Question A1 Below are extracts from the financial statements of a listed company which operates a chain of bakery and sandwich retail outlets in the United Kingdom. Required: a) Prepare a report describing how the liquidity and working capital management of the company has changed between 2014 and 2015. Comment on why these changes may have occurred. What possible changes in the business's activities and /or efficiency may have had an effect on the changes in liquidity? You should use appropriate ratios in your analysis. (20 marks) (b) Imagine you are a prospective investor in this company's shares. Calculate 4 ratios on the company's overall performance for each of 2015 and 2014 which would help you to decide whether to invest, briefly explain the meaning of each ratio, and interpret the implications of the changes between the years. (14 marks) Total 34 marks Income statement for the year 2015 £'000 2014 £'000 Revenues 658,186 628,198 Cost of sales (252,284) (241,939) Gross profit 405,902 386,259 Distribution costs (321,686) (309,735) Administrative expenses (35,783) (35,944) Other income - 8,033 Operating profit 48,433 48,613 Interest receivable and similar income 346 857 Profit before taxation 48,779 49,470 Taxation (14,405) (15,375) Profit for the year 34,374 34,095 Statement of financial position at the year-end 2015 £'000 2014 £'000 Non-current assets Intangible assets 579 686 Property, plant and equipment 211,155 210,455 Current assets Inventories 11,886 12,152 Trade and other receivables 21,206 22,698 Cash and cash equivalents 34,619 4,433 Current liabilities Trade and other payables (71,738) (62,761) Current tax liabilities (8,857) (8,337) Provisions for liabilities and charges (857) (2,843) Net current liabilities (13,741) (34,658) Non-current liabilities Other payables (30,460) (26,108) Provisions for liabilities and charges (3,296) (2,428) Net assets 164,237 147,947 Capital and reserves Share capital 2,080 2,080 Share premium account 13,533 13,533 Other reserves 359 359 Retained earnings 148,265 131,975 Total equity 164,237 147,947 Cash flow statement for the year 2015 £'000 2014 £'000 Cash flows from operating activities Cash generated from operations 86,751 59,163 Tax paid (14,731) (14,807) Net cash generated from operating activities 72,020 44,356 Cash flows from investing activities Purchase of property, plant and equipment (30,296) (40,758) Purchase of intangible assets - (686) Proceeds from sale of property, plant and equipment 2,368 2,200 Interest received 346 857 Net cash used in investing activities (27,582) (38,387) Cash flows from financing activities Sale of own shares - 698 Shares purchased and cancelled - (9,738) Dividends paid (15,339) (14,535) Other financing cash flows 1,087 8,083 Net cash used in financing activities (14,252) (15,492) Net increase/(decrease) in cash and cash equivalents 30,186 (9,523) Notes: • The market value of the company's shares at the 2015 year end was £4.37 (2014: £3.50). • Share capital consists of 104 million shares with a nominal value of 2p per share.   Suggested answer to question 1 (a) Ratio 2015 2014 Current ratio current assets/current liabilities (11,886+21,206+34,619) (71,738+8,857+857) 0.83:1 (12,152+22,698+4,433) (62,761+8,337+2,843) 0.53:1 Quick ratio current assets exc. inventory/current liabilities (21,206+34,619) (71,738+8,857+857) 0.69:1 (22,698+4,433) (62761+8337+2843) 0.37:1 Receivables days receivables/revenue x 365 21,206 x 365 658,186 12 days 22,698 x 365 628,198 13 days Payables days payables/cost of sales x 365 71,738 252,284 x 365 104 days 62,761 x 365 241,939 95 days Inventory days inventory/cost of sales x 365 11,886 / 252,284 x 365 17 days 12,152 / 241,939 x 365 18 days Inventory turnover cost of sales / inventory 252,284 / 11,886 21 times 241,939 / 12,152 20 times Asset turnover revenue/equity + non-current liabilities 658,186 / (164,237+30,460+3,296) 3.3 times 628,198 / (147,947+26,108+2,428) 3.6 times Cash generated from operations to current liabilities cash generated from operations/current liabilities 86,751 / (71,738+8,857+857) 1.07 times 59,163 / (62,761+8,337+2,843) 0.80 times   Commenting on the ratios You need to:- • discuss the ratios and relate them to each other • also refer to absolute numbers where relevant e.g. cash balance , whether cash inflows or outflows from operations, investing and financing • comment on the implications of these cash inflows and outflows and relate them to other aspects of the financial statements Points to make might include:- • Improved liquidity: indicated by large increases in operating cash flow, current & quick ratios. • Receivables & Inventory: fairly consistent but slightly improved, suggesting tight control given the increase in revenue since last year • Payables: taking 9 days longer to pay suppliers: enhancing liquidity in the short term, but could this be risky in the long-term? If there has been a deliberate policy to pay suppliers later this may backfire if it damages supplier relationships. However it does offer a cheap source of short-term financing, especially as the company has no borrowings/overdraft so there are limited other sources of finance for them in the short term. A brief discussion of the limitations of the analysis, and further information which might be needed, will also enhance your answer.   b) Imagine you are a prospective investor in this company's shares. Calculate 4 ratios on the company's overall performance for each of 2015 and 2014 which would help you to decide whether to invest, briefly explain the meaning of each ratio, and interpret the implications of the changes between the years. 14 marks Suggested answer to question 1 (b) Ratio 2015 2014 EPS 34,374 / 104,000 33.1p 34,095 / 104,000 32.8p P/E NB: 'earnings yield' 437 / 33.1 33.1 / 437 13.2 times 7.6% p.a. 350 / 32.8 32.8 / 350 10.7 times 9.4% p.a. Dividend per share 15,339 / 104,000 14.7p 14,535 / 104,000 13.9p Dividend cover NB: dividend payout 34,374 / 15,339 15,339 / 34,374 2.24 times 44.6% 34,095 / 14,535 14,535 / 34,095 2.35 times 42.6% Dividend yield 14.7 / 437 3.40% 13.9 / 350 4.00% Return on equity 34,374 / 164,237 20.9% 34,095 / 147,947 23.0% Explanations might include:- • P/E: has increased since last year, driven by a higher share price that has increased much more than earnings. I.e. investors are now prepared to accept a lower earnings yield than they required a year ago. This could reflect any of:- • increased perceived growth prospects in this company • reduced perceived risk of this company • a better economic climate generally, i.e. investors are feeling more optimistic about future returns and risks for all companies • EPS has been fairly stable • Dividends per share have increased slightly more than earnings, so dividend cover (though the increased share price means this represents a lower dividend yield). • These, and items in the CFS such as the share buy-backs last year and the fall in cash spent on investing, are all consistent with the hypothesis that this company sees itself as mature – currently very profitable but with diminishing future growth prospects. It would be interesting to see if this is supported by other information too, e.g. by comparing cash spent on new PPE against the annual depreciation charge. • However return on equity has fallen since equity has increased, largely because of the high retained profits – shareholders may in future be pressing for higher dividends or the equivalent e.g. through share buy-backs.  Question B2 Explain the costing system that Wilkerson (the case study that you studied) currently use, and evaluate how far it is adequate to support management decisions. Suggest an alternative costing system that you consider might generate more decision-relevant information, and assess which system is likely to be most appropriate for Wilkerson's business. Total 33 marks Question B3 Explain why the management of Borealis (the case study that you studied) were dissatisfied with their budgeting system. Explain the alternative approach to planning and control that they introduced in its place, and evaluate the results that this new approach produced. Total 33 marks   Points re answering the Section B questions • in each exam paper there will be a question on each of 2 cases (out of the full set of 3 cases – Wilkerson, Borealis, World Class Lighting) – you are required to attempt either one. • you will be provided with new hard copies of the cases in the exam. • there is no single correct answer to the problems described in the cases. • no additional information is available on the companies or the issues described in addition to what the case studies themselves say. • marks are allocated for the quality of your rational analysis and argument based on the evidence provided in the case, not the conclusion that you reach. • in style and tone, aim to write your answer as if you were writing a paper for the Board to consider at its next meeting. • not just bullet points: develop each point sufficiently to explain it clearly and show you understand it. • aim to be neutral and objective: i.e. critical and sceptical where appropriate but even-handed, rather than partisan either for or against. • consider the contingency factors – what are the circumstances in which each approach might work best? • for both questions, take a systematic approach:- o summarise (briefly) the situation and the options available (i.e. the decision to be made) o define the decision criteria, based on the objectives o explain the alternative options o evaluate each option with respect to the decision criteria: pro's and con's o conclusion, with recommendations if required or appropriate • give each question (and each part of each question) sufficient time to do it justice (NB: in a 2½ hour exam paper, then all else being equal a 33-mark question would justify 50 minutes of concentrated thought and writing). Section C Answer one question in Section C Question C.4 (a) explain the process which a business can follow to set its budget for the forthcoming year, identifying the main inputs and outputs of the budget-setting process. 12 marks (b) distinct from the process which you have explained in part (a), explain the main options open to a business in the managerial approach it takes towards setting its budget and evaluate the advantages and disadvantages of each. 9 marks (c) how can a business use a system of budgetary control based on regular variance analysis to help to control its operations through the year, and what are the strengths and weaknesses of this type of approach to management control? 12 marks Total: 33 marks Some suggested points for answers (a) explain the process which a business can follow to set its budget for the forthcoming year, identifying the main inputs and outputs of the budget-setting process. needed here: a coherent explanation of the procedural process detailed in Study Guide Unit 6 / Scott chapter 11 (as you followed in the A1 assignment; including:- - identify the principal budget factor (usually the sales forecast) - from this, work back through the various processes in the business - what would the expected sales mean for them? - sensitivity analysis – what if the forecasts and assumptions turn out to be incorrect? (consider building some flexibility into the budget) - in practice, an iterative exercise to consider alternative options and 'what-if?' scenarios Inputs might include e.g.:- - information on the previous year's operations (for an incremental approach) - forecasts of relevant external factors e.g. the macro-economy, impending legislation, likely developments in technology, etc. - benchmarks derived from comparable businesses - the business's long-term strategy and vision - operational standards e.g. how much raw materials and labour should it take to produce a product (making a reasonable allowance for waste), etc. - plans and proposals from different people within the business Outputs should include (as a minimum):- - a master budget for the business as a whole: cash budget, budgeted balance sheet, budgeted income statement - micro-budgets for each separate responsibility centre (department) (b) distinct from the process which you have explained in part (a), explain the main options open to a business in the managerial approach it takes towards setting its budget and evaluate the advantages and disadvantages of each. cf. Study Guide Unit 14 + related reading. Some important aspects to cover:- - where to start, and how radical to be (e.g. incremental versus zero-based budgeting); - the extent of participation to aim for, i.e. top-down versus bottom-up. Other aspects might be:- - rolling versus fixed-term budget; - how much detail e.g. in defining different budget headings (which has implications for how far control is centralised versus devolved) NB: note that question requires both explanation and evaluation of all options. Good answers will also make the point that the appropriate choice of style of budget-setting for any specific business should be contingent on its circumstances, e.g. top-down incremental approaches are likely to be more appropriate in homogeneous organisations operating in relatively stable environments than in very diversified organisations which operate in fast-changing or unstable environments.   (c) Explanation of budgetary control:- how can a business use a system of budgetary control based on regular variance analysis to help to control its operations through the year, and what are the strengths and weaknesses of this type of approach to management control? - the budget is set at the start of the year. This requires that forecasts and estimates are made of (i) sales volume, (ii) resource efficiency, (iii) prices - this provides a standard against which performance through the year can be compared to identify whether any aspect of actual performance is going out of control to any significant extent - if this is the case, the variable elements in the original budget are 'flexed' to allow for any difference between volume out-turn and forecast, and the remaining differences are analysed – in the first place, between resource efficiency and price. - the variances put into proportion the relative importance, in terms of impact on final profit, of the various reasons for under or over-performance compared against the original budget. - the managers reviewing the variances must decide which ones to invest time in investigating, to establish the cause … - … and then judge whether or not to consider each variance to be 'controllable' by the relevant person who is responsible for that aspect of performance. Strengths Breaks down the business's overall performance to show which elements are under and over performing. Puts different parts into proportion and shows their impact on final profit. Supports the principle of accountability through responsibility accounting. Can be part of the basis for compensation through rewards (e.g. bonuses) and penalties.   Weaknesses Variance analysis (VA) is only as good as the original budget – this can rapidly become outdated by events and no longer be a suitable standard to judge performance against. The original budgets may deliberately have been based on distortions to some extent (e.g. standards which are based on 'stretch targets' for motivational reasons). VA is best suited for standard products and stable production methods which do not change rapidly over time, may not be so suitable for fast-changing environments and/or businesses with one-off products. Assessing how far a particular variance is controllable is subjective, and a reflection of that business's management style – how far should a manager be held responsible for what happens on his/her "watch" even if they could not really influence it? The term "control" implies an over-simplified view of causes and effects – that they are black or white rather than any of a range of shades of grey. "Significantly influenceable" might be a more accurate term (though not so snappy!). Budgetary control is a form of results-based control. This may not be relevant, or could even be counter-productive, in organisations with alternative approaches to management control e.g. personnel/social or behavioural controls. Interdependencies between different parts of the business could mean interdependencies between the related variances so these are not good guides for responsibility accounting at a micro (individual) level. Variance analysis is inherently reductionist since focussed on individual performance – this may discourage co-operation.   Question C.5 A friend who owns shares in a few companies has asked you for your help in understanding their financial statements, and for you to explain a few points that are puzzling him:- (a) Why is the amount of the final profit which is shown in the income statements for 2014 and 2015 respectively not equal to the year-on-year change in the final cash balances shown in each year' balance sheet? What is the difference between profits and cash, and what do the income statement and cash flow statement respectively indicate about the company's performance during a period? 11 marks (b) One of the companies is a large advertising agency which has grown rapidly in recent years by acquisition (i.e. by taking over other companies). Your friend has noted that unlike several other companies in his investment portfolio, the advertising agency's balance sheet shows very little property, plant and equipment but a high amount of goodwill. He is concerned that this might mean that the other companies' customers do not hold it in as high regard as do the advertising agency's clients. Explain to him:- - what goodwill in company financial reports represents - how it arises and is accounted for in subsequent years after it has first arisen - why different companies' balance sheets should differ so significantly in this respect - how he should take goodwill into account when calculating ratios from the quantities in the financial reports. 12 marks (c) He has also observed from a third company's financial statements, in its Accounting Policies Note, that the amount stated in its balance sheet for property plant and equipment includes not only those properties which the company itself legally owns, but also several which are owned by another party but which the company occupies on a leasing arrangement. He cannot understand why it should be correct to include as an asset in a balance sheet something which the company itself does not actually own. Explain the relevant rules on leasing as stated by IFRS, citing any accounting principles which are relevant and explaining why these rules were considered necessary. 10 marks Total: 33 marks Suggested answer, C.5 (a) why is the final profit as per the income statements not reflected in the changes in the final cash balances as per the balance sheets? How do profits and cash differ, and what do the income statement and cash flow statement respectively indicate about performance? The main differences are likely to be:- • operating cash flow (OCF) may differ from operating profit (OP) because:- o OP is stated after charging depreciation; however this is not a cash flow so it is not part of OCF o changes in BS amounts of inventory, receivables or payables → ↑ or ↓ in OCF but does not affect profit (∴ a reduction in inventory (e.g.) → OCF ↑ relative to operating profit) • some cash flows are not directly related to any IS quantities, e.g. o spending on capital investments (PPE, acquisitions of other companies) o increases (or decreases) in finance through equity or debt o dividends are no longer shown in the IS itself The bakery company in Question A.1 can provide some examples e.g.:- • OCF is substantially more than OP in both years • CFS shows large cash outflows to invest in PPE – though much less in 2015 than in 2014, perhaps showing the business is becoming mature? • substantial dividends paid to shareholders • 2014, a large cash outflow to buy back shares from shareholders and then cancel   (b) Explain:- - what goodwill in company financial reports represents - how it arises and is accounted for in subsequent years after it has first arisen - why the two companies' respective balance sheets should differ so significantly in this respect - how he should take goodwill into account when calculating ratios from the quantities in the financial reports. Goodwill:- - on an acquisition, any excess of consideration paid over the fair value of net assets - recognised on acquisition – 'internally generated goodwill' is never recognised - appears only in the group (consolidated) accounts - parent-subsidiary relationship depends on control (not just % ownership) - not amortised but reviewed annually for any impairment - if impairment, then written down (but never written up) Advertising agency:- - may have grown organically rather than by acquisition - the main assets may be 'soft intangibles' such as brand, reputation, people - may run its business differently, e.g. rent the non-current assets it uses rather than buy them - the absence of goodwill in a BS has no intrinsic significance (it's just a historic balancing item) Implications for financial analysis:- - high goodwill can complicate financial analysis:- o the amount stated cannot be assumed to include all of the company's goodwill (only what has arisen on acquisitions) o the balance shown at any time may be well out of date o there is no recognition of any loss in value through amortisation - NB: there are binding universal rules on calculating ratios; guiding principle is to use those quantities which reflect best the aspect of performance you're interested in - ∴ it's usually best to exclude goodwill from most ratios where it's operating management's performance that you're interested in (c) Explain the relevant rules on leasing as stated by IFRS, citing any accounting principles which are relevant and explaining why these rules were considered necessary. IAS 17 definitions:- - where the right to use an asset for period is agreed – not legal ownership - IAS 17 is based on 'substance over form' principle - a finance lease transfers substantially 'all the risks and rewards of ownership' - this may be indicated by e.g. o the length of the lease term relative to the asset' economic life o the present value of the total payments to which the lessee is committed, relative to the asset's value - an operating lease is any other lease Treatment of a finance lease:- - as if the asset were legally owned - the asset should be:- o included as an asset in BS o depreciated in IS over its useful life - the commitment to make payments to lessor should be:- o recognised in BS as a loan o interest charged each year in IS - depreciation on the asset, and interest on this loan. Treatment of an operating lease:- - no impact on BS - payments to lessor included in IS (like rent) Why was IAS 17 needed? - for finance leases, IAS 17 increases the gearing that the BS shows - previously, some companies could engage in 'off-balance sheet financing' – this conceals from investors the real risk in the company