[ 10 - Finance and Accounting ]

Statement of Profit or Loss (income statements)

An income statement is a financial document of the business that records all income
generated by the business as well as the costs incurred by the business and thus the profit
or loss made over the financial year. It tells managers and shareholders if the business is
profiting.
(The brackets mean we minus from the number above.)

The income statement will consist of :

Sales revenue = total sales ( the total amount of cash made from sales before deducting
costs)
Cost of Sales = total variable cost of production + (opening inventory of finished goods

– closing inventory of finished goods)

Gross Profit = Sales Revenue – Cost of Sales
Expenses = all overheads/fixed costs
Net Profit = Gross Profit – Expenses
Profit after Tax = Net Profit – Tax
Dividends = share of profit given to shareholders; return on shares
Retained Profit for the year = Profit after Tax – Dividends.
These retained earnings is then kept aside for use in the business.
( So retained profit is the money left over once costs, taxes and dividends have been
deducted.)

Amending an income statement / statement of profit or loss

 This may be necessary due to errors or changes in accounting policies or estimates.
 The process of amending a statement of profit or loss involves identifying and
correcting the errors or changes, adjusting the financial figures accordingly, and
reissuing the statement of profit or loss.
 The amendment should include a clear explanation of the reason for the change and
the impact it has on the financial results.
 It's important to note that amendments should be made as soon as possible after an
error or change is discovered to ensure the accuracy of financial information.
 Failure to correct errors or changes in a timely manner can lead to misinterpretation
of financial results and can erode stakeholder confidence in the organization's
financial reporting.

The impact on the statement of profit or loss a given change

There are many changes that could impact the statement of profit or loss, but here are a few
examples :
 Change in revenue: An increase in revenue would result in a higher gross profit and
net profit, while a decrease in revenue would lead to the opposite. For instance, if a
company introduces a new product that becomes very popular, its revenue will
increase, and this will lead to a higher gross profit and net profit.
 Change in cost of sales: A decrease in cost of sales would result in a higher gross
profit and net profit, while an increase in cost of sales would lead to the opposite. For
example, if a company discovers a more cost-effective way to produce its products, it
could reduce its cost of sales and increase its gross profit and net profit.
 Change in expenses: An increase in expenses would lead to a lower profit from
operations and net profit, while a decrease in expenses would lead to the opposite.
For instance, if a company decides to expand its marketing budget, this would
increase its expenses and lower its net profit.
 Change in taxation: An increase in taxation would lead to a lower profit for the year,
while a decrease in taxation would lead to the opposite. For example, if a
government introduces a new tax that applies to a company's products, this would
increase its taxation and lower its profit for the year.

Statement of Financial Position (Covered how to work out on other notes)

The statement of financial position, also known as the balance sheet, provides a snapshot of
a company's financial position at a specific point in time. It shows a company's assets,
liabilities, and equity. The statement of financial position is useful for a variety of purposes,
including:

 Assessing a company's financial health: By examining a company's assets and

liabilities, investors and creditors can determine whether a company has enough
resources to meet its financial obligations and continue operating.
 Analyzing a company's liquidity: The statement of financial position can help
investors and creditors understand a company's ability to pay its short-term debts by
examining the company's current assets and liabilities.
  Evaluating a company's solvency: The statement of financial position can also
help investors and creditors determine whether a company has enough long-term
resources to continue operating by examining the company's long-term assets and
liabilities.
 Comparing a company's financial position over time: By examining a company's
statement of financial position over several periods, investors and creditors can track
changes in a company's financial health.

However, the statement of financial position also has its limitations, including:

 It provides only a snapshot: The statement of financial position provides

information about a company's financial position at a specific point in time, so it does
not show how a company's financial position has changed over time.
 It does not show a company's profitability: The statement of financial position
does not provide information about a company's profitability, which can be found on
the statement of profit or loss.
 It can be affected by accounting policies: The statement of financial position can
be affected by a company's choice of accounting policies, which can make it difficult
to compare the financial position of different companies.
For example, a company's decision to lease assets instead of buying them can have an
impact on its statement of financial position. Leasing an asset allows a company to use the
asset without having to purchase it outright, which can help preserve cash flow. However,
the lease agreement will result in a liability on the company's statement of financial position,
which can affect its solvency and liquidity ratios.

Another example is a company's decision to issue bonds to raise capital. The proceeds from
the bond issuance will be reflected as a liability on the company's statement of financial
position, which can affect its debt-to-equity ratio. However, the company may use the funds
to invest in new projects that can generate future revenue and profits, which will not be
reflected on the statement of financial position.

What is the relationship between the statement of financial position and income statement?
The relationship between the statement of financial position (balance sheet) and the income
statement (profit and loss statement) is that they both provide information about a company's
financial position, but from different perspectives and at different points in time.
 The statement of financial position shows a snapshot of a company's financial
position at a specific point in time, including its assets, liabilities, and equity. It
provides a summary of what a company owns, owes, and what is left over for the
owners.

 On the other hand, the income statement shows a company's financial

performance over a period of time, usually a year or a quarter. It details the
company's revenue, expenses, and profits (or losses) for the period, showing how
much the company earned and how much it spent to generate that revenue.

The two statements are related because the income statement affects the statement of
financial position. The net income (or loss) shown on the income statement is carried
over to the statement of financial position and added to (or subtracted from) the equity
section. In other words, the income statement provides a link between the statement of
financial position at the beginning of a period and the statement of financial position at the
end of that period.
  For example, if a company has a net income of $100,000 for the year, that amount is
added to the equity section of the statement of financial position. This increases the
company's retained earnings, which is part of the equity section. Similarly, if a
company has a net loss of $50,000 for the year, that amount is subtracted from the
equity section, reducing the company's retained earnings.

Overall, the two statements provide complementary information about a company's financial
position and performance, and are both important tools for analyzing a company's financial
health. Potential investors should look at both the statement of financial position and income
statement to gain a complete understanding of a company's financial health

Valuing Inventory
Inventory refers to the stock of goods and materials that a business holds in order to meet
customer demand. It includes raw materials, work-in-progress items, and finished goods that
are ready for sale. Inventory is important for several reasons, including:
 Meeting customer demand: By having inventory on hand, businesses can quickly
fulfill customer orders and avoid stockouts.
 Production planning: Businesses can use inventory levels to plan their production
schedules and ensure they have the necessary materials and components to meet
production targets.
 Cost management: Inventory represents a significant investment for many
businesses, so managing it effectively is important for controlling costs and
maximizing profits.
 Risk management: Holding inventory can help businesses manage risks such as
supply chain disruptions, unexpected demand changes, and production issues.

Why is it difficult to value inventory?

Inventory valuation can be difficult due to various reasons:
 Cost Fluctuations: The cost of inventory items can change frequently, making it
challenging to maintain a consistent valuation method. For example, the price of raw
materials can vary based on market demand or supply chain disruptions, making it
difficult to determine the actual value of the inventory.
 Obsolescence: Inventory items can become obsolete, especially in industries that
rely on technology. For example, a company that produces smartphones may have
inventory that becomes outdated as new models are released, making it difficult to
determine the value of the obsolete inventory.
 Damaged or Lost Inventory: Inventory items may be damaged, lost or stolen,
leading to discrepancies in inventory records. This makes it difficult to determine the
actual quantity and value of inventory on hand.
 Depreciation: Inventory items that are not sold immediately can lose value due to
depreciation, making it difficult to determine their current value.
 Different Valuation Methods: Different valuation methods, such as First-In-First-Out
(FIFO) and Last-In-First-Out (LIFO), can lead to different inventory valuations. This
makes it difficult to compare the financial performance of companies that use
different valuation methods.

For example, let's say a clothing retailer has inventory that includes various types of clothing
items purchased at different times and prices. If the company uses the FIFO method, it
assumes that the oldest items in inventory are sold first, and the newest items remain in
inventory. However, if the company uses the LIFO method, it assumes that the newest items
are sold first, and the oldest items remain in inventory. This can lead to different inventory
valuations and affect the company's financial statements.

Overall, inventory valuation can be difficult due to various factors, and it is important for
businesses to maintain accurate inventory records and use consistent valuation methods to
ensure accurate financial reporting.

Net Realisable Value Method

The net realizable value (NRV) method is a way to value inventory that works by :
estimated selling price of goods (-) the estimated costs to complete and sell them.
It is a conservative approach that assumes a lower value for inventory, compared to the cost
method.
 The NRV method works by taking the estimated selling price of inventory, subtracting
any estimated costs of completing or selling it, and arriving at a net realizable value.
 This net realizable value is then compared to the original cost of the inventory to
determine if there has been any decrease in value.

For example, suppose a company has inventory that cost $10,000 to purchase, but due to
market conditions, it is estimated that the inventory can only be sold for $8,000. Additionally,
there are estimated costs of $1,000 to complete and sell the inventory. Using the NRV
method, the net realizable value of the inventory would be $7,000 ($8,000 selling price -
$1,000 estimated costs), which is lower than the original cost of $10,000.

The limitations of the NRV method include the subjectivity of the estimates used to arrive at
the net realizable value, which may be influenced by factors such as market conditions,
competition, and changes in technology. Additionally, the NRV method may not be suitable
for all types of inventory, such as unique or specialized items with limited markets.

Depreciation
Depreciation is the process of allocating the cost of a tangible asset over its useful life. It is
an accounting method used to reflect the declining value of an asset over time.

The role of depreciation in the accounts is to spread the cost of a long-lived asset over its
useful life, rather than recording the entire cost as an expense in the year of acquisition.
This helps to match expenses with revenues in the periods in which the asset is used to
generate revenue. Depreciation also reflects the idea that assets wear out, become
obsolete, or lose their value over time.

For example, suppose a company purchases a machine for $50,000 that is expected to
last 10 years. The company can depreciate the machine over its useful life, which means it
can allocate $5,000 of the machine's cost to each year of its useful life. This way, the
company can expense $5,000 each year of the machine's use, rather than recording the
entire $50,000 as an expense in the year of purchase.

Depreciation can have a significant impact on a company's financial statements. It reduces

the value of the asset on the balance sheet over time and also reduces the company's
reported profits on the income statement, as depreciation expense is recorded as an
operating expense.

Straight line depreciation

 Residual value, also known as salvage value, is the estimated value of an asset at
the end of its useful life.
 It is the amount that the company expects to receive by selling the asset after it has
been fully depreciated.
 In straight line depreciation, the residual value is deducted from the cost of the asset
to determine the depreciable base, which is then divided by the estimated useful life
of the asset to determine the annual depreciation expense.
 Straight line depreciation affects both the statement of financial position and income
statement in different ways.

Measuring Liquidity
Liquidity refers to a company's ability to meet its short-term obligations or to convert its
assets into cash easily and quickly without incurring significant losses. In simpler terms,
liquidity measures the ability of a company to pay its bills and debts when they are due.
It's essential for a company to maintain sufficient liquidity because it ensures that it can
meet its day to day financial obligations, such as paying employees, suppliers, and
lenders. Failure to do so can result in bankruptcy or insolvency.
 For example, if a company has a high level of liquidity, it can easily pay off its debts
and maintain a good reputation with its lenders. This could also allow the company to
take advantage of new business opportunities as they arise, such as investing in new
projects, acquiring other businesses, or expanding its operations.

 On the other hand, if a company has poor liquidity, it may struggle to meet its
financial obligations, leading to a damaged reputation, missed opportunities, or even
bankruptcy.

In summary, liquidity is essential for the smooth functioning of a business, and it is a critical
measure of a company's financial health.

So, how do we measure liquidity?

The two main ways to measure liquidity are current ratio and acid test ratio

Current Ratio

 Current ratio is a financial ratio that measures a company's ability to pay off its
current liabilities with its current assets. It is calculated by dividing the company's
current assets by its current liabilities.
 The current ratio is an important indicator of a company's liquidity because it helps to
assess whether the company has enough resources to pay off its short-term debts. A
higher current ratio indicates that the company has more current assets than
current liabilities, which means it is in a better position to meet its short-term debts
 However, the current ratio has limitations. It does not take into account the quality of
a company's current assets or the timing of its current liabilities. For example, if a
company has a high amount of inventory that may be difficult to sell or collect
on, the current ratio may be misleadingly high.
 Interpreting the results of the current ratio depends on the industry and the
company's specific circumstances. Generally, a current ratio of 2:1 or higher is
considered favorable, but a ratio lower than 1:1 indicates that the company may
have difficulty meeting its short-term obligations.
 The current ratio is used by investors, creditors, and management to make
decisions about the financial health of a company.
 For example, if a potential investor is considering investing in a company, they may
look at the current ratio to assess the company's ability to pay off its debts in the
short term.
 Similarly, a creditor may use the current ratio to evaluate the risk of lending money
to a company.
 Management may also use the current ratio to monitor the company's liquidity and
make decisions about working capital management.

Acid Test Ratio

  The acid-test ratio, also known as the quick ratio, is a financial ratio that measures
a company's ability to meet its short-term liabilities with its most liquid assets,
such as cash, marketable securities, and accounts receivable.
 It is similar to the current ratio, but excludes inventory and other current assets
that may be difficult to quickly liquidate (sell)
 The acid-test ratio provides a more conservative view of a company's liquidity
position than the current ratio, as it assumes that inventory may not be quickly
sold or converted to cash.
 This makes the acid-test ratio a useful measure of a company's ability to pay off its
short-term liabilities in the event of an unexpected downturn or emergency.
 The main limitation of the acid-test ratio is that it does not take into account the
quality or collectability of a company's accounts receivable (debts owed to them),
which can impact its ability to generate cash quickly.
 Additionally, it may not be an appropriate measure for companies with
significant inventory or those that require a large amount of working capital to
operate.
 Interpretation of the acid-test ratio depends on the industry and company being
analyzed, but in general, a higher ratio indicates a more liquid position and a
better ability to meet short-term obligations.
 A ratio of 1 or higher is typically considered a good benchmark, although this
may vary depending on the industry and other factors.
 If the acid-test ratio is too low, it may suggest that the company is relying too
heavily on inventory or accounts receivable to meet its short-term obligations,
which could increase its risk of insolvency.

How could a business improve their liquidity?

Reduce inventory levels: One way to improve liquidity is to reduce the amount of inventory
held by the business. By selling off slow-moving inventory or reducing the amount of
inventory ordered, a business can free up cash that can be used to pay off debts or invest in
new opportunities. For example, a clothing retailer might decide to run a sale to clear out last
season's inventory, freeing up cash to invest in new designs for the upcoming season.
Tighten credit terms: Another way to improve liquidity is to tighten credit terms for
customers. This could involve reducing the amount of credit offered to customers, shortening
payment terms, or even requiring payment upfront. For example, a software company might
change their payment terms from net 30 to net 15, ensuring that they receive payment for
their products more quickly.
Increase financing options: A third way to improve liquidity is to increase financing options.
This could involve securing a line of credit from a bank, selling equity in the business to
investors, or even crowdfunding. For example, a small business might secure a line of credit
from a bank to help them cover short-term expenses while waiting for payments from
customers.

Measuring Profitability
Profitability refers to a company's ability to generate profit or earnings relative to its
expenses and other costs. Profitability is a key indicator of a company's financial health
and success, as it reflects its ability to earn a return on investment and sustain operations
over the long term.
Profitability is important because it enables a company to:
 Attract investors: Investors are often attracted to companies that demonstrate
consistent profitability and growth potential.
 Secure financing: Banks and other lenders are more likely to extend credit to
profitable companies, as they are viewed as a lower credit risk.
 Retain employees: Companies that are profitable are better able to provide job
security, competitive wages and benefits, and opportunities for career advancement.
 Expand operations: Profitable companies have more resources to invest in new
products, services, or markets.
 Increase shareholder value: Shareholders expect to receive returns on their
investment in the form of dividends and stock price appreciation, both of which are
closely tied to a company's profitability.

So how do we measure profitability?

 Return on capital employed (%)
 Gross profit margin (%)
 Profit margin (%)

Return on Capital Employed

 Return on capital employed (ROCE) is a financial ratio that measures the profitability
and efficiency of a business by comparing its operating profit to the amount of
capital it has invested in the business.
 Where operating profit is the profit before interest and tax, and capital employed is
the total amount of capital invested in the business, including equity and debt.
  ROCE is a useful tool for investors and analysts to assess how well a company is
using its capital to generate profits. A higher ROCE (%) indicates that a company
is generating more profit per unit of capital employed, which is generally viewed as
good
 However, ROCE should not be used as a standalone measure of profitability
 For example, a high ROCE could be due to a company taking on a large amount
of debt, which could increase the riskiness of the business.

Gross Profit Margin

 Gross profit margin is a financial metric that measures the profitability of a

company by calculating the percentage of revenue that exceeds the cost of goods
sold.
 It shows how efficiently a company uses its raw materials and labor to produce
its products or services
 For example, if a company has revenue of $1,000,000 and cost of goods sold of
$700,000, the gross profit margin would be:
 ($1,000,000 - $700,000) / $1,000,000 x 100% = 30%
 This means that for every dollar of revenue, the company retains 30 cents as
gross profit. (profit after deducting cost of goods sold, doesn’t include taxes etc.)
 A higher gross profit margin indicates that a company is generating more profit
from its products or services, which can help to cover its operating expenses and
generate a net profit. (total profit, profit left after all reductions)
 It can also indicate that the company has a competitive advantage in its industry.
 However, a limitation would be that it does not take into account other expenses such
as marketing, salaries, and overhead costs, which can significantly impact a
company's profitability.
 Therefore shouldn’t be only measure of profitability, should use other methods

Profit Margin

 Profit margin is a financial ratio that indicates a company's profitability by measuring

the percentage of revenue that is turned into profit.
  Profit margin shows the efficiency of a business in generating profit from its sales. It
is useful in assessing the financial health of a company and comparing it to its
industry peers.
 A higher profit margin indicates that the company is generating more profit for
every dollar of revenue.
 Profit margin is different from gross profit margin as it deducts all expenses
including operating expenses and taxes from revenue, while gross profit margin
only deducts the cost of goods sold.
 Gross profit margin measures a company's ability to produce goods at a profit,
whereas profit margin measures the overall profitability of the business.
 The limitations of profit margin include the fact that it does not consider a company's
cash flow, capital expenditure, or the risk involved in generating profits.
 Also, the comparison of profit margins across different industries may not be
meaningful due to differences in things like taxation. (different companies may be
taxed different amounts, depending on the industry and deals with the government.)
 Interpretation of profit margin varies by industry, but in general, a higher profit
margin is better than a lower one.
 However, a very high profit margin could mean that the company is not investing
enough in the business and may not be sustainable in the long run. (i.e they’ve got
too much money left over, aren’t doing anything meaningful with it - investing in
better machinary/training etc.)

What are some methods of improving profitability?

 Increasing revenue: Businesses can focus on increasing sales by introducing new
products or services, expanding their customer base, or increasing prices.
 Cost control: A business can reduce their costs by finding more cost-effective
suppliers, reducing wastage, or negotiating better deals with their suppliers.
 Operational efficiency: By improving operational efficiency, businesses can reduce
costs and increase profitability. This may involve implementing new technologies,
improving processes, or reorganizing the business structure.
 Marketing: Effective marketing strategies can help businesses increase their
revenue and improve profitability. This may include advertising, social media
campaigns, or improving the company's website.
 Diversification: By diversifying their products or services, businesses can expand
their customer base and reduce their dependence on a single product or market. For
example, a company that primarily sells clothing may consider expanding into
accessories or footwear.
 Mergers and acquisitions: By acquiring or merging with other companies,
businesses can gain access to new markets, technologies, and customers, which
can help improve profitability.

Measuring Financial Efficiency

Financial efficiency refers to the ability of a business to manage its resources effectively
in order to generate profits and maximize returns on investment. It is a measure of how
well a business uses its assets and liabilities to generate revenue and control costs.
Financial efficiency is important because it enables a business to increase profitability
and competitiveness in the market.
By using resources more efficiently, a business can improve its cash flow, reduce its
operating expenses, and make better use of its capital. This allows a business to invest
in new projects, expand its operations, and provide better returns to shareholders.

The 3 main methods of measuring financial efficiency include :

 Rate of inventory turnover (amount of times)
 Trade receivables turnover (days)
 Trade payables turnover (days)

Rate of Inventory Turnover

 Where the cost of goods sold refers to the total cost of goods sold during the
year
 The average inventory is calculated by taking the beginning and ending inventory
balances and dividing by two.
 The rate of inventory turnover is a financial efficiency ratio that measures the
number of times a company sells and replaces its inventory over a specified
period, usually a year.
 A high inventory turnover ratio is generally considered a positive sign as it
indicates that the company is selling its inventory quickly and efficiently.
 A low inventory turnover ratio could indicate that the company is holding onto
inventory for too long or that they are having trouble selling their products.
 For example, let's say a company has a cost of goods sold of $500,000 and an
average inventory of $100,000. The inventory turnover ratio would be calculated as
follows:
 Inventory Turnover Ratio = $500,000 / $100,000 = 5
 This means that the company is selling and replacing its inventory five times a
year.
 One limitation of the inventory turnover ratio is that it can vary significantly between
industries, making it difficult to compare companies in different sectors.
 Additionally, it does not take into account the profitability of the company or the
quality of the inventory, which can also impact a company's financial efficiency.
Trade Receivables Turnover

Where:
 Average Trade Receivables = (Opening Trade Receivables + Closing Trade
Receivables) / 2
 Annual Credit Sales = Total credit sales made during the year
 Trade receivables turnover (days) is also known as debtors days.
 It is a financial ratio that measures the average number of days it takes for a
business to collect payment from its customers after a sale has been made.
 For example, if a company has an average trade receivables balance of $100,000
and annual credit sales of $500,000, the trade receivables turnover (days) would be:
 Trade Receivables Turnover (Days) = ($100,000 / $500,000) x 365 = 73 days
 This means that, on average, it takes the company 73 days to collect payment
from its customers.
 Important because it provides insight into how efficient a business is in collecting
payments from its customers.
 The lower the number of days, the better, as it indicates that the business is able
to collect payment more quickly and has a better cash flow.
 On the other hand, a higher number of days could indicate that the business is
struggling to collect payment from customers and may have cash flow issues.
Trade Payables Turnover

Where:
 Trade payables are the amount owed to suppliers or creditors
 Cost of sales represents the total cost of goods or services sold during a given
period.
 Trade payables turnover, also known as creditor days, is a financial ratio that
indicates the average number of days it takes for a company to pay its
suppliers or creditors.
 It is an important measure of a company's financial efficiency and cash flow
management.
 Interpreting the trade payables turnover ratio requires an understanding of the
industry norms and the company's payment policies. (differs between
businesses.)
 A high trade payables turnover indicates that a company is paying its suppliers
quickly, which could indicate a strong cash position. (or not, could just be paying
based on the agreed upon terms, may be struggling financially still.)
 On the other hand, a low trade payables turnover may indicate that a company is
taking too long to pay its suppliers, which could strain supplier relationships.
 For example, let's say a company has a cost of sales of $500,000 and an average
trade payables balance of $50,000.
 Trade payables turnover (days) = ($50,000 / $500,000) x 365 = 36.5
 This means that the company takes 36.5 days on average to pay its trade
payables (creditors).
 Whether or not this is good, will depend on the business itself and their relationship
with suppliers/lenders (maybe they have a good relationship, with generous payment
terms that can be extended.)
 Limitations of the trade payables turnover (days) ratio include the fact that it only
provides a snapshot of a company's financial efficiency at a given point in time,
and it does not take into account the different payment terms of each supplier.
  Additionally, it may be more difficult to interpret the ratio if the company has
seasonal fluctuations in its business.

How to improve Financial Efficiency :

Inventory turnover:
 Improve forecasting accuracy to better match inventory with demand.
 Streamline the supply chain to reduce lead times and increase inventory turns.
 Implement lean manufacturing or just-in-time inventory systems to minimize waste
and inventory holding costs.
Trade receivables turnover:
 Implement credit checks and screening processes to ensure that customers have a
good credit history before extending credit.
 Offer discounts for early payment to encourage customers to pay invoices promptly.
 Follow up on overdue invoices with timely reminders, statements, and phone calls.
Trade payables turnover:
 Negotiate more favorable payment terms with suppliers.
 Implement a system of continuous improvement to streamline the purchase-to-pay
process, reducing the time between order placement and payment.
 Explore alternative financing options, such as factoring or supply chain finance, to
improve cash flow and reduce reliance on trade payables.

How to measure Gearing

Gearing refers to the use of debt financing by a company to fund its operations or
growth, as opposed to using only equity financing. So borrowing money to fund operations
rather than funding them through sale of shares. Measures risk involved with loans basically.
Gearing is important because it can increase a company's returns and growth potential, but
it also increases the risk of financial distress or bankruptcy.

It is measured using the gearing ratio.

Where:
 Total Debt: includes all of the company's short-term and long-term debt obligations.
  Total Equity: represents the value of the company's assets that are owned by
shareholders.
 Gearing ratio measures the proportion of the company's financing that comes
from debt.
 Interpreting the gearing ratio requires some context, as the ideal ratio will vary
depending on the industry and business model.
 Generally speaking, a higher gearing ratio means that a company is taking on
more risk by relying on debt financing, but it may also indicate that the company
is able to generate higher returns on investment.
 A lower gearing ratio, on the other hand, may indicate that the company is more
conservative in its financing and may have more stable cash flow.
 One limitation of the gearing ratio is that it does not take into account the specific
terms and conditions of the company's debt. For example, a company may have
a high gearing ratio but a low cost of debt, making the debt financing more attractive.
 Another limitation is that the ratio may not accurately reflect a company's ability
to repay its debt, as it only considers the company's current debt and equity levels.

How to improve gearing :

Gearing can be improved by reducing the amount of debt in the company's capital
structure or by increasing the equity. Here are some examples of how to improve gearing:
 Debt reduction: One way to reduce gearing is to pay off debt or refinance it at a
lower interest rate. This will reduce the amount of interest expense and decrease the
overall debt-to-equity ratio. For example, a company might choose to issue bonds
with a lower interest rate to replace existing debt.
 Selling shares: Another way to improve gearing is to raise additional equity capital.
This can be done through a rights issue or by issuing new shares to investors. By
increasing equity, the company's debt-to-equity ratio decreases, and the company
becomes less leveraged.
 Asset sales: A company can also improve its gearing ratio by selling off assets and
using the proceeds to pay down debt. This will reduce the company's interest
expense and improve its financial position. For example, a company might sell off a
non-core business unit or real estate holdings to reduce its debt load.
 Increase profits: A company can also improve its gearing ratio by increasing its
profits. By generating more income, the company can pay off its debt more quickly
and reduce its debt-to-equity ratio. This can be achieved by increasing sales,
reducing costs, or both. For example, a company might launch a new product line or
enter into a new market to increase sales and profits.

Measuring Return to Investors

The return to investors refers to the profits or benefits that investors receive from their
investments in a business. This could come in the form of dividends, capital gains, or
other forms of returns on their investment.
The importance of return to investors lies in the fact that it can attract more investors and
help a business to grow and expand. Additionally, satisfying the expectations of investors is
important for maintaining good relationships and reputations in the financial markets.
Ultimately, a business's ability to generate consistent returns to investors is a key factor in its
long-term success.
How to measure Return to Investors
 Dividend Yield (%)
 Dividend Cover (ratio)
 Price/Earnings Ratio

Dividend Yield

 Dividend yield is a financial ratio that measures the return on investment from a
company's dividend payments to its shareholders.
 It indicates how much a company pays out in dividends relative to its current
share price
 For example, if a company pays an annual dividend of $2 per share, and its current
share price is $50, the dividend yield would be:
 Dividend Yield = ($2 / $50) x 100% = 4%
 This means that for every $100 invested in the company's shares, the
shareholder would receive $4 in annual dividends.
 Investors can compare the dividend yield of different companies to identify the
most attractive investment opportunities.
 Investors may also use dividend yield to assess the health of a company.
 A high dividend yield may indicate that a company is financially stable and has
a solid track record of paying dividends
 While a low or no dividend yield may suggest that a company is not generating
enough cash flow to pay dividends to shareholders.
 The limitations of dividend yield include the fact that it only takes into account the
current dividend and share price, and doesn't reflect potential changes in future
dividends or stock prices.
 Additionally, companies may change their dividend policies, which can affect the
yield.
 Therefore, investors should consider other factors in addition to the dividend yield
when making investment decisions.

Dividend Cover

 Dividend cover is a financial ratio that measures a company's ability to pay

dividends to its shareholders from its profits.
  It is a measure of the company's dividend-paying capacity and can indicate whether
the company can maintain or increase its dividend payments in the future.
 For example, if a company has an EPS of $2 and a DPS of $1, its dividend cover
would be 2. This means that the company's profits are twice the amount of its
dividend payments.
 Different to dividend yield. Dividend yield is a percentage that shows the return on
investment for a shareholder, while dividend cover is a ratio that indicates how many
times a company's earnings can cover the dividend payments to shareholders.
 So, while dividend yield shows the return on investment for shareholders, dividend
cover shows the company's ability to maintain or increase the dividend
payments to shareholders based on their earnings.
 Investors and analysts use dividend cover to assess the sustainability of a
company's dividend payments.
 A high dividend cover indicates that a company is generating enough profits to
cover its dividend payments and may be able to maintain or increase its dividends
in the future.
 On the other hand, a low dividend cover may indicate that the company is
struggling to generate sufficient profits to pay dividends and may be at risk of
cutting its dividends.
 Limitations of dividend cover include the fact that it does not take into account a
company's future growth prospects or capital expenditure needs, which may
impact its ability to pay dividends in the future.

Price/Earnings Ratio

 Price-to-earnings ratio (P/E ratio) is a financial metric used by investors to evaluate a

company's stock.
 The P/E ratio is an indicator of how much investors are willing to pay for each
dollar of the company's earnings.
 A higher P/E ratio typically indicates that investors expect higher earnings growth
in the future
 While a lower P/E ratio may suggest that the company's growth prospects are
more limited.
  For example, if a company's stock is currently trading at $50 per share, and its
EPS over the past year was $2, then the P/E ratio would be 25 ($50 divided by $2).
 The P/E ratio is commonly used by investors as a way to compare the relative
value of different stocks in the same industry or sector.
 However, it is important to note that the P/E ratio has some limitations. For example,
it may not be useful for comparing companies with different growth rates or those in
different industries.
 Additionally, the P/E ratio may be influenced by market sentiment or other
factors that may not reflect the underlying value of the company.
 For example, if investors are really excited about a company and think its stock will
do well in the future, they might be willing to pay a higher price for the stock,
which would drive up the P/E ratio even if the company's financial performance
doesn't justify it.
 Conversely, if investors are pessimistic about a company, they might be less
willing to pay as much for the stock, which would drive down the P/E ratio even
if the company is actually doing well financially.

Investment Appraisal
Investment appraisal is a process of evaluating the feasibility and profitability of an
investment project before committing financial resources.
It involves assessing the potential benefits and costs of the project, considering
different scenarios, and estimating the risks and uncertainties involved.
The purpose of investment appraisal is to help a business or investor make informed
decisions about whether to pursue an investment opportunity, and if so, which one is the
most profitable and feasible. This can help to minimize the risk of financial loss and
maximize the return on investment.
Bottom line, investment appraisal is important because it helps organizations evaluate
potential investment opportunities and determine whether they are worth pursuing. By using
appropriate appraisal methods, organizations can make informed decisions and allocate
resources effectively. For example, an organization might use investment appraisal to
evaluate whether to invest in a new production facility, launch a new product line, or
acquire another company.

Methods of investment appraisal can be quantitative or qualitative, the quantitative ones

include:
 Payback Period (time - years normally)
 Accounting Rate of Return ARR (%)
 Net Present Value NPV
Payback Period

 Payback period is a financial metric used to determine the time it takes to recover
the initial investment in a project. Used commonly to evaluate investment
decisions
 To interpret the answer, you look at the number of years and months it takes for
the cash inflows to pay back the initial investment
 For example, if the initial investment is $100,000 and the annual cash inflow is
$25,000, the payback period would be 4 years:
 Payback period = $100,000 ÷ $25,000 = 4 years to payback initial investment
 The limitations of payback period include its failure to consider the time value of
money meaning it doesn't account for the difference in the value of money over
time due to inflation or other factors.
 Additionally, it ignores the cash flows beyond the payback period and may not take
into account the profitability of the project beyond the time it takes to recover
the initial investment.

Accounting Rate of Return

 The Accounting Rate of Return (ARR) is a financial metric used to measure the
profitability of an investment project or asset. It is often used by managers to
evaluate the attractiveness of a project or investment opportunity.
 To calculate the Average Annual Profit, you subtract the initial investment from the
total profit generated over the expected lifespan of the investment, and then divide by
the expected lifespan of the investment.
  For example, if a company invests $100,000 in a project that generates a total profit
of $40,000 over a period of 5 years, the Average Annual Profit would be $8,000
([$40,000 - $100,000] / 5).
 The ARR would then be 8% ($8,000 / $100,000 x 100%).
 The ARR is expressed as a percentage, which represents the return generated by
the investment over its lifespan. If the ARR is higher than the required rate of return
or the company's hurdle rate, the investment may be deemed profitable
 Limitations of the ARR include that it ignores the time value of money and the
timing of cash flows, as it is based on average profits and does not consider the
actual cash flows generated by the investment.
 Additionally, the ARR does not take into account the risk or uncertainty
associated with the investment.

Net Present Value

Where :
 –Co = Initial Cost of Investment
 C = Cash Flow
 r = Discount Rate
 T = Time

Net Present Value (NPV) is a financial tool used to determine the present value of future
cash inflows and outflows of an investment, adjusted for the time value of money. It is
used by businesses and investors to evaluate the potential profitability of an investment or
project.
To calculate the NPV, we need to estimate the expected cash inflows and outflows of
the investment over a certain period, and then discount them to their present value
using a discount rate.
If the NPV is positive, it indicates that the investment is expected to generate a profit,
and if it is negative, it indicates that the investment is expected to result in a loss.

For example, let's say a company is considering investing in a new project :

 That is expected to generate cash inflows of $10,000 per year
 For the next five years.
 The cost of the project is $40,000.
 The company uses a discount rate of 10%.

To calculate the NPV, we first need to discount the future cash inflows to their present value:
Year 1: $10,000 / (1 + 10%)^1 = $9,090.91
Year 2: $10,000 / (1 + 10%)^2 = $8,264.46
Year 3: $10,000 / (1 + 10%)^3 = $7,513.14
Year 4: $10,000 / (1 + 10%)^4 = $6,826.49
Year 5: $10,000 / (1 + 10%)^5 = $6,197.72

The sum of the present value of cash inflows is $37,892.72.

Next, we need to discount the cost of the project to its present value:
$40,000 / (1 + 10%)^1 = $36,363.64

The present value of cash outflows is $36,363.64.

Finally, we can calculate the NPV:
NPV = $37,892.72 - $36,363.64 = $1,529.08
A positive NPV of $1,529.08 indicates that the investment is expected to generate a
profit.

Qualitative Factors and Investment Appraisal

Qualitative factors of investment appraisal are non-financial factors that affect investment
decisions. These factors may include social, environmental, political, or legal factors that
may impact the investment's success or failure. Some examples of qualitative factors
include:

 Reputation: The reputation of the company or project can impact its success. If the
company has a strong reputation for delivering quality products or services, it may
attract more customers or investors.
 Regulatory environment: Changes in laws and regulations can impact the success
of an investment. For example, if a new law is passed that restricts the use of a
particular product, it may impact the investment's profitability.
 Market trends: Changes in market trends can also impact the success of an
investment. For example, if a new technology emerges that makes a product or
service obsolete, it may impact the investment's profitability.
 Sustainability: Investors may be interested in sustainable investments that have a
positive impact on the environment or society. Companies that are seen as
sustainable may attract more investors.
 Management: The quality of the management team can impact the success of an
investment. A strong management team may be able to navigate challenges and
make the investment successful.

The impact of qualitative factors on investment decisions can be significant. For example, if
a company has a poor reputation, investors may be hesitant to invest in the company,
even if the financials look good. Similarly, if the regulatory environment is uncertain,
investors may be hesitant to invest in a project.
On the other hand, if a company has a strong reputation or is seen as sustainable, it may
attract more investors, even if the financials are not as strong.
Therefore, it's important for investors to consider both quantitative and qualitative
factors when making investment decisions.

How can financial statements be used in developing strategies?

Financial statements and accounting data can be used in developing strategies in several
ways:
 Performance evaluation: Financial statements can be used to evaluate a
company's past performance and identify areas for improvement. For example, if a
company's income statement shows declining revenue, it may indicate a need to
reevaluate the company's sales strategy.
 Forecasting: Financial statements can be used to forecast future performance and
help a company make informed decisions. For example, if a company's balance
sheet shows a high level of debt, it may indicate a need to reduce expenses to
improve cash flow and avoid defaulting on loans.
 Resource allocation: Financial statements can be used to determine where to
allocate resources, such as capital investments or marketing expenses. For example,
if a company's income statement shows that a particular product line is generating
high profits, it may indicate an opportunity to invest in that product line to further
increase profitability.
 Benchmarking: Financial statements can be used to compare a company's
performance to industry peers and identify areas where the company can improve.
For example, if a company's financial statements show lower profit margins than
competitors, it may indicate a need to reevaluate pricing strategies.

Annual Report
An annual report is a comprehensive report issued by a company to its shareholders,
stakeholders, and the public at large that provides a detailed overview of the
company's financial performance during the year.
The report typically includes information about the company's financial position, earnings,
cash flow, investments, capital expenditures, and other relevant financial data.
Additionally, it may include a letter to shareholders from the CEO or chairman, an overview
of the company's operations and management structure, a summary of the company's
corporate social responsibility initiatives, and other relevant information.

The primary purpose of an annual report is to provide transparency and accountability to

shareholders and other stakeholders by giving them a comprehensive understanding of the
company's financial health and performance.
Shareholders can use the annual report to evaluate the company's performance,
management strategy, and future prospects, and make informed investment decisions.
Additionally, the annual report can be used by the company's management to evaluate its
financial position and make strategic decisions based on the information presented.

Some examples of the contents of an annual report include:

 Financial statements: These include the balance sheet, income statement, and
statement of cash flows, which provide information about the company's financial
position, earnings, and cash flow.
  Letter to shareholders: This is typically written by the CEO or chairman and
provides an overview of the company's performance during the year and its strategy
going forward.
 Management discussion and analysis: This section provides an in-depth analysis
of the company's operations, performance, and financial condition during the year.
 Corporate governance report: This provides information about the company's
management structure, board of directors, and corporate governance policies.
 Corporate social responsibility report: This section outlines the company's
initiatives and activities related to environmental, social, and governance issues.
Overall, an annual report is a crucial tool for both shareholders and the company's
management in evaluating its financial performance, making informed investment decisions,
and developing strategies for the future.

How is accounting data and ratio analysis in strategic decision-making?

Assessment of business performance over time and against competitors:
 Accounting data, such as financial statements and ratio analysis, can be used to
assess a business's performance over time and against its competitors.
 For example, comparing a company's current financial ratios to its ratios from the
previous year can show how the company's financial performance has changed over
time.
 Similarly, comparing a company's ratios to its competitors' ratios can provide insights
into the company's competitive position in the industry.

The impact of accounting data including ratio results on business strategy:

 Accounting data, including ratio analysis, can provide insights into a company's
financial health and inform its business strategy.
 For example, if a company's profitability ratios are low, it may need to consider
strategies to increase revenue or decrease expenses in order to improve profitability.

The impact of debt or equity decisions on ratio results:

 Decisions related to debt or equity can impact a company's financial ratios.
 For example, if a company takes on a large amount of debt, its debt-to-equity ratio
may increase, which can indicate that the company is relying heavily on debt
financing.

The impact of changes in dividend strategy on ratio results:

 Changes in a company's dividend strategy can impact its financial ratios, particularly
its dividend yield ratio.
 For example, if a company decreases its dividend payouts, its dividend yield ratio will
decrease, which can impact investor perceptions of the company's value.

The impact of business growth on ratio results:

 Business growth can impact a company's financial ratios, particularly its liquidity
ratios.
 For example, if a company experiences rapid growth, it may need to increase its
current assets in order to meet its growing operating expenses, which can decrease
its current ratio.
The impact of other business strategies on ratio results:
 Other business strategies, such as cost-cutting initiatives or product diversification,
can impact a company's financial ratios.
 For example, if a company implements a cost-cutting initiative, its profitability ratios
may improve, which can positively impact investor perceptions of the company's
financial health.

What are the limitations of using published accounts and ratio analysis?
There are several limitations of using published accounts and ratio analysis, including:
 Window dressing: Companies may use accounting techniques to manipulate their
financial statements to present a more favorable view of their financial health. For
example, a company may defer the recognition of expenses to a future period or
accelerate the recognition of revenue to the current period, which can make the
company appear more profitable than it actually is.
 Historical data: Financial statements and ratio analysis are based on historical data,
which may not be reflective of future performance. Economic conditions, industry
trends, and changes in management can all impact future performance, making it
difficult to accurately predict future financial outcomes based solely on past
performance.
 Accounting policies: Different companies may use different accounting policies,
which can make it difficult to compare financial statements and ratios across
companies. For example, one company may use the FIFO method to value
inventory, while another company may use the LIFO method. This can impact the
reported cost of goods sold and inventory levels, which can in turn impact financial
ratios.
 Lack of context: Financial statements and ratio analysis do not provide the full
context of a company's financial health. For example, a high debt-to-equity ratio may
indicate that a company is heavily leveraged, but it does not provide information on
the company's ability to meet its debt obligations or generate cash flow.
 Non-financial factors: Financial statements and ratio analysis do not take into
account non-financial factors that may impact a company's financial health, such as
changes in consumer preferences, technological disruptions, or regulatory changes.
 Limited scope: Financial statements and ratio analysis provide a limited scope of a
company's performance and do not capture all aspects of a company's operations,
such as the quality of its management team, the strength of its brand, or the
effectiveness of its marketing strategy.

Overall, while published accounts and ratio analysis can provide useful insights into a
company's financial health, it is important to consider the limitations and to supplement this
information with additional data and analysis