30.00)
(50.00)
(80.00)

(25.00)
(20.00)
(45.00)

Overhead analysis:
Set up costs/unit
Machine costs/unit
Production planning
Production overhead/unit

(2.00)
(7.50)
(0.80)
(10.30)

(13.33)
(15.00)
(12.00)
(40.33)

Total product cost/unit

(90.30)

(85.33)

29.70

(5.33)

Profit per unit


Workings:
Overhead

Cost driver rate

Set up costs

600,000

1,000 per set up

Machine related costs

Production planning
costs
Total

1,200,000

440,000

7.50 per
machine hour

100 per
production order

2,240,000

37

Overhead
allocated to
Alpha
2 per unit
(1,000 x 200 /
100,000 units)
7.50 per unit

Overhead
allocated to
Beta
13.33 per unit
(1,000 x 400 /
30,000 units)
15 per unit

(7.50 x
100,000 /
100,000 units)
0.80 per unit

(7.50 x 60,000
/ 30,000 units)

(100 x 800 /
100,000 units)

(100 x 3,600 /
30,000 units)

12 per unit

Part 4:
Reference Material

38

4.1 Tesco Financial Statements


Summary Consolidated Income Statements

Notes
Revenue
Cost of sales
Gross profit
Administrative expenses
Profit arising on property related items
Operating profit
Share of post-tax profits of joint ventures and associates
Finance costs
Finance income
Profit before tax
Taxation
Profit for the year
Out of which:
Group share
Minority interests

39

1
2
2

2009
m
54,327
(50,109)
4,218
(1,248)
236
3,206
110
(478)
116
2,954
(788)
2,166

2008
m
47,298
(43,668)
3,630
(1,027)
188
2,791
75
(250)
187
2,803
(673)
2,130

2,161
5

2,124
6

Summary Consolidated Balance Sheets


Notes

2009
m

2008
m

4,027
23,152
1,539
62
1,470
1,758
32,008

2,336
19,787
1,112
305
324
23,864

2,669
1,798
6,069
3,509
14,045

2,430
1,311
771
1,788
6,300

(8,522)
(4,059)
(5,459)
(18,040)

(7,277)
(2,084)
(902)
(10,263)

(3,995)

(3,963)

(1,484)
(12,391)
(763)
(380)
(15,018)

(838)
(5,972)
(825)
(364)
(7,999)

Net assets (G = E F)

12,995

11,902

Equity
Share capital
Share premium account
Other reserves
Retained earnings
Shareholders equity parent company
Minority interests
Equity (H = G)

395
4,638
40
7,865
12,938
57
12,995

393
4,511
40
6,871
11,815
87
11,902

Assets
Non current assets
Intangible assets
Property, plant and equipment
Investment property
Investments in joint ventures and associates
Loans and advances
Other non current assets
Non current assets (A)

2
5
6

Current assets
Inventories
Trade receivables
Other current assets
Cash
Current assets (B)

Current liabilities
Trade and other payables
Debt
Other current liabilities
Current liabilities (C)

Net current liabilities (D = B C )


Non current liabilities
Post-employment benefit obligations
Debt
Provisions
Other non current liabilities
Non current liabilities (F)

9
10
11

40

Explanatory Notes:
1. Finance costs/income
Primarily relates to interest payable and receivable, but also includes exchange gains/losses and
dividends from investments.
2. Income from / Investment in joint ventures and associates
Associates are companies in which Tesco has a significant but not controlling interest (typically a
shareholding between 20% and 49%). Joint ventures are companies which Tesco jointly controls
with one or more other organisations.
The income statement includes Tescos share of the after tax profits of associates and joint ventures
immediately below the line Operating Profit. In the balance sheet, investment in joint ventures
and associates is shown as a separate item under non current assets.
3. Minority interests
Minority interests relate to those companies (known as subsidiaries) in which Tesco has a
controlling interest (typically a shareholding of more than 50%) but does not own all 100% of the
shares. In such circumstances, outside shareholders (minority shareholders) have a claim on the
net income and net assets of that subsidiary company. The total outside shareholders share of the
net income and net assets of Tesco subsidiaries are shown separately on the income statement and
balance sheet.
4. Intangible assets
Primarily relates to goodwill on acquisitions, but also includes items such as development costs and
pharmacy and software licences.
5. Loans and advances
Relates to loans made by Tesco Personal Finance, the companys wholly owned financial services
business.

41

6. Other non current assets


Includes derivative financial instruments, deferred tax assets and other investments.
7. Other current assets
Includes loans and advances (Tesco Personal Finance), derivative financial instruments, current tax
assets and short term investments.
8. Other current liabilities
Includes derivative financial instruments, customer deposits (Tesco Personal Finance), current tax
liabilities and short term provisions.
9. Post-retirement benefit obligations
Refers to the total net deficit on the Groups defined benefit pension plans.
10. Provisions
These are obligations that exist at the year-end where there is some uncertainty as to the amount or
timing of the relevant payments. Primarily relates to deferred tax and property provisions.
11. Other non current liabilities
Primarily derivative financial instruments.

42

TescoSummaryConsolidatedCashFlowStatements
NET CASH PROVIDED BY OPERATING ACTIVITIES
Profit before tax
Net finance costs
Share of post-tax profits of joint ventures and associates
Operating profit
Add: depreciation, amortisation and impairment
Less: increase in working capital
Add/Less: Other items
Cash generated from operations
Less: interest paid
Less: corporation tax paid
Net cash from operating activities (A)
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
Capital expenditure
Investments (eg in subsidiaries and joint ventures)
Disposals
Other
Net cash provided by (used in) investing activities (B)
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
Share purchases net of proceeds from share issues
Dividends paid
Increase in borrowings
Repayment of borrowings
Increase (decrease) in finance lease obligations
Net cash provided by (used in) financing activities (C)
Increase / decrease in cash (D = A + B + C)
Cash at start of year (E)
Net effect of foreign currency translation on cash / reclassifications (F)
Cash at end of year (G = D + E + F)

43

2009
m

2008
m

2,954
362
(110)
3,206
1,167
(582)
1,187
4,978
(562)
(456)
3,960

2,803
63
(75)
2,791
982
(194)
520
4,099
(410)
(346)
3,343

(4,707)
(2,780)
1,354
159
(5,974)

(3,600)
(626)
1,056
216
(2,954)

(135)
(886)
7,387
(2,733)
(18)
3,615
1,601
1,788
120
3,509

(621)
(794)
9,333
(7,593)
87
412
801
1,042
(55)
1,788

Part 5:
Glossary of Terms

44

GLOSSARY OF ACCOUNTING AND FINANCE TERMINOLOGY


A
Absorption (full) costing
The total cost of an activity, product or service based on direct costs and an estimate of overheads.
Accounting
The process of identifying, measuring and communicating economic information to permit
informed decisions by users of the information.
Accounting standards
Rules and guidance which should be followed by preparers of financial statements. International
accounting standards (International Financial Reporting Standards) are issued by the International
Accounting Standards Board (IASB).
Accounts payable
Money owed to suppliers.
Accounts receivable
Money owed by customers.
Accrual
An expense that has not been paid for at the end of the accounting period, typically where the
supplier invoice has not been received by the time the financial statements are prepared.
Acid test ratio
See quick ratio.
Acquisition
The act of one company buying another and taking a controlling interest in it.
Activity Based Costing (ABC)
A method of costing products or services, under which overheads are charged according to the way
in which the product or service consumes the business resources.
Amortisation
Depreciation of intangible fixed (non current) assets.
Analyst
Someone who researches investments in shares (equity analysts) or debt (fixed income analysts).
APR
Annual percentage rate. The rate of interest, calculated by a set formula, to give a true rate of
interest on a loan. All companies offering loans to the public are obliged to quote the APR on the
loans or credit they are offering.
Arbitrage
The act of exploiting price differences of the same security by simultaneously selling the overpriced
security and buying the under-priced security.
Asset
A resource that a business owns or controls to produce goods and provide services that will generate
revenue for the business. There are tangible assets, such as money owed to the business by
customers, money with bankers and cash in hand, inventory, land and buildings, and intangible
assets, such as patents and goodwill.
Asset finance
Hire purchase and lease arrangements that allow a company to use an asset without having to pay
for it up front in full.
Audit
The independent examination of a companys financial statements and expression of opinion as to
whether the financial statements give a true and fair view.
45

B
Bad debt
Accounts receivable that is likely to remain uncollectible and will be written off. Companies should
make an allowance for bad debts since it is unlikely that all of the debtors will pay them in full.
Balance sheet
A financial statement that measures the financial position of an organisation at a single moment in
time. The balance sheet equation is Assets = Liabilities + Equity.
Bear
An investor who believes share prices will fall.
Beta
The measure of systematic risk of a financial security (eg a share), as used in the Capital Asset
Pricing Model (CAPM). It measures the covariance of the securitys return with the market
portfolio return.
Bill of exchange
A bill of exchange is a written document in which you require your customer to pay a specified
amount by a specified date.
Bond
A certificate confirming that the owner of the bond has lent money to a specified borrower which
will be repaid at a fixed date and at a fixed rate of interest. Usually issued by companies and
governments as a means of raising finance.
Book value
The balance sheet value of an item.
Bottom line (The)
The final figure on a profit and loss account that represents the profits attributable to shareholders.
Broker
Assists in the buying and selling of financial securities (eg shares) by acting as a go-between,
thereby reducing search and information costs.
Business plan
Document prepared by management that summarises the operational and financial objectives of a
business and the detailed plans and budgets showing how the objectives are to be realised. It is
different from an investment proposal in that the business plan is considered an internal document.
Break-even analysis
The level of sales necessary for a company to cover all its fixed and variable costs for a given
period of time, ie so that the business will not operate at a loss. Above break-even sales, a company
will be profitable.
Budget
The financial representation of a plan for a defined period of time, usually a year.
Bull
An investor who believes share prices will rise.

46

C
Call option
A contract that gives the purchaser the right but not the obligation to buy a fixed quantity of a
commodity, financial instrument or some other underlying asset at a give price at or before a
specific date.
Capital
The owners claim on the assets of the business. Also called capital and reserves and equity.
Capital allowance
A tax allowance which takes account of depreciation of certain types of business assets such as
machinery, equipment, vehicles etc.
Capital Asset Pricing Model (CAPM)
A theory of asset pricing which assumes that financial assets, in equilibrium, will be priced so as to
produce returns that will compensate investors for systematic risk as measured by the beta.
Capital employed
The long term finance that has been used by a business. Calculated from a balance sheet as long
term liabilities plus equity, or total assets less current liabilities.
Capital expenditure
The amount invested in constructing, purchasing or improving long-term ie fixed assets.
Capital market
A market through those raising finance can do so by selling financial investments to investors (such
as shares and bonds).
Cash-flow forecast
A projection of the timing and amount of a businesss inflow and outflow of cash measured over a
specific period of time, typically on a monthly basis.
Cash flow statement
A statement that shows the sources and uses of cash for a period.
Collateral
See security.
Commercial paper
An unsecured loan note promising the lender a sum of money to be paid in a few days. The average
maturity is 40 days.
Commitment
A cost that has not yet been incurred but that must be incurred in the future as a result of some
contractual or other obligation. An example is future lease payments due under a long term lease
contract.
Commitment fee
A fee payable to a bank in return for the banks commitment to lend money.
Common stock
See ordinary shares.
Consolidated accounts
A set of financial statements that combine the financial performance and financial position of a
group of companies under common control. Also called group accounts.

47

Contingent liability
A possible obligation that arises from past events and whose existence will be confirmed only by
the occurrence of one or more uncertain future events not wholly within the entitys control or, a
present obligation that arises from past events or transactions but is not recognised on the balance
sheet because:
payment is not probable; or
the amount cannot be measured reliably
Contingent liabilities are not recorded on the balance sheet, but details are disclosed in a note to the
accounts.
Contribution
Sales revenue less variable costs.
Corporate Governance
The systems and controls for running a company.
Cost of capital
The rate of return required by investors in a company to compensate them for the time value of
money effect on their investment.
Cost of sales
The cost to a business of manufacturing or purchasing the goods sold during a period, or the cost of
providing services sold during a period.
Credit
The process whereby an organisation provides goods or services to customers, but then allows a
certain amount of time for them to pay for it.
Credit period
The time allowed to customers to pay for goods or services received.
Credit rating
An assessment of the quality of debt from a lenders perspective in terms of the likelihood of
interest and capital not being paid and the extent to which the lender is protected in the event of
default. Credit rating agencies are paid fees by companies, governments, etc that wish to attract
lenders. Credit rating agencies include Standard and Poor, Moodys and Fitch.
Creditors
Organisations or people to whom the organisation owes money. Also called accounts payable.
Creditor days
The financial ratio used to assess how quickly an organisation pays its creditors. (Also called
payables days).
Covenant
A contractual condition attached to a loan agreement that is designed to provide some protection to
the lender.
Current assets
Assets of a business that are turned over or used up frequently in the running of the business. Short
term assets that are either cash or are expected to convert into cash typically within one year.
Examples include stock (inventory), debtors (accounts receivable) and cash.
Current liabilities
Amounts owed by the organisation that will have to be paid within one year. These include trade
creditors (accounts payable), accruals, unpaid taxes and short-term bank loans and overdrafts.
Current ratio
Ratio of current assets to current liabilities.

48

D
Debenture
A long-term loan evidenced by a trust deed. Usually secured against assets.
Debt
In terms of financing a business there is a distinction between debt and equity. Debt is money
borrowed from a bank or other institution which is subject to interest paid at a specified rate. The
total amount borrowed must be repaid either on a specified date or on demand.
Debt to equity ratio
A comparison of debt to equity in a businesss capital structure.
Debtors
Organisations or people who owe the business money. Also called accounts receivable.
Debtor days
Also known as the 'average collection period' this is the financial ratio which shows how quickly
organisation is able to collect what it is owed. (Also known as receivables days).
Default
If the terms of an investment agreement/loan are broken, then the business is in default.
Depreciation
A measure of the amount of a fixed asset (non current asset) that has been consumed during a
period.
Derivative
A financial asset, the performance of which is based on (derived from) the behaviour of an
underlying asset.
Direct cost
A cost incurred in the operation of a business that can be easily and accurately attributed to the cost
of purchasing or manufacturing a product, or providing a service.
Discount factor
The rate applied to a future cash flow to convert into its value in todays terms to take account of the
time value of money effect.
Discount rate
The rate of return used to discount future cash flows to adjust for the time value of money effect.
Dividend
A cash or share payment to shareholders made out of the companys accumulated retained profits to
date.
Dividend yield
The ratio of the amount of dividend received from a share relative to its current market value.
Due diligence
Detailed investigations carried out by lawyers, public accountants and others on a businesss
market, competitors, management, track record, financial and legal status. Due diligence is done
prior to the closing of a transaction, such as a property transfer, corporate merger, share issue or
loan agreement.

49

E
Earnings per share (EPS)
The ratio of profits available to ordinary shareholders earned for a period related to the number of
ordinary shares in issue.
EBITDA
Earnings before interest, tax, depreciation and amortisation.
Economic Profit (EP)
Another name for Economic Value Added. See below.
Economic Value Added (EVA)
A measure of business performance which is calculated as the net operating profits after tax
(NOPAT) less a charge which reflects the cost of using capital in the business.
Efficiency
The business ability to generate sales revenue from the resources it uses.
Equity
Ordinary shareholders investment in a company, being the total of the invested capital and the
accumulation of retained profits during the life of the business.
Eurobond
A bond issued by a company where the finance is raised on an international basis. The bond is
issued in a currency that is different from the currency in the country in which the company raising
the finance is located.
Exit
The realisation of an investment by way of sale or exchange for some sort of marketable
commodity.
Exit route
Method by which an investor intends to, or has realised an investment. This could range from a
trade sale by the directors through to flotation on the stock exchange.
Expected return
The total amount of money (return) an investor anticipates receiving from an investment.
Expenditure
Costs incurred by a project or business.
Expense
The amount of cost recorded in the profit and loss account (income statement) for a period
representing the amount of cost consumed in the generation of income in the period.

50

F
Factoring
The purchase by a factor of a companys outstanding sales invoices at a discount to provide
immediate cash.
Finance
In simple terms, all matters relating to money. Also refers to the study how businesses raise finance
and how they select appropriate investments.
Finance lease
A lease which involves substantially all of the risks and rewards of ownership being transferred the
lessee. For assets used under finance lease arrangements, the asset and liability are included on the
lessees balance sheet.
Financial accounting
The process of identifying, measuring and communicating economic information to permit
informed decisions by external users (such as shareholders, the bank and suppliers).
Financial management
A subject area concerned with decisions that impact on the financial resources of an organisation,
particularly financing and investing decisions.
Fixed assets
Assets that are acquired with the intention of being used in the business on a continuing basis
(usually with a life exceeding one year) and that are not intended for resale. (Also called non
current assets).
Fixed costs
Cost of doing business, which does not change with the volume of business. Examples might be
rent for business premises, insurance payments, heat and light.
Flotation
The launching or financing of a business through the trading of its shares on a stock exchange.
Forward
A contract between two parties to undertake an exchange at an agreed future date at a price agreed
now. Similar to futures but not traded via an exchange and can be tailored to specific requirements.
Free Cash Flow
The amount of cash generated by a business that is available (ie free) to provide as return to the
providers of finance to the business (ie debtholders and shareholders). Calculated as net operating
profit after tax, plus depreciation, less capital expenditure and investments in working capital.
Fund Management
Investment of and administering of a quantity of money (eg pension fund, insurance fund) on behalf
of the funds owners.
Future
A contract between two parties to undertake an exchange at an agreed future date at a price agreed
now. Unlike forwards, trading is via an exchange with restrictions such as size, duration and timing
of contracts.

51

G
GAAP
Generally accepted accounting practice.
Gearing
The ratio of debt to total debt plus equity of a company. In general, the higher the gearing, the
higher the percentage of annual profits which must be used to pay interest and the greater the
vulnerability of the company to events such as a rise in interest rates or a fall in sales. (Also called
leverage).
Going long
Buying a financial security (eg share) in the hope that its price will rise.
Goodwill
The difference between the amount one company pays to acquire the shares of another and the fair
value of the companys assets that have been acquired. Acquired goodwill is recorded on the
balance sheet as an intangible fixed asset (non current asset).
Gross profit
Sales revenue less cost of sales. Represents the profit earned by a business from trading, prior to
the deduction of selling, general and administrative overhead expenses.
Gross profit margin
The gross profit expressed as a percentage of sales revenue for a period.
Guarantee
A promise by a guarantor to repay a loan or part of a loan on behalf of the borrower if the borrower
cannot.
Guarantor
A person who accepts responsibility for the repayment of a financial obligation should the original
borrower default on the terms of repayment or fail to repay the obligation altogether.
H
Hedge Fund
A collective investment vehicle that operates free from regulation, allowing it to act in ways not
available to other fund managers (eg borrowing to invest and short selling).
Hire purchase
Method of financing the purchase of assets. Under a hire purchase agreement, the business pays an
initial deposit with the remainder of the balance and interest being paid over a period of time. At the
end of the period, the asset is owned by the business.
Hostile takeover
The takeover of a company against the wishes of the incumbent management or board.
I
Income
Value generated by the business in a period eg from sales revenue or interest receivable. (Under US
and International Accounting, income is another name for profit).
Income statement
See profit and loss account.
Incremental budget
An approach to budgeting, where the budget prepared for the current year is based on last years
budget with some adjustment for expected changes such as planned growth and the anticipated level
of inflation.

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Initial public offering (IPO)


The initial offer and sale of a companys shares on a public market such as a stock exchange.
Insolvency
The situation where an organisation is unable to meet its liabilities. Technical insolvency arises if
the organisation's balance sheet reveals total assets are less than total liabilities.
Intangible assets
Assets that do not have a physical substance (such as brands, goodwill and debtors).
Interest
A charge for the use of money supplied by a lender.
Interest cover
The ratio of profit before interest and tax to the net interest payable for a period.
Internal Rate of Return (IRR)
The discount rate for an investment that produces a zero net present value,
International accounting (financial reporting) standards
Transnational accounting rules developed by the International Accounting Standards Board.
Inventory
See stock.
Investment appraisal
The financial evaluation of capital expenditure and other long-term investment decisions.
Investment Bank
Banks that carry out a variety of financial services, but usually excluding high street banking.
Services include advice on mergers and acquisitions and share issues as well as trading activities.
Investment grade debt
Debt with a sufficiently high credit rating to be considered safe for investors.
Investors
Providers of capital for the long term, as distinct from lenders of short-term capital. Investors have
rights which short term lenders do not enjoy and accept risks which short term lenders are not
exposed to.
Invoice discounting
A variation of factoring.
J
Joint venture
The cooperation of two or more individuals or businesses in a specific business enterprise rather
than a continuing relationship. It can be simply an agreement between two parties as to who does
what and gets what or it can be an entirely new company set up for the specific purpose of pursuing
the joint business.
Junk bonds
Bonds with a low credit rating. Rated below investment grade bonds and therefore represent high
risk, high return investments.

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K
Key performance indicators (KPIs)
The key financial and non financial measures that are used to track the extent to which a business is
on course to achieve its objectives.
L
Lease
An arrangement whereby the legal owner of an asset (the lessor) grants the use of the asset to
another party (the lessee) for a specified period of time in return for regular rental payments. The
asset is returned to the lessor at the end of the lease period.
Letter of credit
A guarantee given by a bank on behalf of an importer to pay an exporter, on presentation of
specified documents that represent the supply of goods within a specific time. Used in international
trade, it permits two parties to exchange ownership and possession of goods and the money to pay
for them.
Leverage
The amount of debt used to finance the business assets. (See gearing).
Liability
An obligation to pay an amount or perform a service to a third party.
Limited liability
The obligations of the owners of shares in a company with respect to the liabilities of the company
are limited to the amount they have committed for the purchase of their shares.
Line of credit
An agreement negotiated between a borrower and a lender that establishes a maximum amount
against which a borrower may draw. The liability of the borrower at any point is only the amount
drawn against that maximum. The agreement also sets out other conditions, such as how and when
money borrowed against the line of credit is to be repaid.
Liquidity
The ability of a business to meet its short term obligations, or the ease with which an investment
can be sold and converted into cash.
Liquidation
The sale of all of a companys assets, for distribution to creditors and shareholders in order of
priority. This may be as a result of the failure of the company or by agreement amongst
shareholders.
Listing
When a company trades its shares on a stock market, it is said to be listed.
Loan capital
Form of debt which has to be repaid at a specified time in the future (as distinct from a bank
overdraft which may be called in at short notice).
Long term liabilities
Amounts owed by the organisation that will have to be paid in more than one year after the balance
sheet date. These include long term loans and long term provisions for liabilities and charges. Also
called non current liabilities.

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M
Management accounting
The process of identifying, measuring and communicating economic information to permit
informed decisions by managers, to assist them in running the organisation.
Management buy-in (MBI)
Funds provided to enable a manager or group of managers from outside a company to buy into it.
Management buy-out (MBO)
Funds provided to enable operating management to acquire the existing product line or business that
they currently manage.
Marginal (variable) costing
The additional cost of an activity, product or service.
Market capitalisation
The total market value of a companys ordinary shares.
Matching
The accounting concept that requires that for measuring profits, income earned in the period should
be matched against the expenses that have been consumed in earning the income.
Materiality
The relative significance of an item (or error or omission) to the readers view of the financial
statements.
Maturity
The duration of a liability such as a loan before it must be repaid.
Merger
The formation of one company from two or more previously existing companies.
Mezzanine finance
A financing instrument that has elements of both equity and debt, eg debt with rights to convert to
equity or a share in the profits.
N
Net assets
The difference between the balance sheet value of assets and liabilities. Must equal the equity
(capital and reserves) of the business. (Also known as net worth).
Net book value (NBV)
The cost less accumulated depreciation of fixed (non current) assets.
Net operating profit after tax (NOPAT)
A measure of finance performance which is calculated as net operating profits less a deduction for
the amount of tax payable on those profits.
Net present value (NPV)
A method of investment appraisal based on the present value of the cash flows associated with the
investment opportunity.
Net profit
The profit of a business after deducting all of the expenses. (Under US and International
Accounting, also called net income).
Non current assets
See fixed assets.
Non current liabilities
See long term liabilities.
Non-executive director
A part-time director who shares all the legal responsibilities of executive directors on the board of a
company, but who does not get involved in the day-to-day running of the company.
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O
Operating lease
A short term lease arrangement which does not transfer substantially all of the risks and rewards of
ownership to the lessee.
Operating loan
A loan intended for short-term financing to support cash flow or cover day-to-day operating
expenses. Loans of this type are part of the line of credit.
Operating profit
The profit achieved by a business during a period before deducting any financing costs. Generally
taken to mean the profit before interest and tax as disclosed in the profit and loss account (income
statement).
Option
A contract giving one party the right but not the obligation to buy or sell a financial instrument,
commodity or some other underlying asset at a given price at or before a specific date.
Ordinary shares
The equity capital of a company. The holders of ordinary shares are the legal owners of the
company and are therefore entitled to all of the residual profits of the company after other claims
have been met. (Under US and International Accounting, ordinary shares are referred to as
common stock).
Overdraft
An amount of money that a business with a bank account is temporarily allowed to borrow from a
bank at an interest rate and over an agreed period of time.
Overheads
Costs incurred in the operation of a business that cannot be easily and accurately attributed to the
cost of purchasing or manufacturing a product, or providing a service. (Also called indirect costs).
Overtrading
The situation arising when a business is operating at a level of activity which cannot be supported
by the amount of finance available to the business.
P
Payables
See accounts payable.
Payback
A method of investment appraisal that measures how quickly the initial amount invested is expected
to be repaid by cash flows generated by the investment.
Phased budget
A budget that has been analysed into months taking into account of anticipated changes in activity
over the course of the year.
Preference shares
Like ordinary shares (common stock), they represent ownership in a business. However, these
shares are usually non-voting and have a fixed dividend rate. In the event of liquidation, preferred
shareholders rank ahead of ordinary shareholders but behind creditors for claims against the assets
of the business.
Prepayment
Arises where the amount paid exceeds the amount of expense consumed in a period. Classified
within debtors (receivables) on the balance sheet.

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Present value
The value in todays terms of a future cash flow, when adjusted (ie discounted) to take account of
the effect of the time value of money.
Price earnings ratio
The ratio of the market value of a share the earnings per share. Provides an indication of the stock
markets confidence in the future earnings potential of the business.
Primary market
A market in which financial assets (securities) are initially issued.
Private equity
See venture capital.
Profitability
The business ability to generate profits.
Profit and loss account
A financial statement presenting the revenue, expenses and profits (or losses) of an organisation
during a specified period of time. Also called an income statement.
Provisions
There are two types of provisions in accounting. First, there are provisions made against assets to
reflect a reduction in the amount expected to be recovered (eg provision for bad debts). Second,
there are provisions for liabilities and charges, which are potential liabilities where there is some
uncertainty as to the amount or timing of the obligation, or both (eg environmental and warranty
provisions).
Prudence
The accounting concept that requires preparers of financial statements to err on the side of caution.
Put option
A contract that gives the purchaser the right but not the obligation to sell a financial instrument,
commodity or some other underlying asset at a given price at or before a specific date.
Q
Quick ratio
The ratio of current assets excluding stock (inventory) to current liabilities. Also called the acid
test ratio.
R
Receivables
See accounts receivable.
Redeemable shares
Shares which can be repurchased by the company at a predetermined value.
Re-forecast
A prediction of the final performance for the year made part-way through the year in the light of
performance achieved to date and anticipated performance for the remainder of the year.
Retained earnings
Part of the ordinary shareholders investment in a company which represents the accumulated of
profits earned which have reinvested in the company rather than being paid out as dividends.
Return on capital employed (ROCE)
The ratio of operating profit for a period relative to the amount of long-term funding that has been
used by the business.
Return on sales (operating profit margin)
The ratio of operating profit to sales revenue for a period.
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Revenue
See turnover.
Revolving credit
An arrangement whereby a borrower can draw short term loans as the need arises up to maximum
limit, over a specific time period.
Risk
The potential that the future return might be different from the level expected.
S
Securitisation
A structured finance process in which assets (eg receivables) or financial instruments are offered as
security for third-party investment. Involves selling financial instruments which are backed by the
cash flows or value of the underlying asset.
Security
An asset that is pledged to support or secure a loan (eg a house taken as security by a bank to
support a loan). In the case of term loans, the property (eg land, buildings, equipment) being
purchased with the loan usually forms the security for the loan. (Also known as collateral).
Secondary market
Securities already issued that are traded between investors.
Senior debt
Element of a financial package which consists of bank lending. It is called senior debt because if the
business goes bankrupt, the lender has higher priority than those who provided equity or mezzanine
finance.
Shareholders
Owners of one or more shares in a business. (Under US and International Accounting, shareholders
are known as stockholders).
Short selling
The selling of financial securities (eg shares) that are not yet owned, in anticipation of being able to
buy the securities at a lower price before the sale is made. Compare with going long.
Solvency
The ability of a business to meet its long-term obligations.
Stock
Another name for inventory. For a manufacturer represents the amount of raw materials, work in
progress and finished goods. For a retailer represents the amount of goods available to be sold.
(Under US and International Accounting, stock is another name for shares).
Stock exchange
A market where financial securities (eg shares and bonds) are bought and sold.
Stock holding period
An Indication of the length of time stock is held in the business before being sold. (Also known as
inventory days).
Subordinated debt
A debt that an unsecured creditor can only claim, in the event of liquidation, after the claims of
secured creditors have been paid.
Swap
An exchange of cash payment obligations (eg interest rate or currency swap).
Syndication
An arrangement in which a group of investors come together to invest in a business or proposition
which they would not be prepared to consider individually, whether because of risk or the amount
of funding required. There is usually one investor who leads the deal.

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T
Tangible assets
Assets with a physical substance.
Term
The duration of a loan.
Term structure of interest rates
The patterns of interest rates on bonds with different lengths of time to maturity but otherwise with
the same risk. Expressed graphically as a yield curve. We would normally expect bonds with a
longer maturity period to carry a higher interest rate than otherwise equivalent bonds with a shorter
maturity period, due the higher risk from the lenders perspective.
Time value of money
A pound received in the future is worth less than a pound received today for three reasons: the effect
of inflation; our impatience to consume; the effect of risk.
Total shareholder returns (TSR)
The total return earned on a share during a period, based on capital gains and dividends, expressed
as a percentage of the price of the share at the start of the period.
Trade sale
Sale of a company to another company. As a form of exit, it is an alternative to flotation and more
common.
True and Fair View
The requirement that financial statements should be prepared using numbers that are as accurate as
possible, consistent with current best accounting practice and free from deliberate bias or distortion.
Turnover
Sales revenue earned in a period.
Turnover on capital employed
The ratio of sales revenue generated relative to the amount of long-term funding used in the
business.
Turnover on fixed assets
The ratio of sales revenue generated relative to the amount of fixed (non current assets) invested in
the business (measured at net book value).
V
Variable costs
Cost of doing business, which varies in line with changes in the volume of business. Examples
might include raw materials and direct labour costs for production staff for a manufacturing
business.
Variance
The difference between what was planned as part of a budget (the budgeted figure) and what
actually happened. Used as a tool for budgetary monitoring and control.
Venture capital
Originally, capital supplied to early stage, innovative businesses where the risks were high but so
were the potential returns. The term has now come to encompass almost all types of investment in
unquoted companies and includes private equity and management buy-outs.

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W
Working capital
The amount of money a business needs to cover its day-to-day activities such as paying wages,
buying raw materials and paying bills. On a balance sheet, represents the difference between
current assets and current liabilities (ie net current assets or net current liabilities).
Work in progress
For a manufacturing business represents the costs associated with incomplete production. For
service providers, represents work done not yet invoiced .
Z
Zero Based Budgeting (ZBB)
An approach to budgeting, where the budget prepared for the current year must be justified from a
zero starting point.

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