Chapter 3 Case study Solution and discussion 1. First, prepare the statement of profit or loss and statement of financial position for the business. The list which Jimmy has provided is a jumbled mixture of statement of profit or loss items and statement of financial position items, so a useful preliminary step is to identify a category for each item depending upon whether it goes in the trading account, the rest of the statement of profit or loss or the statement of financial position. For statement of financial position items, the terminology used in Chapter 2 can be used: •
Non-current assets
•
Current assets
•
Current liabilities
•
Non-current liabilities
•
Capital
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
1
£ Revenue
Category
143,520
Trading account
Opening inventory
9,274
Trading account
Non-current assets
3,823
Statement of financial position: non-current assets
Opening capital balance 1 March 20X4
19,776
Statement of financial position: capital
Bank
1,685
Statement of financial position: current assets
Rental expense
16,500
Statement of profit or loss
Insurance
2,023
Statement of profit or loss
Electricity
2,056
Statement of profit or loss
Trade payables
8,229
Statement of financial position: current liabilities
Trade receivables
1,800
Statement of financial position: current assets
Drawings
23,153
Statement of financial position: capital
Bank interest received
118
Statement of profit or loss
103,221
Trading account
Income from repairs services
4,389
Statement of profit or loss
Repairs service expenses – bicycle
1,317
Statement of profit or loss
2,278
Statement of profit or loss
Assistant’s wages
8,902
Statement of profit or loss
Closing inventory
16,337
Trading account AND statement of
Purchases
parts Administration, finance and sundry expenses
financial position: current assets
Note that closing inventory always appears in both the trading account and the statement of financial position as a current asset. Inventory which remains unsold at the statement of financial position is deducted, as we have seen, in arriving at the cost of sales figure. However, it is also an asset of the business because it can be sold to make money in the next following accounting period.
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
2
Having categorized all the items the next stage is to pick out those which appear in the trading account, and then prepare the trading account. Then, immediately below it, the rest of the statement of profit or loss items are listed, ending with net profit.
Remember that a heading with the name of the business (in this case Jimmy simply uses his own name – this is common amongst sole traders) and a description of the financial statement is always required.
Jimmy Bowden: Statement of profit or loss for the year ended 28 February 20X5 £ Revenue
£ 143,520
Less: cost of sales Opening inventory Add: purchases
9,274 103,221 112,495
Less: closing inventory
(16,337) (96,158)
Gross profit
47,362
Repairs service: income
4,389
Repairs service: expenses – bicycle parts
(1,317) 3,072
Other income – bank interest received
118 50,552
Expenses Rental expense
16,500
Insurance
2,023
Electricity
2,056
Administration, finance and sundry expenses
2,278
Assistant’s wages
8,902 (31,759)
Net profit
18,793
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
3
Once all of the balances have been put into the statement of profit or loss the remainder should all relate to the statement of financial position, which can then be prepared.
Jimmy Bowden: Statement of financial position at 28 February 20X5 £
£
ASSETS Non-current assets
3,823
Current assets Inventory
16,337
Trade receivables
1,800
Bank
1,685 19,822 23,645
CAPITAL AND LIABILITIES Capital Opening capital balance 1 March 20X4
19,776
Add: net profit for the year
18,793 38,569
Less: drawings
(23,153)
Closing capital balance 28 February 20X5
15,416
Current liabilities Trade payables
8,229 23,645
Remember, the capital account shows the resources committed to the business by the owner. The balance on the capital account increases or decreases in the following ways: Capital introduced For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
4
PLUS Profits retained in the business MINUS Drawings MINUS Any losses made by the business
Jimmy Bowden’s capital account, as shown in his statement of financial position at 28 February 20X5 has been increased by the amount of net profit for the year (calculated in the statement of profit or loss) and has been decreased by the drawings he has made from the business.
2. Having prepared the statement of profit or loss and statement of financial position for Jimmy’s business, it is now possible to address his questions about the profitability of the business. A logical first step is to take the table of figures he provided for 20X4 and slot in the equivalent figures for 20X5:
20X5
20X4
Bicycle revenue for the year
143,520
164,728
Gross profit on bicycle sales
47,362
49,418
Profit on repairs service
3,072
3,422
Total expenses
31,759
27,263
Interest received
118
260
18,793
25,837
Net profit
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
5
From this information a report with recommendations can be constructed by the business adviser, as follows:
18th March 20X5 Report to Jimmy Bowden on business profitability based on the financial statements at 28 February 20X5 There has been a substantial decline in revenue, gross and net profits between 20X4 and 20X5. The fall in sales is over £20,000, which represents a decline of almost 13 per cent.
There has been a small drop in profitability in the repairs service, but this is a fairly insignificant part of the business.
Total expenses have increased from £27,263 to £31,759, an increase of 16.5 per cent. A more detailed comparison of expenses would be useful in order to pinpoint the specific expenses which have risen. There may be a need for better control of business expenses.
Net profits have fallen from £25,837 to £18,793. The decline is significant and an action plan should be drawn up to address the problems the business faces. The business is not under immediate threat. The bank balance at 28 February 20X5 is £1,685 and there are no long-term borrowings. But trade payables total £8,229, and there could be problems if they start to press for immediate payment. However, because of the good record of profitability in the past, the bank is likely to grant overdraft facilities if they are required. The level of drawings from the business of a little over £23,000 is not justified by the present level of profitability. Closing inventory is much higher than opening inventory, because of the shortfall in Christmas sales.
Recommendations For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
6
1. Mr Bowden could consider a campaign of local advertising. This could be allied to an inventory clearance sale at discounted prices. 2. The current level of business profitability does not support drawings at the level of £23,000 per year. Mr Bowden should plan for a lower level of personal expenditure until business profitability improves. 3. Business expenses should be considered item by item to identify areas where savings might be possible. 4. If other measures fail, the possibility of moving to new shop premises nearer the centre of town could be considered. Suitable premises should be identified and a business plan and budget drawn up on the basis of the likely increase in sales and expenses if the move were to be made.
Signed: Business adviser
Summary This case study pulls together in one example some of the basic content of Chapters 2 and 3. Students should ensure that they thoroughly understand how the figures in the financial statements fit together before attempting the more complex of the questions at the end of the chapter.
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
7
Chapter 4 Case Study
Solution and discussion
1. If the amount owed by Charlie cannot be recovered it will be treated as a bad receivable in Richard’s accounts. The appropriate accounting treatment is to deduct the amount that cannot be recovered from the trade receivables balance, thus reducing assets, and from profit for the period. The latter adjustment directly affects the capital account.
The effect, in summary, will be as follows:
Profit for the nine months to 30 September 20X4 currently stands at £41,756. If the amount due from Charlie of £50,600 is deducted a loss arises: £41,756 – 50,600 = £8,844 Loss
In the statement of financial position, the receivable of £50,600 is deducted from the total trade receivables of £93,242, leaving a revised trade receivables balance of £42,642. The redrafted statement of financial position is as follows:
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
1
Richard: Redrafted statement of financial position at 30 September 20X4 £
£
ASSETS Non-current assets
8,311
Current assets Inventory
19,870
Trade receivables
42,642 62,512 70,823
CAPITAL AND LIABILITIES Capital Opening capital balance 1 January 20X4
64,084
Add: loss for the year
(8,844) 55,240
Less: drawings
(61,760)
Closing capital balance 30 September 20X4
(6,520)
Current liabilities Trade payables
51,760
Accruals
1,722
Bank overdraft
23,861 77,343 70,823
2. Note that the statement of financial position now shows a negative capital account. The business is insolvent and Richard is in very deep trouble. There is no money available to pay the trade payables, and the overdraft limit is virtually reached. The future looks bleak for the business, and for Richard.
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
2
Can the business survive this disaster? Looking at the original set of accounting statements before the adjustment is made for the bad trade receivable amount, we can see that the business is basically profitable. If it could be refinanced there is no reason for it not to continue to be a viable concern. The original statement of financial position before adjustment suggests that Richard’s spending has got out of hand: the high level of drawings of £61,760 is not sustainable. Even if new sources of finance were to be found, Richard would need to curtail his spending by a significant amount.
How likely is it that further finance would be available? If Richard had any personal assets these could be sold to raise much-needed cash for the business. What we know of Richard’s personal life suggests that he is short of assets; he cannot borrow on the security of a house because the family home is now owned by Hermione. If the business is to survive Richard needs urgently to explore other options. Some possibilities might be: •
A personal loan. It is possible that the bank may be prepared to lend Richard some money. However, even if this is the case, there are likely to be stringent conditions attached to any loan.
•
A personal loan from a private source. Richard’s mother originally lent him the money to start the business. It is possible that she may be willing to make further loans. There may be other relatives or friends who will stand by Richard in his difficulties.
•
Financial assistance from Richard’s supplier in Italy. For many years Giovanni has been supplying goods to Richard for distribution in the UK. If Richard goes out of business, Giovanni loses his UK outlet and it may be difficult and expensive to establish another. Giovanni may be prepared to, say, go into partnership with Richard in order to keep the distribution outlet open. As the business is basically profitable, it could be to Giovanni’s personal benefit to put money into the venture to keep it afloat.
•
Legal action against Charlie for recovery of the amount owed. This should probably be attempted in any case, but the reports of Charlie’s former business
For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
3
Chapter 9 Case Study 3 Solution and discussion 1. Analysis Horizontal trend analysis Because there are three years of figures available it is possible to carry out, to a limited extent, horizontal trend analysis, as follows: Fitton Parker Limited: horizontal trend analysis for 20X3, 20X2 and 20X1
%age change over
%age change over
previous year
previous year
20X3
20X2
Revenue
21.5%
18.1%
Cost of sales
24.0%
19.7%
Gross profit
16.6%
15.2%
Selling and distribution costs
26.4%
16.0%
Administrative expenses
6.5%
(3.3%)
Directors’ remuneration
0%
0%
Finance costs
27.5%
23.0%
Non-current assets
4.3%
(11.9%)
Inventory
23.8%
23.0%
Trade receivables
25.0%
27.3%
Trade payables
36.7%
10.7%
Overdraft
0.6%
(5.2%)
What does the horizontal trend analysis show?
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
1
There is a general trend towards increases in most items. The increase in revenue is substantial but although there is a corresponding increase in gross profit, the increase is not as great. It looks as though gross profit margin may be declining. Selling and distribution costs have risen a lot between 20X2 and 20X3, but administrative costs appear to be firmly under control. Also, the directors have not increased their own remuneration in the three-year period. Investment in non-current assets has been modest, but all current asset and current liability items have increased substantially. The overdraft remains at a fairly constant level, but trade payables have increased by a large percentage (over 36 per cent) in 20X3, suggesting that the business is relying to an increasing extent on the interest-free source of credit offered by trade payables. This is cheaper than increasing the overdraft (because interest has to be paid on an overdraft) but there is a danger of alienating suppliers if they are not paid promptly. Vertical analysis Vertical analysis of the statements of profit or loss is based upon revenue = 100 per cent. Vertical analysis of the statements of financial position is based upon equity = 100 per cent. The vertical analysis produces the following results: Fitton Parker Limited: vertical analysis of statements of profit or loss for the years ended 31 March 20X3, 20X2 and 20X1 20X3
20X2
20X1
%
%
%
Revenue
100.0
100.0
100.0
Cost of sales
(67.5)
(66.2)
(65.3)
Gross profit
32.5
33.8
34.7
Selling and distribution costs
(12.9)
(12.4)
(12.6)
Administrative expenses
(5.7)
(6.4)
(7.9)
Directors’ remuneration
(10.0)
(12.2)
(14.4)
Operating profit/ (loss)
3.9
2.8
(0.2)
Finance costs
(0.9)
(0.8)
(0.8)
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
2
Profit/ (loss) before taxation
3.0
2.0
(1.0)
Tax
(0.6)
(0.5)
–
Profit for the year
2.4
1.5
(1.0)
Fitton Parker Limited: vertical analysis of statements of financial position at 31 March 20X3, 20X2 and 20X1 20X3
20X2
20X1
%
%
%
Non-current assets
89.1
100.6
125.2
Inventory
57.0
54.2
48.3
Trade receivables
72.2
68.0
58.5
Cash
–
1.0
–
Trade payables
48.8
42.0
41.6
Overdraft
11.0
12.9
14.9
Non-current liabilities
58.5
68.9
75.5
Share capital
46.2
54.4
59.6
Retained earnings
53.8
45.6
40.4
What does the vertical analysis show?
The vertical analysis of the statements of profit or loss confirms the suspicion that the gross profit margin is declining. Administrative expenses are declining as a percentage of sales. This may be because of very good controls over costs and a deliberate attempt to keep administrative expenses to a minimum. However, savings on such costs can be taken too far, and the business may be operating at less than optimal efficiency.
The operating profit margin is low, as is the margin of profit for the year to revenue. Although there has not been a loss since 20X1, profits are not impressive, and even at their highest level in 20X3, there would not be much scope for paying a dividend.
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
3
Inventory and trade receivables have increased as a percentage of equity, with a particularly high increase in trade receivables between 20X1 and 20X2. Trade payables, as noted in the horizontal analysis, have also increased substantially.
Ratio analysis Performance Gross and operating profit margin were discussed in the vertical analysis section. Because Louise is looking to invest as an ordinary shareholder, she will probably be most interested in the return on equity: Profit before tax, and after interest Equity 20X3 Return on equity
18,023
x 100
20X2 9,642
x 100
20X1 (4,188)
x 100
97,368
82,695
75,459
= 18.5%
= 11.7%
= (5.6%)
The overall return has increased rapidly.
Liquidity Information is available to calculate two ratios: current ratio and quick ratio. 20X3 Current ratio:
20X2
20X1
125,765
101,830
80,615
58,187
45,385
42,640
Current assets
=
=
=
Current liabilities
2.2
2.2
1.9
Quick ratio:
125,765 – 55,450
101,830 – 44,791
80,615 – 36,425
Current asset –
58,187
45,385
42,640
inventory
=
=
=
Current liabilities
1.2
1.3
1.0
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
4
Neither liquidity ratio appears to give any cause for concern. Although the figure for payables is very much higher in 20X3 than it was in 20X2 it is covered quite adequately by current assets.
Efficiency ratios Three will be calculated: non-current asset turnover, inventory turnover (in days) and trade receivables turnover (in days). Trade payables turnover cannot be calculated because no figures for purchases are available.
20X3
20X2
20X1
Non-current asset
596,860
491,383
415,985
turnover:
86,790
83,250
94,484
Revenue
=
=
=
Non-current assets
6.88
5.90
4.40
Inventory turnover:
55,450
Inventory
402,964
325,089
271,588
Cost of sales
= 50.2 days
= 50.3 days
= 49.0 days
Trade receivables
70,315
56,233
44,190
turnover:
596,860
491,383
415,985
Trade receivables
= 43.0 days
= 41.8 days
= 38.8 days
x 365
x 365
x 365
44,791
x 365
x 365
36,425
x 365
x 365
Revenue x 365
Non-current asset turnover shows an increasing rate. Inventory turnover at 50 days may indicate that inventory is being managed inefficiently, but we would need to know more about the business activities to be able to conclude on this point. It is gradually taking the business longer to collect trade receivables, although even at 43 days (assuming that trade receivables are allowed 30 days to pay), there is unlikely to be a serious problem.
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
5
Note that the investor ratios are mostly irrelevant because of lack of information. No dividend has been paid in any of the years, and, of course, it would not be possible to calculate P/E ratio because the company is unlisted and so there is no market price for shares.
Gearing In the circumstances it is relevant to calculate gearing since the business has long-term borrowings of significant size: 20X3
20X2
20X1
Gearing:
57,000
57,000
57,000
Debt
57,000 + 97 368
57,000 + 82,695
57,000 + 75,459
Debt + equity
x 100
x 100
x 100
=
=
=
36.9%
40.8%
43.0%
Although debt remains constant at £57,000, equity gradually increases because of retained profits, so debt becomes relatively less important. Nevertheless, it is still significant at 36.9 per cent.
1. Points for Louise to consider in making an investment decision The business appears to be growing fairly rapidly, with increasing revenue, and non-current asset turnover. Current assets and liabilities are growing, but there do not appear to be any immediate liquidity problems. But it is not a particularly profitable business. Louise is being invited to buy into about 18 per cent of the shares of a business with equity at 31 March 20X3 of £97,368. Her ‘share’ of equity would be £97,368 x 18% - approximately £17,500 in exchange for £30,000 in cash. If the equity value in the statement of financial position approximates at all closely to current values it does not appear to be a very good bargain.
Also, a conscientious financial adviser should be pointing out to Louise that this type of investment is almost certainly not appropriate for someone in her position. Investing in shares is risky, and should really be undertaken only by people who are in a fairly sound
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
6
financial position, and who could afford to lose all the money. Investment in a private limited company is especially risky. Usually, it is difficult, sometimes impossible, to get the money out again if it is needed for some other purpose. As Patrick points out, at least by investing in listed company shares, Louise would be able to turn her investments into cash again comparatively easily (although she might well lose money on such investments). It is up to Louise to make her own informed decision on the investment; she should try not to be influenced by either Ben or by her father. 2. Reservations about the information/more information required Ben asks Barney for the company figures towards the end of 20X4, but Barney is able to provide figures up to 31 March 20X3 only. Nine months or so after the year end of 31 March 20X4 it would be reasonable to expect 20X4 accounts to be available. If they are not yet available it may indicate some serious administrative problems within the business. There would be good grounds for serious doubts if the accounts had been prepared but Barney was unwilling to provide them. The question could be easily resolved by checking the latest filing at Companies House. Also, the information Barney provides is limited to the basic statement of profit or loss and statement of financial position. Although Barney assures Ben that the audit report is fine, he does not include it in the information; nor are the notes to the accounts or the directors’ report made available. This looks a little suspect.
Louise or any other potential investor, would need to know a great deal more about the prospects of the business and the directors’ plans for expansion in order to make an informed decision. As noted earlier in part 2, Louise is being invited to invest £30,000 for 18 per cent of a business which is worth, at book values, only around £17,500. The directors would no doubt argue that she would be buying into their expertise and the future prospects of the business, but, again, Louise would need to know a great deal more about these factors before she could commit to the investment. The other directors are not offering Louise a directorship and she will not, therefore, have much, if any, control over her investment.
For use with Business Accounting and Finance 6th edn (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
7
Chapter 9 Case Study 4 Solution 1. Accounting ratios
2023
2022
Gross profit margin
47.8%
49.1%
Operating profit margin
5.0%
8.4%
Profit margin
4.4%
7.6%
Interest cover
7.4
10.8
Pre-tax return on capital employed
16.7%
28.0%
Workings:
2023
2022
Gross profit margin (4,839.7/10,125.0) x
Gross profit margin: (4,208.0/8,563.0) x
100
100
Operating profit margin (509.8/10,125.0)
Operating profit margin (721.2/8,563.0) x
x 100
100
Profit margin (440.9/10,125.0) x 100
Profit margin (654.7/8,563.0) x 100
Interest cover (509.8/68.9)
Interest cover (721.2/66.5)
Pre-tax ROCE (440.9/2,633.4) x 100
Pre-tax ROCE (654.7/2,339.6) x 100
2. Report on the performance of JD Sports & Fashion plc in 2023 The accounting ratios calculated in part 1 show a deteriorating performance in the company between 2022 and 2023. On all measures, the company’s performance is worse.
For use with Business Accounting and Finance 6th edi�on (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
The gross profit margin has deteriorated only by a small amount, relatively speaking, but performance is much worse further down the statement of profit or loss. However, a review of the Chairman’s statement in the 2023 Annual Report suggests that 2023 was unusual. There have been several significant changes in the business’s board. A new chairman was appointed in the 2022/23 financial year, followed very quickly by a new chief executive. The chief financial officer also stepped down during this period, and there were changes to the non-executive structure of the board. The new chief executive, by the 2023 year end, had been in post for only four or five months and so had not had time to make many changes. However, the directors had decided, by the 2023 year end, to exit some of the fashion businesses with which the company is involved. The operating profit figure is after deduction of expenses. In the 2022/23 financial year, additional expenses were incurred as a result of strategic business decisions. The operating profit margin for 2023 (and the profit before tax) are quite likely to be unrepresentative of the group’s underlying performance, and the two sets of figures, for 2023 and 2022, are not strictly comparable. Fundamentally, the business remains profitable. The interest cover ratio, although it has worsened, does not give cause for concern, and the return on capital employed is likely to be quite acceptable to shareholders.
For use with Business Accounting and Finance 6th edi�on (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
Chapter 9 Case Study 1 Solution and discussion 1. Relevant accounting ratios The following table compares relevant ratios for the two companies Sainsbury
Tesco
2023
2022
2023
2022
(2,004/31,491)
(2,366/29,895)
(3,661/65,762)
(4,633/61,344)
margin
x 100 = 6.4%
x 100 = 7.9%
x 100 = 5.6%
x 100 = 7.6%
Operating
(562/31,491) x
(1,156/29,895)
(1,525/65,762)
(2,560/61,344)
100 = 1.8%
x 100 = 3.9%
x 100 = 2.3%
x 100 = 4.2%
(562/309) = 1.8
(1,156/322) =
(1,525/618) =
(2,560/551) =
3.6
2.5
4.6
(327/7,253) x
(854/8,423) x
(1,000/12,230)
(2,033/15,644)
100 = 4.5%
100 = 10.1%
x 100 = 8.2%
x 100 = 13.0%
Gross profit
profit margin Interest cover*
Pre-tax return on equity
*Interest cover has been calculated as (operating profit/finance costs). A valid approach would be to take net finance costs (finance costs less finance income) as the lower part of the fraction.
2. Report comparing the performance of Sainsbury’s and Tesco While both companies are major UK food retailers, it is worth pointing out that Tesco is a much larger company in terms of revenue and equity. Sainsbury's revenue in 2023 was only 47.9 per cent of Tesco's. Also, Tesco derives a substantial part of its revenue from outside the UK, whereas Sainsbury's is an almost entirely UK-based business. Comparing the 2022 and 2023 performance of the two companies, both have turned in poorer performance at gross and operating profit level. Sainsbury’s gross profit margin is slightly better than Tesco’s in 2023, but its performance at operating profit margin level is worse. Interest cover has deteriorated in both companies between the years, For use with Business Accounting and Finance 6th edition (ISBN 978-1-4737-9127-5) © Catherine Gowthorpe, 2024, published by Cengage
1