Introduction & video

There’s a lot to cover here – so I am publishing it early so that you can schedule sufficient time to manage it all.

Password: 83408
Apologies for the poor sound.

Consolidated Statements of Financial Position [CORE]

This is the main work for this session. The previous session covered the preparation of consolidated income statements. Now we move on to the preparation of consolidated statements of financial position (balance sheets).

Basics

Click the link for a structured workbook which covers the basics of consolidated balance sheets: basics of consolidated balance sheets (updated April 2020).

Additional issues

Once you have completed this you should progress to: more basics of consolidated balance sheets (updated April 2020) which introduces intercompany trading issues.

You need to have a thorough knowledge and understanding of both the above.

You should also have another look at last week’s elearning material, particularly these pages.

There are two case studies for you to have a go at.

Mobfin and
Vaslin.

There are suggested solutions to these online:

Mobfin
Vaslin

Statement of Changes in Equity [CORE]

We need to have a quick look at the Statement of Changes in Equity (click on this link for lecture notes and illustrations). It’s the only primary financial statement that we have not looked at in any great detail to date.

There also is a simplified interactive model(updated April 2020 with text and audio annotations) to help you understand the statement a bit better.

There are typical case study type questions in additional resources.

Directed private study – 1 [CORE]

Fair value

A big topic this! We really need to look at the concept of fair value. In the course of the lecture series we’ve encountered a number of valuation bases e.g. cost, depreciated cost, revaluation and more. Sooner or later you’ll come across the term ‘fair value‘ – so we’ll look at this in this session.

Directed private study – 2 [ADD]

Users of financial statements

Why are financial statements prepared. Who are they for.

This resource looks at the target audience for financial reports i.e. users.

There is a booklet I wrote many years ago as a short but clear introduction to the use of financial ratios in the interpretation of financial statements. It is still useful* today although it is a bit dated in some respects.

It can be downloaded from here.

*This resource does not cover the interpretation of cash flow statements (see Week 3 materials and Seminar 2 material) or the interpretation of segmental information (see materials on interpretation for weeks 3 to 5).

Lecture material

The lecture notes for this session are here.

There is an online presentation on investor ratios available at ecourse.co.uk/eps. This will run on your computer or ipad. You may need to download a free player app to use on the Apple ipad.

There is also a worksheet showing worked examples for calculating earnings per share figures in a number of situations.

Investor ratios

This week we’ll start looking at company financial statements from the perspective of an investor, concentrating on some of the financial indicators (often ratios) which are used in the financial press and which are useful to investors and potential investors in a company.

Last week we looked at the Hunting plc (The Stobart Group was 100% taken over by Muller Group, renamed Esken Ltd, and delisted). This week we will revert to Tesco. There are lots of sources of investment information on the web. Some cost a lot of money (that’s because they are useful – and contain real time information, comment and analysis). Others are free and will be good enough for our purposes. One such is Google Finance and you can find stock market information on Tesco  at Google Finance.  A good alternative is Yahoo Finance (see below). Spend some time exploring these pages and following some of the links to get a feel for the information. Also practice looking up the information for other companies.

The section on stocks at about.com may be quite useful in supporting your studies – particularly the section on Fundamental Analysis.

Case studies

Once you’ve worked your way through the worksheet have a go at these case studies:

Brora plc – bonus issue and new issue of shares at full value.

Champlon plc – rights issue and new issue of shares at full value.

Introduction

The lecture material for today’s session is available here.

This week we will look at the financial structure of a company. We’ll look at how companies are financed, and the relationship between debt and equity, as well as the nature of long and short term finance. We’ll use the financial statements of the Hunting plc to support the session. You can download the group’s latest available financial statements (2023) from here.

Here is the graph of Hunting plc’s share price over the past five years.

Source: Google Finance, 25 October 2024

What does this tell you about the performance and/or prospects of Hunting plc?

Gearing

The relationship between debt and equity is called gearing (leverage in the US). The higher the proportion of borrowing to shareholders capital the higher the financial risk of both equity shareholders and lenders. Risk here means the variability of the returns to shareholders and lenders.

This is demonstrated in the following spreadsheet.

The first line shows example figures from the financial statements. Capital employed is analysed into debt and equity. The relationship between equity and debt is gearing – here 20%.

Continuing along the first line, there are example figures from the Income Statement. Interest is 10% of debt (10% 0f 200). Tax is calculated at an effective rate of 18% of profit after interest. Profit after interest and tax as a percentage of equity (148/800) (19%) is calculated – this is return equity.

The next section deals with a company which has the same capital employed as the ‘basic data’ company i.e. 1000. However, its gearing is low – 5%. The table shows that a profit of 400 will give equity shareholders a return of 34%. If profit fell to 50 the return on equity would fall to 4% – a drop of 30 percentage points.

The bottom section shows a company with high gearing (70%). When gearing is high a profit of 400 will give equity shareholders a return of 90%. If profit fell to 50 return on equity would fall to -5% – a drop of 85 percentage points.

So the variability of returns (and hence financial risk) to the shareholders is higher when gearing is high. So high gearing increases the financial risk of both lenders and shareholders.

However, in the right circumstances gearing can be used creatively to increase the returns to equity shareholders (here, 34% to 90%).

Exam type questions

Your exam will contain TWO short essay questions. These are typical examples.

Question 1

‘It is evident, however, that operational and financial gearing have the common feature that an increase in either … reduces the earnings available to shareholders and thereby increases their risk.’

John Ogilvie, Financial Strategy
CIMA, 2009, p160

Required

Demonstrate how increasing financial gearing increases the risk of both lenders and shareholders.

Discuss whether or not more efficient working capital management can reduce financial gearing.

Question 2

a)  Using the financial statements of Flybe Group plc for 2016 (you can download from here) calculate capital and operating gearing ratios for 2016 and 2015 and assess the level of gearing of the group over the two years.

b)  Compare your calculations with Flybe’s own calculation of gearing (page 109) exploring the reasons for any differences. Which measurement basis do you think is the best?

c)  An investment section in a newspaper gives the following gearing information for Flybe:

Net Gearing (%)    44.12
Gross Gearing (%)    72.89
Debt Ratio    49.26
Debt-to-Equity Ratio    0.36

Research how these ratios have been defined. How to these values compare with your own calculations and the company’s calculation?

Additional resources on liquidity and cash flow management

We’ll also try and find the time to look at a short case study – Lemonstane plc –  on the use of the statement of cash flows to evaluate liquidity. There is suggested solution here.

Additional Reading

Optimum capital structure ACCA F9 Revision Material

Capital Structure Decisions of a Public Company Oxford Academic

Introduction

Liquidity is a huge issue – especially now. In many cases we don’t really think about it – until it becomes an issue. It usually becomes an issue when liquidity is too low. And when it becomes an issue it can escalate alarmingly and cause considerable damage and distress.

• Liquidity issues can affect countries. There have been recent major economic and political issues in Venezuela [2017] and Lebanon (2023). See also here from the International Monetary Fund (IMF) blog.
• It can affect individual companies, for example here.
• And it can affect individuals and be close to home, see personal insolvencies.

For individual businesses the efficient management of short term assets (current assets) and short term liabilities (current liabilities) is crucial for the survival and growth of a business. This week we’ll be looking at the management of these items (working capital) and will see the process as a series of interlinks and trade-offs.

Lecture slides

The lecture slides for today are here.

If cash is the ‘lifeblood’ how much is needed? Like animals the amount of working capital needed may depend on the size of the business. Big businesses generally need more working capital. However, it may be too high or too low (perhaps like blood pressure). So what’s right?

Discussion question

Discussion question from a previous exam paper:

a) Businesses need to balance the trade-offs between holding too much cash and holding too little cash.

Discuss the costs to a business of holding too little cash and the costs of holding too much cash.

(15 marks)

b) A business intends to increase its profit by increasing its sales.

Discuss the pressures that increasing sales can put on a business’s working capital.

(10 marks)

Supportive reading

Philip McCosker, The Importance of Working Capital, ACCA (2000)
– available online

Working Capital: Meaning and Formula: a basic introduction – available online

Cash Management: online at Kaplan Financial Knowledge Bank

D. Chandra Bose: Fundamentals of Financial Management, Prentice-Hall, 2006, chapters 9, 10, 11, and 12 – available on Google Books

Firth: Management of Working Capital, Macmillan, 1976
– a bit dated, but still remains a useful introduction. It’s in the university library.

Dhiraj Sharma: Working Capital Management, 2014, New Delhi : Himalaya Publishing House
– an electronic resource, available in the university library.

Profitability – learning notes

The learning notes can be found here.

Profit

In the previous session we saw that liquidity needs to be carefully managed, especially in times of economic depression/recession, if a business is to survive. The current pandemic provides a vivid example of this.

However, in order to grow and provide a return to investors a business must make profits i.e. create wealth. In this session we’ll look at the various concepts of profit encountered in a set of financial statements, and how profitability can be evaluated.

Profit is a difficult concept to understand, and, as we’ll see here, there are lots of different profit figures provided in a company’s financial statements. Not only is profit a difficult concept to understand, there are many ‘versions’ of it. So try not to use the term ‘profit’ without labelling it e.g. ‘gross profit’, ‘net profit’, ‘profit before tax’, and so on.

Profitability

Profitability is profit relative to size. It is based on the rather simple idea that the bigger a business is, the bigger its profit should be.

So, if Company B is twice as big as Company A we might expect it to make twice as much profit if it is equally profitable.

So, looking at profit relative to size can be meaningful concept.

However, size is also a difficult concept and there are different ways of measuring it.

There can be an inverse relationship between profitability and liquidity. Increasing profitability can usually only be achieved by sacrificing liquidity. It’s a balancing act – greater profitability can mean lower liquidity.

We’ll finish this next time and look in greater detail how profitability and liquidity depend on good working capital management.

Case study

If we have time we shall start looking at Moor plc. Teaching slides here. Suggested solution here.

[ADD] Directed private study

Review your understanding of this week’s lecture material

Locate and download the most recent financial statements for Tesco [follow link] and calculate profitability ratios (this week’s work) and liquidity ratios (from last week).

Luca Pacioli, a Venetian mathematician was the first to describe in print the double entry system used by Venetian merchants to record transactions. Click picture for more information.

Recording transations – double entry and the accounting system

Last week we looked at business transactions and how they affected the assets, liabilities and capital of a business. Businesses need a system for recording transactions as they occur. That system is based on double entry bookkeeping. Bookkeeping and the accounting system are introduced in this section.

Link to learning materials (pdf notes)

Financial reporting and decision making

The objective of financial reporting is to present information to users. Users include owners, creditors and other external users.

Users use this information to make decisions. Decisions can be:

a) stewardship decisions, e.g. is the business being run well, is everything above board, and are there systems in place to make sure that all money and transactions are properly recorded and accounted for, and

b) economic decisions, e.g. how well has the business performed, and what are its prospects.

The end result of financial reporting is three principal financial statements:

• The cash flow statement – basically a summary of the entity’s cash and bank accounts for a reporting period (usually a year)
• The statement of financial position [or balance sheet] –  a summary of the assets, liabilities and equity of the business as at the end of the period.
• The income statement [or profit and loss account] – a performance statement summarising income, expenses and profit for the period.

We will look at the fundamental structure of these statements today. A lot of concepts will be covered, and we will need to cover things quite fast to get through everything. We’ll have a look at Tesco’s latest financial statements. At this stage focus on the ‘big picture’ and don’t get bogged down in the detail.

Link to learning materials (pdf notes)